Two things on the outlook for oil prices. One, the violence of the recent spike is likely short-position covering. Two, the outlook for North American oil prices will likely be determined by the interplay between U.S. crude inventories and the Baker Hughes rig count.
Futures data from the Commodity Futures Trading Commission (CFTC) suggest that hedge funds got carried away with pessimistic bets against the oil price. The Non-Commercial (non-energy industry) section of the CFTC's weekly report is widely used as a proxy for hedge-fund positioning. Last week's update showed that bearish short-position bets against the oil price had jumped 70 per cent in January to the highest levels in more than four years.
WTI crude oil vs Commitment of Traders: Non-Commercial Total Short Positions WTI
SOURCE: Scott Barlow/Bloomberg
When the next CFTC report is released Friday, I expect a sharp reduction in hedge-fund short positions. Friday's 8.3-per-cent rally in oil prices had all the hallmarks of panic buying – a rush to cover short positions that were losing value as the crude price climbed.
In itself, hedge-fund positioning in West Texas intermediate crude prices isn't positive or negative as an indicator. Short covering does signal better sentiment at the margin, but overall it doesn't tell us much about the short- or mid-term outlook for the oil price.
On the other hand, the catalyst for the late-week rally in the commodity price – the Baker Hughes report showing a drastic 19-per-cent year-to-date decline in the number of U.S. oil drilling rigs in operation – may hold the key to future prices. Further large declines in operating oil rigs would suggest that U.S. oil production is falling and the current glut in supply is short-lived.
So far, there are few signs of lower U.S oil production despite the falling rig count. The U.S. Department of Energy reported last Wednesday that the amount of U.S. oil in storage (not including the government's Strategic Petroleum Reserve) has climbed to post-financial-crisis levels, surpassing 406 million barrels.
The number of producing rigs wouldn't be falling so fast at the same time that inventories reach record levels in normal circumstances. Something has to give.
For investors in the energy sector, the most positive scenario is for the U.S. rig count to continue its rapid decline and for U.S. crude storage to, at the very least, stop growing. This would suggest that the glut is over and corporate profits for oil producers can start on the long road to recovery.
The more bearish investor outcome would see U.S. inventories continue to climb despite fewer producing wells. Higher storage levels would form a "supply overhang" that would limit upside for the commodity price.
The abrupt change in direction for the oil price Friday means this is a big week for the oil patch. On Wednesday, the U.S. Department of Energy will announce inventory levels and an increase of 5,160 barrels is the consensus expectation. Friday will see the release of the Baker Hughes rig count, which is expected to remain unchanged at 1,543. The CFTC report on futures positioning will be available late Friday. Any unexpected results in any of these reports is likely to cause major market swings in the current environment.
Follow Scott Barlow on Twitter @SBarlow_ROB.