How a Rate Hike Could Halt Oil Market's Recovery

The energy industry is displaying symptoms of recovery: The price for a barrel of oil is flirting with $50, prompting several producers to consider adding rigs and starting to drill again.

Pioneer Natural Resources (PXD) , for example, said in April that it would add as many as 10 horizontal rigs if the price of oil reached that level and the supply-and-demand outlook appeared positive.

Such optimism is fragile, though, and an interest-rate hike might squelch it. Potential fallout ranges from worsening a supply glut to curbing demand because the dollar becomes more valuable.

For starters, higher rates make storage more expensive for oil and gas companies, which might prompt them to dump their stockpiles onto the open market, Philip Verleger, an economist at PKVerleger in Colorado, said in an interview.

"The sale of that oil would put downward pressure on prices," he said.

Higher rates would also strengthen the U.S. currency, making oil priced in dollars more expensive and prompting overseas buyers to look elsewhere.

"If the Fed hikes rates and the U.S. dollar strengthens, oil prices go down," said Paul Sankey, managing director at Wolfe Research in New York.

Falling prices would hurt oil and gas explorers and producers across the board, including Exxon Mobil (XOM) , Chevron (CVX) and Conoco Phillips (COP) , but would help refiners such as Valero Energy (VLO) , Phillips 66 (PSX) and Tesoro (TSO) , which wouldn't have to pay as much for raw materials.

That inverse dollar-oil correlation may begin to diminish, however, as the underlying supply-and-demand fundamentals tighten over the next year, says Dan Pickering, co-president of energy-focused investment bank Tudor, Pickering, Holt & Co. in Houston. "With supply falling and demand rising, prices are going to be much more reactive to falling inventories than the dollar," he says.

Under ordinary circumstances, higher interest rates might undermine yield-starved investors' enthusiasm for certain energy infrastructure holdings, such as Enterprise Products Partners (EPD) , Plains All American Pipeline (PAA) and Energy Transfer Partners (ETP) -- as well as dividend-paying blue chips such as Exxon and Chevron, said Kevin Book, managing director of research at ClearView Energy Partners in Washington.

Collapsing oil prices did most of the work on that front already, however, and another 25 basis points "might be hard to tease out of the noise, especially if crude reverts to the low side," he said.

Rusty Braziel, CEO and president of Houston energy consulting firm RBN Energy, agrees with Book, saying it's unlikely a Fed decision to raise rates would be enough to materially impact oil. "There are so many other fundamental factors influencing the supply-and-demand balance of global oil markets that my guess is that an increase in interest rates would have a very minor impact," he said.

Among other things, the effects would be limited by the nearly 4 million barrels per day of supply that have been cut from the market because of fires, violence, banking issues and payment disputes scattered around the globe. 

"I don't think the Fed decision, or indecision, will have much impact in the oil market, although higher interest rates are definitely a speed bump for liquidity and for price appreciation," he said.

They might, for instance, hurt oil and gas companies trying to borrow money through the downturn -- especially those with big projects like Exxon and Chevron, said Lysle Brinker, director of equity research at data provider IHS.

Geopolitical and supply-related events will have more lasting effects, though. "Those things are more important day in and day out than the interest rate," he says.

Overshadowing everything is the failure of the Organization of Petroleum Exporting Countries to agree on any production ceiling at the same time that a global surplus is worsened by Iran continuing to boost output just as Libyan oil may begin returning to the market, said Andy Lipow, whose Lipow Oil Associates provides information and analysis of market trends.

"Right now, the oil market is banking on continued disruptions to help ease the oversupply situation combined with increasing demand to stabilize prices throughout the rest of 2016," he said. "While in the short term I think oil prices could drop back to $45 per barrel, I believe they will move back over $50 by January 2017."

See full coverage on the Fed's upcoming interest-rate decisions.

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