Oil after QE2

People are finally starting to get it. And that is that the Federal Reserve policy moves markets and that quantitative easing drives up the price of oil. Most had never heard the term "quantitative easing" when the Fed made their move to print money the first time in March, 2009. The Fed made this move to try to save the economy from what they thought was leading us to a deflationary depression. For those of you who still need enlightening, quantitative easing is basically the monetary policy of last resort. When even zero percent interest rates fail to generate economic activity, the central banks flood the banks with excess cash reserves by buying back paper debt the banks hold with freshly printed money.

The hope is therefore, that these banks will in turn lend that freshly printed money to businesses and you and I, who in turn will expand and spend, thereby, hopefully, hire people and create more jobs. It also hopes to take away that deflationary mood by devaluing the U.S. dollar making commodities more expensive.

Quantitative easing by the Fed is the greatest economic story of modern times. Back in 2009 when I tried to explain this concept, many looked at me as if I was from outer space. QE was a mystery to them and all they could figure was it was those evil oil and commodity speculators that were driving up prices. Prominent oil bulls went as far as saying the value of the dollar had nothing to do with the value of crude. They seemed to believe that the sudden surge oil was due to the world hitting its peak ability to get oil that was running out. Others railed against speculators saying they caused the run up in prices yet failed to mention the dollar or the financial crisis when they spewed their diatribe to anyone who would listen, even Congress.

Now of course the world is more familiar with the inflationary impact of quantitative easing. In fact if they were not, well they got a crash course after the last Fed meeting. We saw oil rally over $10.00 after the Fed signaled that the printing we're getting warmed up. Gold went up over $100 an ounce and silver exploded more than $4 higher. Cotton prices hit the highest level since the US Civil War, sugar prices above 30 cents, corn prices above $5.00. If you don't get that the Fed policy of printing money is driving up prices of commodities, well then you never will I guess. That is exactly what the Federal Reserve wants. They want commodity price inflation to get our minds off deflation. The Fed is trying to create inflation.

When I said that back in 2009, again people thought I was nuts. Yet the truth is that the Fed said that they are indeed trying to create inflation. As I wrote in 2009, "By creating inflation and money out of thin air they (the Fed) can change the entire commodity trend as we know it and drive away the deflation demons of that particular moment. Being short commodities has become a more dangerous proposition and the Fed has put us on notice. At anytime they can run the printing press and change the fate of a commodity."

They do this not because they created a global shortage of a commodity or because of sky rocketing demand. It is because the Fed has the ammunition to make it so. At the same time the Fed's policy of quantitative easing is as simulative to the economy as a good old fashion interest rate cut, yet has the potential to be much more inflationary (especially for commodities). The inflationary impact of printing more money also makes our total debt appear less onerous. It's all a big mind game in the end.

And now that the Fed has opened Pandora's Box, the markets now from this point forward, have a more complex element to them that we need to consider when coming to a fair price for any commodity. That is not to say that we do not have tight supplies in some of these commodities because we do. Cotton, corn and sugar demand is strong and we have very bullish fundamentals. Gold has become a proxy not only for fear but for every currency on the globe but mostly from the US dollar. Still at the end f the day none of these commodities would have achieved their current levels without the help of the Fed.

Now what? The Fed is widely expected to do its dirty deed at today's Fed meeting and we have already seen major market reactions. The question now is where they go from here? The first round of quantitative easing kept commodities strong but oil failed to get a breakout because the move failed to inspire strong US demand. US inventories of oil are near record highs for this time of year and we just saw a sweep of Congress by the Republicans in part because QE 1 failed to create jobs

The other issue is the longer term impact of the economy from the Fed Inspired creation. One concern is inflation. Bloomberg News reported that former United States Federal Reserve Chairman Paul Volcker, an adviser to Barack Obama, said quantitative easing may lead to inflation in the future and the amount involved may be a cause for concern. "When money is too easy for too long, we will have more asset bubbles. Not only is there a risk of asset bubbles but a rising risk of currency and trade wars around the globe from what I call a race to the bottom in a game of competitive currency devaluations.

Now there are worries that even if the Fed avoids deflation here it may create deflation elsewhere. Bloomberg News quotes Nobel Prize winning economist Robert Mundell as saying the Federal Reserve QE may send the euro soaring against the dollar creating deflation in Europe. Mr. Mundell says he believes that U.S. quantitative easing would hurt nations around the world. Deflation, he reasons, would worsen European sovereign credit woes by making debts harder to pay off. He is warning of potential unintended consequences of U.S. policy with the Fed risking inflating asset bubbles elsewhere. On top of that he says that the European Central Bank's mandate to control inflation would likely hamper it from stemming the euro's rise, while the currency's gains would likely lead to deflation increasing the real value of indebtedness.

As I see it, the Fed policy, while bullish for oil, will not get it to $100 a barrel. In fact the risks are heighten that QE2 will cause a bubble burst in emerging economies at some point causing an oil market crash. In the short run, you cannot fight the Fed. In the long run you must be wary.

About the Author
Phil Flynn

Senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. He is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets. His precise and timely forecasts have come to be in great demand by industry and media worldwide and his impressive career goes back almost three decades, gaining attention with his market calls and energetic personality as writer of The Energy Report. You can contact Phil by phone at (888) 264-5665 or by email at pflynn@pricegroup.com. Learn even more on our website at www.pricegroup.com.


Futures and options trading involves substantial risk of loss and may not be suitable for everyone. The information presented by The PRICE Futures Group is from sources believed to be reliable and all information reported is subject to change without notice.

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