Is there a short squeeze on West Texas crude oil prices?

It’s been a bit of a rollercoaster ride in the oil market over the last week. West Texas crude prices have risen to their highest in more than a year on Thursday on what is suspiciously looking like a short squeeze. Some profits have been taken off the table Friday morning but the squeeze has not fully played out yet.

So what is going on with oil markets?

There is some genuine fundamental tightness in the market which started forming in early September when Saudi Arabia caught the market slightly off guard with plans to extend its current production cuts for another three months. Russia followed suit, with a matching supply restriction.

And if you think that Western sanctions have slowed down Russia’s crude exports, you would be wrong. It is just that the oil is flowing East rather than West. Recently, premiums on Russia exports to countries like India have been rising despite the fact that, in theory, there is a cap on Russian oil prices.

On the demand side, a slight pickup in the US economy has bumped up domestic demand and has lead to higher drawdowns of physical oil stocks from storage locations across the US.

What stands out is that stocks at Cushing in Oklahoma, a key delivery point for US oil futures, have been withdraw at a significantly faster rate than elsewhere.

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Lower oil stock levels and a rising demand for short term deliveries of oil have primarily affected the price of West Texas Intermediate crude.

Although Brent crude prices initially remained lower, arbitrage opportunities between WTI and Brent crude have quickly returned the price differential between the two contracts back into its usual range. Before profit taking set in WTI prices spiked to almost $94 a barrel. Brent crude followed suit, rallying to within a whisker of $97/bbl.

Normally oil futures price for dates three, six, nine months, twelve months or further out are higher than nearby delivery dates because they include not only the price of oil but also the cost of storage. The physical tightness in Cushing has instead created backwardation, that is, nearby prices are higher than prices for future dates. This premium for nearby dates over the six months ahead is at $10 compared with around $4 at the start of the month, and a discount of 90 cents earlier in the summer.

Is there a WTI short squeeze on at the moment?

The Saudi production cut extension has triggered withdrawals across the US and in key demand locations in Europe and Asia, but withdrawals in Cushing have been far higher, consistent with a short squeeze. A sum total of 21 million barrels have been withdrawn from that location since 23 July, with drawdowns taking place in 12 out of last 13 weeks.

Stocks in Cushing account for only about 10% of all the stocks in the US yet the decline since July makes up around 60% of all the withdrawals since that period.

Looking at the Commitment of Traders report the likely recipients of the squeeze are hedge funds with short positions in nearby contracts. Their positions have recently been cut to 20 million barrels from 136 million in July. If this is a case of a short squeeze playing out the much higher price for nearby dates is likely to last until the current front month contract expires on 19 October. Or until reserve level of oil stocks in Cushing start to rise.

This is not to imply that investors are mostly on the short side of the oil trade. They are not. Hedge funds and other money managers have bought the equivalent of over 25 million barrels of oil over the seven days ending on September 19. Investor buying has now slowed down as most of the short positions have now been covered.

With the winter drawing closer in the western hemisphere demand for crude oil and oil products will start picking up. While supplies are being kept on a tight leash by OPEC & Co. there is little scope for a series withdrawal. But over the next few weeks we are likely to see the price premiums in the futures markets being rearranged, leading to some short term volatility.

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