Commodities & Energy Sector
Executive Summary Russia’s Crude Oil Output Will Fall Russia will have to lower oil production to ensure output it hasn’t placed with non-EU buyers does not tax its limited storage facilities, ahead of the bloc’s December 5 embargo. The EU’s insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonight’s close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russia’s Crude Oil Output Will Fall Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EU’s embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russia’s crude sales last month – ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russia’s seaborne crude oil sales, according to Bloomberg data. Related Report Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end – vs its current output of 10.6mm b/d output presently – and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSA’s max capacity is 12mm b/d, while the UAE’s is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producers’ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply Chart 3Spare Capacity Concentrated In Core OPEC 2.0 Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand – particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year – +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand – the US and Europe – show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level – even with China’s negative y/y growth – while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track – it excludes the market-share wars of 2015-17 and that of 2020, and the pandemic’s effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after they’ve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EU’s embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will push crude oil prices higher and inventories lower (Chart 7).3 Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonight’s close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate inventories – diesel and heating oil mostly – were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the People’s Bank of China’s decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 Chart 9 Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloyd’s List 9 August 2022. The report notes, “All the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.“ 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. Investment Views and Themes Strategic Recommendations Trades Closed in 2022
Executive Summary Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets. The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end. In February 2023, another 800k b/d of refined products will be embargoed. December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term. Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months. The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil. Even so, oil balances still will remain tilted to deficit conditions in 2023. We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Chart 5Energy Driving High US Prices US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Chart 7…And Refining Capacity Are Bullish For Petrol Products There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Chart 10 Footnotes 1 Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2 Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3 Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022. According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d. In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4 Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5 Please see footnote #4. 6 The background factor in this situation is Russia’s involvement in Libya’s civil disorder. We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7 Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8 Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9 Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10 After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11 Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12 For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis Investment Views and Themes Strategic Recommendations Trades Closed in 2022
The price of Brent experienced a sharp drop last week due to a series of bearish news. On Wednesday, OPEC announced plans to raise output by 100 thousand bbl/day in September (though this is a significant slowdown from quota increases in July and August).…
Executive Summary China Copper Consumption Failed To Revive Post-Pandemic A greater-than-expected contraction in manufacturing and construction in China – evidenced by the latest PMI and home sales data – will keep pressure on copper prices. Higher inflation will continue to drive the cost of labor, fuels and materials higher. Lower copper prices and higher input costs will weaken margins, leading to reduced capex. This also will put pressure on the rate of spending on projects already sanctioned. Payouts to shareholders – buybacks and dividends – will fall, reducing the appeal of miners’ equities. Debt-service costs will rise as interest rates are pushed higher by central banks. Civil unrest in critically important metals-producing provinces is forcing some miners to suspend production guidance. This will be exacerbated in Chile by changing tax regimes, which likely will reduce capex as well. Bottom Line: As global demand for copper increases with the renewable-energy transition and higher arms spending in Europe, miners’ ability to expand supply is being seriously challenged. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. With demand expected to double by 2030-35, copper prices will have to move higher to keep capex flowing to support supply growth. We remain long the XME ETF as the best way to express our bullish, decade-long view. Feature Just as the world is scrambling to develop additional energy supplies in the wake of Russia’s invasion of Ukraine, copper supplies – the critical element of the renewable-energy buildout – are being squeezed by an unusual convergence of fundamental, financial and social factors. Chart 1China Copper Consumption Failed To Revive Post-Pandemic Firstly, copper demand is weak, which, all else equal, is suppressing prices. This is largely down to China’s zero-tolerance COVID-19 policy, and uncertainty over whether the EU will be pushed into a massive recession, following the cutoff of its natural gas supplies from Russia. These are two of the three major pillars of the global economy, and their economies are entwined via trade in goods. China’s COVID-19 policy is hammering its critically important property market – sales were down almost 40% y/y in July – and forcing a contraction in manufacturing. Construction represents ~ 30% of total copper demand in China. Manufacturing is contracting, based on China’s official July PMI report, which showed the index fell below 50 to 49.0 for July.1 Related Report Commodity & Energy StrategyOne Hot Mess: EU Energy Policy China accounts for more than half of global copper demand, and, because of its zero-tolerance COVID-19 policy, was the only major economy to register a year-on-year contractions in copper demand throughout the pandemic up to the present (Chart 1). The EU accounts for ~ 12.5% of global copper demand, which we expect will continue to be supported by the bloc’s renewable-energy and defense buildouts.2 We noted in earlier research the odds of the EU going into recession remain high as the bloc scrambles to prepare for winter, in the wake of its attempts to replace its dependence on Russian natural gas supplies.3 We continue to expect the EU will avoid a major recession, and that it will be able to navigate this transition, leaving it on a better energy footing in subsequent years.4 Lower Copper Prices Will Hurt Capex Chart 2Copper Price Rally Fades After bottoming in March 2020 at $2.12/lb on the COMEX, copper prices staged a 125% rally that ended in March of this year. This was due to the post-pandemic reopening of most economies ex-China, which was accompanied by massive fiscal and monetary stimulus that super-charged consumer demand. Copper prices have since fallen ~33% from their March highs on the back of a substantial weakening of demand resulting from China’s zero-tolerance COVID policy and a concerted global effort to rein in the inflation caused by governments’ largess (Chart 2). Most year-end 2021 capex expectations for 2022 and into the future among copper miners were drawn up prior to the price collapse in June. After that, fear of central-bank policy mistakes – chiefly over-tightening of monetary policy that pushes the global economy into recession – and weak EM demand took prices from ~ $4.55/lb down to less than $3.20/lb by mid-July. A strong USD also pushed demand lower during this time. Chart 3DRC Offsets Chile, Peru Weakness Following the copper-price rout, miners are re-thinking production goals, dividend policy and capex. Social and governance issues also are contributing to weaker copper output. Rio Tinto, for example, notified markets it would shave $500mm from its $8 billion 2022 capex budget. For 1H22, Rio cut its dividend to $2.67/share from $5.61/share in 1H21. Elsewhere, Glencore said copper output from its Katanga mine in the DRC now is expected to come in 15% lower this year, at 1.06mm MT, owing to geological difficulties. Separately, output guidance for Chinese miner MMG Ltd’s Las Bambas mine in Peru has been suspended, following a 60% drop in production. The company expected it would be producing up to 320k tons this year. Civil unrest at Las Bambas has been ongoing since production started in 2016, according to Reuters. Big producers like Chile and Peru – accounting for ~ 35% of global ore production – along with the DRC face multiple challenges. Chile accounts for ~ 25% of global copper ore production. Its output fell ~ 6% in 2Q22 vs year-earlier output due to falling ore quality, water-supply constraints, and rising input costs (Chart 3). Chile’s government expects copper ore output to decline 3.4% y/y in 2022, with many of the country’s premier mines faltering (Chart 4). Chart 4Chile Expecting Lower Copper Output Chile also is proposing to increase taxes and royalties, to raise money for its budget. However, this may have the effect of driving away investment in the country’s copper mining industry. Fitch notes, “Increased costs will decrease mining cash flows and discourage new mining investments in Chile, favoring the migration of investors to other copper mining districts.”5 BHP Billiton, on que, said it will reconsider further investment in Chile, if the new legislation is approved. Renewables Buildout Will Widen Copper Deficit Markets appear to be trading without regard for the huge increase in copper supply that will be required for the global renewable-energy transition, to say nothing of the upcoming re-arming of the EU and continued military spending by the US and China. In our modeling of supply-demand balances, we move beyond our usual real GDP-based estimates of demand, which estimates the cyclical copper demand, and include assumptions for the demand the green-energy transition will contribute. Hence, this additional copper demand for green energy needs to be added to the copper demand forecast generated by the model. Using projections for global supply taken from the Resource and Energy Quarterly published by the Australian Government’s Department of Industry, Science and Resources, we estimate there will be a physical refined copper deficit of 224k tons in 2022 and 135K tons next year (Chart 5). Among