LONDON (Reuters) - Oil prices have been rising gently during the past four trading sessions despite concerns about the continued rise in the U.S. rig count and enormous excess inventories.
Front-month Brent futures prices are up by about $2 a barrel since touching a low of $44 on June 21, which could herald a break in the downtrend that had been in place since late May.
Rising prices most likely reflect hedge funds covering some short positions rather than a fundamental reappraisal of the outlook for supply, demand and inventories.
Hedge fund managers have become progressively more bearish about petroleum prices in recent weeks (tmsnrt.rs/2ti1hd0).
By June 20 hedge funds had amassed 480 million barrels of short positions in the five main futures and options contracts linked to crude, gasoline and heating oil, up from only 350 million barrels on June 6.
Fund managers have only held a larger number of short positions in petroleum once before, in January 2016, when their combined shorts in the five contracts totaled 484 million barrels.
The position in January 2016 coincided with the trough of the oil price cycle and marked the start of the recovery.
The question is whether the large number of shorts now will mark a similar turning point.
In crude, hedge fund long positions still outnumbered short positions by a ratio of 2.1 to 1 on June 20, but this was one of the lowest ratios recorded in recent years (tmsnrt.rs/2shAw3n and tmsnrt.rs/2shpefo).
The attempt to accumulate a large number of long positions tends to push prices higher, while efforts to accumulate short positions has the opposite effect.
But once the positions have been established, the existence of large concentrations of long or short positions and a stretched ratio have often signaled the price trend is about to reverse.
With so many shorts now in crude, gasoline and heating oil, the risk of a short-covering rally when fund managers attempt to lock in some of their profits has increased significantly.
And with relatively few long positions left to close, the downside threat from further liquidation has been reduced.
From a pure positioning perspective, the balance of risks in the oil market has therefore shifted to the upside, with the probability of a short-covering rally now much greater than further liquidation-driven price falls.
The fundamental outlook remains uncertain, meanwhile, with an unsustainable increase in the number of rigs drilling for oil in the United States and doubts about whether global inventories will fall to their five-year average in 2018 and stay there.
If the U.S. rig count continues rising beyond the end of July, oil prices may need to fall further to bring the drilling boom back under control.
In the meantime, however, the huge number of short positions in the market could help to put a short-term floor under prices and potentially trigger a rally.
Editing by David Goodman