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Rise in real interest rates could cause commodity price declines, bearish for energy stocks

2013.02.12 - US Five Year RateEnlarge GraphLow real interest rates have a positive effect on commodity prices for several reasons. Current low real interest rates could be one factor in inflating commodity prices, and a rise in real rates could cause prices to fall which would be bearish for oil and gas producers such as ExxonMobil (XOM), ConocoPhillips (COP), Chevron Corp. (CVX), and Chesapeake Energy (CHK). Additionally, it could be negative for an energy ETF such as Energy Select Sector SPDR (XLE) which holds many oil and gas producing names.

Currently, real interest rates (that is interest rates adjusted for inflation) are at close to historic lows as seen in the graph above.

This is due to the Federal Reserve’s quantitative easing policy, which has poured money into the financial system and has caused yields (or interest rates) to decrease. High interest rates have the effect of dampening commodity prices for several reasons. Firstly, high rates incentivize market participants to shift investments from commodity contracts such as oil (which does not produce any yield), to yielding instruments such as US Treasurys. The higher interest rates are, the more incentive there is to purchase securities with yield.

Secondly, a high real interest rate is an incentive to minimize the amount of inventories one might hold. This is because holding inventories ties up capital, and capital is more expensive when real interest rates are high. If with higher real rates, parties are incentivized to minimize inventories, this puts more supply onto the market which can dampen prices.

As stated before, current rates are low, and most indications are that rates will stay relatively low over the next few years. However, many market participants have stated “there is only one direction for rates to go”. That is, at already real negative rates, there isn’t much room for rates to move much lower. Therefore, many eventually expect rates to increase, which is a negative catalyst for commodity prices and therefore oil and gas producers. Readers should note, however, that there are many forces that determine commodity prices (ex: GDP growth, OPEC production, non-OPEC production) of which interest rates are just one factor.

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