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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 11, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil futures continue to fall under the spell of the gasoline market. Although crude oil prices appear to have discounted Iraq's return to the market, recent pressure in gasoline is carrying over to crude. However, crack spread trading (buying crude/selling products) helped mitigate the decline. The recent 10-cent-per-gallon surge in gasoline prices had helped crude oil overcome pressure from Iraqi exports, higher OPEC output and forthcoming refinery turnarounds in Europe and Asia.
The physical market is showing signs of weakness due to Iraq's eminent return to the world export market. Buyers are reluctant to procure supplies while sellers are anxious to unload them ahead of the Iraqi barrels coming onstream. As a result, there is a growing risk that some of these pressures will affect the futures market. However, the impact will most likely hinge on the ultimate quantity of Iraq's exports. The industry believes Iraq can sell 1.3-1.5 million barrels per day (BPD), but these figures may be too high.
Iraq has decided to play favorites with their exports, limiting sales to the U.S., U.K. and Japanese firms, while rewarding their “friends” at the United Nations: Russia, France and China. Given the urgency that Iraq has less than 30 days to sell $1.0 billion of crude oil, it may be that its sales bias is a convenient excuse to cover the likelihood that they cannot sell enough in the short time frame ahead. If so, some near-term pressure on the crude oil market would be relieved.
Unless that scenario unfolds, the crude oil market is facing a decisively bearish picture on three fronts: (1) U.S. gasoline and other product demand is easing; (2) crude oil supplies are increasing; and (3) physical prices are declining. Indeed, many markets are now reentering a contango structure. Also, the WTI September/October spread is becoming increasingly negative in both the cash and futures markets. While some of this weakness is due to a growing overhang of sweet barrels in the Atlantic, the Iraqi situation also seems to be contributing to the decline.
The low global inventory build during the second and third quarters will enable the market to absorb a significant amount of new supplies ahead of the seasonally strong fourth and first quarters. However, a marked increase in inventory would still weigh on the futures market. Indeed, despite the record U.S. run rates, stocks remain at relatively comfortable levels. For example, stocks in PADDs I-IV are still running 6 million barrels ahead of last year's levels. A softening in refinery demand and/or increase in imports could send stocks even higher.
September crude oil's settlements below $20.00 per barrel encouraged our bearish leaning and reaffirmed our belief in a price target of $19.00. Still, subsequent price moves will hinge on the U.S. gasoline market and the amount of crude oil exports from Iraq. In addition, the bulls can gain some ammunition if ongoing rebel activity continues to crimp production and exports from Colombia. Given the pending national elections there in October, stepped-up rebel activity appears likely.
Assuming Iraq can export 1.3 MBD during the remainder of August, we anticipate pressure for crude oil futures. However, a bear spread may lessen the impact of upside surprises, such as those stemming from Iraq, Columbia and the gasoline market. We recommend selling October and buying December at a 15-cent December premium or less in anticipation of a possible move to the 40- to 50-cent area, December premium. The likelihood of this market returning to backwardatim ahead of October's termination seems low.
GASOLINE–Following an exceptionally strong advance in July, gasoline prices have declined in recent sessions. So far, the downswing appears corrective, as both short-term uptrends remain intact. Bearish factors have included a weakening in Gulf Coast and Mid Continent spot markets, a development that gradually carried to the East Coast. East Coast values also were undermined by talk of unplaced cargoes from the recent August futures contract deliveries. However, New York Harbor cash prices have generally held a 6- to 7-cent premium to the August screen. While conceding to some contraction in this basis during the next few sessions, we would expect the cash market to generally remain firm in view of exceptionally low primary stock levels and a surprisingly robust pace of summer demand.
We believe the underlying bullish forces that prompted last month's 10-cent price advance generally remain intact. First, refinery problems at two Venezuelan facilities will tend to keep imports at a relatively low level. Second, a recent upswing in U.S. refinery activity likely will be countered partially by another week of downtime at Tosco's large East Coast facility. Unless primary supplies begin to post significant builds of at least 2 million barrels per week, a renewed price advance appears likely. While another significant “up leg” may be contingent upon additional refinery outages, the likelihood of such an occurrence has increased as most facilities are producing at maximum capacity.
While conceding to some additional price slippage, we would anticipate good support at the 61.50-cent area, basis September. This support could set the stage for another test of resistance at the 67.60-cent level. In view of expected volatile market conditions, we are suggesting initiation of long October/short December gasoline spreads at levels below 2 cents, October premium, as a proxy for an outright long position. Also, we anticipate renewed expansion in the gasoline crack spreads following some further narrowing toward $6.00 per barrel, basis the September contracts.
