Commodities & Energy Sector
Highlights The Kingdom of Saudi Arabia (KSA) is taking a well-timed tactical decision to make room for increased Libyan and Nigerian output, by reducing allocations to refiners by more than 500k b/d in September. The bulk of these reductions will be directed at U.S. refiners, which are running their units at close to record output, while reducing their crude imports and boosting product exports. This will keep the year-on-year (yoy) reductions in OECD commercial oil stocks now showing up in the data on track, driven by continued sharp draws in U.S. inventories. Most importantly, these reductions will occur in the highly visible, high-frequency data produced by the U.S. every week. Energy: Overweight. Reports of foreign workers being pulled from Venezuelan oil fields will keep markets on edge. We remain long Dec/17 $50/bbl calls and short $55/bbl calls in Brent and WTI, which are up 127% and 74% since inception on June 22 and June 15, respectively. Base Metals: Neutral. Aluminum rallied on the back of news reports China's Shandong province ordered more than 3.2mm MT/yr of capacity shuttered by end-July. While surprising, such actions are not inconsistent with the stricter enforcement of environmental regulations in China we expect going forward. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. Recent geopolitical tensions between the U.S. and North Korea are supporting this position, which is up 2.1% since inception on May 4, 2017. Ags/Softs: Underweight. Grains were treading water ahead of today's WASDE. We remain bearish, but continue to avoid shorting the complex. Feature Chart of the WeekU.S. Refiners Running At Close To Record Rates KSA's decision to reduce crude oil allocations to refiners in September, particularly in the U.S., is a well-timed tactical move.1 U.S. refinery net crude inputs hit record levels in early June at 17.3mm b/d, and remain close to that level (Chart of the Week). U.S. product exports continue at near-record levels, while imports have been trending lower (Chart 2). Crude oil exports from the U.S. are running close to record levels, and imports are trending lower (Chart 3). U.S. exports of crude and products hit a record in January at 5.9mm b/d - 5.24mm b/d of products, and just under 650k b/d for crude exports. At the end of July, total exports of crude and products stood at 5.44mm b/d, or 7.4% below the record set in January. U.S. product exports fell to 4.6mm b/d, while crude exports stood at 845k b/d. It is worthwhile pointing out that, in terms of total oil and products exports, the U.S. ranks among the top exporters in the world: KSA exports ~ 7mm b/d of crude, while Russia exports ~ 5mm b/d of crude. Chart 2U.S. Product Export Remain Strong,##BR##While Imports Continue Trending Lower ... Chart 3... While U.S. Crude Exports Remain High,##BR##And Imports Are Moderating With net U.S. crude and product imports declining (Chart 4), we expect U.S. commercial oil inventories - crude and products - to continue to draw sharply, which, since they account for close to 45% of OECD inventories, will draw down total DM stock levels as well (Chart 5). Indeed, U.S. commercial inventories drew close to 4% yoy in July, based on EIA historical data, the second month in a row the yoy comparisons came in negative in America. For the OECD as a whole, July marked the first month this year that the yoy percent change in stock levels was negative (-1.8%). Thus, as the summer driving season - and peak refiner crude demand - reaches its denouement next month, KSA's well-timed move to reduce shipments to U.S. refiners will push inventories lower and advance OPEC 2.0's agenda to clear out surplus OECD commercial oil inventories over the short term (Chart 6). Chart 4U.S. Net Crude And##BR##Product Imports Are Falling ... Chart 5... Which Will Support Continued Draws In##BR##Commercial Oil Stocks (Crude And Products) Chart 6KSA Will Continue Reducing##BR##Shipments To U.S. Refiners The OPEC 2.0 Agreement Is Holding ... On Average ... KSA is following through on Energy Minister Khalid al-Falih's "whatever it takes" assertion and making room for Libya and Nigeria, which together have added some 750k b/d of production to the market vs. April's level - 470k b/d for Libya and 280k b/d for Nigeria. April happens to be the month during which OPEC's producers recorded their largest production cuts vs. October's levels (1.12mm b/d), based on the EIA's historical tallies. OPEC 2.0 benchmarks to October 2016 production levels. Among OPEC members, neither Libya nor Nigeria were bound by the historic OPEC 2.0 Production Agreement. However, for those states that did obligate themselves to the agreement, compliance has been fairly high on average. OPEC member states that are party to the 2.0 deal have overproduced