Oil
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 Zaldívar 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
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." 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 rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.
Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Chart 2Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Chart 5Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Chart 7Financials Have##br## The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS Chart 12Margin Expansion##br##Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Odds the leaders of the OPEC 2.0 petro-states will be forced to back up last month's "whatever it takes" declaration - perhaps deepening and extending the 1.8mm b/d production cuts agreed at the end of last year - are not yet overwhelming. All the same, they will continue to increase, if markets do not see sustained draws in visible storage. Our updated supply-demand balances indicate global crude inventories will continue to draw, and that these draws will accelerate. This will keep global storage levels on track to normalize later this year or in 1Q18. We continue to expect Brent to trade to $60/bbl by December, with WTI ~ $2/bbl under that. Energy: Overweight. Our low-risk call spread initiated last week - long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls - is down 18.9%, following continued selling. We are adding to the position with the same Dec/17 strikes in Brent at tonight's close. These are strategic positions. Base Metals: Neutral. SHFE copper inventories fell on the back of increased demand for collateral to support financing deals in China. Tightening credit conditions are beginning to bite as the government pushes deleveraging policies, according to Metal Bulletin. Precious Metals: Neutral. We remain long gold, despite the hawkish rhetoric being thrown around by Fed officials, particularly William Dudley, head of the NY Fed. Our long gold portfolio hedge is up 1.1% since it was put on May 4, 2017. Ags/Softs: Underweight. Chicago and KC winter wheat remain bid, as concerns over drought-induced damage to the crop continue to weigh on markets. Feature Chart of the WeekUpdated Balances Leave Us Bullish Crude Insomuch as such things can ever be "official," crude oil officially entered a bear market - down 20% or more from recent highs - with the unexpected arrival of WTI futures below the lower end of our long-time $45-to-$65/bbl trading range this week.1 The proximate causes of this turn of events are persistently sticky inventory levels - most visible in the high-frequency data from the U.S. - and growing fears increasing Libyan and U.S. shale-oil production will undermine OPEC 2.0's 1.8mm b/d production cuts. We are hard-pressed to see the case for such fears, even though the market is consistently trading in a manner that is more aligned with supply cuts being far less than advertised by OPEC 2.0, or demand slowing considerably more than any agency or data service has yet picked up on. We will never be able to confirm sovereign hedging - e.g., Mexico or Iraq hedging oil-production revenues - until after the fact. However, this cannot be dismissed out of hand. Based on our latest supply-demand analysis, OPEC 2.0 - the coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia - will have removed some 1.4mm b/d of production on average from the market between January 2017 and end-March 2018 vs. peak production in November of last year (Chart of the Week). This will be diluted somewhat by the Libyan and U.S. production gains, but this increased production will not be sufficient to counter the OPEC 2.0 cuts entirely. Global Oil Supply Contracting Sharply Chart 2OECD Storage Draws On Track Against peak production in November 2016, we see just over 1.2mm b/d of crude oil production being cut by OPEC between January and end-March-2018.2 Throw in another 200 - 300k b/d or so from the non-OPEC members of the OPEC 2.0 coalition - mostly Russia - and we get to 1.4 to 1.5mm b/d of production taken off the market in the Jan/17 - Mar/18, interval in our modeling. This will leave the highly visible OECD storage levels being targeted by OPEC 2.0 at ~ 2.70 billion barrels by the end of the year, or some time close to the start of next year (Chart 2). In our modeling, we do not agree with the implied 1.9mm b/d of production cuts that follow from the reported OPEC 2.0 compliance statistics in the press. These reports indicate OPEC 2.0 coalition members are at 106% compliance. This is remarkably high, even if reports of this compliance rely on anonymous sources speaking to reporters following the coalition's technical committee meeting in Vienna earlier this week.3 If the production discipline attested to is true, we will raise our estimate of how quickly inventories will draw this year, and lower our expected global inventory levels for the end of March 2018. As for U.S. crude production, while we do have Dec/17 production 1.1mm b/d over Dec/16, we expect America's contribution to yoy global production growth to be only ~ 340k b/d on average over the course of 2017. The U.S. gains will be driven by shale-oil production, which we expect to grow ~ 410k b/d to 5.2mm b/d this year (Chart 3). Libya's production recently surged to 900k b/d, according to press reports, but, so far this year, it is averaging just under 700k b/d (Chart 4). This is slightly higher than the level we've been modeling in our balances for this year. The 300k b/d yoy increase in Libya's production is impressive, but it does not overwhelm OPEC 2.0's cuts. Even if Libyan production were to average 1mm b/d in 2H17, its net contribution to global production this year would be ~ 840k b/d, an increase of ~ 400k b/d over 2016's levels. We also note that as production and revenue increase the likelihood of