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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 13, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil futures started last week with a steep correction that erased most of the gains induced by Middle East anxiety the previous Friday. Nevertheless, prices subsequently recovered as more bullish headlines crossed the wire, and the positive sentiment seems solid. Indeed, price dips are being used as buying opportunities. However, the technical picture shows some cracks that warrant caution.
Despite record refinery operations, statistics from the American Petroleum Institute (API) and the Department of Energy (DOE) show that crude oil has been readily available to U.S. refineries even though domestic production is running about 40,000 barrels per day (BPD) below year-ago levels. The slower decline in U.S. output this year reflects production gains in the Gulf of Mexico that are mitigating ongoing declines in Alaskan output. Additional gains from the Gulf may enable total U.S. production to stabilize in 1998. What's more, imports were about 6%–or 460,000 BPD–higher than year-ago levels for the first nine months of the year. On a four-week moving average basis, imports are running at a brisk 8.9 million barrels per day (MBD). Clearly, higher refinery demand (and the dip in domestic production) is at least partially behind the increase in imports; crude runs have increased 425,000 BPD, or about 3%, during the same time frame.
The numbers behind the percentage changes reinforce the U,S. market's apparent tightness. While year-to-date crude oil demand is up 425,000 BPD, net supply has increased about 420,000 BPD. Total U.S. crude oil demand is averaging 14.5 MBD, while total supply (domestic production and imports) is running at about 14.4 MBD for the first nine months of this year. This difference explains the lower crude oil inventory levels seen in the third quarter. As a result, the significance of potential supply disruptions is heightened, and price shocks should once again be expected, especially if tensions flare further in the volatile Middle East.
For the time being, issues in the Middle East appear to be stabilizing. The United States will allow Iraq to import spare pipeline parts to keep crude oil exports flowing. Part of the motivation behind the move may be that Turkey, a U.S. ally, will be providing these parts to Iraq. Moreover, the market appears to be growing more immune to the harsh U.S. rhetoric concerning Iraq and its push for increasing sanctions because many doubt that the United States will be able to overcome the French, Russian and Chinese support for Iraq in the U.N. Security Council. Additionally, we doubt that Iraq will test the U.S. resolve to enforce the no-fly zone now that the aircraft carrier Nimitz is in the area. Moreover, Iran appears to want better relations with the west (probably due to their need for foreign capital and technology), and thus it does not seem likely to test the United States either.
Overall, we expect crude oil utilization to remain relatively robust, but with some easing likely. Any refinery response to weaker product prices will take time, so the crude balance likely will be just modestly impacted over the next several weeks. However, refinery maintenance also appears to be diminishing U.S. crude oil demand. Overall, look for runs to stay in the area of 14.6-14.8 MBD; as a result, imports will need to stay above 8.4 MBD. Assuming these expectations are likely, we anticipate some additional builds in crude (as was the case last week), which will work against higher crude oil values.
We continue to approach the crude oil market with a short-term bullish bias given the potential for more bullish headlines and further emotional buying responses. Still, we caution that the risk/reward ratio does not warrant fresh longs above $22.00 per barrel, especially with Middle East tensions apparently easing and trader emotions subsiding. The Mideast military price premium appears to be about $1-$1.50 per barrel. Moreover, we sense that managed funds are heavily weighted on the long side of the market, which increases the risk of establishing fresh new longs at current prices. Lastly, the technical picture has turned toward the negative side.
GASOLINE–Bearish sentiment has been increasing, and recent futures market action shows that gasoline continues to underperform the complex. Any price increases have required strength in crude oil, a situation that likely will remain in place in the future.
Bearish fundamentals, namely high refinery operating rates that are spewing product across all domestic markets, are pressuring the physical markets and causing premiums to the screen to narrow. Additionally, the futures market also is flirting with a contango structure. Supply worries have been heightened by recent stock additions (as reported by the API) and rumors surrounding an influx of imports. Additionally, demand continues to move further off its summer peak. Given both increased supplies and lower demand, inventories are likely to expand further over the next several weeks. We anticipate that gasoline demand will stabilize between 7.8 MBD and 7.9 MBD, a level considerably above those seen last year at this time.
Even though many of this market's negative factors appear well- discounted, gasoline still appears likely to remain the weak leg of the complex. As a result, we would not be an outright buyer at current levels. Instead, we suggest considering a bull spread trade–buy December and sell February only if December is at a discount–as a long-term, low-risk way to approach the market. Although stocks are growing, they remain historically low. Thus, gasoline should react favorably to the following factors: (1) any potential supply worries (e.g., refinery snags); (2) higher year- over-year demand; and (3) strength in the crude oil market.
HEATING OIL–Heating oil prices have consolidated following the strong upmove early in the month. The market appears to be maintaining a Mideast military premium of at least 2-3 cents per gallon. This premium should gradually dissipate if the Mideast situation stabilizes. In the meantime, fundamentals continue to lean toward the bearish side with stocks holding above average levels.
Distillate stocks of about 136 million barrels are about 5 million above the five-year average for late September and are a whopping 22 million above last year's unusually low level.
It also is important to consider stocks in relation to consumption. October 1 stock levels are on the low side historically when measured as a ratio against third-quarter demand. This relatively low ratio partially explains recent price strength. Ongoing seasonal stock building is expected to last through next month, with supplies peaking in the area of 140-145 million barrels, thus implying an average weekly stocks build of about 1 million barrels in October and November. This rate would be slightly above the average increase seen during these two months over the last 10 years, thanks to this fall's unusually strong refinery pace. The East Coast high sulfur category, which corresponds to the futures market specifications, is projected to account for about 40%, or 140 million barrels, of the total distillate supply by the end of November.
It also appears likely that more product is being held this year in storage beyond the primary terminal stage. This assumption is based upon this year's relatively wide carrying charges in the winter futures 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 as bullish consideration in September, it could come back to haunt the market in November as the secondary suppliers back away from fresh purchases.
Support in the November contract is still expected in the 59.00-59.50 zone, Although rebounds to the 62.00-cent area are still possible, such an advance would provide longer-term selling opportunities. We also anticipate a further contraction in the December heating oil crack spread toward the $3 per barrel area.
NATURAL GAS–The bears, who have been hibernating since the late summer, appear to be stirring a bit, awakened by last week's warm spell. Additionally, storage concerns are easing because of robust injection rates over the last several weeks. Together, these issues have lowered Henry Hub cash prices significantly, and as a result, natural gas futures hold a premium to cash of 20-30 cents per million Btu. This dichotomy should undermine support for the futures market in the near term.
The storage picture has lost most of its bullish luster. Injections averaged 86 billion cubic feet (BCF) over the last six weeks. Total storage, as measured by the American Gas Association (AGA), is 2,643 BCF. Consequently, the industry will not have trouble surpassing last year's winter season starting level of 2,725 BCF. Now the only question is how high storage gas supplies will climb. A mere 30 BCF per week over the remaining four weeks of the refill season would put total storage at about 2,750 BCF. A rate of 60 BCF per week would lift storage to nearly 2900 BCF. As a result, it appears injection demand will not be able to support cash prices throughout October. Therefore, we expect physical gas prices to weaken further unless weather conditions turn more bullish.
The latest weather outlook does not offer much hope for natural gas bulls. The recent warmer-than-normal conditions are expected to turn more seasonable this week, before another bout of warm temperatures moves in. Cash prices will be able to push lower only if the cooler portion of that pattern fails to materialize or proves to be minor. In order to overcome resistance in the mid- $2.80 area, basis November, futures need to see additional weakness in the physical market.
The market appears poised to move lower, but the return of cold weather this week could scuttle these plans and renew the latent bullish sentiment. In addition, concerns are increasing with respect to coal supply availability in Texas. This is an important issue because such scarceness would increase reliance on natural gas in the utility sector. However, the significance of this factor will be highly contingent on weather in that region. Those holding short positions should maintain them, but lower stops and closely monitor weather patterns. We would not be a buyer at the current time, unless weather conditions turn more supportive and cash values rise to reflect such a development. We remain long-term bullish, but are currently short-term bearish because of the largely negative weather outlook and light storage injection considerations.
Rich Redash and Jim Ritterbusch
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