relative to their agreed production volumes by some 20k b/d over the January - July period on average.2 So, relative to the deal the OPEC members agreed, they've managed to cut 800k b/d of crude production on average versus their October 2016 production levels.3 During this period, Iraq stands out for its overproduction, having pumped 100k b/d on average over its agreed OPEC 2.0 volume of 4.35mm b/d (Chart 7). Among the non-OPEC members of the OPEC 2.0 coalition, Russia's compliance appears to be holding up, at close to 300k b/d below its October levels of crude and liquids production in 2Q17 and July (Chart 8). Oman produced ~ 980k b/d, over the first seven months of the deal vs. 1.02mm b/d in October, while Kazakhstan has faltered, with production averaging 1.88mm b/d in Jan - July, versus 1.79mm b/d in October. Chart 7Iraq Stands Out For Overproduction;##BR##Libya, Nigeria Not Covered In OPEC 2.0 Deal Chart 8Russia And KSA##BR##Continue To Lead OPEC 2.0 ... But Markets Await Articulated Strategy We continue to expect compliance with the OPEC 2.0 deal to remain relatively high to March 2018, which will draw OECD storage down to five-year average levels. We also are maintaining our expectation Brent prices will trade to $60/bbl by year end, with WTI trading ~ $58/bbl. Nonetheless, when we update our balances this month, we will continue to model for "compliance fatigue" among the OPEC 2.0 coalition. The fact that KSA and Russia are able to keep their rapport strong and compliance levels among OPEC and non-OPEC states relatively high, is a necessary condition for keeping OPEC 2.0 a viable coalition. However, the sufficient condition remains articulating a position on managing production via OPEC 2.0 that all these states can buy into, and support with concrete action. If, once the deal expires, the parties to the OPEC 2.0 coalition are left to go their own way and resume a production free-for-all, prices almost surely will fall, as the battle for market share is resumed. The ironic outcome of all this likely would be further destruction of capex budgets, which will set up another violent price surge that kills demand. We have no doubt the principal negotiators in OPEC 2.0 continue to discuss this, and that they are working on guidance. Bottom Line: KSA's tactical move to reduce exports to the U.S. likely will accelerate the commercial oil storage drawdown now apparent in OECD inventories, if current U.S. trends hold up - i.e., refinery runs remain high, exports of crude and products remain strong, and imports continue to fall yoy. Strategically, OPEC 2.0 still needs to convince markets there is a longer-term game plan for managing its output, short of a production free-for-all. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This tactical move was reported by Reuters earlier this week. Please see "Saudi Arabia cuts crude oil allocations in September by more than its OPEC pledge," which was published by reuters.com August 8, 2017. 2 We are using the production levels specified by the Cartel in its "OPEC Bulletin 11 - 12/16" on p. 35. 3 This likely overstates the actual production available for export by KSA, since the Kingdom typically consumes some 500 - 600k b/d of crude domestically over the June - September period as direct-burn fuel to power generation producing electricity for air conditioners. So the reported data likely are noisy at this time of year. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Feature Recommended Allocation When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation
Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Reduced demand in oil-exporting countries and higher supplies from distressed states is whittling down the amount of oil being removed from the market this year, based on our latest supply-demand balances. As a result, even though OECD inventories will be drawn down to their five-year average levels by year end, this average will be a higher end-point than we projected last month. The Kingdom of Saudi Arabia (KSA) continues to reassure markets through anonymous media leaks it will cut production further to accommodate higher Libyan and Nigerian production. This is not unexpected, but it still is speculative. Ecuador's opting out of OPEC 2.0's production cuts raises the odds other financially distressed non-Gulf producers also will head for the exits. Energy: Overweight. Crude oil prices remain supported by actual production cuts, and the promise of further reductions by KSA and possibly other OPEC 2.0 members. Base Metals: Neutral. Labor and management at the ZaldÃvar copper mine in Chile are negotiating, according to Metal Bulletin. Separately, a three-year deal was agreed at the Centinela copper mine in Chile last week. Precious Metals: Neutral. Gold rallied on the back of lower inflation readings in the U.S., which suggested the Fed will back off aggressively pursuing its rates normalization policy. This would leave real rates low. Our strategic long portfolio hedge is up 1.