Just what is happening with the oil price?

Even though the Federal Reserve seemingly served up to investors what they were looking for in launching QE3 in a last desperate attempt to revive the US economy, commodities just aren’t following the script… Oil in particular has been singled out, after hitting a three month high on September 14 the day that Bernanke unveiled his latest bag of tricks, oil has now dropped sharply during the last several days. As QE3 is supposed to boost the economy, why is oil retreating this way and is it due a recovery?

One of the main effects that results from both conventional and unconventional monetary easing is supposed to be upward pressure on commodity prices. A cut in interest rates or a bond-buying program have the effect of boosting equity prices and so propagate all over the economy propelling demand and so the use of oil. In anticipation, oil prices start to rise at the first signal the central bank will engage in monetary easing.

If we look at the following chart, showing the price evolution for both WTI crude (light sweet) and Brent during the last year, we can identify a period, just before the QE3 announcement when prices were in fact rising. In fact they rose substantially between June 21 and September 14, WTI and Brent crude appreciating by 26% and 29% respectively. The rise was in anticipation of QE3 being launched.

With rises above 25%, we can safely say that almost all the positive immediate effects on the oil price deriving from QE3 were already incorporated in the price at the time the FED announced it –  a classic “buy the rumour, sell the fact” set up. Enthusiasm for oil and other commodities has seemingly vanished in recent days and it was interesting to read that the positioning of market participants in recent weeks was the most bullish for over a year – in short, largely everybody who wanted to buy had.

Hedge funds, commentators, economists, and other analysts have been saying that QE3 is not likely to boost employment and so not filter through to the expected incremental demand. Adding to this, we have a still broken Eurozone that will again remain mired in recession this quarter and has to content with continued rising social unrest that may undermine ECB plans to buy sovereign debt. Demand will stay weak in the Eurozone maybe for years if austerity measures are continued to be pursued.

With all this in mind, it seems that the 8.9% drop in WTI and 6.3% in Brent since September 14, is nothing compared with what could potentially happen. Geopolitical issues in the Middle East, especially in Iran, have been supporting the price, on the supply side. Apart from this, every other factor is negative for the price evolution of oil.

Filipe R Costa

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