renewed violence in Libya also increases.4 Chart 3U.S. Shale-Oil##BR##Growth Could Slow Chart 4Libya's Recover Is Impressive,##BR##But It Won't Reverse OPEC 2.0's Cuts Between them, combined growth in U.S. and Libyan production looks like it will be a touch under 650k b/d yoy (on average). Meanwhile, OPEC 2.0's production cuts - assessed against peak output for 2016 - are on track to exceed targets set at the outset of the agreement last December. Net, on a yoy basis, we expect to register inventory draws of close to 900k b/d this year. This should lead to cumulative draws in global storage levels of at least 400mm bbls by end-March. Demand Remains Strong The EIA revised its liquids demand estimates in its most recent Short-term Energy Outlook (STEO), and now has 2015 global consumption up 300k b/d from previous estimates at 95.4mm b/d, and 2016 consumption up 180k b/d at 96.9mm b/d. Our expected growth in global demand for this year and next is in line with the EIA's average estimate of ~ 1.6mm b/d, which will put 2017 demand at 98.5mm b/d and 2018 at 100.1mm b/d, respectively. Growth this year and next is expected to be slightly higher than last year's level (Chart 5). Once again, we expect EM demand - proxied by non-OECD liquids consumption - to lead global growth this year and next. Concern over apparent slowing in U.S. refined-product demand - particularly gasoline - is, we believe, overdone. Growth this year is being compared to stellar rates last year (Chart 6), which still leaves the level of demand above 20mm b/d. Growth in gasoline demand specifically also has slowed, but, again, this is occurring in a market where the level of demand remains high, pushing toward 10mm b/d, which is a mere 2.5% below record demand set in August of last year (Chart 7). Chart 5Expect Global Demand##BR##To Remain Stout Chart 6The Level Of U.S. Product##BR##Demand Remains High Chart 7U.S. Gasoline Demand##BR##Also Remains Stout 2018 Getting Foggy Uncertainty surrounding the evolution of the oil market next year is growing. The EIA believes markets will tighten in 3Q17, but then get progressively looser going into 2018, apparently disregarding OPEC 2.0's efforts to date, and the high likelihood - in our view - that the coalition will maintain production discipline for the most part (Chart 8). Combined with the robust demand growth BCA and the EIA expect, we get a fairly balanced market next year (Chart of the Week). U.S. shale-oil production, once again, will dictate just how tight markets become next year. Presently, we have average 2018 U.S. shale production in the Big 4 basins - Bakken, Eagle Ford, Niobrara, and the Permian - coming in more than 1mm b/d over 2017 levels. However, the recent sell-off that took WTI into bear-market territory this week could have a profound effect on shale-drilling activity next year, if it persists. Recent econometric work we've done confirms rig counts in the Big 4 plays are highly sensitive to WTI price. A prolonged stretch below $45/bbl could reduce rig counts by as much as 40% next year, especially if private-equity-backed companies cut spending. With hedging levels down, this is not a trivial concern (Chart 9).5 If prices stay depressed for any length of time for whatever reason - an outcome we do not expect - U.S. shale drilling activity could once again plummet. Chart 8EIA Fades OPEC 2.0's Resolve,##BR##BCA Does Not Chart 9Weak Prices Could##BR##Reduce Shale Rig Counts In addition, low prices also increase fiscal stress levels in petro-state revenues. This is of particular concern for KSA and Russia. The former is almost wholly dependent on oil revenues to fund its budgets, and will be looking to IPO its state-owned oil company, Aramco, next year. The latter is heavily dependent on oil and gas revenues, and will be holding an election in mid-March, just ahead of the expiry of the OPEC 2.0 production-cut extensions. The benchmark Russian crude, Urals, trades ~ $1.00 to $1.25/bbl under Brent, and any prolonged excursion into the low-$40s by Brent would stress the state's revenues. This is not our base case, but it is worthwhile considering. This mutual dependence on oil prices to support their respective economies is what compels strong compliance with the OPEC 2.0 production deal. Bottom Line: Our updated balances modeling continues to support our view global oil storage will draw, with OECD inventories likely falling below five-year average levels by year-end or early next year. Self-reported compliance with OPEC 2.0's production-cutting agreement exceeds 100%, implying the coalition is tracking to a 1.9mm b/d reduction in crude-oil output at present. On the demand side, even after upward revisions to 2015 and 2016 demand figures by the U.S. EIA, liquids consumption still is expected to grow on average ~ 1.6mm b/d this year and next. Cuts in production by OPEC 2.0 this year are more than sufficient to offset increases in Libyan and U.S. production, leaving overall production below consumption globally by close to 900k b/d, which will ensure inventories draw. For next year, after storage draws have abated, we expect supply and demand to be roughly balanced. We continue to expect Brent prices to trade to $60/bbl by year-end, and, on that basis, are recommending a long Dec/17 $50/bbl Brent call vs. short a Dec/17 $55/bbl Brent call. Longer term, our central tendency for price remains $55/bbl, with a range of $45 to $65/bbl prevailing most of the time. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We are using the front-line WTI futures contract, which hit its recent high on Feb. 23 at $54.45/bbl (last price) and traded down to $43.23/bbl on June 20, registering a drop of 20.6%. First-line Brent has yet to fall more than 20% from its recent high of $57.10/bbl on Jan. 6 to $46.02/bbl on June 20 (a 19.4% drop). 