Climate Change
Dear Client, We will not be publishing the Commodity & Energy Strategy next week, as I will be participating in a panel discussion with Dr. Bassam Fattouh, Director of the Oxford Institute for Energy Studies (OIES), which will focus on global energy markets and their evolution. Our panel will be moderated by my colleague Roukaya Ibrahim, Managing Editor of BCA Research's Daily Insights. We will return to our regular publishing schedule on September 15, 2022. Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary The Biden administration’s Inflation Reduction Act (IRA) will throw just under $370 billion at incentivizing renewable-energy development via tax credits, grants and loans, and, in what arguably is a concession to common sense, to adding and extending incentives for conventional energy sources, carbon capture and hydrogen. In the short run, the IRA could add to systematic stress in the North American bulk power supply market, which still is contending with grid stability issues caused by solar PV generation. In a direct shot at the dominance of EV supply chains by China, the IRA subsidizes EVs assembled in North America using batteries sourced from there and critical minerals sourced either from the US or states which have a Free Trade Agreement with the US. The IRA will increase global competition for base metals supplies, which already are tight. This will push prices higher to incentivize the development of the mines and local metals-refining operations required to satisfy this demand. IRA’s $370 Billion Allocations Bottom Line: The IRA incentivizes investment in clean energy, pollution reduction and GHG remediation, and employment in the energy-supply market writ large. The next year likely will be taken up writing the actual regulations implementing the IRA. If it succeeds in significantly boosting renewable energy investment and EV sales, it will stoke already-tight base metals markets and drive costs higher. By incentivizing the development of carbon-capture and hydrogen technologies, it would extend the life of traditional hydrocarbon energy. Feature The Inflation Reduction Act (IRA) will make $370 billion available to energy providers and households via tax credits, grants and loans to incentivize green-energy production and deployment in the US (Chart 1). It also seeks to incentivize the expansion of locally built EVs in North America, the batteries that will power them, and the critical minerals crucial for green energy, as it attempts to break China’s dominance of EV and critical mineral supply chains globally. Support for carbon-capture and use, and hydrogen as a fuel also will be expanded. Chart 1IRA’s $370 Billion Allocations The US DOE estimates the IRA and the previously passed Bipartisan Infrastructure Law will reduce Greenhouse Gas (GHG) emissions by 1,150 MMT CO2e in 2030, equivalent to a 40% reduction vs 2005 GHG levels, in 2030.1 The inclusion of Carbon-Capture-Use-and-Storage (CCUS) technology in the IRA will incentivize technology that would allow for fossil fuels to be used as a bridge for the green energy transition, which, if successful, will dramatically extend the useful life of hydrocarbon resources. Per the IRA, tax credits for CCUS can reach a maximum of USD 60 – USD 85/ MT of CO2 captured depending on how successful the technology is in actually removing CO2.2 This is $25-$35/MT more than what is provided by the existing CCUS tax credits. As we argued in previous reports, lower production costs for nascent green technologies such as CCUS will spur research and development, unlocking a virtuous cycle of increased production and deployment, and lower costs.3 The IRA is technologically agnostic as to how low-carbon energy is produced – i.e., via renewables, hydrocarbons, or nuclear power. From 2025, Investment- and Production-Tax Credits (IC and PC tax credits) will be available for technology-neutral electricity production, meaning electricity from fossil fuels or nuclear power will receive tax and investment credits alongside renewables, provided no toxic GHG emissions are released. This will catalyze the development and use of CCUS technology, especially in existing power plants, which can be retrofitted with this technology. Controversy Around Oil, Gas Attends The IRA Among the more controversial features of the Act are provisions supporting oil and gas production. One of the provisions requires 2mm acres of public land and 60mm acres of water to be offered for lease to oil and gas companies a year prior to issuing new onshore solar or wind rights-of-way. We do not believe this will meaningfully increase US oil production since its main constraint isn’t a dearth of land but investor-induced drilling restraint – i.e., the capital discipline that compels oil and gas producers to only produce what can profitably be produced. We also are doubtful that increasing oil and gas royalties to 16.6-18.75% under the IRA will influence drillers’ production decisions since most states’ royalties, most notably Texas and New Mexico’s will be at parity or higher than the revised rate under the new law.4 The duration and coverage of investment and production tax credits for solar and wind projects have increased. Furthermore, energy storage technology will now receive ITCs and PTCs, which should encourage the development of this technology. Energy storage technology – e.g., utility-scale lithium batteries – will make green electricity more reliable, providing a competitive alternative to fossil fuel-generated electricity. Increasing Solar PV Resources Strain Power Grids As Chart 1 shows, renewables are receiving massive support from the IRA, particularly solar PV and wind resources. This will, over the short run, present problems for grid stability. The North American power grid is being stressed by lack of investment in systems capable of fully integrating renewables – particularly solar PV – with incumbent bulk power supplies from fossil fuels and nuclear power. This is being exacerbated by extreme-weather events (e.g., prolonged heat waves, droughts, fire storms, flooding, etc.).5 The IRA focuses on incentivizing particular power-generation technologies and, in conjunction with the Bipartisan Infrastructure Law, investing in and bolstering North American electric grids.6 This is and will remain a critical issue, given the threat to bulk power system (BPS) stability posed by the large amount of small-scale solar supplies, which are not required to meet NERC reliability standards, per the NERC’s analysis. This risk is being analysed in depth following widespread loss of solar PV power in California during the summer of 2021, which was compounded by droughts and wildfires.7 “The ongoing widespread reduction of solar PV resources continues to be a notable reliability risk to the BPS, particularly when combined with the additional loss of other generating resources on the BPS and in aggregate on the distribution system,” the April 2022 NERC report notes. In an earlier report, NERC analysts noted much of the solar PV resource operates at a smaller scale than other supplies (baseload nuclear power, e.g.), and are not part of the NERC’s bulk electric supply (BES) system (Chart 2).8 Practically speaking, the NERC noted, “the vast majority of solar PV plants connected to the BPS, totaling over half the capacity, are not considered BES and are therefore not subject to NERC Reliability Standards.” Chart 2Solar PV Resources Strain Grids In theory, this could limit the expansion of solar PV resources until the grid stability problems are addressed. Because of its intermittency, wind resources also can be unreliable sources of power, which means fossil-fuels alternatives – particularly natural-gas-fired generation – will continue to be favored to maintain grid stability and to provide back-up generation if wind or solar PV generation becomes unavailable. If CCUS technology can be harnessed to significantly reduce methane discharge – another goal of the IRA – along with particulates, natural gas production stands to increase as the US migrates to a low-carbon future. Investment Implications The recently enacted IRA law will incentivize increased investment in renewables and conventional resources. In addition, it will spur investment in energy-transmission and –transportation resources. The drafting and implementation of the regulations required to implement the law will be done over the next year or so, so it is difficult to forecast which investments will get off to the fastest start. We remain bullish base metals – the sine qua non of the renewal-energy transition – and conventional hydrocarbon resources. We continue to favor equity exposure via ETFs – the XME and XOP for exposure to miners and oil-and-gas producers, respectively. We also remain long the COMT ETF, an optimized version of the S&P GSCI to retain exposure to commodities directly. 