other things, we are assuming refined copper demand will double by 2030 and reach 50mm tons/yr by then. This is a somewhat more aggressive assumption than S&P Global’s estimate of demand doubling by 2035. If we assume refined copper production is 2% lower than the REQ’s estimate, we expect the physical deficit in the refined copper market rise to a ~ 532k-ton deficit in 2022 and ~ 677k-ton deficit in 2023. These results including renewables demand highlight the need to not only account for cyclical demand but also the new demand that will be apparent as the EU, the US and China kick their renewables investments into high gear. Importantly, this kick-off is occurring with global commodity-exchange inventories still more than ~ 35% below year-ago levels (Chart 6). Chart 5Coppers Deficit Will Narrow On Lower Demand Chart 6Exchange Inventories Remain Exceptionally Low Investment Implications Copper prices will have to move higher to keep capex flowing to support supply growth normal cyclical demand and renewable-energy demand will require over coming decades. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. This situation cannot persist unless governments call off their renewable-energy transition, and, in the case of the EU, their efforts to re-arm Europe’s militaries following the invasion of Ukraine by Russia. We remain bullish base metals, particularly copper. We remain long the XME ETF as the best way to express this decade-long view. Commodities Round-Up Energy: Bullish OPEC 2.0 agreed a token increase in oil production Wednesday of 100k b/d, partly as a sop to the US following President Biden’s visit to the Kingdom last month. KSA will be producing close to 11mm b/d in 2H22. We have argued this is about all KSA will be willing to put on the market, in order to maintain some spare capacity in the event of another exogenous shock. OPEC 2.0 spare capacity likely falls close to 1.5mm b/d in 2023 vs. an average of 3mm b/d this year, which will limit the capacity of core OPEC 2.0 – KSA and the UAE – to backstop unforeseen production losses. Separately, the US EIA reported total US stocks of crude oil and refined products rose 3.5mm barrels (ex SPR inventory). Demand for refined products in the US was down 28mm barrels in the week ended 29 July, or 4mm b/d. We continue to expect prices to average $110/bbl this year and $117/bbl next year (Chart 7). Base Metals: Bullish China flipped from a net importer of refined zinc in 2021 to a net exporter for the first half of 2022, despite a high export tax on the metal. This is indicative of the premium Western zinc prices are commanding over the domestic price. Chinese zinc demand has fallen, following reduced manufacturing activity and an ailing property sector. Thursday’s Politburo meeting did little to encourage markets of a Chinese rebound later this year. A subdued Chinese recovery, along with European zinc smelters operating at reduced capacity, if at all, could see this reversal in trade flow perpetuate for the rest of the year. Precious Metals: Bullish As BCA’s Geopolitical Strategy highlighted, US House Speaker Nancy Pelosi’s visit to Taiwan will increase tensions between the US and China but will not lead to war. For now. Increased uncertainty normally is good for gold and its rival, the USD. While geopolitical uncertainty from Russia’s invasion of Ukraine initially buoyed the yellow metal, gold has since dropped below the USD 1800/oz level. The greenback was the main beneficiary from the war (Chart 8). It is yet to be seen how this round of geopolitical risk will impact gold and USD, with the backdrop of increasing odds of a US recession and a hawkish Fed. Chart 7 Chart 8 Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Footnotes 1 Please see China’s factory activity contracts unexpectedly in July as Covid flares up published by cnbc.com on July 31, 2022. The PMI summary noted contractions in oil, coal and metals smelting industries led the index’s decline. 2 Please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022, for additional discussion. 3 Please see Copper Prices Decouple From Fundamentals, which we published on July 7, 2022. It is available at ces.bcaresearch.com. 4 Please see Energy Security Rolls Over EU's ESG Agenda published on July 28, 2022. It is available at ces.bcaresearch.com. 5 Please see Proposed Tax Reform Weakens Cost Positions for Chilean Miners (fitchratings.com), published by Fitch Ratings on July 7, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2022
Dear Client, On Monday August 8, I will be sending you an abbreviated version of our monthly Chart Pack. Our regular publication will resume on August 15. Kind regards, Irene Tunkel Executive Summary The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home In the following report we continue answering questions from our “Bear Market 2.0” webcast, by reviewing recent US legislative actions, and their effects on semiconductor and energy stocks. Semiconductors Bill: Over the long term, the recently passed CHIPS+ bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Semiconductors Overview: Semis are "growthy" and have surged on the back of falling yields. They are also highly cyclical, and slowing growth will become a headwind to performance. Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. We prefer more stable growth areas of the Technology sector and are overweight Software and Services as opposed to semis stocks. The bill is not enough to "move the needle". What To Do With Energy? The stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As a result, we downgrade the Exploration & Production segment, maintain our overweight in the Equipment & Services, and boost Storage & Transportation from underweight to neutral on the back of the upcoming new pipeline construction. Bottom Line: We remain underweight semis as the one-off boost from the CHIPS+ bill does not counterbalance demand headwinds. When it comes to Energy, the capex upswing will lower the price of oil which warrants an underweight stance in Exploration & Production names. Feature This week investors experienced a deluge of news and data, spanning the Fed rate decision, the Q2-2022 GDP estimate, and earnings reports from some of the largest US corporations, such as Apple, Amazon, and Facebook. To top it off, we had major developments on the legislation front after a multi-month hiatus. Two major bills, the Chips and Science Act of 2022 (aka CHIPS+) and the Inflation Reduction Act of 2022 (an incarnation of Build Back Better), are close to passage, after months and months of dithering. In this report, we will discuss the potential effects of these pieces of legislation on the two equity sectors most affected, Semiconductors and Energy. Since these sectors are also at the epicenter of recent market action, we hope that this report is timely and will help you make the right investment decisions. Sneak Preview: We maintain our underweight on Semiconductors, and downgrade Energy Exploration and Production to an underweight on the back of falling energy prices. Semiconductors: Is It Time To Close The Underweight? When it comes to semis stocks, the current bear market caused a deeper peak-to-trough correction (40%) than at the bottom of the pandemic, implying that, perhaps, much of the bad news was priced in. We have been underweight semis since early January and are up 14% relative to the S&P 500. With the industry bouncing 20% off its June lows, we question whether we have overstayed our welcome and it is time to close this underweight, especially in light of the imminent passage of the CHIPS+ bill. Let’s start by discussing the bill: Designed In The US, Made In Asia In a November 2021 “Semiconductors: Aren’t They Fab?!” Special Report, we highlighted that semiconductor production is divided among chip designers and manufacturers, a so-called “fabless model,” which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. The entire semiconductor industry depends on cooperation between two regions: North America, which houses global leaders in designing the most sophisticated chips, and Asia, which is home to companies that have the technology to manufacture them (Charts 1 & 2). As a result, the US share of chip manufacturing has been falling steadily for the past 30 years, from 37% to 10% (Chart 3). Recent, supply chain disruptions and heightening geopolitical tensions have underscored this country’s vulnerability due to outsourcing of chip manufacturing, which led to renewed calls for chip independence and onshoring. Chart 1Chips Are Designed In The US... Chart 2...And Manufactured In Asia Objective Of The CHIPS+ Bill Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. The bill will provide financial incentives for both US and non-US chip makers to open manufacturing plants in the US while restricting semiconductor companies’ activities “in specific countries that present a national security threat to the United States.” The provision ensures that China, which has also been recently striving for chip independence, will not be a beneficiary of US government funds. The bill also comes with strings attached: It states that it will not allow companies to use any of the funds to buy back stocks or issue dividends. Chart 3The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home Cost Of The Bill Preliminary analysis from the Congressional Budget Office assesses that the bill will trigger roughly $79 billion in new spending over the coming decade. The key provision in the bill is the $52.7 billion for chip makers. Of those funds, $39 billion is earmarked to “build, expand, or modernize domestic facilities” for chip-making, while $11 billion is set aside for research and development. Funds will be spread over five years. The bill also adds $24 billion in tax incentives and other provisions for semiconductor manufacturing. In addition, $2 billion is allocated to translate laboratory advances into military and other applications. While $79 billion sounds like a lot of money, we need to keep things in perspective. As Barron’s pointed out: “According to IC Insights, total semiconductor industry capital spending is estimated to grow 24% this year, to $190 billion. Assuming some growth over the next several years, the bill would be a modest single digit percentage of the aggregate spending over the five-year time period.” Therefore, the financial benefits the bill provides are modest. Key Beneficiaries US chip makers with fab facilities, such as Intel (INTC), Micron Technology (MU), and Texas Instruments (TXN) will be the key beneficiaries of the bill as they are offered financial incentives for opening new plants. Foreign companies, such as TSMC, Samsung, and Global Foundries, might also qualify for financial incentives to open chip production facilities in the US. In fact, Intel, TSMC, and Global Foundries have already announced plans to build plants in the US contingent on the bill’s passing. Fabless chip designers, such as Nvidia (NVDA), AMD, and Qualcomm are unlikely to benefit from the package in a major way. Over the long term, the bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Demand For Chips Is Fading While the bill will have some positive effect on chip manufacturing, there is a lurking danger that production is being ramped up globally just at a time when, after prolonged shortages, demand for chips is starting to fade. Historically, this highly cyclical industry has gone through boom and boost cycles every three to four