PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
212-778-1000(March 27, 2000) ENERGY COMPLEX: CRUDE OIL--The "O" word has the whole market on edge, but we probably shouldn't curse the group until we hear what they say following Monday's big meeting. OPEC was surprisingly tight-lipped last week about their production intentions. The uncertainty led to a lot of options plays late last week as traders likely were hedging against various outcomes of the OPEC meeting.
OPEC's Economic Commission Board (ECB) finished analyzing global supply and demand on Thursday in preparation for the full meeting on Monday. However, current price levels ultimately will determine the size of the production increase. Based on previous statements, OPEC would like crude oil prices to be between $20 and $25 per barrel. If futures prices are already at $25, OPEC might not increase production at all. Conversely, if futures move back to $32, OPEC might want to increase output by a large amount. Officials have commented that they do not want to include "cheating" barrels in a production increase. Obviously, we will be reading closely any statements from OPEC after the meeting to see exactly what will change.
As far as the United States is concerned, Mexico could be a favorable wild card. Mexican Energy Minister Luis Tellez has said Mexico will increase production, independently from OPEC if necessary, and most of those barrels will come to America. The United States also has worked itself into a better spot with the Iraqis. If the United Nations approves measures on Monday to double funding for Iraq's faltering oil infrastructure, more oil ultimately will be exported. As we see it, the worst-case scenario would be if OPEC does nothing. Still, Mexico, Iraq and possibly Norway could make a small difference in terms of increasing the supply of oil. Under that scenario, we would expect crude oil to make new highs. It is very likely that OPEC will make a conservative production increase because it is easier to make up a shortfall by overproducing than it is to curtail production again. U.S. Energy Secretary Bill Richardson has asked for a net increase of 3 million barrels per day. We think that looks like a good number, and will use it as a basis point by which to measure the actual number that OPEC announces.
Cash prices for sweet crudes yo-yoed last week as the North Sea and Nigerian arbitrage windows have been slowly closing. April futures went off the board on Tuesday very weakly. At one point, the April/May spread was down 200 points, causing both arbitrages to lose $2.00 in value and effectively closing the North Sea arbitrage. Louisiana Light Sweet (LLS), the domestic equivalent, has gained a lot of territory versus WTI as refiners are forced to look to domestic markets. The latest report from the American Petroleum Institute (API) showed refinery operations above 90%, and that number should keep creeping toward 95%. Refiners will continue to buy North Sea Brent, Nigerian Bonny light or LLS depending on economics.
We have covered our long put position and recommended that any outright short positions be covered as well. We will remain on the sidelines until OPEC comes out of its meeting this week.
GASOLINE--Gasoline futures have managed a strong independent recovery in recent sessions due to several reported and rumored refinery problems. However, the spot gasoline markets at both coasts have been described as routine, with supply and offtake apparently in relative balance. Futures-grade product has traded about even with the screen, and the April contract appears poised for an uneventful expiration on Friday. However, the market will be looking for indications of a successful restart at Exxon's huge Baytown, Texas refinery over the March 25-26 weekend. A successful resumption of activity at this facility likely will place downside pressure on spot gasoline values.
We are looking for an OPEC-related price advance this week for an opportunity to establish short positions and/or back spreads, such as long September/short May.
HEATING OIL--The heating oil market firmed last week with the help of several reported refinery snags. While the refinery problems provided a boost to April values relative to the deferred contracts, we believe the April/May switch has stretched too far in view of last week's softening in the cash basis. Spot quotes at New York Harbor (NYH) are holding a small 25- to 50-point premium to the April contract, and a routine expiration of the April contract appears likely at week's end.
Supplies appear ample now that the dust has completely settled from last month's East Coast supply dislocations and related upward price spike. Stock draws during the last three weeks have fallen short of usual declines for this time of year. At about 103 million barrels, distillate stocks are only 2-3 million barrels below the 15-year average for mid-March. Given our expectations for a strong recovery in refinery activity during the spring, supplies should be restored to normal spring levels by mid-April.
We continue to look for the heating oil market to hold up better than gasoline during the coming weeks as refineries place heavy emphasis on gasoline output at the expense of heating oil production. We would suggest holding long heating oil/short gasoline spread positions in the May contracts. On an outright basis, we look for heating oil to take its cue from the crude oil market during the next few sessions as the complex attempts to discount the size of an expected OPEC production increase.
NATURAL GAS--Taken at face value, the supply/usage picture for the 1999/2000 winter looks average at best, but that is not the case. Total supplies in 1999 rose by 1.9%, or 409 billion cubic feet (BCF) versus 1998, and consumption rose by 0.4%, or 94 BCF. The supply/demand picture for this winter looks balanced, but there have been some important fundamental differences compared with last winter. Domestic production in 1999 was 0.1% greater than in 1998, yet imports rose 13.2% versus 1998. In the fourth quarter of 1999, imports rose 17% versus a year earlier to bring annual imports to a record 3,389 BCF. From 1986 to 1999, imports have increased at an average rate of just over 208 BCF per year. The Energy Information Administration (EIA) is predicting first-quarter 2000 imports at a record 925 BCF with lower-than-average storage levels. The result should be higher storage refill in the spring and summer, causing higher prices.
Larger-than-normal nuclear power plant turnarounds and near-normal temperatures so far this year have strained early storage injection attempts. Weather forecasters are calling for higher-than-normal temperatures for both coasts and the southern third of the United States from June to August. Summer cooling demand has been a concern in the gas markets, and recent forecasts have become increasingly bullish. Weather experts also have been calling for a "good" hurricane season (assuming of course, that you are a hurricane follower, not a resident along the lower eastern seaboard, the Gulf Coast, or the Caribbean Islands). An above-normal number of hurricanes this year could cause havoc with the natural gas market. Even if a hurricane doesn't make landfall, offshore operators will shut in production and batten down if they feel their rigs are in danger.
Relatively low storage levels and increased summer cooling demand already have been priced into the market. The next big test will be how much lower storage levels can fall. Weather patterns into mid-April call for above-average temperatures for most of the country, which may allow for early injections. By mid-April, we will be waiting to see how high temperatures will climb in the early summer. This wait-and-see mode already has been reflected in the market's recent sideways trade. Neither cash nor futures can find clear direction, yet the market is capable of moves of 5 cents per million Btu without batting an eye. As a result, we have moved to the sidelines.
Jim Ritterbusch and Aaron Kildow
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