Commodities & Energy Sector

Special Report

Highlights Metals prices are likely to suffer in the short term on the back of weakening Chinese demand and fading inflationary pressures. Accordingly, in our most recent Global Asset Allocation (GAA) Quarterly Outlook, we downgraded the AUD to underweight against the greenback. Bond yields, globally, are bound to rise moderately over the course of the coming 12 months. Australian yields, however, are likely to rise slower than those in the US. The RBA has been explicit in communicating what it would take to adjust its policy stance and is likely to lag behind other central banks in DM. We therefore recommend investors favor Australian government bonds in a global bond portfolio. Australian equities, now dominated by Financials rather than the Materials sector, would benefit from a rise in bond yields. However, a weaker AUD and declining metal prices warrant no more than a benchmark exposure to Australian equities within a global equity portfolio. Introduction Recently, clients have often been asking about Australia. The reasons seem clear. With a potential commodities “super-cycle” driven by a shift to renewable energy and electric vehicles (EVs), both the Australian economy and equities should be in a position to benefit. The reality, however, has been much less positive. Particularly the divergence between the core driver of the Australian market, industrial metals, and the performance of both equities and the currency over the past few years has been a concern (Chart 1). Over the past year and a half, Australian equities have underperformed the MSCI ACWI by 12.4% (Chart 2, panel 1). This underperformance was mainly due to the outperformance of the US. However, even against global markets excluding the US, Australian equities did not match the rise in commodity prices – particularly industrial metals (Chart 2, panel 2). Chart 1Despite The Rise In Metals Prices... Chart 2...Australian Equities Have Not Outperformed   Chart 3Financials Dominate Australian Equities The structure of the Australian market has changed over the past few years. The commodities boom and subsequent global liquidity boom over the past two decades have fueled a housing bubble in Australia and an unsustainable rise in household debt. As a result, Australian equities are no longer dominated by metals and mining stocks, but rather by banks (Chart 3). We structured this Special Report in a Q&A format, answering questions we think are most relevant for investors to assess both the short- and long-term outlook for Australia. We aim to provide an overview of the economy and draw some conclusions on how investors should be positioned. Our conclusions are as follows: Over the past year and a half, the Australian economy has shown how complementary actions between fiscal and monetary policy, as well as social restriction measures, can mitigate both economic and human damage. The Reserve Bank of Australia (RBA) will be in no rush to adjust its policy stance until wage growth is back to its 3% target. However, RBA officials risk running the economy hot in the meantime given that measures of employment are back to their pre-pandemic levels. The RBA is not likely to change its policy stance before reaching its wage growth and inflation targets and will probably lag behind other global central banks in tightening. In that case, investors should favor Australian government bonds in a global bond portfolio. Australian banks remain well-funded and in good health. But their excessive exposure to the housing sector puts them at grave risk if home prices collapse. Despite this, there seems to be a feedback loop where a decline in mortgage rates fuels further demand for loans, pushing up home prices. A slowdown in Chinese credit growth and economic activity will hamper commodity demand, weighing down on Australian equities. The longer-term outlook remains compelling for Australian equities and metals as we enter into a new commodities “supercycle” fueled by a transition to renewable and alternative energy. The Australian economy stands to benefit given that the country has high levels of both production and reserves of the minerals needed for this transition.   Q: How Does The Economy Look In The Short-Term? A: Australia can be regarded as one of the few countries that successfully navigated the pandemic with a minimal amount of damage, both to its population and economy. With swift measures to limit travel and implement social restrictions, the spread of the outbreak was curtailed to slightly over 30,000 total cases, representing only 0.12% of its population (Chart 4). On the other hand, its vaccination campaign has been much slower (at 38 doses administered per 100 people) than in other DM economies such as the US, UK, France, or Germany with 100, 120, 90, and 102 doses per 100 people, respectively. In the short term, this might not seem particularly damaging to the economy. However, if vaccination rates do not pick up rapidly, Australia’s international travel restrictions (which cannot sustainably be kept in place) will hamper economic growth and become a major drag on the tourism and education sectors (Chart 5, panels 1 & 2). Chart 4Government Policies Contained The Pandemic Outbreak... Chart 5...At The Expense Of Tourism Ample fiscal support – in the form of wage subsidies and business support through the JobKeeper program – mitigated the shortfall in household incomes (Chart 6). This provided a boost to both consumers and businesses with Q1 GDP growth coming in at 1.8% quarter-on-quarter (7.4% annualized). GDP expectations for the remainder of this year and next show a resilient strong momentum for Australian growth and domestic demand (Chart 7). Chart 6Fiscal Stimulus Supported Employment... Chart 7...And Overall Growth Chart 8Labor Market Back To Pre-Pandemic Levels...   The labor market recovery has been an excellent example of how fiscal support and lockdown measures complement each other. Most employment indicators have almost recovered or surpassed their pre-pandemic levels: The unemployment rate stands at 4.90%, compared to 5.13%, the underemployment rate is at 7.44%, compared to 8.60%. The total number of those employed is now above its pre-pandemic level, albeit still below the 2018-2019 growth trend (Chart 8).   Q: When Will The RBA Shift Its Policy Stance? A: The RBA has been explicit in communicating that changes in its policy stance hinge on Australian wage growth rising sustainably towards 3% – a level last reached in Q1 2013. Even with economic activity mostly restored, wage growth remains low at 1.49% (Chart 9). Our belief is that until that occurs, the RBA will probably maintain its accommodative stance. Our global fixed-income strategists, in a recent report, highlighted their belief that the RBA is likely to be less hawkish than markets currently expect – on both tapering and hiking rates. We agree with that assessment. Comments by RBA Governor Lowe earlier last month back our dovish belief: He stated that “The Board is committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target…This is unlikely to be until 2024 at the earliest”. Market expectations nevertheless remain much more hawkish – pointing to a first rate hike by mid 2022 and almost 70 basis points of hikes by 2024 (Chart 10). Chart 9...However Wage Growth Remains Muted Chart 10Market Expects A Hawkish RBA...   Chart 11...And Is Already Pricing That Down The Curve Chart 12Inflation Remains Well-Below The RBA's Target This means that the RBA will probably risk running the economy hot for a while. With total employment back to its pre-pandemic level and other employment indicators closely behind, inflationary pressures, sooner or later, will begin to mount. Higher growth prospects and inflation risks are being discounted further down the curve (Chart 11). The June CPI print is likely to reflect a transitory short-term base effect and the RBA is mostly going to see through that. In the meantime, we would watch other broad inflation indicators to gauge for price pressures. Broader measures such as the trimmed-mean inflation index or median inflation remain subdued at 1.1% and 1.3%, respectively. The 10-year breakeven rate currently stands at 2.1%, within the RBA’s range of 2%-3%, highlighting the market’s belief that long-term inflation remains well under control (Chart 12). Bottom Line: The RBA is likely to maintain its dovish stance for longer than the market expects. A return to sustainable levels of wage growth and inflation will remain the top objectives and it is unlikely that policy will be reversed before they are achieved. Our global fixed-income strategists laid out a checklist of what would make the RBA turn less dovish. So far, only 1 out of 5 items on their list (the recovery in private-sector demand) signals the need for a more hawkish stance. The remaining items signal no imminent pressure on the RBA to adjust policy (Table 1). The RBA is also wary of the currency appreciating if it took a more hawkish stance ahead of other central banks (e.g., the Fed) and is therefore likely to switch policy only after other central banks do so (Chart 13). Accordingly, investors should favor Australian government bonds within a global bond portfolio. Table 1RBA Checklist Chart 13The RBA Will Be Wary Of A Rising AUD   Q: Are There Signs Of Improvement In The Banking Sector? A: Headline indicators of the health of the Australian banking sector paint a picture of a well-capitalized, highly funded, and profitable industry. Return on equity (ROE) has averaged 12.1% over the past decade. Capital adequacy and Tier 1 capital ratios stand at 14.5% and 18.2%, respectively – much higher than at the start of the Global Financial Crisis (GFC). The ratio of non-performing loans remains low and Australian banks’ reliance on leverage has also decreased (Chart 14). Chart 14Banks Look Healthy... Chart 15...But Remain Exposed To The Housing Sector... However, these indicators mask a major underlying risk. Banks remain heavily exposed to the housing market, with housing loans as high as 62% of banks’ gross outstanding loans and 40% of total assets (Chart 15, panel 1). Over the past decade and a half, banks have lent an average of A$56 of housing-related loans for every A$100 in total loans (Chart 15, panel 2).   