Do Real Interest Rates Influence Commodity Prices?

July 2008

The recent rise in energy prices is a hot topic.  Beyond issues of supply and demand, the media has also considered the role of financial markets in energy price trends. For example, there is a belief that speculation by institutional investors (e.g., hedge funds, pension funds) with no connection to the energy industry have bid up prices as they try to increase their portfolios' value by buying and selling large volumes of energy-indexed securities. American regulators have been investigating crude oil trading, storage and transportation since the autumn of 2007 with the results of the investigation due later this year. Economists such as Jeffrey Frankel of Harvard University and James Hamilton of the University of California believe that the Federal Reserve's policy of setting interest rates plays a role in the trends of energy prices. Indeed, Dr. Frankel extended his analysis and concluded that real interest rates are negatively related to the prices of all commodities. Reinforcing his conclusion is his finding that global economic growth is slowing, which should mean that growth in energy demand would be moderating or even declining.

Let's examine Dr. Frankel's analysis.  First, lets define what a real interest rate is. A real interest rate is one which is adjusted for inflation. On the other hand, a nominal interest rate is one which is not adjusted for inflation. An estimate of a real interest rate can be calculated by subtracting the inflation rate from the rate of a 1-year treasury bill.

As the Federal Reserve has cut interest rates substantially over the last year in an attempt to encourage spending and avert a recession, real interest rates are now estimated to be near zero or even negative. According to Dr. Frankel, these very low real interest rates could be helping to pump up energy prices..

As the rate of return offered on bonds issued by the American government falls and inflation rises or remains constant then the real interest rate declines. Bonds issued at lower interest rates would be less attractive to foreign investors/lenders which leads to a depreciation of the American dollar as the demand for these dollar-denominated securities falls. Because contracts in crude oil, natural gas and other commodities are often traded in American dollars, the weakening of the American dollar makes these commodity contracts less expensive to non-Americans and thus entices them to invest more in commodities. Remarks by some OPEC members that the current rise in prices can be attributed to a weak American dollar stem from this link between real interest rates and dollar-denominated assets.

Frankel has also suggested that low real interest rates can decrease the supply of commodities by encouraging the deferral of commodity extraction or withholding of inventories. At very low real interest rates, producers' desire to extract more of the resource for sale is countered by the fact that the sales proceeds would be invested in relatively low-yielding bonds. In addition, Frankel postulates that investors would have greater incentive to invest in equities (including energy-indexed securities) than bonds.  This could explain the investment flows from institutional investors into commodities and accusations of speculation.

While real interest rates do have an influence in setting commodity prices, it is important not to overlook the numerous other influences on prices incuding fundamental issues such as supply and demand. It is also worth noting that the parties accused of playing a role in the rise in energy prices (OPEC, institutional investors, energy multinationals, and Federal Reserve officials) have each tried to assign more blame on the other parties. For example, one hears from OPEC that speculators and the weak American dollar are more important causes than their own production policies. On the other hand, officials from the Federal Reserve tend to focus on higher global demand and the potential role of speculators as significant factors rather than on the weakening American dollar caused largely by their decisions on cutting lending rates.

Readers of our newsletter will recognize that there are numerous factors that influence the price of energy. To date, we've discussed the role of liquified natural gas and the potential link between oil and natural gas prices, as well as ongoing fundamental issues of supply and demand. At Aegent we strive to ensure that we maintain a constantly evolving understanding of the global energy environment. This knowledge helps our clients effectively manage their energy costs. If you have questions about this article, or about the services that we offer contact Aegent Energy Advisors at 416-622-9449.