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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(September 22, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil futures faltered after a brief one-day rally lifted the nearby contract to the high end of its recent trading range of $19.15-$19.90 per barrel. The crude oil market was like a referee caught in the middle of a heavyweight title fight. Gasoline and heating oil battled for control of the complex, with heating oil's strength dominating early, but gasoline's low blows proving to be too much in the end. Meanwhile, crude oil ended the week with its ears intact at price levels not much changed from before the fight, but still awaiting clearer direction.
We were not impressed with how prices moved higher. Last Tuesday's rally lacked heart, and the subsequent reversal confirmed our suspicions. The product markets remain the key to our crude oil outlook, given the impact they have on refinery utilization (i.e., crude demand). So far, domestic refinery, operations continue to hum at near-record levels, primarily due to healthy crack spreads. However, the pressure on margins has begun to pick up, as evidenced by a decline in the 3-2-1 crack spread of more than $2.00 per barrel since Labor Day; the drop is largely due to weakness in gasoline. Indeed, commercials attempting to lock in these margins have indirectly supported crude with their related spread transactions, preventing (for now) a further move lower. Because the spread remains above $4.00, additional declines are needed to quell the refineries' insatiable appetite for crude oil. We expect the contraction to deepen because gasoline prices have begun their seasonal descent and heating oil fundamentals are a far from positive.
A scenario of easing demand, will not mix well with the growing supply picture. The final numbers for the October North Sea loading program were not positive, as it appears nearly 0.4 million barrels per day (MBD) will be added to the market. Additionally, the United Nations allowed Iraq to carry over crude oil sales, and the final terms will result in 1.1 MBD of exports through the agreements end in early December. These supplies should appear directly or indirectly via higher imports into the United States. Throw in some refinery maintenance around the globe and it seems that inventories will be expanding in all the major international markets as the northern hemisphere winter approaches.
A warning shot was fired across the bow of the crude market when the American Petroleum Institute (API) reported that imports exploded to 9.4 MBD during the week ended September 12, the second highest level on record. Some of this figure must have “borrowed” from the previous week's relatively low level of 7.6 MBD, but the two-week average of 8.5 MBD was still high enough for U.S. stocks to climb. The outlook for additional inventory increases is reinforced by the growing availability of crude supplies. New weakness, albeit modest, in the Louisiana light sweet premium relative to West Texas intermediate also reaffirms our opinion that either exports to the United States are rising or demand is easing in the import-sensitive Gulf Coast market (home to nearly 45% of U.S refining capacity).
We still favor a bearish trading approach, but believe the sideways action will continue until the market breaks lower due to technical considerations or the emergence of more concrete signs of easing refinery demand and growing inventories. Hence, we recommend a sideline stance for now, as we wait for the fundamentals to reveal what we believe will be their decidedly bearish nature.
GASOLINE–We are no longer friendly to the gasoline market. Last week's price action was not encouraging to the bulls as gasoline was a leader during downmoves, and a reluctant follower during up days.
The cash market remains weak, prompted by an upswing in imports that were fixed about a month ago and are now washing ashore as well as the ongoing torrid rate of refinery operations. Indeed, even though the utilization rate has dropped slightly, gasoline production remains at a very healthy 8.1 MBD. Imports of both gasoline and blending components also have been edging higher as well. For example, for the week ended September 12, gasoline imports were 367,000 barrels per day (BPD) while blends totaled 267,000 BPD.
The steady to higher,supply picture comes at a time when demand is falling. So far, the decline in demand has been modest at about 200,000 BPD. However, a decline to 7.8 MBD from 8.2 MBD (reflecting previous seasonal tendencies) would be dwarfed by production and imports. Moreover, there have been no significant refinery mishaps, and prior downed units have since returned. Indeed, the balance has already turned in favor of supply, which is reflected by the recent modest increases in inventories. Even though stocks are low based on historical measures, the support that factor provides for the market diminishes as demand drops.