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 EU gas storage facilities were 80.17% full as of August 29 , reaching the bloc’s 80% target two months early (Chart 3) and raising the possibility of natgas rationing to reduce demand will not be needed this winter. The EU’s willingness to purchase gas at high prices over the summer injection months, given the dire consequences of possibly low gas storage levels in the winter withdrawal period, is responsible for this result. As Russian gas flows have dropped, the EU has had to rely on other sources, namely the US. LNG imports of 39 Bcm from the US to the EU over the first six months of this year have surpassed full year 2021 flows, according to Reuters. Elevated US gas flows to Europe have come at the expense of gas flows to states which are unable to afford the fuel at such high prices. In the US, high Henry Hub gas prices signal low domestic fuel availability primarily due to higher gas exports (Chart 4). Base Metals: Bullish High electricity and fuel prices in Europe are making metal smelting increasingly expensive, and are forcing refiners to voluntarily reduce operations. Nyrstar’s Budel zinc smelter and Norsk Hydro’s Slovalco aluminum smelter are the latest refinery operations forced to shutter operations going into the winter. Reduced domestic metal production runs counter to the continent’s aim of becoming more self-reliant on the supply of minerals critical to strategic industries such as defense and aerospace. Precious Metals: Neutral Federal Reserve chair Jerome Powell stressed the importance of price stability and reiterated the Fed’s commitment to restrictive policy to reduce inflation at the Jackson Hole conference. Gold prices fell on his speech as markets adjusted to higher interest rates than previously expected. However, counter to BCA’s US Bond Strategy view, markets still expect the Fed to start cutting rates in 2023. Two key drivers for gold prices next year will be the Fed’s rate hike regime and inflation perpetuated by potentially high oil prices following European sanctions on Russian oil and oil products. Chart 3 Chart 4 Footnotes 1 Please see The Inflation Reduction Act Will Significantly Cut the Social Costs of Climate Change, published by the US Department of Energy on August 23. See also 8.18 InflationReductionAct_Factsheet_Final.pdf (energy.gov) for additional DOE analysis of the IRA. 2 Manufacturers of different green technologies can maximize tax credits by ensuring certain labor and materials sourcing requirements are met. 3 For a report with our most recent discussion on this issue, please see EU Gas Crisis Boosts Hydrogen’s Prospects, which we published on April 7, 2022. See also Assessing Risks To Our Commodity Views, published on July 8, 2021, and Industrial Commodities Super-Cycle Or Bull Market?, published on March 4, 2021, for additional discussion on the need for carbon-capture investment. 4 The Permian basin, which constitutes 60% of total US shale production is located in these two states. 5 Please see the North American Electric Reliability Corporation’s recent report entitled Summer Reliability Assessment, May 2022, for an in-depth discussion of electric grid reliability going into the 2022 summer. 6 Please see “The Inflation Reduction Act Drives Significant Emissions Reductions and Positions America to Reach Our Climate Goals,” published by the US DOE as DOE/OP-0018, August 2022. 7 Please see “Multiple Solar PV Disturbances in CAISO, Disturbances between June and August 2021, April 2022,” published by the North American Electric Reliability Corporation. 8 Please see “Summary of Activities, BPS-Connected Inverter-Based Resources and Distributed Energy Resources,” published by NERC in September 2019. Investment Views and Themes New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS & MINING ETF (XME) TRADE ON AUGUST 29, 2022 WITH A RETURN OF 19.43%. WE WILL RE-ESTABLISH A LONG POSITION IN THE XME AT TONIGHT'S CLOSE. Strategic Recommendations Trades Closed in 2022
Executive Summary Natural Gas Markets Eerily Quiet An eerie calm in European natural gas markets belies the state of war in Ukraine that already is producing a cutoff of Russian natgas supplies in retaliation for the EU’s oil embargo. Such cutoffs will accelerate, and send natgas prices in Europe and Asia sharply higher if they occur sooner – as we expect – rather than later. The US will continue to send most of its LNG exports to Europe. These exports are expected to average 12 Bcf/d this year, up 22% from last year’s level. Planners in Europe and Asia will want to secure as much natgas supply as possible by the end of October to refill storage for the November-March withdrawal season, which is beginning to look like another La Niña winter. The US Climate Prediction Center makes the odds of such an event, which is associated with colder-than-normal winters in the Northern Hemisphere, just over 60%. Bottom Line: European governments are preparing their citizens for natgas rationing, in the event of a cutoff of Russian gas. This will occur sooner rather than later. In its wake, EU GDP will fall, and inflation will rise as knock-on effects constrict base metals, fertilizer and food supplies. At tonight’s close, we will be getting long 1Q23 TTF futures on the ICE, expecting prices to again exceed €225/MWh. Feature Related Report Commodity & Energy StrategyHigher Gasoline, Diesel Prices Ahead Russia is at war with Ukraine. NATO military support for Ukraine – with the EU at the forefront – is being maintained at a high level, and Ukrainian forces are vigorously defending their homeland.1 The EU embargoed Russian oil imports to sharply reduce funding for Russia’s war machine. Russia will be compelled to follow through on its threat to cut off pipeline gas shipments to Europe, following the embargo.2 It is highly doubtful Russia will countenance the timetable envisioned in the EU embargo, which calls for a phase-out of oil imports by yearend that removes close to 3mm b/d, or 90% of Russia’s sales into its largest market (Chart 1). Equally doubtful is the notion the EU will countenance funding Russia’s war on Ukraine over the course of such a phase-out. Our colleague Matt Gertken, who runs BCA’s Geopolitical Strategy, demonstrated that while such a phase-out schedule may be optimal for both sides – i.e., it prolongs revenue flows to Russia and gas flows to the EU – it almost surely is not an equilibrium.3 An equilibrium in this prisoners’ dilemma obtains when both sides act immediately to end their vulnerability to the other unilaterally upsetting the optimal state – i.e., endure short-term pain for long-term gain (Diagram 1). For this reason, we believe Russia’s cutoff of natgas shipments to the EU will occur sooner rather than later, to inflict maximum pain on the EU going into the coming winter season. The EU knows this, and is preparing its citizens for rationing of natgas. Chart 1EU’s Russian Oil Embargo Cuts Sales By 90% By Year-end Diagram 1The EU, Russia Prisoners’ Dilemma Russian Natgas Cutoff To The EU Underway Russia already has begun reducing natural gas supplies to the EU (Chart 2). Russian gas flows to Finland, Poland, Bulgaria, Netherlands, and Denmark were embargoed after these states refused to pay for gas in rubles (Chart 3). Russia reduced gas shipments to Germany – albeit marginally – after Shell refused to pay for natgas supplied to Germany in rubles. While this only disrupted 1.3% of total natgas consumption in Germany, it showed Russia will quickly act against what it views as “unfriendly” customers.4 Ukraine was forced to shut a gas transit point through which 8% of total Russian gas flows reach Europe, after Russian occupying forces were found to be siphoning gas, according to Gas Transmission System Operator of Ukraine (GTSOU). As a result, gas flows from Russia have taken a further hit and have not recovered (Chart 4). EU member states whose supply of Russian gas has been disrupted will need to search for alternatives. Orsted, an energy company supplying natgas to Denmark, stated it will source gas from the EU market. Given supply constraints in Europe, an increase in the number of bids on the single EU market will raise the Dutch Title Transfer Facility (TTF), all else equal. Chart 2Russia Starts Cutting Gas Flows Chart 3Russian Gas Flows To EU Falling Overall... Chart 4...Particularly Via Ukraine Higher TTF prices will direct gas flows from the US to Europe, reducing gas available for domestic consumption. LNG