Chart 16...Which Is Showing No Signs Of Slowing Down Chart 17Households Remain Heavily Indebted With interest rates falling over the past few decades, construction activity has boomed. Consequently, the demand for loans for new homes has been rising, leading home prices higher (Chart 16). This also meant that household debt levels have climbed and currently standing at a staggering 130% of GDP and 180% of disposable income (Chart 17).   So what does this mean for banks’ stock prices? The short answer is that absent a bursting of the bubble in house prices, banks should continue to fare well. Interestingly, the long-standing relationship between bond yields and banks’ relative stock price returns – one that works in other financial-heavy markets such as the euro area – did not hold in Australia, at least until recently. In fact, we find that, historically, Australian banks outperformed the broad market when bond yields were falling. This relationship changed post-GFC, most likely when inflation expectations became unanchored and trended lower – reflecting lower commodity prices (Chart 18). Bottom Line: Rising rates, reflecting better growth prospects and higher long-term inflation, should be a tailwind for bank stocks in the short term. Accommodative monetary policy will spur activity in the property market, propping up bank profits. This, however, puts banks at even greater risk when profitability starts to decline, NPLs rise and regulations tighten further. The latter risk is one we would highlight following RBA deputy governor Guy Debelle’s statement that monetary policy will not be used as a tool to curtail housing prices and that there are other tools to address that issue. Chart 18Rising Yields Will Be A Tailwind For Australian Equities   Q: How Does Chinese Policy Impact Australian Growth? A: China's role in global supply chains, as both a producer and consumer, has increased dramatically since the early 2000s. China’s demand for commodities generally and industrial metals in particular has grown over the past two decades from an average of 10% of total global demand to 50% for most metals (Chart 19). Australia stood to benefit, redirecting more and more of its metals’ production away from the rest of the world and towards China. For example, during the same period, the share of Australian iron ore exports to China increased fourfold (Chart 20). Chart 19China Is A Major Consumer Of Metals... Chart 20...And This Has Benefited Australia Over The Past Two Decades     However, this dynamic leaves the Australian economy very exposed to the Chinese business cycle – one that is heavily reliant on policymakers’ decisions on how much liquidity to inject into the economy. After strong credit and fiscal support throughout 2020, the Chinese authorities – wary of excessive leverage in the economy – have begun paring back stimulus which is likely to lead to weaker growth in the second half of the year and put downward pressure on metal demand (Chart 21). Chart 21Weakening Chinese Demand Will Hurt Metals In The Short-Term Heightened political tensions between Australia and China have also played a role. China recently imposed restrictions, including additional tariffs and bans, on Australian imports such as beef, wine, coal, and other goods. Consequently, Australian exports to China slowed. However, the goods not imported by China were absorbed by other economies – Australian export growth did not fall that much. It is unlikely that a new commodity-heavy marginal buyer will emerge in the short-term to replace Chinese demand. The recent rise in commodity prices reflected a return to economic activity, as well as inflationary fears, and supply, shipping, and logistical backlogs. These will ease in the short term, weighing on both the AUD and Australian equities.   Q: Can The Shift To Renewable Energy Spur Future Australian Growth? A: The shift to renewable energy and electrification – particularly in the transport sector – will occur sooner rather than later. Some commodity-exporting countries stand to benefit, and Australia is likely to be one. We previously highlighted that modeling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency and recycling rates, and the rate of conversion to renewables. Chart 22The Shift To Renewables Will Require More Resources... The mechanics of the future demand/supply relationship hinge on the following: Demand will rise during this energy transition period – simply due to the fact that the new clean energy systems require more minerals (such as copper and zinc) than the current traditional hydrocarbon-fueled energy system (Chart 22, panel 1). Electric vehicles (EVs) require about four and a half times more of certain commodities – particularly copper, nickel, and graphite – than conventional vehicles do (Chart 22, panel 2). Supply limitations, on the other hand, are what might propel metal prices even higher and lead the world economy into a new commodities “supercycle”. A study by the Institute for Sustainable Futures has shown that, in the most positive energy transition scenarios, demand for some metals will exceed supply, in terms of both available resources and reserves (Table 2). Table 2...Which Are Likely To Be In Short Supply For some of those metals, Australia is either among the top producers, or has the largest reserves. For example, Australia produces almost 45% and 12% of the world’s lithium and zinc, and has 22% and 27% of the world’s reserves. Looking at other metals, supply disruptions – particularly in economies where political, social, and environmental influences are an issue – might be the driver of further price rises. For example, Chile has the largest shares of global lithium reserves (~44%), and copper reserves (~23%), while South Africa has the largest share of global manganese reserves (~40%). Bottom Line: The transition to renewable energy is already underway and is likely to intensify. Forecast demand should outstrip supply and Australia stands to benefit given its large share of current production and/or reserves. How much will depend on the pace of renewable energy integration but miners are likely to be long-term winners.   Q: What Is The Outlook For The AUD? A: The Global Asset Allocation (GAA) service, in its latest Quarterly Outlook, turned negative on the AUD. The currency has historically had a high positive correlation with commodity prices and industrial metals prices, which in turn are very sensitive to Chinese demand (Chart 23). Given our outlook for metals in the short term (falling demand driven by slowing Chinese activity), we expect some weakening in the AUD over the coming 9-to-12 months (Chart 24). Chart 23The AUD Is Highly Correlated To Metal Prices... Chart 24...Which In Turn Are Highly Correlated To Chinese Activity Additionally, short-term weakness in the economy, caused by further lockdowns as Delta-variant COVID cases rise, is a risk since it might reduce domestic demand. From a valuation perspective, the AUD is slightly below its fair value (Chart 25). However, this on its own does not compel us to remain positive on the currency. We also consider other indicators such as investor positioning – which has reached a decade high, according to Citibank’s FX Positioning Alert Indicator (PAIN) (Chart 26). This indicator suggests that active FX traders hold substantial long positions in the AUD against the USD. Historically, this indicator has provided contrarian signals, with extreme optimism (pessimism) providing useful short (long) signals. Chart 25The AUD Is Close To Fair Value Chart 26Investors Are Long The AUD Bottom Line: Short-term weakness in the economy and a reversal in metal prices warrant caution on the currency. While valuations do not signal overbought conditions, investor positioning (a contrarian indicator) does.   