Fed’s Decision Could Help Avoid The Worst Case Scenario For Oil

Newcomers to financial markets could be forgiven for not knowing this, as we haven’t seen a rate hike in the U.S. for nine years, but when the Fed raises rates the responses in financial markets usually follow a predictable pattern. Stocks drop as higher interest rates are predicted to slow investment and economic growth, the currency appreciates as it becomes relatively more attractive, and, as a result of that, commodities, including oil, go down in price.

This week’s news followed that pattern initially in two markets as the dollar surged and oil dropped back to close to the previous lows, but stocks rose immediately following the announcement. That had the look of a self-congratulatory move on behalf of traders…they had all predicted a 25 basis point (that’s a quarter of one percent for those that aren’t fluent in bond speak) increase and an accompanying statement with a distinctly dovish tone and that is what they got.

Once that initial thrill of being correct wore off, however, stock traders have returned to a focus on the problems. Global growth is still somewhat anemic, U.S. stocks look fully valued and there are signs of trouble brewing in the high yield credit markets. All of those initial gains had gone in 24 hours. Given that, it seems counterintuitive to believe that oil will behave in a similar way and reverse course. The reaction in WTI was, after all, the logical one. If we look a little deeper at the possible consequences of a rising rate environment, however, that could well be the case.

As I mentioned there are signs of potential problems in the high yield market, but those problems stem mainly from the energy sector. The spectacular fall in oil prices this year has left many of the smaller, highly leveraged E&P companies looking vulnerable and higher rates can only make that situation worse. Curiously, though, that could be just what the beleaguered WTI price needs. It is obviously bad news for investors in some of those companies, but if the prospect of higher interest leads to some giving up trying to stay afloat and forces some bankruptcies it could result in the production cuts, at least here in the U.S., that are so obviously needed.

The anticipation of that would go some way towards explaining why, despite the initial down move in response to the Fed’s announcement, WTI futures have stayed above the $34.52 low hit on Monday.

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At these levels the absolute worst case scenario for oil, that demand growth slows as high production levels continue unabated, looks completely priced in. The price also reflects the markets belief that the Fed would raise rates. Any hint that either of the supply and demand conditions could change will therefore probably lend support. In addition it should be noted that the initial surge in the dollar has faded somewhat over the last day or so. That too is understandable. This rate hike was extremely well telegraphed by the Fed and the dollar had risen in anticipation.

This could then, be a rate hike with a difference when it comes to the price of oil. 25 basis points is small enough to have little effect on actual economic growth in the U.S. but still enough to add to the pressure on leveraged oil companies, which in turn could result in production level cuts speeding up. If that is the case, or even just if traders believe it could be, then a rally going into the year’s end would come as no surprise.