gas exports to Europe have maintained their upward trend since 2016 and were up by 87% (674 BCF) in 1Q22 vs the same period in 2019 (Chart 5). Chart 5US LNG Exports To Europe Surge Simultaneously, the US witnessed its largest inventory withdrawal this winter in the last four years (Chart 6). Warmer-than-normal temperatures and drought conditions in the US also are increasing domestic demand, as electricity companies are forced to substitute hydroelectric power with natgas-fired generation. Increased exports and weather phenomena have combined to push the Henry Hub contract above $9.50/MMBtu this week, the highest level since 2008. Chart 6US Natgas Inventories Slowly Filling US LNG Exports To Europe Surge Higher European prices for US natgas have disincentivized shipments to Asia, where prices – measured by the Japan Korea Marker (JKM) – have been trading below the TTF so far this year on average (Chart 7). This has allowed European gas inventories to refill at a rapid pace. As of 4 June, the EU’s working gas inventories were ~49% full and are above last year’s level for this time of the year (Chart 8). Chart 7Natural Gas Markets Eerily Quiet Chart 8European Gas Storage Refill Off To A Good Start Shanghai’s reopening will propel Chinese economic activity and demand for natgas, making an already tight global natural gas market tighter. However, the risk of rolling lockdowns in China will keep Asia’s LNG demand in check.5 LNG vessel charter rates have increased sharply since the Russia-Ukraine war began, largely on the back of European demand (Chart 9). We expect this to be a regular feature of the international gas market going forward, as more LNG export capacity is added in the US – it will rise to 12.6 Bcf/d next year, e.g. – and global demand remains strong. Chart 9Surge in LNG Charter Rates Europe Is Critically Short LNG Infrastructure Most of the EU’s existing 158 Bcm of annual regasification capacity is located around the Iberian Peninsula (Chart 10), which is not well-connected to the rest of Europe. As a result, to substitute Russian piped gas for LNG imports, investments for import terminals and regasification capacity will be required. In its REPowerEU program the European Commission expects to move closer to complete independence from Russian fossil fuels by importing an additional 50 Bcm of LNG per year, reducing demand, and ramping up renewable energy. Germany is aiming for independence from Russian gas flows by planning a shoreside LNG terminal and ordering four Floating Storage and Regasification Units (FSRUs). The FSRUs, which are expected to come online between year-end and the start of next year will have a combined capacity under 24 Bcm per year. Chart 10Europe Needs More Re-Gasification Capacity These plans, however, are not aligned with the nation’s pathway to go carbon neutral by 2045. An environmental activist group has filed a lawsuit to halt the construction of the LNG terminal. The group also is opposed to Germany’s draft LNG acceleration bill, which will allow imports until two years before 2045.6 This reflects two problems all EU nations will face as they transition to LNG from pipeline Russian gas imports. Firstly, member states will need to invest billions of euros in new LNG capacity, and given current politics, likely will have to decide to scrap or repurpose this infrastructure in during the transition to green energy. Opposing this possibility is the high likelihood that EU states will need to enter long-term LNG contracts to ensure supply security and shield themselves from volatile natgas prices. For the immediate future, the EU likely will kick this can down the road for as long as possible. Investment Implications Back in March, Germany and Austria began preparing their citizens for natgas rationing.7 Now the IEA is warning all of Europe the likelihood of such action is increasing rapidly.8 State and local planners throughout Europe will spend the next five months or so lining up as much LNG and pipeline gas as possible going into the coming winter season. While the inventory-injection in Europe is off to a good start, planners most likely hope to exceed their minimum target for filling 80% of storage in time for the November-March withdrawal season. In addition to the risk of a Russian cutoff of supplies, planners have to account for a higher likelihood of a colder-than-normal winter, given the odds of another La Niña winter, which is associated with colder-than-normal winters in the Northern Hemisphere. The US Climate Prediction Center makes the odds of such an event – the third such event in as many years – just over 60%. If European states are forced to implement rationing of natgas, knock-on effects resulting from prioritizing human needs over industrial concerns will, once again, restrict base metals, fertilizer and food supplies. We remain long energy, metals and grains exposure via the S&P GSCI and COMT ETF as the natural-gas drama in Europe plays out. In addition, we remain long the XOP, XME, PICK, and CRAK ETFs to maintain our equity exposure to industrial commodities. At tonight’s close, we will be getting tactically long 1Q22 futures on the ICE, expecting prices to again exceed €225/MWh. This will complement our existing tactical commodity exposures in 4Q22 TTF futures. 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 refined product demand rose just under 4% for the week ended 3 June 2022, led by a surge in jet-fuel demand of 26.5% yoy – finishing at 1.6mm b/d vs. 1.26mm b/d the year earlier, according to the US EIA. This provides further evidence consumer pent-up demand for travel is being released, after the long shut-downs in travel caused by COVID-19 beginning in 1Q20. The surge in jet-fuel demand was enough to offset yoy declines in gasoline and distillates such as diesel fuel and heating oil of 0.9% and 2.8%, respectively. Gasoline inventories were down 800k barrels yoy, which put them 10% below their five-year average level at the end of the reporting week. Distillate inventories rose 2.6mm barrels, but this still left them 23% below their five-year average. Crude oil inventories in the US including those in the Strategic Petroleum Reserve (SPR), which is being drawn down to provide charging stock to refiners, drew 7.3mm barrels, and stood at 519mm barrels. Versus year-ago levels, crude inventories including the SPR are down 17%. Base Metals: Bullish Copper production in Chile fell 9.8% yoy in April as state-owned copper giant Codelco’s monthly supply fell 6.1% yoy to 116,000 tons. In Peru, protests against mines by displaced communities have seen suspensions in copper mine production, including that of MMG-owned Las Bambas. Although the International Copper Study Group (ICSG) expects a physical surplus for refined copper markets next year, falling production in Chile and civil unrest in Peru continue to plague the rebuilding of stocks (Chart 11). Globally, a risk matrix we reproduced in a report last year showed that approximately 570 million Metric Tons of copper faced a significant ESG risk.9 This increases the risk of new copper projects being stymied by activist groups, and further curtailing future copper production. Precious Metals: Bullish According to data from World Gold Council, gold ETFs faced net outflows in May as the USD and interest rates strengthened, following the Fed rate hikes (Chart 12). In his speech, Fed Governor Christopher Waller explained that by increasing interest rates, the Fed aims to match labor demand to supply and reduce wage growth, which in turn will lower inflation.10 This, however, does not deal with high inflation via the mechanism of elevated food and fuel prices, which will remain high as long as supply disruptions continue in these markets. Chart 11 Chart 12 Footnotes 1 Please see The Institute For The Study Of War for daily updates of the Russia-Ukraine war. 2 Please see Higher Gasoline, Diesel Prices Ahead, which we published last week, for further discussion of the EU’s embargo of Russian oil imports. The EU embargo initially will be on Russian seaborne oil imports, which will tighten global crude oil and refined-product markets further. Pipeline imports are due to phase out by year-end. Cumulatively, this will translate to a 90% decrease in Russian crude and product exports to the EU, representing ~ 3mm b/d of lost sales. Our report is available at ces.bcaresearch.com. 3 Please see Energy Cutoff Continues (GeoRisk Update), published by BCA Research’s Geopolitical Strategy on June 1, 2022. It is available at gps.bcaresearch.com. 4 According to a recent report from Gemeinshcafts Diagnose institution prepared on behalf of Germany’s Federal Ministry of Economics and Climate Protection, if Russia embargos oil and gas to Germany immediately the German economy will fall into a sharp recession. The cumulative loss to macroeconomic output in 2022 and 2023 will amount to 220 billion euros, or more than 6.5% of annual economic output. 5 For more on the risk of rolling lockdowns in China, please see Not The Time To Be A Contrarian, published by BCA’s Emerging Markets Strategy on May 19, 2022. 6 Please see Germany’s Cabinet Moves to Head Off Lawsuits Against LNG Terminals, published by The Maritime Executive on May 11, 2022 7 Please see Germany Closer To Rationing Natgas, which we published on March 31, 2022. 8 Please see Europe at risk of winter energy rationing, energy watchdog warns, published by ft.com on June 8, 2022. 9 Please see Renewables ESG Risk Grows With Demand, which we published on April 29, 2022 10 For the speech, please see Responding to High Inflation with Some Thoughts on a Soft Landing. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trades Closed in 2022
