Is the Federal Reserve about to wreak havoc on crude oil prices?

Oil prices are already rising this week, to $90 per barrel on July 18, as the U.S. Energy Information Administration reports that demand for oil in the U.S. has risen for the third week in a row. Breaking the $90 barrier is a breakthrough of sorts -- it’s the highest level oil prices have seen since May 30, 2012.

Oil prices would likely climb further if the Federal Reserve opted to further stimulate the economy with a third round of quantitative easing (QE3)-- even though the Fed has revealed scant clues on what steps it may take -- if any -- on the economy.

Federal Reserve
Vice Chairman Janet Yellen offered a hint about the Fed’s strategic direction last week, commenting that the "scope remains for the FOMC to provide further policy accommodation…It may well be appropriate to insure against adverse shocks that could push the economy into territory where a self-reinforcing downward spiral of economic weakness would be difficult to arrest."

Analysts and experts outside the Fed think QE3 is already a done deal.

Peter Schiff, a noted economic pessimist (or realist, as some say) appeared on Yahoo’s “Breakout” podcast on July 18, and said that QE3 is a “foregone conclusion”, even though he considers it a big mistake.

It would be better if Federal Reserve Chairman Ben Bernanke “'fessed up, and leveled with the American public and tell them what needs to be done,” Schiff said.

In another appearance on “Breakout” on July 12, one Wall Street trader believes that another round of fiscal stimulus is coming, and that oil prices will “skyrocket” as a result.

Kevin Craney
, a senior broker at Chicago-based RJO Futures, says that most pieces of economic data should trigger a decline in oil prices, but the reason that crude oil prices are rising is the prospect of QE3 coming down the pike from Washington, D.C.

“Crude oil prices are making everyone really nervous,” he says. “You have the Asian economy slowing, and the troubles in Europe have really sent a shiver up the spine of investors.”

“In the back of everyone’s mind is what is going on over in Iran. Iraq is producing more oil than Iran on a monthly basis. But the U.S. is not in a recession, although we are flat on our back. There is still demand for oil in the U.S.”

But the real wild card, Craney says, is how the Federal Reserve responds to a slowing U.S. economy.

“One factor that could push crude oil is additional quantitative stimulus from the Federal Reserve,” he adds. “We hear a lot of chatter about that. That’s the catalyst that a lot of people are looking for to send commodities, including crude, rocketing higher.”

Other industry observers who spoke to Oil and Gas Investor this week tend to agree that QE3 is on the way, but are decidedly mixed on whether or not it would dramatically impact oil prices.

James J. Cerna, CEO, at Dearborn, Michigan-based Armada Oil Inc., tells OGI that the U.S. economic recovery remains threatened, given recent global events, and that investors remain reluctant to allocate capital into riskier investments, regardless of the support from the Federal Reserve.

“Quantitative easing is failing to yield the results as it did in the past and in fact, data (graph below) indicates the velocity of M2 is actually at a level now that is lower than in the recession of 2008-09,” he says. “This is a critical point as the velocity of the money supply is a measure of economic activity associated with the given money supply. Even with a QE3, we may not see an increase in oil price unless the money makes its way through the system.  The trend of the velocity of the money supply is showing that the excess liquidity is not making its way to GDP.”

Cerna sees additional stimulus as needed, but it’s when rolled out, it will have little sway with commodities prices.

“Our recovery outlook right now is flat on its back, or low–to–no growth. There needs to be some qualitative efforts to stimulate growth,” he adds.  “Who’s to say that QE3 will create hyperinflation? Quantitative easing will serve to shore banks and financial systems, but until they are healthy excess liquidity will probably not make its way to the economy and hence, commodity prices.”
Others aren’t so sure.

Matt Tormollen, CEO of FuelQuest, a Houston, Texas, on-demand fuel management firm, says prices may rise upon QE3, but not as high as some people may think.

"QE3 will surely apply upward pressure on commodity prices including oil, but there are countervailing effects that may limit rising prices including a global economic slowdown -- this includes not only a recessionary Europe, but also traditionally high-growth BRIC countries -- and the related slump in oil demand,” he tells OGI.

“These same countries are already reacting to slower growth by enacting similar monetary policies lowering interest rates and devaluing local currencies, which is something that may again limit the U.S.'s expected run-up of oil prices.  The ultimate effect of QE3 though would be higher prices, but the real question is how high they will go."

That is, indeed, the question on investors’ lips as the Federal Reserve plays hide-and-seek with its stimulus intentions.

If the economy grows any worse, the Fed may have no choice but to light another stimulus candle, and commodities investors may well have a real powder keg on their hands.