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ENERGY COMPLEX
QUARTERLY OUTLOOK
Prepared by Prudential Securities, Inc.
Heating Oil
Overview
As of mid-October, the heating oil market had lost about half of a strong late summer/early fall rally that lifted prices by 9 cents per gallon. Easing of tensions in the Mideast and the downward pull of an increasingly negative crude oil market provided much of the downside impetus. Additionally, an exceptionally large contingent of speculators on the long side of the market facilitated a heavy dose of bearishness as they liquidated their positions. Price support through the fall will largely hinge on broad-based factors influencing the crude oil market, primarily the political/military situation in the Mideast. Notwithstanding further Mideast developments, we project a tendency toward heating oil price weakness through the balance of the fall.
Stocks
Distillate stocks, at about 136 million barrels as of October 10, were 4 million barrels above the five- year average for that time and a huge 22 million barrels above last year's level. However, last year's supplies were unusually low. It is also important to consider stocks in relation to the level of consumption, and October 1 stock levels were on the low side historically when measured as a ratio against third-quarter demand. With the exception of last year, the stocks/usage ratio as of October 1 was at its lowest level since 1988. Stated differently, current distillate stocks represent about 37 days' supply, compared to a 39-day average over the last four years. This consideration may partially explain the late summer price strength amid seemingly ample heating oil supplies.
The ongoing seasonal stock-building process is expected to last through November, with supplies peaking between 140 million and 145 million barrels. Implied in this outlook is an average weekly build of about 1 million barrels during October and November. This rate, spurred by an unusually strong refinery pace, would be slightly above the average increase over the last 10 years.
It also appears likely this year that more product is being held in storage beyond the primary terminal stage. This assumption is based on the relatively wide carrying charges seen in the winter contracts, a situation that has afforded holders of inventory an opportunity to hedge their product at attractive price levels. While movement into this type of storage represented a bullish consideration in September, it could come back to haunt the market in November as secondary suppliers begin to de-stock by backing away from fresh purchases.
Statistical Observations On Distillate Supply:
The seasonal peak in distillate stocks can occur as early as the beginning of October to as late as January of the subsequent year. During the last 10 years, the fourth-quarter's stocks increase has averaged about 6.4 million barrels, with supplies peaking at an average of about 138 million barrels. This year's projected peak is expected to approximate levels during the 1991-1994 period, which ranged from 145 million to 147 million barrels.
Production
Heating oil production has been running at a relatively strong pace in recent months as refineries have taken advantage of attractive margins. In conjunction with seasonal tendencies, distillate yields have begun to increase ahead of the heating season, a development that facilitates the fall stocking process. During the third quarter, heating oil production likely achieved record levels. Some slowing in output is expected in the fourth quarter as a gradual deterioration in margins translates into a reduction in refinery activity, probably back toward 1995/96 levels of about 95%-96% of capacity.
Imports
Distillate imports play a relatively small role in the overall supply picture except during a cold winter when other producing countries can provide an incremental supply source. During the 1990's, the significance of imports has been further diminished by increased export activity, which has virtually offset the amount of incoming product. As a result, the international trade factor should have negligible impact on the distillate supply situation during the fourth quarter.
Consumption
So far this year, distillate consumption is running about 1.6% above year-ago levels. This strong growth rate reflects an unusually robust U.S. economy, a factor that has boosted diesel fuel consumption. On the heating oil side, last year's relatively warm winter provided an ample supply base during the spring to accommodate a normal stock-building process through the summer months. The upcoming winter could prove equally mild given the El Nino phenomenon, which is expected to prompt warmer temperatures by as much as 5% to 8% in much of the U.S. heating oil consumption areas. With the fall season off to an unusually warm start, the odds lean in favor of at least some downshift in consumption from the strong year-to-year gains registered during the first three quarters of the year.
Commitment Of Traders
Much of the late summer/early fall upmove in heating oil prices appears to have been fueled by small speculators. The non-reportable segment of the Commitments of Traders report indicated small “specs” held a net long position of more than 22,000 contracts as of early October, a level that approaches the highest seen over the last year. The significance of this large speculative holding lies in the possibility of an accelerated downside reaction as speculators liquidate their positions. This was vividly demonstrated during the early October price break, particularly as key support levels were violated on the charts.
Spread Relationships
Nearby heating oil futures have remained at a sizable discount to the forward contracts in recent months. While seasonal considerations are partly accountable for this price structure, this year's unusually wide spreads also reflect ample supplies. With premiums in the winter contracts approaching the cost of acquiring and storing the product, oil companies have been active in purchasing the lower-priced product via the spot market or by taking delivery of nearby futures while simultaneously selling the product in the higher-priced, more distant months. While this activity can temporarily support cash values, the stored product acts as a supply buffer to occasional product shortfalls in the future. In view of expected production and import trends, this carrying charge, or contango, market likely will persist through the fall.
Also, adequate supplies of heating oil have tended to exert downside pressure in heating oil values relative to crude oil prices. The recent dichotomy between a relatively constructive crude oil supply/usage situation (i.e., low stocks and strong refinery demand) and a negative heating oil fundamental situation suggests further contraction in the heating oil crack spreads. Differentials between the December heating oil and crude oil contracts could eventually narrow toward $3.00 per barrel from their mid-October levels near $3.65.
Conclusion And Trading Recommendations
The strong price advance during September and early October appears to have been fueled almost entirely by speculative interests as well as by gains in the crude oil market. With heating oil supplies at ample levels ahead of the upcoming heating season, additional commercial selling interest is expected to develop on any renewed price rallies. Assuming some weakening in crude oil values as Mideast tensions ease, further declines in heating oil prices appear likely both in absolute terms and in relation to the rest of the energy complex.