Executive Summary EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply The EU's failed foreign policy – premised on ever-deeper engagement with the Soviet Union and, after it collapsed, Russia – will drive its hot mess of an energy policy for years. In the short term, the EU's REPowerEU scheme proposed last week to fund the decoupling from Russia will lift its green-house gas (GHG) emissions, if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward. Markets traded lower over the week, to make room for the higher ETS pollution-permit supply. This could increase the volume of allowances sales needed to reach the €20 billion target. Another €10 billion investment in natgas pipelines also will be funded. Longer-term, the acceleration of the EU's renewable-power build-out via so-called Projects of Common Interest (PCI) will get an €800 billion boost, with another round of funding to be proposed for early next year. EU funding will lift base metals and steel prices – raising the cost of the renewables build-out – and keep fossil-fuels well bid. Bottom Line: The REPowerEU scheme will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. The propensity of EU policymakers to interfere in its ETS market makes it unattractive. We remain long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. Tactically, we are getting long 4Q22 Brent calls struck at $120/bbl, anticipating an EU embargo of Russian oil imports. Feature Over the past three decades, foreign policy for the EU largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.1 This change-through-trade policy survived the Cold War, the collapse of the Soviet Union and rise of Russia from its ashes. It also survived Russia's first invasion of Ukraine in 2014. Indeed, following that invasion, Russia marked the completion of its Nord Stream 2 (NS2) natural gas pipeline – running parallel to NS1 – in September of last year. If NS2 were up and running now, it would have increased Russian gas flows into the EU and its revenue flows.2 As our Geopolitical Strategists noted, Germany even got the Biden administration to agree in summer 2021 to set aside any sanctions so that Germany could operate NS2 with Russia. Related Report Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Yet Russia did not share the German commitment to economic engagement within a US-led liberal international order. Russia's second invasion of Ukraine in February was a bridge too far, and catalyzed the EU's response, again led by Germany, to de-couple from Russia in the energy sector. The EU's reversal of a failed foreign policy, which produced its dependence on Russian energy, leaves it with a hot mess of an energy policy that is evolving rapidly. In its wake, volatility in the EU carbon-trading market has ensued, along with the promise of an accelerated doubling-down on renewable-energy generation. Higher Emissions, Lower Emissions Prices Last week, the EU proposed its REPowerEU scheme, which is meant to enable the decoupling of the EU from Russian energy dependence by funding hundreds-of-billions-of-euros in new energy investments over coming years.3 Chart 1EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply In a history heavily laden with paradox, this new scheme will lift the EU's green-house gas (GHG) emissions – including CO2 – if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward.4 So, in the breach, the EU is willing to significantly relax its environmental goals – the E in ESG – to begin undoing its failed foreign policy. Markets already are making room for this increased ETS pollution-permit supply, which, as allowances prices weaken, will require additional supplies to reach the €20 billion target (Chart 1). This will lead to higher coal and fossil fuel usage during Germany's hot-mess de-coupling with Russia. In addition to raising funds by selling pollution permits, the EU will invest another €10 billion in natgas pipelines. This will help counter the likely loss of Russian gas when it embargoes Russian oil imports, but will take time (a few years) to actually put in the ground.5 The additional pipe would address one of the EU's weakest energy links: the lack of pipeline capacity to transport liquified natural gas (LNG) inland once it arrives in Europe. Europe pushed hard to re-load natgas inventories ahead of the coming winter season, and appears to have made progress in this regard (Chart 2). Europe was a strong bid for LNG in the first four months of this year, according to Refinitiv reporting.6 LNG imports were up 58% over the first four months of this year, totaling 45.3mm MT. This kept European natgas prices elevated vs. Asia (Chart 3). Chart 2Europe Re-Loads Storage Chart 3Europe Outbids Asia For LNG The back-and-forth between the Asian and European markets will continue for the rest of this year, particularly going into the Northern Hemisphere's summer, when demand for natgas in Asia, in particular, will remain strong. REPowerEU Will Boost Base Metals Demand Longer term, the EU's REPowerEU proposal, if approved, will accelerate the EU's renewable-power build-out via so-called Projects of Common Interest (PCI). The proposal contains €800 billion to support new renewable-energy proposals, with another round of funding proposed for early next year. The doubling down by the EU on renewables will lift base metals and steel prices as soon as the REPowerEU program starts funding investments in renewable technology and short-term projects like pipeline buildouts (maybe sooner as hedges are placed). Given the tightness already apparent in the base metals markets, this will raise the price of critical materials – copper, aluminum, steel – and will, in the process, keep fossil-fuels well bid: large capital projects do not get done without a lot of diesel and gasoline being consumed.7 The EU is not alone in its desire to accelerate renewables investment: The US is funding a similar build-out, as is China, which will be accelerating its infrastructure and renewables investments. The constraint on all of these programs to build out renewables is low capex in base metals (Chart 4), and oil and gas (Chart 5). This has kept the level of supply from quickly responding to increased demand, which keeps these markets in sharp backwardations. Market tightness in metals and energy will be compounded by stronger bids from the three largest economic centers in the world – the EU, US and China.Chart 4Weak Capex Holds Base Metals Supply Growth Down … Investment Implications Chart 5… And Oil + Gas Supply Growth The EU's REPowerEU scheme is not a done deal, but we give it high odds of being adopted. It will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. In terms of where to take risk, now that this proposal has been floated, we would avoid getting long carbon permits traded on the EU's ETS carbon market, given the propensity of policymakers to meddle excessively, which, in and of itself, is a risk that is difficult – if not impossible – to forecast. However, we do continue to favor being long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating an EU embargo of Russian oil imports. 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 officials involved in negotiations to restore the Iran nuclear deal appear to be signaling US interests could be served by agreeing such a deal.8 Allowing Iran back into the market as a bona fide oil exporter would return ~ 1mm b/d or more to global crude markets by year-end. This would partly reverse the higher prices we expect in the wake of an EU to embargo Russian oil imports this week. Presently, oil markets are rallying as the necessity for Russia to shut in oil production post-embargo is discounted (Chart 6).9 That said, a deal to allow Iran back into export markets would dampen the move we expect in the wake of an EU embargo. The market will remain tight after a US-Iran deal, but this might be attractive to the Biden administration as mid-terms approach, and to the EU, as it also would reduce the funds available for Russia to wage war on Ukraine. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating the EU embargo. We will close this position out if the US and Iran reinstate the Joint Comprehensive Plan of Action (JCPOA), which would allow Iran to resume oil exports. Precious Metals: Bullish The World Platinum Investment Council (WPIC) projects a 2022 surplus of 627 koz, slightly lower than the previous forecast of 657k oz for this period. This year, strong automotive demand is expected to be offset by reductions in jewellery and industrial demand. Car manufacturers’ switch from Russian palladium to platinum – as they self-sanction – will bullish for platinum. Russia accounts for ~40% of global palladium mined output. The organization predicts lower mine supply caused primarily by supply-chain bottlenecks and COVID-19 restrictions. Nornickel, one of the world’s largest platinum miners is expected to reduce mined output on the back of supply-chain disruptions due to Russian sanctions. Base Metals: Bullish Iron ore prices rose on the wider than anticipated cut in China’s benchmark interest rate for mortgages on May 20th (Chart 7). The upcoming easing of lockdowns in Shanghai will further boost iron ore prices, as markets expect Chinese economic activity to pick up. However, if China sticks to its zero-COVID policy, lockdowns will continue to occur in different cities and regions. BCA’s Emerging Markets Strategy expects these ‘rolling lockdowns’ to last at least until the end of this year. This will affect manufacturing and steel production, primary iron ore demand drivers. Iron ore’s reliance on China’s economic health means price of the industrial metal will not meaningfully rise this year, barring a supply shortfall. Chart 6 Chart 7 Footnotes 1 Please see The Former Chancellor Who Became Putin’s Man in Germany, published by the New York Times 23 April 2022. This is an excellent precis of the history of German-Russian trade vis-à-vis the career of former German chancellor Gerhard Schröder, who held the office from 1998 – 2005. The deep energy relationship with Russia began in the late 1960s under the chancellorship of Willy Brandt. As much as 55% of Germany's gas needs were supplied by Russia prior to its invasion of Ukraine 24 February 2022. Now its Russian gas imports are closer to 20%; Germany and the EU are scrambling to eliminate any and all energy trade with Russia, beginning with reducing gas imports by two-thirds this year, and likely embargoing all oil imports by year-end. 2 Russia completes Nord Stream 2 construction, gas flows yet to start, published by reuters.com 10 September 2021. 3 Please see REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition* published by the European Commission 18 May 2022. Energy accounted for 62% of the EU's Russian imports in 2021, just under €100 billion worth of gas (40%), oil (27%) and coal (46%), according to the European Commission's tally in In focus: Reducing the EU’s dependence on imported fossil fuels published 20 April 2022. In 2011, energy accounted for 77% of the EU's imports from Russia. 4 Please see Felix K. Chang's report Legacy of Ostpolitik: Germany's Russia Policy and Energy Security published by the Foreign Policy Research Institute in May 2014. This includes a summary of the paradoxical nature of Germany's Ostpolitik policy following Russia's first invasion of Ukraine. 5 Please see German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 6 Please see LNG momentum swinging back to Asia as Europe demand eases: Russell published by reuters.com on 24 May 2022. 7 Please see Tight Commodity Markets: Persistently High Inflation, which we published 24 March 2022. It is available at ces.bcaresearch.com. 8 Please see Analysis: Subtle shift in U.S. rhetoric suggests new Iran approach published by reuters.com 24 May 2022, and German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 9 Please see Oil, Natgas Prices Set To Surge, which we published last week. Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022 Summary of Closed Trades
Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India – the four top LNG consumers in Asia – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter. In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm. As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth Chart 6US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%. 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 Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Chart 10 Footnotes 1 Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2 Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3 Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4 Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5 Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6 Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7 Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE). This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2 Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside. 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 Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday. Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation. Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at 56%. Chart 6 Chart 7 Footnotes 1 Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2 Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3 Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021. 4 Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Alternative energy is priced to deliver spectacular long-term earnings growth, but this will be a very tough ask. While alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. At its current valuation, alternative energy does not meet the conditions to be in a long-term investment portfolio. As the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, such services will have to be paid in ETH giving the token an economic value. ETH should certainly form a small part of a long-term investment portfolio. A near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. Fractal analysis: India versus China. Feature Chart of the WeekThe World Is Using Much Less Energy Per Unit Of Economic Output Alternative Energy Blues Alternative energy is the meme theme of the moment. Hardly a day passes without some exhortation to save the planet, by substituting fossil fuels with cleaner forms of energy. Yet this year, alternative energy stocks have performed dismally. Since January, the sector is down 30 percent in absolute terms, and almost 40 percent versus the broad market. Begging the question, how can one of the biggest themes of the moment be one of the worst investment performers? Last year, the forward earnings of the alternative energy sector rose by 35 percent, helped by post-pandemic stimulus measures that targeted the clean energy industry. But as investors fell in love with this meme theme, the bigger story was that the valuation paid for the sector skyrocketed from 13 times forward earnings to a nosebleed 42 times, an increase of 220 percent (Chart I-2 and Chart I-3). Chart I-2Alternative Energy Earnings Rose... Chart I-3...But The Valuation Skyrocketed To put the 42 into context, the peak multiple of the tech sector has reached ‘only’ 29 this cycle, meaning that alternative energy was trading at a near 50 percent premium even to the daddy of growth sectors! This year, as investors have pared back the nosebleed valuation, the alternative energy sector has underperformed. Nevertheless, it is still trading at a 25 percent premium to tech, meaning that its profits will have to deliver spectacular long-term growth to justify the sky-high valuation. Is this likely? We are not convinced. The world is using less energy per unit of economic output. A fundamental rule of long-term investment is that you shouldn’t own any sector whose sales are shrinking as a share of the economy. The problem for alternative energy is that it is, ultimately, energy (Chart I-4). And the world is using less energy per unit of economic output. Chart I-4Alternative Energy And Traditional Energy Show Similar Earnings Profiles In 1995, every $1000 of real GDP used 157 kilograms of oil equivalent energy. Today, that has plunged to 109 kilograms. Meaning that over the past 25 years, the world economy has reduced its energy intensity by 30 percent.1 And the downtrend persists (Chart I-1). Granted, over the past 25 