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Opinion: Oil in the $30s? It may happen as a ‘short squeeze’ ends

Crude has soared 40% from its low this year, but weaker demand and high production might lead to another leg down

It’s springtime, and the birds are singing, the trees and flowers are blooming, and oil prices are soaring.

On Tuesday, ICE Brent crude hit its 2015 high near $68 a barrel. It’s been a remarkable comeback: Brent rallied 21% in April alone, its strongest month since 2009, and it’s gained almost 40% from its January low just above $49.

The rally has been so powerful that people who called for much lower oil prices earlier this year have been drowned out by a chorus of bulls who say the worst is over for crude.

Not so fast. Sharp countertrend rallies like this are common in extended bear markets. The oversupply that caused crude to tank has eased a little, but Saudi Arabia’s price war against Russia and U.S. shale-oil producers continues.

In fact, despite some slightly improved fundamentals, this rally was likely a reaction to overcrowded hedges against lower oil prices and near-unanimity on the strength of the dollar. Those trades have unwound sharply, so the consensus appears to have swung 180 degrees in the opposite direction.

That’s happening just as gasoline prices may be hitting their seasonal highs and weeks before oil prices usually peak. Too much complacency may surprise the bulls now as much as it shocked the bears back in March.

In short, for those who’ve profited from this rally, it may be a good time to cash in some chips, and there are signs that’s happening: Investors and traders “pulled $672 million from oil ETFs [last] month as of April 29, the biggest outflow in four years,” Bloomberg reported.

Stephen Schork, editor of Villanova, Pa.-based “The Schork Report,” which analyzes energy cash and derivatives markets for professional investors, said the move in oil prices is based on technical and trading factors tied mostly to the strength of the U.S. dollar.

“There is a very strong link between the dollar and crude oil prices. They’re usually in perfect synchronization,” he explained.

Late last year it was received wisdom that because the U.S. Federal Reserve was preparing to raise short-term interest rates just as the European Central Bank was starting extraordinary bond-buying, or “quantitative easing,” owning the dollar (and shorting the euro) was a no-brainer.

Within months, the U.S. dollar index soared from a 52-week low around 78 to top 100 in March. But since then, it’s fallen to 95 or below. That’s just about the period when oil rallied.

“We’ve had a very overcrowded trade in the dollar to an 11-year high,” Schork told me in a phone interview. “Lately, though, the dollar has taken a significant tumble.”

Meanwhile, Reuters reported, “money managers had amassed a record number of short positions in futures and options contracts linked to WTI (West Texas intermediate) by the end of March 17, equivalent to 209 million barrels of oil,” according to the Commodity Futures Trading Commission, and hedge funds’ ratio of long to short positions in oil “was the lowest in 4 1/2 years.”

Something had to give. “In oil, you’ve [also] had an overcrowded trade,” said Schork. “This is a short squeeze.”

The supply-demand imbalance remains, however. In April, the International Energy Association said oil demand should increase by 1.1 million barrels a day in 2015, up from growth of 700,000 last year. Nonetheless, production continues apace, so there is still a global oil oversupply of 1.6 million barrels a day, and it’s not all Saudi Arabia’s fault.

For instance, energy companies have profited from shrewd hedging. In the fourth quarter, Schork told me, many producers took profits from their shorts and hedges “and used the money to re-hedge themselves.”

“They’ve hedged all this production,” he said. “We’re not going to see a significant pullback in production this year, because you have a significant number of producers who are well-hedged.”

As summer-driving season approaches, regular unleaded gas averaged $2.45 a gallon last week, its highest price of the year and up from January’s low of $1.98. Gasoline prices peaked after Memorial Day only three times since 2000, according to NACS, which tracks convenience and gasoline retailing. Oil prices tend to rise into July, sometimes later.

But this year may be different. “Demand will level off … some time in June,” Schork predicted. “Demand is not as strong as it was five years ago.”

“Strong production, reduced demand, and lack of storage capacity could lead to another leg lower,” he added. “We got down to $45 [in WTI]. I wouldn’t be surprised if we got down to the $30s.”

That would be in line with some of the more bearish predictions. So if you were smart or lucky enough to be invested in oil over the past few weeks, it might be prudent to take at least some of your money off the table and get out while the getting’s good.

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