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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 12, 1997) ENERGY COMPLEX: CRUDE OIL–The assault and battery on crude oil and petroleum products continued last week as traders reacted further to news that OPEC was officially increasing its production quotas, despite the latest Commitments of Traders report that indicated a large concentration of speculative positions (about 64.000 contracts) already on the short side of the market. After a brief fling with $19.00 per barrel, prices were soon establishing new lows for 1997 as they swooned toward the $18.00 mark. Suddenly, the market is now eyeing the 1996 low of $17.45.
Both OPEC and non-OPEC production are trending higher, while future demand growth is being questioned, largely due to Asia:s currency woes and winter weather. Saudi Arabia reaffirmed OPEC's new policy by indicating it will be able to produce 8.8 million barrels per day (MBD) by January 1, 1998. Furthermore, the market is growing more convinced that Iraq will be back sooner rather than later. Moreover, a possible warming in U.S./Iranian relations, which have been largely on ice since 1979, did not help this soft market rise. While we are not convinced that Iraq will be exporting by January, nor do we see any actual headway in U.S./Iranian relations any time in the near future, the headlines created enough waves that the market nearly drowned. To top off the bearish sentiment, the latest monthly report from the International Energy Agency (IEA) showed that it has placed its bets on a supply glut in 1998.
Despite the avalanche of negative news, we believe the concerns have been fully discounted given that WTI and Brent prices have lost about 20% since hitting this year's highs in mid-September. However, further weakness is likely if winter temperatures do not visit lower levels for an extended stay. Indeed, the lack of many sustained periods of significantly colder-than-normal temperatures and the related weakness in both heating oil and natural gas suggests traders are leaning toward the idea that the El Nino will produce a warmer-than-normal winter. Ironically, the 1997/98 winter has been colder-than-normal so far, albeit modestly.
Both OPEC and non-OPEC supply likely will continue to expand, but as we witnessed throughout 1997, unplanned curtailments are “normal” occurrences for this market. Furthermore, crude oil demand should remain strong, especially once refinery maintenance is completed during the first quarter of the new year. A downshift in demand from Asia due to recent financial/currency weakness should assure some degree of easing, thus lessening the impact of production problems. Although Asia's crude oil demand may drop by as much as 15%-20%, such a downshift on a worldwide basis could prove minor as growth in world demand would fall a mere 0.2 MBD.
The short-covering rally we anticipated last week failed to materialize with any conviction, with support petering out at the $19.00 level. Barring any surprises from the Middle East (namely Iraq), we anticipate prices will fluctuate within the $17.45-$19.05 trading range, basis January, through year's end. Support at $18.00 should prove formidable, but in light of the bearish fundamentals and the negative charts, pressure on the market remains likely. Still, we do not advise chasing the market lower, especially since any bullish surprises could result in a sharp rally as shorts rush to cover their positions.
Because our long-term bearish price target has been nearly achieved, we are waiting to buy. The resiliency of demand (thanks to unabated economic growth) is tough to ignore, even if Asia's crisis is worsening. Consequently, we are not ready to predict a move to 816.00 crude oil. Instead, we believe economic strength in the United States will pull the global economy through the “Asia problem.” As a result, we are looking for a place to buy the February contract, preferably at $17.75, risking 50 cents, for a rebound to $19.00. As a proxy for an outright long position. consider a February/May bull spread when February is at an 80-cent discount or better. We expect the once-dominant $17.00$21.00 historical trading range to prevail through 1998.
HEATING OIL–The spot cash market is maintaining a soft undertone with discounts of 60-80 points to the screen still intact. However, this fall's price break of about 20% and the proximity to support near 51.00 cents per gallon on the weekly futures has begun to encourage “bottom picking” by users of some off-contract grade distillates. Jet fuel differentials to the futures were especially strong late last week as airlines have priced barrels for future consumption. However, fixed commitments for heating oil parcels will continue to be stymied by mild/normal East Coast weather forecasts, which have been extended to Christmas by some weather observers. Mild temperature forecasts for the next 10 weeks across Western Europe should add to the current negative sentiment. Distributors will remain preoccupied with working off storage rather than building inventory until crude oil values improve or the weather patterns shift. Recent inventory reductions due to the colder-than-normal start to the heating season have decreased the stock overhang and brought levels down to more normal readings. That situation should limit independent weakness in heating oil futures, but warmer-than-normal temperatures through December would change that outlook. For heating oil to garner independent price support, imports would have to continue their slow pace or refinery activity would have to experience further reductions.
