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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 3, 1997) ENERGY COMPLEX: CRUDE OIL–The petroleum market remains on razor's edge due to Iraq's defiant attitude toward U.N. sanctions. The bears stand to lose a lot of blood if the situation results in a halt to the oil-for-aid export program. We believe such a development probably would result in a crude oil rally of at least $2.00 per barrel, especially because it would come at a time coincident with the beginning of winter in the northern hemisphere. However, there is considerable risk for the bulls as well if the situation ends diplomatically.
Prior to the latest round of Iraq developments, the market appeared ready to move more firmly into its earlier $19.00 to $21.00 trading range. Maintenance schedules and margin pressure have curtailed refinery operations in the United States, leading to a rise in inventory. Indeed, the reduction in stocks reported last week was the sole function a reduced refinery demand. Imports have been below 8-0 million barrels per day (MBD) according to the two most recent American Petroleum Institute (API) reports. Given the likelihood for imports to rebound, a period of rising stocks is probable. In addition, global crude oil production from both OPEC and non-OPEC sources continues to show signs of rebounding after nearly a year of stagnant comparisons. Lower demand and higher supply should work against higher prices.
As for the turmoil across the world's financial markets, the situation does not bode well for Asia. Currency troubles in Asia likely will result in lower economic activity within those nations, and that may carry over into their trading partners (e.g., Japan) as well. Some have suggested that growth rates of non-OECD Asian countries, recently at 7% to 8% annually, may be shaved in half. The related reduction in crude demand will cause supplies to back up and result in higher inventories and lower prices, but this is a longer-term concern.
Iraq appears to have backed itself into a corner. By ordering all American U.N. representatives out of the country with much fanfare, it would be hard for Saddam Hussein to swallow his pride and retreat from this position. Because Iraq may stand firm despite the “consequences,” it appears that the export deal is in jeopardy. Iraq will pay a cost for its defiance–the loss of humanitarian aid used to help the Iraqi people. Sadly, the people's blame for this development and their related anger would be aimed at the United States rather than their own government. In many ways, the current situation parallels that in Germany during Hitler's rise to power between the two World Wars. Additionally, Arab sentiment appears to be slowly turning in favor of Iraq and against the United States. The bottom line is that it appears Iraq can forego oil exports if it has to, despite the negative impact it would have on that country's citizens. However, the United States would still be hard-pressed to justify military action in the eyes of the global community.
The fate of the crude oil market now lies in the hands of Saddam Hussein, and that is not very encouraging for the bears, given his penchant for what often appears to be irrational actions. Consequently, a wide swinging and volatile trade is expected in both crude oil and product futures this week. We are maintaining a bearish opinion on crude, but recognize the bullish consequences associated with a curtailment of Iraq's exports. As a result, we recommend using spread positions to limit the risk of the market moving the “wrong” way. We advise a bear spread that entails selling December and buying May on rallies that widen the backwardation to 50 to 60 cents, December premium. We anticipate the market will move into a more solid contango structure once the Iraqi situation settles down assuming the export program remains intact).
PRODUCTS–The product markets also will continue to be jostled by Iraq issues, even though crude oil will remain the primary beneficiary. Gasoline and heating oil will exhibit independent strength if refinery operations (and thus product output) drop further in coming weeks. The implied crack spread margins (based on the December NYMEX contracts suggest refinery crude runs will rebound; the 3:2:1 crack is still at about the $4.00 per barrel mark. Colder-than-normal weather also will lend support to heating oil futures.
GASOLINE–Gasoline continues to garner a more bullish following than heating oil. Most recently, the reduction in gasoline production to 7.8 MBD has encouraged fresh buying in the futures market and stabilized prices in the cash market. Nevertheless, with finished gasoline imports likely to remain in the 0,3-0.5 MBD area and demand headed below the 8.0-million-barrel mark, the weight of increasing inventories should result in futures price pressure. The recent period of contango pricing suggests the market is expecting a loose supply/usage balance over the next several weeks. Additionally, the premiums that had been attached to cash market barrels all summer and fall are now a distant memory.
Selling gasoline outright appears too risky in light of the Iraq/United Nations turmoil. Instead, we favor the low-risk, long-term bull spread using the December and February contracts. This trade will benefit from an escalation in the Iraqi situation, as well as from any refinery problems. Look to buy December and sell February when February is offering a premium or 0.5 cents per gallon (or better).
HEATING OIL–Heating oil continues exhibiting weakness in relation to the rest of the complex despite the more favorable seasonal forces working to its advantage. (With the gasoline/heat spread still favoring gas, we can discern the market's opinion of the two products.) We expect heating oil futures to remain the weak leg of the group.
Heating oil futures are in desperate need of colder-than-normal weather in order to work off the high stocks being held in both primary and secondary tanks. The regularity in which cash quotes are discounted to the “screen” suggests supplies are more than ample. While cash prices firmed late last week ahead of the November contract expiry, this appeared to be the result of actions by those wanting to hold supplies in hopes of higher prices later in the year. Such an outlook appears likely only if Iraqi tensions mount and/or colder-than-normal weather materializes. The ongoing carrying charge price environment is encouraging such a position, but neither bullish expectation (Iraq or weather) is particularly certain.
Action in the cash market should prove interesting and insightful this week as pressure on the physical market in relation to NYMEX heating oil deliveries should determine the near-term fate for futures unless Iraq continues to cloud the market's underlying fundamentals. We anticipate weakness due the apparently ample supplies.
Further price gains in heating oil futures still appear highly contingent upon strength in the rest of the complex. The December contract appears likely to push through the 60.00-cent- per-gallon mark solely on Middle East tensions. If the situation escalates, a move to 63.00 cents is possible. However, assuming stable-to-weaker crude oil values (and thus, an easing in relations between Iraq and the United Nations), we expect the nearby heating oil contract to head toward the 58.00-cent area. In light of the uncertainty surrounding Iraq, we suggest a sideline stance in this market.
NATURAL GAS–Strong downward price pressure from long liquidation ahead the November contract's termination appeared to have rattled the bullish confidence in the natural gas futures market. Also, the lack of any buying interest after the “bullish” American Gas Association (AGA) report reaffirmed our opinion of growing negative sentiment. The price charts suffered considerable technical damage, and time will be needed to turn that around.
Natural gas held in storage should have reached about 2,850 billion cubic feet (BCF) by the official start of the heating season on November 1. Such a level would be about 125 BCF ahead of last year's level, and only 75 BCF below the three-year average of 2,927 BCF. Because the refill season is all but over, attention will now gravitate to storage withdrawals and winter temperatures. The El Nino phenomenon suggests that warmer- than-normal temperatures are more likely in the Midwest and possibly the Northeast, but again this relationship is loose. More importantly, the El Nino should not have a strong impact (if any) until December. However, one still cannot rule out the possibility of warmer-than-normal weather.
We expect the trading range of $3.25 to $3.85 per million Btu will remain in place during the next week or two, with pressure leaning toward lower prices. We would be a cautious buyer at $3.25, assuming support holds. If selling momentum picks up, a decline toward $3.00 should not be ruled out. At the $3.00 mark, we would look to be a more aggressive buyer. Given the market's resiliency late last week, December appears poised to challenge its contract high at $3.88. Consider shorting December above $3.80, risking to $3.93, seeking a return to $3.32.
Rich Redash and Jim Ritterbusch
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