We advise selling January heating oil on any price advances back toward the 61.00- to 62.00-cent zone, with stop protection above 64.00 cents. Assuming normal temperature patterns through the balance of the fourth quarter, we would look for downside potential near 55.00 cents.
Gasoline
Overview
After bottoming in late June, gasoline futures exploded a month later in response to steady demand increases coupled with supply problems. As a result, refining crack spreads soared and prices at the pump moved sharply higher, albeit less than that at the wholesale level. This scenario of price spikes may occur with more regularity, especially next year (at least during periods of peak demand) given the United States' limited refinery capacity and growing reliance on gasoline imports. Long term, this market has significant upside potential unless inventories rise significantly.
Through November, we expect additional pressure on gasoline futures. High U.S. crude runs have kept gasoline production comfortably above 8.0 million barrels per day (MBD). Additionally, overseas refinery operations are back to normal following maintenance/repairs and production problems; thus, imports into the United States have returned to their previous healthy levels. Indeed, talk of additional imports, distressed cargoes, etc. is working to undermine cash values, which should keep the futures market on the defensive. Clearly, the supply/usage balance currently favors supply. Furthermore, a pattern of excesses is likely to continue into November, and the related inventory builds should increase pressure on the gasoline futures market.
Recent demand gains, with the likelihood of further additions, will continue to test the industry's ability to meet demand through production and imports. For example, assuming crude runs average between 14.6 MBD and 14.8 MBD, gasoline production would average 7.4 MBD to 7.6 MBD. Consequently, if demand remains in the 7.8- to 8.0-MBD area, imports will have to average a healthy 0.2-0.6 MBD. Any supply problems would pressure the supply/usage balance because inventories remain at historically low levels. Hence, volatility and price spikes are likely.
Stocks
During the early summer, the long-standing inventory deficit was erased and replaced with a surplus. However, it proved to be very short-lived thanks to refinery snags and a strong surge in mid-summer gasoline demand. Indeed, demand outstripped supply through much of July and August. Even the seasonal post-Labor Day dip in demand proved less than most expectations. As a result, stocks are once again hovering near historical lows. Robust demand should keep inventory gains in check, even though it is likely that builds will materialize through November due to ongoing high refinery production; we expect stock additions to reach 0.1 to 0.3 MBD (i.e., 0.5-1.5 million barrels per week on average). This forecast assumes relatively smooth refinery operations here and abroad. If weaker margins finally result in run cuts, a tighter supply/usage balance should return.
Production And Imports
Domestic gasoline production has been very strong due to high refinery utilization rates that have yet to slow significantly. Additionally, short-term supply curtailments resulted in some very wide margins (e.g., a 1:1 gasoline crack in excess of $10.00 per barrel), thus encouraging even stronger production. These economics have not turned bearish enough yet to “force” refineries to ease their production. Year-to-date production is up nearly 3% versus last year, or about 0.2 MBD. The gains are even more pronounced when excluding figures from the first quarter, when refinery maintenance was in high-gear production from April through September averaged 8.0 MBD, a gain of 4.0% or 0.3 MBD versus the same period in 1996. Production is likely to average 7.7-7.9 MBD for the rest of year, barring a collapse in crack spread margins.
Imports are increasing even faster than domestic production, but still only account for a small share of total supply. However, because the U.S. gasoline supply/usage balance can be tight, any disruption in imports can have a very significant effect on prices, as witnessed last summer. Year-to-date finished gasoline imports have averaged more than 300,000 BPD. Additionally, when blending component imports are considered, imports averaged 540,000 BPD, up 15% versus 465,000 BPD last year. The prevalent trend of bringing in blends has been seen since 1994, and is not likely to reverse. More importantly, the unfinished material is significantly augmenting total gasoline supplies. However, because it takes both domestic production and imports to meet the strong U.S. demand, the market can be well balanced. As long as stocks are low, any disruptions will have an exaggerated price response. Total imports should remain between 0.4 MBD and 0.5 MBD for the rest of 1997.
Consumption
Year-to-date gasoline consumption is up 1.6% versus 1996, starting slow but accelerating since summer; recent demand is running about 4% above last year's pace. More importantly, demand has remained well above 8.0 MBD because of a lower-than-normal seasonal slowdown in consumption. Consumption has declined only about 3%, or 0.2 MBD, since Labor Day; in the last two years, the fall-off has been in the 4%-5% range. This year's strong demand has raised the importance of inventory levels, especially in terms of stocks/usage ratios.
Several factors are behind the demand growth, which continues to exceed historical averages, including: (1) continued robust economic activity; (2) greater use of sport utility vehicles; and (3) higher speed limits. What's more, consumers are unlikely to change their consumption habits anytime soon because the price spikes in the futures market were neither long-lasting nor fully reflected at the pump. As a result, we expect strong consumption to continue, implying gasoline demand will remain between 7.7 MBD and 8.0 MBD through year's end, with an average of about 7.8 MBD.
Conclusion And Price Outlook
During the fourth quarter, a relatively volatile and wide-swinging trade appears likely in the gasoline futures market, with the January contract expected to trade between 55.00 cents per gallon and 68.00 cents. The low side of this range could be tested by early November. Traders should consider bull spreads such as long January/short March on a possible decline near this support level, especially when a carrying charge (contango) structure exists. On rallies toward the 67.00- to 68.00-cent area, we would suggest outright sales of the January contract. This strategy is contingent on a stable political/military situation in the Middle East and a continued flow of Iraqi crude oil exports.
October 23, 1997 Richard Redash and Jim Ritterbusch
Prudential Securities, Inc.
One New York Plaza, New York, New York
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