wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza,
New York, New York
(June 9, 1997) CRUDE OIL: Crude oil prices are poised for consolidation
and possible recovery following last week's drubbing by commodity funds
and speculators who covered long positions. In addition to an increasingly
negative technical picture, expanding crude oil and product inventories
as well as the United Nations' renewal of the Iraqi oil-for-food agreement
were behind the heavy liquidation.
The bearish fundamental picture remains intact for the petroleum complex,
partly due to our negative opinion of the U.S. products market. Healthy
margins continue to provide U.S. refineries with the economic incentive
to hum at high operating rates, thereby absorbing crude oil supplies. What's
more, crude oil inventories continue to rise (especially in PADDs I-IV),
despite the insatiable appetite of domestic refiners. Those four districts
have a 15.0- million-barrel surplus relative to 1996, and the upward trend
in stocks remains firmly in place.
With refinery utilization rates approaching maximum levels, physical crude demand has no where to go but down, thus it seems likely that U.S. crude stocks will rise further. The high levels of domestic refinery output and product imports portend a further contraction in the crack spreads. Lower cracks eventually will rein in utilization and result in crude oil demand cut backs.
We recognize that a narrower Brent/WTI spread (currently at about $1.10
per barrel) and a recovery in European refining margins should limit exports
to the United States. However, weakness in Asian refining margins has continued
(even though refinery maintenance is peaking), thus the lower level of
profitability should keep crude oil demand in check. Overall, we expect
U.S. crude oil imports should remain between 8.0 million and 8.6 million
barrels per day (BPD). Looming production increases from Colombia and fewer
maintenance shutdowns in the North Sea also should mitigate the impact
of future demand increases from Asia as that region completes its refinery
maintenance schedule and summer weather increases cooling demand.
The United Nations approved renewing the Iraqi oil-for-food agreement without any changes to the dollar and volume limits, originally set at $2 billion (plus $140 million for Turkish pipeline charges) for six months. The only surprise was that the United States did not voice any significant complaints or try to prolong the approval process. At current prices Iraq mill be able to export 650,000-700,000 barrels per day. Exports will be closer to 700,000 barrels if crude oil prices continue to fall.
We do not envision any surprises at the upcoming OPEC meeting beginning June 25. However, OPEC oil ministers typically reiterate the need for lower output and price stability, and those comments have a tendency to encourage buying that could support a short lived rally. A sustainable rally would materialize only if quotas are actually cut, and this appears highly unlikely. If oil prices remain on the high side of historical ranges (i.e., WTI at about $19-$20 per barrel), we doubt OPEC members will complain too much about quota violations, at least not publicly. Consequently, expect a quiet meeting and that existing quotas will be continued. However, the meeting could be contentious if global prices drop significantly below current levels, i.e., WTI at $17-$18.
Because prices already have eclipsed the March lows at $18.86, some consolidation is probable while the bulls lick their wounds and digest recent losses. However, so far, there are no clear signs that the market has bottomed, but do not rule out a bullish correction that could lift July crude oil futures to $20.00.
Welcome such levels with new short positions, looking for an objective
of $19.25. Employ stop-loss protection at about $20.25, ratcheting down
accordingly as prices fall.
GASOLINE--Although gasoline stocks remain below year-ago levels, the gap is slowly closing with the Department of Energy (DOE) indicating total supplies now lag by just 4 million barrels. With most refineries maximizing output by running at more than 98% of capacity, amidst only slight margin deterioration, gasoline production has risen sharply. Mounting crude oil supplies have tended to negate the bullish impact of higher refinery runs on crude values. As a result, crude oil prices have generally kept pace with product values amidst the recent price slide.
Eventually, product supply will become sufficiently burdensome to reduce
margins, a scenario that unfolded in each of the last two summers. In the
meantime, the upswing in gasoline production is almost keeping up with
a strengthening pace of demand. Demand rose about 1% during the first five
months of 1997 compared to the same period in 1996. What's more, 99% of
gasoline demand in May was met by domestic production, up from 96% the
previous year. Thus, May's gap between demand and production is estimated
at only about 80,000 BPD versus 300,000 BPD a year ago. This supply gap
is filled by imports, and usually at this time of year, imports do an efficient
job of closing the gap without significant overages. However, this year's
exceptionally strong import pace could boost stock levels significantly
more than in recent years. If imports maintain their April-May levels during
June and July, gasoline stocks could build by as much as 2 million barrels
per week unless the demand/output ratio falls.
We continue to look for gasoline prices to respond more to the dynamics of higher production and import levels rather than low stock levels. While we maintain our bearish trading posture, we recommend caution in establishing new short positions because July prices have reached our downside target of 59.00 cents per gallon.
Alternatively, we would advise long August crude oil/short August gasoline spread positions near current levels of $4.85 per barrel in anticipation of an eventual contraction toward $3.50.
HEATING OIL--Despite out-of-season vigor,
we remain bearish on the distillate market and contend that it will become
the weakest component of the complex in coming weeks. Besides the obvious
seasonal considerations, heating oil should feel the pressure from ample
supplies and above-normal stock additions. We expect supply will outstrip
demand throughout the summer, even though heating oil demand stayed strong
due to the cool spring and diesel consumption is robust from steady railroad
and agriculture usage.
Our bearish opinion stems from the lofty utilization rates brought on
by relatively high refining margins. As refiners continue to take advantage
of the healthy crack spreads (especially in gasoline), distillate heating
oil output will remain high. It would be wise to remember the old adage
"you can't make gasoline without making distillate."
The American Petroleum Institute (API) and the DOE showed stock additions
last week, a trend the market should expect for the rest of the summer.
The year-over-year surplus, now at 12.0 million barrels, continues to grow,
and total distillate inventories are rapidly approaching 1995 and 1994
levels. Count on further additions in the next several inventory reports.
However, the increases should not be as high at the 5.0-million-barrel
amount witnessed last week.
Previously stated price targets have been achieved. Therefore, we would
await significant price rallies to establish new short positions. In addition,
we continue to recommend shorting the August heating oil crack spread.
NATURAL GAS--Prices moved slightly
below our trading range target ($2.10-$2.40 per million Btu) last week,
when July dipped to $2.08, as mild weather and negative technical signals
encouraged selling. Prices stabilized late in the week, and a bullish sentiment
appears to have returned.
We believe weather will be the key price determinant for natural gas prices this summer because demand and supply were well balanced during the during the spring shoulder months. Given the recent sell-off, the risk seems greater for price increases rather than declines. Storage injection demand should provide a floor at about $2.10 ($2.00 if summer cooling demand remains below normal), because the wide winter/summer spread (30- to 35-cent premiums in the December and January contracts) economically justifies refills.
In addition, weather conditions (air conditioning demand and hurricane
threats) should help expand the bullish sentiment. (According to the latest
6- to 10-day forecast, temperatures are expected to head higher late this
week.)
We favor a bullish trading posture. Look to buy July natural gas on
dips that push prices down to $2.10. We look for prices to advance to the
mid- to high-$2.20's. Protect positions with a stop at $2.04. This week's
American Gas Association (AGA) report should show another increase of nearly
100 billion cubic feet in storage gas, given the unseasonable weather.
If a sell-off ensues, use it as a buying opportunity.
Selling the winter spread (buying July and selling December) is both
less risky and less costly than taking an outright position. The winter/summer
spread currently stands at a July discount of 30 cents. The spread could
move to a July discount of 15 to 20 cents if July rallies as we expect.
If the spread exceeds 32 cents July discount, there is downside risk
to a 35-cent July discount.
Rich Redash and Jim Ritterbusch
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