Commodities & Energy Sector

Saudi oil policy, like its defense policy, will be more aggressive and less predictable, following Deputy Crown Prince Mohammed bin Salman's apparent nullification of a production "freeze" deal at Doha.

Monday's upgrade of the energy sector to neutral and the exploration & production index to overweight does not mean that refiners are out of the woods. In fact, the opposite is true, because the crude oil supply glut will morph into a refined product glut. Refiners are still running full out, likely in response to strong gasoline demand, but that is creating a glut of distillate inventories and boosting overall fuel supplies. Overall refined product consumption is barely growing, underscoring that inventories will continue to build. Weakening overall demand for finished oil product is also evident in the plunge in railcar shipments, which heralds a potentially painful decline in relative stock performance (top panel). Part of the plunge in rail shipments of oil reflects reduced shale oil production, which will boost refiner input costs via higher crude oil prices. Keep in mind that refining margins are already under cyclical stress, because of the tight spread between Brent and WTI crude oil prices (third panel). Our refiner earnings model, based on refining margins and utilization rates, is plunging. Consequently, the odds of a sustained profit squeeze are high. We reiterate our high conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, TSO.

BCA's Energy Equity Strategy, our newest sector-specific service, recently published a report arguing for a rebalancing of global oil markets in the second half of this year, and modestly higher oil prices, a view which was not predicated on an OPEC production freeze. Instead, rebalancing should be driven by larger-than-expected production declines. Low prices are doing their job. Plunging cash flows and the resulting massive increase in capital constraints have strangled exploration budgets, particularly in U.S. shale formations. BCA's forecasts signal that consumption will outpace production significantly by yearend. Consequently, the heavily bombed out S&P energy exploration & production (E&P) index could surprise on the strong side as the year progresses, as relative E&P performance is highly correlated with oil prices, irrespective of the trend in production. In other words, even if production growth is contracting, as long as the latter leads to higher commodity prices, then share prices can outperform. Importantly, producers are enjoying the benefits of technology advancement in drilling techniques, which are driving down production costs. Massive overcapacity in the services industry means that producers will continue to dictate pricing terms. Consequently, we upgraded the S&P E&P index to overweight in yesterday's Weekly Report, which brings our overall energy sector weighting up to neutral, locking in a 14% profit from our underweight call.

Bearish sentiment is a red herring, as most other measures of investor positioning point to a strong undercurrent of bullishness. That is contrarily worrying.

Special Report

This week <i>Global Alpha Sector Strategy</i> in conjunction with <i>Emerging Markets Strategy</i> is sending out a <i>Special Report</i> on EM deep cyclical sectors, discussing debt and cash flow dynamics, identifying how far advanced the capital expenditure down cycle is, and determining if recent EM deep cyclical strength should be bought or faded.

A weaker USD resulting from more dovish forward guidance from the Fed, and evidence of continued production declines in non-OPEC and OPEC countries will continue to buoy oil prices.

We upgraded gold shares to overweight in early March, because gold rises in stature as monetary policy loses its efficacy. The spreading global shift to negative deposit rates is creating a significant amount of uncertainty, as the unintended consequences of this unorthodox policy remain unknown. In the meantime, real interest rates, the opportunity cost of holding a zero-yielding asset like gold, have slipped back into negative territory, and may need to fall further to reverse the decline in economic confidence. That is a plus for gold, and gold shares. While gold and gold shares may look overbought on a short-term basis, it is important to keep the longer-term context in mind. Gold is still far below its 2012 highs, while gold share relative performance is barely above its secular lows, which should trump any near-term concerns about overbought conditions. Consequently, we continue to believe that gold equities provide attractive portfolio protection and are an excellent hedge against monetary policy exhaustion. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S15GOLD - NEM, RGLD.

Special Report

We do not expect Russia and OPEC members to reach a production-limiting agreement at the April 17 meeting in Doha, but that does not diminish our bullish expectations for a rebalancing of oil markets in H2 2016.

Special Report

In this <i>Special Report</i>, we discuss the state of the New Zealand business cycle and propose some trade ideas to capitalize on the excessive pessimism currently at play in New Zealand bond and currency markets.

Risk assets will continue to edge higher over the next couple of months on improving economic data, notably from China. Longer term however, EMs - including China - are starting a prolonged deleveraging cycle, keeping commodities and cyclical stocks on the back foot. The dollar will likely follow the mirror image of commodities: down slightly the next two months, up substantially thereafter. A stronger dollar, in turn, will limit any rise in Treasury yields. Long-term investors should remain modestly overweight duration.