Is the Market About to Have a Freak-Out Moment After Multiple Oil Inventory Draws?

For the third straight week, data from the U.S. Energy Information Administration showed that the amount of oil the country has in storage had fallen. Further, these declines have been much deeper than the market had expected. This week, for example, crude oil storage inventories fell 4.7 million barrels from last week. Not only was that better than the 3.2 million barrel inventory draw that analysts had expected, but it completely contradicted an earlier report by the American Petroleum Institute showing that crude inventories spiked by 1.6 million barrels this week.

That said, instead of applauding the news, oil traders shrugged, evidenced by the slight rise in the U.S. oil benchmark WTI, which edged up slightly more than 1% to around $47 per barrel. Oil traders had the same reaction yesterday after a report out of Saudi Arabia indicated that the country was considering cutting its oil exports by another 1 million barrels per day (bpd). While oil initially popped on the news, that rally didn't go very far because oil traders remain skeptical. That said, this skepticism could be lulling them into believing that we're in a go-nowhere market. Because of that, it's growing increasingly possible that oil traders could go into a frenzy if they get caught off-guard by an unexpected barrage of bullish news.

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Lulled to sleep by lackluster data

Even with today's rise, crude remains well below the mid-$50 a barrel level that the market expected to see this year. Three factors have been weighing on oil prices this year: weaker oil demand growth in the first quarter, a rapid rise in shale output, and increasing production from Libya and Nigeria, which are exempt from OPEC's cuts. Because of these factors, crude oil inventories haven't drained as quickly as OPEC expected. In fact, according to the EIA, even with this week's significant draw, they remain in the upper half of the average range for this time of year.

Meanwhile, there have been some recent hiccups in OPEC's efforts to cap its production. Last month, OPEC's production surged 720,000 bpd thanks to growth from not only Libya and Nigeria, but an unexpected rise from Saudi Arabia. Because of that, OPEC's compliance with its cuts fell to 78% in June. Meanwhile, Ecuador recently said that it no longer plans to hold up its end of the bargain and cap its production at 520,000 bpd because it needs the money. It's issues like these that have oil traders largely ignoring an equally healthy dose of bullish news in recent weeks.

In fact, oil traders have been cutting their speculative bets over the past few months. According to data from the U.S. Commodity Futures Trading Commission (CFTC), after peaking at more than 550,000 contracts in late February, market speculators only held 358,000 contracts as of mid-July. With participation from market speculators waning, it could lead to a significant spike in volatility if traders get caught flat-footed by a barrage of bullish news in the coming months because it could cause a torrent of buying to both take bullish positions and cover short ones.

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Missing the forest for the trees

One reason to believe market traders could get blindsided is that the bullish data set extends far beyond a three-week stretch where oil inventories have been draining at a healthy clip. One of the most important data points is that "there was a dramatic acceleration" in oil demand last quarter, according to the International Energy Agency's latest market report. Overall, demand grew by 1.5 million bpd during the second quarter after only expanding by an average of 1 million bpd during the first quarter. This spike caused the Agency to bump up its full-year forecast by 100,000 bpd to 1.4 million bpd.

Meanwhile, the rapid rise in shale output might be slowing down. That seems to be the indication of the latest rig count report by oil-field services giant Baker Hughes (BHGE +0.02%), which showed that the U.S. rig count flattened out last week. That's the second time in three weeks that Baker Hughes' rig count data didn't show a gain, which is worth noting since the rig count rose for a record 23 straight weeks earlier this year. That data seems to suggest that shale drillers are making good on their promise not to drill themselves into oblivion.

However, what could push the crude market over the top if shale drillers announce budget cuts and downward guidance revisions when they report second-quarter results in the coming weeks. Several drillers were banking on $55 oil when they set their budgets, and they now might need to reset expectations given where oil is these days. One candidate is leading Bakken Shale producer Whiting Petroleum (WLL +0.00%). The company has been ramping up its drilling activities this year after doubling its capital budget to $1.1 billion. That money would enable Whiting Petroleum to run enough rigs to increase its output 23% by the end of the year. However, given that Whiting has $1.5 billion in debt coming due starting in 2019, and it needs $55 oil to balance the budget, it can't afford to keep drilling at its current pace, making a spending cut all the more likely.  

Is a flat-footed freak-out moment on the horizon?

If several shale drillers announce that they're pulling back the reins on their ambitious growth plans, it will signal that U.S. supplies are starting to top out. Combine that with continued robust demand growth and the potential for deeper inventory declines if OPEC gets its act together, and it could shake oil traders out of their slumber. Given the enormous drop in speculative positions, it's possible that oil prices could rally sharply in the second half as traders reposition. It's a rise that would likely take oil stocks up with it, potentially making now a great time to buy top-tier producers as well as service companies like Baker Hughes since they should ride that wave higher.