With little fanfare, crude oil entered a new bull market last week after notching a more than 20% rebound from its bottom in June. Fueling that rally was a noticeable improvement in oil market fundamentals thanks to accelerating demand growth and a decline in supplies, which combined to drain some of the excess inventory. In fact, the market has rebalanced so quickly, that some analysts think oil prices could skyrocket from here, especially if supplies were to tighten unexpectedly.
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That said, while the market's mood is turning bullish, this could be a short-lived high because it's still in a fragile state. Here are three things that might upend the recent bull run.
No. 1: Demand growth decelerates
One of the drivers of the rapid improvement in market fundamentals is surging demand. According to the International Energy Agency (IEA), oil demand grew by a brisk 2.3 million barrels per day last quarter, up 2.4% year over year. Consequently, the IEA upwardly revised its full-year outlook once again and now expects demand to increase by 1.6 million barrels a day this year.
That said, while demand has been unexpectedly robust in the U.S., Europe, and China this year, several factors could slow it down. For example, higher gasoline prices, an economic slowdown, or another devastating string of natural disasters could curb demand, which might cause supplies to start piling up in storage again.
No. 2: OPEC starts pulling back support
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Another significant contributor to the improvement in market fundamentals has been the high compliance rate of OPEC members with their output reduction pledges. Overall, members have maintained an 86% compliance rate, which has kept those supplies off the market and out of storage.
Not all members, however, are pulling their weight. For example, Iraq, Ecuador, and the UAE only met 30% of their pledge last month, which could cause others to pull back their support. Furthermore, the current agreement only lasts through the first quarter of next year. While several OPEC members have hinted that they would support another extension beyond that date, it's no sure thing. That's a concern because the lack of an agreement to limit production might cause members to pump at will, which could quickly push supplies back above demand.
No. 3: Shale drillers quickly reaccelerate
Another important factor fueling crude's rise from the bottom is that shale drillers noticeably slowed down their drilling activities when prices started falling in the second quarter. Whiting Petroleum (NYSE: WLL), for example, announced plans to drop two drilling rigs and only run a four-rig program for the rest of the year. As a result, Whiting's production would only increase 14% by year-end, as opposed to spiking 23%. Sanchez Energy (NYSE: SN), likewise, announced plans to cut its rig count and defer production into 2018. Sanchez Energy said it would reduce its drilling fleet from the eight rigs it had running in late July to five by the end of September. So, Sanchez's goal to boost production up to a range of 90,000-100,000 barrels of oil equivalent per day wouldn't happen until the first half of next year, instead of the end of 2017.
That said, while several shale drillers exercised caution by cutting spending and reducing drilling activities when prices fell, the industry has a history of quickly ramping up when prices rise. Whiting initially planned to spend twice as much this year as it did in 2016. Marathon Oil (NYSE: MRO) also set its spending level at twice last year's mark. While Marathon trimmed its budget last quarter, it has $2.6 billion in cash and no near-term debt maturities, which gives it the financial resources to quickly ramp back up if it wants to accelerate its growth rate and chase the higher prices.
We've seen this all before
Oil prices have run up several times over the past few years only to retreat quickly. More often than not, the cause of the decline has been a gusher of new supplies due to overzealous producers. Investors should therefore remain cautious when buying oil stocks amid crude's latest run-up and stick with top-tier names just in case the market changes its mind once again.
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