The Fed Cut: Impact on Oil Price

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 |  Includes: OIH, USO
by: James Picerno

Maybe the cut was justified, maybe not. But now that it's a done deal, investors are left with the job of deciphering the implications.

The immediate reaction on Wall Street: yee-hah! Stocks across the board have surged in the wake of the Fed's bold 50-basis-point cut. The S&P 500 jumped 3% by Tuesday's close alone.

But there's more than one bull market unfolding, and therein lies the potential for trouble down the road. Indeed, it's hardly irrelevant that crude oil closed at a new high yesterday. Ditto for the ascent of gold prices, which climbed to over $720 on Tuesday.

But not every market's celebrating. The beleaguered buck took another hit on the news that the Federal Reserve lowered the price of money. The U.S. Dollar Index slumped half a percentage point yesterday, leaving it at a record low.

The falling dollar's not-so-subtle implication: higher inflation. One only has to look at the bull market in oil to understand the risk. The United States is the world's biggest importer of crude. It's safe to assume that foreign exporters of oil aren't insensitive to receiving payment in a currency that's falling in value. One way to offset the forex risk is to charge more for oil in dollar terms.

Yes, oil's a global commodity and its price is set internationally and so price-fixing is difficult if not impossible. But the next best thing is limiting production. OPEC will no doubt give that prospect serious consideration if the dollar keeps dropping.

Part of that consideration includes the issue of investing today to lift oil production tomorrow. Most if not all OPEC members are in need of technological upgrades to boost production to keep pace with rising global demand for the years ahead. But that takes money, and lots of it. Suffice to say, it's a hard choice. Will a sinking dollar make the choice easier to delay such investment? If so, how will that affect the price of oil?

Then again, the man who heads the Federal Reserve has a paper trail arguing that a bull market in oil doesn't necessarily bring higher inflation. The rationale is that oil prices are largely statistical noise and so they should be ignored when making monetary policy choices. Our guess is that notion will be put to the test big time in the coming months and years. The Fed, in short, will be proven right or wrong on the issue of whether higher oil prices can bring higher inflation. The question for strategic-minded investors then becomes: Is the potential risk worthy of hedging? That's another way of ask: How much confidence do you have in the central bank? Judging by the dollar's descent of late, there's no doubt where forex traders stand.