The rapidly rising number of active U.S. oil rigs is getting a lot of attention, but it's speculative excess in futures markets that poses the greatest short-term risks to investors in the energy sector.
The West Texas intermediate crude price has rallied more than 20 per cent since early November as OPEC nations managed to cobble together an agreement to limit production. Signs that the Organization of Petroleum Exporting Countries is adhering to the agreement continue to provide support to oil prices, but for investors there is short-term trouble brewing in the United States.
The first chart below shows the oil price and the weekly Baker Hughes count of active U.S. oil rigs. The number of active drill rigs has risen 85 per cent from a low of 316 in May, 2016 to 583 on February 3, 2017. A lag effect is also apparent – the number of rigs rises only after a sustained climb in the oil price.
The second chart shows the effects of increased activity on U.S crude production. It's still a long way from the high in June, 2015, of 9.6 million barrels per day, but well above the lows of 8.4 million barrels in July, 2016.
The third chart indicates where the risk lies, in my opinion. The lines compare the oil price with Commodity Futures Trading Commission data showing the net futures positioning – bullish bets on crude minus bearish bets – for speculative investors. (The "non-commercial" sections of the weekly CFTC report are widely used as a proxy for hedge fund trades.)
The number of bullish futures bets on oil is at five-year highs, above levels when the commodity price was $107 (U.S.) per barrel. The OPEC deal makes it reasonable to expect higher prices but this extreme degree of exuberance appears overdone.
For one, the inventory glut remains. The Energy Information Agency is hopeful that global supply and demand will finally be in balance in late 2017, but current U.S. inventories remain 40 per cent above the 10-year average and 26-per-cent above the five-year average (inventory data not shown on charts).
As the first two charts suggest, U.S. oil production is also climbing, threatening to further offset the positive effects of the lower OPEC production on global energy prices. The lag effect on the rig count chart implies that the longer crude prices remain at current levels, the more rigs will be put to work, and U.S. production will continue to increase.
None of this is necessarily disastrous. I suspect that the number of bullish futures trades will decline in the weeks ahead once it becomes clear that the limited short-term upside for the commodity price doesn't warrant the risk. The process of removing these trades will put temporary negative pressure on oil prices but once the futures markets become more balanced between bull and bear, the fundamentals of supply and demand should reassert themselves as the main driver of crude in the mid-term.