Electric Utilities

Executive Summary At the margin, the European Union’s proposed €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power will blunt the message markets are sending to consumers to conserve energy, by distributing this windfall to households to offset higher energy costs. A “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of “fossil-fuel tax” – will reduce capex at a time when it is needed to expand supply. These measures – the direct fallout of the EU’s failed Russia-engagement policy – will compound policy uncertainty in energy markets, which also will discourage investment in new supply. Efforts to contain energy prices of households and firms in the UK will be borne by taxpayers, who will be left with a higher debt load in the wake of the government’s programs to limit energy costs, and higher taxes to service the debt. EU Still At Risk To Russia Gas Cutoff EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Bottom Line: The EU and UK governments are inserting themselves deeper into energy markets, which will distort fundamentals and prices, leaving once-functioning markets “unfit for purpose.” This likely will reduce headline inflation beginning in 3Q22 by suppressing energy prices, and will discourage conservation and capex. Energy markets will remain tight as a result. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We will re-open these positions at tonight’s close with 10% stop-losses. Feature The EU is attempting to address decades of failed policy – primarily its Ostpolitik change-through-trade initiative vis-à-vis Russia – in a matter of months.1 This policy was brought to a crashing halt earlier this year by Russia’s invasion of Ukraine, which led to an economic war pitting the EU and its NATO allies against Russia. This conflict is playing out most visibly in energy markets. For investors, the most pressing issue in the short term center around the trajectory of energy prices – primarily natural gas, which, unexpectedly, has become the most important commodity in the world: It sets the marginal cost of power in the EU; forces dislocations in oil and coal markets globally via fuel substitution, and drives energy and food inflation around the world higher by increasing space-heating fuel costs and fertilizer costs. These effects are unlikely to disappear quickly, especially in the wake of deeper government involvement in these markets. The EU is dealing with its energy crisis by imposing taxes on power generators and hydrocarbons producers. It is proposing a €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power, and is advancing a “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of a “fossil-fuel tax. Lastly, the EU will mandate energy rationing to stretch natural gas supplies over the summer and winter heating season. The tax hikes under consideration will reduce capex at a time when it is needed to expand supply. Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy The UK is taking a different route v. the EU, by having the government absorb the cost of stabilizing energy prices for households and firms directly on its balance sheet. Beginning 1 October, annual energy bills – electricity and gas – will be limited to £2,500. The government is ready to provide support for firms facing higher energy costs out of a £150 billion package that still lacks formal approval via legislation to be dispensed. This obviously has businesses concerned.2 Over the medium to long term, this economic war will realign global energy trade – bolstering the US as the world’s largest energy exporter, and cementing the alliance of China-Russia energy trade. Whether this ultimately evolves into a Cold War standoff remains an open question. EU Policy Failures And The Power Grid’s Limitations Chart 1Russia Plugged The Gap In EU Energy Supply EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason In addition to its failed Russia policy, the EU’s aggressive support of renewable energy disincentivized domestic fossil fuel production and forced an increased reliance on imports – with a heavy weighting toward Russian hydrocarbons – instead. Once Russia stopped playing the role of primary energy supplier to the EU, the bloc’s energy insecurity became obvious (Chart 1). The EU’s current power-pricing system is forcing households and industries to bear the brunt of energy insecurity and high natgas prices resulting from poor energy policy design.3 And it forces the government to tax energy suppliers – with “windfall profits” taxes ostensibly meant to capture economic rents, as officials are wont to describe the taxes – to fund consumer-support programs. While REPowerEU aims to alleviate the bloc’s energy insecurity by importing non-Russian LNG and increasing renewable energy’s share in the energy mix, both alternatives face bottlenecks, which could delay their implementation. This could keep energy markets in the EU tight over the medium term, until additional LNG capacity comes online in the US and elsewhere. Renewable electricity is not as reliable as electricity generated by fossil fuels on the current power grid, which needs to be constantly balanced to avoid cascading failure. This means power consumed must equal power supplied on a near-instantaneous basis to avoid grid failure. However, given its reliance on variable weather conditions, renewable energy by itself cannot keep the grid balanced, primarily due to the lack of utility-scale storage for renewable power. Battery-storage technology and green-hydrogen energy can be used in conjunction with other renewables to balance the power grid, but they still are nascent technologies and not yet scalable to the point where they can replace hydrocarbon energy sources. Furthermore, the continued addition of small-scale renewables-based power generation located further away from demand centers – cities and industrial complexes – will continue to increase the complexity and scale of the power grid.4 Realizing the importance of incumbent power sources and the infrastructure requirements to diversify away from Russian fuels, the EU labelled investments in natural gas and nuclear power as green investments in July.5 Of the two energy sources, natural gas will likely play a larger role in ensuring the bloc’s energy security over the next 3-5 years, given the polarized views on nuclear power.6 In its most recent attempt to stabilize power prices, the EU plans to redirect “inframarginal” power producers’ windfall profits to households and businesses, provided those producers do not generate electricity using natgas. The Commission did not suggest capping Russian natgas prices since that could be divisive among EU member states, and could further jeopardize the bloc’s energy security. The redistribution of the windfall profits taxes is coupled with calls for mandatory electricity demand reductions in member states. We are unsure of the net effect of these directives on physical power and natural gas balances. However, government interference will feed into the policy uncertainty surrounding electricity and natural gas markets. EU Storage Continues To Build Against all odds, the EU has been aggressively building gas in storage (Chart 2), as demand from Asia has been low during the summer months (Chart 3). This has allowed high Dutch Title Transfer Facility (TTF) prices – the European natgas benchmark – to lure US LNG exports away from Asia (Chart 4). According to Refinitiv data, US exports of LNG to Europe increased 74% y/y to a total of over 1,370 Bcf for the first half of 2022. Chart 2Europe Has Been Aggressively Building Gas Storage EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Chart 3US LNG Exports To Asia Dropped In H1 2022 US LNG Exports To Asia