MERRILL LYNCH & CO.
World Financial Center, New York, New York
(October 16, 1997) ENERGY COMPLEX: CRUDE OIL–WE CONTINUE TO HARBOR BULLISH CONCERNS REGARDING THE INTERMEDIATE-TERM PRICE OUTLOOK–After having traded at $20/barrel +/— $1.50 for 30 consecutive weeks, spot WTI crude oil recently made an advance to levels above $23 before then pulling back towards $20. The rise in price reflected market concerns about Middle East tension which specifically included the following:
–Iranian air raids reaching into Iraq's territory and a resultant fear that the incidents could somehow cascade into producing another Iran-Iraq war. Because the U.S. sent a new warship to the Persian Gulf in reaction to the recent Iranian raids, there was also some concern in the market about a possible military confrontation involving the U.S. and Iran.
–A series of confrontations between Iraq and UN personnel, including weapons inspectors, which raised concerns about further sanctions being levied against Baghdad and a possible interruption in exports via the humanitarian sale.
–Lastly, statements by Iraq that oil exports via the Trans-Turkey pipeline –which are currently running at about 600,000 barrels/day–might suffer from unplanned outages if spare parts were not obtained.
From our perspective, the probabilities currently appear limited regarding another Iran-Iraq war, as do the prospects for the UN to levy further sanctions against Iraq–we do not see the U.S. as having enough support within the Security Council. Regarding an interruption of oil flows from Iraq through the Turkish pipeline, indications from private sources we consider reliable suggest that such a scenario warrants a moderately low probability.
As prices rallied, we found that the large non-commercial traders in the crude oil market (i.e., the “hedge funds”) took on an almost record high long position in the market, based on our analysis of the CFTC's Commitment of Traders Report. The net long open interest position of the “funds” totaled approximately 55,000 contracts which for the 12 years that we've been tracking the data was exceeded only during the late-March to early-May 1995 period. Historically, when the funds take on extreme net long open interest positions in crude oil, prices have generally made interim price tops. In the most recent case, we would argue that fundamental develops triggered a rally, but that mass buying by the “funds” were the critical factor which pushed prices over $23. Conversely, we would posit that when the “funds” took on this extreme long position in the crude oil market, there were no new fundamental considerations which warranted a continuation of the rally. As a result, it appeared to us that the “funds” began to liquidate their long positions which resulted in the pullback to levels just over $20. So where do we go from here?
In terms of the intermediate-term price outlook, we continue to harbor a bullish bias based on the prospects for tightness to be recognized in the global oil balance. Our target remains $25 per barrel, basis spot WTI versus current levels just north of $20. We have updated our global supply/demand models going back to 1971, commensurate with the very recent definitional changes for the OECD (Hungary is now a member) and revised/updated data for China, Iran and some other non-OECD countries. The net effect of these data changes does not alter our current view about the underlying global oil balance being prone to supply tightness. In looking specifically at the 2Q97 and 3Q97 data, our supply/demand model suggests that commercial oil stocks should have been built up by about 260 million barrels. Based on our estimate for end-September OECD stocks, we can not account for almost 200 million barrels of that projected build as shown in the accompanying chart which compares our model value for commercial stocks as compared with OECD actuals.
Once again, this dilemma of the “missing barrels” suggest that:
–the current and previous year's demand figures may be understated and/or that the current and previous year's supply figures may be overstated
–that the global oil balance is probably much tighter than generally recognized.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
Michael Rothman
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