2 Measuring against peak production - rather than the October levels referenced by OPEC 2.0 coalition members - is an inherently more conservative way of assessing the effect of the production cuts. 3 Please see "OPEC, non-OPEC compliance with oil cuts hits highest in May: source," published by reuters.com on June 21, 2017. 4 An uptick in Nigerian production also is cited by some observers as a cause for concern vis-à-vis slowing the normalization of global storage levels. However, as Chart 4 illustrates, that country's production remains on either side of 1.5mm b/d, more than 500k b/d below recent steady-state levels. 5 Looking at rig-count sensitivity to prices and rig productivity, we find a 1% increase (decrease) in nearby prices translates into a roughly 70bp increase (decrease) in rig counts, while a 1% increase (decrease) in lagged, deferred WTI futures prices (out to 3 years forward) translates into a 2% change in the same direction. The R2 coefficients of determination for the models we estimated average ~ 0.95. 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 sharp downturn in oil prices triggered last week by an unexpected jump in weekly U.S. oil inventories, along with word Mexico's finance ministry had begun soliciting offers for its 2018 oil-revenue hedge, will be reversed by strong fundamentals in the next few weeks. On the data side, we believe markets simply over-reacted to high-frequency U.S. statistics. Taking a slightly broader view of the data suggests the trend in U.S. oil markets is continued tightening, as the northern hemisphere enters the summer driving season. Globally, we expect the OPEC 2.0 production-cut extension and continued strong EM demand to lead to a normalization of global storage levels by end-2017. We continue to expect Brent to trade to $60/bbl in 4Q17, with WTI trailing by ~ $2/bbl. Energy: Overweight. We were stopped out of our long Dec/17 vs. short Dec/18 WTI and Brent spreads by last week's sell-off. We continue to favor long front-to-back exposure, but will wait to re-establish these positions. We will, however, take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Base Metals: Neutral. Copper's brief rally stalled, taking front-month COMEX prices below $2.60/lb this week. The IMF's upgrade of China's growth prospects likely will support copper prices. Precious Metals: Neutral. Spot gold's chart has formed a bullish inverted head-and-shoulders pattern, which could take prices into a gap that opened in the continuation chart at $1,292/oz in the aftermath of November 2016's price plunge. We remain long spot gold. Ags/Softs: Underweight. The USDA's WASDE report did little to temper expectations for another record harvest - or something close enough to it. Even so, given recent U.S. Midwest weather, we would close any shorts. Feature This past week in the oil markets amply demonstrates that the old adage "One week does not a trend make" is more honored in the breach than in the observance. Events we view as transitory - the unexpected 3.3mm bbl jump in weekly U.S. crude-oil inventories, along with news Mexico's finance ministry began lining up offers on crude-oil put options for its 2018 revenue hedge - conspired to shave close to 6% from Brent prices in less than a week. From just over $51/bbl at the beginning of the month, when the Mexican finance ministry reportedly began soliciting offers on crude-oil put options, to the end of last week, Brent prices had fallen ~ $3/bbl. Front-month Brent continued to languish around that level as we went to press.1 Stronger fundamental data, particularly from the U.S., where last week's inventory shock hammered prices, will reverse these transitory effects going into 2H17. Chart of the WeekU.S. Refinery Runs At Record Levels U.S. Fundamental Strength Will Reverse Weak Crude Prices Third-quarter refining - typically a high-activity period in the U.S. - is opening on a very strong note: U.S. refining runs are at record highs, with net crude inputs posting a four-week average 17.3mm b/d run rate at June 2, 2017 (Chart of the Week). U.S. demand is reviving and now is back over 20mm b/d (Chart 2). We expect low product prices, particularly for gasoline, to boost demand going into the summer driving season. In addition, surging refined-product exports, particularly into Latin American markets, will keep U.S. refiners' appetite for crude high, allowing storage levels to drain (Chart 3). Note the end-2016/early-2017 surge and the ongoing strength in product exports year to date - exports are seasonally strong, even if they dipped a bit. The resumption in export growth after a short-lived downturn will continue to pull total crude and product net imports down in the U.S. (Chart 4). Chart 2U.S. Product Demand Back##BR##Over 20mm b/d Chart 3U.S. Product Exports##BR##Are Surging Chart 4U.S. Crude And Product Export Growth##BR##Continues To Lower Net Import Levels On the supply side, U.S. crude-oil production is up sharply after bottoming yoy with a decline of ~ 850k b/d last September, and stood at ~9.20mm b/d at the beginning of June, based on monthly production data from the EIA (Chart 5). This is up 330k b/d yoy. Much of this is being consumed domestically, but export volumes continue to increase, after hitting a recent high of close to 1mm b/d on a four-week-moving-average basis in March (Chart 6). Given the reception U.S. light crude is receiving in Asian markets, we expect continued growth, which will support the build-out of export-related facilities along the Gulf. Chart 5U.S. Crude Production Is Recovering Smartly ... Chart 6... And U.S. Crude Exports Are Surging Strong product demand and exports will allow crude inventories to continue to draw in the U.S. (Chart 7), particularly in the critically important Cushing storage market, where the NYMEX WTI futures contract delivers (Chart 8). Note that using 4-week-moving-average data shows yoy crude