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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 10, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil prices continue to be swayed by the Iraq/United Nations standoff. However, the effect on prices has been tepid. It appears that traders are concerned that the market is vulnerable to price declines if the issue is resolved without any impact on Iraq's oil-for-aid export program. However, ongoing uncertainty prevents them from taking a strong stance. We agree with this outlook, and thus, remain bearish on crude oil. However, prices are poised to rally sharply if the standoff results in curtailment of exports.
Recent inventory additions in the United States are a bearish portent for crude oil prices, especially because they should be declining in the fourth quarter. Stocks have climbed 4% in the last two weeks, largely without help from imports. Indeed, imports have not climbed above 9.0 million barrels per day (MBD) since early October.
Price action in the cash market also is looking more negative. For example, the Louisiana Light Sweet crude premium relative to WTI has narrowed, and WTI prices at Midland, Texas also have weakened. In the North Sea, dated Brent prices have lost ground, with the discount at a large 60-70 cents per barrel. Moreover, as refineries in PADD III (the Gulf Coast) look to reduce inventories before year-end to lessen their tax exposure, additional pressure on the cash market is expected.
Crude oil futures also face downside pressure from the upcoming OPEC meeting on November 26. Last week, it was reported that Saudi Arabia wants OPEC's quota increased to about 27.0 MBD in order to capture market share that it has been losing to non-OPEC producers. This would mark a significant change in Saudi's stance on the subject as they have been the loudest proponent of the existing system. Moreover, it would lend Venezuela some support for its opinion that a new marketshare-based system is needed. The impact on the market from fruition of an increase in the quota would be largely negative initially, but could produce somewhat mixed results later. From a psychological perspective, these changes would rattle the market's confidence and probably result in lower prices. However, the impact on the actual supply/usage balance is less certain, given that OPEC's actual output has been regularly exceeding 27.0 MBD according to numerous surveys. Furthermore, most OPEC members already are producing near or at capacity. Thus, a quota increase would only bring the paperwork up to date with reality.
For now, the degree of tightness in crude oil's supply/usage balance is still wed to Iraq. If the country does not renew the oil-for-food agreement, the market would lose about 0.7 MBD of crude oil at a time of year when demand typically peaks. Iraq's overall defiant stance as well as its recent cancellations of November cargoes suggest that it is not motivated to renew the agreement. However, the Iraqi government would still have to justify the decision in the eyes of its citizens. In addition, the United Nations has gone out of its way to make it clear that the standoff is not tied to the oil-for-aid agreement. Thus, the situation still appears it could go in either direction.
Because the near-term direction for crude oil prices remains tied to actions by Iraq and Saddam Hussein, we expect a choppy trading environment for both crude oil and product futures again this week. Overall, we are maintaining a bearish opinion on crude, but recognize the bullish consequences associated with a curtailment of Iraq's exports. The “best” trade for this kind of market still appears to be via the use of spread positions (both bull and bear spreads) to limit the risk of the market moving the “wrong” way. We advise a bear spread, i.e., selling December and buying May at rallies that widen the backwardation to 50 to 60 cents, December premium. Similarly, a bear spread using January and June should also be considered. Action last week did not afford us the opportunity to initiate this trade, but the spread widened closer to the recommended level on Friday, suggesting that the possibility to enter this position may arise early this week. We think the market will move into a more solid contango structure once the Iraqi situation settles down (assuming the export program remains intact).
GASOLINE–The gasoline market still appears well- balanced between supply and offtake. The PADD I (Northeast) market absorbed supply pressure from PADD III (Gulf Coast) pipeline shipments last week thanks to steady demand and a refinery snag at Sun Oil's Marcus Hook, PA refinery. That unplanned outage also lent support to the pivotal Northeast heating oil market.
The steady supply/demand balance is reflected by inventory statistics from the American Petroleum Institute (API) and the Department of Energy that show stocks have remained well within a range of 195-200 million barrels. This level is higher than last year's depleted readings, but still on the low side of historical levels. Stocks have not changed lately due to stable demand and supply. Demand has remained stubbornly above 8.0 MBD despite seasonal tendencies to decline. Indeed, demand rose 0.2 MBD last week to about 8.3 MBD. Nevertheless, we still expect demand to drop closer to the 8.0 MBD mark in coming weeks, bottoming in January between 7.7 MBD and 7.8 MBD.
The recent drop in refinery operations has resulted in lower gasoline output. However, the reduced level of production was mitigated by an increase in imports. In the weeks ahead, gasoline's fate will depend on domestic refinery operations, which appear ready to rebound from the recent drop-off in utilization rates, thus likely expanding production. Indeed, refinery margins have not narrowed enough to warrant a widespread reaction in operations. As a result, gasoline production appears likely to return toward the 7.9-8.1 MBD area. Considering that imports should stay within a range of 0.3-0.5 MBD, the potential for expanding inventories remains a bearish concern.
