Alternative energy

Executive Summary Natgas Price Surge Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in clean-hydrogen technology, which uses renewable energy to separate water into hydrogen and oxygen. This already has pushed the cost of clean – or "green" – hydrogen below the cost of competing forms of the fuel on the continent. Widespread adoption of carbon pricing will further enhance the attractiveness of green hydrogen, making it more competitive in transportation and refining applications. The cost of producing clean hydrogen in China also has fallen, owing to the competition for liquified natural gas (LNG) with the EU. Relatively low US natural gas prices are keeping the cost of green hydrogen above alternatives. The US DOE is prioritizing hydrogen development, and is funding research to reduce its cost from ~ $5/kg to $1/kg over the next 10 years. Falling clean-hydrogen costs raise the risk of stranded investment in natural-gas exploration and production. Bottom Line: The EU's drive to diversify away from Russian natural gas as quickly as possible will keep competition for scarce LNG between the EU and Asian markets high, as both bid for scarce supplies. This will redound to the benefit of clean hydrogen and its supporting technology, but might limit natgas E+P. Feature The war in Ukraine will keep the price of natural gas, particularly in its liquid state (LNG), elevated, as the EU and Asia compete for scarce supplies to refill inventories and prepare for the coming winter, along with keeping their heavy industries operating (Chart 1). In the Europe-Middle East-Africa (EMEA) markets and China, higher natgas prices, including LNG, already have lifted the cost of pulling hydrogen from natgas – so-called blue and grey hydrogen – above that of green (or "clean") hydrogen, which is produced by separating the hydrogen and oxygen in water via electrolysis. With natgas prices remaining elevated this year and next, investment in clean-hydrogen technology and its supporting infrastructure can be expected to increase. Government support for hydrogen as a clean fuel – i.e., research funding and tax support – will allow this technology to reach economies of scale and lower costs over the coming decade. Chart 1Russia's Invasion Of Ukraine Will Boost Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Related Report  Commodity & Energy StrategySurging Metals Prices And The Case For Carbon-Capture Government policy can increase the advantage of green-hydrogen and other clean-energy technologies by adopting carbon-pricing schemes on a large scale, as well. Such schemes would assess actual – and avoidable – costs of pollution to incentivize investment in non-polluting technologies. We have argued in the past that this is best done via taxes that can provide revenues to support and fund the development of renewable energy. Ideally, such schemes would include mechanisms to offset the regressive nature of such taxes. Absent a tax, Carbon Clubs that impose tariffs or duties on states not abiding by carbon-reduction policies seeking to export to states that do employ such policies, as developed by William Nordhaus, would be useful.1 Ukraine War Improves Hydrogen Economics Governments supporting low- or zero-carbon emission technologies in their push to contain the rise in the Earth's temperature are focused on hydrogen, which, when consumed in a fuel cell, emits no pollution. Apart from being a fuel source, hydrogen also can be used to store energy. It can power electric grids when there is intermittent electricity supply, making it ideal as a back-up energy source for renewable-energy technologies – solar and wind, in particular – which, as the UK and Europe discovered last summer, can be extremely variable and unreliable. Based on its method of production, hydrogen is assigned a color – grey, blue, or green (Chart 2). In a nutshell: Chart 2Types of Hydrogen By Color EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Grey hydrogen is produced when steam reacts with a hydrocarbon fuel (typically natural gas) to produce hydrogen via a process known as steam-methane reforming (SMR). The downside of this technology is it can result in CO2 and carbon escaping into the environment. Blue hydrogen is created by the same SMR process as grey hydrogen; however, carbon capture and storage (CCS) technology is added to the process to reduce carbon emissions from the steam and fuel reaction. Green hydrogen – aka "clean hydrogen" – is produced with electricity from renewables like wind or solar – in a process that separates water into oxygen and hydrogen via electrolysis. Electricity is the primary cost driver in the production of green hydrogen, followed by the elctrolyzers used to separate oxygen and hydrogen (Chart 3). For this reason, countries where renewable electricity is abundant will be ideal candidates for so-called clean hydrogen. Among renewables, wind and solar are the most developed, and cheapest sources of electricity (Chart 4). As a result, the International Renewable Energy Agency (IRENA) believes countries in the Middle East, Africa, and Oceania have the highest potential to become green hydrogen exporters.2 A constant electric load is crucial for efficient and cost-effective hydrogen production. Electrolyzers will either underperform or overheat if subjected to a variable electric load, reducing their lifespan, and hence increasing overall capital costs. This is yet another reason why countries with vast quantities of wind and solar energy will be at an advantage producing clean hydrogen. Chart 3Renewables Are Primary Cost For Green Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Chart 4Cheap Wind And Solar Electricity Can Reduce Green Hydrogen Costs EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Until now, deficient electrolyzer investment and production have resulted in high capital costs. Low innovation in the technology is due to a dearth of consumer demand due to the high prices, leading to a vicious cycle (Diagram 1). According to IRENA, increasing the manufacturing intensity of stacks – the primary component of the electrolyzer – could reduce the share of its cost from 45% to 30% of the total.3 Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in green-hydrogen technology. The war already has pushed the cost of clean hydrogen below the cost of competing grey and blue forms of the fuel on the continent. We expect this will persist over the next two years, as the EU and Asia compete for scarce natural gas and LNG supplies going into the coming winter to rebuild depleted gas inventories, and to keep base metals smelters and refineries up and running. Diagram 1The Vicious Cycle Plaguing Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects The cost of grey hydrogen from natgas was ~ $6.70/kg last month vs a mid-point estimate of ~ $5.75/kg for green hydrogen in the Europe-Middle East-Africa (EMEA) markets.4 In China, green hydrogen was running at ~ $3.20/kg vs a grey cost of ~ $5.30/kg. The US is the outlier here, given its abundance of natural gas production. Grey hydrogen cost $1.20/kg, while green hydrogen was running at ~ $3.30/kg. It is difficult to determine whether green hydrogen will remain cheaper than blue in the EMEA and China markets. Under normal conditions – absent highly backwardated fuel markets – blue hydrogen is considered a bridge to the green variant, since it only builds on the incumbent grey hydrogen production process and is cheaper (Chart 5). Approximately 90% of total hydrogen produced annually is grey. If the EU is forced to ration natgas – Germany, e.g., is preparing its population for such a contingency in the event Russian supplies are shut off – reduced fuel availability will act as a hard constraint for blue-hydrogen production. This would prolong green-hydrogen's cost advantage. Chart 5Green Hydrogen Typically Most Expensive Hue EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects That being said, green hydrogen has its own geopolitical problems. Procuring the critical minerals and metals required to build electrolyzers can prove to be challenging, given the metals’ locations are highly concentrated in states with stressed electrical infrastructures like South Africa, which produces 85% and 70% of global iridium and platinum supply respectively (Chart 6). Both metals are in commonly used electrolyzers. Metals supply disruptions in China similar to those that occurred this past winter can affect numerous metal supply chains necessary for hydrogen production. Chart 6Concentration Risks In Hydrogen Materials EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Displacing High-Polluting Technology According to the IRENA, hydrogen could cover up to 12% of global energy use by 2050.5 Green hydrogen has numerous potential applications: Backstopping intermittent renewable energy; Performing as a “zero-emissions” fuel for maritime shipping and aviation; An energy source for high-heat industrial processes that cannot otherwise be electrified; A feedstock in some industrial processes, like steel production.6 The adoption of hydrogen for new applications has been slow, with uptake limited to the last decade, when fuel cell electric vehicle (FCEV) deployment started gaining traction. In addition, this energy source can be used to produce commodities such as steel, cement and glass used in construction, and ammonia needed to fertilize crops.7 In terms of size, global hydrogen demand was 90 Mt in 2020, with most of it coming from refining and industrial uses. Governments have committed to greater hydrogen use, but not nearly enough to meet net-zero energy emissions by 2050 (Chart 7).8 IRENA estimates that over 30% of hydrogen could be traded across borders by 2050, a higher share than natural gas today.9 According to the Energy Networks Association, up to a fifth of natural gas consumption currently used could be replaced by hydrogen.10 Countries most able to generate cheap renewable electricity will be best placed to produce competitive green hydrogen.11 Chart 7Hydrogen Contributes To Lower Emissions EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Investment Implications High natgas prices – in its pipeline and liquid forms – will redound to the benefit of clean hydrogen and its supporting technology. The relative cost advantage green hydrogen has over its grey and blue competition will persist this year and most likely in 2023, as the EU and China continue to bid for scarce natgas supplies in the wake of Russia's invasion of Ukraine. This could persist, if markets begin pricing the availability and future reliability of clean hydrogen on par with fossil-fuel availability. However, this will require significant increases in green-hydrogen technology investment, particularly in electrolysers. Government support – e.g., the US DOE's efforts to reduce the cost of green hydrogen to $1/kg over the next 10 years from $5/kg – will be important in this regard. The development of green-hydrogen capacity and its infrastructure could limit the further development of natural gas, which will be increasingly important during the global energy transition. The conventional natgas resource base benefits from a fully developed global infrastructure, which, if augmented with funding and tax support for carbon-capture and storage technology, will provide a necessary bridge to a low-carbon energy grid.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Industrial bulks (iron ore and steel) and metals are becoming more expensive, increasing the cost of Europe’s effort to diversify away from Russian natural gas. European countries that relied on pipeline natgas from Russia will need to construct import facilities and regasification plants to switch to LNG from other exporters. Cross-border European pipelines also will be required to transport imported natural gas from the Iberian Peninsula and Eastern Europe to inland Europe. The US will be expanding LNG export facilities in the Gulf out to 2025, after which growth in export capacity will level off at ~ 10 Bcf/d. It has a large latent export capacity of ~ 187 million tons of LNG, however 48% of that capacity will come via projects currently under construction or awaiting permits. The build-out and expansion of LNG import and export facilities will be steel- and metals- intensive. Renewables-based energy the EU will look to as another alternative to Russian gas will compete with new LNG facilities’ metal demand, given green energy’s infrastructure requirements (Chart 8). The US and China will compete with the EU for these metals, as the world aims to achieve net-zero carbon emissions by 2050. The downside risk is the current COVID wave in China, and the stringent lockdown accompanying it, which started in end-March. Lockdowns will slow down economic activity and demand for metals. So far, however, copper - widely used in the nation’s large property sector - seems to have been untouched by activity in China. This is likely due to low inventory levels, the Ukraine crisis, and political uncertainty in the copper rich countries of Peru and Chile, which has slowed investment activity in the region. According to BCA’s China Investment Strategy, China’s zero-tolerance COVID policy will lead to frequent lockdowns and outweigh the positive effects of stimulus, given the high transmissibility of the Omicron variant now spreading there. Copper demand growth likely slows in China, but outside China demand for steel and base metals is holding up.. Chart 8 EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Footnotes 1     Please see Surging Metals Prices And The Case For Carbon-Capture, which we published 13 May 2021. It is available at ces.bcaresearch.com. Nordhaus is the 2018 Nobel Laureate in Economics in 2018. Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016. The intellectual and computational framework for this technology was developed by Nordhaus. 2     Please see Geopolitics of The Energy Transformation: The Hydrogen Factor, published by IRENA. 3    Please see Green Hydrogen Cost Reduction: Scaling Up Electrolyzers to Meet the 1.5°C Climate Goal, published by IRENA. 4    Please see Ukraine war | Green hydrogen 'now cheaper than grey in Europe, Middle East and China': BNEF, published by rechargenews.com on March 7, 2022.  5    https://www.irena.org/newsroom/pressreleases/2022/Jan/Hydrogen-Economy-… 6    Please see Hydrogen: Future of Clean Energy or a False Solution? published by Sierra Club 5 January 2022. 7     Please see Green hydrogen has long been hyped as a replacement for fossil fuels. Now, one of the industry’s biggest players is preparing its IPO published by Fortune on January 10, 2022. 8    Please see Global Hydrogen Review 2021 published by IEA November 2021. 9    Please see Hydrogen Economy Hints at New Global Power Dynamics published by IRENA on January 15, 2022. 10   Please see Hydrogen could replace 20% of natural gas in the grid from next year published by Institution for Mechanical Engineers 14 January 2022. 11    See footnote #9. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Executive Summary Europe Is Russia's Key Gas Customer Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Full-on rationing of natural gas by Germany took a step closer to reality, as the standoff with Russia over its insistence on being paid in roubles for gas plays out. News that Germany initiated its first step toward rationing spiked European and UK natgas prices by more than 12% on Wednesday. Higher prices for coal, oil and renewable energy will follow, as these energy sources compete at the margin with natgas in Europe. Inflation and inflation expectations will move higher if Germany ultimately rations scarce natgas supplies. We are watching to see who blinks first – Germany or Russia. The risk of aluminum-smelter shut-downs in Europe once again is elevated. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week. This will further confound the energy transition. Western governments will be forced to accelerate investments and subsidies in carbon-capture technology as fossil-fuel usage and prospects revive. Bottom Line: Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets.  This is throwing up confusion around the global renewable-energy transition and extending its timetable.  Fossil fuels fortunes are being revived, as a result. We remain long commodity index exposure and the equities of oil-and-gas producers and base-metals miners.   Feature Events in the EU natural gas markets are changing rapidly in the wake of fast-changing developments in the Russia-Ukraine war.  In the wake of these changes, economic prospects for Europe and Russia are rapidly evolving – both potentially negatively over the short run. Full-on rationing of natural gas by Germany took a step closer to reality, as its standoff with Russia over payment for gas in roubles plays out.  News Germany is preparing its citizens for rationing spiked European and UK natgas prices by more than 12% Wednesday. It's not clear whether Russia or Germany are bluffing on this score.  Russia's oil and gas exports last year accounted for close to 40% of the government's budget. According to Russia's central bank, crude and product revenue last year amounted to just under $180 billion, while pipeline and LNG shipments of natgas generated close to $62 billion last year.  Europe is Russia's biggest natgas market, accounting for ~ 40% of its exports.  However, as the relative shares of revenues indicate, natgas exports are less important to Russia than crude and liquids exports.  Losing this revenue stream for a year would amount to losing ~ $25 billion of revenue, all else equal.  In the event, however, the net loss might be lower, since this would put a bid under the natgas market ex-Europe, which would offset part or most of the lost natgas sales to Europe.  If Russia is able to re-market those lost volumes, it could offset the loss of European sales. Knock-On Effects The immediate knock-on effect of this news turns out to be higher prices for oil, UK and European natgas.  This is not unexpected, as gasoil competes at the margin with natgas in space heating markets, while competition across regions also can be expected to increase.  Once again, the risk of aluminum-smelter shut-downs in Europe is elevated if rationing is imposed by Germany.  Other metals-refining operations also are at risk of shutdown if rationing is invoked.  Lastly, fertilizer production in Europe would be materially impacted, given some 70% of fertilizer costs are accounted for by natgas. In addition to these endogenous EU effects, trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week.1 This will further confound the energy transition as the world's third-largest aluminum smelter faces sanctions – official and self-imposed – and the loss of inputs from Western suppliers, along with reduced access to capital and funding from the West. If, over time, Russia's base metals industries are degraded by the lack of access to capital and technology as oil and gas will be, the global renewable-energy transition will be slowed considerably.   We already expect Russia's oil and gas production to fall over time due to the economic isolation created by Russia's invasion of Ukraine, rendering it a diminished member of OPEC 2.0.  Russia accounts for ~ 10% of global crude oil supplies, and is the second largest producer of crude oil in the coalition.  A long-term degradation of its production profile will exacerbate the persistent imbalance between demand relative to supply globally, which continues to force oil inventories lower (Chart 1). On the metals side, Russia accounts for 6%, 5% and 4% of global primary aluminum, refined nickel and copper production.  Persistent supply deficits have left inventories in these markets – particularly nickel and copper – tight and getting tighter (Chart 2).2 Chart 1Oil Inventories Remain Tight... Oil Inventories Remain Tight... Oil Inventories Remain Tight... Chart 2… As Do Metals Inventories Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Europe's Radical Pivot In a little over a month's time, the EU has been forced to abandon once-immutable post-Cold War beliefs shared by the electorate and politicians of all stripes.  Ever-deepening commercial ties with Russia did not ensure EU energy security, nor did they obviate what arguably is any state's primary responsibility: Protecting and defending its citizens.  Because of its failed engagement policy with Russia over the post-Cold War interval, the EU is forced to scramble to restore its energy production and expand its sources of energy imports.  In addition, it is repeatedly asserting its intent to "double down" of the speed of its renewable-energy transition.  And, last but certainly not least, it is forced to rapidly rearm itself in industrial commodity markets that are in the midst of prolonged physical deficits and inventory drawdowns.3 The Russian invasion of Ukraine spurred the EU to action on both the energy and defense fronts.  It is rushing head-long into eliminating its dependence on Russia for fuel, particularly natural gas, and will pursue re-arming its member states forthwith (Chart 3).  Chart 3Weaning EU Off Russian Gas Will Prove Difficult Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas On the energy front, the EU adopted a two-prong approach to cleave itself from Russian natgas: 1) Diversify its sources of natural gas, which largely will be in the form of liquified natural gas (LNG), and 2) doubling down on renewable energy generation. EU officials are aiming to replace two-thirds of their Russian gas imports by the end of this year, which is an ambitious target.  Over the next two years or so, EU officials hope to fully wean themselves from Russian natgas via a combination of infrastructure buildouts and a renewed push to increase domestic production, which was being throttled back by earlier attempts to secure increased Russian supplies, and a strong focus on renewables. EU's US LNG Deal The EU signed a deal with the US to receive an additional 15 Bcm of natural gas in 2022, and 50 Bcm annually by 2030, which is equal to ~ 30% of the EU’s 2020 Russian gas imports.  How exactly this will be done is unknown. In 2021, the EU imported 155 bcm of natgas from Russia, or more than 3x the amount being discussed with the US; 14 bcm of that was LNG.4 Just exactly what meeting of the minds was achieved between the EU and US government is totally unclear at this point.  The US is not an LNG supplier, nor can it order private companies to renege on existing contacts.  The US government likely will use its good offices to attempt to persuade Asian buyers to allow their contracted volumes to be diverted to European buyers, but that would, in all likelihood, mean they would switch to another fuel (e.g., coal) as an alternative if they take that deal.  This would, we believe, require some sort of financial incentive to induce such behavior. US liquefaction capacity is also running at near full capacity (Chart 4). While there are projects in the pipeline, in the medium-term (2 – 5 years) the lack of export capacity will act as a constraint to the amount of LNG that can be shipped to the EU. Chart 4Europe Critical To Russia's Gas Industry Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas For Russia, its shipments of gas to OECD-Europe represent more than 70% of its exports (Chart 5). Arguably, Europe is just as important to Russia as Russia is to Europe.  With the EU set on a course to sever ties completely, Russia will be forced to invest in pipeline capacity to take more of its gas to China via the Power of Siberia 2 pipeline. In the short-term, US LNG exports to the EU will face headwinds since much of Central and Eastern Europe rely on piped gas from Russia. As a result, many countries within Europe are not equipped with sufficient regasification facilities and are running at near peak utilization rates (Chart 6).  Germany does not have any such capacity.  Chart 5Not Much Room For US LNG Exports To Grow… Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Chart 6…Or For Additional European LNG Imports Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas LNG import facilities that have additional intake capacity in the Iberian Peninsula and Eastern Europe do not have sufficient pipeline capacity to move gas inland.  This will require additional infrastructure investment as well.  To deal with this lack of infrastructure, Germany, Italy and the Netherlands are moving quickly to procure Floating Storage and Regasification (FSRUs) to convert LNG back to its gaseous state.  While not the five-year proposition a dedicated LNG train requires to bring on line, setting up FSRUs still could be a years-long process.5 How quickly these assets can be mobilized, and the volumes they can deliver remain to be seen. Investment Implications Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets.  This is throwing up confusion around the global renewable-energy transition and extending its timetable.  Fossil fuels fortunes are being revived, as a result. At this point it is impossible to handicap the odds of a cut-off of Russian natgas to Europe, or its duration if it does occur.  Either way, competitive suppliers to Russia – particularly US shale-gas producers selling into the LNG market and the vessels that transport it – will benefit regardless of the course taken by Germany and Russia on rationing. We remain long commodity index via the S&P GSCI and COMT ETF, and the equities of oil-and-gas producers and base-metals miners via the PICK, XME and XOP ETFs.   Commodity Round-Up Energy: Bullish Oil prices were whipsawed by new reports suggesting Russia would substantially reduce its military operations in Kyiv ahead of ceasefire talks with Ukraine, only to have that speculation dashed by US officials indicating nothing had changed in the status quo to warrant such a view.  Markets restored the risk premium that fell out of prices on the unwarranted speculation, with Brent prices once again above $110/bbl this week.  At present, the fundamental oil picture remains tight.  In the run-up to a decision from OPEC 2.0's March meeting today, we continued to expect  KSA, the UAE and Kuwait to increase production by up to 1.6mm b/d this year, and another 600k b/d next year.  To date, OPEC 2.0 has fallen short by ~ 1.2mm b/d since it started returning production taken off line during the pandemic.  In return for higher output, we continue to expect the US to deepen its commitment to defending the Gulf Co-operation Council (GCC) states making up core-OPEC 2.0.  If we do not see an increase in core-OPEC 2.0 production, we will have to re-assess our fundamental outlook on KSA's, the UAE's and Kuwait's ability to increase production.  We also will have to determine whether – even if the supply is available to return to the market – these states have embraced a revenue-maximization strategy, given the fiscal breakeven price for these states now averages ~ $64/bbl.  It also is possible that heavily discounted Russian crude oil – trading more than $30/bbl below Brent (vs. the standard $2.50/bbl Urals normally commands) – convinces core-OPEC 2.0 states that oil prices are not so high for large EM buyers like India and China as to create demand destruction.  We believe the latter view likely is prevailing at present.  We continue to expect Brent to average $93/bbl this year and next (Chart 7). Base Metals: Bullish BHP Group Ltd. will invest more than $10 billion to expand metals production over the next 50 years in Chile.  The metals giant aims to stay ESG compliant, provided there is a supportive investment environment provided by the Chilean government. Resource-rich Latin American countries such as Chile and Peru have elected left-leaning governments intent on redistributing mining profits and ensuring companies comply with the ESG framework. As Chile considers raising mining royalties and redrafts its constitution, mining investment in the country has stalled. Political uncertainty in these countries has coincided with low global copper inventories (Chart 8) and high demand. Chart 7 Higher Prices Expected Higher Prices Expected Chart 8 Copper Inventories Moving Up Copper Inventories Moving Up     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see Aluminum Giant Rusal Flags Stark Risks Triggered by War in Ukraine published by Bloomberg on March 30, 2022. 2     Please see our Special Report entitled Commodities' Watershed Moment, published on March 10, 2022.  It is available at ces.bcaresearch.com. 3    Please see footnote 2. 4    Please see How Deep Is Europe's Dependence on Russian Oil? published by the Columbia Climate School on March 14, 2022. 5    Please see Europe battles to secure specialised ships to boost LNG imports published by ft.com 28 March 2022.  Germany appears to be most advanced in its procurement of FSRU capacity, and is close to concluding a deal that would allow it to regasify 27 bcm annually.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Executive Summary Earnings Growth Outpacing Multiple Expansion Energy: After Seven Lean Years (Part II) Energy: After Seven Lean Years (Part II) The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0 translate into a price of oil anchored at around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of US producers. High prices have also created an opening for US Energy producers to restart Capex to increase production. Further, the Energy sector tends to outperform in an environment of high inflation and rising rates. As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities.  The favorable macro backdrop is also complimented by bombed-out valuation. Meanwhile, technicals are overbought signaling that a near-term pause is needed for prices to reset. Bottom Line: We reiterate our cyclical overweight in the Energy sector, despite the rising probability or a near-term pullback. Within Energy, we recommend a cyclical overweight of the upstream and equipment & services segments, underweight midstream, and equal weight downstream and integrated stocks.  Feature Dear client, In lieu of the February 28th publication, we will be sending you a Special Report on Wednesday, February 23rd written by our US Political Strategy service colleagues. Our regular weekly publication will resume Monday, March 7th. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy Part I Recap Last week, in Part I of this Special Report, we described the structure of the Energy sector, its value chain, key industry drivers, and supply/demand/oil price dynamics. The Energy value chain consists of four distinct segments, with each segment corresponding to a section of the oil production value chain. The GICS classifies them as Oil & Gas Exploration and Production (Upstream or E&P), Oil & Gas Equipment and Services (E&S), Storage and Transportation (Midstream or S&T), and Refining and Marketing (Downstream or R&M). Integrated Oil & Gas straddles the entire supply chain (Integrated). Demand exceeds supply: We concluded that crude oil demand is expected to return to trend, driven by strong economic growth and the receding pandemic. In the meantime, production remains suppressed because of curtailments by OPEC 2.0 members, investment restraint from US producers, and multiple supply disruptions. Sizzling tensions with Iran, Russia, and a possible new market share war with the Saudis exacerbate supply problems and lead to heightened volatility in crude oil prices. The US Energy producers are ramping up supply: To meet the increasing oil demand, US shale oil producers are now perfectly positioned to pick up the slack in supply. To ramp up production, the US oil companies will have to invest in new and existing wells, starting a new Capex cycle, after “seven lean years” of Capex (Chart 1). There are early signs that the US Energy sector is in the early innings of new Capex and production. This week, we rely on our investment process, i.e., analysis of the macroeconomic backdrop, fundamentals, valuations, and technicals to shape our view on each segment of the Energy value chain. We are currently overweight the Energy sector and are ahead of the benchmark by 35%. Chart 1The Energy Industry Is In The Early Innings Of New Capex Cycle The Energy Industry Is In The Early Innings Of New Capex Cycle The Energy Industry Is In The Early Innings Of New Capex Cycle Macroeconomic Backdrop Can Withstand Rising Rates And High Inflation The Energy sector tends to outperform in the environment of high inflation and rising rates (Chart 2). As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities. Appreciating Dollar Is A Temporary Phenomenon There is a tight inverse relationship between the USD and energy prices due to the simple fact that commodity prices are quoted in dollars. Over the past seven years, the nominal WTI oil price has been over 70% inversely correlated with the strength of the USD trade-weighted index (TWI), with a beta of oil to USD of -1.6. That is, a 1% change in the TWI would be expected to translate into a $1.60/barrel change in the price of WTI (Chart 3). Chart 2The Energy Sector Is Resilient To Rising Rates Energy: After Seven Lean Years (Part II) Energy: After Seven Lean Years (Part II) Chart 3Price Of Oil And USD Are Inversely Correlated Price Of Oil And USD Are Inversely Correlated Price Of Oil And USD Are Inversely Correlated According to the BCA Research FX Strategy team, the recent dollar strengthening is a temporary phenomenon, catalyzed by the rising interest-rate differential with the rest of the world. However, historically, equity portfolio flows have been more important than other factors in explaining dollar moves. Rising rates undermine the performance of US equities and are likely to lead to a reversal in cross-border equity flows, damaging the key pillar of support for the dollar. Hence, risks to the dollar are on the downside. Fundamentals And Valuations The Energy Sector Is Enjoying Strong Sales EIA reports that “global oil consumption outpaced oil production for the six consecutive quarters, ending with the fourth quarter of 2021 (4Q21), which has led to persistent withdrawals from global oil inventories and significant increases in crude oil prices”.1 As a result of higher production, and WTI prices increasing from $52 to $85 over 2021, energy company sales have soared (Chart 4). Looking ahead, we expect sales growth to remain robust, albeit lower than in 2021: Not only are comparables more challenging, but economic growth is also decelerating. What can bring the strong sales growth to a halt? The answer is that it may be either higher prices or higher volumes: Surging prices destroy demand while surging volumes suppress oil prices, which, eventually, weigh on Capex and production. At the moment, both production levels and price are in a sweet spot: All segments of the value chain are benefiting from high but not excessive prices and volumes. Chart 4Energy Sales Surged In 2021 Energy Sales Surged In 2021 Energy Sales Surged In 2021 Chart 5Sector Profitability Is Tied To The Price Of Oil Sector Profitability Is Tied To The Price Of Oil Sector Profitability Is Tied To The Price Of Oil Profit Recovery Continues The overall profitability of the Energy sector is also tightly linked to the price of oil (Chart 5). The BCA Research house view is WTI centered around $80-85, with substantial volatility triggered by geopolitical tensions. With oil prices likely peaking, barring any negative geopolitical developments, earnings growth normalization off the high levels is expected (Chart 6). However, even if they are slowing, Energy sector earnings are expected to grow by 26% over the next 12 months, exceeding S&P 500 earnings by 17%. Further, over the next five years, energy earnings growth is expected to re-accelerate towards the 26% range. Chart 6Energy Sector's Earnings Growth To Exceed The Market's Energy Sector's Earnings Growth To Exceed The Market's Energy Sector's Earnings Growth To Exceed The Market's Chart 7Margins To Continue To Expand Margins To Continue To Expand Margins To Continue To Expand Importantly, sector operating margins are expected to expand towards 10% (Chart 7), which is quite a feat considering the broad-based margin contraction of the other S&P 500 sectors and industries. Our verdict? Earnings growth expectations look darn good! Despite Recent Outperformance, Valuations Are Still Attractive The BCA valuation indicator, which is a composite of P/B, P/S, and DY relative to the S&P 500, standardized relative to its own history, shows that the sector is still undervalued (Chart 8), despite a recent run of performance – earnings growth still outpaces multiple expansion (Chart 9). The energy sector is currently trading with a nearly 40% discount to the S&P 500 (Table 1) on a forward earnings basis (12.4x vs 20.3x). Chart 8Still Undervalued… Still Undervalued… Still Undervalued… Chart 9Earnings Growth Outpacing Multiple Expansion Energy: After Seven Lean Years (Part II) Energy: After Seven Lean Years (Part II) Table 1Valuation Summary Energy: After Seven Lean Years (Part II) Energy: After Seven Lean Years (Part II) Cheap But Overbought! Curiously, despite modest valuations, from a technical standpoint the sector appears overbought (Chart 10). Worse yet, our Energy Sentiment Composite is outright in the bullish zone (Chart 11) with a reading last achieved in 2009. This is certainly concerning, as euphoria is inevitably followed by panic and disappointment. However, we need to keep in mind that the technical indicators are short term in scope by design, and their main use is to help refine the position entry and exit timing. Chart 10...But Overbought! ...But Overbought! ...But Overbought! Chart 11Sentiment Is Extended Sentiment Is Extended Sentiment Is Extended Why such a pronounced dichotomy with valuations? Technical indicators are based on returns, which have been rather outstanding for the sector, while valuations take into account earnings growth, which explains and justifies the surging returns. Too Much Cash Our analysis would be amiss if we did not bring energy companies’ free cash flow (FCF) into the discussion. With a curtailed supply of energy and rising prices, these companies have been awash in cash (Chart 12) – their FCF has increased by nearly 80% year over year, and profits have surged. What will companies do with this windfall? Well, first and foremost, during the seven lean years of extreme Capex discipline, these companies have gotten their commitment to returning cash to shareholders embedded in the corporate psyche, which is something that is unlikely to change fast. Energy continues to be the highest-yielding sector in the S&P 500 (Chart 13). However, having learned the lesson the hard way, many companies are adopting variable dividends to avoid potential disappointment if the oil price collapses. In addition to disbursing cash, the energy companies are paying off debt and are investing in expanding production. Chart 12Windfall Of Cash Windfall Of Cash Windfall Of Cash Chart 13Energy Is The Highest Yielding Sector Energy: After Seven Lean Years (Part II) Energy: After Seven Lean Years (Part II) Investment Outlook By Segments Of The Energy Value Chain The macroeconomic backdrop for Energy appears benign, with rates rising, inflation elevated, and the dollar likely contained. The sector also appears attractive from both a profitability and a valuation standpoint. However, a near-term pullback is likely as the sentiment around the sector is overly bullish – but that is likely to be short-lived. While we like the sector overall, we aim to provide granular industry group recommendations. To do so, we will zoom in on each segment of the value chain. Oil And Gas Exploration & Production (Upstream) Strong demand recovery and OPEC 2.0 oil production shortages bode well for the US E&P companies, which are cautiously starting to restart capital investment and ramp up production. We expect the E&P, especially shale oil production, companies to be one of the best performing energy subsectors, with WTI anchored around a consensus of $80-85/bbl. The upstream segment is highly dependent on the price of oil, which is currently in a sweet spot: High but not high enough to cause demand destruction (Chart 14). With oil prices peaking, E&P sales growth is decelerating (Chart 15). However, upstream also benefits from the sustainable cost reductions achieved through improved experience in well siting, drilling, and completion techniques. Chart 14Upstream Earnings Depend On The Price Oil Upstream Earnings Depend On The Price Oil Upstream Earnings Depend On The Price Oil Chart 15Sales Growth Is Normalizing Sales Growth Is Normalizing Sales Growth Is Normalizing As a result of growing, albeit decelerating, sales and effective cost management, E&P is one of the most profitable segments of the energy complex: Operating margins are currently at 22% and are expected to expand to 27% (Chart 16). From a valuation standpoint, the industry is trading at 10 times forward earnings, which represents an 50% discount to the S&P 500. The BCA valuation indicator for the industry group is also in the undervalued territory (Chart 17). Chart 16Margins To Continue To Expand Margins To Continue To Expand Margins To Continue To Expand Chart 17E&P Is Still Cheap E&P Is Still Cheap E&P Is Still Cheap Overweight Oil and Gas Exploration & Production industry Equipment And Services Is A High Octane Play On The New Capex Cycle Upstream Capex is revenue for E&S companies. After “seven lean years” of the Capex cycle, the fortunes of E&S companies are finally turning, with a rising price of oil finally enticing upstream companies to expand production by reopening existing and drilling new wells (Chart 18). According to CFRA, upstream Capex is expected to increase by 25% in 2022, and 7% in 2023. With the new energy Capex cycle in sight, Oil Services is the only energy segment for which sales growth is expected to accelerate over the coming year (Chart 19). In fact, sales will continue to grow at a healthy clip until the cycle matures – a time period measured in years. Chart 18Capex Has Restarted Capex Has Restarted Capex Has Restarted Chart 19Sales Growth Is Rebounding Sharply Sales Growth Is Rebounding Sharply Sales Growth Is Rebounding Sharply   The profitability of the sector is also normalizing after a pandemic slump, and margins are expected to stay flat (Chart 20) despite industry labor costs rising sharply to 8% year over year (Chart 21). Earnings are expected to rise by a third in 2022, albeit off very low levels. Chart 20Profit Margins Will Stabilize Profit Margins Will Stabilize Profit Margins Will Stabilize Chart 21Rising Wages Are Cutting Into Profitability Rising Wages Are Cutting Into Profitability Rising Wages Are Cutting Into Profitability In terms of valuations, the E&S industry is one of the cheapest in the sector, with the BCA Valuations Indicator standing at -1.5 standard deviations below a long-term average. We are positive on the Energy Equipment and Services space, which we consider a high octane play on the upcoming production increases and the new energy cycle. Overweight Energy Equipment and Services Storage And Transportation Will Benefit From Rising Production Volumes The midstream segment is one of the most profitable in the energy supply chain. This industry has high fixed costs, and its profitability is a function of production volume, not oil price. (Chart 22). From that standpoint, the industry is in a good place: US production volume, especially of shale oil, is poised to increase, filling the pipelines and driving sales growth. However, there are also challenges: Pipelines installed in older shales start to see original contractual commitments expiring, resulting in lower cash flows as the pipelines try to re-commit suppliers within a market that has an abundance of pipeline capacity. On the cost side, the S&T segment is seeing an increase in labor costs, with average hourly earnings (AHE) rising close to 10%. Chart 22Production Volume Is A Driver Of Midstream Segment's Profitability Production Volume Is A Driver Of Midstream Segment's Profitability Production Volume Is A Driver Of Midstream Segment's Profitability With challenges on the sales side and rising costs, it is not surprising that the market expects earnings in the S&T industry to stay flat over the next year or so (Chart 23). Operating profit margins will contract over the next year from the 19% the industry is enjoying now to roughly 14% (Chart 24). Chart 23Midstream Earnings Are To Stay Flat Midstream Earnings Are To Stay Flat Midstream Earnings Are To Stay Flat Chart 24Industry Is Highly Profitable But Margins Are Contracting Industry Is Highly Profitable But Margins Are Contracting Industry Is Highly Profitable But Margins Are Contracting In addition, it is important to note that pipelines run through public land. The recent tightening of EPA regulations and an administration hostile to fossil fuel may halt or slow down pipeline build-out. This may be a short-term negative as some companies may have to forego some of their investments. Over the long run, this may limit pipeline availability and lead to higher energy transportation and storage costs. Underweight Energy Storage and Transportation Industry Energy Refining And Marketing– Favorable Backdrop But No Oomph Similar to the midstream segment, refiners are a high fixed cost operation, and their business is only loosely dependent on the price of oil. Profitability of downstream companies is a function of capacity utilization of the refining facilities, and the crack spread or price differential between the price of crude and refined oil. Thanks to rising demand for oil, and rising volumes, capacity utilization stands at nearly 90% and is approaching pre-pandemic levels (Chart 25, bottom panel). Crack spreads are also high in absolute terms thanks to low inventories (Chart 25, top panel). Chart 25High Capacity Utilization and Wide Crack Spreads Are A Boon For Downstream… High Capacity Utilization and Wide Crack Spreads Are A Boon For Downstream… High Capacity Utilization and Wide Crack Spreads Are A Boon For Downstream… Chart 26...But Razor-Thin Margins Make The Industry Vulnerable ...But Razor-Thin Margins Make The Industry Vulnerable ...But Razor-Thin Margins Make The Industry Vulnerable With the upstream segment ramping up production, refining volumes should increase, further improving capacity utilization. And while margins are razor-thin, they are projected to increase over the next year (Chart 26). The key concern about the industry is that, with margins this narrow, there is little or no buffer to absorb changes in crack spreads or capacity utilization should oil prices rise or volumes decline. And yet, downstream, while cheap, is more expensive than Oil Services, midstream, or Integrated Oil. Equal-weight Energy Refining and Marketing industry Integrated Oil & Gas Is A Safe Bet Integrated Oil is an industry that is diversified across all the segments of the value chain. The characteristics that allowed Integrated Companies to maintain their stock prices better during the downturn – less financial leverage, less reinvestment volatility, stronger dividend support, and counter-cyclical improvement of downstream operations – will work against these stocks during an oil price recovery. As such, while Integrated stocks should benefit from higher prices and production volumes, this is a lower beta proposition: It is better to own Integrated Oil on the way down, but riskier and higher beta E&P or Oil Services stocks during the up leg of the energy cycle. Equal-Weight Integrated Oil & Gas Investment Implications The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0, translates into a price of oil anchored around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of the US producers. Rising oil prices had resulted in windfall profits and surging free cash flow, which the Energy companies are dutifully returning to shareholders. High prices have also created an opening for US Energy producers to restart their Capex to increase production. This positive stance of upstream companies is benefiting the entire supply chain. Energy Equipment and Services providers are enjoying accelerated sales growth as E&P increases Capex. Transportation and storage companies are benefiting from higher volumes. And last, the downstream segment benefits from high-capacity utilization of its refineries and wide crack spreads thanks to low refined oil inventories. We are cyclically positive on the Energy sector, the fundamentals of which are solid, and for which valuations are modest. However, overextended technicals indicate that a near-term correction after a strong run is highly likely. We won’t sell to avoid the pullback but will use it as an opportunity to add to the existing positions. Within the Energy Sector, we are constructive on the upstream and E&S segments, both of which benefit from the high price of oil. We are less keen on the midstream segment, which, despite the benefits of increased production volume, is handicapped by rising labor costs, and expiring transportation contracts. And lastly, we are equal-weight the downstream segment, which, despite rising volumes and wide crack spreads, has razor-thin margins. Integrated Oil is the most diversified segment, which is more resilient during the down leg of the energy cycle, but too tame during the upcycle. Bottom Line We recommend a cyclical overweight to the Energy sector as it is in the early innings of the new energy cycle, thanks to surging demand and constrained production capacity out of the US. It is also the highest yielding sector in the S&P 500. However, a near-term pullback after a strong run is likely – we will leverage it to add to our existing overweight. We also recommend a cyclical overweight of the upstream and Oil Equipment & Services segment, underweight midstream, and equal weight downstream.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     https://www.eia.gov/outlooks/steo/   Recommended Allocation

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Risk Premium In EU Gas Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase ​​ Regardless of whether Russia invades all, part of or none of Ukraine again, its current standoff with the West will force the EU to reconfigure its gas markets to assure reliability of supplies, and remove geopolitical supply disruptions. We expect the EU's renewable energy taxonomy scheduled for release Wednesday will include natgas as a sustainable fuel, which will help build more diversified sources of supply and deeper spot and term markets.  Success here will increase market share of natgas in EU power generation. In the short run (1-2 years), neither the EU nor Russia can afford Gazprom's pipeline supplies to be significantly curtailed. Over the medium term (3-5 years), alternative supplies from US and Qatari LNG exports will be required to deepen EU gas-market liquidity and supply. Longer term (i.e., beyond 2025), EU energy markets will remain volatile as the renewable-energy transition progresses. High and volatile natgas prices will translate into persistent EU inflation – particularly food prices, because of higher fertilizer costs, and base metals' prices.  Shortages in these markets will slow the energy transition, and raise its price tag. Bottom Line: The Russian standoff with the West over Ukraine puts a higher risk premium in EU gas prices.  We remain long commodity-index exposure (S&P GSCI, and COMT ETF), and the XME ETF.  We are getting long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) at tonight's close. Feature We expect the EU's financial taxonomy for renewable energy scheduled for release Wednesday will include natgas as a sustainable fuel. This will help in building out more diversified sources of supply and deeper spot and term markets. Success here will increase the market share of natgas in the EU's power generation (Chart of the Week). This coincides with natural gas supply uncertainty, arising from geopolitical tensions. On the back of already-low inventory levels, European natural gas markets are forced to handicap the odds of a major curtailment of Russian pipeline gas supplies resulting from another invasion of Ukraine (Chart 2).  This is keeping a significantly increased risk premium embedded in natgas prices: Russian exports to the EU account for 40% of total gas supplies.  Germany is particularly exposed, as  ~65% of its gas comes from Russia (Chart 3). Chart of the WeekEU Natgas Generation Will Rise In Energy Transition Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase BCA’s Geopolitical Strategy desk upgraded the odds of Russia invading Ukraine to 75% from 50% in its latest research report.1  Our colleagues, however, keep the probability of Russia invading all of Ukraine low.  Their analysis concludes Russia will only invade a part of Ukraine, so as to argue for lighter sanctions being imposed on it by the West, as opposed to having to incur the full wrath of US and EU sanctions.  The other 25% of the probability space includes a diplomatic settlement between the West and Russia. Chart 2Risk Premium In EU Gas Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase While Russia has been trying to diversify its customer base – by increasing natgas exports to China, e.g. – data from the BP Statistical Review of World Energy shows ~ 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020.2  Chart 3EU Highly Dependent On Russian Gas Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase In light of the fact that Russia likely will face watered-down sanctions, and the EU’s gargantuan share of total Russian exports, we do not believe Europe’s largest natural gas exporter will stop all supply to the EU now or in the near future. In case Russia does go through with its invasion, it likely will cut off natural gas supply to Ukraine, implying Europe will loose slightly more than 6% of total natgas imports as opposed to 40% in the event of a halt to all natgas exports to Europe (Chart 4).  Gas consumption of the EU-27 in 2021 was ~ 500 Bcm, according to the Oxford Institute For Energy Studies (OIES).  Some 85% of EU gas consumption was met by imports. Chart 4Imports Cover Most EU Gas Consumption Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Can The EU Mitigate The Loss Of Russian Gas? The EU and the US have entered discussions with other countries to plug the potential 6% reduction in imports from Russia.  While in theory, there is enough spare pipeline capacity to import natural gas from existing and new sources (Chart 5), practical limitations may prevent this from occurring.3 The US is working with the EU to ensure energy supply security in case Russia cuts off natural gas supply. However, as can be seen in Chart 6, Panel 1, the US currently is and likely will continue to export nearly at capacity until end-2023. Panel 2 shows global liquefaction also is nearly at capacity. Chart 5EU Gas Import Capacity Exists, But Filling It Will Be Problematic Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Chart 6US LNG Export Capacity Maxed Out Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase While an increase in gas production at the earthquake-prone Groningen field in the Netherlands is theoretically viable, it will induce a public backlash, as was evidenced when the Dutch government announced plans to double output from the field earlier this year. In the short run, facing few sources of alternate gas supply, the EU will need to focus on curtailing demand. Fossil fuels will need to be considered as an alternative for electricity and heating, since nuclear is not used in all EU countries.  The depth of this crisis and the Dutch TTF price rise will be capped by the fact that we expect the EU to lose a relatively small fraction of total imports.  Further, while we expect Dutch TTF prices to be volatile and face upward pressure, any price increases also will be capped by the fact that the colder-than-expected Northern Hemisphere winter has not yet materialized, and the warmer Spring and Summer months will be approaching soon. Medium-, Long-Term EU Gas Supply On the supply side, over the medium- and long-term, the EU will need to deepen and stabilize its gas supply, so that firms and households can rationally forecast and allocate spending and investment.  This would include finding back-up or alternative supplies to Russian imports, which carry with them uncertain geopolitical risk.  If Brussels includes natural gas as a sustainable fuel in its energy taxonomy, over the medium term (3-5 years), alternative supplies from US and Qatari LNG exports will be required to deepen EU gas-market liquidity and supply.  Longer term (i.e., beyond 2025), EU energy markets will remain volatile as the renewable-energy transition progresses.  Natgas will be a critical component of this transition, until utility-scale battery storage is able to support renewable generation and grid stability.  We believe over the remainder of this decade, high and volatile natgas prices will translate into persistent EU inflation, as pricing pressures spill into oil and coal markets at the margin, as happened over the course of last year.  This will work in the other direction as well – e.g., higher coal prices will spill over into gas and oil markets as price pressures incentivize fuel switching at the margin. Food prices will be right in the inflationary cross-hairs, given the fertilizer required to produce the grains and beans consumed globally consists mostly of natgas in urea and ammonia fertilizers (Chart 7).  This will feed into higher food prices (Chart 8). Chart 7High Natgas Prices Will Show Up In High Fertilizer Prices High Natgas Prices Will Show Up In High Fertilizer Prices High Natgas Prices Will Show Up In High Fertilizer Prices Chart 8… And Higher Food Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Base metals' prices also will be upwardly biased as natgas price volatility remains elevated.  Supply shortages in natgas markets will, at the margin, slow the energy transition by reducing reliable energy supplies in the EU, forcing states to compete for back-up and replacement supply in the global LNG markets.  Fuel-switching into oil, gas and coal will transmit EU gas volatility to markets globally. Tight energy and base metals markets also will feed directly into higher inflation and inflation expectations (Chart 9). Chart 9Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher   Investment Implications The standoff between the West and Russia over the latter's amassing of troops on the Ukraine border, plus the marked increase in the tempo of Russian naval operations, will keep the risk premium in EU natgas prices high.  This is not a sustainable equilibrium over the medium- to long-term.  We expect little if any curtailment of Russian natgas exports over the short term; however, prudence suggests EU member states will be forced to find back-up and alternative gas supplies over the medium- to longer-term, as the global renewable-energy transition gains traction. The knock-on effects from the current European geopolitical standoff are keeping EU natgas prices elevated via a higher risk premium to cover possible supply losses.  This will feed into other markets – particularly metals and ags – which will feed directly into inflation and inflation expectations. We remain long commodity index exposure – the S&P GSCI and the COMT ETF – and metals producers via the XME ETF.  At tonight's close, we will be getting long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0's decision to stay with its policy of returning 400k b/d every month appeared to be a foregone conclusion in the markets.  In our January 2022 balances and price forecasts, we anticipated a larger increase, given the producer coalition led by Saudi Arabia and Russia has fallen significantly behind its goal of returning 400k b/d to the market monthly due to declining production among OPEC 2.0 member states ex-Gulf GCC member states, chiefly KSA, UAE and Kuwait (Iraq's exports fell in December and January; production data have not been released).  In the past, KSA has said it will not make up for production shortfalls of OPEC 2.0 member states, and would abide by its production allocation. The upside risk to prices remains, in our estimation, and we continue to expect KSA and its GCC allies to increase output if production from the price-taking cohort led by the US shale-oil producers fails to materialize in over the coming months.  Failure to cover production shortfalls among OPEC 2.0 member states would lift Brent prices by $6/bbl above our baseline forecast, which assumed higher production from the GCC states would be forthcoming at Wednesday's OPEC 2.0 meeting (Chart 10, brown curve). Base Metals: Bullish An environmental committee in Chile's Senate voted out a proposed bill that would, among other things, reportedly make it easier for the government to seize mines developed and operated by private companies.  The proposed legislation still has a long road ahead of it, but copper prices rallied earlier in the week as this news broke.  Even if the odds of the bill's passage are slim, a watered down version of the proposed legislation would markedly change the economic proposition of developing and maintaining copper mines in Chile (Chart 11).  We continue to follow this closely.   Chart 10 Brent Forecast Restored To $80/bbl For 2022 Brent Forecast Restored To $80/bbl For 2022 Chart 11 Bullish For Copper Prices Bullish For Copper Prices     Footnotes 1     Please see All Bets Are Off ... Well, Some (A GeoRisk Update), published by BCA Research's Geopolitical Strategy service 27 January 2022.  It is available at gps.bcaresearch.com. 2     Please see bp's Statistical Review of World Energy 2021 | 70th edition. 3    Norway, the EU’s second largest gas exporter after Russia stated that its natural gas production is at the limit. Apart from the issue of production, current LNG flows will need to be redirected from Asia and the Americas. Defaulting on long-term contracts to redirect fuel to Europe could mire exporters’ relationships with importing countries. Finally,  infrastructure in the Eastern and Central section of the EU may not be equipped to receive supplies from the West, thus increasing costs and time associated with putting these systems in place.    Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Chart 2Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 4… But The Nominal USD Value Rises Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 8 Uncertainty Weighs On Gold Uncertainty Weighs On Gold   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter NatGas: Winter Is Coming NatGas: Winter Is Coming Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal NatGas: Winter Is Coming NatGas: Winter Is Coming US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong US Natgas Exports Remain Strong US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth NatGas: Winter Is Coming NatGas: Winter Is Coming Chart 6US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer NatGas: Winter Is Coming NatGas: Winter Is Coming Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps NatGas: Winter Is Coming NatGas: Winter Is Coming The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Aluminum Prices Recovering Aluminum Prices Recovering Chart 10 Weaker USD Supports Gold Weaker USD Supports Gold       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Alternative energy is priced to deliver spectacular long-term earnings growth, but this will be a very tough ask. While alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. At its current valuation, alternative energy does not meet the conditions to be in a long-term investment portfolio. As the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, such services will have to be paid in ETH giving the token an economic value. ETH should certainly form a small part of a long-term investment portfolio. A near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. Fractal analysis: India versus China. Feature Chart of the WeekThe World Is Using Much Less Energy Per Unit Of Economic Output The World Is Using Much Less Energy Per Unit Of Economic Output The World Is Using Much Less Energy Per Unit Of Economic Output Alternative Energy Blues Alternative energy is the meme theme of the moment. Hardly a day passes without some exhortation to save the planet, by substituting fossil fuels with cleaner forms of energy. Yet this year, alternative energy stocks have performed dismally. Since January, the sector is down 30 percent in absolute terms, and almost 40 percent versus the broad market. Begging the question, how can one of the biggest themes of the moment be one of the worst investment performers? Last year, the forward earnings of the alternative energy sector rose by 35 percent, helped by post-pandemic stimulus measures that targeted the clean energy industry. But as investors fell in love with this meme theme, the bigger story was that the valuation paid for the sector skyrocketed from 13 times forward earnings to a nosebleed 42 times, an increase of 220 percent (Chart I-2 and Chart I-3). Chart I-2Alternative Energy Earnings Rose... Alternative Energy Earnings Rose... Alternative Energy Earnings Rose... Chart I-3...But The Valuation Skyrocketed ...But The Valuation Skyrocketed ...But The Valuation Skyrocketed To put the 42 into context, the peak multiple of the tech sector has reached ‘only’ 29 this cycle, meaning that alternative energy was trading at a near 50 percent premium even to the daddy of growth sectors! This year, as investors have pared back the nosebleed valuation, the alternative energy sector has underperformed. Nevertheless, it is still trading at a 25 percent premium to tech, meaning that its profits will have to deliver spectacular long-term growth to justify the sky-high valuation. Is this likely? We are not convinced. The world is using less energy per unit of economic output. A fundamental rule of long-term investment is that you shouldn’t own any sector whose sales are shrinking as a share of the economy. The problem for alternative energy is that it is, ultimately, energy (Chart I-4). And the world is using less energy per unit of economic output. Chart I-4Alternative Energy And Traditional Energy Show Similar Earnings Profiles Alternative Energy And Traditional Energy Show Similar Earnings Profiles