Base Metals & Iron Ore

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? ...Could The Same Happen To US Stocks? ...Could The Same Happen To US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse CAD/SEK Could Reverse CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) 6-Month Recommendations Structural Recommendations Closed Fractal Trades 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 The bond market assumes that when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. High inflation is followed by lower than average inflation. This means that the ex-post real yield delivered by 10-year T-bonds will turn out to be much higher than the negative ex-ante real yield that 10-year Treasury Inflation Protected Securities (TIPS) are now offering. Long-term investors should overweight 10-year T-bonds versus 10-year TIPS. Underweight (or outright short) US TIPS. Underweight commodities, and especially underweight those commodities that have not yet corrected. Fractal trading watchlist: the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. Feature Chart of the WeekThe Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected Real interest rates are negative. Or are they? Given that real interest rates form the foundation of most asset prices, getting this question right is of paramount importance. Over the short term, yes, real interest rates are negative. Policy interest rates in the major developed economies are unlikely to rise quickly from their current near-zero levels. So, they will remain below the rate of inflation. But what about over the longer term, say ten years – are long-term real interest rates truly negative? The Real Bond Yield Is The Mirror Image Of Backward-Looking Inflation The negative US real 10-year bond yield of -0.7 percent comprises the nominal yield of 1.8 percent minus an expected inflation rate of 2.5 percent. This means that the negativity of the real bond yield hinges on the expectation for inflation over the next ten years. Therein lies the big problem. Many people believe that the bond market’s expected 10-year inflation rate is an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. Specifically, in the pandemic era, the bond market has derived its expected 10-year inflation rate from the historic six month (annualized) inflation rate, which it assumes will gradually converge to a long-term rate of just below 2 percent during the first four years, then stay there for the remaining six years2 (Figure I-1). We recommend that readers replicate this simple calculation for themselves to shatter any illusion that there is anything forward-looking about the bond market’s inflation expectation! (Chart I-2). Chart I- Chart I-2Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like now or in early-2008, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words, the bond market extrapolates the last six months of inflation into the next ten years. This observation leads to an immediate investment conclusion. The US six-month inflation rate has already peaked. As it cools, it will also cool the expected 10-year inflation rate, thereby putting upward pressure on the mirror image Treasury Inflation Protected Securities (TIPS) real yield. It follows that investors should underweight (or outright short) US 10-year TIPS (Chart I-3). Chart I-3As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform The Real Bond Yield Is Based On A False Expectation There is a more fundamental issue at stake. The market assumes that when recent inflation has been low, it will be lower than average for the next ten years. And when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. The price level is lower than the 2012 expectation of where it would stand in 2022! Another way of putting this is that the market assumes that any breakout of the consumer price index (CPI) will be amplified over the following ten years (Chart I-4). Yet the reality is that any breakout of the price level tends to trend-revert over the following ten years. This means that after the CPI’s decline in late 2008, the market massively underestimated where the price level would be ten years later. But earlier in 2008, when the CPI had surged, the market massively overestimated where the price level would be ten years later. Chart I-4The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future Today in 2022, the price level seems to be uncomfortably high. But the remarkable thing is that it is still lower than the 2012 expectation of where it would stand in 2022! (Chart I-5). Chart I-5The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The crucial point is that after surges in the price level, realised 10-year inflation turns out to be at least 1 percent lower than the bond market’s expectation (Chart I-6). This means that the ex-post real yield delivered by 10-year T-bonds turns out to be at least 1 percent higher than the ex-ante real yield that 10-year TIPS offered at the start of the ten year period (Chart of the Week). Chart I-6Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected It follows that after the current surge in the price level, the (actual) real yield that will be delivered by 10-year T-bonds over the next ten years will not be the -0.7 percent indicated by the TIPS 10-year real yield. Instead, if history is any guide, it will be at least +0.3 percent. Therefore, in answer to our original question, the real long-term interest rate is almost certainly not negative. Of course, the obvious comeback is that ‘this time is different’. But we really wouldn’t bet the farm on it. Many people thought this time is different during the price level surge in early 2008 as well as the lows in late 2008 and early 2020. But those times were not different. And our bet is that this time isn’t any different either. This means that the real yield on T-bonds will turn out to be much higher than that on TIPS. Long-term investors should overweight T-bonds versus TIPS. Commodities Are Vulnerable A final important observation relates to commodities. Commodity prices have been tightly tracking the 6-month inflation rate, but which way does the causality run in this tight relationship? At first glance, it might seem that the causality runs from commodity prices to the inflation rate. Yet on further consideration, this cannot be right. It is not the commodity price level that drives the overall inflation rate, it is the commodity inflation rate that drives the overall inflation rate. And in the past year, overall inflation has decoupled (upwards) from commodity inflation (Chart I-7 and Chart I-8). Chart I-7Inflation Is Tracking ##br##Commodity Prices... Inflation Is Tracking Commodity Prices... Inflation Is Tracking Commodity Prices... Chart I-8...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation Therefore, the causality in the tight relationship between the 6-month inflation rate and commodity prices must run from backward-looking inflation to commodity prices. And the likely explanation is that investors are bidding up commodity prices as a hedge against the backward-looking inflation which they are incorrectly extrapolating into the future. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. It follows that as 6-month inflation cools, so will commodity prices. The investment conclusion is to underweight commodities, and especially to underweight those commodities that have not yet corrected. Fractal Trading Watchlist This week’s observations relate to the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. The US dollar reached a point of fragility in early December, from which it experienced a classic short-term countertrend sell-off. As such, the countertrend sell-off is mostly done. Alternative energy versus old energy is approaching a major buying point. Biotech versus the market is very close to a major buying point. Nickel versus silver is very close to a major selling point. Semiconductors versus technology was on our sell watchlist last week, and has now hit its point of maximum fragility (Chart I-9). Therefore, the recommended trade is to short semiconductors versus broad technology, setting a profit target and symmetrical stop-loss at 6 percent. Chart 9Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Inflation is based on the PCE deflator. Fractal Trading System Fractal Trades Image 6-Month Recommendations Structural Recommendations Closed Fractal Trades 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 Data from the UK revealed it is tantalizingly close to declaring COVID-19 an endemic virus, indicating Britain likely will exit the pandemic ahead of other states soon. The UK is a bellwether market regarding its public-health response to the coronavirus. Some 95% of its population is estimated to carry COVID-19 antibodies (Chart of the Week). Other states – e.g., the US, the EU – have followed the UK with a lag, which we expect will continue. While the Fed's reassurance it will be able to hike rates without disrupting labor markets no doubt encourages markets – and boosted commodity prices – we believe the return to economic normalcy