years, the share of the energy pie taken by non-fossil fuels has increased from 13.4 to 16.9 percent, of which renewables have increased from 0.6 to 5.7 percent. But the marginal prices of wind, solar, and geothermal power generation are collapsing. As a recent report from the International Renewable Energy Agency (IRENA) points out: Generation costs for onshore wind and solar photovoltaics (PV) have fallen between 3 percent and 16 percent yearly since 2010 – far faster than anything in our shopping baskets or household budgets… (and) auction results show these favourable cost trends continuing through the 2020s.2 Given that the alternative energy market is competitive rather than monopolistic or oligopolistic, a large part of these massive cost savings will be passed on to end-users. Constituting a long-term boon to consumers rather than to alternative energy profits. To repeat, with the alternative energy sector still trading at a 25 percent premium to tech, it must deliver spectacular long-term earnings growth. But this will be a very tough ask. Energy sector profits tightly track the value of energy produced, meaning volume times price (Chart I-5). The risk is that while alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. Chart I-5Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) We conclude that with an ambiguous outlook for long-term earnings growth, alternative energy does not meet the conditions to be in a long-term investment portfolio at its still nosebleed valuation multiple of 32 times forward earnings. Now let’s turn to an investment that you should have in a long-term investment portfolio. The London Hard Fork Is A Boon For The Ethereum Network The Ethereum network’s London hard fork – an event that passed under most radar screens – marks the shape of things to come for the blockchain and the cryptocurrency space. Crucially, it signals an ongoing sea-change that favours the Ethereum network’s users at the expense of its cryptocurrency miners. For those interested in the nerdy details, we direct you to Ethereum Improvement Protocol (EIP) 1559. But to cut to the chase, the fork has drastically reduced the profitability of Ethereum mining while “ensuring that only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform.” Only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform. The statements of intent address, and will ultimately alleviate, two of the biggest investment concerns about cryptocurrencies – first, that cryptocurrency mining is a prodigious user of energy, particularly dirty energy; and second, that as cryptocurrencies cannot be readily exchanged for goods and services, they have no value other than that from other investors believing they have value. Addressing the first concern, mining becomes irrelevant if the blockchain users employ the skin in the game ‘proof-of-stake’ protocol to validate transactions rather than the energy-intensive ‘proof-of-work’ protocol that relies on external miners. Which is where Ethereum is headed with the fully proof-of-stake Ethereum 2.0. Addressing the second concern, if the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, then such services will have to be paid in ETH, giving the tokens an economic value. Hence, the key structural question is, which blockchain networks will become the go to places for decentralised intermediation? Ethereum is an excellent candidate. Note that the lending arm of the EU, the European Investment Bank, has effectively endorsed the Ethereum network by issuing a €100 million digital bond on it. And although the principal “is expected to be repaid in euros”, the intermediators get paid in ETH. Crucially, the token of a successful blockchain network will become the de-facto currency of the network, exchangeable for intermediation services on that network. With a value independent of speculative investments, investors can also justifiably own these tokens as a ‘digital gold.’ Clearly, cryptocurrencies experience a higher volatility than gold, but this can be adjusted through position sizing. To equalise drawdowns in digital gold versus gold, investors should own $1 of cryptocurrency for every $3 of gold (Chart I-6). On this relative risk basis, cryptocurrencies should constitute at least one quarter ($3.8 trillion) of the $15 trillion ‘anti-fiat’ market that gold currently dominates. Chart I-6Cryptocurrency Drawdowns Are Becoming Less Severe Therefore, if Ethereum became the dominant cryptocurrency based on its network size, it would command a market capitalisation of at least $1.9 trillion, a more than five-fold increase from today. ETH should certainly form a small part of a long-term investment portfolio. Stocks Versus Bonds Face A Double Constraint Since mid-March the world stock market (MSCI All Country World Index) has rallied by 10 percent, but the ultra-long bond (30-year T-bond) has done even better, rallying by 14 percent. Hence stocks to bonds have drifted gently lower, for which there are two reasons. First, the valuation of the most highly-rated parts of the stock market have reached the limit that has held in the post-GFC era. Specifically, tech’s earnings yield premium versus the 10-year T-bond has reached its 2.5 percent lower bound (Chart I-7). Chart I-7Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Second, the groupthink in overweighting stocks versus bonds reached an extreme. All investors up to 260-day investment horizons are already in the trade, and this level of extreme groupthink correctly signalled stocks versus bonds major-tops in 2010 and 2013 (as well as major-bottoms in 2008 and 2020) (Chart I-8). Chart I-8The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme This near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. In the near term, stocks will struggle to outperform ultra-long bonds. Nevertheless, if bonds rally, it will support stocks. But if bonds sell off, it will undermine stocks. The implication of the above is that a bond sell-off – should it even occur – will be self-limiting. As we explained last week in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields, the upper limit to the 10-year T-bond yield is 1.8 percent. India Trading At A Precarious Premium This week’s fractal analysis highlights that the spectacular outperformance of India versus China has reached the limit of fragility on its 260-day fractal structure that marked previous major-tops in 2014, 2016, and 2019 (as well as major bottoms in 2015, 2018, and 2020) (Chart I-9). Chart I-9The Outperformance Of India Versus China Is Fragile In effect, as China’s tech sector has recently corrected, tech stocks in India are now trading at a precarious 60 percent premium to those in China (Chart I-10). Chart I-10India Is Trading At A Precarious Premium To China The recommended trade is to short India versus China (MSCI indexes), setting the profit target and symmetrical stop-loss at 19 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Source: World Bank, and BP Statistical Review of World Energy 2021 2 Source: Renewable Power Generation Costs In 2019, International Renewable Energy Agency Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains TightTheoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it. Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%. 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 OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 Chart 8 Footnotes 1 Please see Trade Tables below. 