wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 18, 1997) ENERGY COMPLEX: CRUDE OIL–Crude oil futures continue to be driven by a volatile U.S. gasoline market. However, crude oil appears vulnerable to price weakness due to a possible softening in gasoline futures and mounting crude oil supply pressures. September crude oil reluctantly broke through the psychological $20-per- barrel mark, rising just above $20.40 before giving way to its own selling pressures as well as weakness in gasoline.
Some slackness in the light sweet crude oil market, as represented by a contraction in the cash differentials, is starting to concern us. (In the sour crude market, wider differentials relative to Dated Brent and WTI are justified given the restart of Iraqi Kirkuk and Basrah Light sour crude exports.) Additionally, the contango structure in both the cash and futures market for sweet crude is gradually increasing, implying near-term price pressure. Another bearish consideration is the possibility for Iraqi exports to weigh further on physical values as shipments increase.
The global supply/demand balance will be tested in coming months by several factors: (1) Iraq's return to exporting at a rate of 0.8 million barrels per day (MBD); (2) increasing OPEC contributions (July's production was 26.7 MBD without Iraq); (3) higher Cusiana output (a doubling to 15 cargoes); (4) planned autumn refinery turnarounds in Europe and the Middle East (0.8 MBD); and (5) the start to German Strategic Petroleum Reserve sales last week (0.1 MBD). These supply additions will heighten the importance of winter weather in 1997/98, especially if stocks begin to bulge in the third quarter, which comes on the heels of an historically low second-quarter build.
The narrow WTI/Brent futures spread may limit weakness in U.S. prices in the short term. However, the spreads between both WTI and LLS versus dated Brent are wide enough for transatlantic arbitrage. Given transportation costs ($0.80-$1.10 per barrel) and import, taxes and lightening fees ($0.40 per barrel), the recent spread levels help justify the "surprisingly" high import rate of 9.0 MBD for the week ended August 8, as reported by the American Petroleum Institute (API). However, some of that week's 1.2 MBD increase in imports may have been related to Hurricane Danny's belated impact on the statistics. Regardless, U.S. imports of both Brent and other crudes linked to dated Brent prices (e.g. Nigerian crudes) will continue. Indeed, when Iraqi imports and the growing Cusiana cargoes also are considered, imports should not have a problem exceeding 8.0 MBD in coming weeks.
Such a high import rate could prove to be a serious drag on the U.S. market, especially if domestic refinery operations show any sign of slowing. Last week's 2.1 percentage-point decline in U.S refining utilization should be not be repeated, given steady margins and the return of Tosco's crude distillation unit and catalytic cracker at its Bayway refinery in New Jersey. However, PADD III utilization will be hampered by Exxon's refinery snag that idled the 110,000 catalytic cracker last week, and a similar snag as Ashland's Kentucky refinery. Given U.S. crude oil production of 6.3 NOD, stocks will grow unless crude runs remain above 14.3 NOD (or about 94%-95% of the 15.0 MBD peak capacity rate). Despite numerous production problems and Iraq's absence, crude oil stocks remain comfortable, especially in PADDs I-IV (Figure 1). The market's ability to deal with mounting supplies will be tested further during any U.S. turnaround this fall or other refinery outages.
These bearish fundamental factors should pressure the near-term contracts as September crude oil approaches termination. However, if gasoline prices make another run higher, crude oil will more than likely follow. Because gasoline stocks remain very low, the potential for another gasoline rally is high, and that may keep crude oil trade choppy in the short term. The more aggressive trader may wish to sell the October contract outright. Look to enter at $20.00 or better, risking to $20.50, and seeking $19.00.
GASOLINE–We are concerned about gasoline's long-term upward trend, given its inability to surpass our 67.50-cent-per- gallon price target convincingly. The September contact traded only as high as 67.60 cents before the return of Tosco's Bayway refinery and the Northwest Europe refineries contributed to a pullback Nevertheless, little chart damage was done, and given still very low stocks, this market may not be dead just yet. However, the potentially bullish issues on the horizon are predominately short term in natural and thus, buying support should fade with the termination of the September contract.