Dropped In H1 2022 US LNG Exports To Asia Dropped In H1 2022 Chart 4High TTF Prices Attract US LNG EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Since Russian gas flows to Asian states have not been completely cut off, this will reduce ex-EU demand for US LNG, providing much needed breathing room for international LNG markets. However, as the pre-winter inventory-injection period in Asia continues, there is an increasing likelihood the spread between Asian and European gas prices narrows. This could incentivize US producers to export more fuel to Asia, slowing the EU’s build-up of gas storage. US plans to increase LNG export capacity will alleviate current tightness in international gas markets over the medium term, as new export facilities are expected to begin operations by 2024, and be fully online by 2025 (Chart 5). Until US LNG exports increase, global natgas markets will continue to remain tight and prices will be volatile. Chart 5US LNG Export Capacity Projected To Rise EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Russia’s Asian Gas Pivot Since the energy crisis began, China has accelerated the rate at which it imports discounted Russian LNG.7 Russia is aiming to increase gas exports to China to replace the sales lost to the EU following its invasion of Ukraine. Russia recently signed a deal with China to increase gas flows by an additional 353 Bcf per year, with both states agreeing to settle this trade in yuan and rouble to circumvent Western currencies, primarily the USD. Additionally, the Power of Siberia pipeline is expected to reach peak transmission capacity of ~ 1,340 Bcf per year by 2025. Chart 6China Will Not Want All Eggs In One Basket EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Adding to the China-Russia gas trade is the planned Power of Siberia 2 pipeline, which will have an annual expected capacity of 1,765 Bcf. This will move gas to China from western Siberia via Mongolia, and is expected to come into service by 2030; construction is scheduled to begin in 2024. This will redirect gas once bound toward the EU to China. Russia’s ability to develop and construct the required infrastructure to pivot gas exports to China and the rest of Asia will be hindered by Western sanctions, as international private companies walk away from Russian projects and international investment in that state decline. This is a deeper consequence of the sanctions imposed by the US and its allies, as it denies Russia the capital, technology and expertise needed to fully develop its resource base. On China’s side, even if both Power of Siberia pipelines are developed to operate at full capacity, the world’s largest natgas importer may be wary of becoming overly reliant on Russia for a significant proportion of its gas (and oil) imports. China has developed a diversified network of natgas suppliers, which, as the experience of the EU demonstrates, is the best way to avoid energy-supply shocks (Chart 6). Investment Implications We expect natural gas price volatility to remain elevated over the next 2-3 years. EU governments’ interference with the natgas and power markets' structure and pricing mechanisms – be it via natgas price caps or skimming gas suppliers’ profits – will distort price signals, detaching them from fundamental gas balances. This will perpetuate the energy crisis currently plaguing the EU, by encouraging over-consumption of gas and reducing capex via taxes and levies on profitable companies operating below the market’s marginal cost curve. As a result of the dislocations caused by Russia’s invasion of Ukraine, dislocations in natural gas trade flows will continue, forcing markets to find work-arounds to replace lost Russian pipeline exports in the short-to-medium term. The EU will become more reliant on US LNG supplies, and will – over the next 2-3 years – have to outbid Asian states for supplies. Trade re-routing will take time and likely will lead to sporadic, localized shortages in the interim. The US is the largest exporter of LNG at present, but, by next year, it’s export capacity will max out. It will only start to increase from 2024, reaching full capacity by 2025. While higher export capacity from the world’s largest LNG supplier will help alleviate tight markets, in the interim, global gas prices, led by the TTF will remain elevated and volatile. The EU still receives ~ 80mm cm /d of pipeline gas from Russia, or ~ 7.4% of 2021 total gas consumption on an annual basis (Chart 7). A complete shut-off of Russian gas flows to the EU means the bloc would face even more difficulty refilling storage in time for next winter. This would keep the energy- and food-driven components of inflation high, and constrain aggregate demand in the EU generally. Chart 7EU Still At Risk To Russia Gas Cutoff EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason We continue to expect global natural gas markets to remain tight this year and next. We also expect natural gas prices to remain extremely volatile – particularly in winter (November – March), when weather will dictate the evolution of price levels. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We remain bullish commodities generally and oil in particular, and will re-open these positions at tonight’s close with 10% stop-losses.   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 distillate and jet-fuel stocks recovered slightly in the week ended 9 September 2022, rising by 4.7mm barrels to just over 155mm barrels, according to the US EIA. Distillate inventories – mostly diesel fuel and heating oil – stood at 116mm barrels, down 12% y/y. At 39.2mm barrels, jet fuel stocks are 7% below year-earlier levels. Refiners are pushing units to build distillates going into winter, in order to meet gas-to-oil switching demand in Europe and the US. Distillate inventories have been under pressure for the better part of the summer on strong demand. This is mostly driven by overseas demand. Distillate demand fell by 492k b/d last week, which helped domestic inventories recover. Year-on-year distillate demand was down 1.6% in the US. Ultra-low sulfur diesel prices delivered to the NY Harbor per NYMEX futures specification are up 50% since the start of the year (Chart 8). Base Metals: Bullish On Monday Chile’s government launched a plan to boost foreign investments, which includes providing copper miners with a 5-year break from the ad-valorem tax proposed in a new mining royalty. The plan however does not provide relief from the tax on operating profits, which are also part of the royalty. According to Fitch, the originally planned mining royalty would have significantly depleted copper miners’ profits, disproportionately impacting smaller operators, which cannot avail themselves of the benefits of economies of scale. In a sign that higher taxes spooked bigger players as well, in mid-July, BHP stated that it would reconsider investment plans in Chile if the state proceeded with the mining royalty in its original format. Ags/Softs: Neutral In its September WASDE, the USDA adjusted its supply and demand estimates for soybeans, and made substantial changes to new-crop 2022/23 US production estimates. This reduced acreage and yields by 2.7% from the previous August 2022 forecast. Ukraine’s soybean production was increased in the USDA's estimate. The USDA's soybean projections also include lower ending stocks, which are reduced from 245 million bushels to 200 million bushels. This is 11% below than 2021 levels for beans. The USDA's 2021/22 average price for soybeans remains at $14.35/bu, unchanged from last month but $1.05/bu above the 2021/22 average price (Chart 9). Chart 8NY Harbor ULSD Price Going Down NY Harbor ULSD Price Going Down NY Harbor ULSD Price Going Down Chart 9Soybean Prices Going Down Soybean Prices Going Down Soybean Prices Going Down   Footnotes 1 For a discussion of the EU’s past policy mistakes which laid the foundation for current crisis, please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022. It is available at ces.bcaresearch.com. 2 Please see UK business warned of delay to state energy support, published by ft.com on September 13, 2022. 