and product storage levels down an average 2.4mm bbl/week over the past eight weeks even with the unexpected surge in stocks reported last week. Cushing storage has become increasingly integrated with U.S. Gulf storage, which supports the strong refining activity there. Chart 7Strong Demand And Exports Allow##BR##U.S. Crude And Product Stocks To Draw Chart 8Cushing Crude Storage##BR##Continues To Draw Mexico's Revenue Hedge Is A Transitory Event Earlier this month, Mexico's Ministry of Finance reportedly began soliciting market-makers for offers on put options, signalling its annual revenue hedge will be forthcoming in the not-too-distant future. Reportedly, the finance ministry began lining up offer indications at the beginning of June, and by the end of last week the news was on the wire services.2 By purchasing puts, the finance ministry secures the right - but not the obligation - to sell oil at the strike price of the options. This puts a floor on the revenue realized by the ministry, since, if oil prices move higher next year, they will be able to sell into the market at the higher market-clearing price. However, if prices go below the strike price of the options, the market-makers - typically banks and, last year, for the first time, the trading arm of a major oil company - have to pay the difference between the puts' strike price and the market price. These hedges paid out $6.4 billion in 2015 and $2.7 billion last year, according to Bloomberg. The Mexican finance ministry's program, which can hedge up to 300mm bbl worth of production revenue, will keep markets leery for a couple of weeks. This is because the market-makers writing the puts for Mexico's ministry of finance will soak up available liquidity by hitting bids across the WTI, Brent, and refined products futures and swaps forward curves. The market-makers typically try to trade out of the exposure they've taken on by providing the hedge to the ministry, because, at the end of the day, they do not want to be made long oil if the options go into the money. This is what would happen if oil prices were to fall below the strike price of the puts purchased by the ministry, when the options approach their monthly expiry dates and their value is determined. To hedge themselves against this potential risk, the market-makers will sell volumes into the futures and swaps markets that are determined by the output of an option-pricing model. The lower prices go, the more they sell forward, and vice versa. More than likely, market-makers will be selling into rallies, so, at least while this hedge is moving through the market, any rally likely to be short-lived, as market-makers hedge themselves. However, once this activity is out of the way and refinery demand for crude kicks into high gear, we expect the physical reality of crude and product draws to take prices higher and backwardate WTI and Brent curves later this year. As an aside, we would expect lower prices will accelerate the draws at the margin, as we approach the peak of the northern hemisphere's summer driving season, as noted above. Strong Demand, Lower Supply Will Draw Stocks And Lift Prices Chart 9OPEC Really Is Cutting ~1.0mm b/d##BR##For More Than 400 Days The extension of OPEC 2.0's production cuts to the end of 1Q18 means that - for more than 400 days from January 2017 to March 2018 - OPEC producers with the ability to hold production at relatively high levels, and to even increase it, will have removed more than 1mm b/d from global flows (Chart 9). This will be supplemented by some 300k b/d of cuts from Russia and sundry non-OPEC producers.3 On the demand side, we continue to expect robust growth, given the behavior of EM global trade volumes and non-OECD oil demand strength, led by continued growth in China and India (Chart 10).4 We will be updating our balances next week, but we see no reason to lower our expectation that global demand will grow by more than 1.5mm b/d this year, especially following the IMF's upgrade of China's expected GDP growth this year to 6.7% from 6.6% on the back of "policy support, especially expansionary credit and public investment."5 This is the third upward revision to China's GDP growth made by the Fund this year. We continue to expect lower supply and robust demand this year and into early 2018 to draw visible inventories down to more normal levels (Chart 11), lift prices and backwardate the Brent and WTI forward curves. Given our analysis, we expect Brent to trade to $60/bbl later this year, with WTI trailing it by ~ $2/bbl. Chart 11... And Inventories Will Normalize Bottom Line: Markets appear to have extrapolated the weekly data into a trend that would reverse - or at least materially slow - the normalization of inventories, despite the extension of OPEC 2.0's 1.8mm b/d production cuts to the end of 1Q18, and continued strength in EM oil demand, which is driven by continued strength in China's and India's economies. Net, we believe Mexico's revenue hedge and the one-week surge in U.S. inventories are transitory events, which will be reversed in the weeks ahead. Despite being stopped out of our long Dec/17 vs. short Dec/18 Brent and WTI recommendations following last week's sell-off we still are inclined to keep this exposure. However, we will wait for the market to process Mexico's revenue hedge and to work through the IEA's subdued 2017 demand forecast before re-establishing these positions. In the meantime, we will take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Mexico Said to Take First Steps in Annual Oil Hedging Program," published by bloomberg.com on June 9, 2017. 2 Please see footnote 1. 3 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", published June 1, 2017, for an in-depth analysis of OPEC 2.0's production cuts. It is available at ces.bcaresearch.com. 4 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017. It is available at ces.bcaresearch.com. 5 Please see "IMF Staff Completes 2017 Article IV Mission to China," published June 14, 2017, on the IMF's website imf.org. 