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PRUDENTIAL SECURITIES, INC.
One New York, New York, New York
(November 21, 1997) ENERGY COMPLEX: CRUDE OIL–NYMEX crude oil prices easily slipped below $20.00 per barrel last week, a development that highlighted the weakening fundamental picture that has begun emerging more clearly. Now that the Iraq/United Nations standoff appears to be over, attention will shift to the OPEC meeting (set to begin November 26) and Iraq's oil-for-aid rollover negotiations. The current deal expires on December 4. Normally, a holiday-shortened week would result in light volume, but in light of the upcoming OPEC meeting, most market participants probably will stick around through Wednesdays trade, the final session of the week. Termination of the December gasoline and heating oil contracts that day also will keep traders close to the “screens.”
Trading and price action surrounding the NYMEX December crude oil contract termination last Thursday suggests that the U.S. crude market is weak. The December/January crude oil spread widened beyond 40 cents, discount December, even flirting with negative values exceeding 50 cents intraday. The spread has not experienced such weakness since prices cratered in late spring/early summer. This movement is a bearish omen, suggesting refiners are willing to forgo futures delivery and take their chances in the spot market, which appears amply supplied. Inventory levels in PADD II (the Midcontinent) reaffirm this belief.
Softness in the U.S. market stems from several factors. First, the spike that lifted prices above $23.00 was primarily due to special events (e.g., the Iraq standoff and other short-term supply worries). Second, the refineries' insatiable appetite for crude oil during the summer and fall had also buttressed the market by keeping the demand/supply balance very tight. However, both those factors have almost completely reversed. Supply concerns now center on having too much. Meanwhile, crude oil runs have fallen precipitously over the last six to eight weeks, which is enabling inventory to grow.
Maintenance and unplanned outages were the primary reasons behind the lower U.S. refinery utilization rates, but margin pressure in September/October may have accelerated the schedule. Margins have improved recently, but crude runs have not yet showed signs of turning around. We expect margins to move lower due to growing product inventories around the globe.
In the short term, the market likely will focus on Wednesday's OPEC meeting and the oil-for-aid agreement between Iraq and the United Nations. The OPEC meeting should aid the bearish sentiment, given the likelihood that talks will center on quota increases. The market seems to be expecting an increase given recent statements by Saudi Arabian officials, as well as Venezuela's long-held desire for such boosts. However, Iran also has publicly stated that it does not want the cartel's ceiling raised–probably because it does not have much, if any, spare capacity. As for Iraq's oil exports, risks still remain that the U.N. rollover deal could experience delays, thus, the market remains vulnerable to related rallies. We would not rule out actions on Saddam Hussein's part that will postpone the rollover as he seeks to have sanctions lifted.
The bears should enjoy their Thanksgiving meal more than their bullish counterparts, thanks to the recent price slide. Moreover, it appears that dessert has yet to be served. We still expect negative developments on the supply side to continue dominating futures trade. Consequently, we are maintaining a bearish opinion on crude oil. There are bullish consequences associated with a curtailment of Iraq's exports, but those should be mitigated by an increase in output from Saudi Arabia and other OPEC members, assuming OPEC increases its quota. As a result, prices seem poised to move lower. However, in light of the steep declines witnessed over the last two weeks, do not rule out a short-covering bounce. We suggest considering selling January crude oil on rallies that lift prices into the $20.25 to S20.50 area. Set a stop at about $20.95, while seeking a move to the S19.15 area. A break through support at S19.15 exposes the market to further losses.
HEATING OIL–The weather factor has turned more firmly bearish for the all energy commodities sensitive to heating demand as normal to warmer-than-normal temperatures are likely to extend through month's end in the Northeast and Midwest markets. Such a development has accentuated speculative long liquidation and price weakness. Last Friday's Commitments of Traders report should have shown a sharp reduction in net long speculative holdings. Depending on the extent of the decline, further near-term weakness could develop as the remaining “stale” longs are forced to the sidelines.
