As rates rise, inventories fall

Central banks are fighting inflation with the most potent weapon in their arsenal, interest rates. The higher the cost of borrowing the more expensive life. Not only does it act as a break on economic growth but also has a profound impact on total oil inventories. Using the 10-Year U.S. Treasury yields as a proxy for interest rates and comparing it with U.S. aggregate inventory levels, including SPR, the inverse relationship is clearly visible.

Where does this connection come from? It is based on the fundamental rule of economic law that the higher the price the less the demand. In this particular case, the rising price of money, interest rates, prevents market players from borrowing it, and using it to purchase oil whenever market conditions allow it. When the market displays contango, where shorter dated contracts are cheaper than their peers further down the curve it makes economic sense to acquire physical crude oil, put it in storage, and hedge the sale at a later stage by shorting the futures contracts for delivery months ahead. This strategy works when the extent of the contango exceeds the "cost of carry," the price the owner of a barrel has to pay to store the oil for a month. The "cost of carry" is the function of storage costs, insurance, and interest rates. If any one of these elements rises the storage play becomes less attractive. The recent and relentless increase in borrowing costs have certainly made the "cost of carry" more expensive.

The reverse relationship between rates and stocks is neatly displayed on the chart above. As inflationary pressure increased, interest rates and bond yields were on the move higher and it has had a palpable impact on total U.S. oil inventories. Depleting stocks, in turn, are price supportive. It is important to point out that several other and possibly more salient factors affect the formation of oil prices, but it seems certain that as long as lending rates remain high the implausible build in oil inventories will underpin a stable oil market.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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