PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 8, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil prices have dropped sharply during the last two weeks, with the nearby NYMEX futures contract losing more than $2.00 per barrel. The primary lubricants behind the market's descent were OPEC's quota hike and a seeming easing of tensions between Iraq and the West. The lack of significant, sustained cold weather so far this winter is adding to the downside pressure. Even though the OPEC quota increase appears fully discounted by the market, the move lower may not yet be over.
At the OPEC meeting, members approved lifting the quota by 9.85%, or 2.5 million barrels per day (MBD), thus raising the ceiling to 27.5 MBD. As we stated ahead of the meeting, the increase merely legitimizes (at least part of) OPEC's actual production, which some have estimated to be as high as 28.4 MBD lately. The change may also help restore some of OPEC's lost credibility. We now expect expanded output from the primary quota supporters (ironically, those members with spare capacity), namely, Saudi Arabia. Kuwait and the UAE. The others (most of whom appear to be already producing above quota) likely will leave their operations and strategies unchanged and continue to violate the new, expanded quota. As a result, overall OPEC production should expand more rapidly than we had forecast in our most recent Quarterly Energy Outlook. Specifically, we have increased our 1998 annual forecast of OPEC production by 0.6 MBD to a total of 28.7 MBD, while the first quarter should be up at least 0.4 MBD (assuming Iraq is exporting again).
The increase in OPEC output is closely tied to Iraq, and estimates for production in that country are subject to much debate in light of the ongoing U.N. sanctions and Iraq's unpredictable behavior. Even though the United Nations unanimously approved rolling over the humanitarian oil agreement, it appears Iraq's demand for a revamped aid distribution plan will result in a delay. Until the length of the delay is better known, expect a price rally due to short-covering. As of last Friday, it appeared the trade was expecting at least a one-month delay.
Afterward, focus should shift to the possibility of an increase in the dollar size of the agreement, perhaps to $3- $4 billion from the current $2 billion limit. Iraq's successful campaign to raise attention to the plight of its ordinary citizens has resulted in more vocal support from its Arab neighbors as well as many European nations. Even the United States has hinted at agreeing to a hike after the ongoing issues are settled. As a result, an increase should be anticipated; we believe it may come as early as the first quarter of 1998. A $4-billion-dollar limit would result in an export jump of about 0.8 MBD, depending on global oil prices.
Table 1 lists recent OPEC production levels, the old and new quotas for each member, and our latest 1998 production estimates. Because internal OPEC demand has been increasing despite efforts to utilize more natural gas, the production gains will be partially mitigated. Additionally, capacity limitations will prevent some members, namely Iran and Libya, from fully exploiting their new allotments.
Some OPEC members believe the 1998 call on OPEC supplies will approach 28.0 MBD because world demand is expected to grow by 1.8-2.0 MBD next year. Such a call on OPEC supplies may prove too optimistic. Estimates for 1998 non-OPEC supply additions are concentrated in the 1.2-1.8 MBD area. The wide range implies much uncertainty, reflecting the recent track record of non-OPEC producers. The anticipated increase in total supply (up 0.5 MBD from OPEC and 1.5 from non-OPEC) should prove difficult to swallow, at least relative to the last two years, and thus, the demand/supply balance will ease in favor of supply (barring any significant production problems). A downshift in demand from Asia due to recent financial/currency weakness within most of those countries should assure some degree of easing, thus lessening the impact of production problems. Indeed, Asia's crude oil demand may fall by as much as 15%-20%. However, such a downshift on a worldwide basis could prove minor, with world demand dropping a mere 0.2 MBD.
The probability of making new lows appears considerably higher when you consider the OPEC increase as well as the U.N. deal extension and Iraq's increased export program (assuming the dollar limit is raised as we anticipate). However, given the delay in Iraqi exports, such a price move likely will be deferred until the first quarter. Still, there likely will be too much oil from OPEC to avoid further price weakness, despite the recent recovery in domestic refinery demand and ongoing relative price strength in Europe. Moreover, planned refinery maintenance in the United States scheduled for the first quarter should prevent a sustained increase in U.S. crude oil runs. Asia, too, should provide less help than it has in light of the recent financial turmoil in that region. Moreover, a mild northern hemisphere winter could spell further gloom and doom, but winter conditions remain a wild card for the market this early in the season.
The market's most recent push appears to have established a lower trading range for the remainder of the year unless the Iraqi situation escalates. Some form of crude oil export delay in the latest oil-for-aid round appears likely, and that should begin to temporarily ease the downside pressure. Expect the January NYMEX contract to range between $18.35 and $19.65 unless Iraq/U.N. negotiations take a significant turn for the worse.
HEATING OIL–The overall decline in the petroleum complex should have cleansed the market of seasonal speculators expecting a rise in heating oil values. As a result, heating oil appears ready to assume a more favorable following. Moreover, even though winter conditions have been far less than spectacular for demand, we are only just entering the peak period of December through February.
