QE and oil prices.

Author:Verleger, Philip K., Jr.
 
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Most observers believe the impetus for the current oil price collapse began on November 27, 2014, Thanksgiving Day in the United States. On that date, Saudi Arabian officials left a meeting of OPEC members and informed the world that their country would not cut production as many had expected. Dated Brent, the accepted benchmark for world oil prices, traded at $77.74 per barrel the day before the announcement. Within two months, it had declined to $46.13, 40 percent below the pre-meeting price and 60 percent less than the July 2014 high of $115.

This is a convenient but incorrect explanation. The seeds for the price collapse were sown years before, probably in October 2008, when then-Federal Reserve Chairman Ben Bemanke stated forcefully that the central bank would "do what it takes" to avoid a depression. The Fed did what it took via its quantitative easing program. Interest rates dropped to record lows and have remained low.

The low interest rate policy maintained by the Federal Reserve since 2008 has been controversial. Theorists such as Allan Meltzer and some Federal Reserve Bank presidents such as Richard Fisher have aggressively fought to raise interest rates and failed. Recently, Bemanke blogged that low interest rates were not "a short-term aberration but part of a long term trend." He explained that long-term interest rates have declined with the fall in inflation. He added that the central bank has little control over real interest rates, noting that these are low because prospects for economic growth are very gloomy.

Bernanke, like his predecessor Alan Greenspan, overlooked one consequence of low rates: the search for yield by investors, particularly those who have retired. The quantitative easing program pursued by the Fed from 2009 to 2014 has prompted a flood of cash into the oil industry. The money in turn sparked the expansion of master limited partnerships and the activity of independent drilling firms bent on boosting oil and gas output quickly with fracking technology.

These developments ultimately flattened the global supply curve for oil while dramatically expanding storage capacity. In effect, oil supply was boosted along with the tankage to store it. This all occurred as the global economy slipped into stagnation, a state that will likely continue for years.

The growth in global oil use will fall well below expectations if it does.

In November 2014, the key low-cost Middle Eastern oil producers came to a belated realization: the QE-induced supply expansion combined with secular stagnation would likely require year after year of production cuts from them to preserve $100 per barrel prices. These countries concluded that allowing higher-cost QE-funded companies to capture larger and larger shares of the market was not in their best interest. In response, they acted to change expectations regarding future prices.

The role of QE-induced investment in the oil sector in sustaining the crude price decline through the end of March 2015--and quite possibly into 2016 or 2017--has gone unnoticed. Yet this flow of money--probably more than $1 trillion--will likely lay the foundation for energy industry prospects over the next decade. If the lessons from other such cycles apply, the outlook for energy is not good. Prices will...

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