Market Report: Oil Held Hostage Day 353

It has almost been a year since the day the oil market was changed forever. After collapsing in a heap of deflationary despair, oil was saved by what could only be described as a historic government intervention. It was the day that the US Federal Reserve changed the world by printing more money and therefore, essentially putting a floor under the price of oil. It was the day that the Federal Reserve, after having nowhere to go on interest rates, made a move to save the banks and the economy by taking the unprecedented step to use quantitative easing in the United States to save our economy. This move of course changed the way oil moved and was valued. And to this day this government intervention and newly created Fed policy inspired the largest move in crude oil prices there has ever been even when considering geo-political events or even data on supply and demand. As we come upon the one year anniversary let's look back and see how the global oil market was changed and what that means for our future.

A year ago the economic world was stunned. We were 6 months away from the collapse of Lehman Brothers investment bank, a failure thought almost impossible. The world started to realize that this sub-prime crisis was a much larger problem than at first glance and wasn't going to go away very easily. The Federal Reserve was aggressive and moved the target range for the federal funds rate at 0 to 1/4 percent and even took the step to buy some bad assets like mortgage backed securities from the banks. Yet despite these moves and some short term stabilization in the market place many markets still seemed frozen.

Oil, despite a three month spike in price, appeared to be getting ready for a collapse of its own. Tight credit and still plunging demand made price prospects dim. It was obvious that because of lack of confidence and real problems with toxic assets still festering in our nation's banks, that even a zero percent fed funds rate would not be enough to ward of deflationary fears. Demand destruction was rampant. Oh yes, oil had recovered from its January lows but that was after we had experienced the biggest peak to valley price drop in the history of the oil market reflecting what was the biggest peak to valley drop in the history of oil demand. This drop in demand reflected the fact that the economy was still contracting and we were getting ready to see more de-leveraging and more deflation.

The Fed knew this and they feared increasing economic slack here and abroad. The Fed said the risk of low inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. For oil this meant that the Fed had to stop a major price drop. Why would anyone risk buying oil today if they could get it cheaper a day later? Why buy it a day later if you could get it even cheaper still the day after that? The Fed needed to create inflation and the best way to do that was to print money. On March 18, 2009 the Federal Open Market committee changed the world when they said that, "the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months." In other words, in one sentence the Federal Reserve basically created $300 billion dollars out of thin air.

This instant money creation had a major impact on oil and how it was viewed. Instead of looking to supply and demand we now had to revalue oil on the perceived value of global current exchange rate. The Fed move helped create what was called the mother of all carry trades. Traders taking advantage of the Fed's negative interest rates sold dollars and borrowed money to essentially buy oil. The price of oil is now a creation of the Fed. Now traders had to forget everything they believed about supply and demand and wet barrels and dry barrels and had to focus on the many intricacies of currency exchange rates and global macro economics. Traders had to view a barrel of oil not so much as a commodity but as pawn.

Yet some day the stimulus will have to come off. The removal of stimulus will be a bearish event for crude. We will see the dollar rally and the fear that higher interest rates will slow demand should cause a major break in the price of oil. But after a big drop the low price of oil should create a buying binge creating the type of sizable swings and opportunities that we saw a year ago. The price at that point will be predominantly driven by improving demand but demand that has to be real, demand inspired by low prices and not artificial demand created by fiscal stimulus. Oil could fall as low as the $40 handle before we see a bottom and the prices to work higher once again. The big question is when. While we have been living off printed money for close to a year and the day is coming when the party will finally come to an end.