3 The current EU power pricing system is set up so that the most expensive power generator – currently plants using natgas – set the price for the entire electricity market. This system was put in place to incentivize renewably  generated power, however, the EU does not have the required infrastructure and technology to be reliant solely on green electricity. 4 For a more detailed discussion on power grid stability, and how renewables will affect it, please ENTSO-E’s position paper on Stability Management in Power Electronics Dominated Systems: A Prerequisite to the Success of the Energy Transition. According to estimates by WindEurope and Hitachi Energy, Europe will need to double annual investments in the power grid to 80 billion euros over the next 30 years to prepare the power grid for renewables. 5 For our most recent discussion on the infrastructure requirements of pivoting away from Russian piped gas, please see Natgas Markets: The Eye Of The Storm, which we published on June 9, 2022. It is available at ces.bcaresearch.com.  6 In 2021, nuclear power constituted majority of France’s energy mix at 36% and had nearly the lowest share for Germany at 5%. In response to the current energy crisis, Germany has opted to restart coal power plants and only keep nuclear plants on standby, signaling that the EU’s largest energy consumer would prefer to use coal despite its carbon emissions target. 7 According to Bloomberg, China signed a tender to receive LNG from Russia’s Sakhalin-2 project through December at nearly half the cost of the spot gas rates at the time. Investment Views and Themes  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG THE COMT ETF WITH A LOSS OF 5.4% AND OUR XOP ETF WITH A GAIN OF 24.6%. WE WILL RE-OPEN THESE POSITIONS AT TONIGHT’S CLOSE WITH 10% STOP-LOSSES. Strategic Recommendations Trades Closed in 2022

HighlightsThe power shortage in China due to depleted coal inventories and low hydro availability will push copper and aluminum inventories lower, as refineries there – which account for roughly one-half of global capacity – are shut to conserve power (Chart of the Week).Given the critical role base metals will play in the decarbonization of the global economy, alternative capacity will have to be incentivized ex-China by higher prices to reduce refining-concentration risk in the future.Unexpectedly low renewable-energy output in the EU and UK following last year's cold winter will keep competition with China for LNG cargoes elevated this winter.  It also highlights the unintended consequences of phasing down fossil-fuel generation without sufficient back-up.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere.  Normal-to-warmer temps cannot be entirely dismissed, however.Increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers.We remain long 1Q22 natgas exposure via call spreads; long commodity index exposure (S&P GSCI and COMT ETF) to benefit from increasing backwardation as inventories of industrial commodities fall; and long the PICK ETF to benefit from expected tightening of base metals markets.FeatureNatgas prices are surging in the wake of China's and Europe's scramble to cover power shortages arising from depleted coal inventories and low hydroelectric generation in the former, and unexpectedly low output from renewables in the latter (Chart 2).1Given all the excitement of record-high gas prices in the EU and surging oil prices earlier this week, it is easy to lose sight of the longer-term implications of these developments for the global decarbonization push. Chart of the WeekBase Metals Refining Concentrated In China La Niña And The Energy Transition La Niña And The Energy Transition   Chart 2Surge In Gas Prices Continues La Niña And The Energy Transition La Niña And The Energy Transition  Global copper inventories have been tightening (Chart 3) along with aluminum balances (Chart 4).2 Power shortages in China- which accounts for ~40% of global refined copper output and more than 50% of refined aluminum - are forcing shutdowns in production by authorities seeking to conserve energy going into winter. In addition, the upcoming Winter Olympics in February likely will keep restrictions on steel mills, base-metals refiners, and smelters in place, so as to keep pollution levels down and skies blue. Chart 3Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper   Chart 4Along With Aluminum Balances... Along With Aluminum Balances... Along With Aluminum Balances...  This will keep prices well supported and force manufacturers to draw on inventories, which will keep forward curves for copper (Chart 5) and aluminum (Chart 6) backwardated. Higher costs for manufactured goods can be expected as well, which will exacerbate the cost-push inflation coming through from clogged global supply chains. This slowdown in global supply chains is largely the result of global aggregate demand improving at a faster rate than supply.3 Chart 5Copper Prices And Backwardation Copper Prices And Backwardation Copper Prices And Backwardation   Chart 6...Will Increase Along With Aluminum ...Will Increase Along With Aluminum ...Will Increase Along With Aluminum  The pressures on base metals markets highlight the supply-concentration risks associated with the large share of global refining capacity located in China. This makes refined base metals supplies and inventories globally subject to whatever dislocations are impacting China at any point in time. As the world embarks on an unprecedented decarbonization effort, this concentration of metals refining capacity becomes increasingly important, given the centrality of base metals in the build-out of renewable-energy and electric-vehicles (EVs) globally (Chart 7).In addition, increasing tension between Western states and China supports arguments to diversify supplies of refined metals in the future (e.g., the US, UK and Australia deal to supply US nuclear-powered submarine technology to Australia, and the tense Sino-Australian trade relationship that led to lower Chinese coal inventories).4 Chart 7The Need For Refined Metals Grows La Niña And The Energy Transition La Niña And The Energy Transition  EU's Renewables Bet SoursUnlike China, which gets ~ 11% of its electricity from renewables and ~ 63% of its power from coal-fired generation (Chart 8), the EU gets ~ 26% of its power from renewables and ~ 13% from coal (Chart 9). In fact, the EU's made a huge bet on renewables, particularly wind power, which accounts for ~55% of its renewables supply. Chart 8China's Dependence On Coal … La Niña And The Energy Transition La Niña And The Energy Transition   Chart 9… Greatly Exceeds The EU's La Niña And The Energy Transition La Niña And The Energy Transition  Unexpectedly low renewable-energy output in the EU and UK this summer – particularly wind power – forced both to scramble for natgas and coal supplies to cover power needs.5 As can be seen in Chart 9, the EU has been winding down its fossil-fuel-fired electric generation in favor of renewables. When the wind stopped blowing this year the EU was forced into an intense competition with China for LNG cargoes in order to provide power and rebuild storage for the coming winter (Chart 10). Chart 10The Scramble For Natgas Continues La Niña And The Energy Transition La Niña And The Energy Transition  The current heated – no pun intended – competition for natgas going into the coming winter is the result of two policy errors, which will be corrected by Spring of next year. On China's side, coal inventories were allowed to run down due to diplomacy, which left inventories short going into winter. In the EU, wind power availability fell far short of expectations, another result of a policy miscalculation: Nameplate wind capacity is meaningless if the wind stops blowing. Likewise for sun on a cloudy day.Natgas Price Run-Up Is TransitoryThe run-up in natgas prices occasioned by China's and the EU's scramble for supplies is transitory. Still, uncertainty as to the ultimate path global gas prices will take is at its maximum level at present.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere. Even so, this is a probabilistic assessment: Normal-to-warmer temps cannot be dismissed, given this probability. A normal to warmer winter would leave US inventories and the availability to increase LNG exports higher, which would alleviate much of the pricing pressure holding Asian and European gas prices at eye-watering levels presently.Going into 1Q22, we expect increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers as hospitalization and death rates continue to fall (Chart 11).6 At that point, we would expect economic activity to pick up significantly, which would be bullish for natgas. We also expect US and Russian natgas production to pick up, with higher prices supporting higher rig counts in the US in particular. Chart 11Expect Continued COVID-19 Progress La Niña And The Energy Transition La Niña And The Energy Transition  Investment ImplicationsAs the world embarks on an unprecedented decarbonization effort, it is important to follow the supply dynamics of base metals, which will provide the materials needed to build out renewable generation and EVs.The current price pressure in natural gas markets resulting from policy miscalculations cannot be ignored. Still, this pressure is more likely to be addressed quickly and effectively than the structural constraints in base metals markets.On the base metals side, producers remain leery of committing to large capex projects at the scale implied by policy projections for the renewables buildout.7In addition, current market conditions highlight concentration risks in these markets – particularly on the refining side in base metals, where much of global capacity resides in China. On the production and refining side of EV materials, battery technology remains massively concentrated to a few countries (e.g., cobalt mining and refining in the Democratic Republic of Congo and China, respectively).This reinforces our view that oil and gas production and consumption likely will not decay sharply unless and until these capex issues and concentration risks are addressed. For this reason, we remain bullish oil and gas. Robert P. Ryan Chief Commodity & Energy Strategistrryan@bcaresearch.comAshwin ShyamResearch AssociateCommodity & Energy Strategyashwin.shyam@bcaresearch.com Commodities Round-UpEnergy: BullishDelegates at OPEC 2.0's Ministerial Meeting on Monday likely will agree to increase the amount of oil being returned to markets by an additional 100-200k b/d. This would take the monthly production rate of production being restored from 400k b/d to 500-600k b/d. Depending on how quickly mRNA vaccine production in large EM markets is rolled out, this incremental increase could remain in place into 2Q22. This would assuage market concerns prices could get to the point that demand is destroyed just as economic re-opening is beginning in EM economies. Our view remains that the producer coalition led by Saudi Arabia and Russia will continue to balance the need for higher revenues of member states with the fragile recovery in EM economies. We continue to expect prices in 2022 to average $75/bbl and $80/bbl in 2023 (Chart 12). This allows OPEC 2.0 states to rebuild their balance sheets and fund their efforts to diversify their economies without triggering demand destruction.Base Metals: BullishA power crunch and decarbonization policies in China are supporting aluminum prices at around 13-year highs, after reaching a multi-year peak earlier this month (Chart 13). The energy-intensive electrolytic process of converting alumina to metal makes aluminum production highly sensitive to fluctuations in power prices. High power prices and electricity shortages are impacting aluminum companies all over China, one of which is Yunnan Aluminium. According to the Financial Times, the company accounts for 10% of total aluminum supply in the world’s largest producer.Precious Metals: BullishGold prices dipped following a hawkish FOMC meeting last week. More Fed officials see a rate hike in 2022, compared to the previous set of projections released in June. Fed Chair Jay Powell also hinted at a taper in the asset purchase program on the back of a rebounding US economy, provided a resurgence in COVID-19 does not interrupt this progress. A confirmation of what markets were expecting – i.e., paring asset purchases by year-end – and possible rate hikes next year have buoyed the US dollar and Treasury yields. The USD competes directly with gold for safe-haven investment demand. Higher interest rates will increase the opportunity cost of holding the yellow metal. As a result, gold prices will be subdued when the USD is strengthening. We remain bearish the USD, and, therefore, bullish gold. Chart 12Oil Forecasts Hold Steady Oil Forecasts Hold Steady Oil Forecasts Hold Steady   Chart 12Aluminum Prices Recovering Aluminum Prices Recovering Aluminum Prices Recovering    Footnotes1     Please see China's Yunnan imposes output curbs on aluminium, steel, cement makers published by reuters.com on September 13, 2021.2     NB: Global aluminum inventory data are unreliable and we do not publish them.3    Please see, e.g., Supply Chains, Global Growth, and Inflation, published by gspublishing.com on September 20, 2021.4    Please see US-China: War Preparation Pushes Commodity Demand, a Special Report we published on August 26, 2021, for further discussion.5    We discuss this in last week's report entitled Natgas Markets Continue To Tighten, which is available at ces.bcaresearch.com.6    Please see Upside Price Risk Rises For Crude, which updated our oil-price balances and forecasts. We highlight the recent agreements to mass produce the highly effective mRNA COVID-19 vaccines globally as bullish for oil prices. It also will be bullish for natgas and other commodities.7     Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021, for additional discussion. Investment Views and ThemesStrategic RecommendationsTactical TradesCommodity Prices and Plays Reference TableTrades Closed in 2021Summary of Closed Trades

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

Highlights US natural gas prices will remain well supported over the April-October injection season, as the global economic expansion gains traction, particularly in Europe, which also is refilling depleted storage levels. China's natgas demand is expected to rise more than 8% yoy, and EM Asia consumption also will be robust, which will revive US liquified natural gas (LNG) exports. Exports of US light-sweet crude into the North Sea Brent pricing pool – currently accounting for close to half the physical supply underpinning the global oil-price benchmark – also will increase over the course of the year, particularly in the summer, when maintenance will markedly reduce the physical supply of crudes making up the Brent index. At the margin, coal demand will increase in the US, as industrial natgas demand and LNG exports incentivize electric generators to favor coal. Higher-than-expected summer temperatures in the US also would boost coal demand.  This will be tempered somewhat in Europe, where carbon-emissions rights traded through €50/MT for the first time this week on the EU's Emission Trading System (ETA). We expect US LNG and oil exports to revive this year (Chart of the Week) and remain long natgas in 1Q22. Feature The importance of US LNG and crude oil exports out of the US Gulf to the global economy is only now becoming apparent. As demand for these fossil fuels grows and the supply side continues to confront a highly uncertain risk-reward tradeoff, their importance will only grow. In natgas markets, US LNG cargoes out of the US Gulf balanced demand coming from Asia and Europe this past winter, which was sharply colder than expected and stretched supply chains globally. As a widening economic recovery from the COVID-19 pandemic spurs industrial, residential and commercial demand, and inventories in Europe and Asia are re-built in preparation for next winter, US LNG exports will be called upon to meet increasing demand, particularly since they are priced attractively vs regional importing benchmarks, with differentials vs the US presently $4+/MMBtu vs Europe and $5+/MMBtu vs Asia (Chart 2).1 Chart of the WeekUS LNG, Oil Export Growth Will Rebound US LNG, Oil Export Growth Will Rebound US LNG, Oil Export Growth Will Rebound Chart 2Lower US Natgas Prices Encourage LNG Exports Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily In oil markets, an ongoing kerfuffle in the pricing of Brent Blend brought about by falling North Sea crude oil production makes American light-sweet crude oil exports from the Gulf (i.e., WTI produced mostly in the Permian Basin) account for almost half of the physical supplies in this critical benchmark-pricing market.2 US LNG Exports Will Increase US natural gas prices will remain well supported as the global economic expansion gains traction, and the US and Europe open the April-October injection season well bid (Chart 3). US inventories are expected to end the Apr-Oct injection season at just over 3.7 TCF according to the EIA, very close to where they ended the 2020 injection season. Chart 3US, Europe Rebuild Storage Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily Higher US LNG exports, industrial, commercial and residential demand will be offset by lower consumption from electric generators this year, netting to a slight decline in overall demand. The EIA expects generators to take advantage of lower generating costs to be had burning coal to produce electricity, a view we share given the current differentials in the forward curves for each fuel (Chart 4).3 On the supply side, the EIA's expecting output to remain unchanged from last year at just under 91.5 BCF/d in 2021. Higher LNG exports, even as generator demand is falling, pushes prices higher this year – averaging $3.04/MMBtu this year – which leads to a slight increase in output in 2022. For our part, we continue to expect higher prices during the November-March heating season than currently are clearing the market and remain long 1Q22 $3.50/MMBtu calls vs. short $3.75/MMbtu calls. As of Tuesday night, when we mark to market, this position was up 20.8% since inception on 8 April 2021. Chart 4Lower Prices Will Favour Increased Coal Demand Lower Prices Will Favour Increased Coal Demand Lower Prices Will Favour Increased Coal Demand Natgas demand could surprise on the upside during the injection season if air-conditioning demand comes in stronger than expected and production remains essentially unchanged this year. This could reduce LNG exports and slow the rate of inventory refill in the US, which could further advantage coal as a burner fuel for generators in the US. The US National Weather Service's Climate Prediction Center expects above-average temperatures for most of the US population centers this summer (Chart 5). This could become a semi-permanent feature of the market if current temperature trends persist (Chart 6). Based on analyses’ run by the NOAA's National Centers for Environmental Information, 2021 "is very likely to rank among the ten warmest years on record," with lower (6%) odds of ranking in the top five hottest years on record.4 Chart 5Odds Of Hotter Summer Rising Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily Chart 6Higher Global Temperatures Could Become A Recurring Phenomenon Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily The Crude Kerfuffle As the Chart of the Week shows, US exports of light-sweet crude oil peaked at ~ 3.7mm b/d in February 2020, just before the COVID-19 pandemic hit the world full force. Exports out of the US Gulf – i.e., WTI priced against the Midland, TX, gathering hub – accounted for ~ 95% of these volumes. With exports currently running ~ 2.5mm b/d, more than 1mm b/d of readily available export capacity remains in place. Additional volumes will be developed as dredging of the Corpus Christi, TX, progresses. While the surge in US crude oil production has subsided in the wake of the pandemic, it most likely will revive as the markets return to normal operating procedure, additional dredging operations are completed, and storage facilities are built out.5 Existing and additional export capacity of the US's light-sweet crude could not arrive at a more opportune time for the Brent market, which remains in a state of uncertainty as to whether markets will have to adjust to CIF contracts or a work-around to the existing FOB pricing regime, which can be augmented to accommodate increasing WTI volumes.6 This will have to be sorted, as this is the future of the market's most important pricing index (Chart 7). The buildout in crude-oil exporting capacity – and natgas LNG exporting capacity, for that matter – ideally accommodates shale-oil- and -gas assets, which can be ramped up quickly to meet demand, and ramped down quickly as demand falters. The quick payback – 2 to 3 years – on these investments allow the producers to expand and contract output without the massive risks longer-lived conventional assets impose. As OPEC 2.0's spare capacity is returned to the market, this will be a welcome feature of a market that most likely will require oil and gas supplies for decades, despite the uncertainty attending oil-and-gas capex during the transition to a low-carbon energy future. Chart 7Permian Replaces North Sea Losses Permian Replaces North Sea Losses Permian Replaces North Sea Losses Bottom Line: As the future of hydrocarbons evolves, the LNG and crude oil exported from the US Gulf will occupy an increasingly important role in these markets. Oil and gas producers are making capex decisions under increasingly uncertain conditions, which favor exactly the type of resources that have propelled the US to the position of the world's largest producer of these fuels – i.e., shale-oil and -gas. Production from these resources can be ramped up and down quickly as prices dictate, and have quick paybacks (2-3 years), which means capital is not tied up for decades as a return is earned.7   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 begins returning 2mm b/d to the market this month, expecting to be done by July. Half of these volumes are accounted for by Saudi Arabia, which voluntarily cut output by 1mm b/d earlier in the year to help balance the market. In line with our maintained hypothesis that OPEC 2.0 prefers prices inside the $60-$70/bbl price band, we expect the return of curtailed production to be front-loaded so as to bring prices down from current levels approaching $70/bbl for Brent (Chart 8). If, as we expect, demand recovers sooner than expected as Europe leans into its vaccination program, additional barrels will be returned to the market to get prices closer to a $60-$65/bbl range. Base Metals: Bullish The International Copper Study Group (ICSG) forecast copper mine production will increase by ~ 3.5% in 2021 and 3.7% in 2022, after adjusting for historical disruption factors. This forecasted increase – after three years of flat mined production growth – is due to a ramp-up of recently commissioned and new copper mines becoming operational in 2021. An improvement in the pandemic situation by 2022 will also boost mined copper production, according to the ICSG. 2020 production remained flat as recoveries in production in some countries due to constrained output in 2019 balanced the negative impacts of the pandemic in others. In Chile, the largest copper producer, state-owned Codelco and Collahuasi reported strong results in March. However, this was countered by a continued downturn at BHP’s Escondida. The world’s largest copper mine saw a drop in production for the eighth consecutive month. This mixed output resulted in a decline in total production of 1.2% year-on-year in March. Precious Metals: Bullish COMEX palladium touched a record high during intraday trading on Tuesday, reaching $3,019/oz due to continued tight market conditions (Chart 9). On the supply side, Nornickel is recovering from flooded mines, which occurred in February. By mid-April, one of the two affected mines was operating at 60% capacity; however, the company's other mine is only expected to come back online by early June. On the demand side, strength in US vehicle sales and a global economic recovery from the pandemic buoyed the metal used in catalytic converters. Palladium prices closed at $2,981.60/oz on Tuesday. Ags/Softs: Neutral Corn again traded above $7/bu earlier in the week on the back of drought-like dry weather conditions in Brazil's principal growing regions and surging US exports, according to Farm Futures. Chart 8 Brent Prices Going Up Brent Prices Going Up Chart 9 Palladium Prices Going Up Palladium Prices Going Up   Footnotes 1     Stronger demand from China – where consumption is expected to rise more than 8% yoy – and EM Asia will continue to support LNG demand through the year.  S&P Global Platts Analytics expects Chinese natural gas demand to reach 12,713 Bcf in 2021, up 8.4% from the previous year.  Chinese national oil company Sinopec is slightly more conservative in its outlook, expecting gas demand of ~ 12,006-12,184 Bcf in 2021, up 6-8% from 2020.  China’s average annual increase in natural gas demand is expected to exceed 716 Bcf in the 14th FYP and reach 15,185 Bcf in 2025. 2     Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies for a discussion. 3    In Chart 3, we plot a rough measure of coal- vs natgas-fired generation economics for these fuels based on their average operating heat rates published by the EIA. We would note that a carbon tax would erase much of the benefit accruing to coal at this point in time. 4    Please see NOAA's Global Climate Report - March 2021. 5    Please see Low Rider - Corpus Christi's Ship Channel Dredging Will Streamline Crude Oil Exports published by RBN Energy 3 May 2021. 6    The OIES analysis cited above concludes, "… the volumes of the FOB deliverable crudes are diminishing and some change, bolstering the contract is certainly needed. The most likely compromise is to retain the existing FOB Brent with an inclusion of CIF WTI Midland assessment, netted back to an FOB equivalent North Sea value."  We agree with this assessment.  Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies, p. 8. 7     Please see Is shale activity actually profitable? Size matters, says Rystad published 7 February 2019.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE Chart 9 Covid Uncertainty Could Push Up Gold Demand Covid Uncertainty Could Push Up Gold Demand   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Underweight Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top and second panels). Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. The bottom panel of our chart illustrates the safe haven status of utility stocks (ISM survey shown inverted). Despite the above, spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy present risks to our view; rising interest rates and a vibrant U.S. economy should nevertheless overwhelm. Bottom Line: We downgraded the S&P utilities sector to underweight yesterday; please see yesterday's Weekly Report for more details. Lights Are Out For Utilities Lights Are Out For Utilities

Highlights Portfolio Strategy A playable sector rotation opportunity has emerged, as we first argued at the recent BCA investment conference: Financials, industrials and select tech subgroups will lead the next phase of the market advance, a result of the bond market selloff gaining steam into year-end and beyond. In contrast, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that it is time to shed utility stocks. Recent Changes Trim the S&P Utilities sector to underweight today. Table 1 The "FIT" Market The "FIT" Market Feature On the eve of earnings season, the SPX remains close to an all-time high. The most recent spate of investor optimism was driven by President Trump cementing another deal last week, this time with Canada. While the renaming of NAFTA to USMCA is a step in the right direction (i.e. a deal was struck), a deal with China remains the elephant in the room. On that front, U.S. hawkish trade rhetoric should remain in vogue and any deal will have to wait until at least after the election, if not until Q1/2019. Up to now Trump's trade hawkishness has not infiltrated U.S. profits, but we continue to closely monitor IBES reported profit growth expectations. Following up from last week, the rest of the world is bearing the brunt of the U.S. trade-related rhetoric according to our profit growth models, a message sell-side analysts' forecasts also corroborate (we use forward EBITDA in order to gauge trend profit growth and filter out the tax-induced jump in U.S. EPS, Chart 1). Meanwhile, at the margin, seasonality can prop up stocks. While September - a historically negative return month, but not this year - is behind us, stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise. Beyond October's dreaded crash history, the Presidential cycle has piqued our interest, especially years two and three. Building on our sister Geopolitical Strategy publication's research,1 and given the upcoming midterm elections, we created a cycle-on-cycle profile of SPX returns during these two middle Presidential cycle years (Chart 2). Chart 1U.S. Has The Upper Hand U.S. Has The Upper Hand U.S. Has The Upper Hand Chart 2Seasonality Boost Until Midyear 2019? Seasonality Boost Until Midyear 2019? Seasonality Boost Until Midyear 2019? In more detail, we analyzed 17 cycles starting in 1950 using S&P 500 daily data (reconstructed S&P 500 prior to 1957). During these iterations, only two two-year periods ended in the red, 1974/75 and 2002/03. The first coincided with a recession and the second took place in the aftermath of the dotcom bust. In addition, two other cycles produced roughly 5% two-year returns, 1962/63 and 1966/67. Finally, 1954/55 was the outlier when the SPX went parabolic and nearly doubled. While every cycle is different, it is clear from Chart 2 that the Presidential cycle should continue to underpin the SPX, if history is an accurate guide, especially given our forecast of no recession in the coming 9-to-12 months. In fact, the S&P could rise another 10%, in line with our 2019 expectation, predicated upon a 10% increase in profits and a lateral multiple move. Interestingly, according to the median Presidential cycle-on-cycle roadmap, while the back half of 2019 is likely to prove more