Q: How Should Equity Investors Be Positioned? A: Our recent Special Report on whether country or sector effects drive equity performance showed that sector composition was relatively important in Australia, given the large difference in sector weightings relative to the global benchmark. Our analysis showed that cumulative Australian sector performance over the past two decades detracted from overall returns (Chart 27). Given that framework, and the relationship between the Australian economy and industrial metals, we find that Australian equity performance relative to the US mirrors the performance of global metal and mining relative to global tech stocks (Chart 28). This underperformance makes sense: Commodity prices have been in a structural downtrend throughout the past decade. Chart 27Country Vs Sector Effect Chart 28Australia / US = Metals / Tech Therefore, given our view of the outlook for metals, we would not want to shun Australian equities. The Global Asset Allocation (GAA) service is currently neutral the Australian market within a global equity portfolio, and underweight the Materials sector over the next 12 months. We believe this positioning makes sense given the slowdown in the Chinese economy and the improbability that another country will emerge as the alternative marginal buyer of commodities. The longer-term outlook is more compelling however, as the shift to decarbonization, renewables, and alternative energy gets underway. Conclusions In the short term metals prices are likely to suffer on the back of weakening Chinese demand (with no immediate substitute as a marginal buyer) as well as fading inflationary fears and an easing of supply/logistical issues. Our analysis shows that sector composition is a larger driver of Australian equity relative performance than country composition. While Australian equities – dominated by Financials – would benefit from a moderate rise in global bond yields, yields will rise more slowly in Australia than in the US and the AUD is likely to weaken. Over the next 12 months, investors should remain neutral on Australian equities within a global equity portfolio. The RBA is likely to lag other central banks in tightening policy. Investors should therefore favor Australian government bonds over other developed economies such as the US and Canada.   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com        

Highlights Global oil demand will remain betwixt and between recovery and relapse through 3Q21, as stronger DM consumer spending and increasing mobility wrestles with persistent concerns over COVID-19-induced lockdowns in Latin America and Asia. These concerns will be allayed as vaccines become more widely distributed, and fears of renewed lockdowns – and their associated demand destruction – recede.  Going by US experience – which can be tracked on a weekly basis – as consumer spending rises in the wake of relaxed restrictions on once-routine social interactions, fuel demand will follow suit (Chart of the Week). OPEC 2.0 likely will agree to return ~ 400k b/d monthly to the market over the course of the next year and a hal. For 2021, we raised our average forecast to $70/bbl, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl. These estimates are highly sensitive to demand expectations, particularly re containment of COVID-19. Feature For every bit of good news related to the economic recovery from the COVID-19 pandemic, there is a cautionary note. Most prominently, reports of increasing demand for refined oil products like diesel fuel and gasoline in re-opening DM economies are almost immediately offset by fresh news of renewed lockdowns, re-infections in highly vaccinated populations, and fears a new mutant strain of the coronavirus will emerge (Chart 2).1 In this latter grouping, EM economies feature prominently, although Australia this week extended its lockdown following a flare-up in COVID-19 cases. Chart of the WeekUS Product Demand Revives As Economy Reopens Chart 2COVID-19 Infection And Death Rates Keep Markets On EdgeOur expectation on the demand side is unchanged from last month – 2021 oil demand will grow ~ 5.4mm b/d vs. 2020 levels, while 2022 and 2023 consumption will grow 4.1 and 1.6mm b/d, respectively (Chart 3). These estimates reflect the slowing of global GDP growth over the 2021-23 interval, which can be seen in the IMF's and World Bank's GDP estimates, which we use to drive our demand forecasts.2 Weekly data from the US seen in the Chart of the Week provide a hint of what can be expected as DM and EM economies re-open in the wake of relaxed restrictions on once-routine social interactions. Demand for refined products – e.g., gasoline, diesel fuel and jet fuel – will recover, but at uneven rates over the next 2-3 years. The US EIA notes the recovery in diesel demand, which is included in "Distillates" in the chart above, has been faster and stronger than that of gasoline and jet fuel. This is largely because it reflects the lesser damage done to freight movement and activities like mining and manufacturing. The EIA expects 4Q21 US distillate demand to come in 100k b/d above 4Q19 levels at 4.2mm b/d, and to hit an all-time record of 4.3mm b/d next year. US gasoline demand is not expected to surpass 2019 levels this year or next, in the EIA's forecast. This is partly due to improved fuel efficiencies in automobiles – vehicle-miles travelled are expected to rise to ~ 9mm miles/day in the US, which will be slightly higher than 2019's level. Jet fuel demand in the US is expected to return to 2019 levels next year, coming in at 1.7mm b/d. Chart 3Global Oil Demand Forecast Remains Steady Quantifying Demand Risks We use the recent uptick in COVID-19 cases as the backdrop for modelling demand-destruction scenarios in this month’s oil balances (Chart 2). We consider different scenarios of potential demand destruction caused by the resurgence in the pandemic (Table 1). Last year, demand fell by 9% on average, which we take to be the extreme down move over an entire year. In our simulations, we do not expect demand to fall as drastically this time. Table 1Demand-Destruction Scenario Outcomes We modelled two scenarios – a 5% drop in demand (our low-demand-destruction scenario) and an 8% drop in demand (our high-demand-destruction scenario). A demand drop of a maximum of 2% made nearly no difference to prices, and so, we did not include it in our analysis. In both cases, demand starts to fall by September and reaches its lowest point in October 2021. We adjusted changes to demand in the same proportion as changes in demand in 2020, before making estimates converge to our base-case by end-2022. The estimates of price series are noticeably distinct during the period of the simulation (Chart 4). Starting in 2023, the low-demand-destruction prices and base-case prices nearly converge, as do their inventory levels. Prices and inventory levels in the high-demand-destruction case remain lower than the base-case during the rest of the forecast sample. OPEC 2.0 and world oil supply were kept constant in these scenarios. World oil supply is calculated as the sum of OPEC 2.0 and Non-OPEC 2.0 supply. Non-OPEC 2.0 can be broken down into the US, and Non-OPEC 2.0, Ex-US countries. Examples of these suppliers are the UK, Canada, China, and Brazil. OPEC 2.0 can be broken down into Core-OPEC 2.0 and the cohort we call "The Other Guys," which cannot increase production. Core-OPEC 2.0 includes suppliers we believe have excess spare capacity and can inexpensively increase supply quickly. Chart 4Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios OPEC 2.0 Remains In Control We continue to expect the OPEC 2.0 producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to maintain its so-far-successful production policy, which has kept the level of supply below demand through most of the COVID-19 pandemic (Chart 5). This allowed OECD inventories to fall below their pre-COVID range, despite a 9% loss of global demand last year (Chart 6). We expect this discipline to continue and for OPEC 2.0 to continue restoring its market share (Table 2). Chart 5OPEC 2.0 Production Policy Kept Supply Below Demand Chart 6...And Drove OECD Inventories Down Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our expectation last week the KSA-UAE production-baseline impasse will be short-lived remains intact. We expect supply to be increased after this month at a rate of 400k b/d a month into 2022, per the deal most members of the coalition signed on to prior to the disagreement between the longtime GCC allies. This would, as the IEA notes, largely restore OPEC 2.0's spare capacity accumulated via production cutbacks during the pandemic of ~ 6-7mm b/d by the end of 2022 (Chart 7). It should be remembered that most of OPEC 2.0's spare capacity is held by Gulf Cooperation Council (GCC) states, which includes the UAE. The UAE's official baseline production number (i.e., its October 2018 production level) likely will be increased to 3.65mm b/d from 3.2mm b/d, and its output in 2H21 and 2022 likely will be adjusted upwards. As one of the few OPEC 2.0 members that actually has invested in higher production and can increase output meaningfully, it would, like KSA, benefit from providing barrels out of this spare capacity.3 Chart 7OPEC 2.0 Spare Capacity Will Return As we noted last week, we do not think this impasse was a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy. In our view, this impasse was a preview of how negotiations among states with the capacity to raise production will agree to allocate supply in a market starved for capital in the future. This is particularly relevant as US shale producers continue to focus on providing competitive returns to their shareholders, which will limit supply growth to that which can be done profitably. We see the "price-taking cohort" – i.e., those producers outside OPEC 2.0 exemplified by the US shale-oil producers – remaining focused on maintaining competitive margins and shareholder priorities. This means maintaining and growing dividends, and returning capital to shareholders will have priority as the world transitions to a low-carbon business model (Chart 8).4 For 2021, we raised our average forecast to $70/bbl on the back of higher prices lifting the year-to-date average so far, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl (Chart 9). These estimates are highly sensitive to demand expectations, which, in turn, depend on the global success in containing and minimizing COVID-19 demand destruction, as we have shown above. Chart 8US Shale Producers Focus On Margins Chart 9Raising Our Forecast Slightly Investment Implications In our assessment of the risks to our views in last week's report, we noted one of the unintended consequences of the unplanned and uncoordinated rush to a so-called net-zero future will be an improvement in the competitive position of oil and gas. This is somewhat counterintuitive, but the logic goes like this: The accelerated phase-out of conventional hydrocarbon energy sources brought about policy, regulatory and legal imperatives already is reducing oil and gas capex allocations within the price-taking cohort exemplified by US shale-oil producers. This also will restrict capital flows to EM states with heavy resource endowments and little capital to develop them. Our strong-conviction call on oil, gas and base metals is premised on our view that renewables and their supporting grids cannot be developed and deployed quickly enough to make up for the energy that will be foregone as a result of these policies. Capex for the metals miners has been parsimonious, and brownfield projects continue to dominate. Greenfield projects can take more than a decade to develop, and there are few in the pipeline now as the world heads into its all-out renewables push. In a world where conventional energy production is being forced lower via legislation, regulation, shareholder and legal decisions, higher prices will ensue even if demand stays flat or falls: If supply is falling, market forces will lift oil and gas prices – and the equities of the firms producing them – higher. As for metals like copper and their producers, if supply is unable to keep up with demand, prices of the commodities and the equities of the firms producing them will be forced to go higher.5 This call underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. We will look for opportunities to get long oil and gas producer exposure via ETFs as well, given our view on oil and metals spans the next 5-10 years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects growth in large-scale solar capacity will exceed the increase in wind generation for the first time ever in 2021-22. The EIA forecasts 33 GW of solar PV capacity will be added to the US grid this year and next, with small-scale solar PV increasing ~ 5 GW/yr. The EIA expects wind generation to increase 23 GW in 2021-22. The EIA attributed the slow-down in wind development to the expiration of a $0.025/kWH production tax credit at the end of 2020. Taken together, solar and wind generation will account for 15% of total US electricity output by the end of 2022, according to the EIA. Nuclear power will account for slightly less than 20% of US generation in 2021-22, while hydro will fall to less than 7% owing to severe drought in the western US. At the other end of the generation spectrum, coal will account for ~ 24% of generation this year, as it takes back incremental market share from natural gas, and ~ 22% of generation in 2022. Base Metals: Bullish Iron ore prices continue to trade above $215/MT in China, even as demand is expected to slow in 2H21. Supply additions from Brazil, which ships higher quality 65% Fe ore, have been slower than expected, which is supporting prices (Chart 10). Separately, the Chinese government's auction of refined copper earlier this month cleared the market at $10,500/MT, or ~ $4.76/lb. Spot copper has been trading on either side of $4.30/lb this month, which indicates the Chinese market remains well bid. Precious Metals: Bullish The 13-year record jump in the US Consumer Price Index reported this week for the month of June is bullish for gold, as it produced weaker real rates and sparked demand for inflation hedges. Fed Chair Powell continued to stick to the view that the recent rise in inflation is transitory. The Fed’s dovish outlook will support gold prices and likely will lead to a weaker US dollar, as it reduces the possibility that US interest rates will rise soon. A falling USD will further bolster gold prices (Chart 11). Chart 10 Chart 11     Footnotes 1     We highlighted this risk in last week's report, Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. Two events – in the Seychelles and Chile, where the majority of the populations were inoculated – highlight re-infection risk. Re-infections in Indonesia along with lockdowns following the spread of the so-called COVID-19 Delta variant also are drawing attention. Please see Euro 2020 final in UK stokes fears of spread of Delta variant, published by The Straits Times on July 11, 2021. The news service notes that in addition to the threats super-spreader sporting events in Europe present, "The rapid spread of the Delta variant across Asia, Africa and Latin America is exposing crucial vaccine supply shortages for some of the world's poorest and most vulnerable populations. Those two factors are also threatening the global economic recovery from the pandemic, Group of 20 finance ministers warned on Saturday." 2     Please see the recently published IMF World Economic Outlook Reports and the World Bank Global Economic Prospects. 3    If, as we suspect, KSA and the UAE are playing a long game – i.e., a 20-30-year game – this spare capacity will become more valuable as investment capex into oil production globally slows. Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by kapsarc.org on July 17, 2018. 4    Please see Bloomberg's interview with bp's CEO Bernard Looney at Banks Need ‘Radical Transparency,’ Citi Exec Says: Summit Update, which aired on July 13, 2021. In addition to focusing on margins and returns, the company – like its peers among the majors – also is aiming to reduce oil production by 20% by 2025 and 40% by 2030. 5    This turn of events is being dramatically played out in the coal markets, where the supply of metallurgical coals is falling as demand increases. Please see Coal Prices Hit Decade High Despite Efforts to Wean the World Off Carbon published by wsj.com on June 25, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Stay short USD/JPY. The drop in global bond yields should give this trade a welcome fillip. Short GBP/JPY positions also make sense. We are long CHF/NZD as a play on a potential increase in currency volatility. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2% from today’s levels. Remain long silver both in absolute terms and relative to gold. Our limit buy on EUR/USD was triggered at 1.18. Place tight stops given the potential for the dollar rally to continue for the next few weeks. We also believe the change in the ECB’s framework portends another bullish tailwind for the euro beyond the near term. Feature In our webcast last week, we made the case that the recent FOMC meeting (perceived as hawkish by market participants) has not altered the longer-term downtrend in the US dollar. This week, we are revisiting some of the sentiment and technical indicators that could help gauge how high the dollar can rise in the interim. Our view remains that three fundamental forces will continue to dictate currency market trends into the year end and beyond. First, the Federal Reserve will lag other central banks in raising rates amidst a shift in economic momentum from the US towards the rest of the world. This will boost short-term interest rates outside the US and provide a floor for procyclical currencies. Second, US inflation will prove stickier compared to other countries such as the eurozone or Japan. This will depress real interest rates in the US relative to the rest of the world, and curb bond inflows. And finally, an equity market rotation towards non-US stocks will improve flows into cyclical currencies. The transition could prove volatile in the coming month or so. Equity markets remain overbought, bond yields are falling, PMIs have stopped rising, and cyclical stocks are lagging growth stocks. More widespread infection from the Delta variant of Covid-19 will continue to reprice risk to the downside. As a countercyclical currency, the dollar will be a critical variable to watch. Sentiment and technical indicators make up an important component of our currency framework and are usually good at gauging significant shifts in financial markets. Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Momentum Indicators Our momentum indicators suggest that while the dollar is very oversold, the bear market remains very much intact. The dollar advance/decline line is sitting below its 200-day moving average (Chart I-1). Historically, bull markets in the dollar have been characterized by our advance/decline line breaking both above its 200-day and 400-day moving averages. This suggests a rally towards these critical resistance levels is in play but will constitute more of a countertrend bounce. Speculators are only neutral the dollar while, admittedly, leveraged funds are very short (Chart I-2). Historically, whenever the percentage of leveraged funds that are short the dollar has dipped near 40%, a meaningful rally has ensued. There are two important offsets to this. First, as Chart I-1 suggests, the dollar is a momentum currency. As such, during the bull market of the last decade, speculators were either neutral or long the dollar. If indeed the paradigm has shifted to a decade-long bear market, we expect speculators to be either short or neutral. Meanwhile, leveraged funds are a small subset of overall open interest, suggesting they are not the elephant in the room when it comes to dictating dollar movements. Leveraged funds were short the dollar during most of the bull market run last decade. Chart I-1The US Dollar Downtrend Is Intact Chart I-2Leveraged Funds Are Short The Dollar Carry trades are relapsing anew, suggesting the environment may be becoming unfavorable for high-yielding developed and emerging market currencies. The dollar has been negatively correlated with the Deutsche Bank carry ETF, DBV, since investors ultimately dump carry trades and fly to the safety of Treasurys on any market turbulence (Chart I-3). High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been consolidating recent gains. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. Our carry index tends to do well when the yield spread between US Treasuries and the indexes’ constituents’ is low. As such, there is some more adjustment underway, but one of limited amplitude (Chart I-4). Chart I-3The Carry Trade Rally Is Relapsing Chart I-4Carry Trades Have Hit An Air Pocket Chart I-5Currency Volatility Is Very Low Both expected and actual currency volatility are extremely depressed. Whenever currency volatility has been this low, the dollar has staged a meaningful rally. For example, the most significant episodes were the lows of 1996-1997, 2007-2008, and 2014-2015, and early 2020 (Chart I-5). Usually, low currency volatility is a sign of complacency, while higher volatility allows for a more balanced and healthy market rotation. The nature in which currency volatility adjusts higher this time around might be the same playbook as in previous episodes. The Asian crisis of the late 90s set the stage for the dollar bear market of the 2000s. The adjustment higher in the dollar during the Global Financial crisis jumpstarted the bull market the following decade. This time around, the Covid-19 crisis might have commenced a renewed dollar bear market. If this analogy is correct, then we should be selling the dollar on strength rather than buying on weakness. It is important to remember that the policy environment remains bearish for the dollar. These include deeply negative real rates, quantitative easing (which, admittedly, will soon end), generous liquidity swap lines to assuage any dollar funding pressures abroad (Chart I-6), and a global economy on the cusp of a renewed cycle. In our portfolio, we are long CHF/NZD since this cross has historically been a good hedge against rising currency volatility (Chart I-7). So is being short AUD/JPY. Being short the GBP/JPY cross might prove even more profitable, given that the UK has been a pandemic winner this year. Chart I-6The Fed Extended Its Swap Lines Chart I-7Buy CHF/NZD As Insurance Bottom Line: The message from our momentum indicators is that the bounce in the dollar was to be expected. We remain in the camp that believes the rally will be short-lived but are opportunistically playing what could be a more volatile environment. Equity Markets Signals A potential catalyst that could trigger further upside in the dollar is an equity market correction. Both the dollar and equities tend to be inversely correlated (Chart I-8). On this front, a few equity market indicators continue to flag that the rally in the dollar has a bit further to go.  Chart I-8The Dollar And Equities Move Opposite Ways Chart I-9Global Industrials Are Relapsing Anew The underperformance of cyclical stocks, especially global industrials, suggests equity markets could be entering a more volatile phase (Chart I-9). The dollar tends to strengthen when cyclical stocks are underperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. In more general terms, non-US markets are underperforming the US, a clear sign that the marginal dollar is rotating back towards the US (Chart I-10A and I-10B). Technology stocks have also been well bid in recent weeks, on the back of lower bond yields. These are all temporary headwinds for dollar weakness. Chart I-10ANon-US Stock Markets Are Underperforming Chart I-10BNon-US Stock Markets Are Underperforming Chart I-11US Relative Earnings Revisions Are High, But Rolling Over Earnings revisions continue to head higher across most markets, but US profit expectations are still higher compared to other countries (Chart I-11). Non-US bourses will need much higher earnings revisions to stimulate portfolio inflows, and for the dollar bear market to resume. On this front, both the euro area and emerging markets are showing only tentative improvement. The character of any selloff in equity markets will be worth monitoring. Cyclicals and value stocks are at historically bombed-out levels and could start to outperform high-flying stocks on any market reset.    Bottom Line: Whether a correction ensues, or the bull market continues, requires a change in equity market leadership from defensives to cyclicals. This is a necessary condition for the dollar bear market to resume. Commodities, Bonds, And The Dollar Commodity and bond prices give important cues about the health of the global economy. For example, rising copper prices and rising yields are a sign that industrial activity is humming, which in turn points to accelerating global growth. As a counter-cyclical currency, the dollar usually weakens in this scenario. Rising gold prices are generally a sign that policy settings remain ultra-accommodative, which also points to a weaker dollar. At the FX strategy service, we tend to focus more on the internal dynamics of commodity and bond markets, which can provide early warning signs. Chart I-12The Copper-To-Gold Ratio Is Consolidating Gains The copper-to-gold ratio is important since it indicates whether the liquidity-to-growth transmission mechanism is working. A rising ratio suggests policy settings are stimulating growth, while a falling ratio is a warning shot that the environment might be becoming deflationary. Correspondingly, this ratio has tended to track the dollar closely (Chart I-12). The copper-to-gold ratio is consolidating at very high levels. This is consistent with a healthy reset, rather than a reversal in the dollar bear market. The gold/silver ratio (GSR) tends to track the US dollar, and its recent price action also appears to be a welcome reset (Chart I-13). Like copper, silver benefits from rising industrial demand, especially in the electronics and renewable energy space. A falling GSR will be a sign that the manufacturing cycle is still humming. We are short the GSR with a target of 50, and a stop-loss at 71. The bond-to-gold ratio has bounced from very oversold levels. Both US Treasurys and gold are safe-haven assets and thus are competing assets. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). Gold has always been considered the perfect anti-fiat asset vis-à-vis the dollar, making the bond-to-gold ratio both a good short-term and long-term sentiment indicator. For now, the bounce in the ratio is not yet worrisome. We have noticed that inflows into US government bonds have risen sharply, while those into gold are falling. This should soon reverse with the fall in US rates, and the correction in gold prices. Chart I-13The Gold-To-Silver Ratio Is Consolidating Losses Chart I-14Competing Assets And The Dollar Bottom Line: The US is ultimately generating the most inflation in the G10, which is dampening real rates, and should curtail investor enthusiasm for gold relative to US Treasurys. The underperformance of Treasurys relative to gold will be a bearish development for the dollar. A Final Word On The Euro The strategic review from the European Central Bank had three key changes. The ECB now has a symmetric 2% inflation target. This is not a game changer, since it brings it in line with other global central banks, including the Bank of Japan. House prices will meaningfully begin to impact monetary policy, as the committee eventually includes owner’s equivalent rent (OER) in the HICP index (the ECB’s preferred inflation measure) for the euro area. This could be a game changer for the ECB’s price objective. Climate change was reiterated as important for price stability. Financial stability was also repeated as an important objective. As FX strategists, the second change was the most important. Shelter constitutes 17.7% of the euro area CPI basket, but it is 32.9% of the US CPI basket (Table I-1). Meanwhile, the shelter component of both the CPI basket in the US and euro area have tracked each other (Chart I-15). Table I-1Euro Area CPI Weights Chart I-15What Will Happen To Eurozone Inflation?   An adjustment in the weight of the shelter component in the euro area will boost the European CPI relative to the US and could trigger a major policy shift from the ECB in the coming years. This will especially be the in case if the current environment generates an inflationary shock. Bottom Line: The ECB will stay very accommodative in the next 1-2 years, but the change in its mandate could portend a bullish tailwind for the euro beyond the near term. Investment Implications We expect the current dollar rebound to be short-lived. As such, our strategy is as follows: Stay long other safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Investors can also short GBP/JPY from current levels. Chart I-16The Euro, Yen And Real Rates Our limit-buy on EUR/USD was triggered at 1.18. Given our expectation that the dollar could rally in the near term, we are setting the stop-loss at the same level. However, the improvement in real rates in the euro area relative to the US could cushion any downside (Chart I-16). We are also long CHF/NZD, as a bet on rising currency volatility. Correspondingly, we are setting a limit buy on Scandinavian currencies relative to the euro and USD at a trigger level of -2%. Both gold and silver benefit from the current environment, but we prefer silver to gold, due to the former’s call option on continued improvement in global growth. We are short the gold/silver ratio from the 68 level. Overall, we expect the dollar to weaken towards the end of the year, as has been the case since the 1970s (Chart I-17). Chart I-17The Yen And Swiss Franc Are Usually Winners In H2   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar USD Technicals 1 USD Technicals 2 The recent data out of the US have been robust: June non-farm payrolls showed an increase of 850K jobs, versus expectations of a 700K increase. The unemployment rate was relatively flat at 5.9% in June.  Factory orders came in at 1.7% year-on-year in May, in line with expectations. The US dollar DXY index is relatively flat this week, but with tremendous volatility. It was a relatively quiet week in the US, due to Independence Day, but the key theme remained a drop in US yields, with the 10-year yield moving from a high of near 1.8% this year to 1.3% currently. This move has catalyzed rallies in lower beta currencies, such as the yen and Swiss franc. The FOMC minutes released this week continue to suggest a Fed that will remain very patient in both tapering asset purchases and lifting interest rates.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro EUR Technicals 1 EUR Technicals 2 Recent data from the euro area were mixed: The PPI print for May came in at 9.6%, in line with expectations. Both the services and composite PMI were revised higher by 0.3 in June. At 59.2, the composite PMI is the highest in over a decade. ZEW expectations for the euro area fell sharply from 81.3 to 61.2. In Germany, there was a big decline in automotive surveys. The euro was flat this week against the dollar, despite gains overnight. The big news was the change in the ECB’s monetary policy objectives, which we discussed briefly in the front section of this report. The euro rallied on the news of three fundamental drivers in our view – real rate differentials are improving in favor of Europe, the ECB’s consideration for house price inflation could allow its price stability objective to be achieved sooner, and consideration for financial stability will be less favorable for negative interest rates.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021   The Yen JPY Technicals 1 JPY Technicals 2   Recent data from Japan remains subpar, but is improving: Labor cash earnings rose 1.9% in May, in line with expectations. Household spending rose 11.6% in May, in line with expectations. The Eco Watchers Survey for June came in at 47.6 from a May reading of 38.1. The outlook component rose from 47.6 to 52.4. The yen was up by 1.6% against the USD this week, the best performer. We argued a month ago that the yen is the most underappreciated G10 currency today. The catalyst that triggered yen gains were a drop in US real rates, that favored other safe-haven currencies. Going forward, further yen gains should materialize on the back of Japan successfully overcoming the pandemic like its Western counterparts. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021   British Pound GBP Technicals 1 GBP Technicals 2 There was scant data out of the UK this week: The construction PMI rose from 64.2 to 66.3 in June. House prices remain robust, with the RICS house price balance printing an elevated 83% in June. The pound was flat this week against the USD. The new delta variant of the COVID-19 virus is gaining momentum in the UK and will likely erode some of the dividends GBP had priced in from a fast vaccine rollout. As such, short GBP positions may pay off in the near term. Shorting GBP/CHF could be an attractive near-term hedge.   Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar AUD Technicals 1 AUD Technicals 2 There was scant data out of Australia this week: The Melbourne Institute of Inflation survey came it at 3% year on year in June, from 3.3%. The RBA kept interest rates unchanged at 0.1%, reiterating its commitment to stay accommodative until inflation and wages pick up meaningfully. The AUD was down by 0.4% this week against the USD. The RBA is decisively lagging other central banks in communicating less monetary accommodation in the coming years. This will create a coiled spring response for the AUD, because the RBA will have to eventually play catchup as the global economic cycle gains momentum.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021   New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The was scant data out of New Zealand this week: ANZ commodity price index rose by 0.8% in June. The NZD was down 0.3% against the dollar this week. Our long CHF/NZD position paid off handsomely in this environment. We recommend holding onto this trade, as a reset in global rates hurts the hawkish pricing in the NZD forward curve. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020   Canadian Dollar CAD Technicals 1 CAD Technicals 2 Canadian data softened but remained robust: Building permits fell by 14.8% month on month in May. The Markit manufacturing PMI fell from 57 to 56.5 in June. The Canadian trade balance deteriorated from C$0.6bn to a deficit of -C$1.4bn in May. Business Outlook Survey indicator hit the highest level on record. As the Bank of Canada put it, improving business sentiment is broadening. The CAD fell by 0.8% against USD this week. The results of the BoC survey highlight that a reopening phase is categorically bullish for economic activity in general and financial prices. Until recently, the CAD was one of the best performing currencies in the G10. This is a sea change from a country that was previously a laggard in vaccination efforts. CAD should hold up well once the dollar rally fades, but other currency laggards such as SEK and JPY could do even better.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc CHF Technicals 1 CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate was near unchanged at 3.1% in June, from 3.0%. Total sight deposits were unchanged at CHF 712 bn on the week of July 2. The Swiss franc was up by 1.1% this week against the USD. Falling yields improved the relative appeal of the franc that has bombed out interest rates. The franc is also benefiting from the rising bout of volatility as a safe-haven currency. On this basis, we are long CHF/NZD cross, which performed well this week. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020   Norwegian Krone NOK Technicals 1 NOK Technicals 2 Data out of Norway is improving: The unemployment rate fell from 3.3% to 2.9% in July. Industrial production growth came in at 2.1% year-on-year in May. Mainland GDP rose by 1.8% month on month in May. The NOK was down by 1.8% this week against the dollar, the worst performing G10 currency. The NOK is bearing the brunt of a reset in the US dollar, but our bias is that we are nearing a buy zone. NOK is cheap, would benefit from high oil prices and the economy is on the mend. We are looking to sell EUR/NOK and USD/NOK on further strength.   Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data from Sweden have been mildly positive: The Swedbank/Silf composite PMI fell from 70.2 to 66.9 in June. Industrial production came in at 24.4% year on year in May, after a rise of 26.4% in April. Household consumption jumped 8.8% year on year in April. The SEK was also up this week against the USD. Bombed-out interest rates in Sweden have also improved the appeal of the franc, given falling global bond yields. Meanwhile, the SEK remains one of the cheapest currencies in our models.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Over the short term – 1-2 years – the pick-up in re-infection rates in Asia and LatAm states with large-scale deployments of Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery (Chart of the Week). The UAE-Saudi impasse re extending the return of additional volumes of OPEC 2.0 spare capacity to the oil market over 2H21 will be short-lived.  The UAE's official baseline production will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly.  Over the medium term – 3-5 years out – the risk to the expansion of metal supplies needed for renewables and electric vehicles (EVs) will rise, as left-of-center governments increase taxes and royalties, and carbon prices move higher. Rising metals costs will redound to the benefit of oil and gas producers, and accelerate R+D in carbon- and GHG-reduction technologies. Longer-term – 5-10 years out – the active discouragement of investment in hydrocarbons will contribute to energy shortages. In anticipation of continued upside volatility in commodity prices and share values of oil, gas and metals producers, we remain long the S&P GSCI and COMT ETF, and long equities of producers and traders via the PICK ETF. Feature Our conversations with clients almost invariably leads us to considering the risks to our long-standing bullish views for energy and metals. This week, we reprise some of the highlights of these conversations. In the short term, our bullish call on oil is underpinned by the assumption of continued expansion in vaccinations, which we believe will lead to global economic re-opening and increased mobility, as the world emerges from the devastation of COVID-19. This expectation is once again under scrutiny. On the supply side, the very public negotiations undertaken by the UAE and the leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and Russia – over re-basing the UAE's production reminds investors there is substantial spare capacity from the coalition available for the market over the short term. The slow news cycle going into the US Independence Day holiday certainly was a fortuitous time to make such a point. Chart of the WeekWorrisome Uptick Of COVID-19 Cases KSA-UAE Supply-Side Worries The abrupt end to this week's OPEC 2.0 meeting was unsettling to markets. Shortly after the meeting ended – without being concluded – officials from the Biden administration in the US spoke with officials from KSA and the UAE, presumably to encourage resolution of outstanding issues and to get more oil into the market to keep crude oil prices below $80/bbl (Chart 2). We're confident the KSA-UAE impasse re extending the return of additional volumes of spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production number (i.e., its October 2018 output level) will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Coupled with a likely return of Iranian export volumes in 4Q21, this will bring prices down into the mid- to high-$60/bbl range we are forecasting. Chart 2US Pushing For Resolution of KSA-UAE Spat Longer term, markets are worried this incident is a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy, which has lifted oil prices 200% since their March 2020 nadir. At present, the producer coalition has ~ 6-7mm b/d of spare capacity, which resulted from its strategy to keep the level of supply below demand. A breakdown in this discipline – in extremis, another price war of the sort seen in March 2020 or from 2014-2016 – could plunge oil markets into a price collapse that re-visits sub-$40/bbl levels. In our view, economics – specifically the cold economic reality of the price elasticity of supply – continues to work for the OPEC 2.0 coalition: Higher revenues are realized by members of the group as long as relatively small production cuts produce larger revenue gains – e.g., a 5% (or less) cut in production that produces a 20% (or more) increase in price trumps a 20% increase in production that reduces prices by 50%. Besides, none of the members of the coalition possess the wherewithal to endure another shock-and-awe display from KSA similar to the one following the breakdown of the March 2020 OPEC 2.0 meeting. We also continue to expect US shale-oil producers to be disciplined by capital markets, and to retain a focus on providing competitive returns to their shareholders, which will limit supply growth to that which maintains profitability. Until we see actual evidence of a breakdown in the coalition's willingness to maintain its production-management strategy, we will continue to assume it remains operative. Worrisome COVID-19 Re-Infection Trends Reports of increased re-infection rates in Latin American and Asia-Pacific states providing Chinese Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery. Conclusive data on the efficacy of these vaccines is not available at present, based on reporting from Health Policy Watch (HPW).1 The vast majority of these vaccines were purchased in Latin America and the Asia-Pacific region, where ~ 80% of the 759mm doses of the two Chinese vaccines were sold, according to HPW's reporting. This will draw the attention of markets to this risk (Chart 3). Of particular concern are the increases in re-infection rates in the Seychelles and Chile, where the majority of populations in both countries were inoculated with one of the Chinese vaccines. Re-infections in Indonesia also are drawing attention, where more than 350 healthcare workers were re-infected after receiving the Sinovac vaccination.2 The risk of renewed global lockdowns remains small, but if these experiences are repeated globally with adverse health consequences, this assessment could be challenged. Chart 3COVID-19 Returning In High-Vaccination States Transition Risks To A Low-Carbon Economy Over the medium- to long-terms, our metals views are premised on the expectation the build-out of the global EV fleet and renewable electricity generation – including its supporting grids – will require massive increases in the supply of copper, aluminum, nickel, and tin, not to mention iron ore and steel. This surge in demand will be occurring as governments rush headlong into unplanned and unsynchronized wind-downs of investment in the hydrocarbon fuels that power modern economies.3 The big risk here is new metal supplies will not be delivered fast enough to build all of the renewable generation, EVs and their supporting grids and infrastructures to cover the loss of hydrocarbons phased out by policy, legal and boardroom challenges. Such a turn of events would re-invigorate oil and gas production. Renewable energy and electric vehicles are the sine qua non of the drive to achieve net-zero carbon emissions by 2050. However, the rising price of base metals will add to already high costs of rebuilding power grids to make them suitable for green energy. Given miners’ reluctance to invest in new mines, we do not expect metals prices to drop anytime soon. According to Wood Mackenzie, in 2019 the cost of shifting just the US power grid to renewable energy over the next 10 years will amount to $4.5 trillion.4 Given these cost and supply barriers, fossil fuels will need to be used for longer than the IEA outlined in its recent and controversial report on transitioning to a net-zero economy.5 To ensure that fossil fuels can be used while countries work to achieve their net zero goals, carbon capture utilization and storage (CCUS) technology will need to be developed and made cheaper. The main barrier to entry for CCUS technology is its high cost (Chart 4). However, like renewable energy, the more it is deployed and invested in, the cheaper it will become, following the trend seen in the development of renewable energy and EVs, which