June Hike Likely – What is the Effect on Oil?

On Wednesday May 18, 2016, the Federal Reserve released the minutes from its April meeting, sending vibrations throughout the markets.

The message from the Fed to the market was simple:  stay on your toes because the Fed is seriously considering raising interest rates in June. There has been speculation as to when and if the Fed would consider increasing rates any time soon. The bears and the bulls have offered varying opinions, the consensus seems to be leaning more in the bear’s favor that the Fed wouldn’t raise rates in June and defer until later in the year.

Raising the interest rate would certainly have an effect on the value of the U.S. dollar in global markets, and consequently on the price of the oil. Oil is traded around the world in U.S. petrodollars, and the correlation between the U.S. dollar and oil prices has been well documented. When the value of the U.S. dollar goes up, the value of oil tends to go down, and vice versa based upon circumstance.

USD vs oil

The raising of interest rates would obviously have an effect on the broad market, but what would the implications be for the oil and gas sector?

World Wide Interest Rates

The scope of the world interest rates has changed in the past few years. Historically interest rates were typically utilized to counter or encourage inflation within a specific currency, and decisions were made based upon the health or well-being of the country’s economy. If a country raised interest rate, it very well could be done to counter expected inflation. If a currency will encounter inflation, investors may flee that currency. However, as globalization has taken hold, that perspective has shifted slightly.

Fed minutes from the January 2016 meeting show concern for the plummeting price of oil and the economic uncertainty in China. The U.S. interest rate is not an indicator of Chinese economic health, but the fact that the Fed is concerned about factors outside the U.S. hits on the point of globalization within these decisions.

The issue of global economic health ties into another point, in recent years many of the major economies around the world have lowered interest rates significantly in an effort to stimulate growth. The U.S. was one of the leaders in this policy, with China, Japan and Europe following suit. The effect of this policy is a more predictable result on the value of the U.S. dollar with a rising interest rate.

Although interest rate differentials are only one potential determinant of the value of a currency, rising rates in the U.S. will ultimately lead to an appreciation of the U.S. dollar against a basket of low-yielding developed market currencies. In search of a safe harbor for money, many investors will push money in to the U.S. market. In countries where the interest rate differential is positive, these currencies tend to attract capital to take advantage of higher interest rates compared to lower-yielding alternatives.

Effect on Oil

With the possibility of the Fed raising interest rates, the likely effect of would be the appreciation of the dollar and the fall of oil price. While certain catalysts in the oil market could pose a counter to this effect, they will likely be outweighed by the value of the dollar increasing or decreasing.

With oil price on a tear as of late, the Fed choosing to raise interest rates in could bring a dip in oil prices. Or, should the Fed pass on raising rates, then oil may very well continue to rise.

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