We no longer view the gasoline market with favorable eyes. We closed out our previously established bull spread (long November/short December) positions late last week with a modest loss. We anticipate further weakness in the October contract and see potential downside risk to 55.00 cents per gallon. However, the low stock situation leaves the market exposed to a knee-jerk advance stemming from any significant supply disruptions.
HEATING OIL–Further seasonal-related price gains in the heating oil are expected to checked by ample supplies. Although U.S. supplies were trimmed by recent export movement out of the U.S. Gulf region, distillate stocks remain near their historic averages for mid- September. With refinery activity continuing at a relatively high level, larger- than-normal stock increases appear likely into autumn. Also, secondary suppliers are believed to be holding larger stocks this year relative to recent years, so long hedging interest from the distributors should be limited.
The spot heating oil markets strengthened last week with the help of aggressive storage purchases. Price premiums in the winter contracts have provided a viable short hedge, so a sizable amount of East Coast product has been transferred from pipelines and refineries to long-term storage facilities. Because this transfer of product doesn't reduce total supply, the storage- related price strength likely will be short-lived.
From a longer-term vantage point, prices will be influenced by winter weather patterns. The current El Nino, should result in a warm winter with temperatures in some heating oil consuming regions averaging as much as 6-8 degrees above normal. With these forecasts well publicized, distributors could prove cautious in building inventories further, a development that could back up supplies toward the primary level.
An exceptionally large net long position held by small speculators will keep the market vulnerable to sharp price declines. Occasional violation of price support levels could be accentuated by long liquidation from funds and small seasonally oriented traders. Taking all these factors into consideration, the heating oil market appears vulnerable to price breaks of 34 cents per gallon. We will look to approach the short side of the December contract on further advances toward the 57.00-cent area, with stop protection above 58.25 cents.
NATURAL GAS–Natural gas prices experienced an orderly liquidation early last week before staging a strong recovery to new contract highs after the American Gas Association (AGA) released its latest storage figures. The storage report, which showed injections of 88 billion cubic feet (BCF) during the week ended September 12, was generally in line with expectations. However, it did eliminate some bearish uncertainty because certain participants were expecting higher figures. Just ahead of the report. prices traded at the week's low of $2.665 per million Btu.
The market's resiliency is not surprising, despite the “bearish” AGA numbers over the last three weeks, because it obviously recognizes that storage demand must remain strong or else there is a risk that the industry may enter winter with supplies that are much below normal. As we noted last week, storage demand must increase, 4%-6% over last year's levels and by 27% to 33% when compared with the three-year average if the industry plans to enter winter with about 2,800 BCF in storage. Last year, storage was filled to 2,725 BCF, while in 1994 and 1995, it peaked at 3,099 BCF and 2,958 BCF, respectively.
The combination of growing demand and lower U.S. production (partially offset by a rise in imports) has tightened the natural gas market. On an annual basis, 1997 total supply (production and net imports) may likely be eclipsed by total usage (industrial residential, commercial and utility). Indeed, 1997 U.S. natural gas production in the first six months of the year fell 0. 1% versus the comparable year-earlier period, according to the Energy Information Administration (EIA). First quarter demand was down 2.8%, largely due to weather, but second quarter demand jumped a similar percentage and we believe that growth has continued into the third quarter due to greater utility, industrial and commercial usage.
Supportive weather is needed to keep pressure on the supply/usage balance. For this time of year, hot temperatures are needed to maintain air conditioning loads. The latest forecast available, heading into last weekend, painted a much cooler picture. While some may believe heating demand will pick up, we contend that it should be more than offset by lower air conditioning loads. So, even though cash price's were able to hold a premium to the screen, it appears short-term price weakness lies ahead. In light of the high number of speculators in the market, who were shown to hold more than 50,000 long positions in List week's Commitments of Traders report, the downside risk has increased.
Selling this market warrants extreme caution given the markets fortitude to move higher. Although we are long-term bullish, we believe prices have gotten ahead of the fundamentals. Short positions above $2.90, basis November, can be considered by the aggressive trader, using stop protection at $3.02-$3.03. We would reenter the market as a buyer in the November contract on dips that pull prices into the $2.70-$2.72 range.
Rich Redash and Jim Ritterbusch
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