After almost hitting our target of $20 to $25 per barrel on Feb. 11, 2016, the price of West Texas Intermediate (WTI) crude oil has rebounded by almost 40 percent to a recent high of about $39 per barrel.
This rally stands out when you consider the steady flow of negative news since mid-February. Two weeks ago, for example, the Energy Information Administration (EIA) announced that US oil inventories increased by 10.374 million barrels (three times the consensus estimate), swelling this stockpile to 517.981 million barrels—the highest level in 80 years.
Meanwhile, crude-oil inventories in Cushing, Oklahoma, increased by another 1.18 million barrels to 66.256 million barrels—dangerously close to the trading hub’s capacity of 74 million barrels.
Gasoline stockpiles also declined by less than expected, and distillate inventories increased by a wider margin than Wall Street’s hive mind had estimated. Implied demand for gasoline—one of the few bright spots in recent weeks—even took a hit.
WTI sold off sharply after the EIA released this inventory report at 10:20 a.m., giving up about $1 per barrel in a manner of seconds, before rallying later that day and through the remainder of last week. When markets respond well to bad news, it’s a sign of strong near-term momentum.
Last week, the EIA reported yet another 3.88 million barrel build in US oil inventories and a 690,000 barrel increase in Cushing. Yet the market quickly shrugged off the inventory news, and traders bought the dips in oil.
Recent data from the Commodity Futures Trading Commission (CFTC) help to explain the forces driving the oil market. Hedge funds covered 25.64 million barrels worth of short positions in WTI futures in the week ended March 1 and a whopping 38.2 million barrels in the week ended March 8—the biggest decline in a single week wince the CFTC began reporting data in 2006.
Since peaking at an equivalent of 201 million barrels on Jan. 12, 2016, hedge funds’ aggregate reported short position in WTI futures has declined by about 88.5 million barrels.
Hedge funds may be covering their short positions, but they are not betting on a rally in crude-oil prices. Over the past two weeks, hedge funds have added less than 1 million barrels to their long positions in WTI futures.
What’s the rationale behind this move? Hedge funds accumulated the bulk of their short position between mid-October and early December 2015, when WTI ranged from $44 to $53 per barrel; depending on their exact entry points, these funds still sit on decent profits even with oil at $37 per barrel.
When WTI traded in the mid- to high $20s per barrel, hedge funds sat on sizable gains, which probably made some portfolio managers nervous that their unrealized profits could shrink rapidly in a short squeeze.
A short squeeze occurs when traders betting against oil prices seek to take profits on their position, a move that requires them to purchase the commodity. A wave of short covering squeezes the price higher, spurring similar moves by other investors who have placed the same bet. This action can result in sharp price upswings over a short period.
Short covering by hedge funds helps to explain why WTI prices have rallied so hard despite a string of negative weekly oil inventory reports and a still huge glut of oil in storage globally.
Why are short sellers nervous about oil prices? Are these concerns legitimate? Let’s examine three popular rationales for the rally in WTI prices over the past few weeks.