wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 27, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil futures bounced higher last week, with buying spurred by bullish inventory numbers that showed a 3.6-million- barrel stock draw that lowered total U.S. inventory to 301.4 million barrels. Also, ongoing Mideast tensions, especially regarding Iraq, continue to provide a firm underpinning. Decreased imports and reduced refinery demand were behind the unexpected inventory draw. Relatively low imports and/or refinery demand will result in reduced stocks.
U.S. refinery demand, which has been on the high side of its range of 14.3-15.1 million barrels per day (MBD) this year, has been behind repeated inventory reductions throughout the third quarter. With stocks now hovering around 300 million barrels, the lower “safety net” implies higher volatility (like that of 1996) and a greater tendency for price spikes. Although the potential for inventory growth exists, it requires either reduced refinery demand or higher imports. We expect crude runs to fluctuate within the 14.6- to 14.8-MBD area this quarter, and imports to expand into the 8.5- to 8.9-MBD area in coming weeks. These estimates suggest inventory additions in a period that normally produces stocks declines.
Signs of growing imports are slowly emerging. OPEC production continues to grow (mainly due to Venezuela), while recent data suggests that non-OPEC supplies are also rising again. The fourth-quarter production estimate for non-OPEC countries issued by the International Energy Agency (IEA) of 45.9 MBD still appears too high (despite several revisions), but reports that production hit 45.0 MB in September should alleviate some of the related concerns. Reports from the last two North Sea monthly loading programs also suggest growth: October's figures were up 0.40 MBD versus September and are expected to climb another 0.15 MBD in November. Hence, we believe imports will rise toward the 8.5 MBD area, at least. The resultant build in stocks will work against higher prices. Moreover, if margins contract under the weight of growing product stocks, lower refinery demand also will contribute to higher inventories.
Despite our concerns for increased inventories, a bullish bias appears entrenched in the market, at least for the short term. While we are holding a long-term bearish opinion, we advise short-term oriented clients to approach crude futures from the long side. The December futures contract appears likely to rise toward $21.80 per barrel before strong resistance kicks in. (Friday evening's Commitments of Traders report may scuttle this potential rally if it shows funds are still heavily long.) Such a rally should be used to establish bear spreads, i.e., sell December and buy May. Look to enter the spread only if December is trading at a 50- to 60-cent premium to May. We would hold off on selling this market if Nigerian exports are curtailed on Monday due to labor problems and/or if Iraq moves closer to ending the oil-for-food agreement.
GASOLINE–Recent bullish stirrings in gasoline futures is not expected to last long, even though the relative price performance within the complex looked favorable. Strength in gasoline was primarily the result of a strong crude oil market, which rallied because of favorable numbers from the American Petroleum Institute (API). Gasoline demand figures also were friendly, showing consumption continues to run well above 8.0 MBD.
We believe gasoline prices will soften as they approach termination on October 31. Supplies appear ample near term and should increase further because imports are expected to post additional gains by early November. Spot trade remains routine at best, with recent spot premiums giving way to slight discounts. Bullishly inclined traders looking for a treat may be tricked with an expected decline to the 58.00-cent area, basis December, by Halloween.
HEATING OIL–Heating oil futures continue to lag the gains in crude oil and gasoline despite the United State's first encounter with significantly colder-than-normal temperatures east of the Mississippi. Secondary distribution channels appear full, especially in the Northeast. This hunch is reaffirmed by the inability for the existing New York Harbor cash discount to narrow; instead the discount has increased a bit and is hovering in a range of 1.20-1.50 cents per gallon. An expanding discount this close to futures termination is a sign of weakness, i.e., ample supplies.
Distillate inventories unexpectedly decreased by 0.3 million barrels in the week ended October 17, according to the API. Given the highest production level of the year (3.7 MBD) and steady imports (0.3 MBD), the draw implies increased demand that was probably due to heating oil stock shifting and a seasonal increase in diesel usage due to the fall crop harvest. Nevertheless, the year-over-year distillate surplus remains about 22 million barrels. More importantly, primary supplies remain about 5.0 million barrels ahead of the five-year average. PADD I heating oil supplies declined (0.1 million barrels) for the first time in weeks. However, total heating oil stocks grew by 1.6 million barrels; in the Gulf region, supplies swelled by 1.2 million barrels. These supplies may soon find their way to PADD I, the largest U.S. heating oil market. However, the year-over-year surplus in PADD I heating oil inventory (at 18.4 million barrels above last year's low level) is still large and accounts for 90% of the total distillate surplus. Thus, additional price weakness seems likely to accompany any product movement from the Gulf to the Northeast.
Further price gains in heating oil futures still appear highly contingent upon strength in the rest of the complex, and we would not rule out an advance by the nearby contract to the 59.50 level. However, assuming stable-to-weaker crude oil values, we expect the November heating oil contract to head toward the 56.50- to 57.00-cent area by Friday's termination. Expect similar weakness to carryover into the December contract.
NATURAL GAS–Natural gas is firmly in the midst of a bull market that conceivably could last through winter's end, assuming normal weather and temperatures. The ongoing El Nino episode muddies the picture, but we do not advise trading off long-term weather forecasts, given their generally low probability of being accurate. Despite our favorable outlook, the current winter contract prices are already so high that fresh longs face significant downside risk from profit taking, as evidenced by the reversal of 25 cents per million Btu last Thursday.
Natural gas storage levels of 2,787 billion cubic feet (BCF) is now at 87% of capacity. Two months of weekly injections that ran about 80 BCF are to blame for the sharp increase in storage and some of the price support seen in the physical market lately, The remaining two weeks of the refill season should not bring with it much more injections; over the last two years, injections have averaged only 25 BCF in these final weeks. Thus, we expect storage will approach 2,850 BCF, or 90% of capacity. Such a level would be 4%-5% above last year's peak of 2,725 BCF. This year's level of storage is considerably higher than many had expected but still below the three-year average, thus we view storage as a neutral pricing consideration.
The current cash prices for natural gas ($3.30 at the Hub and $3.60 to $3.80 at the city-gate) reflect limited price appreciation potential this week. Such prices on a per barrel basis equate to $23.00 to $25.00. Because the most expensive residual fuel oil (0.3% sulfur, low pour #6 oil) in the New York Harbor is currently trading at $21.00 to $21.50 per barrel, natural gas is at a price disadvantage. Consequently, fuel switching should limit further price gains.
Overall, we see cash prices rising this week due to the colder weather and cash market pressures to converge with futures. However, we do not see Henry Hub cash values rising all the way up to the “screen.” Fuel-on-fuel competition and light storage demand should limit physical demand. Such a scenario implies that the screen will have to soften somewhat as well, or cash will once again not converge with the futures market at termination (as was the case last month). As cooler temperatures settle in for winter, utility natural gas demand will wane and therefore, lessen the significance of fuel-on-fuel competition, But, that's a longer-term consideration that may not unfold until December-February.
We remain bullish, but are expecting a correction. If such a scenario unfolds, we would look to establish fresh longs. Specifically, look to reenter the December contract at the $3.50 area, risking to $3.38 and seeking $3.86 or better. As for the bears out there (if you are all not extinct yet), do not try to pick a top merely because “prices seem just too high.” This strategy is too risky in light of the still favorable technical picture and the strong bullish bias in the market.
Rich Redash and Jim Ritterbusch
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