Total U.S. gasoline stocks, as well as reformulated gasoline (RFG) supplies (especially in the East) are bullish considerations that will result in exaggerated price responses to supply problems. Assuming no supply disruptions (and considering the high prices and attractive crack spread margins). domestic production and imports will be sufficient to meet demand. Indeed, last week's rally probably enabled importers to lock in an adequate spread for transatlantic shipments.
As we expected, implied demand has apparently peaked for the year and will continue to trend lower. However, another increase is likely ahead of the Labor Day holiday weekend, usually the last hurrah for summer U.S. gasoline consumption. Consequently, we expect to see one or two more supportive API reports.
There is a good chance that the highs are in for the September gasoline contract, given the market's apparent failure to push into new territory last week when the rally stalled at 67.60 cents. However, the potential for supply trouble, coupled with the low stocks situation are enough to warrant caution. Any problems could lift September as high as 71 cents, the August contract's high, assuming no sharp sell-off occurs beforehand. As a result, we will continue to hold our bull spread position (long October/short December).
HEATING OIL–The bulk of heating oil's price strength last week was attributable to a strong gasoline market. Although distillate stocks have been trimmed to about average levels for this time of year, the strong pace of refinery activity and attractive margins suggest a larger-than-normal stocks build into the M. The lack of seasonal stocks build during the last five weeks implied an exceptionally strong pace of demand, particularly during July when distillate deliveries increased almost 9% compared to year-ago levels. While much of this upswing has resulted from surprisingly strong diesel consumption, it also appears that this summer's lower prices have prompted a larger-than-normal shift of high sulfur product from primary to secondary channels. This presents the bearish possibility of a de-stocking process through the distribution system on any periods of sustained price weakness. Additionally, small speculators are still holding a sizable net long position, which could accentuate potential price declines.
Heating oil futures are vulnerable to price weakness. However, the market's focus will likely remain concentrated on gasoline through the September contract's termination. We would like to see gasoline drag heating oil futures higher so that we have a better place to sell. An upmove in the complex that lifts December heating oil into the 59.50- to 60.50-cent zone should be welcomed with fresh short positions in anticipation of a move to 56.50 cents.
NATURAL GAS–After new contract highs were recorded by the nearby contracts (e.g., $2.605 per million Btu. basis September), prices fell 20 cents before finding support. Profit-taking, cool weather and numerous nuclear plant returns across the United States were behind the negative sentiment. After the retreat, prices briefly rallied. induced by a “neutral” Inventory report and a general reluctancy by commodity funds to sell.
Fundamentals still suggest the market is overvalued in the short term. Recent weather conditions have kept cooling demand down, and the latest weather forecast does not appear to bullish for usage either. However, reemergence of seasonal weather should not be ruled out. The detrimental impact of hurricanes also remains a threat through November. As nuclear plants come back on-line, their production should also eat into natural gas' market share for electric generation. Natural gas prices also are at a competitive disadvantage to fuel oil (even 0.3% low sulfur), which will keep utility consumption light.
Longer term, a couple of factors will provide underlying support. First, nuclear plant shutdowns are planned in late September and October, when cooling needs decrease; the October contract will be the main beneficiary. Second, we view the existing storage situation as only moderately supportive, but stocks are tight enough that problems on either the demand or supply side could increase this factor's bullish influence.
Although we anticipate further selling, we are cautious given last week's price decline and the surprising rebound, which occurred without solid fundamental support. The weather picture is mixed. No significant heat is expected in the northern United States this week, but continued warm temperatures are likely for the south. In the upcoming American Gas Association (AGA) report, we expect the recent spate of high prices will show the industry injected a low 70 billion cubic feet for the week ended August 15. Such a figure may raise concerns about storage levels, and thus lift prices.
Nevertheless, we would approach this market with a bearish trading posture, using bear spreads. Last week, the October/December bear spread widened as expected. We continue to favor this bear spread approach, and those holding this position basis our previous advice should continue to do so. For new positions, enter the trade by selling October and buying December at 10- to 12-cents December premium. Risk 4-5 cents for an objective of the spread widening a dime. Given the current 14-cent level in this spread, we would expect an entry opportunity to emerge after Wednesday's AGA report, assuming the injection figures are supportive to the market.
Rich Redash and Jim Ritterbusch
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