Given the warmer weather and price weakness, distributors are more apt to destock. Currently, total distillate inventories are at about average levels for this time of the year. However, East Coast stocks are above normal and appear burdensome. Consequently, if secondary channels begin to work off their inventories (as compared to initiating fresh purchases), the physical market is likely to weaken further. Such action should restrain, if not act as a drag, on the screen.
Keep in mind that both December product contracts will terminate this Wednesday. While a widening of the December/January heating oil spread would carry bearish connotations, such a development may renew interest in storage plays. For now, we see the December heating oil contract likely heading for support at 54.50 cents per gallon, which should pull January down into the 55.00-to 55.50-cent area. We are holding a long-January crude oil/short-January heating oil spread that was established at $4.09 per barrel. The objective for this trade has been set at $3.30, while risking 30 cents.
GASOLINE–The gasoline supply/usage balance is largely on an even keel and should afford gasoline futures better performance relative to the overall complex. Recent reductions in refinery activity, accentuated by unplanned outages as well as a dip in imports have lowered supply. So even though demand has begun to edge downward, inventories have not expanded at a worrisome rate. Stock additions are still expected to continue in the coming weeks, and that should restrain this market. Moreover, given the bearish sentiment currently entrenched in the complex, we anticipate ancillary pressure as well.
We like gasoline in relation to heating oil, but see outright prices moving lower, too. Last Thursday's close below support at 58.00 cents per gallon suggests an additional push toward the 55.00- to 56.00 cent area. The December contract terminates on Wednesday.
NATURAL GAS–The natural gas market is living proof that what goes up must come down as prices have dropped more than $1 per million btu from the fall highs. More importantly, the charts suggest that additional declines may lie ahead. Fundamentally, the market clearly needs cooler weather to get prices moving higher. Long-range forecasts and the EL Nino suggest that winter temperatures will be relatively warm, but the accuracy of such predictions is by no means assured.
Weather remains the critical factor for this market. Now that the injection season is over, incremental demand is largely dependent on weather- sensitive loads. The free fall in crude oil prices has lowered residual fuel oil prices as well, but we anticipate limited support from electric utility demand for gas due to the time of year.
A brief period of cold weather was forecast to emerge, over the weekend and carry over to the early portion of this week. Weather conditions through month's end do not offer much hope for the bulls. If cooler-than-normal conditions do emerge, they should lend support to both the physical and futures markets as the December contract goes off the board on Monday (November 24), which should let the nearby contract escape near current prices. Moreover, given the aggressive selling that has transpired, further short-covering during the last day of trading should not be ruled out.
Storage inventories appear adequate, especially in light of the warm weather. However, last year's cold weather resulted in large draws, and that will make year-to-year comparisons more difficult. Consequently, the current surplus of 133 billion cubic feet (BCF), or 5.1% above last year's level, seems poised to rise, which also will undermine buying interest.
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. Look for commercial parties to sell into any rallies unless fundamentals turn sharply bullish. Those producers that did not take advantage of prices above $3. 00 may now be more willing to price some output in light of the sudden, bearish turn of events. Such hedging sales will restrain the market's ability to advance.
Prices have moved beyond our most dire forecasts. The push below $2.65 oil Friday marks nearly a complete reversal of the gains experienced since August. Nevertheless, it is too early in the heating season to predict that natural gas prices have seen their highs for the 1997/98 winter. Current prices are more realistic in terms of history, but we caution that this market remains vulnerable to sharp gains if cool weather conditions return for a sustained period.
Do not expect much of a price recovery this week. Traders will likely head home for the holidays after Monday's contract termination, and thus, volume should taper off. As a result, we anticipate that the market will consolidate its recent losses, inching higher as shorts close out positions ahead of Thanksgiving. Specifically, we see the January contract trading between $2.55 and S2.95 over the next two weeks, barring any significant changes to the current fundamental picture.
Jim Ritterbusch
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