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 Crude oil prices will find support from stronger EM trade volumes, which broke out of an extended low-growth period at the end of last year and finished 1Q17 on a very strong note. Sustained growth in EM trade volumes will boost inflation at the consumer level in the U.S. and Europe, and will lift the Fed's preferred inflation gauge, provided the Fed does not constrict the growth of money supply this year and next. Energy: Overweight. We remain long Dec/17 WTI and Brent vs. short Dec/18 WTI and Brent, expecting the extended OPEC 2.0 production cuts and stronger oil demand to drain inventories this year. Base Metals: Neutral. China's Caixin manufacturing PMI for May fell below 50, indicating the manufacturing sector may be contracting. We will wait to see if this is confirmed this month and next, but for now this keeps us neutral with a negative tilt on the base metals complex. Precious Metals: Neutral. A weaker USD, and market expectations the Fed will be constrained in lifting interest rates later this year is supporting our strategic gold portfolio hedge, which is up 5.1% since it was initiated May 4, 2017. Ags/Softs: Underweight. Front-month corn is trading through the top of the $3.55 to $3.75/bushel range it has occupied since the beginning of the year. We are not inclined to play the momentum. Feature EM import and export volumes moved sharply higher in 1Q17 after breaking out of an extended low-growth funk late last year (Chart of the Week). The year-on-year (yoy) increase in the volume of imports and exports for EM economies reported by the CPB World Trade Monitor were up on average 8.74% and 5.29% in 1Q17, respectively, versus 12-month moving average levels of 2.2% and 2.5%.1 EM trade volumes are highly correlated with EM oil demand (Chart 2), particularly in the post-Global Financial Crisis (GFC) era, when EM import and export growth made significant gains relative to DM trade volumes (Chart 3).2 Indeed, EM imports and exports both grew at twice the rate of DM trade between the end of 2010 and the end of 1Q17: EM import volumes grew 22% vs. DM growth of 10% over the period, while EM export volumes grew 21% vs. DM growth of 11%. Chart of the WeekEM Imports And Exports##BR##Surge In 1Q17 Chart 2EM Oil Demand Closely##BR##Tracks Trade Volumes Chart 3EM Trade-Volume Growth##BR##Surpasses DM Growth We expect EM demand will account for some 80% of ~1.53mm b/d of global oil demand growth this year. If the strong 1Q17 performance in EM trade were to carry into 2Q, we will be raising our estimated oil-demand growth for the year significantly. We will be updating our global supply-demand balances next week. Coupled with the extension to end-March 2018 of the 1.8mm-barrel-per-day crude-oil production cuts recently agreed by the OPEC 2.0, the strong EM oil-demand growth could accelerate the draw-down in global storage levels, putting the WTI and Brent forward curves into backwardation sooner than the late-2017/early-2018 timeframe we currently expect.3 EM Trade Growth Will Stoke Oil Prices And Inflation Because EM demand is the driving force of global oil-demand growth, a continuation of the strong trade performance from this sector will support oil prices going forward, and likely will lift inflation as the year progresses. In the post-GFC period, we would expect a 1% increase in EM import and export volumes to boost oil prices by a little more than 2%, and vice versa.4 This is almost twice the effect an increase in trade produces in estimates beginning pre-GFC in 2000; most likely, it reflects the increase in EM trade volumes relative to DM trade volumes post-GFC.5 Our modeling confirms key inflation gauges - particularly the Fed's preferred gauge, the core PCE; the U.S. CPI; and EMU Harmonized CPI - all are highly sensitive to EM oil demand, as expected, and, no surprise, to EM trade volumes.6 In the post-GFC period, a 1% increase (decrease) in EM oil demand can be expected to lift (drop) core PCE and the U.S. CPI by a little more than 50bps; for the EMU CPI, a 40bps increase (decrease) can be expected.7 In addition, we have found the EM trade data also is a highly explanatory variable for these inflation gauges. Imports explain ~ 84%, 91% and 89% of core PCE (Chart 4), U.S. CPI (Chart 5), and EMU CPI (Chart 6), respectively, in the post-GFC period, while exports explain 94%, 93% and 81% of these inflation gauges. The elasticities for the U.S. gauges is ~ 50bps, similar to the EM oil demand estimates, and ~35bps for the EMU CPI. Chart 4Core PCE Is Highly Sensitive To EM Trade Volumes... Chart 5...As Is U.S. CPI... Chart 6...And EMU CPI A continued expansion of EM trading volumes this year can be expected to lift inflation in the U.S. and Europe. We also would expect this to hold for China as well, given the results of our earlier research.8 Fed Could Kill The Party Chart 7U.S. M2 Is Important To EM Trade Volumes One variable we are watching closely is U.S. money supply, M2 in particular, vis-à-vis EM trade volumes (Chart 7). We find that in the post-GFC world, EM trade volumes are highly sensitive to M2, with M2 explaining 92% of EM exports and 82% of imports. This relationship did not exist in the pre-GFC world, or in estimates starting pre-GFC and extending to the present day. This no doubt is related to massive monetary accommodation and QE experiments post-GFC, but, as of this writing, we are not at all sure how this relationship will evolve going forward. Bottom Line: EM trade volumes have broken out of a long-term funk, which will be supportive of crude oil prices and will lift inflation going forward. Strong EM trade growth at the pace at which it ended 1Q17 