Trader Talk

Why we may be moving in the right direction on oil

Workers drill at the Saudi Aramco oil field complex facilities at Shaybah, Saudi Arabia.
Reza | Getty Images

A major factor in the recent stock rally has been the rise in oil. Increasingly, there is hope that the data is moving in the right direction.

Oil prices collapsed last year on: 1) slower global growth, 2) excess global production, particularly from U.S. shale, and 3) the lifting of sanctions on Iranian oil.

Look what we have now. Oil has rallied to just over $40 from $26 a barrel, thanks to:

1) Talk of a production freeze among major producers. This will not reduce supply, but the Russians and the Saudis finally seem to be heeding the call of the Venezuelans and others that they can at least avoid actively making things worse by standing pat on supply.

A major motivation for the Saudis may be the fall in their foreign reserves, which dropped to $616 billion from $732 billion in 2015, according to the IMF.

If implemented, this would be a major change in policy: a few months ago, "market share at any price" was the main priority.

Just on Tuesday, Saudi Arabia said it would participate in freeze talks even if Iran does not participate.

2) A drop in supply, particularly in the U.S., which is another reason Saudi Arabia may be more amenable to a production freeze.

Many have claimed that any rise in oil will immediately be met with a ramp-up in shale production, but it's not clear how rapidly that would occur. Hess' CEO, John Hess, recently noted that there is typically a one-year to two-year lag from the first investment decision to the production of oil, longer than many anticipated. He also said that he was more concerned with managing his balance sheet than growing in a low-price environment.

3) Continuing strong demand for oil and particularly gasoline, at least in the U.S.

4) A notable decline in short positions in oil futures. Many have claimed that the rise in oil is nothing more than a short covering rally; while this is certainly an important factor, long positions have also increased, suggesting at least some are betting that some kind of bottom has been put in.

5) Iran supply has come on the market but perhaps more modestly than government projections.

Certainly, there are still tremendous issues. U.S. commercial crude stocks, for example, still stand at 523 million barrels, historically high for this time of year.

And oil is certainly being helped by the weak dollar, which could reverse at any moment.

But looking at the overall trend — slightly higher demand and lower supply, and you cannot help but think we are at least moving in the right direction.