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

Thursday, July 24, 2008

Oil Edges Higher

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Associated Press

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Energy market investors tried but failed to start a rally in crude Thursday, and continued to drive natural gas prices sharply lower as a three-week sell-off of that fuel continued unabated.

Light, sweet crude for September delivery rose 12 cents to $124.56 a barrel on the New York Mercantile Exchange. August natural gas tumbled 55.3 cents to $9.235 per 1,000 cubic feet, its lowest point since March.

Meanwhile at the gas pump, prices continued their retreat. The national average for a gallon of regular dropped more than a penny and a half to $4.026 a gallon, according to auto club AAA, the Oil Price Information Service and Wright Express. Retail diesel is down nearly half a cent to $4.788.

Falling prices at the filling station reflect the concern of many energy traders that the weakening U.S. economy is hurting demand. Analysts say that is helping keep oil prices from racing back higher.

The day's gains followed a sharp drop on Wednesday, when oil tumbled $3.98 to settle at $124.44 a barrel, its lowest finish since June 4. Crude has fallen in six of the previous seven sessions, and is now trading nearly 15% below its peak above $147 a barrel earlier this month.

In overnight trading, oil rose as high as $126.01 as some investors tried to see if the market had reached a bottom and could rebound. But the gains couldn't hold amid a growing belief that falling demand does not justify the recent high price.

Americans used 2.4% less fuel over the past four weeks than they did last year, the latest figures by the Energy Department's Energy Information Administration show. While that may not sound like much, industry experts say it represents a significant shift by the world's largest energy consumer. A bigger-than-expected increase in gasoline supplies only added to concerns that drivers are cutting back.

"We've grounded airplanes. People are driving less, they're trading in their SUVs," said James Cordier, president of Tampa, Fla.-based trading firms Liberty Trading Group and OptionSellers.com. "For the foreseeable future -- at least for the next 6 to 12 months -- we have demand destruction."

Cordier predicted prices could yet drop further, with oil possibly falling as low as $110 a barrel by September.

"People have changed their driving habits, and they're not going to change back anytime soon," he said.

A modestly stronger dollar helped keep prices in check Thursday, by discouraging traders who had been buying commodities as a hedge against inflation and a softer greenback.

"More than any other factor, a strong dollar would help take the air out of this market," editors at energy consultancy Cameron Hanover noted in their daily market commentary.

Investors remained on guard over a threat by Nigeria's main militant group Wednesday to destroy major pipelines in the oil exporting country within 30 days. The threat -- which only weeks ago might have caused oil prices to spike -- did little to push crude higher, however.

"We can only suggest that the market, finally weighed down by the specter of decreasing energy demand, may not be as responsive to geopolitical headlines as it once was," MF Global analyst Edward Meir wrote in a research note.

Natural gas extended its decline after the Energy Department's Energy Information Administration said in its weekly report that natural-gas inventories held in underground storage in the lower 48 states rose by 84 billion cubic feet to nearly 2.4 trillion cubic feet last week.

In other Nymex trading, heating oil futures more than a penny to $3.5609 a gallon while gasoline futures were up half a cent at $3.04 a gallon.

In London, Brent crude for September delivery rose 63 cents to $125.92 a barrel on the ICE Futures exchange in London.