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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(September 18, 1997) ENERGY COMPLEX: ENERGY AND EL NINO–The occurrence of an El Nino (originally named “Christ Child” by Peruvian sailors because the event begins near Christmas) is correlated with various weather anomalies for different parts of the world. Because the relevant meteorological data for El Nino events have only been collected for the past 25 years, the amount of information is relatively limited. Since 1972, there have been seven El Nino incidents which impacted the winters (i.e., December-March period) of '72/'73, '76/'77, '82/'83, '86/'87, '91/'92, '92/'93, and '93/'94. The climatological events that surround an El Nino vary for different parts of the word, but for the global energy markets, the key impact appears to be warmer than normal winter weather in the northeast U.S. The European basin is not affected, nor is the market encompassing the former Soviet Union. Accordingly, the key U.S. winter fuels affected are natural gas and high sulphur distillate fuel (i.e., heating oil). Based on our analyses of the demand effects during these El Nino winters, it appears as if the natural gas markets are more susceptible to the temperatures effects than heating oil. As a result, the current concerns about natural gas supply availability–which has boosted winter price levels–should be used as an opportunity to purchase out-of-the-money put options in the event of a winter which is warmer than normal. We have separate bearish concerns about the winter heating oil crack spreads (i.e., heating oil-crude oil price differential) owing to high distillate inventories on both sides of the Atlantic and the prospects for U.S. distillate production to remain high headed into winter.
We examined temperature deviations from normal during the December-March period for each of the 7 El Nino events of record. For our analyses, we used New York City as the proxy for weather in the northeast U.S. market. On the whole, temperatures during El Nino years averaged 0.9 degrees warmer than normal. The two year's which were considered to have had the most severe El Ninos ('72/'73 and '82/'83) averaged 2.8 degrees warmer than normal. As a matter of comparison, last year's winter (which was not an El Nino event) saw temperatures average 3.5 degrees warmer than normal.
With the heating season now just 6 weeks away, the weather probabilities associated with a true El Nino take on more precedence, in our opinion. Surface water temperatures west of South America have warmed dramatically over the past 6 months, with the most recent readings showing some areas to be 10-12 degrees warmer than normal. One climatological event which helps define the occurrence an El Nino is a drop in the air pressure in Tahiti relative to Darwin, Australia which is gauged by the Southern Oscillation Index (SOI), a standardized reading of the sea-level air pressure between these two areas. An SOI of —1 (meaning one standard deviation below normal) for 3 consecutive months partly constitutes an El Nino event. We have examined the SOI for the month of December in each El Nino event. The SOI for the August just-past is considered to be significant.
If we consider the possibility that the current reading of the SOI and relevant water temperatures will produce an El Nino this winter, the question to ask is, “how are the affected energy markets likely to be impacted?” To help answer this question, we first examined the year-over-year demand changes for the December-March period in each of the seven El Ninos occurring since 1972. In the case of natural gas, there is a strong correlation between warmer than normal winters (i.e., lower degree days) and lower natural gas consumption. We focused on natural gas demand in the residential and commercial sectors since they represent the predominant heating-related sectors. Also, we used temperature deviations from normal (i.e., degree days) for both Chicago and New York City since these two markets represent the principal natural gas heating markets (temperature variances in these two markets are highly correlated). Please recall that the most severe El Ninos occurred in '72/'73 and '82/'83. While the year-over-year demand change for the '72/'73 period is not available (data was not collected by Federal agencies until 1973), the drop in demand during '82/'83 winter was quite severe, having been 521 billion cubic feet (BCF). As a matter of comparison, last year's winter (which was not an El Nino event), saw temperatures average at warmer than normal levels (i.e., lower degree days) with residential and commercial natural gas demand declining by 269 BCF.
If we switch gears and focus on the U.S. heating oil market, the demand effects produced during El Nino winters are quite contrary to what one might expect. The seven El Ninos since 1972 produced only one winter which saw lower year-over-year demand levels–this happened to be the severe El Nino during the '82/'83 period. Demand actually rose during four El Nino periods even though temperatures for those same 4 periods were warmer than normal. Even in last year's winter, which saw temperatures average almost 3.5 degrees warmer than normal, distillate demand declined only 43,000 barrels/day (or 1.2%). The question is, “why?”
If we look at the distillate fuel demand in the U.S., there has been a dramatic shift in end-use consumption over the past 30 years. More specifically, the use of distillate fuel for space heating purposes has fallen by about 40%–owing to displacement by natural gas units–while on-highway diesel consumption has grown by almost 800%. As a result, changes in the total level of distillate fuel demand are much less sensitive to change in weather related consumption. We note, however, our separate bearish concerns about the upcoming winter's heating oil crack spread outlook (i.e., the price spread between heating oil and crude oil) owing to the currently high level of distillate fuel oil stocks on both sides of the Atlantic, and the prospect that U.S. distillate fuel oil production rates will remain high. The latter stems from the prospects that refiners will keep crude runs at relatively high rates in order to meet gasoline market needs. The related effect is that the high throughput rates lead to “inadvertent yield” of distillate fuel. With regards to inventories, current U.S. distillate stores are 20 million barrels ahead of last year with OECD Europe distillate stocks about 25 million barrels ahead.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
Michael Rothman
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