Despite some moderation in this week's East Coast weather forecasts, spot markets in the Gulf and Northeast have remained well supported. For example, prompt discounts narrowed further late last week, holding at about 75 points under the “screen.” We anticipate demand will remain about normal (mostly due to weather), but see buying interest continuing to favor heating oil rather than gasoline, given some tightness on the supply side.
In light of the bearish climate within the overall complex, we see the nearby heating oil contract approaching 51.00 cents per gallon, assuming crude oil values continue to weaken. If the complex rallies, the January contract should approach 54.00 cents, which would provide for selling opportunities. Last week, we initiated a long heating oil/short gasoline spread (basis February) at 2.85 cents, premium gasoline, reflecting our belief that heating oil will gain in relation to gasoline. We think heating oil should eventually trade at a premium to gasoline.
GASOLINE–Recent production increases coupled with sharp drop in demand have finally resulted in a sizable increase in inventories. In view of what has become an amply supplied market, we anticipate lackluster price support. Indeed, gasoline is likely to continue underperforming the overall market for the next few weeks. Furthermore, RFG stocks have been driven higher in recent weeks and now stand about 15% above year- ago levels in PADDs I-IV, and are near a three-year high.
According to the most recent American Petroleum Institute (API) report, imports rose sharply. Imports jumped sharply for both finished gasoline (up 0.3 MBD) and blending components (up 0.2 MBD) during the week ended November 28 thanks to apparent shipments from Europe and Latin America. Such an import level is burdensome currently, and thus bearish in the short term. However, these imports likely will be needed to prevent any tightness in the market when the United States begins planned refinery maintenance in the first quarter of the new year.
Higher supply (in both production and imports) and the long-awaited drop in demand suggest lower prices are in store for gasoline, despite the recent sell- off. Recent weakness in the MTBE market will only add to the downside pressure. Furthermore, the carrying-charge price environment is likely to continue in the coming weeks. Despite our bearishness, we still favor bull spreads (long January/short February) as a low-risk alternative to outright long hedge positions for commercials seeking protection against bullish market surprises. On an outright basis, we favor short positions at or above 50.00 cents per gallon, basis -January.
NATURAL GAS–Natural gas futures remained under heavy fire last week due to the lack of significant, sustained below-normal temperatures so far this winter. Indeed, the steepness of the downtrend that began in late October would make even the most experienced skier a bit nervous. If it were a ski run, we would give this market a triple-black-diamond rating.
Clearly, long liquidation by speculators (namely the commodity funds) has accentuated the recent decline. The drop in open interest to 210,000 contracts from the record in October of 265,000 lots reaffirms this assumption. Last Friday's Commitments of Traders report should have confirmed this development.
The market has given back all of its pre-winter gains, and prices are hovering at the summer lows, basis the January contract. This price level, near $2.45 per million Btu, probably appears attractive to many. especially with the heating season a mere month old. Nevertheless, there are not many (if any) bullish fundamental factors that raise the risk of waiting for even lower prices. True, the current price level will look like a bargain if weather turns significantly colder and is sustained. However, we prefer not to bet on weather, especially considering the long-term forecast track record of meteorologists. Moreover, the ongoing El Nino episode suggests a warmer-than-normal winter. A quick reminder, though, normal readings will continue to drift lower as the heart of winter approaches, thereby lifting demand.
Given winter weather to date, storage levels remain comfortable but are leaning toward burdensome. Stocks are about 3.0% below the three-year average, but 6.5% above last year's lean level. Additionally, weekly withdrawals have averaged only 50 billion cubic feet thus far, compared with 74 billion and 70 billion per week in 1995 and 1996, respectively. Weather conditions in the remaining three weeks of December should set the tone for the rest of the heating season. Keep in mind that warmer-than- normal temperatures will leave storage at high levels, which will restrain price advances in January and February, possibly carrying over into the spring.
Support from other factors (e.g., competing fuel prices and coal delivery problems) seems limited at best. The recent decline in petroleum prices also has lowered residual fuel oil prices, keeping them in line with the falling natural gas market. This development affords duel-fuel capable end-users with fuel choice options. The significance of the Union Pacific Railroad's coal delivery problem has been lessened by the absence of extreme weather conditions; moreover, the problem is being resolved, albeit slowly.
We cannot overemphasize the influence and importance of weather conditions on prices. In the short term (this week), the latest weather forecast does not suggest a price recovery is in store. Still it is hard to believe that prices will fall significantly, below $2.40, at least this early in the winter. Aggressive traders who want to go long must realize that they are doing nothing more than trying to pick a bottom. We still recommend approaching this market with a “sell rallies” mentality. Near-term upside possibilities exist to $2.80, but resistance at $2.50 should prove formidable in the short term; on the downside, $2.25 seems plausible.
Rich Redash and Jim Ritterbusch
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