Impact of Fed Rate Cuts on Oil Prices

The impact of Federal Reserve interest rate cuts on oil prices was evident in December 2024, as US crude inventories dropped and the Fed's decision to lower rates provided support. 

However, the market's gains were limited after the Fed indicated a slower pace of future cuts. Brent crude rose by 20 cents, reaching $73.39 a barrel, while US West Texas Intermediate crude climbed 50 cents to $70.58. 

Despite earlier gains, both benchmarks eased from session highs. US crude stocks and distillates have seen declines since, while gasoline inventories have increased, reflecting shifts in market dynamics.

The potential of another rate cut in 2025 could further influence oil prices. Let's dive into the impact of Fed rate cuts on the oil industry moving forward.

What is the Fed?

The Federal Reserve (or the Fed) is the central bank of the United States. It's a government agency responsible for overseeing the country's monetary system. The Fed plays a crucial role in maintaining a stable and efficient financial system for the United States.

Here are some of its key roles –

• Monetary policy: The Fed sets interest rates to influence the economy. Lower interest rates encourage borrowing and spending, while higher rates can slow down the economy to combat inflation
• Bank regulation: The Fed supervises banks and other financial institutions to ensure stability and protect consumers
• Currency issuance: It prints and distributes the US currency (the US Dollar)
• Check clearing: The Fed facilitates the clearing of checks between banks across the country

What is the role of the Fed in setting interest rates?

The Federal Reserve sets interest rates primarily through its Federal Open Market Committee (FOMC). The FOMC is a group of Fed policymakers that meets regularly to discuss economic conditions and determine appropriate monetary policy actions.

Here's a breakdown of how the Fed sets interest rates –

1. Economic assessment: The FOMC analyzes various economic indicators, including GDP growth, inflation rates, unemployment levels, and consumer spending.
2. Interest rate decision: Based on its assessment of the economy, the FOMC decides whether to raise, lower, or maintain the federal funds rate.
3. Open market operations: To implement its interest rate decision, the Fed engages in open market operations, which involve buying or selling government bonds in the open market.
   • Buying bonds: When the Fed wants to lower interest rates, it purchases government bonds from banks. This increases the money supply, making it easier for banks to lend money at lower rates
   • Selling bonds: The Fed sells government bonds to banks to raise interest rates. This reduces the money supply, making it more expensive for banks to lend money

While setting interest rates, the Fed uses the Federal funds rate, the interest rate at which banks lend reserves to each other overnight. By adjusting the federal funds rate, the Fed influences the cost of borrowing for consumers and businesses. When the Fed lowers interest rates, it becomes cheaper for people and businesses to borrow money. This encourages spending and investment, stimulating economic growth. 

Conversely, raising interest rates makes borrowing more expensive. This can slow down economic activity, particularly when inflation is a concern. It further continues with a balancing act, as the Fed's goal is to find a balance between economic growth and price stability (controlling inflation). If the economy is overheating and inflation rises, the Fed might raise interest rates to cool things down. If the economy is sluggish, it might lower rates to stimulate growth.

What is the role of the Fed in impacting oil prices?

The Federal Reserve's interest rate cuts can significantly influence oil prices by shaping investor sentiment. When interest rates are lowered, it often signals a more favorable economic outlook, making investors more optimistic and willing to take on risk. This increased risk appetite can drive demand for assets like oil, often seen as more speculative than traditional bonds. Oil prices can be pushed up as investors seek to allocate their capital to these riskier assets.

Conversely, higher interest rates can dampen investor sentiment and increase risk aversion. Investors may become more cautious and shift their investments away from riskier assets like oil, seeking the perceived safety of bonds or other less volatile investments. This reduced demand for oil can put downward pressure on prices.

How are Fed rate cuts and oil prices linked? 

Fed rate cuts and oil prices are linked because interest rates directly influence the economy, currency values, and overall demand for commodities like oil. When the Fed cuts interest rates, it leads to a weaker US dollar. Since oil is priced in dollars, when the dollar weakens, oil becomes cheaper for foreign buyers, which boosts demand and can drive oil prices up. Let's understand the different ways in which Fed rate cuts and oil prices are linked –

Economic stimulus

When the Fed cuts interest rates, it usually does so to stimulate economic growth. Lower interest rates make borrowing cheaper, encouraging businesses to invest and consumers to spend. This increased economic activity can lead to higher demand for oil, driving up prices.

Investor sentiment

Lower interest rates can also impact investor sentiment. When investors see that the Fed is trying to boost the economy, they may become more optimistic about future economic prospects, including the demand for oil. This optimism can drive up oil prices.

Impact on oil-producing economies

Lower interest rates in the United States can also affect oil-producing economies. These countries often rely on oil exports for revenue. If the US economy weakens due to higher interest rates, demand for oil may fall, hurting these economies and potentially leading to increased oil production to maintain revenue. This increased supply could put downward pressure on oil prices.

Oil speculation

Lower interest rates can sometimes encourage speculation in commodity markets, including oil. Investors seeking higher returns may allocate more funds to commodities like oil, driving up prices.

Inventory levels

Suppose the Fed cuts interest rates and the economy starts to grow. In that case, businesses may increase their oil inventories as a precaution against potential supply shortages or price increases in the future. This increased demand can also contribute to higher oil prices.

The current impact of the Fed rate cuts on oil prices 

The Federal Reserve's decision to cut interest rates in December 2024 has significantly impacted oil prices directly and indirectly. While lower interest rates generally boost economic activity and energy demand, the specific effects on oil prices can be complex and depend on various factors.

The Federal Reserve has cut interest rates by 25 basis points, followed by a 50 basis points cut in September 2024, a larger-than-expected move that signaled a potential economic slowdown. 

