Last week, crude oil rallied the most so far this year, gaining more than 8 percent, or $4 per barrel. Oil traders are much more optimistic than they were just a month ago, and the market is on the upswing. However, the rally could run out of steam in the not-so-distant future, a familiar result for those paying attention to the oil market in the last few years.

There are several significant reasons why oil prices have regained most of the lost ground since the end of May. First, the OPEC cuts continue to have an effect. We can quibble over the degree to which OPEC members are complying with their promised cuts, but the cartel is taking more than 1 million barrels per day off the market, with a small group of non-OPEC countries contributing about half as much in reductions. As time goes on, that will help narrow the imbalances.

Second, U.S. shale is showing some signs of slowing down. There are a variety of reasons for this, including fear of another price downturn, more caution from oil companies themselves and even a bottleneck in drilling services. But the bottom line is that we can’t simply look at the shale rebound that we saw in the first half of the year, and extrapolate that into the future. There is a good chance that things start to slow down from here, and the market is starting to wake up to that fact.

Another reason oil prices bounced last week was because several OPEC members promised deeper cuts. Saudi Arabia said that it would cut exports by another 600,000 barrels per day. The de facto OPEC leader will also be specifically curtailing exports to the U.S., which will help drain inventories. In the ensuing days, the UAE and Kuwait have also pledged to cut their output further.

"Fundamentals continue to suggest a more-balanced crude-oil market," said ANZ. The bank, along with other investment banks, are eyeing the shift in the futures market towards backwardation – a situation in which front-month crude futures trade at a premium to oil futures further out. Backwardation tends to signal near-term market tightness, a measure of bullishness that the oil market has not seen in quite a while. Backwardation suggests demand is strong and it also signals greater inventory drawdowns are coming down the pike.

The final and arguably most important reason for the latest price gains is the sizable drawdowns in U.S. crude oil inventories recently, a tangible signal that the market is finally rebalancing. Last week saw the biggest draw yet, with more than 7.2 million barrels taken out of storage.

But even as the oil market is suddenly looking a lot tighter than it did in June, there are also reasons to believe that the rally is running out of room.

Inventories are still high, and not just in the U.S. Also, while shale is slowing down, the U.S. is expected to add more output. Then there are other producers outside of the U.S. adding new supply. "We believe the latest price rise is on a fragile footing," analysts at Commerzbank wrote in a note, pointing to higher forthcoming production from Libya and Nigeria. "I don't see the physical market getting all that much better. There's still a lot of crude that's unsold, still a lot of Nigerian barrels floating out there," John Kilduff, founder of Again Capital, told CNBC.

There are also reasons less to do with the fundamentals and more related to the financial market that point to limited upside potential. The surge in oil prices over the past month has corresponded with a shift towards bullish positioning among hedge funds and other money managers. But the net-long positioning, as Reuters notes, has more to do with a liquidation of shorts rather than a major accumulation of long bets. That may seem like a trivial distinction, but if hedge funds are not scrambling to buy up long bets, that suggests that they are not all that confident about further price increases in the near-term.

Meanwhile, the oil market probably needs a breather after the gains since June. Matt Smith of ClipperData cites the fact that oil prices have surpassed their 200-day moving averages, which will make it more difficult for crude benchmarks to move even higher. "From a technical perspective, it seems as though this rally should be done," Smith told CNBC.

The one variable that could upend all market forecasts is Venezuela, which has been in economic turmoil for quite some time but is entering a new phase of crisis. The involvement of the U.S. government, which is retaliating against Venezuela for what it argues is a step towards dictatorship, threatens to accelerate the oil production declines in the South American nation.

If Venezuela sees its exports disrupted in a sudden way, the ceiling for oil prices in 2017 could be quite a bit higher than everyone expects at the moment. Otherwise, there is not a lot of room on the upside for oil prices in the short-term.

Link to original article: http://oilprice.com/Energy/Oil-Prices/This-Oil-Price-Rally-Has-Reached-Its-Limit.html

By Nick Cunningham of Oilprice.com