What: Oil stocks zoomed higher today thanks to a 4% rally in oil prices. That fueled a pretty big short squeeze in the energy sector, which drove SM Energy (NYSE:SM), Encana (NYSE:ECA), Murphy Oil (NYSE:MUR), Northern Oil & Gas (NYSEMKT:NOG), and Chesapeake Energy (NYSE:CHK) all up double digits today.
So what: The price of oil capped a strong week, rallying 9.5%, to close at nearly $36 per barrel. This is due to the view that production in the U.S. is about to head meaningfully lower. It's a view that was further confirmed by data from an oil-field service company today, which showed that the U.S. rig count fell by eight more rigs this week, putting it within one rig of a low not seen since April of 1999. With so few rigs currently running, oil companies can't maintain their production levels. That's good news for oil prices, because falling supplies will enable the market to work off its oversupply.
Short-sellers, however, saw this as an ominous sign. Higher oil prices suggest that oil company cash flows will head higher, meaning that the sector might not see the bankruptcy wave they'd been betting on. Investors bet heavily that companies like Chesapeake Energy, Northern Oil & Gas, and SM Energy could be headed to zero. That's evidenced by the fact that almost 44% of Chesapeake's stock was sold short, with shorts also making big bets against Northern Oil & Gas and SM Energy, which had 30% and 25%, respectively, of their stock sold short according to the most-recent data. Meanwhile, investors had also sold a meaningful amount of Encana and Murphy Oil stock short. These short-sellers, however, are now being forced to reverse these short bets, which is leading to heavy buying and scorching stock prices.
Now what: After beating down oil stocks for quite some time, the market is taking a breather. That's forcing short-sellers to run for the exits because they're growing worried that the rally in both the price of oil and the stocks of their short targets could continue.
They were short these stocks for a reason: All have significant balance sheet issues that still need to be addressed. Further, these companies also need to see oil prices rally a lot more until they hit the point where their operations would again be on firmer footing. In other words, they are not out of the woods just yet.