would cause us to lift our expectation for global oil demand significantly for this year. This, combined with the extension of the OPEC 2.0 production cuts to March 2018 could normalize global inventories faster than markets currently expect. EM trade is, importantly, highly exposed to U.S. monetary policy, particularly to what happens to U.S. M2 money supply. This is a feature of the global trade picture that was not present pre-GFC. Our research affirms our conviction on the bullish oil exposure we have on - chiefly the long Dec/17 Brent and WTI vs. short Dec/18 Brent and WTI backwardation trades. Our results also support remaining long gold as a strategic portfolio hedge against inflation and geopolitical risk, and remaining long commodity-index exposure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for EM imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports was changing so as to better see how the relative shares of EM and DM are evolving. 2 EM export and import volumes are cointegrated with non-OECD oil consumption, our proxy for EM oil demand, in regressions starting pre- and post-GFC, meaning they share a common trend and are in a long-term equilibrium. The adjusted R2 coefficient of determination for EM oil demand as a function of EM export volumes is 0.91 for estimates starting in 2003 and 2010 (the pre- and post-GFC periods); for EM imports, it is 0.84 post-GFC, and 0.90 pre-GFC. Post-GFC, we estimate a 1% increase (decrease) in EM import and export volumes translates to an 88bp and 85bp gain (decline) in EM oil demand. The read-through on this is EM trade volumes are closely tied to income growth, given the income-elasticity of demand for oil is ~ 1.0 in non-OECD economies, 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). In our modeling, we assume the GFC ended in 2010. 3 Please see our discussion of this production-cut extension in the joint report we did with BCA Research's Energy Sector Strategy on June 1, 2017, entitled "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories." It is available at ces.bcaresearch.com. 4 The R2 coefficients of determination for the cointegrating regressions of Brent prices on EM export and import volumes are 0.90 and 0.93, respectively, for post-GFC estimates. For estimates beginning in 2000, the R2 coefficients are 0.88, while the elasticities are ~1.20 for the EM trade variables. These models also include a parameter for the broad trade-weighted USD, which, post-GFC, has become more important to the evolution of Brent prices: A 1% increase in the currency parameter translates to a price decline of more than 5%, which is approximately twice the value of the estimates starting pre-GFC. 5 Our estimates for WTI produce similar results for the pre- and post-GFC periods. 6 We examined this in our August 4 and 11, 2016, in "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," and "Global Inflation And Commodity Markets." Both are available at ces.bcaresearch.com. 7 The R2 coefficients of determination for the core PCE, U.S. CPI and EMU CPI estimates as a function of EM oil demand are 0.97, 0.94 and 0.85, respectively. It is interesting to observe that prompt measures of inflation are not correlated to oil prices, but that 5-year 5-year CPI swaps remain highly correlated with oil prices, the 3-year forward WTI futures contract in particular; the R2 for the estimate of the 5y5y CPI swap as a function of the 3-year WTI contract is 75%. 8 In the August 11, 2016, article "Global Inflation And Commodity Markets," we found Chinese inflation to be equally sensitive to EM oil demand. We will be exploring this further when we look at base metals demand vis-à-vis EM trading volumes in forthcoming research. 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 Will Trump's trade rhetoric damage the U.S. service sector's abilities to generate a trade surplus and create high-paying jobs? Our assessment of the latest Beige Book via the BCA Beige Book Monitor supports the Fed's view that Q1 weakness was an anomaly and inflation is headed higher. This will keep the Fed on track to tighten in June and again later this year. GDP growth in 2017 is poised to exceed the Fed's forecast for the first time in seven years if the recent pattern of 2H GDP beating 1H GDP growth is repeated. Global oil inventories are set to move lower and drive oil prices higher. The odds of a recession remain low even with the economy at full employment. Feature The May employment report fell short of expectations, but the average gain of 121,000 jobs per month over the past 3 months and the drop in the unemployment rate are still enough to tighten the labor market and keep the Fed on track to tighten later this month. The unemployment rate dipped to 4.3% in May and is now 0.4% below the Fed's view of full employment. Wage growth remains stagnant despite the state of health of the labor market, as year-over-year average hourly earnings growth remained at just 2.5% in May (Chart 1). Chart 1Labor Market Still Tightening##BR##Despite Disappointing May Taking a broader view, the job picture in the service sector remains robust and wages in the export-oriented service industries remain well above wages in the goods sector. In this week's report we examine the impact of trade on the labor market and highlight areas where Trump's rhetoric may hurt trade-related job growth. Trump At Your Service The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market. Trump campaigned on his ability to create high paying manufacturing jobs, but his America First rhetoric is threatening jobs in the high paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side. U.S. imported goods exceeded exports by $1.3 trillion in 2016. Service exports totaled an all-time high of $778 billion in 2016, $270 billion more than imports. Exports of services have increased by 7% per year on average since 2000, which is nearly twice as fast as nominal GDP (Charts 2A & 2B). Chart 2AThe U.S. Runs Trade##BR##Surplus In Services... Chart 2B...