PRUDENTIAL SECURITIES, INC.

One New York Plaza, New York, New York

(November 17, 1997) ENERGY COMPLEX: CRUDE OIL–Last week's action was largely uneventful due partly to the Veterans' Day holiday and the American Petroleum Institute (API) industry gathering. The lack of fresh news also kept activity light. Was it the calm before storm? We think so, but the path that prices will take remains somewhat uncertain because of the continued standoff between Iraq and the United Nations. As we saw late last week, the market remains sensitive to escalating Mideast tensions. and prices are still vulnerable to move higher. It seems clear some confrontation is probable, however, the form such action will take remains difficult to discern.

Concerns about OPEC and a possible increase in its quota appear to be quietly working against the market. Saudi Arabia's announcement that OPEC should consider lifting the cartel's self-imposed limit by nearly 2.0 million barrels per day (MBD) to 27.0 MBD caught some by surprise. The Middle East standoff overshadowed the news at the time, but the market has not forgotten about it, especially with the November 26 OPEC meeting looming.

Clearly any such change in OPEC's official quota would weaken prices purely from a psychological perspective as we have seen already, albeit modestly. However, the impact on tile supply/usage balance is less certain. For starters, OPEC output has easily exceeded the existing quota all year. Moreover, most surveys indicate OPEC supplies to market are above (if not well above) the new 27.0-MBD proposed ceiling. As a result, little new supply would be expected from the proposed change if OPEC members complied with the new limits. We do not agree with this scenario. Instead, it appears that the quota- increase proponents will now be able to “legally” expand output, while the quota-busters will continue to go their own way, producing at or near capacity and in excess of their higher allotted shares. As a result, we expect to see increased supplies of as much as 0.5 to 0.6 MBD hit the market in 1998. That estimate, of course, assumes Iraq will continue to export crude under the existing oil-for-food agreement. Table 1 outlines OPEC's 1997 production capacity, existing quota allocations and the proposed quota (assuming a proportional increase in each member's output). Capacity restrictions will limit some members' increase, but not that of Saudi Arabia, Kuwait or the United Arab Emirates.

		1997	Current	Revised
Country		Average	Quota	Quota
Algeria		0.85	0.75	0.81
Indonesia	1.46	1.33	1.43
Iran		3.67	3.60	3.88
Iraq		1.16	1.20	1.29
Kuwait		2.10	2.00	2.16
Libya		1.43	1.39	1.50
Nigeria		2.22	1.87	2.01
Qatar		0.58	0.38	0.41
S. Arabia	8.15	8.00	8.63
UAE		2.24	2.16	2.33
Venezuela	3.18	2.36	2.54

Total		27.04	25.03	27.00

				New	Old
Country		Capacity	1998*	1998*
Algeria		0.90		0.86	0.86
Indonesia	1.50		1.48	1.48
Iran		3.80		3.80	3.75
Iraq		1.70		1.50	1.50
Kuwait		2.40		2.20	2.15
Libya		1.48		1.45	1.45
Nigeria		2.35		2.30	2.30
Qatar		0.60		0.60	0.60
S. Arabia	10.00		8.65	8.25
UAE		2.40		2.30	2.30
Venezuela	3.50		3.50	3.50
Total		30.63		28.64	28.14

*Estimate

Source–PSI

One unknown in our scenario is the assumption that each member's quota will be increased by a proportional amount. Not all OPEC members may agree to a proportional increase, and negotiations at the pre- Thanksgiving meeting may cause indigestion. Such discord also would work against higher prices. OPEC developments and related rhetoric should garner more press and attention as November 26 approaches, which should encourage would-be sellers to stake out their position more aggressively.

The potential for extra supplies as well as other related OPEC discussions (both prior to and at the official meeting) may become the straw that breaks the market bulls' back. It is interesting that the OPEC meeting will come just before Iraq and the United Nations begin negotiation on extending the oil-for- food agreement. Saudi Arabia's announcement to increase the quota seems to be a message to the world that it will help cushion any tightness caused by the absence of Iraqi exports. Still, the market may initially rise if Iraq's exports are halted. Even though the United Nations has gone to great lengths to make it clear that the current issue with Iraq is not tied to the oil-for-food agreement, separating the two appears to be easier said than done, especially because the current export window closes on December 6. Moreover, it appears that Iraq's strategy may be to halt the agreement and the U.N. aid, which would highlight the ongoing suffering of its citizens and may raise additional Arab support.