years. During the Q2 earnings call, TSMC Chief Executive Mr. Wei said that the broader industry is dealing with an “inventory correction” that has led customers to cut orders from some of its peers. After two years of pandemic-driven demand, “our expectation is for the excess inventory in the semiconductor supply chain to take a few quarters to rebalance to a healthier level.” This is not surprising. Semiconductors are highly economically sensitive with sales declining in lockstep with slowing global growth (Chart 4), while inventory levels are picking up (Chart 5). Chart 4Sales Are Declining In Lockstep With Slowing Global Growth Chart 5Chip Inventory Levels Are Picking Up Demand for two of the industry’s key markets, computers and mobile phones, which account for 50% of the overall chip demand, seems to be deteriorating rapidly amid the slowing global economy. Demand for consumer electronics is fading after a pandemic surge of buying, when consumers pulled forward their spending on phones and computers. Most of these items don’t need to be upgraded or replaced for years. COVID-related lockdowns in China, meanwhile, have also weighed on consumer demand. According to IDC, worldwide shipments of personal computers fell 15% in the June quarter from a year earlier, due to “macroeconomic headwinds.” IDC has also lowered its forecast for 2022 expecting computer shipments to retreat by 8.2%. Canalys said global shipments for mobile phones fell 9% year over year, following economic headwinds, sluggish demand, and inventory pile-up. Memory chips represent 28% of the industry, and DRAM accounts represent three-fifths of memory sales. DRAM prices are falling (Chart 6). According to TrendForce, the average contract price for a DRAM, used widely in consumer items ranging from cars to phones to fridges, fell by 10.6% during the second quarter, compared to a year ago, the first such decline in two years. DRAM prices are expected to slide by 21% in Q3-2022. Companies are telling us similar stories: Micron, the No. 3 player in memory, recently issued revenue guidance well below analysts’ estimates. Chief Executive Sanjay Mehrotra warned that “the industry demand environment has weakened,” with PC and smartphone sales declining. Lisa Su, Chief Executive of AMD, expects computer demand to be roughly flat. Nvidia is bracing for a slowdown in the crypto space and game consoles. Intel has reported disappointing results: PC customers are reducing inventory levels at a rate not seen in a decade, Chief Executive Pat Gelsinger said in a call with analysts. PC makers typically reduce inventory levels of chips when they are expecting lower sales. Chart 6DRAM Prices Are Falling Of course, there is significant variability in demand for chips across sectors: While demand for phones and computers is fading, there is still pent-up demand for auto chips, and servers (Chart 7). According to Ms. Su, demand remains hot for chips used in high-performance computers and servers. TSMC, which has Apple and Nvidia among its clients, seconds this notion: Quarterly revenue for high-performance computers, increased 13% from the previous quarter and was greater than the revenue from smartphones, which rose 3%. There are also significant shortages of less-advanced auto chips (Chart 8). In a recent Q2 earnings call, GM reported that it carries 95,000 unfinished cars in its inventory due to the auto chip shortage. According to Mr. Wei of TSMC, the company will continue investing in auto chips, a product that historically it didn’t emphasize as much as its cutting-edge chips, in response to strong demand. Texas Instruments, which reported stellar results, also said that while it saw strength in the auto and industrial segments, demand from the consumer electronics market remained weak in both the second quarter and the current quarter. Chart 7Demand For Servers Is Still Strong Chart 8More Chips Will Boost Auto Sales Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. Pricing power is also fading. However, there are still areas immune to the downturn, such as chips for servers, high-performance computers, and less advanced auto chips. Valuations and Fundamentals Earnings growth expectations have also come down significantly off their peak, and are currently at 5% for the next 12 months, which indicates negative real growth (Chart 9). Chart 9Earnings Growth Is Slowing Chart 10Valuations Are Above Pre-Pandemic Trough Semi valuations have pulled back from a 33x trailing multiple to 17x over the course of six months, only to bounce back another 3x since June 16, currently trading at 20x multiple. While valuations certainly moderated, they are still above the pre-pandemic trough in 2019 when the global economy was also slowing. The BCA Valuation Indicator, an amalgamation of various valuation metrics, indicates that semiconductors trade at fair value (Chart 10 & Chart 11). The rebound rally was fast and furious; at nearly 20% off market lows, it feels like much of the recovery from severely oversold conditions has run its course. Chart 11Chips Are Moderately Priced, While Investor Position Is Light Semis Investment Implications Semiconductors are somewhat unique in that they are both cyclical and “growthy” (Chart 12). Since semis are “growthy,” the past six-week rebound may be attributed to falling rates, which have led to multiple expansion of most growth sectors. However, we need to keep in mind that rates have stabilized because of signs of global slowdown, and that the cyclical nature of semis will get in the way of further outperformance. While we also believe that the CHIPS+ bill is a modest tailwind, it is hard to commit to an industry in the early innings of contraction. For investors who would like to top up