Commodities & Energy Sector

Equities, bonds and commodities are becoming suddenly, unusually, and dangerously correlated. But it cannot last.

The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.

We recommend deploying the proceeds of our E&P downgrade into oil & gas field services. The typical conditions required for energy services share price outperformance are falling into place. First, oil consumption is growing relative to production. OPEC production has continued climbing even as non-OPEC output has contracted, underscoring that a deal to curb future output should ensure that the consumption/production ratio stays in an uptrend. Recent strength in emerging market (EM) currencies signals that non-OECD oil consumption can continue to grow via better purchasing power, and also reduces the odds of an EM financial credit accident. Second, OECD oil supply growth rates appear to have peaked. Third, oil & gas field services pricing power has troughed. We doubt there is much upside given the scale of the excess capacity that was built up in the last decade, but an end to deflation would take away a large negative. Finally, the rig count has ticked higher, and has more upside if firms shift out of maximum retrenchment mode. Relative valuations are sufficiently cheap enough to expect that even a modest increase in the rig count could spur a re-rating. Boost the S&P oil & gas field services index to overweight. bca.uses_in_2016_10_12_002_c1 bca.uses_in_2016_10_12_002_c1

The energy sector is up marginally from its lows when compared with the overall market, an abysmal performance given the rally in crude oil and natural gas. Our strategy has been to keep only a market neutral weight on the overall sector this year via an overweight in oil & gas producers and underweight in refiners. While this has served our portfolio well, we are fine-tuning our intra-sector exposure. OPEC recently agreed to make a modest production curtailment. Whether members adhere to quotas and/or actually reduce output remains to be seen, but the more important point may be that the quest to drive down prices to cause financial pain for high cost producers appears to have come to an end. BCA's Energy Strategy Service believes that despite significant improvements in drilling efficiency and productivity during the downturn, current drilling levels are 30-40% lower than needed just to stem production declines. Re-inflating the rig count to an expansionary level will take time (~6 months), and then realized production will lag the rig count by 4-6 months. Renewed acceleration in drilling and completion activity will create inflationary pressures: pricing power will shift in favor of services firms relative to producers at a time when oil & gas extraction labor cost inflation has spiked to double-digit rates (third panel). If commodity prices are flat, it will be difficult for E&P firms to grow cash flow unless production is on the upswing. Take profits of 15% and downgrade the S&P oil & gas exploration & production index to neutral, funneling the proceeds into energy services firms, see the next Insight. bca.uses_in_2016_10_12_001_c1 bca.uses_in_2016_10_12_001_c1

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

As the U.S. median voter is shifting to the left, redistributive policy could come into play. A strong dollar helps to achieve this goal as it results in a bigger share of labor income in the economy. EM and commodity currencies could bear the brunt of the pain. Favor the euro on its crosses. Stay short CAD/NOK, but tighten stops.

Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.

Gold prices and gold-related equities have been caught in a sharp selloff. The motivation behind our early-August profit-taking stemmed from extremely overheated sentiment at a time when the yellow metal was vulnerable to an increasingly more hawkish Fed. Despite rumblings about asset purchase tapering at the ECB and Bank of Japan, we continue to see gold as an excellent long-term play given the likelihood of a prolonged period of depressed real interest rates. We are looking for an opportunity to return to an overweight position, but are reluctant to add just yet given that the Fed still seems intent on tightening policy, which could support U.S. dollar strength. In addition, neither technically overbought conditions nor extreme bullishness have been fully unwound. The bottom line is that near-term policy threats may keep gold and gold shares in consolidation mode for a while longer. Stay neutral, but be prepared to lift positions in the coming months. What's Next For Gold? What's Next For Gold?

Contrary to the almost universal bearish market consensus, we are raising our tactical view on iron ore to bullish from neutral. We remain tactically neutral on the steel market over the next three months. Strategically, we are bearish iron ore and steel.

Deutsche Bank's woes highlight a much wider malaise within European banks: under-capitalisation and under-profitability. We explain why getting the banks right is crucial to a successful investment strategy in equity, bond and currency markets.