We like to think that when we deposit a dollar at the bank, it goes into a big vault and we can pull out that same dollar at any time. But that¿s not how the U.S. banking system works. Banks take that money and invest it to make money themselves, so cash gets spread around. This, naturally, leads to a big risk: What happens if those investments go sour? Well, you¿d be out of luck. You can¿t get your dollar back.

The Federal Reserve doesn¿t like that scenario, so it prohibits banks from putting all the cash it has on deposit on the line. In fact, the Fed forces banks to keep a portion of their assets at the Federal Reserve itself, to make sure that some of your assets won¿t get squandered if the bank¿s bets go south. These are called ¿reserves,¿ (hence, Federal Reserve. Got it? Good), and usually amount to 10% of the total cash kept in checking accounts.

These reserves are never exactly 10%, and banks like to keep a little extra in reserve ¿ not, as you might think, to make you more comfortable that they¿re in good financial shape, but rather so they can take that excess and lend it to other banks and make money off it. (They¿re banks, they can¿t help themselves.) The rate at which they make these loans is called the Federal Funds rate, which is set by the Federal Reserve¿s Federal Open Market Committee.

When you hear people chattering about how the Fed cut or hiked interest rates, this is what they¿re talking about: the interest rate banks can charge for lending money from their reserves. This begs the question: If these are essentially loans between banks, why is the Fed Funds rate so important for the rest of the economy?

Well, simply put, because loans make the financial world go round. Bank A lends Bank B $10,000 at a Fed Funds rate of 5%. Bank B then lends out $10,000 to a small business at 7%. The small business then takes that money and expands the business and hires new workers. Now someone is employed, Bank B has made interest off the loan, and Bank A is the richer for making it all happen. It¿s perhaps overly simplistic, but you get the idea. When you want the economy to thrive, you make lending cheaper.

Of course, sometimes you don¿t want the economy to thrive. In fact, you might want it to cool down, mostly to avoid money flooding the system and causing inflation. In that case, the Fed raises interest rates, making it difficult to lend or borrow.

Home / Markets / Industries / Energy

Friday, October 10, 2008

Oil Plunges Below $78 on Global Economic Concerns

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Adam Samson

FOXBusiness

Oil futures sunk to a one-year low Friday morning as a spiraling financial crisis weighed on global demand expectations.

The benchmark oil contract settled lower by $8.89 to $77.70 a barrel as the International Energy Administration warned increased financial and economic trauma would cut into global demand for oil.

Oil prices have fallen roughly 47% since reaching a record $147.27 on July 11.

“The oil market is dreary,” said Fadel Gheit, managing director and senior analyst covering the oil and gas sector for Oppenheimer & Co.

Gheit cited two key reasons for oil’s recent downturn. For one thing, the financial crisis is going to put incredible pressure on global economies, which is bound to substantially constrain demand for oil, he said.

Secondly, many hedge funds and investment banks that bet oil would rise are hemorrhaging capital as oil plunges, he said. These companies are being forced to sell contracts to recover cash and to cover margin calls, causing a multiplier effect that is further depressing oil prices.

“When oil prices are coming down, people are trying to cover their losses as quickly as they can, that’s why they are selling everything,” Gheit said.

The IEA’s monthly oil report that came out today paints a gloomy picture for global oil demand for the rest of the year and into 2009.

The IEA cut its projection for oil demand this year by 240,000 barrels per day, and slashed its 2009 forecast by 440,000 barrels per day. The energy watchdog now projects world oil demand to total 86.5 million barrels per day this year and 87.2 million barrels per day next year.

The credit crunch is also expected to take a toll on crude supply: "Credit shortages are rapidly becoming yet another in a long line of impediments to industry investment," the report said.

Taken together the IEA report, and other technical factors, it appears there could be substantial downward pressure on oil prices.

“Oil prices are still artificially high. When the dust settles oil prices shouldn’t be a dime above $60,” Gheit said.

Lower oil prices could mean good news for drivers, who were forced to pay record prices at the pump during summer months.

The average price for a gallon of regular gasoline is $3.35 nationwide, compared with the record $4.11 on July 17, according to the AAA's Daily Fuel Gauge Report. Still, there is a long way to go -- drivers paid just $2.76 for regular gasoline just a year ago.