MERRILL LYNCH & CO.

North Tower, 21st Floor, New York, New York

(October 2, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil prices have continued to trend sideways, in line with our expectations, with spot WTI having averaged at $20/barrel plus-or-minus $1.50 for the past seven months. Over the near term, we expect more of the same. However, as we look beyond the near term, we continue to harbor a bullish bias on the prospect that pressures will heighten for available supply and, importantly, because we continue to sense that OPEC's key members wish to administer an elevated oil price range vis-a-vis the price band witnessed between 1986 and 1995.

Regarding our supply/demand balance, if we first focus on the second- quarter 1997 period, the currently estimated stockbuild of 1.1 million barrels/day appears too high based on the most recently available data for the OECD group of countries. As discussed in previous reports, stock figures are available only for the OECD countries. However, information from sources we consider reliable indicate that non-OECD countries carry virtually no discretionary oil stocks and instead operate on a hand-to-mouth basis. As a result, we can compare our model value for total commercial oil stocks versus the OECD actuals. For the second quarter, OECD oil stocks rose by 21 million barrels as compared with a typical stockbuild of 100 million for the period. As a result, it appears to us that there is about 75 million barrels which are unaccounted for. Because we rely on International Energy Agency series for historical data on non-U.S. countries, we would not be surprised if we again need to revise demand higher or supply lower (or both) for the second quarter.

Examining the projections for the current quarter, non-OPEC supplies are forecast to average 44.5 million barrels/day or 1.1 million more than the corresponding year-earlier level. Global demand is forecast to average 72.9 million barrels/day or 1.9 million more than the respective year-ago figure. Based on an assumed level of OPEC crude output totaling 27.1 million barrels/day, the “top down” stock change is estimated to be 1.5 million barrels/day for 3Q97. We note, however, that preliminary OECD data for end-August show only a 15-million-barrel stock build to have occurred since the end of June as compared with a typical build of 50 million barrels. Consequently, depending upon just how much oil shows up by end-September, it appears as if the third-quarter figures may have to be adjusted to show either significantly higher global demand, lower levels of supply or a combination of both.

With regards to the fourth-quarter 1997 outlook, we are projecting non-OPEC output to average 45.5 million barrels/day or 1.2 million more than the previous year's figure. Global oil demand is projected to average 76.1 million barrels/day, or 3.2% above the corresponding year-earlier level. Growth is projected to take place across the spectrum of major categories detailed in our model which includes the former Soviet Union (FSU). If OPEC crude oil production averages 27.2 million barrels/day–which would be the group's highest quarterly average since the second quarter of 1980–global oil stocks could decline by 600,000 barrels/day, which is about 200,000 barrels/day more than average. If it comes to pass that global oil stocks were not built up as projected during the spring and summer months–which is what our analyses suggest–the pressure on available supply this winter could be much greater than currently anticipated.

With regards to our forecast for full year 1998, global oil demand is projected to increase 2.5% year-over-year which translates into a gain of about 1.8 million barrels/day. The ratio of global oil demand growth to global GDP growth averages about 0.6. Global economic activity is expected to grow by about 4.5% in 1998, or about the same as is currently projected for this year.

Because of significant currency devaluations in Thailand, Indonesia, Malaysia and the Philippines, concerns–which we do not share–have arisen about the possible derailment of non-OECD Asia economic growth and the consequent impact on petroleum demand. Concerns about a marked slowdown in Asian oil demand growth is not without cause. Approximately two-thirds of the increase in total global oil consumption this decade is accounted for by the gains registered in non-OECD Asia. The four countries in question represent about 20% of total non-OECD Asia oil demand. With the exception of Thailand, our economists see relatively strong growth for these countries into 1998, and for Asia as a whole. Total non-OECD Asia economic growth is expected to decline slightly in 1998 to 7.7% versus the current year's projected growth of 8.3%. Even with the small decrease in projected economic growth next year, non-OECD Asia oil demand is projected to grow by about 7%, contributing just over 900,000 barrels/day to the growth in global oil demand.

Shifting the focus to the projected supply from non-OPEC countries for full-year 1998, our expectation is for a gain of 1.2 million barrels/day, versus the 1.0 million barrel/day gain projected for 1997. Of this growth, approximately 25% is expected to come from the North Sea. Our 1998 non-OPEC supply figure is lower than the industry consensus projection of about 1.7-1.9 million barrels/day reflecting more conservative expectations on our part about the ability to bring new projects on-stream.

Non-crude oil output from OPEC is projected to increase by 0.1 million barrels/day. If OPEC crude oil production averages 27.1 million barrels/day for full-year 1998, global oil stocks could go unchanged leaving storage, on a forward days of supply basis, at the low end of the historical range.

(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)

Michael Rothman

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