We anticipate the support found last week in the 51.00-cent area will hold into this week. However, we would await evidence of price consolidation before approaching the long side. Maintain your long February heating oil/short February gasoline spreads.
GASOLINE–Both the futures and physical markets were hammered last week as oversupply concerns reigned supreme. Cash values, in particular, moved sharply lower with prices in the New York Harbor, Gulf Coast and Chicago markets all making new lows for 1997. In addition to the overall weakness in the petroleum markets, it appears the stepped up pace of refinery activity is resulting in too much supply. Indeed, higher production has contributed to some stock building, especially of reformulated gasoline (RFG). The moderate inventory build is especially bothersome because it coincides with stock shifting that should be resulting in reduced inventory numbers as reported by the American Petroleum Institute (API). Product is being shifted from primary into secondary channels to make room for imports that reportedly are on the way. Additionally, tax positioning is also motivating holders to dump supplies ahead of the new year. The carrying charge price environment reaffirms the general belief that the United States has ample supplies.
We, expect further weakness in the short term. High RFG stocks, a soft cash market and a bearish trading environment will limit buying interest in gasoline. High refinery output and low demand should enable gasoline inventories to climb higher. All of these factors should pressure the nearby contract. pushing it toward support near 53.25 cents per gallon, basis January. While well publicized, the heavy round of U.S. refinery maintenance scheduled for the first quarter of 1998 should limit gasoline production and thus, tighten the physical market. A more stable cash market should lend support to the futures market into the first quarter. However, the maintenance work win overlap the slowest period for demand, thus, we are not anticipating a sharp rally, but rather a more stable price environment after the 53.25 price target is achieved. Consider fresh short positions above 55.00 cents, risking 60 points, seeking the 53.25 cent mark.
NATURAL GAS–Natural gas futures continue to get pummeled. Last week's futures low of $2.28 per million Btu, basis January, marked a complete reversal of the wild, woolly period of bullish speculation that sent prices to just tinder $3.90. However, it appears that the same influence–speculation, which exaggerated the price effect from fairs supportive fundamentals–is now working in the other direction, thus exaggerating the impact of newfound negatives. Prices at $2.25 seem fairly valued, if not undervalued, because weather conditions have proven normal, if not colder-than-normal in the key consuming regions so far this heating season. However, the United States has barely begun the whiter's peak period, so the trading tone is in the process of being set.
The latest weather forecast suggests more lackluster temperature readings, and thus, a continuation of the negative pall currently enveloping this market. Indeed, it appears that the market is betting more heavily on the prevalence of warmer-than-normal temperatures in the primary heating markets of the Midwest and Northeast, possibly due to the ongoing El Nino episode. There is some merit to this thought because the current El Nino is the strongest on record. Moreover, past El Ninos have been known to limit the frequency and duration of arctic blasts, which has been largely true with the current El Nino to date. Still, the jury has not yet reached a decision.
Storage withdrawals continue to disappoint the bulls. Indeed, last week's figure of 69 billion cubic feet (BCF) increased the growing year-over-year surplus to 162 BCF, 7% above 1996 levels. Furthermore, weekly withdrawals to date are averaging just 54 BCF as compared with 70 BCF and 74 BCF per week in 1995 and 1996, respectively. Last week's normal- to colder-than-normal weather should result in a draw of about 70-80 BCF. but that is not likely to quell the bearish sentiment unless weather conditions turn significantly cooler. The latest 6- to 10-day weather forecast does not suggest such a development is likely.
As stated last week, we cannot overemphasize the influence and importance of weather conditions this winter. Unless something changes to suggest cold weather is coming, prices should continued to spiral lower. More importantly, because the latest forecast suggests warmer temperatures this week, only limited buying support (from shorts taking profits or bargain hunters looking for a rebound) is expected. We still recommend approaching this market with a “sell rally” mentality. Near term, upside possibilities exist to $2.50, while $2.25 seems likely on the downside.
Rich Redash and Jim Ritterbusch
Metals
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Energy Complex
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