What the Fed Taper Means for Oil Prices

[Editor's Note: This exclusive look at how oil prices will be affected by the Fed's decision to begin a QE taper in January was first published in Dr. Kent Moors' Oil & Energy Investor on Dec. 19. Go here to learn how to access Moors' research as soon as it's released.]

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Last Wednesday afternoon, after much gnashing of teeth, the Fed finally revealed its long-awaited quantitative easing (QE) taper plans...

And the Dow jumped by almost 300 points.

Now, the taper itself is small to start - just a $10 billion reduction for the month of January. But the announcement was coupled with a pledge to keep the Fed funds rate at zero beyond the 6.5% unemployment threshold.

As a result, two things collided in the last 90 minutes of yesterday's trade: a clear indication that the economic recovery was strengthening and a classic "short squeeze," which merely added fuel to the fire.

As we approach the end of the year, that means the "Santa Claus rally" may have a bit longer to run.

But longer term, the market is now faced with less artificial stimulus next year and a gradual return to a market where direct pressures influence its direction.

Here's what that will mean for oil prices in 2014...

A Walk into the Great Unknown

Now, there have been opinions expressed (which in large measure parallel my own) that the Fed's stimulus has had a declining net influence on stock market performance.

Certainly, the low interest rate environment has made money more affordable (cheaper, actually), had a positive impact on the real estate sector, and provided some incentive to leverage moves in the M&A market.

Yet the genuine benefit of these has been disappearing.

The great unknown is still the effect all of this stimulus will have on forward inflationary pressures.

The bond-buying programs, after all, are financed with manufactured money, not proceeds from actual market operations.

But most of the more reasoned arguments among competent analysts have centered on what successive stages of QE contribute to the building of inflationary expectations.

To date, that appears to have been negligible.

The Fed may have achieved its primary purpose of fiscal support while avoiding a longer-term erosion of overall market value. Now I admit, it is too early to say for sure, but so far, so good.

Of course, should there be a serious downturn in the recovery, a return to adding manufactured liquidity to the market is always possible. However, absent a major setback or crisis, that may be unlikely in the medium term.

And that means, as tapering works itself out, the process will impact different market sectors in different ways.

OK, then, so what is in store for the energy sector?...

What Really Drives Oil and Gas Investments

The single most important force in energy prospects will remain the aggregate demand indicators.

This is the primary immediate driver of energy prices, especially oil and gas, in just about any market environment (save one complicated by crisis or war). I regularly comment on such developments here, developments that have little to do with Fed policy.

Of course, they do have something to say about the expectations surrounding the economic recovery. And that recovery is the main reason the tapering is happening in the first place. A reversal in one will lead to a change in the other. But demand levels are not something swayed by the taper.

In addition to the range of energy sector-specific market considerations we regularly review here, the selection of energy companies will remain tempered by three considerations in a tapering environment:

(1) The company's levels of indebtedness and cash flow;
(2) Its reliance on credit markets to fund short-term obligations;
(3) And whether the overall scope of operations subjects revenues to foreign exchange risk.

This last point introduces one of the tradeoffs likely to occur now that the Fed will be moving out of the stimulus business. Tapering will create a rise in interest rates. With the departure of cheap credit, we are going to witness another round of dollar weakness. That will put some pressure on the bottom lines that are dependent on operations in countries where the dollar has forex problems.

And this relationship introduces what may be the biggest impact of all.

Oil Prices: Oil Is the New "Storehouse of Value"

As I have noted in earlier editions, the traditional position of gold as a basic barometer indicator of market health is being replaced by crude oil.

In this case, I'm referring to the way in which futures contract pricing for oil provides a better gauge of market value as gold loses its "luster" as a contrarian play. Until the last six months or so, investors tended to buy gold as a hedge against declining market performance. As the market weakened, gold would usually strengthen.

Well that certainly has not been happening of late and is not going to return anytime soon. Gold had served as a bridge mechanism between market performance and the value of the dollar. That position is now being taken over by crude prices.

As a result, it is oil prices that will benefit most from the departure of cheaper money as interest rates rise in a post-stimulus environment.

Now, the tapering will be gradual, and is always subject to a reintroduction if the economy falters. The rate of tapering is certainly going to influence how quickly bond yields rise and what the resulting interest levels will be.

This is the important point. As interest rates rise, so will the attractiveness of oil futures contracts - or "paper barrels" - as a surrogate barometer and, thereby, an attractive investment quite apart from the genuine value of the underlying "wet barrels" available for actual delivery.

Tapering is not single-handedly going to spike oil prices. But I can tell you it will add a proportional "enticement" to oil prices.

Keep your eye on this. As it kicks in, I will be providing ways to move on it with selected opportunities across the energy sector.

As Dr. Kent Moors travels the world developing energy policy and finding the next best oil and gas investments, he finds news you can't uncover in just any energy newsletter. Check out the latest development in Russia: Why Shale Gas Spells Trouble for the Russians

About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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