The theoretical, risk-reducing relationship between oil prices and interest rates is not observed in practice. Correlations have often been detrimental to the financial risk of energy producers.
Recent charts make it look like interest rates (IR) and oil are highly correlated, but that’s not typical of the last 20 years,
Rates and oil have been negatively correlated since 2000, the opposite of what you would want as a producer.
Good: In 2015-2019, the IR-oil correlation was positive, so oil prices were offsetting the financial impact of higher rates,
Bad: In 2000-2014, rates were clearly higher when oil was low — not a good combination,
Very Bad: There were quarters when oil price was falling while rates were rising.
Conclusion: IR and oil have a theoretical relationship, but that relationship has not held in the last 20 years except in fits and starts. They should be hedged independently.
As an oil producer, you would hope that the cost to service your debt would be low when oil prices are low. It’s easier to tolerate higher interest payments when oil prices are high. Since 2015, that correlation between interest rates (IR) and oil has been positive and beneficial.
The chart above shows the 10-year Treasury yield (10YR) and the 12-month WTI oil price strip, for each month since 2000. Finding a relationship between oil and interest rates before 2015 was difficult when looking at both these time series. Since 2015, the correlation has been much better.
But what about 2000-2014? The story is much different:
The chart above shows each quarter’s combination of 10YR and WTI price, from 1Q2000 through a partial 2Q2020. What happened to that positive correlation? This chart shows that from 2000 – 2014, relatively lower crude oil prices were mostly associated with relatively higher rates. Of course, this is opposite of ideal. Just at the time when oil revenues were low, interest costs were higher. The 2015-2020YTD portion, shown in dark blue, is the positive, tighter correlation mentioned earlier.
We realize this is a summary of very complex interactions between rates, currencies, commodities, etc. But when we see an unreliable correlation between oil and rates, we draw three big conclusions:
1. Oil price is not a reliable hedge against interest rates.
2. Oil prices often fall while rates are rising, and rates are now at historic lows at which to hedge.
3. Simultaneously hedging both revenue (oil price) and interest expense (IR) is wise to control your interest-coverage ratios.
We continue to monitor interest rates, oil, gas, NGLs, and regional markets for hedging opportunities. To learn more and see AEGIS opinion and recommendations, go to AEGIS View publications, or contact [email protected]. Like what you see? Share this article with the button on the bottom right of your desktop. Market questions or comments? Contact us at [email protected].
NOTICE: The content of this report is provided for information purposes only and has been prepared to describe current trends in the commodities markets. This information does not constitute either investment or hedging advice and is intended only for AEGIS clients. If you are not the intended recipient of this report, then you may not disclose, print, copy or disseminate this information. Otherwise, if you have received this transmission in error, then please notify the sender and delete the report.