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212-776-1000(March 13, 2000) ENERGY COMPLEX: CRUDE OIL--Volatility was the market's most consistent feature last week as prices responded to an apparently united OPEC. Indeed, implied volatility rose above 50% for the first time since last March. Last Wednesday, OPEC suggested it would start increasing output in April, prompting an exaggerated market sell-off. Now the burning question is: How much will output rise? We see nothing to suggest that OPEC has a specific number in mind and probably will wait until its March 27 meeting to start discussing it seriously, with the price of WTI and Brent at the time playing a significant role in the final decision. We think that if WTI prices stay below $30.00 per barrel, OPEC will increase output by only 1-1.5 million barrels per day (MBD). If WTI prices stay above $30.00, OPEC will be forced to increase production by 2-2.5 MBD. We believe last Wednesday's $3 sell-off was overdone considering the amount of news, and such a downmove ahead of the OPEC meeting in two weeks could have adverse long-term effects on the market because it may lead to a less-than-desirable cut in output.
Recent polls suggest that OPEC compliance with its current cutback plan has been slipping lately. Reuters reports that compliance has slipped to 67%, which would mean an extra 1.4 MBD is being pumped into the world market compared with the target of 23 MBD. Meanwhile, WTI and Brent are making record highs. The latest American Petroleum Institute (API) report revealed an increase in imports of 1.6 MBD, a rise that is surprising even though we have been expecting more oil to arrive in the United States from Nigeria and the North Sea. Unfortunately, the API data does not reveal the origin of imports, but we have to presume that some of it is from OPEC because an output increase of 1.4 MBD doesn't just disappear.
Crude oil will continue to lead the complex for the time being as the API report showed gasoline supplies at higher-than-expected levels. Thus, traders can now focus solely on crude oil and what OPEC will do at its end-month meeting. Even with the strong downmoves last week, the bullish trend was not broken. As long as the uptrend line is not violated (break below $30.25), prices could test their highs again on the back of bullish headlines. We recommend taking a short position only on a sustained break below $30.25.
GASOLINE--The gasoline market generally has followed crude oil prices in recent sessions. However, the supply situation appears to be loosening even more than in the crude oil market. The impact of various refinery snags in early March has been mostly diffused as affected facilities have generally managed successful restarts. The most recent API/DOE statistics also eased concerns over potential supply tightness as stock increases of 4.0-4.5 million barrels easily exceeded expectations and boosted supplies toward their highest levels since October 1999.
Much of the stocks build was attributable to strong upswing in production. At 7.92 MBD for the week ending March 3, gasoline output was at its highest level since mid-January. While production is expected to level during March, we still anticipate a record rate for the first quarter; our projected pace of almost 8.0 MBD exceeds last year's comparable level by almost 3%. We expect further strong increases in refinery runs during the spring as more refiners come out of maintenance and as much-improved margins, particularly on the gasoline side of the product slate, provide economic incentive to produce gasoline product.
Assuming that refinery snags are not inordinately severe in the coming weeks, we anticipate a strong recovery in gasoline production into April. We expect this year's March-April production hike will be above average and in line with last year's increase of about 0.6 MBD, or roughly 8%. Such an upswing in output would tend to keep gasoline stocks concentrated in the 195- to 200-million-barrel range during the next couple of months. Although supplies in this range at the beginning of April would be below the five-year average of about 207 million barrels, such a level is not unprecedented for the start of the second quarter and likely will be viewed as ample in view of unused refinery capacity.
The spot market has shown reluctance in following the screen higher in recent sessions. The switchover from winter- to summer-grade specifications has resulted in a surplus of winter product, which has dropped to discounts of 2.00-2.50 cents per gallon for the NYMEX deliverable RFG product. In contrast, summer-grade product has been trading at a slight premium to the April futures.
Although gasoline remains in a decided uptrend from both a short- and long-term vantage point, we anticipate a more two-sided trade during the next two weeks as the OPEC meeting approaches. Previously suggested upside possibilities in the $1.06-$1.11 zone per nearby futures now appear out of reach. A test of last week's highs ($1.025) remains possible, but is contingent upon a rebound in crude oil prices to new highs or another spate of refinery outages. We still consider the gasoline crack spreads as excessive in view of underlying fundamentals. On an outright basis, we are still bullish, but would abandon this stance on a trendline violation in the 92.00-cent area, basis April.
HEATING OIL--The heating oil market continues to seek price direction from the rest of the complex as last month's supply tightness has eased and distillate demand makes the seasonal transition from heating fuels to increased focus on the diesel market. Distillate stocks failed to post a normal seasonal decline in the latest reporting period. The distillate supply deficit against the five-year average has narrowed to less than 12 million barrels from about 20 million barrels a month ago. However, a significant drop in distillate imports to 227 MBD suggests that the impact of last month's gas oil influx into the East Coast has been fully absorbed.
The spot heating oil market remains under pressure, with spot premiums versus April futures dropping to about 4.50 cents per gallon at the end of last week from as much as 8.00 cents at the beginning of the week. We look for these premiums to contract another 1-2 cents in this week's trade as more East Coast refineries return from maintenance and as weather-related consumption becomes less of a market factor. Heating oil differentials for prompt barrels in the Gulf Coast region also appear soft despite good agricultural demand for the diesel product.
The heating oil market appears to have established a high at the 82.70-cent level. However, longer-term uptrends remain intact. This market is low-priced relative to the rest of the complex. While we believe it is premature to consider purchases of heating oil against sales of crude oil or gasoline, traders who have been short heating oil in the intercommodity spreads should consider moving to the sidelines.
NATURAL GAS--As warm weather helped quell demand, the producing region managed to inject supplies, resulting in an American Gas Association (AGA) stocks number, reported last Wednesday, well below the five-year average. Higher-than-normal temperatures remain in the forecast through month's end, so withdrawals should remain below average. Storage supplies remain below the five-year average. Commercial traders are still planning for stronger-than-normal summer demand, which is providing strength to the front half of the curve.
Given that domestic production has slowed and U.S. dependence on imports has risen, there are some dark clouds on the northern horizon. Although Canadian producers were able to increase exports by 20 trillion cubic feet in 1999 versus 1998, two factors threaten Canada's ability to keep up the pace. The more serious factor is the difficulty in moving rigs to more efficient locations. Much of Canada's producing regions are frozen in the winter, which provides vehicles with a firm foundation. Once those fields start to thaw, they become swamp-like, with sticky mud that can make moving rigs around very difficult. A second factor is the decline in rig counts. According to the Canadian Association of Oil-Well Drilling Contractors (CAODC), rig counts at the end of February had fallen to 550 from 561 out of an available 598 rigs in the area. As a result of declining rig counts and increased exports, working gas storage in Canada has dropped dramatically versus a year ago. Last week's storage number was only 32.5% of capacity, or 184.6 billion cubic feet (BCF). Import prices have been rising and will continue to do so as stocks tighten.
The increased construction of natural gas-fired power plants means natural gas production needs to keep up. In previous years, natural gas supplies built up during the summer in preparation for winter, but the summer demand picture is changing. Electric companies Duke Energy and Dynergy Power Marketing are planning on natural gas-powered generation capacity of about 85,000 megawatts (combined) in the next four years in a move away from more traditional sources of electrical generation.
Natural gas has proven that it is not dependent on the oils for direction. Even with bearish weather and a weakening heating oil market, natural gas prices have remained strong. Last week's close above $2.77 per million Btu, basis April, will allow a test of $2.88 and perhaps $2.90.
Jim Ritterbusch and Aaron Kildow
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