The short covering rally in the crude oil complex continued for yet another session on Tuesday but seemed to be cut short in early overnight trading after a bearish API oil inventory report released late Tuesday afternoon (see below for more details on the API report). The market has been in a three day short-covering rally on the growing view that the market may have bottomed as oil production cuts will likely follow the decline in U.S. drilling rigs.

Based on my analysis and model runs I do not see any cuts in U.S. production happening until the second quarter at the earliest. That said for all of the reasons I discussed in Tuesday’s newsletter we may not see any cut rather a leveling of production by the middle of the year.

If you accept the fact that the global surplus of oil is in the vicinity of 1.5 to 2 million barrels per day a simply leveling of U.S. production is not going to change the overall supply and demand balances enough to eliminate the surplus and bring supply and demand back in balance. Thus I still think that for any assurance that we have hit bottom will come when we see a clear path to supply cuts from some combination of OPEC and non-OPEC countries in the magnitude of what the aforementioned surplus is running at.

The above chart shows the market remains surplus and inventories will continue to build as the Brent and WTI forward curve remain in a wide enough contango to justify storage trades. I do not think we formed a bottom yet and I believe the market still has downside exposure, That said while the market is in this short covering rally it is prudent to adjust any short positions to be in sync with the market move in the short term. I view this as a short covering rally in a broad bearish market.