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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 6, 1997) ENERGY COMPLEX: CRUDE OIL–Fundamentals, technical and emotions are all aligned and are pointing to higher crude oil futures prices, especially with Middle East tensions flaring. Strong refinery demand around the world, coupled with regular reports of potential supply disruptions of all sorts have prevented any inventory increases. Indeed, inventories continue to fall, especially in the United States, and the stocks picture is looking very much like 1996 when crude oil was trading in the mid-$20-per-barrel area. More importantly, inventories will not expand until crude demand (refinery utilization) eases and/or world crude supplies increase (without corresponding offsets from unplanned curtailments). The inventory situation is compounded further by the futures markets' switch from contango to backwardation, a move that encourages a de-stocking mentality within the refining sector.
Relatively lean inventories leave the market vulnerable to sharp gains on word of supply problems. Supply disturbances (actual or potential) have been all too common of late (e.g., Iraq, Iran, North Sea, Colombia, Mexico, etc.). The corresponding rallies in crude oil appear justified in light of its tight supply/usage balance that is leaning hard in favor of demand.
Although the market is in an uptrending mode, there are several risks to holding long positions, including: (1) the potential for a decline in refinery utilization rates; (2) problem-free crude oil production; and (3) reduced tensions in the Middle East. As for refinery activity, lower crude runs are not likely anytime soon in light of the still-healthy crack spreads as reflected in the futures market. In coming weeks, we envision commercial participants will step up their efforts to lock in the futures margins. The fundamentals associated with the product markets, already somewhat negative, should grow more bearish as gasoline and heating oil output continues at brisk rates. Furthermore, tanker rates have risen sharply due to the increased shipping activity that is being driven not only by higher Iraqi exports, but also soaring demand. The increase in freight rates is putting some pressure on margins. As these factors force margins lower, crude oil demand should ease somewhat. Additionally, the turnaround season should begin to pick up soon, and even though the maintenance schedule is relatively light, demand will fall when plants shut down temporarily. Indeed, since runs are humming at 99% of capacity, demand really has just one way it can go–down. One additional note of caution involves Iraq's supply: There is talk that some United Nations members will soon begin to press for an increase in the dollar size of the oil-for-aid deal, which would tend to pressure crude oil values.
We recommend approaching this market with a short-term bullish bias until we see concrete signs of easing refinery demand and growing inventories. In light of the uncertainty surrounding the Middle East and the potential for tensions to either increase or decrease, we advise staying in touch. If the tensions do ease, a realistic equilibrium price for crude oil should be near the $21.50 mark.
GASOLINE–We grew more friendly to this market last week when the nearby futures contract was trading between 59.00 cents per gallon and 60.00 cents. At that time, values appeared relatively cheap in comparison to last year's mid- to high-60.00-cent levels. However, the sharp rally, ignited by worries over the Middle East, has taken the bullish luster off this market.
From a fundamental perspective, gasoline is in the midst of a period of falling demand and rising supply. Although these ingredients generally do not bode well for higher prices, these issues are well known and should already be discounted by the market. Indeed, the rate of decline for demand has been gradual, and consumption should stabilize at about 8.0 million barrels per day (MBD). Domestic production should be able to meet this level of consumption, and when imports are considered, the balance will clearly favor supply. However, gasoline inventories, both conventional and reformulated (RFG), are near record-low levels. Given current prices and the likelihood of additional stock increases (i.e., 1.0 to 1.5 million barrels per week) in the coming weeks due to the strong pace of refinery activity, additional price pressure lies ahead. However, the lean stock picture leaves little room for error on the supply side.
We expect commercials to put pressure on the futures market crack spreads as they look to lock in margins due to the high level of refinery activity, which will generate continued high gasoline and heating oil output. Such crack hedges entail buying crude oil and selling the product contracts, which should support crude oil and pressure both product markets. Moreover, even if further gains materialize in the overall complex, we anticipate gasoline will continue to lag. Last week, we established a short gasoline crack position and will be looking to add to it possibly on Monday.
HEATING OIL–Heating oil has generally followed the advancing crude market, but has lagged somewhat as concerns about the high rate of refinery activity linger. There also are signs of some weakness in the cash market after its related strong showing. For example, Sun Oil cut its heating oil price in the New York Harbor market several times late last week. Still, the nearby futures contracts rode the momentum in the crude oil market to new highs. The price charts look very favorable now, and more gains seem likely in the short term, despite the less-than-bullish fundamentals.
In spite of relatively mild weather patterns, heating oil continues to garner support from storage buying interest. Significant carrying charges in the nearby spread continue to support movement into storage. However, recent heavy deliveries against the October contract suggest potential supply pressure. While most of these deliveries have gone to large firms, the recent price upmove could mean these barrels will be placed back into the market. In the background, primary supplies continue to grow–stocks are more than 23 million barrels ahead of last year's low levels, and are about 5.0 million barrels above the five-year average for this time of year. Additionally, the exceptionally strong pace of refinery activity should assure ample supply builds in the coming weeks.
Further price gains in heating oil futures appear highly contingent upon strength in the rest of the complex. We would not rule out further advances toward 63.40 cents per gallon in the nearby contract. We suggest a sideline stance for the time being.
NATURAL GAS–The volatility surrounding the October futures termination at the end of September bordered on insanity. The gains in the futures market, and subsequent decline in October mid-week cash prices after the futures market termination indicated that the long speculators were in control of the market but also “out of control” as well. Clearly, cash and futures did not converge, which can only mean that those who took delivery have lost money. The cash market weakness that materialized last Monday helped send November futures down nearly 60 cents per million Btu from the previous Friday's high of $3.48; that correction brought futures more in line with the fundamentals.
The latest Commitments of Traders report showed that speculators remain very bullish, holding a net long position equivalent of more than 50,000 contracts, or about 20% of the total open interest. Their presence helps explain the volatility and the bullish bias of late. In addition, it is easier to see how the futures market can rally well beyond what the fundamentals can justify, especially when others hop on the bulls' bandwagon. Moreover, would-be shorts (including natural sellers such as producers) probably are reluctant, given the favorable supply/usage picture, the innate desire to avoid giving away upside potential and basis risk. Their absence (or, at least, diminished presence) can further exaggerate any upmoves.
The bottom line is that the fundamentals are positive–production is flat and demand is strong. Overall demand has been aided further by robust injection demand. Additionally, weather conditions have been cool enough to spur some heating consumption, which is mitigating the decline in air-conditioning loads.
Nevertheless, we think the big gains are over until winter weather conditions become more prevalent and severe. Moreover, the industry's recent high injection rates are alleviating the need to keep up the current pace. Indeed, storage levels will climb above 2,900 billion cubic feet (BCF) If just 70 BCF per week is injected during the next five weeks; a rate of only 30 BCF per week would leave storage at 2,700 BCF. The average rate over the last two years in this same period was about 40 BCF per week. Last year, the industry started the winter with 2,725 BCF In storage.
The influence on prices from commodity funds and other speculators remains a significant risk to short positions. As a result, short sales should be established only in conjunction with tight stops. The same is true for fresh long positions because any significant selling by the funds could result in a sharp reversal. Specifically, we would only approach the markets long side on dips back to the $2.93-$2.94 area. but with a tight stop (e.g., at about $2.89). If the $2.90 mark is convincingly violated, we would advise a short sale, using a similarly tight stop. Similarly, upon a failure at the $3.20 level, we will also consider selling futures, using a stop at $3.25.
Rich Redash and Jim Ritterbusch
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