Even though gasoline appears rich in relation to crude oil, this well-balanced market should seek direction from the complex. If crude oil makes a move toward the $20.00 mark as we expect, December gasoline should be able to break through support at 37.80 cents per gallon, setting the stage for a further push toward support near 57 cents. Nevertheless, selling gasoline outright still appears too risky in light of the Iraq/United Nations turmoil. Instead, we still favor the low-risk, long-term bull spread using the December and February contracts. This trade will benefit from an escalation in the Mideast row, as well as any refinery problems. Look to buy December and sell February when February is offering at least a 0.5-cent premium to December.
HEATING OIL–Heating oil futures were tugged around by the ups and downs in crude oil futures last week. Despite the seasonal tendency for heating oil futures to move higher with the onset of cold weather, the market continues to encounter difficulties. Last week, the physical market could only inch higher on cooler temperatures (both actual and forecast). Although the downed Sun refinery also lent support, the futures market could not make significant gains.
Recent stock declines, albeit moderate, have pushed inventories to about average levels for this time of year. The draws were the result of a reduction in output and an increase in apparent demand. However, the aggregate numbers are hiding parts to the story. For starters, a seasonal pick up in diesel demand is largely behind the increase in overall distillate demand and partly behind the reduction in total distillate stocks. Indeed, PADD I heating oil supplies have continued to expand despite stock-shifting activities and cooler weather patterns in the Northeast. The latest API heating oil supplies in statistics reveal that the Northeast are at a healthy 45.5 million barrels, up about 4 million barrels in the last five weeks. In contrast, total distillates have declined by about 1.0 million barrels over the same period. Furthermore, the 1997 PADD I inventory level exceeds all years since 1992 except 1994, when supplies were 49.6 million barrels. It secondary holdings also are nearly full (as we suspect), supplies are more than ample.
Weather and production remain the keys to price direction in heating oil. Runs appear likely to rise in light of the end of maintenance schedules and decent crack spread margins. Thus, if U.S. weather conditions (especially in the Northeast) do not start turning significantly cooler soon, supplies will back up further and weigh heavily on prices. The pressure may be exacerbated as diesel usage drops off after fall harvest ends and drags total distillates consumption down.
Near-term price action for heating oil futures remains tied to the overall energy complex, with further gains highly contingent upon strength in crude oil. The trading range of 57.00-60.25 cents per gallon held again last week, and it appears likely to do the same over the next five days. We expect weakness in crude oil will result in a test of the low end of heating oil's trading range. Nevertheless, in light of the uncertainty surrounding Iraq, we suggest a sideline stance in this market.
NATURAL GAS–The markets confidence was shaken, after the weak November contract expiration. Furthermore, both the fundamentals and technicals are hinting at the possibility for additional price weakness. Nevertheless, colder-than-normal temperatures remain a risk to would-be sellers as the United States moves further into the winter heating season.
Last week's “bullish” American Gas Association (AGA) report failed to induce a sustained advance. The industry will enter the winter heating season with 2.807 billion cubic feet (BCF), which is a relatively comfortable level. However, even though the overall AGA storage level is largely in line with the three-year average, supplies in the Eastern consuming region are about 3.5% below their average. If early cold weather forces withdrawals, the market is poised to advance sharply.
The importance of weather to the natural gas market is heightened now that the refill season is over. Given the absence of injection demand, the cash/physical market will be driven predominately by weather-sensitive demand. Without cold weather, physical prices are subject to further declines (as witnessed last week), which also will pressure the screen. In light of the strong move in gas prices already, the market appears to be betting on at least normal winter weather conditions, despite the volumes written on El Ninos and their loose association with warmer-than-normal weather in the Midwest and Northeast.
November and December are very important months in gauging both winter weather and the industry's response with respect to storage gas. Many storage holders “hope” for cold weather in November to get prices off and running, thus setting the stage for heavy withdrawals in a high-price environment during December, However, if such a scenario does not materialize, excess gas will overhang the market in January and February and act as a drag on prices.
Our $3.25 per million Btu price target was hit Friday as weakness continued in the natural gas futures market, The sharp declines of late have significantly damaged the price chart, and other technical indicators suggest that the selling may not yet be complete. There is still potential for the December contract to reach the $2.95-$3.00 area, but that will hinge on near-term weather conditions. We would recommend aggressive buying at those levels, using a stop at about $2.92.
Rich Redash and Jim Ritterbusch
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