HEATING OIL–Heating oil futures are beginning to take on a life of their own. Last week's negative statistics from the American Petroleum Institute (AIT and Department of Energy (DOE), as well as a softening in the diesel market were the primary factors behind the market's individual weakness, independent of other energy complex influences. Indeed, we expect that the negativity associated with these independent factors should continue.
Last week's statistics and price action were in line with our bearish opinion, and thus, our outlook has not changed. First, we believe additional seasonal builds will continue, and envision that 1997 inventories will rival 1994 levels, the only year out of the last five that current supplies are significantly trailing. Second, we believe that secondary supplies also are at high levels, given the earlier carrying-charge environment. The light U.S. refinery turnaround program planned for autumn–that may be lessened further in light of the healthy and resilient crack spreads–reaffirms our outlook for continued seasonal builds. Additionally, if diesel demand softens further, the rate of build will likely accelerate. Also, the large net long position (23,000 lots) currently held by speculators is another negative consideration, assuming they must eventually liquidate those positions.
Consequently, we are bearish on heating oil and favor short positions in the December contract. The window to establish a short position opened last week when the contract eclipsed 60.00 cents per gallon. Any rally in the complex that pulls the December contract back into the 59.00- to 60.00-cent area should be sold, using stop protection at 60.50 or higher. Hold existing positions, but adjust the stop to a lower level than used currently. If December fails to rise beyond last week's highs, it would portend an ensuing downmove to support at 56.50 cents, and subsequently, 55.00. Our long-term objective remains the contract low near 51.80 cents, but weakness in crude oil mill be needed for such a decline.
NATURAL GAS–Natural gas broke out of its recent trading range and the ensuing buying momentum helped push the nearby contract to record levels. Because the fundamentals have not turned bullish, we conclude that the main influence was fund buying, encouraged after prices surpassed the resistance line of an evolving triangle formation on August 1 and held above it. A surprisingly low injection figure reported by the American Gas Association (AGA) produced additional buying and short-covering as the week came to a close.
The price rise of 25 cents per million Btu is difficult to explain from a fundamental perspective, especially considering that the threat of Hurricane Danny off the Gulf Coast did not illicit such a response. We see four fundamental factors that belie the recent upmove:
1. Although the hot weather that drives air conditioning demand has been present in the Southern United States (especially the Southwest), it has been largely absent from the Northeast and Midwest. That difference helps justify why the spread between the Kansas Cit and New York futures markets has narrowed, but does not explain New York's steep ascent.
2. Nuclear plant maintenance has been high this year, but given the generally moderate temperatures through the summer, the related pressure on natural gas has been tame.
3. Competitive residual fuel oil prices and the recent decline in those inventories (after swelling early in the year due to the mild winter) makes it clear that utilities are not relying solely on natural gas for their peaking needs.
4. Given the low rate of storage injections over the last three weeks, recent storage demand could not have accounted for the meteoric price rise.
However, these fundamentals may be catching up with the recent price gains. The weather watch indicates that temperatures in the North should return to normal or above-normal levels. In addition, the year- over-year storage cushion has shrunk to a mere 133 billion cubic feet (BCF), the lowest level since winter's end. Storage can still reach 2.7 to 2.8 BCF if injections average 70 BCF per week, but this assumes no impediments (e.g., a sustained period of high heat, a hurricane in the Gulf and/or negative economics) emerge during the remaining 12-14 weeks before the winter heating season officially begins.
The low storage levels can be viewed as a supportive (and possibly bullish) factor on three counts:
1. Hot weather remains a risk because summer is far from over.
2. Despite the evolving strong El Nino and its tendency to lessen the risk of hurricanes, that risk will overhang the storage situation (as well as the overall market).
3. Current economics warrant storage draws rather than builds. Few, if any, producers are singing the blues given the current $2.50 price level. More importantly, the summer/winter spread (using the September and December contracts) is only about 20 cents versus the normal breakeven point of 30 cents.
Even though we feel values are inflated beyond fair value, we do not advise an outright short sale, given the positive technical picture and the improving fundamentals. Instead, a “safer” way to try to exploit the anticipated correction would be with a bear spread (i.e., sell October and buy December). Those with a greater conviction that the highs are in may wish to buy a contract further out, such as the March 1998, as the long leg of the spread.
Rich Redash and Jim Ritterbusch
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