How a Fed rate cut raises oil prices
Expect even higher crude prices if the central bank cuts interest rates Wednesday.
NEW YORK (CNNMoney.com) -- If you think oil prices are high now, wait till Wednesday.
That's when the Federal Reserve is set to announce its decision on interest rates. Most say a cut is coming.
"If the Fed cuts rates, it will probably push oil prices higher," said Adam Sieminski, chief energy economist at Deutsche Bank.
There are a couple of reasons lower interest rates usually cause higher oil prices. The first is lower interest rates are designed to spur economic growth by making money for investment cheaper to borrow. Stronger economic growth usually entails using more energy, so traders bid up oil prices on the expectation of higher demand.
Second, lower interest rates usually cause the dollar to fall, as they make dollar-denominated investments like Treasurys less attractive for foreign investors.
Oil, like many other commodities, is priced in dollars worldwide. If the dollar falls, oil producing nations, like those in OPEC, need a higher price per barrel to maintain a the same level of revenue. While oil producing countries don't set the price of oil in the market, they do have control over production and are less likely to increase it when faced with the declining dollar. Also, foreign consumers have less incentive to reduce demand if oil is, relatively, getting cheaper for them.
The real question is this: Is a rate cut already priced into the cost of a barrel and, if not, how much higher is crude expected to go?
"Some has been priced in, but we could see more," said Neal Dingmann, a senior energy analyst at Dahlman Rose & Co., a New York-based energy investment boutique. "I think a couple of bucks is possible."
That would push crude prices, already at record nominal levels, to somewhere near $95 a barrel. That's just shy of the all-time inflation adjusted level of between $93 and $101 a barrel (depending on which calculation is used) set in early 1980s during the Iran-Iraq war.
Sieminski didn't say how much higher oil could go, but also suggested a rate cut hasn't been fully priced in.
"The temptation is to say it must be priced in, but it could still go higher," he said.
He also noted that a deeper rate cut from the Fed, like half a percentage point, would cause prices to jump further.
According to futures listed on the Chicago Board of Trade, investors say there's an 86 percent chance the Fed will cut its federal funds rate by a quarter percentage point to 4.5 percent. The funds rate is an overnight bank lending rate that influences how much interest business pay for capital loans and consumers pay for things like auto, credit card and home equity lines of credit.
Investors say there is a 14 percent chance the Fed will cut rates by half a percentage point, according to futures on CBOT.
Dingmann said the falling dollar is a fairly prominent reason oil prices are moving higher, as "fundamentally, there really haven't been that many things to cause this price rise."
But others say the dollar's role has been exaggerated.
"The dollar has weakened, but not so much," said Paul Horsnell, head of commodities research at Barclays Capital in London. I'm a little skeptical it's a major influence at this point."
Horsnell didn't expect to see much of a price jump if the Fed cuts rates, and attributed oil's recent record run to rising worldwide demand running up against limited supplies.