were aided by large-scale subsidies from governments to encourage the development of the technology. These cost reductions are already visible: In its 2019 report, the Global CCS Institute noted the cost of implementing CCS technology initially used in 2014 had fallen by 35% three years later. Chart 4CCUS Can Be Expensive Metals Mines' Long Lead Times In 2020 the total amount of discovered copper reserves in the world stood at ~ 870mm MT (Chart 5), according to the US Geological Service (USGS). As of 2017, the total identified and undiscovered amount of reserves was ~ 5.6 billion MT.6 The World Bank recently estimated additional demand for copper would amount to ~ 20mm MT p.a. by 2050 (Chart 6).7 Glencore’s recently retired CEO Ivan Glasenberg last month said that by 2050, miners will need to produce around 60mm MT p.a. of copper to keep up with demand for countries’ net zero initiatives.8 Even with this higher estimate, if miners focus on exploration and can tap into undiscovered reserves, supply will cover demand for the renewable energy buildout. Chart 5Copper Reserves Are Abundant Chart 6Call On Base Metals Supply Will Be Massive Out To 2050 While recent legislative developments in Chile and Peru, which together constitute ~ 34% of total discovered copper reserves, could lead to significantly higher costs as left-of-center governments re-write these states' constitutions, geological factors would not be the main constraint to copper supply for the renewables energy buildout: Even if copper mining companies were to move out of these two countries, there still is about 570 million MT in discovered copper reserves, and nearly ten times that amount in undiscovered reserves. As we have written in the past, capital expenditure restraint is the principal reason the supply side of copper markets – and base metals generally – is challenged (Chart 7). Unlike in the previous commodity boom, this time mining companies are focusing on providing returns to shareholders, instead of funding the development of new mines (Chart 8). Chart 7Copper Prices Remains Parsimonious Chart 8Shareholder Interests Predominate Metals Agendas Of course, it is likely metals miners, like oil producers, are waiting to see actual demand for copper and other base metals pick up before ramping capex. Sharp increases in forecasted demand is not compelling for miners, at this point. This means metals prices could stay elevated for an extended period, given the 10-15-year lead times for copper mines (Chart 9). For example, the Kamoa-Kakula mine in the Democratic Republic of Congo (DRC) now being brought on line took roughly 24 years of exploration and development work, before it started producing copper. Technological breakthroughs that increase brownfield projects’ productivity, or significant increases in the amount of recycled copper as a percent of total copper supply would address some of the price pressures arising from the long lead times associated with the development of new copper supply. Another scenario with a non-trivial probability that threatens the viability of metals investing is a breakthrough – or breakthroughs – in CCUS technology, which allows oil and gas producers to remove enough carbon from their fuels to allow firms using these fuels to achieve their net-zero carbon goals. Chart 9Long Lead Times For Mine Development Investment Implications Short-term supply-demand issues affecting the oil market at present are transitory, and do not signal a shift in the fundamentals supporting our bullish call on oil. Our thesis based on continued production discipline remains intact. That said, we will continue to subject it to rigorous scrutiny on a continual basis. Our average Brent forecast for 2021 remains $66.50/bbl, with 2H21 prices averaging $70/bbl. For 2022 and 2023 we continue to expect prices to average $74 and $81/bbl, respectively (Chart 10). WTI will trade $2-$3/bbl lower. Our metals view has become slightly more nuanced, thanks to our client conversations. One of the unintended consequences of the unplanned and uncoordinated rush to a net-zero carbon future will be an improvement in the competitive position of oil and gas as transportation fuels and electric-generation fuels going forward. This will be driven by rising costs of developing and delivering the metals supplies needed to effect the net-zero transition. We expect markets will provide incentives to CCUS technologies and efforts to decarbonize oil and gas fuels, which will contribute to the global effort to arrest rising temperatures. This suggests the rush to sell these assets – which is underway at present – could be premature.9 In the extreme, this could be a true counterbalance to the metals story, if it plays out. Chart 10Our Oil Price View Remains Intact     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The monthly OPEC 2.0 meeting ended without any action to increase monthly supplies, following the UAE's bid to increase its baseline reference production – determined based on October 2018 production levels – to 3.8mm b/d, up from 3.2mm b/d. S&P Global Platts reported the UAE's Energy Minister, Suhail al-Mazrouei, advanced a proposal to raise its monthly production level under the coalition's overall output deal, while KSA's energy minister, Prince Abdulaziz bin Salman, insisted the UAE follow OPEC 2.0 procedures in seeking an output increase. We do not expect this issue to become a protracted standoff between these states. The disagreement between the ministers is procedural to substantive. Remarks by bin Salman last month – to wit, KSA has a role in containing inflation globally – and his earlier assertions that production policy of OPEC 2.0 would be driven by actual oil demand, as opposed to forecasted oil demand, suggest the Kingdom is not aiming for higher oil prices per se. Base Metals: Bullish Spot benchmark iron ore (62 Fe) prices traded above $222/MT this week in China on the back of stronger steel demand, according to mining.com (Chart 11). Market participants are anticipating further steel-production restrictions and appear to be trying to get out in front of them. Precious Metals: Bullish The USD rally eased this week, allowing gold prices to stabilize following the June Federal Open Market Committee (FOMC) meeting. In the two weeks since the FOMC, our gold composite indicator shows that gold started entering oversold territory (Chart 12). We believe gold prices will start correcting upwards, expecting investor bargain-hunting to pick up after the price drop. The mixed US jobs report, which showed the unemployment rate ticked up more than expected, implies that interest rates are not going to be raised soon. Our colleagues at BCA Research's US Bond Strategy (USBS) expect rates to increase only by end-2022.10 This, along with slightly higher odds of a potential COVID-19 resurgence, will support gold prices in the near-term. Ags/Softs: Neutral The USDA's Crop Progress report for the week ended 4 July 2021 showed 64% of the US corn crop was in good to excellent condition, down from the 71% reported for the comparable 2020 date. The Department reported 59% of the bean crop was in good to excellent shape vs 71% the year earlier. Chart 11 Chart 12     Footnotes 1     Please see Are Chinese COVID Vaccines Underperforming? A Dearth of Real-Life Studies Leaves Unanswered Questions, published by Health Policy Watch, June 18, 2021. 2     According to HPW, the World Health Organization's Emergency Use Listing for these two vaccines "were unique in that unlike the Pfizer, AstraZeneca, Moderna, and Jonhson & Johonson vaccines that it had also approved, neither had undergone review and approval by a strict national or regional regulatory authority such as the US Food and Drug Administration or the European Medicines Agency. Nor have Phase 3 results of the Sinopharm and Sinovac trials been published in a peer-reviewed medical journal.  More to the point, post-approval, any large-scale tracking of the efficacy of the Sinovac and Sinopharm vaccine rollouts by WHO or national authorities seems to be missing." 3    Please see A Perfect Energy Storm On The Way, which we published on June 3, 2021 for additional discussion.  It is available at ces.bcaresearch.com. 4    Please refer to The Price of a Fully Renewable US Grid: $4.5 Trillion, published by greentechmedia 28 June 2019. 5    Please refer to the IEA's Net Zero By 2050, published in May 2021. 6    Please refer to USGS Mineral Commodity Summaries, 2021. 7     Please refer to Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition, published by the World Bank. 8    Please refer to Copper supply needs to double by 2050, Glencore CEO says, published by reuters.com on June 22, 2021. 9    Please see the FT's excellent coverage of this trend in A $140bn asset sale: the investors cashing in on Big Oil’s push to net zero published on July 6, 2021. 10   Please refer to Watch Employment, Not Inflation, published by the USBS on June 15, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades