How will the Quantitative Easing affect the Crude oil price – 4th of November

Now that the quantitative easing – second stage, is on its way, it could stir up  crude oil price; As a result, we might consider oil as a good investment for now. Let’s review some issues that occurred  this passing week, and try to understand the effects of QE2 on crude oil price in the short and long term.

Yesterday, November 3rd the Federal Reserve with Ben Bernanke at its helm approved the quantitative easing for the second time in the past couple of years. In this program, the Fed pledged to purchase nearly 75 billion USD treasury bonds until June 2011, i.e. nearly 600 billion USD, which is double the amount it pledged to buy in the previous quantitative easing. Therefore, the US central bank will de-facto prints US dollars to purchase these treasury bonds in order to provide commercial banks funds so they, in turn, will release these funds to businesses, consumers and real estate (god forbids after the last economic crisis) etc. in forms of loans.

The main purpose of this program is to provide funds much needed to the US economy. This idea has some merit, however it also has some pitfalls, one of them is that the QE could devalue the US dollar. The logic behind this claim is simple:  since the QE will result in more US Dollar spread around, as a result the value of the US dollar will drop.

This process could also have some spillover effects as investors will consider hedging their investments in US Dollar and moving them towards commodities such as crude oil and gold. The investors will do so out of scare that the value of their US dollars investments will be worth much less. Therefore it is speculated that because of the quantitative easing, the prices of many commodities including the crude oil price will start to rise.

Let’s review what happen the last time this quantitative easing occurred.

The first quantitative easing took place back in March 2009, when Bloomberg reported about it; that time, the amount which was allocated for this maneuver was 300 billion US dollar, half the amount which was allocated for this time’s quantitative easing. There were many valid quantitative easing explanations for taking this expanding policy road back then. One of them is the element of surprise; since the QE took the markets by surprise, it had a strong and volatile effect on the markets including, among other, the crude oil price and dollar rate as I will show shortly. Nevertheless, the problem with the QE from March 09 is that it seems, in retrospect, to be ineffective on the US economy, and the funds the Fed used didn’t converted into a stimulating effect on the  US economy. In summary, there are several reasons to consider why the QE of 2009 didn’t work, some of them are:

  • The amount of quantitative easing wasn’t enough (that is why this quantitative easing of November 2010 is double the amount)
  • It could be that the funds didn’t reach the people they suppose to reach who could have positively affect the economy, this might include, for example, banks that just “sat on the money” and didn’t provide loans to businesses.

Regardless of the reasons why the quantitative easing from March 2009 didn’t work let’s review how it affected the crude oil price and dollar rate back in 2009:

It seems that there were speculative short term effects as a result of implementing the first round quantitative easing as the US dollar did suffer a bit of a blow by devaluating compare to the main other currencies such as Euro and Canadian dollar. In the graph below (a graph of a month by month percent change), the dollar compare to main currencies started plummeting from March 2009 below the red line, which is the 0% mark line. The US dollar continue to be below the red line and devalue every month until the end of 2009 when it started to return to the previous levels before the first quantitative easing. As an example, the level of the USD compare to the EURO was at 0.7814 EU/USD during February 2009, reached back this level at May 2010 with a monthly average of 0.796.

Graph Crude Oil Price and USD/EURO rate - Average Prices Monthly Change (%)  Jan 09-Oct 10

So what could be the effects of quantitative easing on crude oil price ?  During the first QE, back in March 2009, crude oil jumped by nearly 23% in March compare to February 2009, and by the end of 2009 crude oil price reached an average price of 74.47 USD per barrel compare to a mere 39 USD per barrel in February 2009. Therefore, it seems that the quantitative easing back in March 2009 did drive crude oil price to high levels of nearly 70-80 USD which is still up to date at these levels.

Furthermore, this week, crude oil price started to rise as investors hedged against the forthcoming quantitative easing plan. This rise has very little to do with other news such as the decline in gasoline stock in the US, and mostly to do with the quantitative easing.

After reviewing the positive effect of quantitative easing on the crude oil price back in March 2009, should we assume that it’s going to happen again in October 2010? After all, if we look at this week’s oil prices we will see that it increased to nearly 87 USD per barrel nearly a five dollar rise compare to last week.

Before we jump to the conclusion that crude oil price will increase sharply to a 130 USD mark, consider the following: the USD did deflate in March 2009 however it rallied back by the beginning of 2010. Also, last time’s quantitative easing was a surprise which affected more sharply then this time’s quantitative easing. Therefore, the effects of the quantitative easing only seem to affect the crude oil price for a few months at best.

Therefore, if the crude oil price will continue to rise on the long run (few months to a year) it won’t necessarily be due to this quantitative easing plan but due to other reasons that might come up. This is even truer if the quantitative easing will prove to be ineffective as the previous one. Nevertheless, it seems there is short term effect (up to several weeks) as investors will continue to stock up their portfolio with commodities, which in turn, could continue to affect the petroleum price rally towards the 90 USD mark and further.