2 Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3 Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021. Peru has seen significant capital flight on the back of these fears. See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector. The risk of nationalization is de minimis, according to IHS. 4 Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5 Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy. It is available at ces.bcaresearch.com. 6 Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7 Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Over the 2021-22 period, renewable capacity will account for 90% of global electricity-generation additions, per the IEA's latest forecast. This will follow the 45% surge (y/y) in renewable generation capacity added last year, which occurred despite the COVID-19 pandemic (Chart of the Week). Continued investment in renewables and EVs – along with a global economic rebound – are pushing forecasts at banks and trading companies to a $13k - $20k/MT range for copper, vs. ~ $10.6k/Mt (~ $4.80/lb) at present. Should these stronger metals forecasts prove out, investments that extend low-carbon use of fossil fuels via carbon-capture and circular-use technologies will become more attractive. Investment in these technologies has been limited because there is no explicit global reference price to assess investments against. A carbon market or tax would provide such a bogey and accelerate investment. It could be monitored via a Carbon Market Club, which would limit trade to states posting and collecting the tax.1 Feature At almost 280GW, renewable energy capacity additions last year increased 45% y/y, the most since 1999, according to the IEA's most recent update on renewable energy.2 For this year and next, renewables are expected to account for 90% of capacity additions, led by solar PV investment increasing ~ 50% to 162GW. Wind capacity grew 90% last year, increasing to 114GW, and is expected to increase ~ 50% to end-2022. As renewables generation – and EV investment – continues to grow, demand for bulks (steel and iron ore) and base metals, led by copper, will pull prices higher. This is occurring against a backdrop of flat supply growth and physical deficits over the four years ended 2020 (Chart 2). According to the IEA, a 40% increase in steel and copper prices over the September 2020 to March 2021 period played a role in higher solar PV module prices. Chart of the WeekRenewables Capacity Surges The supply side of the copper market will remain in deficit this year and next, in our assessment, and may continue on that trajectory if, as Wood Mackenzie expects, demand grows at a 2% p.a. rate over the next 20 years and miners remain reluctant to commit to the capex required to keep up with demand.3 Chart 2Physical Deficits Will Draw Copper Stocks... ESG risk for copper – and other metals required to build the generation and infrastructure required in the renewables buildout – will increase as prices rise, which also will add to cost.4 Cost increases coupled with increasing ESG risks in this buildout will increase the attractiveness of carbon-capture and circular-economy technology investment, in our view. This would extend the use of low-carbon fossil fuels if the technology can move the world closer to a net-zero carbon future. However, unless and until policy catalyzes this investment, – e.g., via a global carbon trading price or tax – investment in these technologies likely will continue to languish. Carbon-Capture Tech's Unfulfilled Promise The history of Carbon Capture, Utilization and Storage (CCUS) has been one of high hopes and unmet expectations. It is generally recognized as a route to mitigate climate change; however, its deployment has been slower than expected. Low-carbon technology requires more critical metals than its fossil-fuel counterpart (Chart 3). Apart from the issue of cost, the ESG risks of mining metals for the renewable energy transition will increase as more metals are demanded, which we discussed in previous research.5 According to Wood Mackenzie, mining companies will need to invest nearly $1.7 trillion in the next 15 years to help supply enough metals to transition to a low carbon world.6 Chart 3Low-Carbon Tech Is Metals Intensive Given these looming physical requirements for metals, fossil fuels most likely will need to be used for longer than markets currently anticipate, as a bridge to the low-carbon future, or as part of that future, depending on how successfully carbon is removed from the hydrocarbons used to power modern society. If so, using fossil fuels while mitigating their environmental impact will require highly focused technology to lower CO2 and other green-house gas (GHG) emissions during the transition to a low-carbon future. Enter CCUS technology: This technology traps CO2 from sources that use fossil fuels or biomass to make the energy required to run modern societies. In the current iterations of this technology, CO2 can either be compressed and transported, or stored in geological or oceanic reservoirs. This can then be used for Enhanced Oil Recovery (EOR) to extract harder-to-reach oil by injecting CO2 into the reservoirs holding the hydrocarbons.7 The Scope For CCUS Investment CCUS investment spending is increasing, as are the number of planned facilities using or demonstrating this technology. In the 2020 edition of its Energy Technology Perspectives, the IEA noted 30 new integrated CCUS facilities have been announced since 2017, mostly in advanced economies such as US and Europe, but also in some EM nations. As of 2020, projects at advanced stages of planning represented a total of $27 billion, more than double the investment planned in 2017 (Chart 4). Among its many goals, the Paris Agreement seeks a balance between emissions by man-made sources and removal by greenhouse gas (GHGs) sinks (absorption of the gases) in the second half of the 21st century. Practically, many countries – especially EM economies – will still need to use fossil fuels to develop during this period (Chart 5).8 Chart 4Carbon-Capture Projects To Date Chart 5EM Development Will Require Fossil-Fuel Energy CCUS In The Energy Sector As a fuel that emits fewer GHGs than coal – i.e., half the CO2 of coal – natural gas can be used effectively as a bridge to green-power generation (Chart 6). Chart 6Natural Gas Will Remain Attractive As A Bridge Fuel The CO2 in natgas needs to be removed before dry gas is sold as pipeline-quality gas or LNG. This CO2 is normally vented to the atmosphere; however, by using CCUS technology, it can be reinjected into geological formations and used for EOR. For this reason, LNG companies in the US, the world’s largest LNG exporter, have been looking into investing in CCUS technology in a bid to become greener.9 CCUS can also be used to produce low-cost hydrogen – so-called blue hydrogen – using natural gas and coal, as opposed to the more expensive electrolysis process, which uses renewables-based electricity to produce "green" hydrogen. The lower blue-hydrogen costs will make clean hydrogen more accessible to emerging nations, opening new avenues for the world to use the energy carrier in its decarbonization effort. The Value Of Ccus In Other Industries CCUS technology can be retrofitted to existing power and industrial plants, which, according to the IEA, could otherwise still emit 8 billion tons of CO2 in 2050, around one-quarter of annual energy-sector emissions in 2020. Of the fossil fuel generators, coal-fired power generation presents the biggest CO2 challenge, with most of the emissions coming from China and other EM Asia nations, where the average plant age is less than 20 years. Since the average age of a coal fired power plant is 40 years, according to the US National Association of Regulatory Commissioners, this implies that these plants have a long remaining life and could still be operating until 2050. CCUS is the only alternative to retiring or repurposing existing power and industrial plants. The IEA believes that CCUS is imperative to reach net-zero carbon emissions. In its Sustainable Development Scenario - in which global CO2 emissions from the energy sector decline to net-zero by 2070 – CCUS accounts for 15% of the cumulative reduction in emissions. If the world needs to reach net-zero by 2050 instead, it will need almost 50% more CCUS deployment.10 Properly implemented and scaled, CCUS can allow industries to continue using oil, gas and coal and to attain net-zero carbon emission targets, boosting demand for fossil fuels in the medium term. This is especially important to EM development. Why Aren’t We Further Along In CCUS? What Can Be Done? The main reason CCUS isn’t used more widely is because of its cost. Currently, the cost of capturing carbon varies, based on the amount of CO2 concentration, with Direct Air Capture being most expensive (Chart 7). Given the prohibitive costs, CCUS has not been commercially viable. However, the same argument could have been used against implementing renewable sources of energy. While at one point the Levelized Cost of Energy from renewable sources was high, as these sources have been scaled up – aided in no small part by government subsidies – costs have fallen, following something akin to a Moore’s Law cost-decay curve. A Levelized Cost of Energy for solar generation reported by Lazard Ltd., which allows for comparisons across technologies (e.g., fossil-fuel vs renewable), shows generation costs fell by 89% to $40/MWh from $359/MWh from 2009-2019 (Chart 8). This learning curve was able to take place because of government subsidies, which promoted the deployment of solar technology. Chart 7CCUS Can Be Expensive Chart 8Subsides Could Support CCUS, Just As Was Done For Solar The cost of CCUS technology is falling. For example, in 2019 the Global CCS Institute reported it cost $100/ton to capture carbon from the Canada-based Boundary Dam using a CCS unit built in 2014. The