Markets fell nearly 3% on the rate cut news but began recovering the next week. The Fed's statement showed minimal changes but added a qualifier on future rate cuts, hinting at a slower pace in 2025. The Summary of Economic Projections revised 2025 growth and inflation forecasts upward, while lowering the unemployment rate. The core inflation forecast was raised from 2.2% to 2.5%, reflecting stronger-than-expected economic growth.

While a crude oil inventory decline helped limit price declines, investors attributed it to the short-lived impact of Hurricane Francine. Though intended to boost economic activity and energy demand, the rate cut could also slow the economy if it leads to a weaker labor market.

According to the Energy Information Administration (EIA), US crude stocks fell by 1.178 million barrels, below the expected 2.75 million-barrel drop, marking a sixth consecutive decline in the week ending December 27. Cushing stocks dropped by 142,000 barrels. Gasoline inventories rose by 7.717 million barrels, and distillates increased by 6.406 million barrels, both exceeding forecasts. Net US crude imports rose by 323,000 barrels per day. This decline could suggest tighter supply dynamics, which could support higher oil prices in the future.

The Organization of the Petroleum Exporting Countries (OPEC) and its allies (OPEC+) have gradually increased oil production to meet growing demand. However, due to geopolitical tensions and other factors, there is a risk of supply disruptions.

Future outlook of the impact of Fed rate cuts on oil prices

The Federal Reserve has indicated plans for further interest rate cuts totaling 1.5 percentage points by 2026. These cuts and the lingering effects of Hurricane Francine are currently supporting the oil market. The prospect of additional rate cuts has instilled hope for economic stability. While a decline in US crude inventories and rising tensions in the Middle East have provided additional support for oil prices, the overall outlook for the market remains challenging due to slowing economic growth in China and declining refinery gains globally.

Advantages and risks of Fed rate cuts on oil

Advantages

• Stimulation of refineries: Lower interest rates can make it more affordable for refineries to invest in upgrades and expansions. This could increase refining capacity and lead to higher oil demand
• Increased investment in oil exploration and production: Lower borrowing costs can encourage oil companies to invest more in exploration and production activities, potentially leading to increased oil supply
• Reduced costs for oil producers: Lower interest rates can reduce the cost of borrowing for oil producers, improving their gains and potentially increasing their willingness to invest in production

Risks

• Inflationary pressures: Lower interest rates can contribute to inflation, which can erode the purchasing power of consumers and reduce demand for oil
• Currency speculation: Lower interest rates can attract currency speculators, potentially leading to fluctuations in exchange rates that could impact oil prices
• Environmental regulations: Governments may tighten environmental regulations in response to economic growth, which could increase costs for oil producers and reduce gains

Insights for oil traders and investors

Traders (short-term approach)

1. Short-term volatility: The oil market is likely to remain volatile in the near term due to a combination of factors, including Fed rate cuts, geopolitical tensions, and fluctuations in global demand. Traders should be prepared for rapid price movements and consider using stop-loss orders to manage risk.
2. Focus on fundamentals: While short-term factors can drive price volatility, traders must focus on underlying fundamentals like global supply and demand, economic indicators, and geopolitical events. A strong understanding of these factors can help identify potential trends and opportunities.
3. Diversify strategies: Given the uncertainty in the oil market, traders may want to diversify their strategies to reduce risk. This could include using options, futures, or spreads to hedge positions and potentially gain from different market scenarios.

Investors (long-term approach)

1. ESG considerations: As environmental, social, and governance (ESG) factors become increasingly important, investors may want to consider the ESG performance of oil companies when making investment decisions. This could include factors such as greenhouse gas emissions, social responsibility, and corporate governance.
2. Technological trends: Investors should be aware of technological advancements that could impact the oil industry, such as the development of electric vehicles, renewable energy sources, and carbon capture technologies. These trends could have long-term implications for oil demand and prices.
3. Global energy transition: The transition to a low-carbon economy is a major global trend that could have significant implications for the oil industry. Investors should assess how oil companies are positioning themselves to adapt to this transition and whether they are investing in sustainable energy sources.

How to trade/invest in oil?

Oil stocks

Investing in the stocks of oil companies is one of the most straightforward ways to participate in the oil market. This involves purchasing shares of oil exploration, production, refining, or transportation companies.

Oil ETFs and mutual funds

Exchange-traded funds (ETFs) and mutual funds offer a way to invest in a basket of oil stocks, providing diversification and reducing overall risk.

Oil futures

Oil futures are contracts that obligate the buyer to purchase and the seller to deliver a specific quantity of oil at a predetermined price and time. It allows investors to trade larger positions with a smaller initial investment, providing leverage.

Oil options

Oil options are contracts that give the trader the right, but not the obligation, to trade oil at a predetermined price and time. They can be used to hedge existing oil positions or to speculate on future price movements.

Oil-linked commodities

Investing in oil-related commodities, such as gasoline or heating oil, can provide indirect exposure to the oil market.

Oil Contract for Differences (CFDs)

Oil CFDs are financial contracts that allow traders to speculate on oil price movements without owning the underlying asset. Traders can gain from both rising and falling prices.

*This is an example only to enhance a consumer's understanding of the strategy being described above and is not to be taken as Blueberry providing personal advice.

Will the oil prices retrace again?

Crude oil prices surged in mid-September, defying bearish trends. A Fed rate cut and declining global inventories boosted sentiment. OPEC+'s production pause and supply disruptions further supported prices. However, China's slowing demand remains a concern. The market's outlook hinges on global economic conditions and OPEC+'s future moves for the oil prices to surge again.