wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(September 29, 1997) ENERGY COMPLEX: CRUDE OIL–The October contract went off the board at $19.60 per barrel without much fanfare. However, the early days for the new prompt contract, November, proved much more exciting as the energy complex broke out of the trading ranges that had dogged these markets. The rally was largely technical and aided by short- covering. Still, traders were able to point to several “bullish” headline stories relating to Iraq, Colombia and the offshore oil workers strike.
The crude oil supply/usage balance remains on an even keel, largely due to the strong pace of U.S. refinery activity. Overall global demand also seems strong, in light of the high interest in October barrels from the North Sea and West Africa. More importantly, we do not expect domestic crude oil demand to provide much relief for the bears anytime soon. Even though utilization has edged lower during the last few weeks (and still has very limited room to climb higher), steady margins should keep crude runs well above year-ago levels. Furthermore, U.S. fall refinery maintenance schedules, estimated at 0.4 million barrels per day (MBD), are considered relatively light.
What could provide the bears with ammunition is the potential for increased imports. On a four-week moving average basis, imports have been hovering at a rich level of 8.5 MBD. Until additional supplies begin to back up and appear via consistent inventory additions, crude oil futures are likely to remain supported given the relatively lean inventory picture, in which total stocks are just above 300 million barrels and about 8 million below year-ago levels. Because PADD I-IV supplies still running at 12 million barrels above year-ago levels, we do not envision any serious tightness (or a squeeze) in the underlying market unless a significant supply disruption actually develops.
We are holding on to our longer-term bearish outlook, but are reluctant to advise fresh short positions in the near term in light of the market's recent resiliency and the tight supply/usage balance. Indeed, given the bullish background issues (including the offshore oil workers strike in Norway, ongoing rebel activity in Colombia and concerns about Iraqi exports), prices may advance further before they begin moving lower. This view is reinforced by the lack of any concrete signs that refinery demand is easing or that inventories are rising. Indeed, recent U.S. cash market weakness was short-lived, which suggests that excess barrels were placed and that the market is currently in balance. Hence, we continue to recommend a sideline stance for now, as we await the fundamentals to turn more decidedly bearish.
GASOLINE–Gasoline futures boasted a strong advance at week's end on concerns over more extensive refinery maintenance over the next month than had been previously expected. However, decreasing demand, steady supplies and the resulting growth in inventory levels should tend to limit further price advances. especially in the Gulf Coast cash market. As reported by the American Petroleum Institute (API) last week, the surprising build of 5.5 million barrels (including 3.6 million in the Gulf), suggests that secondary channels have largely replenished their inventories.
Considering that output remains stubborn at well above 8.0 MBD and has not yet shown any signs of slowing, relief from the supply side appears unlikely. The 1:1 gasoline crack is hovering firmly above $4.00 per barrel, a respectable return that should assure continued high production. The bearish situation likely will be compounded by the steady stream of imports (finished gasoline and blending components), which have been hovering in the area of 0.4 to 0.5 MBD. The seasonal tendency for demand to drift 4%-5% below its summer peak does not provide bullish comfort either. Consequently, we envision a weekly increase in inventories of 1.5 million barrels, and that may prove too conservative.
While conceding to the possibility of additional gains toward 62 cents per gallon, we would anticipate near-term price consolidation given the current relatively balanced supply/usage situation. This expected consolidation could set the stage for a renewed price decline toward the 58-cent mark.
HEATING OIL–Heating oil's upsurge lifted values to levels not seen since midsummer. The strength has been fueled by strong demand through the secondary portion of the pipeline in anticipation of winter needs. Also, it appears that heating oil's ability to advance despite ample supplies is partially associated with the recent upsurge in natural gas prices. Given the capability of some fuel consumers to alternate purchases between the two commodities, some switching to heating oil appears likely. The spot heating oil market has been generally firm as a result of storage purchases. With the fall to winter switches providing recent carrying charges of almost 1 cent per gallon per month, the storage play could continue until available storage is depleted or storage costs discourage further in movement.
With spot price discounts erased, an orderly expiration of the October contract on Tuesday appears likely. However, some recent softening in some of the #2 oil cousins, such as diesel fuel and kerosene, could undermine cash heating oil values, especially if natural gas prices decline. Background fundamentals continue to lean toward the bearish side, with the unusually strong production pace virtually assuming ample winter heating oil supplies, especially in the pivotal Northeast market. With stocks slightly above average levels, higher prices will not be needed to ration available supplies. as was the case last year.
We were stopped out of our short December positions at the 59.10 mark. We will look to reestablish fresh short positions in this contract month upon evidence of failure in the 60.00- to 60.50-cent area.
NATURAL GAS–Natural gas futures prices exploded to the upside last week as new contract highs were recorded with more regularity than the daily sunrise. Holders of short October natural gas positions panicked in the final week of trading, sending prices toward the stars. Clearly, fundamentals cannot be used to justify either last Thursday's rally of $0.30 per million Btu or the 60-cent weekly move. Still, buyers in the physical market continued to ante up in cash transactions, providing futures traders with “justification” to bid screen values even higher.
With prices well above the $3.00 mark, many end users are switching to alternative fuels where possible. Utilities are seeking out residual fuel oil, which is trading at a substantial discount to city-gate prices in the major markets. Indeed, even the most expensive 0.3% sulfur low pour residual fuel is at a discount to natural gas in the New York market. Additionally, large duel-fuel commercial and industrial customers will be switching to residual fuel oil, heating oil or propane. Heating oil, a higher-priced, “cleaner” fuel relative to residual oil, is usually too expensive to even be considered at this time of year, but at 56.00 cents per gallon (equivalent to a natural gas price of about $3.30), it looks rather attractive in light of natural gas city-gate prices. Such fuel switching should alleviate some demand pressures on the natural gas market.
The need for further storage injections should prevent the cash market from sliding too far during the next few weeks, unless more firms begin to balk at the current high prices. Last week's report from the American Gas Association (AGA) that showed only 73 billion cubic feet (BCF) was injected into storage suggests that more gas needs to be injected into storage before winter. If weekly injections total 60 BCF over each of the next five weeks, the industry will lift storage to about 2,830 BCF. Such air injection rate would imply 8% higher demand than last year, and would be a 35% increase relative to the three-year average. However, if the industry refills storage to only 2,740 BCF (a level more in line with last year), then the resulting average weekly injection demand of 45 BCF would be about 19% lower than last year's level and only about 2% more than the three-year average. The high-priced environment may “force” the latter of the two scenarios to unfold, which would also contribute to a softer cash market.
In spite of our bullish bias, the futures market seems poised for a sharp correction. The influence on prices from commodity funds and other speculators remains a significant risk to establishing short positions. Moreover, we believe many natural shorts (i.e., producers) are avoiding selling into this market in light of the positive fundamentals that spell upside potential. As a result, we would not sell this market at the current time. Instead, we look to reestablish long positions only after a substantial price decline (i.e., $0.20 to $0.30) that lowers the December contract back toward $3.00. Given the volatility of late, we advise staying clear of this market for now.
Rich Redash and Jim Ritterbusch
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