cost of carbon captured at the US-based Petra Nova plant – built three years later – using improved technology was $65/ton. Both are coal-powered electricity plants. The report also noted coal-fired power plants planning to commence operations in 2024-28 using the same CCS technology as those at Boundary Dam and Petra Nova expect carbon costs to be ~ $43/ton, due to steeper learning curves, research, lower capital costs due to economies of scale, and digitalization. One commonality amongst these sources of cost reductions is that companies need to invest more into CCUS and familiarize themselves with this technology. As was the case with renewables, government subsidies would reduce the prohibitive costs of operating CCUS technology, and draw more participation to refining this technology. Early, first-of-its-kind CCUS will be expensive, however subsidies in the form of capital support or tax credits will increase CCUS implementation and research. Boundary Dam and Petra Nova are examples of facilities that benefitted from government subsidies. The facilities received $170 million and $200 million respectively from Canadian and US Government agencies at the time of the CCS units’ construction. The US has also implemented a 45Q tax credit system which pays facilities $50/ton of CO2 stored and $35/ton of CO2 if it is used in applications like Enhanced Oil Recovery. According to the Global CCS Institute, in late-2019, of the eight new CCUS projects that were added in the US, four cited the presence of 45Q as the key driver. Putting Carbon Markets And Taxes To Work The EU’s Emissions Trading System (ETS) market, which was implemented in 2005, is an example of innovative policy which incentivizes companies to curb emissions, using market forces. The price of carbon measured in these markets puts a tangible value on a negative externality, which before this went unrecorded. The downside of this ETS is its reliance on the EU's environmental policy implementation, which is subject to policy changes that complicate supply-demand analysis for longer-term planning – e.g., the recent increase in its emissions target to a minimum of 55% net reduction in GHG emissions by 2030. An alternative to policy-driven trading of emissions rights is a per-ton tax on emissions, which governments would impose and collect. This would raise costs of technologies using fossil fuels – including those used in the mining industry to increase supply of critical bulks and base metals needed for the renewables transition. At the same time, such a tax would give firms supplying and using technologies that raise CO2 levels an incentive to lower CO2 output using CCUS technologies. ETS markets and governments imposing CO2 taxes could form Carbon Market Clubs – a technology developed by William Nordhaus, the 2018 Nobel Laureate in Economics – that restrict trading to states that can demonstrate their participation and support of actual carbon-reduction detailed in the Paris Agreement via trading or tax schemes.11 As the green energy transition gains traction and governments implement more net-zero emissions policies, the price of carbon will rise. As the price of carbon rises, the price tag associated with companies’ carbon emissions will increase with it. With market participants expecting the price of carbon to continue to rise after hitting record values, the incentive for companies operating in the EU to use CCUS technology will rise, as would the incentive for firms facing a carbon tax.12 Bottom Line: Given the meteoric price rise of green metals, underfunded capex, and the ESG risks associated with mining metals for the low carbon future, we expect fossil fuels to play a larger role in the transition to a low-carbon society than markets are currently expecting. For countries to be able to use fossil fuels while ensuring they achieve their climate goals, the use of CCUS technology is important. To increase CCUS uptake, governments will need to subsidize this technology until demand for it gains traction, just like in the case of renewables. Encouraging ETS and carbon-tax schemes also will be required to catalyze action. 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 Brent prices were knocking against the $70/bbl door going to press, following the IEA's assessment of a robust demand recovery in 2H21 (Chart 9). The IEA took its 1H21 demand growth down 270k b/d, owing to COVID-19-induced demand destruction in India, OECD Americas and Europe, but left its 2H21 estimate intact, making overall demand growth for this year 5.4mm b/d. The EIA also expects 5.4mm b/d demand growth for this year, and growth of 3.7mm b/d next year. OPEC left its full-year 2021 demand growth estimate at 6mm b/d. OPEC 2.0 meets again on June 1 and will look to return more of its sidelined production to the market, in our estimation. We will be updating our supply-demand balances and price forecasts in next week's report. Base Metals: Bullish Spot copper prices traded on either side of $4.80/lb on the CME/COMEX market this week as we went to press. Threats of a tax increase in Chile, where a bill calling for such a measure is making its way through Congress; a potential strike by mine workers; and a shortage of sulfuric acid used in the extraction of ore brought about, according to Bloomberg, by reduced global sulfur supplies due to lower refinery runs during the pandemic all are keeping copper well bid. Our target for Dec21 COMEX copper remains $5/lb (~ $11k/ton on the LME). We remain long calendar 2022 COMEX copper vs short 2023 COMEX copper expecting physical supply deficits to continue to force storage draws, which will backwardate the metal's forward curve. Precious Metals: Bullish US CPI data on Wednesday showed that headline inflation rose by 4.2% for the month of April compared to the previous year. While this increase is the highest since 2008, this jump could also be fueled by a low base effect – Inflation levels were falling this time last year as the pandemic picked up. While rising prices increases demand for gold as an inflation hedge, if the Federal Reserve increases interest rates on the back of this data, the US dollar will rise, negatively affecting gold prices (Chart 10). However, we do not expect the Fed to abruptly change its guidance on this report, and therefore expect the central bank will treat this blip as transitory. As of yesterday’s close, COMEX gold was trading at $1,835.9/oz. Ags/Softs: Neutral Going to press, the Chicago soybean market was surging ahead of the scheduled World Agriculture Supply and Demand Estimates (WASDE) report due out later Wednesday. Front-month beans were trading ~ $16.70/bu, up 2% on the day. This month's WASDE will contain the USDA's first estimate for demand in ag markets for the 2021/22 crop year. Markets are expecting supplies to tighten as demand strengthens. Chart 9 Chart 10 Footnotes 1 Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016. The intellectual and computational framework for such technology was developed by William Nordhaus, the 2018 Nobel Laureate in Economics. 2 Please see Renewable Energy Market Update, Outlook for 2021 and 2022.pdf, published by the IEA this week. 3 WoodMac notes, "without additional substantial investment, production will decline from 2024 onwards. Coupled with demand growth, this decline in output will lead to a theoretical shortfall of around 16 Mt by 2040." The consultancy estimates an additional $325 - $500+ billion will be needed to meet copper demand over this period. Please see Will a lack of supply growth come back to bite the copper industry? Published 23 March 2021 by woodmac.com. 4 Please see Renewables ESG Risks Grow With Demand, which we published 29 April 2021. It is available at ces.bcaresearch.com. 5 Refer to footnote 4. 6 Please see Low carbon world needs $1.7 trillion in mining investment, published by Reuters. 7 This method is used to increase oil production. It changes the properties of the hydrocarbons, restores formation pressure and enhances oil displacement in the reservoir. Using EOR, oil companies can recover 30% to 60% of the original oil level in the reservoir. Please see Enhanced Oil Recovery published by the US Department of Energy. 8 Please see the Reuter’s column CO2 emission limits and economic development. 9 Please see World Oil’s U.S. LNG players tout carbon capture in bid to boost green image. 10 Please see IEA’s Special Report on Carbon Capture Utilisation and Storage, published as a part of the Energy Technology Perspective 2020. 11 See footnote 1 above. 12 Please see Cost of polluting in EU soars as carbon price hits record €50 by the Financial Times. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades