Commodities & Energy Sector

Listen to a short summary of this report.     Executive Summary Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year   That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop.  Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on        LinkedIn Twitter       View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear Client, Next Friday we will publish a Special Report on Gold in conjunction with our colleagues in BCA Research’s Foreign Exchange and Global Investment strategy groups.  We will return to our regular schedule of publishing on Thursdays the following week, with our June 30 ESG report.  Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary Brent Forecast Slightly Lower On Global Growth Downgrade The World Bank’s somewhat sanguine expectation re stagflation risks for 2023 and beyond misreads continuing pressure on commodity markets due to low capex, and disincentives to invest. If central banks are successful in cooling consumer spending via a policy-induced recession, pressure on spare capacity in oil-producing and refining markets will lessen slightly. However, higher interest rates will increase capex costs. Weaker demand from a recession will not batter crude oil prices: core-OPEC 2.0 – KSA and the UAE – and US shale producers will maintain their production-management strategies, keeping markets relatively balanced. Our forecast for 2H22 and 2023 Brent is $115/bbl and $117/bbl on average, down ~ $6 and $5/bbl from last month’s forecast. WTI will trade $3/bbl lower. Europe will enter a recession earlier than other DMs, with natural-gas shipments to the EU from the US and Russia set to decline precipitously. This will tighten food and metals markets, and keep inflation expectations elevated. Bottom Line: Low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will offset lower demand, and continue to support crude and product prices. The odds of prices exceeding $140/bbl remain high. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). Separately, we were stopped out of our XOP, XME and PICK ETFs, with gains of 19%, 7.2% and 7.6% respectively. We will look for opportunities to re-instate them. Feature Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy While the World Bank sharply downgraded its global growth expectations for this year and next, it nonetheless maintains a somewhat sanguine view of the risk of stagflation going forward.1 The Bank notes current market conditions closely resemble those of the last bout of prolonged stagflation in the 1970s – characterized by flat-to-lower economic growth and high inflation – but differs in important ways that reduce the likelihood of a recurrence.2 In particular, the Bank cites research indicating the proximate causes of the 1970s stagflation have mostly been addressed, and how central banks are better equipped to avoid the mistakes that produced it: Thus far, markets expect that inflation in the near future will decline, albeit remaining elevated, as global growth cools, monetary policy gets tighter, fiscal support is withdrawn, energy and food prices level off, and supply bottlenecks ease. Moreover, most commentators argue that monetary policy has the tools to return inflation to target rates over time (pp. 53-4). We disagree with this assessment, and expect stagflation risks to remain elevated. This is driven by our high-conviction view that weak capex – and, importantly, continued disincentives to invest in hydrocarbon production and refining – will keep industrial-commodity markets tight well into this decade. Base metals producers also have been parsimonious in capex allocations. The Russia-Ukraine war brought forward the capex reckoning for commodity markets and inflation by highlighting the EU’s near-total dependence on Russian oil and natural gas imports, and the risks on outsourced manufacturing and refining away from domestic markets.3 Addressing long-term policy errors and re-forging global supply chains will be expensive, and will require decades of capex investment to overcome the lack of capacity needed to meet higher demand for coal, oil and natgas. This will delay the global energy-transition to a zero- or low-carbon economy and – because exploration, production, refining and distribution of hydrocarbon-based fuels remains constrained – will keep energy markets, particularly oil, tight. As a result, these markets will be predisposed to frequent price spikes, which will lift the average cost of crude oil and refined products over the foreseeable future. Downgrading Oil Demand Again We are once again downgrading our demand expectation for this year and next, on the back of the macro forces outlined in the World Bank’s June forecast: 1) Tightening monetary policy globally, led by the Fed; 2) Higher inflation, which has been exacerbated by the Russia-Ukraine war; and 3) Supply dislocations in energy and grain markets. Global GDP growth this year is expected to be close to half that of 2021 – 2.9% in real terms vs 5.7% – and was revised sharply lower vs the Bank’s January forecast of 4% growth. On the heels of the Bank’s lower growth expectation, we lowered our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast (Chart 1). For next year, we expect oil demand to grow 1.8mm b/d. Of particular interest, China’s growth in the first five months of this year was negative – actual demand from Jan-May22 averaged 15.2mm b/d vs 15.4mm b/d last year. This reflects the demand destruction caused by the lockdowns arising from China’s COVID-19 zero-tolerance policy, and is the first time since 2009 y/y growth has fallen (Chart 2). Chart 1Oil Demand Downgraded Following Lower Growth Expectation Chart 2Oil Demand Destruction In China OPEC 2.0 Will Adjust Output We expect core-OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the UAE – to continue to calibrate its supply to match the ebb and flow of demand. As a result we expect production declines among “the other guys” – i.e., member states that cannot increase supply or maintain current output – to not be fully compensated by the core producers if they see actual demand falling sharply in 2H22 and next year (Chart 3). As the supplier of the last resort, crude oil production from core-OPEC 2.0 tracks demand. This is the cohort of suppliers within OPEC 2.0 which has sufficient spare capacity to bring supply online and, importantly, is able to maintain higher levels of production in order to meaningfully influence oil markets. Chart 3Core-OPEC 2.0 Might Be Slower Offseting Declines Among "The Other Guys" All else equal, in 2023 KSA and UAE – the two core-OPEC 2.0 nations with most spare capacity within OPEC 2.0 – will need to collectively raise supply by ~ 2mm b/d relative to average oil production in 2021 to ensure inventories do not draw sharply. OPEC 2.0 has been unable to stick to the 400 kb/d monthly crude oil production increases agreed in its July 2021 meeting, as declining investment and weak governance have plagued output from member states. Most recently, Libya has closed nearly all oil fields over the course of this month and last, taking nearly 1.1 mmb/d of oil supply off the market. The difference between the actual and agreed OPEC 2.0 output increases accumulated to ~ 2.0mm b/d as of May 2022. We continue to expect Russia to be firmly in the camp of the “other guys,” with production falling 1.6mm b/d this year and 2mm b/d in 2023 (vs 2021 levels). The production lost due to not being able to fully offset lost sales to the EU following its invasion of Ukraine could approach 3mm b/d next year (vs 2021 levels), depending on how successful Russia is in finding new customers. We also expect the US shale-oil producers to continue to maintain their capital discipline, and not ramp production in response to higher prices (Chart 4). This will be critical for maintaining access to capital markets, particularly if oil demand weakens in response to a global GDP decline. Chart 4US Shale Producers Forced To Maintain Capital Discipline Markets Will Remain Balanced Our supply-demand assessments leave oil markets relatively balanced with slightly lower prices resulting from lower demand (Chart 5). Oil inventories likely rise somewhat before resuming their downward trajectory as supply and demand adjust to lower growth prospects (Chart 6). Chart 5Expect Oil Markets To Remain Balanced Chart 6Oil Inventories Will Draw Importantly, OPEC 2.0’s core producers might welcome a slight rebuilding of inventories, given the relatively low levels of spare capacity available to meet unexpected supply outages or product shortages, say, for a hurricane in the US Gulf (Chart 7). This becomes particularly acute next year, when, as mentioned above, we expect core-OPEC 2.0 will have to increase their output by 2mm b/d vs 2021 levels to balance markets. Given the dynamics of our supply-demand modeling described above, our price forecasts for 2H22 and 2023 are little changed from last month’s estimates (Chart 8). We expect 2H22 Brent prices to average $115/bbl vs $121.30/bbl. This leaves the 2022 average at $110/bbl vs. $113/bbl estimate last month. For 2023, we expect Brent to average $117/bbl vs our earlier estimate of $122/bbl. Chart 7OPEC Spare Capacity Likely Will Tighten Chart 8Brent Forecast Slightly Lower On Global Growth Downgrade These price forecasts and balances are our base case (Table 1). We do not estimate the risk premium the market is likely to impound in prices to cover the high level of uncertainty around oil, natgas and electricity prices in global markets. A sudden cut-off of Russian oil supplies to the EU could easily spike Brent prices above $140/bbl, e.g. Indeed, we continue to accord this outcome a non-trivial probability. Likewise, the Atlantic Hurricane Season starts this month, with the US Climate Prediction Center calling for a higher-than-average number of hurricanes for 2022, given above-average Atlantic temperatures and an ongoing La Niña event.4 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Investment Implications The World Bank’s weaker GDP growth forecast leads us to expect slightly lower demand in 2H22 and 2023. However, low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will keep Brent prices close to $115-117/bbl in 2H22 and 2023, which, as our base case, is not far removed from last month’s forecasts. The odds of prices exceeding $140/bbl remain high, reflecting the razor-thin back-up supply margins available to the crude and product markets globally. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). We will look for opportuities to re-establish our XOP, XME and PICK ETF positions, which were stopped out with gains of 19%, 7.2% and 7.6%, respectively, over the course of this past week.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas prices are surging on the back of a loss of exportable LNG volumes from the US Gulf, and on press reports Russia will cut exports to Germany on the Nord Stream (NS) 1 pipeline by ~ 40%. The US supply loss arises from an explosion to at a Freeport LNG terminal in Texas, which accounts for more than 15% of US LNG exports and takes ~ 5 bcm of gas out of the export market. Repairs reportedly will take three months. The loss of natgas supplies on NS1 is being blamed by Russia on an inability to move parts needed to repair the line from Canada due to sanctions imposed following its invasion of Ukraine in February. European gas prices – at the Title Transfer Facility (TTF) in the Netherlands and the National Balancing Point in the UK – surged on the back of this news, and were up 44.28% and 10.15% respectively from Monday’s close to Wednesday trading this week (Chart 9). US gas futures were down 13.81% this week, reflecting a back-up of pipeline natgas that will not make it to the LNG pool until repairs at Freeport are done. Base Metals: Bullish BCA’s China Investment Strategy reported a possible inflection point in household borrowing after nearly two decades of growth (Chart 10). Pandemic-induced lockdowns and declining home prices reduced households’ propensity to take on new debt. Household deleveraging could reduce demand for durables spending and real estate investment, driving down industrial metals’ demand. If deleveraging and lower demand becomes structural, China’s relevance in global metal demand likely will decline. Precious Metals: Bullish On the back of last Friday’s hot inflation data, the Federal Reserve announced a 75 bps rate hike following the June Federal Open Market Committee (FOMC) meeting. This likely will reduce the Fed’s credibility after Powell hinted at a 50 bps rate hike for the June meeting in last month’s meeting. The higher rate hike puts the Fed on a more hawkish path, risking the soft landing it has been aiming for. A US recession will be supportive for gold prices.   Chart 9 Chart 10     Footnotes 1     Please see Stagflation Risk Rises Amid Sharp Slowdown in Growth, which includes a link to the Bank’s full June 2022 update. 2     Please see discussion beginning on p. 51 of the Banks June report, “Special Focus 1, Global Stagflation.”  This focus provides a well-researched history of the evolution of inflation. 3    Please see One Hot Mess: EU Energy Policy and Commodities' Watershed Moment, which we published 26 May and on March 10, 2022, for discussion of the EU’s energy dependence on Russia. See also La Niña And The Energy Transition, published on September 30, 2021, for a discussion of refining-concentration risks – particularly for base metals refining, where roughly half of global capacity is concentrated in China. 4    Please see NOAA predicts above-normal 2022 Atlantic Hurricane Season published on May 24, 2022.   Investment Views and Themes Recommendations  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG S&P OIL & GAS EXPLORATION & PRODUCTION (XOP) ETF TRADE ON JUNE 13, 2022 WITH A RETURN OF 19%. WE WERE STOPPED OUT OF OUR LONG MSCI GLOBAL METALS & MINING PRODUCERS (PICK) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.56%. WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS AND MINING (XME) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.17%. Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary ECB & Inflation: Whatever It Takes? Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials.     Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox Chart 11The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade Chart 15An Unusual Disconnect Chart 16German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Chart 22The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Natural Gas Markets Eerily Quiet An eerie calm in European natural gas markets belies the state of war in Ukraine that already is producing a cutoff of Russian natgas supplies in retaliation for the EU’s oil embargo. Such cutoffs will accelerate, and send natgas prices in Europe and Asia sharply higher if they occur sooner – as we expect – rather than later. The US will continue to send most of its LNG exports to Europe. These exports are expected to average 12 Bcf/d this year, up 22% from last year’s level. Planners in Europe and Asia will want to secure as much natgas supply as possible by the end of October to refill storage for the November-March withdrawal season, which is beginning to look like another La Niña winter. The US Climate Prediction Center makes the odds of such an event, which is associated with colder-than-normal winters in the Northern Hemisphere, just over 60%. Bottom Line: European governments are preparing their citizens for natgas rationing, in the event of a cutoff of Russian gas. This will occur sooner rather than later. In its wake, EU GDP will fall, and inflation will rise as knock-on effects constrict base metals, fertilizer and food supplies. At tonight’s close, we will be getting long 1Q23 TTF futures on the ICE, expecting prices to again exceed €225/MWh. Feature Related Report  Commodity & Energy StrategyHigher Gasoline, Diesel Prices Ahead Russia is at war with Ukraine. NATO military support for Ukraine – with the EU at the forefront – is being maintained at a high level, and Ukrainian forces are vigorously defending their homeland.1 The EU embargoed Russian oil imports to sharply reduce funding for Russia’s war machine. Russia will be compelled to follow through on its threat to cut off pipeline gas shipments to Europe, following the embargo.2 It is highly doubtful Russia will countenance the timetable envisioned in the EU embargo, which calls for a phase-out of oil imports by yearend that removes close to 3mm b/d, or 90% of Russia’s sales into its largest market (Chart 1). Equally doubtful is the notion the EU will countenance funding Russia’s war on Ukraine over the course of such a phase-out. Our colleague Matt Gertken, who runs BCA’s Geopolitical Strategy, demonstrated that while such a phase-out schedule may be optimal for both sides – i.e., it prolongs revenue flows to Russia and gas flows to the EU – it almost surely is not an equilibrium.3 An equilibrium in this prisoners’ dilemma obtains when both sides act immediately to end their vulnerability to the other unilaterally upsetting the optimal state – i.e., endure short-term pain for long-term gain (Diagram 1). For this reason, we believe Russia’s cutoff of natgas shipments to the EU will occur sooner rather than later, to inflict maximum pain on the EU going into the coming winter season. The EU knows this, and is preparing its citizens for rationing of natgas. Chart 1EU’s Russian Oil Embargo Cuts Sales By 90% By Year-end Diagram 1The EU, Russia Prisoners’ Dilemma Russian Natgas Cutoff To The EU Underway Russia already has begun reducing natural gas supplies to the EU (Chart 2). Russian gas flows to Finland, Poland, Bulgaria, Netherlands, and Denmark were embargoed after these states refused to pay for gas in rubles (Chart 3). Russia reduced gas shipments to Germany – albeit marginally – after Shell refused to pay for natgas supplied to Germany in rubles. While this only disrupted 1.3% of total natgas consumption in Germany, it showed Russia will quickly act against what it views as “unfriendly” customers.4 Ukraine was forced to shut a gas transit point through which 8% of total Russian gas flows reach Europe, after Russian occupying forces were found to be siphoning gas, according to Gas Transmission System Operator of Ukraine (GTSOU). As a result, gas flows from Russia have taken a further hit and have not recovered (Chart 4). EU member states whose supply of Russian gas has been disrupted will need to search for alternatives. Orsted, an energy company supplying natgas to Denmark, stated it will source gas from the EU market. Given supply constraints in Europe, an increase in the number of bids on the single EU market will raise the Dutch Title Transfer Facility (TTF), all else equal. Chart 2Russia Starts Cutting Gas Flows Chart 3Russian Gas Flows To EU Falling Overall... Chart 4...Particularly Via Ukraine Higher TTF prices will direct gas flows from the US to Europe, reducing gas available for domestic consumption. LNG gas exports to Europe have maintained their upward trend since 2016 and were up by 87% (674 BCF) in 1Q22 vs the same period in 2019 (Chart 5). Chart 5US LNG Exports To Europe Surge Simultaneously, the US witnessed its largest inventory withdrawal this winter in the last four years (Chart 6). Warmer-than-normal temperatures and drought conditions in the US also are increasing domestic demand, as electricity companies are forced to substitute hydroelectric power with natgas-fired generation. Increased exports and weather phenomena have combined to push the Henry Hub contract above $9.50/MMBtu this week, the highest level since 2008. Chart 6US Natgas Inventories Slowly Filling US LNG Exports To Europe Surge Higher European prices for US natgas have disincentivized shipments to Asia, where prices – measured by the Japan Korea Marker (JKM) – have been trading below the TTF so far this year on average (Chart 7). This has allowed European gas inventories to refill at a rapid pace. As of 4 June, the EU’s working gas inventories were ~49% full and are above last year’s level for this time of the year (Chart 8). Chart 7Natural Gas Markets Eerily Quiet Chart 8European Gas Storage Refill Off To A Good Start Shanghai’s reopening will propel Chinese economic activity and demand for natgas, making an already tight global natural gas market tighter. However, the risk of rolling lockdowns in China will keep Asia’s LNG demand in check.5 LNG vessel charter rates have increased sharply since the Russia-Ukraine war began, largely on the back of European demand (Chart 9). We expect this to be a regular feature of the international gas market going forward, as more LNG export capacity is added in the US – it will rise to 12.6 Bcf/d next year, e.g. – and global demand remains strong. Chart 9Surge in LNG Charter Rates   Europe Is Critically Short LNG Infrastructure Most of the EU’s existing 158 Bcm of annual regasification capacity is located around the Iberian Peninsula (Chart 10), which is not well-connected to the rest of Europe. As a result, to substitute Russian piped gas for LNG imports, investments for import terminals and regasification capacity will be required. In its REPowerEU program the European Commission expects to move closer to complete independence from Russian fossil fuels by importing an additional 50 Bcm of LNG per year, reducing demand, and ramping up renewable energy. Germany is aiming for independence from Russian gas flows by planning a shoreside LNG terminal and ordering four Floating Storage and Regasification Units (FSRUs). The FSRUs, which are expected to come online between year-end and the start of next year will have a combined capacity under 24 Bcm per year. Chart 10Europe Needs More Re-Gasification Capacity These plans, however, are not aligned with the nation’s pathway to go carbon neutral by 2045. An environmental activist group has filed a lawsuit to halt the construction of the LNG terminal. The group also is opposed to Germany’s draft LNG acceleration bill, which will allow imports until two years before 2045.6 This reflects two problems all EU nations will face as they transition to LNG from pipeline Russian gas imports. Firstly, member states will need to invest billions of euros in new LNG capacity, and given current politics, likely will have to decide to scrap or repurpose this infrastructure in during the transition to green energy. Opposing this possibility is the high likelihood that EU states will need to enter long-term LNG contracts to ensure supply security and shield themselves from volatile natgas prices. For the immediate future, the EU likely will kick this can down the road for as long as possible. Investment Implications Back in March, Germany and Austria began preparing their citizens for natgas rationing.7 Now the IEA is warning all of Europe the likelihood of such action is increasing rapidly.8 State and local planners throughout Europe will spend the next five months or so lining up as much LNG and pipeline gas as possible going into the coming winter season. While the inventory-injection in Europe is off to a good start, planners most likely hope to exceed their minimum target for filling 80% of storage in time for the November-March withdrawal season. In addition to the risk of a Russian cutoff of supplies, planners have to account for a higher likelihood of a colder-than-normal winter, given the odds of another La Niña winter, which is associated with colder-than-normal winters in the Northern Hemisphere. The US Climate Prediction Center makes the odds of such an event – the third such event in as many years – just over 60%. If European states are forced to implement rationing of natgas, knock-on effects resulting from prioritizing human needs over industrial concerns will, once again, restrict base metals, fertilizer and food supplies. We remain long energy, metals and grains exposure via the S&P GSCI and COMT ETF as the natural-gas drama in Europe plays out. In addition, we remain long the XOP, XME, PICK, and CRAK ETFs to maintain our equity exposure to industrial commodities. At tonight’s close, we will be getting tactically long 1Q22 futures on the ICE, expecting prices to again exceed €225/MWh. This will complement our existing tactical commodity exposures in 4Q22 TTF futures.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish US refined product demand rose just under 4% for the week ended 3 June 2022, led by a surge in jet-fuel demand of 26.5% yoy – finishing at 1.6mm b/d vs. 1.26mm b/d the year earlier, according to the US EIA. This provides further evidence consumer pent-up demand for travel is being released, after the long shut-downs in travel caused by COVID-19 beginning in 1Q20. The surge in jet-fuel demand was enough to offset yoy declines in gasoline and distillates such as diesel fuel and heating oil of 0.9% and 2.8%, respectively. Gasoline inventories were down 800k barrels yoy, which put them 10% below their five-year average level at the end of the reporting week. Distillate inventories rose 2.6mm barrels, but this still left them 23% below their five-year average. Crude oil inventories in the US including those in the Strategic Petroleum Reserve (SPR), which is being drawn down to provide charging stock to refiners, drew 7.3mm barrels, and stood at 519mm barrels. Versus year-ago levels, crude inventories including the SPR are down 17%. Base Metals: Bullish Copper production in Chile fell 9.8% yoy in April as state-owned copper giant Codelco’s monthly supply fell 6.1% yoy to 116,000 tons. In Peru, protests against mines by displaced communities have seen suspensions in copper mine production, including that of MMG-owned Las Bambas. Although the International Copper Study Group (ICSG) expects a physical surplus for refined copper markets next year, falling production in Chile and civil unrest in Peru continue to plague the rebuilding of stocks (Chart 11). Globally, a risk matrix we reproduced in a report last year showed that approximately 570 million Metric Tons of copper faced a significant ESG risk.9 This increases the risk of new copper projects being stymied by activist groups, and further curtailing future copper production.   Precious Metals: Bullish According to data from World Gold Council, gold ETFs faced net outflows in May as the USD and interest rates strengthened, following the Fed rate hikes (Chart 12). In his speech, Fed Governor Christopher Waller explained that by increasing interest rates, the Fed aims to match labor demand to supply and reduce wage growth, which in turn will lower inflation.10 This, however, does not deal with high inflation via the mechanism of elevated food and fuel prices, which will remain high as long as supply disruptions continue in these markets. Chart 11 Chart 12     Footnotes 1     Please see The Institute For The Study Of War for daily updates of the Russia-Ukraine war. 2     Please see Higher Gasoline, Diesel Prices Ahead, which we published last week, for further discussion of the EU’s embargo of Russian oil imports. The EU embargo initially will be on Russian seaborne oil imports, which will tighten global crude oil and refined-product markets further. Pipeline imports are due to phase out by year-end. Cumulatively, this will translate to a 90% decrease in Russian crude and product exports to the EU, representing ~ 3mm b/d of lost sales. Our report is available at ces.bcaresearch.com. 3    Please see Energy Cutoff Continues (GeoRisk Update), published by BCA Research’s Geopolitical Strategy on June 1, 2022. It is available at gps.bcaresearch.com. 4    According to a recent report from Gemeinshcafts Diagnose institution prepared on behalf of Germany’s Federal Ministry of Economics and Climate Protection, if Russia embargos oil and gas to Germany immediately the German economy will fall into a sharp recession.  The cumulative loss to macroeconomic output in 2022 and 2023 will amount to 220 billion euros, or more than 6.5% of annual economic output. 5    For more on the risk of rolling lockdowns in China, please see Not The Time To Be A Contrarian, published by BCA’s Emerging Markets Strategy on May 19, 2022.   6    Please see Germany’s Cabinet Moves to Head Off Lawsuits Against LNG Terminals, published by The Maritime Executive on May 11, 2022 7     Please see Germany Closer To Rationing Natgas, which we published on March 31, 2022. 8    Please see Europe at risk of winter energy rationing, energy watchdog warns, published by ft.com on June 8, 2022. 9    Please see Renewables ESG Risk Grows With Demand, which we published on April 29, 2022 10   For the speech, please see  Responding to High Inflation with Some Thoughts on a Soft Landing.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1   Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price.  When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5)  April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal   Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1  Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Listen to a short summary of this report.       Executive Summary Chinese Stocks Are Relatively Cheap The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. A much better option would be to adopt measures that boost disposable income. Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. With the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales. A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. Go long the iShares MSCI China ETF ($MCHI) as a tactical trade. Bottom Line: China faces a number of economic woes, but these are fully discounted by the market. What has not been discounted is a broad-based stimulus program focused on income-support measures.   Dear Client, I will be visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi next week. No doubt, the outlook for oil prices will feature heavily in my discussions. I will brief you on any insights I learn in my report on June 17. In the meantime, I am pleased to announce that Matt Gertken, BCA’s Chief Geopolitical Strategist, will be the guest author of next week’s Global Investment Strategy report. Best regards, Peter Berezin Chief Global Strategist Triple Threat The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Let us discuss each problem in turn.   Problem #1: China’s Zero-Covid Policy in the Age of Omicron Chart 1China’s Lockdown Index Remains Elevated China was able to successfully suppress the virus in the first two years of the pandemic. However, the emergence of the Omicron strain is challenging the government’s commitment to its zero-Covid policy. The BA.2 subvariant of Omicron is 50% more contagious than the original Omicron strain and about 4-times more contagious than the Delta strain. While 89% of China’s population has been fully vaccinated, the number drops off to 82% for those above the age of 60. And those who are vaccinated have been inoculated with vaccines that appear to be largely ineffective against Omicron. Keeping a virus as contagious as measles at bay in a population with little natural or artificial immunity is exceedingly difficult. While the authorities are starting to relax restrictions in Shanghai, China’s Effective Lockdown Index remains at elevated levels (Chart 1). A number of domestically designed mRNA vaccines are in phase 3 trials. However, it is not clear how effective they will be. Shanghai-based Fosun Pharma has inked a deal to distribute 100 million doses of Pfizer’s vaccine, but so far neither it nor Moderna’s vaccine have been approved for use. Our working assumption is that China will authorize the distribution of western-made mRNA vaccines later this year if its own offerings prove ineffectual. The Chinese government has already signed a deal to manufacture a generic version of Pfizer’s Paxlovid, which has been shown to cut the risk of hospitalization by 90% if taken within five days of the onset of symptoms. In the meantime, the authorities will continue to play whack-a-mole with Covid. Investors should expect more lockdowns during the remainder of the year.   Problem #2: Weaker Export Growth China’s export growth slowed sharply in April, with manufacturing production contracting at the fastest rate since data collection began. Activity appears to have rebounded somewhat in May, but the new export orders components of both the official and private-sector manufacturing PMIs still remain below 50 (Chart 2). Part of the export slowdown is attributable to lockdown restrictions. However, weaker external demand is also a culprit, as evidenced by the fact that Korean export growth — a bellwether for global trade — has decelerated (Chart 3).  Chart 2China’s Export Growth Has Rolled Over Chart 3Softer Export Growth Is Not A China-Specific Phenomenon Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are now well above their pre-pandemic trend, suggesting that the demand for Chinese-made goods will remain subdued over the coming months (Chart 4). The surge in commodity prices is only adding to Chinese manufacturer woes. Input prices rose 10% faster than manufacturing output prices over the past 12 months. This is squeezing profit margins (Chart 5). Chart 4Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 5Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users A modest depreciation in the currency would help the Chinese export sector. However, after weakening from 6.37 in April to 6.79 in mid-May, USD/CNY has moved back to 6.66 on the back of the recent selloff in the US dollar. Chart 6The RMB Tends To Weaken When EUR/USD Is Rising We expect the dollar to weaken further over the next 12 months as the Fed tempers its hawkish rhetoric in response to falling inflation. Chart 6 shows that the trade-weighted RMB typically strengthens when EUR/USD is rising. Chester Ntonifor, BCA’s Chief Currency Strategist, expects EUR/USD to reach 1.16 by the end of the year.   Problem #3: Flagging Property Market Chinese housing sales, starts, and completions all contracted in April (Chart 7). New home prices dipped 0.2% on a month-over-month basis, and are up just 0.7% from a year earlier, the smallest gain since 2015. The percentage of households planning to buy a home is near record lows (Chart 8). Chart 7The Chinese Property Market Has Been Cooling Chart 8Intentions To Buy A House Have Declined China’s property developers are in dire straits. Corporate bonds for the sector are, on average, trading at 48 cents on the dollar (Chart 9). Goldman Sachs estimates that the default rate for property developers will reach 32% in 2022, up from their earlier estimate of 19%. The government is trying to prop up housing demand. The PBoC lowered the 5-year loan prime rate by 15 bps on May 20th, the largest such cut since 2019. The authorities have dropped the floor mortgage rate to a 14-year low of 4.25%. They have also taken steps to make it easier for property developers to issue domestic bonds. BCA’s China strategists believe these measures will foster a modest rebound in the property market in the second half of this year. However, they do not anticipate a robust recovery – of the sort experienced following the initial wave of the pandemic – due to the government’s continued adherence to the “three red lines” policy.1 China is building too many homes. While residential investment as a share GDP has been trending lower, it is still very high in relation to other countries. China’s working-age population is now shrinking, which suggests that housing demand will contract over the coming years (Chart 10). Chart 9Chinese Property Developer Bonds Are Trading At Distressed Levels Chart 10Shrinking Working-Age Population Implies Less Demand For Housing Chinese real estate prices are amongst the highest anywhere. The five biggest cities in the world with the lowest rental yields are all in China (Chart 11). The entire Chinese housing stock is worth nearly $100 trillion, making it the largest asset class in the world. As such, a decline in Chinese home prices would generate a sizable negative wealth effect. Chart 11Chinese Real Estate Is Expensive A Silver Bullet? Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. Luckily, one does not need to fill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. China needs to reorient its economy away from its historic reliance on investment and exports towards consumption. The easiest way to do that is to adopt measures that boost disposable income, which has slowed of late (Chart 12). Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. The authorities have not talked much about pursuing large-scale income-support measures of the kind adopted by many developed economies during the pandemic. As a result, market participants have largely dismissed this possibility. Yet, with the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales (Chart 13). A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. As we saw in the US and elsewhere, stimulus cash has a habit of flowing into the stock market; and with real estate in the doldrums, equities may become the asset class of choice for many Chinese investors. With that in mind, we are going long the iShares MSCI China ETF ($MCHI) as a tactical trade. Chart 12Disposable Income Growth Has Been Trending Lower Chart 13Chinese Stocks Are Relatively Cheap At a global level, a floundering Chinese property market would have been a cause for grave concern in the past, as it would have represented a major deflationary shock. Times have changed, however. The problem now is too much inflation, rather than too little. To the extent that reduced Chinese investment injects more savings into the global economy and knocks down commodity prices, this would be welcomed by most investors. China’s economy may be heading for a “beautiful slowdown.” Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter   Footnotes   1      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Crude Oil Prices Will Remain High The EU embargo on Russian seaborne oil imports will tighten global crude oil and refined-product markets further.  Pipeline imports are due to phase out by year-end.  This will translate to a 90% decrease in Russian crude and product exports to the EU, representing ~ 3mm b/d of lost sales. Russian crude oil production will fall to 7-8mm b/d by year-end 2023, unless the state pre-emptively cuts output before that.  This would push crude oil above $140/bbl.  We expect Russia to reduce natural gas exports to the EU in the wake of the oil embargo. Refined-product markets will remain tight, given refining capacity losses, tight crude oil markets and still-strong gasoline and diesel demand. OPEC 2.0 is expected to maintain its policy to nominally increase oil supply by 432k b/d at its meeting this week.  Actual oil output returned to the market by the coalition is ~ 1.5mm – 1.7mm b/d below nominal levels. Bottom Line: Oil markets will continue to tighten in the wake of the EU’s embargo on Russian imports this week.  Refined-product markets will remain well bid, with prices of gasoline, jet and diesel fuel close to or above record levels.  We remain long oil producers and refiners via the XOP and CRAK ETFs, along with the S&P GSCI and COMT ETF, to retain exposure to higher commodity prices and backwardation. Feature Global refined-product markets are tight and getting tighter. Related Report  Commodity & Energy StrategyOil, Natgas Prices Set To Surge As the Northern Hemisphere driving season gets underway, gasoline and diesel prices in the US are at record levels – up 56.55% and 70.17% respectively yoy. So are jet-fuel prices, which are up 107.97% yoy in the US. Prices are similarly robust ex-US and trading at or close to record levels. During the COVID-19 pandemic, the US permanently lost ~ 5% of total refining capacity. Currently, three of the largest refineries in the US are working on replenishing less than half of that loss by end-2023, which will take total US refining capacity to under 18.5mm b/d. US gasoline stocks are low for this time of the year. Markets expect higher demand this driving season, which unofficially ends in early September with the Labor Day weekend in the US. The US went into the Memorial Day Weekend – the start of the summer driving season – with record high motor gas prices (Chart 1). Gasoline stocks normally build in the off-season winter months. However, this year inventories are depleted (Chart 2) because of relatively high distillate “crack spreads” – gross refining margins – which incentivized refiners to produce more diesel, jet and marine fuels.1 This meant gasoline output was sacrificed in the process, which left markets tight going into the summer driving season.2 Chart 1High Gas Prices Bring In US Driving Season US distillate crack spreads are at record highs, after stocks hit a 14-year low last month (Chart 3). Reduced oil refinery capacity will constrict future supply, keeping prices elevated, which will feed into inflation. Demand destruction will be required to balance markets and bring prices lower. Chart 2Depleted Stocks Due To Low Gasoline Margins Chart 3Low Distillate Stocks Produce Record Cracks Tight Supply-Demand Fundamentals, High Prices US refined-product prices have been strengthening since 2021 due to high crude oil prices, rising demand and lower refinery capacity and utilization rates. This keeps the level of demand for refined products consistently above the level of supply, which forces refiners to pull down inventories or increase imports to cover the supply-demand gaps. Higher refined-product prices ensue as inventories fell. As a result, crack spreads were pushed higher to encourage higher output, which remains problematic because of supply-side pressure in global crude-oil markets (Chart 4). Crude oil prices account for 60% of gasoline and 49% of diesel costs, respectively.3 Last year OPEC 2.0’s production-management strategy kept the level of crude oil supply below demand, but this year additional forces are constraining output. Supply disruptions following Russia’s invasion of Ukraine, lower OPEC 2.0 production, and non-OPEC capital discipline, particularly from US shale-oil producers, have combined to constrain crude-oil production. We expect continued production restraint by core OPEC 2.0 (Saudi Arabia and the UAE); lower output from the rest of the coalition; falling Russian supply due to sanctions and an EU embargo on Russian oil imports; and continued capital discipline by shale producers. These factors will offset weaker global oil demand resulting from slower GDP growth in the EU and China. Chart 4Supply Will Barely Rise Despite High Margins Volatile supply-demand dynamics will keep crude oil prices elevated this year and next (Chart 5).4 The EU’s embargo on Russian oil, in particular, will raise oil-price volatility, and leave prices upwardly biased. Lastly, we do not expect the US and Iran to renew the Joint Comprehensive Plan of Action (JCPOA), which would allow ~ 1mm b/d of Iranian exports to return to the market. Chart 5Crude Oil Prices Will Remain High Tighter Product Markets Will Persist Refined-product stocks in the US and the rest of the world were low prior to Russia’s invasion of Ukraine, owing to strong demand growth and weak crude-oil supply growth last year, along with lower global refining capacity. US refinery utilization rates last year and earlier this year fell as refiners undertook heavier-than-usual maintenance, which was deferred during the pandemic (Chart 6). Refiners also closed ~ 1mm b/d in 2020 during the COVID-19 pandemic, which resulted in ~ 5% of US refining capacity being shut-in at the start of 2021.5 Global refining capacity has fallen by more than 2mm b/d since the COVID-19 pandemic.6 As midterm elections approach, the Biden administration has been urging refiners to restart idle capacity to little or no avail, and has threatened to re-introduce export restrictions on crude oil in an attempt to hold down gasoline and diesel prices. Chart 6US Refiners Were Shut-In For Maintenance Gasoline markets are going into their first summer without COVID-19 restrictions since 2020. While US data for the first 3 months of 2022 suggest Americans’ gasoline consumption was more price-inelastic than in the past (Chart 7), a series of record-breaking gasoline prices recently may have been enough to start curbing US gasoline demand (Chart 8). All the same, US consumers appear to be willing to pay up for holiday breaks and get-aways, which will keep pressure on inventories during the summer driving season. Chart 7US Gasoline Demand Price Inelastic In Q1… Chart 8…But Record Breaking Prices May Change That Jet, Diesel Remain Tight, Especially In Europe The approval of an embargo on Russian oil imports into the EU earlier this week means member states on the continent that rely heavily on Russian distillate exports will remain exposed to higher refined-product prices (Chart 9).7 This will keep European diesel prices and crack spreads elevated this year and next (Chart 10). Chart 9EU Dependent On Russia For Diesel Chart 10Europe Refining Margins Will Remain Elevated Shipping markets also will continue to feel the pressure of higher prices, particularly for marine diesel fuel. Russia’s invasion of Ukraine forced insurance rates higher, which propelled shipping-rates higher in Europe and Russia (Chart 11). The EU is now slapping sanctions on insurers. In addition, the Ukraine war forced a re-routing of ships and port congestion, which led to massive supply-chain disruptions due to closures and blockades.8 High refined-product prices partly is the result of European refineries either permanently shutting in production or switching to renewable energy production when faced with low Covid-19-induced demand in 2020. In the first half of 2021, as product demand started to rise, the parabolic increase in prices of natgas – used as a fuel by refiners – was an additional headwind to refining margins. Chart 11Cost Of Shipping Crude, Products Surges As of last December, more than 800 kb/d – or 5% of the continent’s refining capacity – was permanently taken offline during the pandemic.9 As a result, OECD Europe’s refining capacity for 2022 will be 11.4 mmb/d, ~ 0.8 mmb/d below pre-pandemic levels.10 Europe will need to look elsewhere for distillates. Attempting to substitute refined products in such tight energy markets will not be cheap. Sourcing imports from other states will tighten exporters’ domestic refined product markets and dislocate distillate supply to their traditional importers, which will tighten those states’ domestic markets as well. This could lead to something similar to what we are currently witnessing in LNG markets between Europe and Asia. The US, despite having its own tight refined products market, likely will step up as an alternate supplier to fill the Russian distillate supply void for states reliant on Russian diesel, jet and marine fuels. This can be seen in the 32-month high in Gulf Coast diesel exports from the US, which are the result of stronger imports by Europe and LatAm.11 Investment Implications The EU embargo on Russian oil imports will tighten global refined-product markets. If Russia retaliates by pre-emptively cutting crude oil production by 20-30%, prices would significantly exceed our forecast of $113/bbl this year and $122/bbl next year – reaching or surpassing $140/bbl. Refined-product markets will remain well bid, with prices of gasoline, jet and diesel fuel close to or above record levels. We remain long oil producers and refiners via the XOP and CRAK ETFs, along with the S&P GSCI and COMT ETF, to retain exposure to higher commodity prices and backwardation.   Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Bullish We continue to expect Russia to cut off natural gas exports to the EU in retaliation for the embargo on EU oil imports from Russia agreed this week. The timing of this cut-off is uncertain, however. As our colleague Matt Gertken notes in this week’s Geopolitical Strategy, Russia and the EU both would benefit if exports were maintained as long as possible and phased down slowly. This would provide Russia with revenues to wage war in Ukraine, while allowing Europe to avoid recession as it phases out Russian gas. This is not an equilibrium, however, as it leaves both sides exposed to a sudden reversal of the tacit understanding. In equilibrium – i.e., the strategies that guarantee the EU and Russia lose the least – both states reduce their energy trade immediately. Russia needs to show strength in the face of the EU’s embargo, and Europe needs to cut the revenues fueling Russia’s war in Ukraine, which also will deter similar aggression against member states in the future. As soon as the EU weans itself off Russian natgas, Russia’s leverage disappears. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared. (Chart 12). In the meantime, the EU is moving heaven and earth to fill its natgas storage as quickly as possible (Chart 13). According to the GIE AGSI, the percent-full level was 46.68%  as of May 30, 2022. Precious Metals: Bullish Gold prices pared losses last Wednesday after the Federal Open Market Committee’s (FOMC) minutes of the May meeting indicated the Fed will not raise rates by more than the half percentage points markets had priced in for June and July. Recent weakness in gold prices despite heightened geopolitical uncertainty can be attributed to the Fed’s tightening cycle. Rate hikes will increase real interest rates, the opportunity cost of holding non-yielding bullion and strengthen the USD, which competes directly with gold for safe-haven demand, and will also raise the price of gold in local currencies. Base Metals: Bullish Chile’s National Institute of Statistics reported the country’s Mining Production Index fell 10.6% year-over-year (y-o-y) in April, dragging the country’s overall Industrial Production Index lower by 3.6% y-o-y. The drop in mining was due to a 9.8% fall in copper production y-o-y. The contraction in mined copper output this month follows y-o-y contractions of 15%, 7% and 7.2% in January, February and March respectively this year. Chart 12 Chart 13     Footnotes 1     The “crack spread” (or “cracks”) is an industry term for gross margins. It derives its name from the literal cracking of the bonds holding the hydrocarbon molecules of crude oil together under intense heat and pressure, and reforming them into refined products like gasoline and diesel fuel and other liquids and gases. The crack spread is the difference between the price of a refined product and crude oil in USD/bbl. 2     In this report, we focus on diesel fuel and gasoline. Low stocks, high prices and high crack spreads are a feature of jet-fuel markets as well. 3    Please see the US EIA’s May 2022 Gasoline and Fuel Update. 4    Please see Oil, Natgas Prices Set To Surge published on May 19, 2022 for our latest balances and price forecasts. 5    Please see the U.S. EIA’s 30 June, 2021 edition of This Week In Petroleum. 6    Please see White House Eyes Restarting Idle Refineries, published by ttnews.com on May 26, 2022. 7     Please see Breakingviews: Oil embargo will hurt Putin more than EU, published by reuters.com on May 31, 2022. 8    For more on this, please refer to High Food Prices Drive EM Inflation, which we published on May 12, 2022. 9    Please see Viewpoint: European refiners cautious on cusp of 2022, published by Argus Media on December 30, 2021. 10   Please see the IEA’s January 2022 Oil Market Report. 11    Please see to PADD 3 diesel exports reach 32 month high as the competition for the non-Russian molecule begins, published by Vortexa on May 4, 2022.   Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022