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods The trade surplus in services added 0.07% to GDP in Q1 2017, 0.04% in 2016, and has consistently added to GDP growth over the past few decades, although it is swamped by the large drag on GDP as a result of the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is more than seven times faster than in industries where the U.S. runs a deficit. In addition, median wages ($29 as of April 2017) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24) where there is a trade deficit, even though wages are rising quicker in the goods-producing sector in the past year (Chart 3). U.S. service sector exports tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast of a 10% rise in the next 6-12 months (Chart 4). Chart 3Wages In Export Led Service Industries##BR##20% Higher Than In Goods Sector Chart 4Service Sector Export Orders##BR##At New High Despite Strong Dollar However, Trump's trade policies may threaten to reduce the U.S.'s global dominance in services. The U.S. has the largest trade surpluses in travel (which includes education), intellectual property, financial services, and legal, accounting and consulting services (Table 1). The U.S. also runs a large surplus in areas such as intellectual property, software and advertising. In 2015, foreigners spent $92 billion more to travel to, vacation in and be educated in America compared with what U.S. residents spent for those services overseas. Anecdotal reports note that travel to the U.S. is down by as much as 15% since the start of the year, and that 40% of U.S. colleges and universities have seen a decline in foreign applications, putting the nearly $100 billion trade surplus at risk. Other Trump policies, such as the proposed travel ban and some of his "America First" campaign-style rhetoric, could jeopardize the trade surpluses in financial services ($77 billion), software services ($30 billion), TV and film right ($13 billion), architectural services ($10 billion) and advertising ($8) billion. Table 1Key Components Of U.S. Trade Surplus In Services Trump's trade rhetoric potentially threatens U.S. service exports to NAFTA countries (Canada and Mexico), the Eurozone and the emerging markets. President Trump campaigned on renegotiating NAFTA, supporting Brexit and pulling the U.S. out of the Trans Pacific Partnership (TPP). Trade in services are key to all of those treaties, although trade in goods gets more attention. At $56 billion in 2015, Canada is the U.S.'s second largest service export market, and Mexico is a top 10 destination ($31 billion). Forty percent of U.S. service exports go to Europe, and at $66 billion in 2015, the U.K. is the single largest market for U.S. service exports. The U.S. sends half of its service exports to EM nations, with markets in Asia accounting for just under 30% of all U.S. service exports. Thus investors should carefully monitor the progress of all three of these trade deals to help better assess the impact on U.S. trade and jobs in the service sector. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth as long as there is no retaliation from its trading partners (which is unlikely). But any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. Beige Book Backs The Fed For the Fed, policymakers are treating any potential changes to trade and fiscal policy as risks to their outlook. At the moment, they are judging the need for tighter policy based on the evolution of the labor market and inflation. The Beige Book released on May 31 confirmed the FOMC's base-case outlook. It keeps the Fed on track to tighten in June and then again later this year as it begins to trim its balance sheet. Our quantitative assessment of the qualitative Beige Book that we introduced in April 17 found that the economy had rebounded from a weak Q1 and that inflation was in an uptrend despite recent soft readings.1 The dollar seems to have faded as a key concern for small businesses and bankers. Business uncertainty around government policy (fiscal, regulatory and health) remained elevated. Our analysis of the Beige Book also shows that commercial and residential real estate, the former a surprise source of strength in Q1 GDP, remains stout more than halfway through Q2. Chart 5 shows that the BCA Beige Book Monitor ticked up to 71% in May 2017 from 64% in April. The metric is in line with its cycle highs recorded in mid-2014 as oil prices peaked. "Inflation" words in the Beige Book hit a new peak in May and are in sharp contrast to the recent soft readings on CPI and the PCE deflator. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may be turning up soon. Chart 5May Beige Book Points To Solid Growth In Q2 In Chart 5, panel 4 we track mentions of "strong dollar" in the report. The May Beige Book saw the same number of references to a strong dollar as the May 2016 report. This suggests that the dollar is not as big a concern for business owners as it was from early 2015 through early 2016. Housing added 0.5 percentage points to growth in Q1, and business spending on structures added 0.7 percentage points. The latest Beige Book suggests that both sectors remain robust here in Q2 (Chart not shown). The implication is that the U.S. economy is poised to clear the low hurdle in 2017 set for it by the FOMC in late 2016. The Fed's economic growth target for 2017 (set at the December 2016 FOMC meeting) was just 2.1%, the lowest year ahead forecast since 2009. The projection incorporates the Fed's lowered trajectory for potential output, but may also reflect the fact that actual GDP growth has not exceeded the Fed's forecast every year since 2009 (Chart 6). GDP growth in 1H 2017 is tracking between 2% and 2.5% despite the weak start to