Alternative Energy And Traditional Energy Show Similar Earnings Profiles In 1995, every $1000 of real GDP used 157 kilograms of oil equivalent energy. Today, that has plunged to 109 kilograms. Meaning that over the past 25 years, the world economy has reduced its energy intensity by 30 percent.1 And the downtrend persists (Chart I-1). Granted, over the past 25 years, the share of the energy pie taken by non-fossil fuels has increased from 13.4 to 16.9 percent, of which renewables have increased from 0.6 to 5.7 percent. But the marginal prices of wind, solar, and geothermal power generation are collapsing. As a recent report from the International Renewable Energy Agency (IRENA) points out: Generation costs for onshore wind and solar photovoltaics (PV) have fallen between 3 percent and 16 percent yearly since 2010 – far faster than anything in our shopping baskets or household budgets… (and) auction results show these favourable cost trends continuing through the 2020s.2 Given that the alternative energy market is competitive rather than monopolistic or oligopolistic, a large part of these massive cost savings will be passed on to end-users. Constituting a long-term boon to consumers rather than to alternative energy profits. To repeat, with the alternative energy sector still trading at a 25 percent premium to tech, it must deliver spectacular long-term earnings growth. But this will be a very tough ask. Energy sector profits tightly track the value of energy produced, meaning volume times price (Chart I-5). The risk is that while alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. Chart I-5Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) We conclude that with an ambiguous outlook for long-term earnings growth, alternative energy does not meet the conditions to be in a long-term investment portfolio at its still nosebleed valuation multiple of 32 times forward earnings.  Now let’s turn to an investment that you should have in a long-term investment portfolio. The London Hard Fork Is A Boon For The Ethereum Network The Ethereum network’s London hard fork – an event that passed under most radar screens – marks the shape of things to come for the blockchain and the cryptocurrency space. Crucially, it signals an ongoing sea-change that favours the Ethereum network’s users at the expense of its cryptocurrency miners. For those interested in the nerdy details, we direct you to Ethereum Improvement Protocol (EIP) 1559. But to cut to the chase, the fork has drastically reduced the profitability of Ethereum mining while “ensuring that only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform.” Only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform. The statements of intent address, and will ultimately alleviate, two of the biggest investment concerns about cryptocurrencies – first, that cryptocurrency mining is a prodigious user of energy, particularly dirty energy; and second, that as cryptocurrencies cannot be readily exchanged for goods and services, they have no value other than that from other investors believing they have value. Addressing the first concern, mining becomes irrelevant if the blockchain users employ the skin in the game ‘proof-of-stake’ protocol to validate transactions rather than the energy-intensive ‘proof-of-work’ protocol that relies on external miners. Which is where Ethereum is headed with the fully proof-of-stake Ethereum 2.0. Addressing the second concern, if the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, then such services will have to be paid in ETH, giving the tokens an economic value. Hence, the key structural question is, which blockchain networks will become the go to places for decentralised intermediation? Ethereum is an excellent candidate. Note that the lending arm of the EU, the European Investment Bank, has effectively endorsed the Ethereum network by issuing a €100 million digital bond on it. And although the principal “is expected to be repaid in euros”, the intermediators get paid in ETH. Crucially, the token of a successful blockchain network will become the de-facto currency of the network, exchangeable for intermediation services on that network. With a value independent of speculative investments, investors can also justifiably own these tokens as a ‘digital gold.’ Clearly, cryptocurrencies experience a higher volatility than gold, but this can be adjusted through position sizing. To equalise drawdowns in digital gold versus gold, investors should own $1 of cryptocurrency for every $3 of gold (Chart I-6). On this relative risk basis, cryptocurrencies should constitute at least one quarter ($3.8 trillion) of the $15 trillion ‘anti-fiat’ market that gold currently dominates.  Chart I-6Cryptocurrency Drawdowns Are Becoming Less Severe Cryptocurrency Drawdowns Are Becoming Less Severe Cryptocurrency Drawdowns Are Becoming Less Severe Therefore, if Ethereum became the dominant cryptocurrency based on its network size, it would command a market capitalisation of at least $1.9 trillion, a more than five-fold increase from today. ETH should certainly form a small part of a long-term investment portfolio. Stocks Versus Bonds Face A Double Constraint Since mid-March the world stock market (MSCI All Country World Index) has rallied by 10 percent, but the ultra-long bond (30-year T-bond) has done even better, rallying by 14 percent. Hence stocks to bonds have drifted gently lower, for which there are two reasons. First, the valuation of the most highly-rated parts of the stock market have reached the limit that has held in the post-GFC era. Specifically, tech’s earnings yield premium versus the 10-year T-bond has reached its 2.5 percent lower bound (Chart I-7). Chart I-7Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Second, the groupthink in overweighting stocks versus bonds reached an extreme. All investors up to 260-day investment horizons are already in the trade, and this level of extreme groupthink correctly signalled stocks versus bonds major-tops in 2010 and 2013 (as well as major-bottoms in 2008 and 2020) (Chart I-8). Chart I-8The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme This near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. In the near term, stocks will struggle to outperform ultra-long bonds. Nevertheless, if bonds rally, it will support stocks. But if bonds sell off, it will undermine stocks. The implication of the above is that a bond sell-off – should it even occur – will be self-limiting. As we explained last week in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields, the upper limit to the 10-year T-bond yield is 1.8 percent. India Trading At A Precarious Premium This week’s fractal analysis highlights that the spectacular outperformance of India versus China has reached the limit of fragility on its 260-day fractal structure that marked previous major-tops in 2014, 2016, and 2019 (as well as major bottoms in 2015, 2018, and 2020) (Chart I-9). Chart I-9The Outperformance Of India Versus China Is Fragile The Outperformance Of India Versus China Is Fragile The Outperformance Of India Versus China Is Fragile In effect, as China’s tech sector has recently corrected, tech stocks in India are now trading at a precarious 60 percent premium to those in China (Chart I-10). Chart I-10India Is Trading At A Precarious Premium To China India Is Trading At A Precarious Premium To China India Is Trading At A Precarious Premium To China The recommended trade is to short India versus China (MSCI indexes), setting the profit target and symmetrical stop-loss at 19 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Source: World Bank, and BP Statistical Review of World Energy 2021 2 Source: Renewable Power Generation Costs In 2019, International Renewable Energy Agency Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 2Global Manufacturers' Prices Moving Higher Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold Weaker USD Supports Gold Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View BCAs Gold Fair-Value Model Supports $2000/oz View BCAs Gold Fair-Value Model Supports $2000/oz View Chart 8Sentiment Supports Oil Prices Sentiment Supports Oil Prices Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 10Wider Vaccine Distribution Will Support Gold Demand Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices Chart 12 Platinum Prices Going Up Platinum Prices Going Up Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases OPEC 2.0s Could Expand If Investor Activism Increases OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Coppers Physical Deficit Likely Persist Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Theoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges  to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it.  Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 8 Gold Prices Going Up Gold Prices Going Up Footnotes 1     Please see Trade Tables below. 2     Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3    Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021.  Peru has seen significant capital flight on the back of these fears.  See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector.  The risk of nationalization is de minimis, according to IHS. 4    Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5    Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy.  It is available at ces.bcaresearch.com. 6    Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7     Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way