Europe Muddying Up the Oil Plan

All the ammunition available to provide short-term economic stimulus has been used up.  The short term fiscal stimulus from tax cuts or increased government spending in the current climate is a definite no-no.  The major discussion right now in Washington is over debt reduction.  As to monetary stimulus, the Federal Reserve has provided the maximum support by holding down the short-term rate at zero for quite some time and even printed significant amounts of extra money labeled as Quantitative Easing, not once but twice.  Further printing of money is off the table because inflation is beginning to pick up.  Simply, there is no government-directed stimulus left.   Or so we thought.

Unexpectedly, President Obama announced in late June that there would be a release of oil from the strategic petroleum reserve to help lower oil and gasoline prices.  Lower oil prices act like a tax cut because less money spent at gas pumps means more money left to spend on other things.  Think of the 1990s when the economy was booming and oil prices were in the $20 range.  On the day of the announcement, oil prices fell by $5 on West Texas Intermediate and by $10 on London Brent Crude.  This also sent a subtle message, which implied that even more oil could be released if market conditions should warrant.  That effectively told oil traders to back off.  There is no money to be made on oil trading.  Oil prices will not go above the recent peak in April at $115 per barrel on West Texas Crude.

The plan, however, may not work.  That is because the European Central Bank raised interest rates this week and has indicated further hikes on the way later this year.

How are oil prices and European interest rates related?  Higher interest rates in Europe mean global investors at the margin would prefer to park their money in Germany, the Netherlands, and other countries in the European Union, save Greece.  Getting something in Europe is much better than getting the near zero-percent rate in the U.S.  The U.S. Federal Reserve has clearly implied that the U.S. short-term interest rates will not be rising this year.  The Fed cannot control long-term rates like the 10-year Treasury yield or 30-year mortgage rates, but it directly controls the short term fed funds rate.

For investors, short-term parking of money in Germany first requires converting the U.S. dollar into the euro.  Higher demand for the euro pushes up the value of the euro in relation to the dollar.  The U.S. dollar depreciates.  Because most major commodities are priced in dollars and not euros, a weaker dollar means that the price of oil has to rise to compensate for the weaker purchasing power of the U.S. dollar.  In other words, oil producers, be it companies in Russia, Nigeria, or Venezuela, will now demand a higher oil price since the dollar received from selling the oil cannot buy as much.

The oil prices in the real world are influenced by thousands of impacting variables, such as discovery of new oil, OPEC agreements, alternative green energy usage, or Chinese energy demand.  The above analysis was only to show that recent actions by the European Central Bank have complicated the outcome that President Obama was looking for.  It’s hard to say where oil prices will move from this point, but do not be surprised if oil and gasoline prices were to reach a new peak later this year.