the year. In late May, Q1 GDP growth was revised to +1.2% from the 0.7% reading reported in late April. Based on the Atlanta Fed's GDP Now, the NY Fed's Nowcast and readings on ISM, vehicle sales and the Beige Book, GDP in Q2 is tracking to near 3%. If the economy rebounds from the lackluster first quarter as we expect, then real output will be on course to match or exceed the Fed's forecast for the first time since the recession. We expect an acceleration for fundamental reasons and due to poor seasonal adjustment. In 5 of the past 7 years, real GDP growth in Q3 and Q4 was the same or stronger than the pace of expansion in the first half of the year (Table 2). During that period, 2H output growth averaged 2.4%, while 1H growth was an anemic 1.8%. In the years when Q1 GDP was weak,2 as it was this year, real economic output in the second half of the year accelerated from 1H growth nearly every time. Table 2GDP Growth In 2H Has Met Or Exceeded 1H Growth In 5 Of Past 7 Years Bottom Line: The latest Beige Book (prepared for the June 13-14 FOMC meeting) confirms policymakers' assessment that the weak growth in Q1 was transitory and inflation is in an uptrend. The economy remains on target to hit or exceed the Fed's growth objectives. The FOMC is poised to raise rates in June and one more time by year end. This view is not discounted in the bond market, implying that Treasury yields are too low. Equity prices could be undermined by higher yields and the dollar, but this will be offset by rising growth (and profit) expectations if our base-case view pans out. Oil Prices: Fade The Recent Weakness A pickup in U.S. growth will also be positive for oil prices, although it is OPEC's efforts to curtail excess inventories that is the main driver of our bullish view. Our commodity strategists believe that OPEC 2.0's recent production cut extension will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating).3 Shale production is bouncing back quickly. OPEC's November 2016 agreement signaled to the world that OPEC (and Russia) would abandon Saudi Arabia's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers to pour money into vastly increased drilling programs. Nonetheless, global oil demand continues to grow robustly. Moreover, production is eroding for oil producers outside of (Middle East) OPEC, Russia and U.S. Shale, which collectively supply half the market. The cumulative effects of spending constraints during 2015-18 will result in falling output in the coming years for this group of producers. Adding it all up, we expect demand to exceed supply for the remainder of 2017, which will result in a significant drawdown in oil inventories (Chart 7). Our strategists think the inventory adjustment will push the price of oil up to US$60 by year end. They expect a trading range of US$45-65 to hold between now and 2020. Chart 8 shows a simple model for oil prices, based on global industrial production, oil production, OECD oil inventories and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, the model implies that oil prices will surge by more than US$10! The coefficient on oil inventories in the model is probably overly influenced by the one major swing in inventories we have seen in the last couple of decades, suggesting that we must take the results with a grain of salt. Nonetheless, our point is that oil prices have significant upside potential if the excessive inventory problem is solved. Chart 7Significant Drawdown##BR##In Inventories Is Coming Chart 8Upside Potential For Oil##BR##If Inventory Issue Is Resolved Bottom Line: The extension of OPEC 2.0 production cuts reinforces our bullish view for oil prices. Revisiting The Odds Of A Recession It seems odd at first glance to be discussing recession risks at a time when growth is poised to accelerate. Nonetheless, BCA's Global Investment Strategy service recently noted that investors should be on watch for recession now that the economy has reached full employment.4 Historically, once the unemployment rate reached estimates of full employment, the odds of a recession in the subsequent 12 months increased four-fold. In last week's report, we maintained that the lack of progress on fiscal policy by the Trump administration may actually be positive for risk assets in the medium term because it would stretch out the cycle and thus lower recession risks.5 The economic data have disappointed so far this year, as highlighted by the economic surprise index (Chart 9). Despite this, there is not much talk of recession in the news media and various models also show slim chances of recession this year (Chart 10). Only one of eight components in our BCA model is flashing recession: the three-year moving average of the Fed funds rate is rising because the Fed rate hike cycle began in late 2015. Chart 9Economic Data Still Disappointing, But Does Not Signal A Recession Chart 10Odds Of A Recession This Year Remain Low In a prior report we dismissed the rollover in commodity prices as a recessionary signal and noted that Trump's political woes would only slow the GOP's legislative agenda. Nonetheless, even without fiscal stimulus, the U.S. economy will still grow above its long-term potential, tighten the labor market and push up wages and inflation in the coming quarters. Bottom Line: The odds of recession remain low despite the U.S. economy being at full employment. The delay in Trumponomics' will prolong the expansion and will support risk assets over the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 3 Please see Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", dated June 1, 2017, available at ces.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight", dated May 26, 2017, available at gis.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Corporate Earnings Versus Trump Turbulence", dated May 29, 2017, available at usis.bcaresearch.com.