Will Oil Prices Pop or Drop Post QE2?

NEW YORK (TheStreet) -- The end of the government's second round of quantitative easing could have a significant impact on the value of the dollar and directly impact oil prices.

Schork Group Analyst Hamza Khan, who predicts longer-term weakness in oil following the end of QE2, draws a clear line between price weakness and lower prices.

"Wall Street bulls have their buying caps on and (as you can see from today's higher prices despite a catastrophic consumer confidence number) seem willing to ignore fundamentals to push prices higher," Khan said in an email on May 31.

July light sweet crude prices rose $2.11 to settle at $102.70 that day, despite a more than 5-point fall in the Conference Board's consumer confidence index to 60.8 in May from a revised reading of 66 in April. The consensus forecast was for the reading to increase further to 66.3.

Khan says investors who watched the oil price rally to almost $150 in 2008 while standing on the sidelines don't want to miss another chance at profiting from oil.

"Buying begets buying, and the end of QE2 may cause the bulls to stumble, but likely won't make them stop," said Khan.

The Federal Reserve's purchase of $600 billion in U.S. Treasuries, known as quantitative easing 2, or QE2, was designed to ensure a healthy supply of dollars on the market and helped to boost asset prices. The end of this program is expected to dry up the dollars and make way for interest rate increases, injecting strength into the currency. With oil being a dollar-denominated commodity, a stronger U.S. currency against the Japanese yen and euro, for instance, would make oil more expensive for those countries to purchase, hurting demand.

The program ends on June 30.

Khan, however, doesn't foresee the end of QE2 having an immediate, tangible effect on oil.

Many market watchers believe that QE2 has already been priced into oil, but are anticipating a rise in prices if the Federal Reserve uses language indicative of a possible QE3.

"I think the loose monetary policy will be with us for some time," says Tradition Energy's senior director of market research, Addison Armstrong, referencing the recent, poor economic data. "I think the Fed's hands are effectively tied."

On Friday, the Bureau of Labor Statistics said nonfarm payrolls increased by 54,000 on a seasonally adjusted basis in May, much lower than analysts had expected.

On Wednesday, the Automatic Data Processing Employment Report showed that companies created far fewer jobs in the U.S. than expected in May, sparking concerns that the economic recovery in the world's top oil consumer is losing steam.

And last week, the Bureau of Economic Analysis released its second estimate for U.S. gross domestic product growth, and it showed that the economy expanded at a mere annual rate of 1.8% versus 3.1% in the previous quarter. Economists, on average, were expecting a 2.1% first-quarter increase.

Armstrong says he wouldn't be surprised if oil tested the upper end of the recent $95 to $105 trading range this week or next week. Still, barring geopolitical events in Libya, the 12th largest oil exporter, and Yemen, which borders Saudi Arabia, the top exporter, the markets are unlikely to move past $115, he adds.

Summit Energy's Commodity Analyst Matt Smith doesn't expect a shift in oil to the downside at the end of QE2, barring an initial knee-jerk selloff.

"After all, an end to it would signal that the government thinks the economy is strong enough to stand on its own two feet," said Smith. "Whether it can or not is yet to be seen."

Oil servicers and producers are mostly higher year-to-date as light sweet crude rises more than 6% in the period. Halliburton ( HAL), Schlumberger ( SLB), Baker Hughes ( BHI) and Tesco ( TESO) have risen 23.1%, 1.8%, 30.5% and 25.4% year to date. Marathon Oil ( MRO) and Occidental Petroleum ( OXY) are up 39.9% and 6.2% in the period, while Hess ( HES) is up 0.6%.

Readers of TheStreet, what do you think: does the end of QE2 point to lower oil prices? Take our poll below to see what your fellow investors have to say....

Does the end of QE2 point to lower oil prices?

Yes, but only initially.
Yes, and for the longer term.
No, though some weakness may occur.
No; oil prices will climb higher.

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-- Written by Andrea Tse in New York.

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