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. We maintain our bearish view on grains. Fears that extreme heat in the U.S. Midwest and Plains will not be sufficient to counter the still-high ending-stocks expectations published in the USDA's WASDE last week. Feature Higher oil production is seeping into global balances. Lower prices, which are stimulating demand in oil-importing markets, are reducing incomes and demand in oil-exporting provinces. As a result, the rate at which inventories will draw this year is slowing. Our latest supply - demand balances shown in Table 1 indicate the net 900k b/d physical deficit we expected for 2017 has been whittled down to just under 500k b/d, as a result of production increases in Libya and Nigeria, and slower demand growth in oil exporters generally (Chart of the Week). Table 1BCA Global Oil Supply -##BR##Demand Balances (mm b/d) Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Ecuador, a small-ish OPEC member producing about 550k b/d, opted out of the Agreement negotiated by KSA and Russia to remove some 1.8mm b/d of production from the markets. This indicates weaker states that are party to the OPEC 2.0 Agreement are finding it impossible to maintain compliance with the cuts they've obliged themselves to undertake in the face of lower oil prices. As a result, they are compelled to increase production in an attempt to recover lost revenue (R), by increasing their quantity (Q) sold when prices (P) are weak, so as to maximize P*Q = R while they can. This only works if they are alone in increasing production while others - notably KSA, other Gulf states and Russia - restrict output to revive prices. Otherwise, if all the distressed states in the OPEC 2.0 coalition took the same action, markets would be flooded with oil. This was demonstrated in the mid-1980s during KSA's netback-pricing regime, when the Kingdom priced its oil as a function of prices received by refiners. This collapsed prices, and, eventually, reined in free-riding on KSA's production cuts.1 While few of these states, mostly outside the Gulf, are capable of significantly increasing production, at the margin, they can have an impact. Production Increases In OPEC, U.S. Partly Counter OPEC 2.0's Best Efforts Year-to-date to June, Iran and Libya have added 110k and 140k b/d of production to the market vs. their respective Oct/16 benchmark levels of 3.7mm and 550k b/d against which the OPEC 2.0 deal is being assessed. June production for these states was up 120k and 300k b/d for Iran and Libya, respectively, vs. October levels, while Nigeria's output was up 90k b/d (Chart 2). Libya and Nigeria are not parties to the OPEC 2.0 deal. Nonetheless, these states together with Iran added close to 500k b/d vs. their Oct/16 output levels in June, without an offsetting decline from members of the OPEC 2.0 coalition. Gulf OPEC ex Iran production is down some 850k b/d on average at 24.6mm b/d in 1H17 vs. Oct/16 levels, while non-Gulf OPEC production is down 215k b/d at 7.5mm b/d. We still see OPEC 2.0's production significantly below the EIA's estimate to March 2018 (Chart 3), which drives our view of inventory behavior. U.S. production also was higher in 1H17, as WTI prices rallied in response to the OPEC 2.0 production-cutting deal (Chart 4). For 1H17, U.S. crude oil production was up 230k b/d vs. 4Q16 levels, at 9.04mm b/d, led by higher shale-oil output. Chart 2Almost 500k b/d Added To Oct/16 Output##BR##By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 Slower Demand Growth Reduces Storage Draw On the demand side, we've lowered our estimate of demand growth this year to close to 1.37mm b/d, down nearly 110k b/d vs. our earlier May estimate. This results from lower consumption in oil exporting states. The combination of stronger supply growth and weaker demand growth reduces our estimated physical deficit for this year to 470k b/d from close to 900k b/d in our May balances estimates. These revised supply - demand estimates still produce enough of a physical deficit to allow storage to fall to five-year average levels (Chart 5). However, with the drawdowns prolonged by slower supply losses and reduced demand, inventories are now projected to remain above 2.8 billion bbls versus our earlier estimate of inventories declining to ~2.75 billion barrels by end-2017 or early 2018. Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Net, at the end of this drawdown, storage will be higher than expected, even if it does make it to five-year average levels. This will leave less room for OPEC 2.0 members to implement a strategy to backwardate the forward WTI curve so as to slow the rate at which shale-oil rigs return to the field, which we've discussed in previous research.2 More Cuts Required By OPEC 2.0 Going into its St. Petersburg meetings next week, there are clearly defined issues to be addressed by OPEC 2.0. The foregoing suggests additional cuts will be needed to empty storage sufficiently by yearend for OPEC 2.0 to be able to move to the next phase of its plan to regain some influence over the evolution of oil prices, particularly the U.S. benchmark WTI price, which drives hedging and profitability of U.S. shale producers. Over the short term, this effort likely will be clearly supported by KSA's stated intention to reduce exports to the U.S. market (Chart 6). All else equal, this will result in sharper draws in the high-frequency U.S. weekly inventory data, by augmenting reduced shipments to the U.S. from OPEC overall (Chart 7). Chart 6KSA's To Reduce##BR##Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments More substantive price-support and inventory-draining measures, as noted at the top of this article, will have to involve further production cuts by OPEC 2.0. KSA again is signaling it is open to additional production cuts, in order to normalize oil inventories.3 We have no doubt the Kingdom's Gulf allies - particularly Kuwait and the UAE - will support KSA in this effort. We also expect Russia to be supportive of this effort. The size of the cuts likely will exceed 500k b/d, so as to offset the production gains of Libya and Nigeria. Iran's higher production discussed herein, and Iraq's recent assertiveness in claiming "the right" to increase its production given the size of its reserves, suggests a short and a long game for the leadership of OPEC 2.0. In the short-term, Iran, Iraq, Libya and Nigeria will be constrained by lack of funds to significantly increase production. Thus, OPEC 2.0 - mostly KSA and its allies - can cut production without triggering an immediate response from these states, which will allow storage to resume drawing at a faster rate. For OPEC 2.0 to have a meaningful effect on U.S. shale production, the stronger storage draws in the near term would have to be accompanied by forward guidance from KSA, Russia and their allies that production will be increased in the medium term - 6 months or so out - so that continued demand growth can be accommodated by higher supplies. This would require storage and production flexibility by OPEC 2.0's leaders. Should all of this fall in place, we would expect a backwardation to develop toward yearend, which would be the first step in a longer-term strategy by OPEC 2.0 to slow the rate at which horizontal rigs return to drilling in the shale fields. Bottom Line: Higher oil production from Libya, Iran and Nigeria, coupled with a slight downgrade in demand growth, will reduce the physical deficit we expected this year. This will, all else equal, reduce the rate at which OECD storage draws, and raise the level of five-year average inventory levels by yearend. We do not believe this is a favorable outcome for OPEC 2.0, particularly KSA and Russia, if they are intent on regaining some influence over the evolution of oil prices. For this reason, we believe KSA and its Gulf Arab allies will reduce production further to put the inventory draws back on track. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes - and will look for opportunities to gain upside exposure once we get clear signaling from OPEC 2.0 leadership. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA's Commodity & Energy Strategy Weekly Report "Sideshow In Vienna," published October 23, 2014, for a review of netback pricing by KSA. It is available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Reports of April 6, 2017, entitled "The Game's Afoot In Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil" for a discussion of this strategy. Both are available at ces.bcaresearch.com. 3 Please see "Saudi Arabia still aims to reduce supply; weighs Nigerian, Libyan barrels," published by reuters.com on July 18, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table
Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been re-established; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (middle panel). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone (bottom panel). Overall, we are upgrading to an above benchmark allocation in the S&P energy index.
Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map Chart 4Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Chart 12...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Chart 14Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective Chart 16Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." 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