their allocations to semis, we recommend companies most exposed to demand from industrial sectors (autos, servers, high performance computers), and staying away from companies most exposed to consumer electronics. Much of the performance of companies that have reported so far hinged on their product mix. Chart 12Semis Are Both "Growthy" And Cyclical Bottom Line We are reluctant to add to semis after the sector gained nearly 20% in just six weeks. Economic challenges remain – demand for chips is slowing, and the process of clearing inventory build-up may take several quarters. CHIPS+ is a positive but, in our opinion, is not enough to move the needle. We prefer more stable growth areas of the Technology sector and are overweight Software and Services. We also prefer semis most exposed to demand from non-consumer sectors. What To Do With Energy? We are currently equal-weight Energy. More specifically, we are overweight Energy Equipment and Services, equal weight Explorations and Production (we closed an overweight in March, booking a profit of 50%), and underweight Energy Transportation industry groups. With Brent down 18% and GSCI down 15%, and economic growth slowing, it is essential to review what is in store for the sector. Further, the Inflation Reduction Act, which is now on President Biden desk expecting his signature, has quite a few provisions relevant to the sector. Inflation Reduction Act And Its Effects On The Fossil Fuels Industry This bill is a true marvel of political negotiation and gives all parties something to be happy about and something to complain about. While the bill earmarks $370 billion for clean energy spending at the insistence of Senator Manchin (D, WV), the legislative package provides support for traditional sources of energy like oil, gas, and coal. Broadly speaking, the bill is a positive for expanding domestic energy production and supporting its nascent Capex cycle, which we called for in the “Energy: After Seven Lean Years” Special Report. Development of new wells has already picked up over the past few months (Chart 13). Chart 13New Energy CAPEX Cycle Here are a few important rules stipulated by the bill, highlighted by the Wall Street Journal: Expanding offshore wind and solar power development on federal land will now require the federal government to offer more access for drilling on federal territory. Under the bill, the Interior Department would be required to offer up at least two million acres of federal land and 60 million acres of offshore acreage to oil and gas producers every year for the next decade. It would be the first-ever required minimum acreage for offshore oil and gas leasing and would significantly increase the acreage requirements for onshore leasing. The bill would also effectively reinstate an 80-million-acre sale of the Gulf of Mexico to the oil drillers last year that a federal judge had invalidated. The bill is also a major positive for the natural gas industry, providing an accelerated timeline for building the pipelines and terminals needed to increase production and export of fossil fuels. In exchange for access to more federal territory, oil and gas companies would also have to pay higher royalty rates for drilling there. It would also require them to pay royalties on methane they burn off or let intentionally escape from their operations on federal lands. The bill aims to increase the supply of oil, gas, and coal, and return the US towards energy independence. Over the medium term, it should lead to a normalization of the price of energy. Demand Vs. Supply Naturally, the price of oil is all about supply and demand. And the performance of the energy sector is inextricably linked to the price of oil (Chart 14). Supply: According to our EM Strategist, Arthur Budaghyan, “fears that sanctions on Russia will considerably reduce global oil supply have not yet materialized.” According to International Energy Agency (IEA) estimates, Russia’s shipments of crude and oil products have declined by only about 5% since January (Chart 15). Clearly, despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. Chart 14Price Of Oil Is Important For The Energy Sector's Profitability Chart 15Russia's Supply Of Oil Has Decreased By Only 5% Demand: Meanwhile, global commodities and energy demand is downshifting in response to both high fuel prices and weakening global growth. US consumption of gasoline and other motor fuel has marginally contracted (Chart 16, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 16, bottom panel). In the rest of EM (excluding China), a strong dollar and high oil prices are leading to demand destruction. Chart 16US And Chinese Oil Consumption Is Weak Prices Are To Trend Down: Hence, the supply of energy and commodities is stable, but demand is flagging, which does not bode well for the prices of energy and materials. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. In addition, as the market anticipates a turn in inflation, there is a pronounced rotation away from Energy and Materials towards Technology and other growth pockets of the market (Charts 17 & 18). With a supply of energy staying steady or even expanding, while demand is slowing on the back of the global slowdown, we expect the price of energy to trend down. Chart 17Energy And Materials Were Biggest Winners In the "Inflation High And Rising" Regime... Chart 18...But They Gave Back Their Gains In "Inflation High But Falling" Regime Energy Investment Implications It appears that the stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As production is expanded and prices fall, the profitability of the Oil Exploration and Production industry (upstream) will decline. In addition, inflation is about to turn, and a change in market leadership has already ensued. We downgrade Exploration and Production to an underweight. In the meantime, the Equipment and Services industry will benefit from contracts to develop new wells and will thrive. We maintain an overweight. We are currently underweight the Energy Storage and Transportation industry (mid-stream) as historically, this industry was marred in multiple regulations and most expansion projects faced obstacles, especially if running through public land. However, under the provisions of the Inflation Act, midstream will benefit from rising production volumes and expedited construction the pipelines and terminals needed to increase production and exports of fossil fuels. We upgrade Storage and Transportation to an equal weight. Bottom Line The Inflation Reduction Act will create conditions favorable for expanding the production of fossil fuels and will support US energy independence. As supply grows while demand is slowing, the price of energy is likely to turn – while a boon for US consumers, this is a headwind to the performance of the Energy sector. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation
The G7 is looking to establish a price cap mechanism on Russian oil exports in time for the December 5 EU ban on insurance and services for ships carrying Russian oil. The sanctions threaten to severely limit Russia’s ability to export oil. Under the price…
Executive Summary EU Will Prioritize Natgas Storage Russia’s reduction in natural gas flows through the Nord Stream 1 (NS1) pipeline to 20% of capacity will test the EU’s ability to keep the lights on going into winter. The EU’s plan to voluntarily reduce natgas consumption by 15% has a higher likelihood of becoming mandatory, following Russia’s cut in NS1 flows. Coal-fired generation in the EU will come online sooner on the back of the NS1 cutoff. This will allow more natgas supplies to be directed to storage injection ahead of winter. Global natgas supplies will remain tight until 2025, as liquified natural gas (LNG) export capacity is developed ex-EU. Bottom Line: EU energy security will be paramount going into the winter, particularly if Russia keeps gas flows through NS1 at or below 20% of capacity going into winter. Russia most likely is seeking a significant reduction or the complete elimination of EU oil sanctions, which were imposed after it invaded Ukraine. If fully enacted, the EU’s embargo will remove more than 3mm b/d of Russian oil exports to the continent by 1Q23. The EU’s coal reserves and its 15% cut in demand could allow the bloc to get through the winter without a massive recession. If, as we believe, these measures are successful, a strong rally in European equities and bonds could ensue. Feature Following Russia’s halving of NS1 gas flows to 20% of capacity yesterday – taking shipments to ~ 33mm cm/d – the EU will be forced to increase its reliance on coal-fired electricity generation sooner than expected, to ensure as much natgas as possible is directed to filling storage ahead of the coming winter. And it will have to count on high levels of cooperation in reducing natgas demand between August and March by 15%.1 There is nothing that more dramatically illustrates the bind the EU finds itself in than rolling over its ESG agenda to ensure it has sufficient gas supplies to heat homes, hospitals and other critical services over the course of the coming winter. Russia’s cutoff of NS1 supplies is being done to focus EU member states on their precarious energy position just as they are scrambling to fill natgas storage. The sense of urgency in this effort is heightened by relatively high odds (67%) of another La Niña event, which usually is accompanied by colder-than-normal winter temperatures in the Northern Hemisphere.2 Russia appears to be seeking a significant reduction or the complete elimination of EU oil import sanctions, which were imposed after it invaded Ukraine. If fully enacted as approved, this will embargo more than 3mm b/d of Russian oil exports to the continent by 1Q23. The EU was Russia’s largest oil customer prior to the sanctions being approved.3 Russia Deploys Its Gas Weapon The EU is aiming to have 80% of its gas storage capacity filled by November, to ensure it has sufficient supplies for the coming winter (Chart 1).4 Achieving this target will prove difficult and uncertain, since it hinges on 1) gas flows from Russia not dropping precariously low or completely cutting off; 2) higher non-Russian flows; and 3) reduced gas consumption, which, as we noted above, likely will become mandatory. We ran different simulations altering these variables to see how inventories could move for the rest of 2022 and into the winter (Chart 2). Chart 1EU Will Prioritize Natgas Storage Chart 2The EU Could Face A Cold Winter In the simulations, if a variable changes more than we expect – e.g. Russian supplies drop by more than projected – one or both of the other variables will need to adjust to ensure the EU can sufficiently fill gas storage. This adjustment is not guaranteed, since all three variables will likely not move in accordance with policymakers’ expectations, especially gas flows from Russia as it seeks to imperil the bloc’s energy security. On the supply side, Russian flows can drop with little or no warning, while non-Russian supplies will need to remain ~ 30-35% higher relative to 2021, for the rest of the year to get natgas inventories to or slightly above 80%. On the demand side, the EU deal to cut gas consumption by 15% over the course of August-March was accepted with caveats for some member states. The debate and member states’ dissatisfaction over the initial agreement signals states may not implement this policy until they must, which could be too little too