MERRILL LYNCH & CO.

North Tower, 21st Floor, New York, New York

(November 26, 1997) ENERGY COMPLEX: CRUDE OIL–OPEC convened its regularly scheduled Ministerial conference in Indonesia on November 26, with the agenda oriented around a review the global supply/demand outlook and the issue of a new, higher production ceiling. The latter stems largely from prompting by Saudi Arabia to address the gap between current OPEC output of more than 27 million barrels/day and the existing 25.033 million barrel/day ceiling. The Kingdom's wish to change quotas stems from concerns about the oil balance possibly becoming “too tight” in 1998, particularly if there are any prolonged disruptions in Iraq's humanitarian oil sales.

To avert a U.S.-led military response against Baghdad, Russia has brokered a deal which allowed UN weapons inspectors, including Americans, to resume their work in Iraq. In return for Iraq's cooperation, Russia has said that it will actively attempt to expedite the lifting of the 7-year old economic sanctions which includes the oil embargo. Whether this quid pro quo proves to be little more than a temporary fix remains to be seen. That the U.S. found little support to employ military means to force Iraq's compliance on weapons issues is, in our opinion, testimony to the widespread deterioration in support of continued economic sanctions against Iraq. It is widely felt that the sanctions have done little to alter the behavior of Iraq's leadership with the genuine causalities having instead become the Iraqi populace. However, issues regarding the lifting of sanctions are numerous and complex, suggesting that the status quo appears to be the higher probability scenario for the foreseeable future.

In a related sense, there has been talk about allowing Iraq to sell more oil than the current $1 billion/90-day allowable to address humanitarian needs. This prospect stands in sharp contrast to recent expectations for a possible interruption in Iraq's exports come December 5th, when the next 180 tranche is due to be renewed. Because of the possibility to allow a hike in Iraq's oil sale allowable, OPEC may choose to forestall a decision to raise quotas. Our supply/demand forecast for 1998 suggests that the demand for OPEC crude oil will rise to about 27.6 million barrels/day versus 27.0 million this year. Our projected level of the demand for OPEC crude would allow for Iraq's humanitarian sale allowable to rise by 50%, even after taking into account likely over-quota production. A hike in Iraq's allowable production in conjunction with a higher OPEC production ceiling could create a significant over-supply situation resulting in sharp downward pressure on the oil price structure.

Oil values have recently declined to below the $20 level (basis spot WTI) owing to a combination of factors which include the following:

–Concerns that the currency debacle in a number of developing Asia economies would result in a significant deterioration in that region's economic growth and, hence oil demand growth.

–Concerns that Saudi prompting to address OPEC quotas signaled a desire to “push” extra barrels into the market to force prices lower.

–Most recently, concerns that Iraq may be allowed to sell additional oil in order to boost available funds for humanitarian supplies.

In this context, it appears to us that oil prices may now be approaching a bottoming area. Based on our supply/demand projections (and assuming we have a northern hemisphere winter which is not as warm as the previous year), our view that the OPEC principals and Saudi Arabia, in particular, wish to see an elevated price band, and the likelihood that both Iraq's allowable and OPEC's quotas will not both increase, we would recommend using price dips to below these levels as a buying opportunity. Depending upon how events unfold, we continue to believe that rallies to the mid-$20s level are probable.

(Reprinted by permission. Coypright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)

Michael Rothman

Consensus National Futures and Financial On Line Index

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