Even though crack spread margins have improved and refinery demand appears poised to rebound, negative developments on the supply side should dominate trade, especially because global product inventories appear ample. Consequently, we are maintaining a bearish opinion on crude. Although there are still bullish consequences associated with a curtailment of Iraq's exports, those should be mitigated by an increase in output from Saudi Arabia and other OPEC members (assuming OPEC increases its quota). As a result, crude oil futures should continue to drift lower, barring any surprises from the Middle East. Thus, consider selling January crude oil in the area of $21.00 per barrel to $21.50, risking to $22.00 and seeking $20.00. More conservative traders can limit the risk of the market moving the “wrong” way by using a bear spread, i.e., selling January and buying June on rallies that widen the backwardation to 45-55 cents, January premium. This trade is based on our belief that the market will return to a more solid contango structure before year's end.

GASOLINE–Although gasoline stocks remain at ample levels for this time of year, a spate of recent refinery outages could tighten supplies. In addition, some slowing in the pace of imports also threatens to reduce supply availability. On the demand side, buying interest remains exceptionally robust with the help of favorable economic conditions and a declining fuel efficiency within the U.S. car fleet.

The gasoline market has the potential of outstripping price gains in the rest of the complex despite the escalating tensions between Iraq and the United Nations. The term structure in the gasoline spreads has recently been discounting an adequate stock situation with a carrying charge (contango) structure intact into the spring contracts. We continue to view purchases of the nearby contracts (e.g., January) against sales of the deferred contracts (e.g., March) as a viable way to take advantage of any future supply dislocations or unexpected declines in output. In conjunction with an expected shift to an inverted spread structure, we expect a firm termination of the December contract when it goes off the board on November 26. On an outright basis, it appears likely that prices will test the upper boundary of the last month's trading range between 58.00 and 61.00 cents per gallon this week.

HEATING OIL–While showing evidence of peaking for the season, heating oil stocks remain ample at about 2-3 million barrels above the five-year average. European supplies also appear plentiful with middle distillates more than 6% higher than year-ago levels.

In view of these adequate supplies, further upside progress in heating oil will be contingent upon either strength in the rest of the complex or cash market gains in off-contract items such as kerosene. Temperature forecasts are leaning increasingly toward the bearish side on both a short- and long-term basis. Any further moderation in these weather forecasts could force a significant contraction in the heating oil crack spreads. Full storage tanks in the New York Harbor region and a continued large net long speculative position still represent latent longer-term bearish considerations. Recent price weakness in the natural gas and propane markets also provide a negative omen.

While upside possibilities toward 60.25 cents per gallon are possible in view of the increasing Iraq/United Nations tensions, such an advance would provide selling opportunities. Downside possibilities exist to the 56.75-cent area before the December contract expires.

NATURAL GAS–Mother Nature's stern warning about winter temperatures prompted the bulls to diligently return to the natural gas futures market last week, but their staying power proved very short-lived. The price rebound was spurred by the onset of much-below-normal temperatures in the Midwest and Northeast. However, the market's ability to hold support in the mid-$3.20's also aided traders' psyche, helping prices to rally. Nevertheless, the “recovery” was not impressive. In light of the market's inability to move through resistance at $3.55 per million Btu, prices ended the week meekly, below where they had started five days earlier.

There is a strong bullish bias in this market, as reflected by the chronic net long holdings by speculators shown in recent Commitments of Traders reports. Furthermore, many utilities (i.e., local distribution companies) are concerned about the potential for price spikes this winter given last year's run-up in which NYMEX prices hit $4.60 as well as numerous predictions for high prices this winter that could reach $4.00 to $5.00. The last two months of price action on NYMEX only underscores these concerns. However, such a bias leaves the market vulnerable to a sharp downturn if cold weather fails to tighten the supply/usage balance enough. Weather patterns and related price action in November and December will set the tone for trading this winter season.

A move much below $3.00 does not seem likely in light of the coal shortage in Texas that is being caused by railroad shipping bottlenecks. Utilities appear to be hoarding coal supplies by burning more natural gas for electric generation when economically feasible. Such action should put a floor under the natural gas cash market, and thus, the futures market.

Barring any new forecasts for prolonged periods of colder-than-normal temperatures in the Midwest and Northeast pressure will continue to work against higher prices. The sharp sell-off has severely damaged the price charts and additional weakness may be forthcoming. We suggest waiting for the market to consolidate before establishing any long positions. Support in the December contract should materialize at $3.00, $2.94 and $2.85.

Richard Redash and Jim Ritterbusch

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