that would be ushed in by endemicity will release pent-up consumer demand for goods and services. This will spur commodity demand. If COVID-19 becomes endemic in enough economies globally, it also would fuel inflation, and inflation expectations.1 Given the tight supplies of industrial commodities – chiefly oil, natural gas and base metals – our assessment of upside price risk is higher now than it was at year-end 2021. We remain long broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Feature Fed Chair Powell's confidence that the US central bank will raise rates and keep inflation under control without destabilizing labor markets stole the show earlier this week. The media credited Powell's remarks for the burst of enthusiasm that lifted commodities as an asset class higher. While none would gainsay the Fed's importance to commodity markets, we would point out the approaching endemicity of COVID-19 in the UK – and the likely follow-on from the US and other large commodity-consuming states – is of equal, if not greater, moment. The UK has been out in front on its public-health response to the COVID-19 pandemic and has become a bellwether in the northern hemisphere; the US will follow. Chart 1 This week, the UK's Office for National Statistics (ONS) reported ~ 95% of England's population tested positive for antibodies to COVID-19 via infection or vaccination in the week beginning 29 November 2021. Similar results were reported for Scotland, Wales and Northern Ireland. This is generally observed in all age cohorts tracked by ONS.2 According to David Heymann of the London School of Hygiene and Tropical Medicine, "population immunity seems to be keeping the virus and its variants at bay, not causing serious illness or death in countries where population immunity is high."3 In a briefing hosted by Chatham House this week, Heymann observed, “And probably, in the UK, it’s the closest to any country of being out of the pandemic if it isn’t already out of the pandemic and having the disease as endemic as the other four coronaviruses” currently in circulation, which are responsible for roughly a quarter of common colds.4 Based on UK government data, the ratios of hospitalizations and deaths to COVID-19 cases has been falling precipitously (Chart 2). This is encouraging, given the sharp increase in cases driven by the rapid spread of the omicron mutant, which appears to be rolling over. Medical experts in the UK suggest the data also point to a possible peaking in the omicron surge. This would lighten the load on hospitals, as well as reduce death rates attributed to the coronavirus (Chart 3).5 Chart 2 Chart 3 Return To Normal? Nothing will return commodity markets to economic normalcy faster than endemicity. If this stays on track over the next month or so, it will spur commodity demand sooner rather than later, as pent-up consumer demand for goods and services is discounted by trading markets. If, as the data appear to indicate, the UK's transition from pandemic to endemic COVID-19 is followed by other states like the US and EU a few months later, we would expect a renewed leg up in the post-pandemic commodities rally. This would be apparent in futures contracts, which already are pricing commodity deliveries a month or more hence. Such a turn of events would force us to accelerate our time table for oil-demand recovery, which we expect will come in 2H22. This could restore our $80/bbl forecast for 2022, and lift our 2023 expectation. We also would have to revisit our copper and base metals view, and bring forward the timing of the copper-price rally we expect will lift COMEX refined copper to $4.80/lb and $6.00/bbl in 2022 and 2023, respectively, on average.6 These industrial commodities would see demand increase amid extremely tight supply conditions. Oil markets are tightening on the back of OPEC 2.0's production discipline, and the inability of many member states to fully restore the 400k b/d every month it signed on for beginning in August of last year, owning to production shortfalls outside the core producers of the coalition (Chart 4). Copper, the base-metals bellwether, remains very tight, as seen in balances (Chart 5) and inventories (Chart 6). Chart 4OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works Chart 5Coppers Physical Deficits Will Persist... Coppers Physical Deficits Will Persist... Coppers Physical Deficits Will Persist... Chart 6Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten China's zero-COVID-19 policy, which has resulted in numerous lock-downs at the local level, has yet to dent oil demand, which, for the time being, is hovering ~ 16mm b/d. We will be updating our oil balances and price forecasts next week, and will have a more extensive analysis of supply-demand balances then. Return Of Speculative Interest Expected With Endemicity Hedge funds have been reducing their exposure to the industrial commodities over the past year, which suggests they either have better alternatives for investing, or did not believe the rallies in commodities over the past year were durable, given the repeated demand shocks visited upon these markets by COVID-19 (Chart 7). We expect that once the pandemic becomes endemic, hedge funds will return to these markets. All the same, given the higher likelihood of price rallies in these markets, we would expect hedge funds to be cited as a cause of higher prices, as typically happens when markets take a sharp leg higher. Regular readers of our research are aware that this generally is not the case – hedge funds follow the news; they don't lead it. This past week we revisited earlier research to see if hedge-fund involvement in commodity markets causes the prices to go up or down to any meaningful degree. And, again, we found no relationship between hedge-fund positioning and the level of commodity prices.7 Chart 7 The presumed influence of hedge funds has been a persistent feature of futures markets in the post-GFC world, following the collapse of commodity prices along with financial markets in 2008. An entire literature has sprung up to explore the influence of these funds on commodity price formation. Below we highlight a few representative articles consistent with our results. Büyüksahin and Harris (2011) show hedge funds and other speculators follow prices – they do not lead them – based on the Granger-causality testing they performed on oil prices and speculative positioning.8 Brunetti et al (2016) argue hedge funds' trading stabilizes markets – i.e., they provide a bid when markets are selling off and an offer when markets are well bid – while swap-dealer trading is uncorrelated with price volatility.9 Knittel and Pindyck (2016) found speculation has reduced volatility in prices since 2004, including during the 2007-08 price run-up.10 Using a straightforward supply-demand-inventory model, they examined cash and storage markets to determine whether speculation had any effect on them or on convenience yields based on cash-vs-futures spreads. They concluded: "We found that although we cannot rule out that speculation had any effect on oil prices, we can indeed rule out speculation as an explanation for the sharp changes in prices beginning in 2004. Unless one believes that the price elasticities of both oil supply and demand are close to zero, the behavior of inventories and futures-spot spreads are simply inconsistent with the view that speculation has been a significant driver of spot prices. If anything, speculation had a slight stabilizing effect on prices." Investment Implications Assuming the UK remains a bellwether for DM economies with reasonably effective vaccine programs, or which have experienced an omicron surge, markets could be close to exiting the COVID-19 pandemic and entering a phase in which the coronavirus is endemic. This would be bullish for demand. And given the extended tightness on the supply side for industrial commodities in particular, it could presage another leg up in prices as economic normalcy returns. We continue to favor broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index.   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 US LNG baseload and peak liquification capacity is expected to rise ~ 13% this year to 11.4 Bcf/d and 13.8 Bcf/d (on a December-to-December basis), based on the EIA's latest estimates. The agency's forecast for LNG exports is up 17.3% to 11.5 Bcf/d this year, and 12.1 Bcf/d in 2023. With these increases in baseload and peak export capacity, the US is set to become the largest exporter of LNG in the world this year, in the EIA's estimation. This will be integral to US foreign policy, particularly in markets where the US competes with Russia for export sales, in our estimation. Within North America, US pipeline gas exports to Mexico and Canada are expected to average just under 9 Bcf/d this year, a 5% increase vs. 2021, and 9.2 Bcf/d in 2023. Base Metals: Bullish In China, seasonally low production, as stainless-steel firms undergo maintenance, and the upcoming Winter Olympics in February are keeping steel production subdued. To compound this supply shortage, tight raw material markets, particularly that of iron ore and nickel are buoying steel prices. Heavy rainfall in southern-eastern Brazil is curtailing iron ore production in the region. After Australia, Brazil is the second largest iron ore exporter to China. Nickel prices hit a 10-year high on Tuesday on the back of falling inventories. An LME outage also precipitated the price rise. Dwindling inventories point to increasing demand for the metal as electric vehicle companies ramp-up production and sales this year, particularly in China, where the government stated it will remove EV subsidies by the end of 2022. According to The China Passenger Car Association, EV sales in the country will double to 6 million this year. Precious Metals: Bullish Based on the December FOMC minutes, the markets are now pricing in a more hawkish tilt from the Fed, and expect an initial rate hike by March. The Fed may also shrink its balance sheet soon after the initial rate hike, in line with its expectation the U.S. economy will recover faster this time around. While higher nominal interest rates and tighter monetary policy will increase the opportunity cost of holding gold (Chart 8), the commodity-driven inflation we expect this year – especially if COVID-19 becomes endemic across major economies – will buoy demand for the yellow metal as an inflation hedge. An endemic virus this year will also boost physical gold demand from China and India. Chart 8       Footnotes 1     Please see More Commodity-Led Inflation On The Way, which we published on 9 December 2021. 2     Please see Coronavirus (COVID-19) latest insights: Antibodies, published by the ONS on December 23, 2021. 3    Please see Covid-19: UK ‘closest of any country in northern hemisphere to exiting pandemic’, published on January 11, 2022 by msn.com. 4    Please see What four coronaviruses from history can tell us about covid-19, published by newscientist.com on April 29, 2020. 5    Please see Omicron may be headed for a rapid drop in US and Britain, published by msn.com on January 11, 2022 published by msn.com. 6    Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. 7     We ran cointegrating regressions – using DOLS and ARDL models – to check for any equilibrium between prices and hedge fund positioning and found none. We looked at the post-GFC period from 2010 to now, since this is the data the US Commodity Futures Trading Commission (CFTC) provides for hedge funds and tested whether hedge-fund positions (in the form of open interest) explained prices vs. the alternative (i.e., prices explain hedge-fund positioning). We again found prices explain position (and not vice versa) for crude oil, natural gas, copper and gold. 8    Please see Büyüksahin, Bahattin and Jeffrey H. Harris (2011),"Do Speculators Drive Crude Oil Futures Prices?" The Energy Journal, 32:2, pp. 167-202. This paper used unique data sets provided by the CFTC. 9    Please see Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), "Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74. 10   Please see Knittel, Christopher R. and Robert S. Pindyck (2016), "The Simple Economics of Commodity Price Speculation," American Economic Journal: Macroeconomics 8:2, pp. 85–110. Investment Views and Themes Strategic Recommendations Trades Closed In 2021 Image

Highlights Chinese stocks are currently trading close to their fair value in absolute terms. When equity valuations are neutral, the direction of the next move in stocks depends on the profit outlook. Chinese corporate earnings are set to contract in the next six months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Historically, share prices lagged the turning points in China’s money/credit impulses by several months. Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in the coming months at a lower level. Relative to EM and global stocks, Chinese equities offer value. Hence, their relative performance will likely enter a rollercoaster phase. The secular outlook for corporate profitability among listed Chinese companies remains uninspiring. Hence, a structural re-rating of China stock indexes is unlikely. Feature With Chinese share prices down considerably in the past 12 months, a pertinent question is whether they offer an attractive entry point. Dissecting both valuations and the corporate earnings outlook are the key to getting the cyclical view right. This report aims to do this for both the MSCI Investable and MSCI A-share equity indexes. Our conclusion is as follows: in absolute terms, the Chinese MSCI Investable and A-share indexes have neutral valuations. Yet, the risk window for share prices remains open because corporate profits are set to contract. Also, bottoms and peaks in the money/credit cycle lead share prices by several months as illustrated in Chart 1. Hence, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Chart 1China: Lead-Lag Relationship Between Share Prices And Money/Credit Cycles Varies China: Lead-Lag Relationship Between Share Prices And Money/Credit Cycles Varies China: Lead-Lag Relationship Between Share Prices And Money/Credit Cycles Varies Valuations Chart 2Chinese Equity Valuation in Absolute Terms Chinese Equity Valuation in Absolute Terms Chinese Equity Valuation in Absolute Terms Chinese equity valuations are by and large neutral. Specifically: 1. According to our aggregate composite valuation indicators, onshore A shares are fairly valued while the MSCI Investable index is slightly above its historical mean (Chart 2). This aggregate composite valuation indicator for both equity indexes is composed of three components: based on (1) median multiples; (2) 20% trimmed-mean multiples; and (3) equal-weighted multiples. The latter uses equal weights rather than market cap weights for sub-sectors in the calculation. In turn, each component is constructed using the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and the bottom 10% of sub-sectors, i.e., it removes outliers. 2. We have also calculated a cyclically adjusted P/E (CAPE) ratio for both A shares and MSCI Investable stocks. The CAPE ratio for A shares is slightly below its historical mean (Chart 3), and the one for the MSCI Investable index is one standard deviation below its mean (Chart 4). Chart 3China A-Shares: CAPE Ratio China A-shares: CAPE Ratio China A-shares: CAPE Ratio Chart 4Chinese MSCI Investable Stocks: CAPE Ratio Chinese MSCI Investable Stocks: CAPE Ratio Chinese MSCI Investable Stocks: CAPE Ratio The idea behind the CAPE model is to remove the cyclicality of corporate profits when computing the P/E ratio. The CAPE model gauges stock valuations under the assumption that real (inflation-adjusted) EPS converges to its trend line. Importantly, the CAPE ratio is a structural valuation model, i.e., it works over the long run. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions. Below, we discuss the risks to Chinese corporate profits from both cyclical and structural viewpoints. We contend that a low CAPE ratio might not be unreasonable for listed Chinese companies, as their profitability has deteriorated over the past 10-12 years and their secular profit outlook is very uncertain. 3. The equity risk premium incorporates interest rates into valuations. We computed the equity risk premium by subtracting Chinese onshore government bond yields in real terms (deflated by headline CPI) from the trailing earnings yield of stocks. Chart 5 demonstrates that the equity risk premiums for A shares and investable stocks are near their historical mean, signifying neutral Chinese equity valuations at present. Relative to DM and EM equities, Chinese valuations appear to be attractive as Chinese share prices have massively underperformed their EM and DM peers in the past 12 months (Chart 6). Chart 5Equity Risk Premium For China Equity Risk Premium For China Equity Risk Premium For China Chart 6Chinese Equity Valuations Relative To EM And DM Chinese Equity Valuations Relative To EM And DM Chinese Equity Valuations Relative To EM And DM Bottom Line: Chinese equity valuations are by and large neutral in absolute terms. When equity valuations are neutral, the next move in share prices depends on the profit outlook. If profits expand/contract, stocks will rally/sell off. Corporate Earnings: The Cyclical Outlook Chinese corporate profits are set to contract in this downturn. Chart 7 shows that Chinese aggregate industrial profits will shrink by single digits in the next nine months from a year ago. This model is based on a regression of aggregate industrial profits on China’s credit impulse. A similar model that regresses A-share non-financial companies’ net profits on narrow money (M1) growth is also pointing to a roughly 5% corporate earnings contraction in the months ahead (Chart 8). Chart 7China: Industrial Profits Will Post A Single Digit Contraction China: Industrial Profits Will Post A Single Digit Contraction China: Industrial Profits Will Post A Single Digit Contraction Chart 8Chinese A-Share Profits Will Shrink In Mid-2022 Chinese A-share Profits Will Shrink In Mid-2022 Chinese A-share Profits Will Shrink In Mid-2022 Is government stimulus sufficient to produce a recovery in the business cycle and in company earnings? So far, government stimulus has been insufficient to produce a meaningful recovery in H1 2022. In particular, the changes in the excess reserve ratio lead the credit impulse by six months, and the latter signifies only a stabilization, but not a meaningful improvement in the credit impulse prior to May 2022 (Chart 9). Given that the credit impulse leads industrial companies’ earnings by about nine months (please refer to Chart 7 above), odds are that corporate profits will not bottom until H2 2022. As for service industries, online retail sales of goods and services remain weak, reflecting sluggish household income growth (Chart 10). Chart 9Liquidity Is Pointing To Stabilization But Not A Surge in The Credit Impulse Liquidity Is Pointing To Stabilization But Not A Surge in The Credit Impluse Liquidity Is Pointing To Stabilization But Not A Surge in The Credit Impluse Chart 10China: Internet Sales Are Disappointing China: Internet Sales Are Disappointing China: Internet Sales Are Disappointing There has also been another factor weighing on China’s business cycle – a declining marginal propensity to spend among both households and companies (Chart 11). The marginal propensity to spend depends on sentiment and confidence among consumers and companies. A declining propensity to spend will dampen the positive effects from government stimulus. Notably, there has been a dramatic profit divergence in industrial sectors. Commodity-producing sectors – metals and mining, steel, energy and coal – have posted an earnings windfall. In contrast, industries consuming commodities – machinery, construction materials, autos, IT and food/beverages – have seen their profits plunge (Chart 12). Chart 12Dramatic Profit Divergence Between Commodity Producers And Users Dramatic Profit Divergence Between Commodity Producers And Users Dramatic Profit Divergence Between Commodity Producers And Users Chart 11China: The Marginal Propensity To Spend Is Declining China: The Marginal Propensity To Spend Is Declining China: The Marginal Propensity To Spend Is Declining       Chart 13Chinese Imports Of Key Commodities Have Shrunk Drastically Chinese Imports Of Key Commodities Have Shrunk Drastically Chinese Imports Of Key Commodities Have Shrunk Drastically     The reason for this industrial earnings dichotomy is that commodity prices have not fallen despite the weakness in China’s business cycle and its commodity imports (Chart 13). Critically, commodity users have not been able to pass on higher input costs to their customers due to weak demand. Consequently, commodity users have experienced a drastic profit margin squeeze and their earnings have plummeted. If commodity prices drop meaningfully, the profit divergence between these two groups of industrial enterprises will narrow. Yet, it will not improve the level of overall industrial profits in China. The rationale is that in the past six months, industrial profits of commodity users have accounted for 20% of aggregate industrial profits, while those of commodity producers have accounted for 80%. This reinforces the importance of commodity prices in driving China’s industrial profit cycles. Our view on commodity prices is as follows: Commodity prices have so far ignored China’s slowdown. However, the Fed’s tightening and the US dollar’s persistent strength amid the lack of a meaningful recovery in the Chinese business cycle will eventually produce a drawdown in resource prices in the coming months, as we discussed in last week’s report. Bottom Line: As policy stimulus gets more aggressive, China’s growth and corporate earnings will recover in H2. Yet, in H1 corporate profits are set to disappoint. This implies that Chinese share prices will remain in a risk window for now. Corporate Profitability: The Structural Outlook Investors reward companies with high or rising return on equity by bidding up their equity multiples, and vice versa. One of the main reasons why the structural valuation measures for Chinese equity indexes (like the CAPE ratio) have declined in the past 10 years is worsening corporate profitability. Specifically, the return on assets (RoA) and the return on equity (RoE) for non-financial companies included in the MSCI A-share and Investable indexes have been falling since 2011 (Chart 14, top and middle panels). Periodic government stimulus improved corporate profitability temporarily. Yet, as stimulus waned, corporate profitability deteriorated. Consistently, Chinese investable non-TMT stocks have produced zero price appreciation in absolute terms since 2011 (Chart 14, bottom panel). In the past 10 years, there has been a structural deterioration in the financial performance metrics of industrial companies. Their RoE and RoA have fallen as have turnover in account assets (sales/assets), inventory (sales/inventory) and account receivables (sales/account receivables) (Chart 15). It is unclear if this secular trend of deteriorating corporate financial performance will reverse if authorities repeatedly rescue the economy by unleashing large stimulus. Chart 14Worsening Profitability Has Been Behind Poor Equity Returns in China Worsening Profitability Has Been Behind Poor Equity Returns in China Worsening Profitability Has Been Behind Poor Equity Returns in China Chart 15Chinese Industrial Companies: Structural Deterioration in Financial Performance Chinese Industrial Companies: Structural Deterioration in Financial Performance Chinese Industrial Companies: Structural Deterioration in Financial Performance As for technology/internet/platform companies, we maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity and low multiples. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, many US institutional investors will likely offload their holdings of these companies. Finally, Chinese bank stocks are cheap for a reason. They have not recognized a massive amount of non-performing loans and have not provisioned for them. Going forward, another roadblock to shareholders of Chinese stocks is the common prosperity policies that the Chinese government has championed. These policies will redistribute income away from shareholders to the general population. Chart 16 illustrates the share of labor compensation has been rising since 2011 while the share of profits has been declining. Not surprisingly, Chinese investable non-TMT stocks have been doing very poorly since 2011 (Chart 14, bottom panel). Chart 16National Income Composition: Labor’s Share Will Continue Rising National Income Composition: Labor"s Share Will Continue Rising National Income Composition: Labor"s Share Will Continue Rising The common prosperity policies will only reinforce the existing trend of a rising share of labor compensation at the expense of shareholders in the coming years. This bodes ill for structural profitability and justifies low equity multiples. In short, a low CAPE ratio for Chinese stocks might not be out of line with such a downbeat secular outlook. Bottom Line: Even if there have been – and still will be – great companies in China that deliver phenomenal performance, their shareholders might not be in a position to reap the benefits of such solid performance. In short, the structural outlook for profitability among listed companies remains uncertain. Investment Recommendations Chart 17Our Recommendations For Chinese Equity Investors Our Recommendations For Chinese Equity Investors Our Recommendations For Chinese Equity Investors Chinese stocks, especially investable ones, are oversold and might rebound in the very near term in absolute terms. However, the three-to-six-month outlook for absolute performance remains poor. Relative to EM and global stocks, Chinese equities are very oversold and offer value. Hence, their relative performance will likely enter a rollercoaster phase. Onshore Chinese stocks will underperform onshore government bonds. Within the Chinese equity universe, we have been recommending the following strategies and they remain intact: Long A shares/short MSCI Investable index since March 4, 2021 (Chart 17, top panel). This relative ratio is overbought and will likely pull back in the near term. However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Short Chinese investable value stocks/long global value stocks since November 26, 2020 (Chart 17, middle panel). This strategy remains intact. Short onshore and investable property stocks versus their respective benchmarks since May 9, 2019 (Chart 17, bottom panel). The woes of property developers are not over. Please refer to our Special Report on the Chinese property market. Long large banks/short medium and small listed banks since October 2016. Small and medium banks are exposed to the continuous woes in the property market much more than the large ones. Also, their profitability will be more negatively affected by the retrenchment in shadow banking activities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company.

Dear Client, This week we present our annual Commodities & Energy Strategy outlook, which contains our key views on the principal markets we cover – energy, base metals and bulks, precious metals, and ags.  Over the coming decade, we expect industrial commodity prices to move higher in an increasingly volatile fashion, not unlike these markets' recent experience.  In the short term, commodity markets will remain exquisitely sensitive to the evolution of the COVID-19 pandemic.  The highly transmissible omicron variant of the coronavirus – now spreading at more than 4x the rate of the delta variant – appears to be less lethal than previous mutations, suggesting it could become the dominant variant globally.  We remain wary, however, particularly as China still is operating under a zero-tolerance COVID-19 policy, and has relied on less efficacious vaccines that appear to offer no protection against the omicron variant of the coronavirus.  This also is a risk for EM economies that rely on these vaccines.  However, the roll-out of mRNA vaccines globally via joint ventures will be gathering steam in 2H22, which is bullish for commodity demand. Longer term, the effort to decarbonize global energy markets is gaining traction, with the three largest economies in the world – the US, China and EU – embarked on a massive transition to renewables.  This will be a multi-decade undertaking that literally could transform the world.  We expect this to continue to unfold in an erratic and uncoordinated fashion, as states work out how to decarbonize the production, delivery and consumption of goods and services.  Markets critical to this transition, particularly base metals, face long odds developing the supply that will be necessary for this effort.  Conventional energy markets – oil, gas and coal – are in a forced wind-down imposed by courts, investors, governments, climate activists, public opinion and policymakers, which is reducing supply at a faster rate than demand.  This leaves markets exposed to volatile price bursts.  As is our custom, this will be the last CES report of the year.  This decade promises to be extraordinary for commodities, and we are hopeful we will continue to be of service in navigating the epic transition to a low-carbon future.  As you gather with friends and loved ones, we wish you all the best in this beautiful season, Robert Ryan Chief Commodity & Energy Strategist Highlights Macro: Bullish. Systematically important central banks will remain wary of moving too strongly too soon, in the wake of the COVID-19 omicron variant. US real rates will remain low and the USD will weaken, which will support commodities. Energy: Bullish. OPEC 2.0 and the price-taking cohort will maintain existing production policies, which will restrain oil supply. The omicron variant likely will dent demand, not tank it. Our 2022 Brent forecast is slightly weaker on omicron risk, averaging $78.50/bbl, with most of the demand hit in 1H22 made up in 2H22, while our 2023 forecast is $80/bbl. Base Metals: Bullish. Supply-demand balances will remain tight. Climate activism in courts and boardrooms; ESG-related costs, local and geopolitical uncertainty will continue to weigh on supply. COMEX copper will average $4.80/lb next year and $6.00/lb in 2023. Precious Metals: Bullish. Rising commodity prices will feed directly into inflation gauges favored by the Fed. Inflation and inflation expectations will remain elevated. Gold will push to $2,000/oz and silver to $30/oz in 2022. Ags/Softs: Neutral. Ag markets will remain balanced, with a bias to the upside from higher costs of fertilizer and transportation. Erratic weather remains an upside risk. Risk: Elevated. On the upside, a less lethal omicron variant that dominates other COVID-19 variants will rally markets. A more virulent mutant would hit demand harder and push prices lower. Hospitalizations/Cases and Deaths/Cases remain the critical ratios – trajectories need to remain flat to downward for growth (Chart of the Week). Recommendations: Our COMT ETF position was stopped out on 13 December 2021, which is when the ETF went ex-dividend. The ETF paid $5.4941/share for an 18.44% dividend (p.a.). Our stop-loss is being overridden, and we remain long the COMT ETF, in the expectation commodity markets will remain tight and backwardation will continue to drive returns. Feature COVID-19 continues to determine the trajectory of global growth – hence commodity demand – and how it will be distributed in the short run. Reports this week indicating the widely used Sinovac COVID-19 vaccine used in China and EM states is ineffective in neutralizing the omicron variant will renew the focus on an underappreciated risk: High vaccination rates in and of themselves are not useful indicators of successful public-health responses.1 More than anything, what appears to matter most is the vaccine that's been used to address the public-health threat posed by COVID-19. A booster of the Pfizer-BioNTech mRNA vaccine, e.g., appears to neutralize the omicron variant, and to convey a higher likelihood of avoiding serious illness and hospitalization.2 Chart 1 This will be important going forward, as the COVID-19 omicron variant appears to be transmitted at a rate that is 4.2x as contagious as the delta variant. This raises the odds that hospital beds will fill faster as the omicron mutant spreads.3 This could again lead to reduced availability of health care, and additional lockdowns to contain the spread of the omicron variant, which would again radiate through global supply chains. Oil Market Outlook Hinges On Omicron Response The risk exposed in these public-health developments is the global commodity recovery – particularly for crude oil and refined products like gasoline and jet fuel – could become more bifurcated this year, with economies using primarily mRNA technology continuing to open and recover. States without access to or distribution of these vaccines will have to rely more on social distancing and lockdowns to contain the spread of the virus. We would expect this to be a powerful inducement to accelerate local production and distribution of mRNA vaccines in Asia, Latin America and Europe. Successful implementation of this strategy would boost commodity demand, particularly for transportation fuels.4 Our prior regarding the omicron variant is it will dent demand but not tank oil demand. To account for the so-far-unknown effects of omicron, we are assuming 1H22 global crude and refined-product demand falls to 100.4mm b/d, versus our earlier estimate of 101.5mm b/d. Most of this demand is recovered in 2H22, when we expect oil consumption to average 101.8mm b/d versus our earlier expectation of 102.5mm b/d. On the supply side, OPEC 2.0 core producers – KSA, Russia, Iraq, UAE and Kuwait – will continue to implement the coalition's production-management strategy – i.e., keeping the level of supply just below demand. Meanwhile, the price-taking cohort led by the US shale-oil producers will continue to focus on profitability, not production for the sake of production. Accelerating production too rapidly at this point would undo much of the work and effort undertaken to establish oil and gas companies as attractive alternatives for investors. Our 2022 Brent forecast is weaker by $1.50/bbl vs last month's estimate, averaging $78.50/bbl. Our 2023 forecast is $1/bbl lower, with our average expectation at $80.00/bbl (Chart 2). Longer term, oil + gas capex remains weak (Chart 3). As we have stressed repeatedly, this is wicked bullish for prices in 2024 and beyond. Chart 2Brent Forecast Slightly Weaker In 2022 Brent Forecast Slightly Weaker In 2022 Brent Forecast Slightly Weaker In 2022 Chart 3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 2022 Key Views: Past As Prelude For Commodities 2022 Key Views: Past As Prelude For Commodities Weak Capex Keeps Base Metals Outlook Bullish Weak capex is a common theme in the industrial commodities – oil and base metals – which points to tight supply-demand balances for these markets going forward. This is as true for base metals as it is for oil (Chart 4). The principal drivers of the capex squeeze are similar in both markets: A desire to regain investors' favor after years of poor returns. This has managements focused on returning capital to shareholders either in the form of share buybacks or higher dividend payments. However, there are additional pressures adding to the cost structures of industrial commodities, particularly the seismic shifts in the political underpinnings of commodity-exporting countries, where left-of-center politicians are proving more attractive to the median voter in states with contestable elections. Once elected – e.g., in Peru, and, likely Chile after this weekend's elections – politicians push hard to secure a greater share of mining revenues for long-neglected poor and indigenous populations.5 Chart 4 The bellwether base metal market – copper – best highlights these factors, which, in our view, will keep base-metals capex tentative and restrained over the medium term. Miners are almost forced to exercise capex restraint until they get greater clarity on how newly elected governments will deliver on their avowed intent to secure a greater share of mining revenues for their constituents. This is particularly true in Chile and Peru – which together account for a combined 40% of global copper ore output – where poor and indigenous populations are engaging in more frequent civil disobedience.6 In addition to the contentious changing of the guard at the political level, ESG-related initiatives brought to the fore by climate activists elected to corporate boards and in court proceedings are adding new layers of cost to base-metals mining (and oil and gas exploration for that matter). This week, Reuters reported on separate court decisions in Australia and Chile that redress mistreatment of aboriginal peoples in key metals-exporting states.7 We believe political and ESG-related costs will raise miners' all-in sustaining costs, which will have to be covered by higher prices going forward. The additional costs that will be imposed on miners trying to meet the demand that will be driven by the global decarbonization and renewable-energy buildout now kicking into high gear will require prices to spur investment in new mine production, and to keep existing and brownfield production up and running.8 Copper prices will get an assist from a weaker USD, which will boost demand for the metal ex-US (Chart 5). We are expecting copper to push to $4.80/lb on average next year and $6.00/lb in 2023 on the COMEX, on the back of stronger supply fundamentals and a weaker USD. Chart 5A Weaker USD Will Boost Copper A Weaker USD Will Boost Copper. A Weaker USD Will Boost Copper. Gold Will Rally As Inflation, Uncertainty Remain Elevated Gold prices will move higher in 2022 – our target remains $2,000/oz – as investors seek cover from higher commodity prices, which will feed directly through to higher inflation (Chart 6).9 This has been apparent in the recent US PCEPI and core PCEPI – the Fed's preferred inflation gauge – and CPI data, and at the wholesale level in PPI data. Most of this results from tight supplies for commodities and strong demand for goods, which is driving the price increases. We expect this to continue into 2022, as pent-up consumer demand continues to drive goods purchases and supply-side tightness for most manufacturing inputs. Higher prices across commodity markets will keep inflation gauges elevated in 2022. In addition to the inflation-hedging demand we expect next year, investors also will turn to gold as a hedge against economic policy uncertainty: As inflation and policy uncertainty increase, gold prices move higher (Chart 7). Chart 6Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Chart 7Investors Will Use Gold To Hedge Inflation, Uncertainty Investors Will Use Gold To Hedge Inflation, Uncertainty Investors Will Use Gold To Hedge Inflation, Uncertainty   Lastly, in line with our colleagues in BCA's Foreign Exchange Strategy service, we remain USD bears in 2022. As is the case with all commodities, gold will benefit from a weaker USD.10 Ags Remain Balanced In 2022 Global ag markets, by and large, will remain balanced over the current crop year (Chart 8), with a bias to the upside as input and transportation costs – chiefly fertilizers and grain vessels, respectively – remain high (Charts 9 and 10). Erratic weather, as always, remains an upside risk. Chart 8 Chart 9 Chart 10… And Fertilizer Costs Will Push Grains, Beans Higher Natgas Price Surge Pushes Fertilizer Prices Higher Natgas Price Surge Pushes Fertilizer Prices Higher While we remain neutral grains, the periodic price spikes resulting from higher freight rates and natural gas prices will support overall commodity exposures. Over the short term, the risk of higher prices is acute: Markets still are contending with the possibility of another colder-than-normal winter. This would push natgas prices – and, because it is 70% natgas, fertilizer costs – sharply higher next year. This will have to be recouped by higher food prices, particularly if shipping costs spike higher due to COVID-19-induced port closures. Surging food prices will keep inflation rates higher globally, making them more persistent (vs. transitory). Investment Implications Global supply-demand fundamentals continue to support our conviction commodity markets will remain tight in 2022. As such we remain long commodity index exposure – the S&P GSCI and COMT ETF – expecting market tightness to result in renewed backwardation. We also remain long the PICK expecting continued tightness in base metals. Risks to our views remain elevated – and occur in both directions. On the upside, commodities will rally if a less-lethal omicron variant becomes the dominant COVID-19 strain and does not overly tax hospital resources or drive death rates higher. It could actually convey a global benefit as the dominant strain, crowding out other mutations and pushing states to herd immunity. On the downside, it's still too early to tell how this new variant and other mutations will behave. Given the fragility of the current global recovery and reopening shown in the initial response to omicron, a more virulent mutant likely would hit aggregate demand hard, forcing yet another supply-side adjustment in commodities generally. Upside risks dominate in our assessment, but, as always, we remain cautious.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Footnotes 1     Please see Sinovac shot offers inadequate shield from Omicron variant, says HK study published by straitstimes.com on December 15, 2021. The Sinovac vaccine is almost half as effective as mRNA-based vaccines, and is widely distributed in EM economies. We flagged this risk earlier in July in our report titled Assessing Risks To Our Commodity Views; it is available at ces.bcaresearch.com. 2     Please see Pfizer Booster Shots Are Effective Against Omicron Variant, Israeli Study Says published by wsj.com on December 12, 2021. 3    Please see Omicron four times more transmissible than Delta in Japan study published by straitstimes.com on December 9, 2021. 4    Please see Upside Price Risk Rises For Crude, which we published on September 16, 2021, for addition discussion of the global joint-ventures engaged in local production of mRNA vaccines. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021 and Chile: Prepare For A Boric Win, published by BCA's Emerging Markets Strategy service on December 15, 2021. The latter report discusses the growing odds of a victory for the left-of-center candidate in Chile's election this weekend. 6    Please see, e.g., Peru's poor Andean hamlets, backed by state, unleash anger at mines, published by reuters.com on December 14, 2021. 7     Please see Australian mining state passes Aboriginal heritage protection law, and Chile's Supreme Court orders new evaluation of Norte Abierto mining project published by reuters.com on December 15 and 14, 2021, respectively. 8    Incremental investment needed to meet 2050 net-zero climate goals will come to almost $2 trillion per year, half of which will go into renewable power generation, industrial processes, and transportation, according to estimates by Goldman Sachs, published on December 13, 2021. 9    Please see More Commodity-Led Inflation On The Way, which we published on December 9, 2021. It is worthwhile reiterating Granger-causality between realized and expected inflation gauges (US PCEPI, core PCEPI, CPI, along with 5-year/5-year CPI swap rates) and commodity price indices (the S&P GSCI and Bloomberg Commodity Index) is very strong. 10   Please see 2022 Key Views: Tug Of War, published by BCA's Foreign Exchange Strategy service on December 10, 2021.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist  Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week).  Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories.  While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes   Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist Low Copper Stocks Will Persist Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD  Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Base Metals Defy Strong USD Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation.   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   Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Brent Prices Are Going Up... Brent Prices Are Going Up... Chart 10 ...As Well As Gold Prices ...As Well As Gold Prices   Footnotes 1     Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2     Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021.  3    Please see Precious Metals commentary in the Commodity Round-Up section. 4    The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables.  It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere.  Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion.   Investment Views and Themes Strategic Recommendations

Highlights The 26th Conference of the Parties (COP26) will open this weekend in Glasgow, Scotland, amid a global crisis induced in no small measure by policies and regulations that led to energy-market failures. Price-distorting regulations and ad hoc fixes – e.g., retail price caps, "windfall profits" taxes – will compound the current crisis. Mad rushes to cover energy and space-heating demand in spot coal and gas markets when renewable-energy output falters will be repeated, given utility-scale battery storage will continue to be insufficient to replace hydrocarbons in the transition to a low-carbon economy.  On the back of higher coal, gas and oil demand, CO2 emissions will return to trend growth or higher this year (Chart of the Week). Base metals capex will have to increase at the mining and refining levels to meet renewables and EV demand.  This includes the need to diversify metals' production and refining concentration risks more broadly.1 We remain strategically long the COMT ETF and the S&P GSCI index, as these fundamental imbalances are addressed.  We also are initiating a resting buy order on the XME ETF if this basic materials ETF trades down to $40/share. Feature Going into the COP26 meetings starting this weekend, delegates no doubt will be preoccupied with the global energy crisis engulfing markets as the Northern Hemisphere winter approaches. In no small measure, the crisis is a product of poor policy design and regulatory measures meant to accelerate the transition to low-carbon economies globally. This is most apparent in China, the UK and the EU. China and the UK use retail price-caps to control the cost of energy to households. In China, the price caps recently brought state-owned electricity providers to the brink of bankruptcy, because suppliers were not able to pass through higher wholesale prices for coal and natural gas to retail consumers. In the UK, retail price caps actually did result in bankruptcies of smaller electricity providers. In the EU, price caps and "windfall profits" taxes are being imposed on retail energy providers in different states in the wake of the energy crisis.2 Chart 1 China's Impressive Renewables Push China has been making significant progress in introducing renewable energy to their energy supply mix, particularly wind and solar (Chart 2), accounting for 81.5% of Asia-Pacific's wind generation last year, and 55.5% of the region's solar generation. Chart 2 China generates just 11% of its energy from renewables. This has been insufficient to meet demand over the past year, owing to a combination of reduced coal supplies; colder-than-normal temperatures last winter, and hotter-than-normal temps during the summer brought on by a La Niña event. While energy demand was expanding over the course of the year due to strong economic growth in 1H21 and weather-related demand over the course of the year (for heating and cooling), provincial officials were vigorously enforcing the state-mandated "dual-control policy," which in some instances led to overly aggressive shutdowns of coal mines that left local markets short of the fuel needed to supply ~ 63% of the country's electricity.3 Chinese authorities have said that they would “go all out” to boost coal production in a bid to tackle widespread power cuts. Some 20 provinces in China have experienced electricity rationing and blackouts over the past month due to power-production shortfalls driven by a lack of coal. The power rationing was imposed due to a shortage of coal supply, which led to the surge in coal prices. The high coal prices, in turn, forced coal-power companies to cut back their production to avoid losses that threatened to bankrupt them.4 To be able to ensure coal and electricity supplies this winter, state authorities released new rules to enforce a policy scheme that includes increasing coal production capacity and revising the electricity pricing mechanism. China's state-owned Global Times news service reported more than 150 coal mines have been approved to re-open.5 The regional governments can prioritize their energy intensity targets over energy consumption. Coal-fired power prices, which are largely state-controlled, will be allowed to fluctuate by up to 20% from baseline levels. However, raising household tariffs is seen as a difficult task politically, given that China's per-capita income remains low.6 UK, EU Market-Distortions The UK electricity production and supply market consists of three segments – producing, distributing, and selling electricity. Entities can operate in any or all of these areas. As in many things, the UK punches way above its weight in renewables, accounting for 15% of wind generation and 7.5% of solar produced in Europe, as seen in Chart 2. Wind can supply ~ 25% of UK power, depending on weather conditions. For all renewables, the UK accounts for 14% of Europe's total generation capacity. Twice a year, the national energy regulator, The Office of Gas and Electricity Markets (Ofgem) sets a cap on the price at which electricity sellers or retailers can supply power to the final consumer. While the maximum price retailers can sell electricity to consumers is capped, the price they can buy it from the electricity producer is not. This price depends on market factors, including fuel costs. When wind power dropped sharply this past summer, electric suppliers were forced to scramble for natgas as a generation fuel, and, at the margin, coal. In the UK, natural gas powers more than 35% of the electricity mix, and accounts for 15% of Europe's natgas-fired generation. Coal generation in the UK accounts for 1% of Europe's coal fueled electricity generation. China's push to secure additional coal and natgas places it in direct competition for limited supplies with European buyers. High demand, stiff competition, reduced supply, and low inventories all contribute to higher gas prices globally (Chart 3). Easing pandemic related restrictions globally has released pent-up energy demand, which is expected to move higher over the next few months, as the Northern Hemisphere possibly sees another colder-than-normal winter, and economic growth boosts manufacturing demand. Chart 3 Capping selling prices during periods of very high fuel costs squeezes retailers’ profit margins. In the last six weeks, seven UK retailers have gone under, affecting ~ 1.5 million consumers. Such a system favors the incumbents: retailers that can produce their own electricity and hedge their exposure to price volatility have access to lower costs of capital and higher economies of scale. When retailers are no longer able to operate due to bankruptcy, their customers are distributed to the remaining suppliers. The British government would prefer to offer financial support to persuade larger companies to take on stranded consumers than save retailers who are being forced to go out of business.7 However, as wholesale gas prices rise, industry operators – even the more established ones – may not be keen to borrow from the government to take on additional consumers. The EU also finds itself facing stiff competition from Asia for natgas imports. According to Qatar’s energy minister, suppliers prefer Asian buyers since they purchase natgas on fixed long-term contracts to ensure energy security, unlike European buyers which purchase much of their  fuel on the spot market.8 The EU's natgas imports are projected to remain uncertain as Russian exports have fallen below pre-pandemic levels and supply via the NordStream2 pipeline is delayed. With one of the lowest working inventories within the EU (Chart 4), the UK, which imports ~ 65% of its natural gas, is unable to protect itself from supply volatility. These high prices coincided with low wind speeds earlier this year, curtailing wind power, which as of 2020, is the UK’s second highest electricity source. Chart 4 Unfocused Policy Hinders Energy Transition It is impossible to gainsay the merit of the decarbonization of the global economy. Disrupting weather patterns, spewing particulates and chemicals into the atmosphere, dumping plastics into the oceans and waterways, and ravaging forests worldwide do not contribute to any species fitness for survival. However, policymakers appear to be completely ignoring existing constraints any serious decarbonization effort would require. Encouraging the winddown of fossil fuels decades before sufficient renewable-energy and carbon-capture technologies are developed and deployed to replace the lost energy indirectly forces a harsh calculation: Do sovereign governments want to restrict income growth and quality-of-life improvements to the energy available from renewables (including EVs) at any point in time? Who actually makes that choice and enforces the rules and regulations that go with it? We have written about the enormous increase in base metals supply that will be required over the coming decades to develop and deploy renewables, most recently in La Niña And The Energy Transition last month. Base metals – like oil and gas markets – are extremely tight, and are operating in years-long physical deficit conditions, as can be seen in the bellwether copper and Brent markets (Charts 5 and 6). Chart 5Base Metals Markets Are Tight … Base Metals Markets Are Tight... Base Metals Markets Are Tight... Chart 6As Is Oil... As Is Oil... As Is Oil... Any policy contemplating a global buildout of renewable-energy generation and its supporting grids, along with EVs and their supporting infrastructure, should start with the recognition laws, regulations and rules need to encourage responsible, safe and sound incentives for developing the supply side of base metals markets. An argument also could be made for fossil-fuels, which arguably should receive technology subsidies and favorable tax treatment – not unlike those granted to renewables and EVs – to invest in carbon-capture tech development. Rules and regulations favoring long-term contracts so that producers are able to address stranded-asset concerns and secure funding for these projects also should be developed. Investment Implications Absent a more thought-out and focused effort to write laws, develop rules and regulations on at least the level of trading blocs, the evolution to a low-carbon energy future will be halting and volatile. This in an of itself is detrimental to funding such an enormous undertaking. Until something like it comes along, we remain long commodity-index exposure – the S&P GSCI index and the COMT ETF – and long the PICK ETF. At tonight's close we are opening a resting order to buy the XME ETF if if trades to or below $40/share.   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 Commodities Round-Up Energy: Bullish Crude oil markets unexpectedly moved lower mid-week on the back of yet another drop in Cushing, OK, inventory levels reported by the US EIA. Cushing crude-oil stocks stood at 27.3mm barrels vs. 31.2mm barrels for the week ended 22 October 2021. Two years ago, Cushing inventories were at 46mm barrels. Markets had been rallying on falling Cushing storage levels over the past couple of weeks. The EIA's estimate of refined-product demand – known as "Product Supplied" – remains below comparable 2019 levels at this time of year, although not by much (19.8mm b/d vs. 21.6mm b/d). We expect global oil and liquids demand to rebound above 100mm b/d in the current quarter. Stronger demand in 2022 and 2023 prompted us to raise our Brent forecasts to $80/bbl and $81/bbl, respectively (Chart 7). Base Metals: Bullish Copper continues to trade lower as markets price in a higher likelihood of softer demand for the bellwether metal as the global power-supply crunch weighs on manufacturing activity, particularly in China. Copper inventories are still at precariously low levels, with the red metal in global inventories hitting lows not seen since 2008 (Chart 8). This will keep copper's forward curve backwardated over time, as inventories are drawn to fill the gap between supply and demand globally. Low inventory levels are expected to persist as power rationing in China, which was responsible for more than 41% of global refined copper output in 2020, persists. Precious Metals: Bullish Federal Reserve Chairman Jerome Powell's remarks stating supply disruptions are expected to keep US inflation elevated next year are supportive to base metals. Higher inflation will increase demand for the yellow metal, as investors look for a hedge against USD debasement. However, the Fed's asset-purchase taper, which we expect to be announced in November, and the interest rate hikes we expect as a result of it beginning in end-2022, will push bond yields higher and raise the opportunity cost of holding non-yielding gold. That said, we believe the Fed will remain behind the inflation curve and will work to keep real rates weak, which will tend to support gold prices. Chart 7 Brent Forecast Lifted Slightly Brent Forecast Lifted Slightly Chart 8 Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y       Footnotes 1     Please see our report entitled La Niña And The Energy Transition, published on September 30, 2021, for discussion. 2     Please see Spain to Cap Windfall Energy Profits as Rally Hits Inflation published by bloomberglaw.com on September 14, 2021. 3    Please see carbonbrief.org's China Briefing for 23 and 30 September and 14 October 2021 for additional discussion, and fn 1 above. 4    Please see ‘All out’ to beat power shortages; 2050 ‘net-zero’ for airlines; ‘Critical decade” for global warming, published by China Brief on 7 October, 2021. 5    Please see Chinese officials move to increase coal output amid shortage published by globaltimes.cn 13 October 2021. 6    Data from the World Bank showed China's GDP per capita reached $10,500 in 2020, below the global average of $10,926. Some experts expect any reform to be gradual. 7     Please see Kwarteng insists UK will avoid power shortages as gas crisis worsens, published by the Financial Times on September 20, 2021. 8    Please see Qatar calls for embrace of gas producers for energy transition, published by the Financial Times on October 24, 2021.   Investment Views and Themes Recommendations Strategic Recommendations