late. Of course, a complete cutoff of natural gas flows on the NS1 pipeline would result in inventories being pulled much harder and earlier, and likely would induce further rationing measures. This would produce a sharper economic contraction, since coal-fired generation and other energy usage likely would have maxed out prior to the sharp fall-off in natgas storage. Higher Coal Usage Buys EU Time Global natural gas markets are expected to remain tight into 2025, given the 5-year lead times required to develop LNG capacity export capacity.5 This is forcing EU member states – particularly Austria, France, Germany and the Netherlands – to place an additional 14 GW of coal-fired generation capacity into its reserve fleet in the event of a complete cutoff of Russian supplies.6 Fossil fuels accounted for 34% of EU generation in 2021, or 1,069 TWh. The largest share of this generation was accounted for by coal (Chart 3). Fossil fuels and renewables provide the largest shares of electricity generation overall in the EU (Chart 4). Chart 3Coal Folded Back Into EU Power Stack The EU would like to see its natgas inventories 80% full by November. This translates to ~ 3.2 TCF of natgas in storage, which would put inventories at the higher end of the 5-year range for November. That’s a big assumption, but it does indicate why the combination of higher coal usage and – critically – the 15% cut in demand (vs. five-year average demand) in our simulations is so important. Together, these measures mean the EU will save almost 1.3 TCF of storage gas from August – March. This assumes, of course, that EU member states pull their weight on the conservation front in this economic war with Russia. If everything goes according to plan for the EU (scenario 2 in the Chart 2), then March 2023 inventories will be at the level of 2.5 Tcf. Compared to last year, that means inventories will be 1.3 Tcf higher. Of course that’s impossible to forecast, but there are realistic outcomes close to this outcome. Chart 4Fossil Fuels, Renewables Provide Most Of EU’s Power Investment Implications The EU and Russia are at a critical juncture as winter approaches. Our analysis indicates the EU can – using its coal reserves and getting full buy-in on the 15% conservation measures adopted this week – weather this storm without experiencing a massive recession. Markets will be watching this evolution carefully. By late January or early February, it will be apparent how well the EU managed this challenge. If, as we believe, these measures are successful, we could expect a strong rally in European equities and bonds. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish The US became the largest exporter of LNG in 1H22 with outbound shipments averaging 11.2 Bcf/d, according to the EIA (Chart 5). US liquefaction peak capacity is estimated at 13.9 Bcf/d, with average capacity at 11.4 Bcf/d. The EU and UK are receiving most of the US LNG, which averaged 7.3 Bcf/d, or 64% of total exports over the January-May 2022 interval. Over 1H22, US exports accounted for close to half of the 15 Bcf/d imported by the EU and UK, making it the largest single exporter to Europe. Export volumes were dented in June with the loss of volumes from the Freeport LNG facility in Texas; this is expected to be restored by year-end. We are expecting exports to Europe to remain strong in the wake of the Russia-Ukraine war, especially as demand from Europe to replace Russian supplies stays strong. Base Metals: Bullish Chinese property stocks rallied on news that the government created a $44.4 billion fund to help alleviate the state’s property sector woes. Housing accounts for ~ 30% of copper consumption in China, and the fund should provide positive price action for the red metal in the face of slowing global growth this year and next. We remain bullish copper on the back of supply disruptions in Peru; increasing concern higher taxes in Chile will no longer support returns to miners that are sufficient to encourage capex, and extremely low global copper inventories, which have remained more than 25% below year-ago levels for more than a year (Chart 6). We will be updating our copper view next week. Ags/Softs: Neutral Russia and Ukraine signed a deal brokered by Turkey and the United Nations aimed at allowing some 22mm tons of grain exports from Ukraine, and some Russian grain and fertilizers to transit the Black Sea to end-use markets. These grain supplies are critically important to Middle East and North African markets. However, it could take weeks for Ukrainian ports to be cleared of mines and other obstacles – and, importantly, for a true cessation in Russian attacks on Black Sea port facilities – to resume operations.7 Chart 5 Chart 6 Footnotes 1 Please see EU allows get-out clause in Russian gas cut deal - BBC News, published by bbc.co.uk on July 27, 2022. 2 Please see the US Climate Prediction Center's most recent forecast, posted on July 14, 2022. 3 lease see Higher Gasoline, Diesel Prices Ahead, for discussion of the embargo on Russian crude and product imports to the EU. Our assessment was published on June 2, 2022, and is available at ces.bcaresearch.com. 4 As of July 25, EU natgas inventories were ~ 67% full at 2.5 TCF. 5 The IEA estimates growth in global LNG supply will slow over its five-year 2021-25 forecast horizon, due to low capex, and COVID-19-induced delays. Please see the IEA’s Gas Market Report, Q3-2022. 6 Please see Coal is not making a comeback: Europe plans limited increase, published by the European think tank Ember on July 13, 2022. 7 Please see Ukraine, Russia Sign Black Sea Grain Export Deal published by University Of Illinois, July 22, 2022. Investment Views and Themes Strategic Recommendations Trades Closed In 2022