challenging, the first half of next year should enjoy most of the returns (Chart 2). An assessment of recent data releases in the U.S. and abroad is also revealing. Chart 3 shows that the domestic economy is firing on all cylinders. Consumer confidence and sentiment hit multi-decade highs recently. Similarly, the job market remains vibrant and small business euphoria reigns supreme. Not only are small business owners optimistic on all employment-related subcomponents of the NFIB survey, but SME capex intentions are also as good as they get. The ISM manufacturing survey ticked down from the August peak, but remains close to 60. Its close sibling, the ISM services survey, vaulted into uncharted territory. All of this is reflected in the still-growing U.S. leading economic indicator and signals that the U.S. equity market remains on a solid footing. Outside U.S. shores, the bearish narrative is well established with EMs, especially the U.S. dollar debt-saddled fragile five that have to contend with twin deficits, sinking in a bear market. China's debt load is also coming under intense scrutiny as U.S. tariffs are all but certain to weigh on Chinese output growth. Nonetheless, there is a chance that the EMs have depreciated their currencies by enough to engineer a modest rebound (bottom panel, Chart 4). In other words, absent the currency peg straightjacket that dominated the region in the late-1990s, free-floating FX devaluations may serve as a relief valve in order to boost exports. The latest Korean MARKIT manufacturing PMI spiked above the boom/bust line to a multi-year high signaling that already humming Korean factories (industrial production is accelerating) will likely remain busy in the coming months. Other hard economic data also confirm these greenshoots: Korean manufacturing exports are expanding smartly. In particular, exports to China are soaring. Reaccelerating manufacturing selling prices also corroborate this budding Korean recovery (third panel, Chart 4). Chart 3U.S. Is On Fire U.S. Is On Fire U.S. Is On Fire Chart 4Reflationary Impulse? Reflationary Impulse? Reflationary Impulse? While it is premature to call an end to the EM carnage, most of the bad news on global export volumes and prices may be nearing an end and the EMs may even export some of their inflation to the U.S. Play The Sector Rotation Into Financials And Industrials... In recent research, we have been highlighting that inflation is slowly rearing its ugly head and there are high odds that the selloff in the bond market gains steam into year-end and beyond2 (as a reminder BCA's fixed income publications continue to recommend below-benchmark portfolio duration). Against such a backdrop, sectors that benefit from rising interest rates and that serve as inflation hedges should outperform in the coming quarters. The "FIT" market refers to financials, industrials and select technology stocks. In more detail, we expect a sector rotation, especially into financials and industrials that have been laggards and remain compellingly valued (Chart 5). With regard to financials, Chart 6 shows that this early cyclical sector enjoys a positive correlation with interest rates and inflation expectations, and a catch up phase in relative share prices looms in the coming quarters. Chart 5Rotate Into Financials...   Rotate Into Financials…   Rotate Into Financials… Chart 6...And Industrials     …And Industrials     …And Industrials Industrials stocks also benefit from rising inflation and interest rates as large parts of this deep cyclical sector are levered to the commodity cycle (Chart 7). In other words, industrials stocks are an indirect inflation hedge and trouble surfaces only when capital goods producers cannot pass rising input costs down the supply chain or to the consumer. But, we are not there yet. Keep in mind that during the last cycle, relative (and absolute) industrials performance peaked prior to relative energy stock prices. Similarly, the relative industrials stock price ratio troughed in early 2009 before their deep cyclical brethren put in a (temporary) bottom a year later (Chart 8). Chart 7Industrials Lead       Industrials Lead       Industrials Lead Chart 8Undervalued     Undervalued     Undervalued True, energy stocks are also going to perform well if our thesis of higher interest rates/inflation pans out in the coming quarters and especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes (Chart 9). Thus, we sustain the high-conviction overweight stance in the broad sector and reaffirm our recent upgrade to an above benchmark allocation in the S&P oil & gas exploration & production (E&P) subgroup.3 We also reiterate our recent market-neutral and intra-commodity pair trade: long S&P oil & gas E&P / short global gold miners.4 This trade is off to a great start up 10.3% since inception and will benefit further from an inflationary impulse. Chart 9Energy Remains A High-Conviction Overweight Energy Remains A High-Conviction Overweight Energy Remains A High-Conviction Overweight While tech stocks have really delivered and led the market advance year-to-date, a bifurcated tech market should remain in place with capex levered S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) outperforming early cyclical tech groups, semi and semi equipment stocks (we remain underweight both semi subindexes). Bottom Line: A playable rotation into financials and industrials is in the offing especially if the selloff in the bond market accelerates on the back of an inflationary whim. We continue to recommend an overweight allocation to both the S&P financials and S&P industrials sectors. ...But Lights Are Out For Utilities Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (Chart 10). While arguably most of the bad news is already reflected in washed out technicals and bombed out short and even long-term profit expectations (Chart 11), the selling will only accelerate into yearend and 2019. Chart 10Higher Yields Bite   Higher Yields Bite   Higher Yields Bite Chart 11Oversold And Unloved... Oversold And Unloved… Oversold And Unloved… Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. Chart 12 illustrates the safe haven status of utility stocks (ISM surveys shown inverted). On the operating front, despite the upbeat economic data, electricity capacity utilization remains anemic. Capacity growth is likely responsible for this weak resource utilization signal as utilities construction continues unabated (private construction shown inverted, top panel, Chart 13). Adding insult to injury, inventory accumulation is also weighing on the sector (turbine inventories shown inverted, middle panel, Chart 13). Chart 12...But More Pain Looms …But More Pain Looms …But More Pain Looms Chart 13Weak Operating Metrics   Weak Operating Metrics   Weak Operating Metrics Worrisomely, all these expansion plans have been financed with debt. While this is not typically an issue for stable cash flow generating utilities, the sector's net debt-to-EBITDA profile has gone parabolic, nearly doubling since the GFC and even overtaking the early 2000s when a California deregulation wave first led to exuberance and then an electricity crisis (Chart 14). Any letdown in cash flow growth will be disruptive, especially given that the sector has no valuation cushion (bottom panel, Chart 14). Nevertheless, there are some risks that could put our underweight position offside. Natural gas prices have spiked of late and given that they are the marginal price setter for the sector they could boost utility pricing power and thus profits (top & middle panels, Chart 15). As the U.S. economy is firing on all cylinders, electricity demand should remain brisk and provide an offset to the otherwise weakening utility operating backdrop (bottom panel, Chart 15). Chart 14Heavily Indebted And Pricey   Heavily Indebted And Pricey   Heavily Indebted And Pricey Chart 15Risks To Underweight View   Risks To Underweight View   Risks To Underweight View Netting it all out, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that the time is ripe to sell utility stocks. Bottom Line: Downgrade the S&P utilities sector to underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Soldiering On," dated July 16, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Overall Investment Grade (IG) Corporates: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, but keep overall spread risk close to neutral levels. U.S. IG: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro IG: Stay underweight and keep spread risk (i.e. DTS) close to index levels. Reduce exposure to Cable & Satellite, Electric Utilities and Natural Gas Utilities. U.K. IG: Stay overweight U.K. IG but keep overall spread risk near index levels. Feature Chart of the WeekCandidates For Additional Spread Convergence Candidates For Additional Spread Convergence Candidates For Additional Spread Convergence Back on January 24th, we published a Special Report that introduced specific Investment Grade (IG) corporate bond sector allocations for the U.S., Euro Area and U.K. to our model portfolio framework.1 The recommended weightings were based on the output from our sector relative value models for each region. We had presented those models on a semi-regular basis in the past, but without any specific numerical allocation among the sectors. By attaching actual weightings to each sector, within a "fully invested" model portfolio, we are now able to more accurately measure the aggregate success of our recommendations. In this follow-up report, we discuss the performance of our sector tilts since January, refresh our relative value models and present changes to our allocations. The broad conclusion is that, while our calls have done well over the past few months and our IG portfolios have outperformed the broad IG bond indices, it remains difficult to find compellingly cheap sectors (particularly in non-financial industries) given the overall tight level of corporate bond spreads. This is especially true in the Euro Area, where we see the poorest risk/reward tradeoff for IG exposure relative to the U.S. and U.K. We are more comfortable recommending an overweight stance on U.S. and U.K. IG corporates versus Euro Area equivalents, in line with our overall allocation in our main model portfolio. Given the tight overall level of spreads in all three regions, however, we are focusing our recommendations on sectors that have cheaper valuations but with riskiness closer to the overall IG indices - like Energy in the U.S. and Wireless in both the Euro Area and U.K. (Chart 1). Good Performance From Our Sector Tilts The performance of our sector recommendations has been reasonably solid since January (Chart 2). Our U.S. sector tilts added +5bps of excess return versus duration-matched U.S. Treasuries, coming mostly from our overweights in Energy and Financials. Within the Euro Area, we were able to generate +9bps of excess return versus government debt, also mainly from above-benchmark allocations to Energy and Financial names. In the U.K., our call to overweight Bank debt provided essentially all of our +23bps of outperformance versus Gilts. These strong excess returns came on top of a very strong performance for corporate debt since January 24th. Excess returns for IG in the U.S., Euro Area and U.K. were 0.9%, 1.3% and 1.3%, respectively. The detailed breakdown of the returns by sector are shown in Appendix Tables at the back of this report. To determine the success rate of our sector tilts, we can define "winners" as sectors where we had an active view (i.e. not neutral) and where the relative performance of the sector versus the overall IG corporate index was in the direction of that active view. For example, our decision to go underweight Diversified Manufacturing in the Euro Area was a good one, as that sector had an excess return of 0.7%, well below that of the overall Euro Area IG index (a 1.3% excess return). We can define "losers" in the same way, where the relative sector performance went against our active allocation. In Chart 3, we show the "winners" and "losers" for our U.S., Euro Area and U.K. sector allocations since late January. Our success rate was quite good, as we had far more winners than losers in all three regions. Chart 2 Chart 3 The Big Picture For Corporate Credit: Favorable Business Cycle, But Valuations Are Not Cheap We have been maintaining an overall overweight allocation to IG corporates since late January. This was based on a view that global economic activity was accelerating, which would support faster profit growth. This would provide cyclical relief for stressed corporate balance sheets in the U.S. Euro Area & U.K. corporates would also benefit from a better profit backdrop, with the added bonus of central bank asset purchases helping to improve the supply/demand balance for IG debt. Yet spreads have already tightened substantially throughout the IG universe. This reflects declining macro volatility and the ongoing investor stretch for yield after the rise in global government bond yields earlier this year faded significantly. The result is that there is now far less dispersion among corporate sectors, by industry or by credit quality, then we've seen in recent years (Charts 4, 5 & 6). Coming at a time of high corporate leverage, and with central bank liquidity growth starting to roll over as we discussed in last week's Weekly Report, we are recommending an "up in quality" bias to sector allocations and credit exposure, while favoring U.S. and U.K. corporates over Euro Area equivalents.2 Chart 4Tight Spreads, Flat Credit Curve##BR##In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Chart 5Tight Spreads, Flat Credit Curve##BR##In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Chart 6Tight Spreads, Flat Credit Curve##BR##In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Bottom Line: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, while keep overall spread risk close to neutral levels. U.S. Investment Grade: Stay Overweight, But Be Selective In Tables 1A and 1B, we present the results of our U.S. IG sector valuation model as of May 31st.3 We are maintaining an overweight recommendation on U.S. IG in our overall model portfolio, as we continue to see the backdrop for U.S. economic growth being much friendlier for corporate debt versus Treasuries. Credit spreads are very tight, however, so we are maintaining some degree of caution in our sector recommendations. Chart Chart Specifically, we are aiming to favor industries with option-adjusted spread (OAS) at or above that of the overall U.S. IG index, but with a positive valuation from our U.S. IG relative value model. We also wish to keep the aggregate level of spread risk, using our preferred "duration times spread" (DTS) metric, in line with that of the overall U.S. IG index. As can be seen in the scatter diagram in Chart 7, which plots the model valuations versus the DTS score for each sector, there are precious few non-financial sectors that offer attractive spreads that are not riskier than the overall index. Chart 7 Our model has shown some improvement in value within the sub-sectors of the Energy space, which is a consequence of the softness in oil prices over the past few months. With our commodity strategists calling for a recovery in oil prices back up towards to $55-60 range by year-end, we see this an opportunity to raise our allocations to Energy by upgrading the Independent and Integrated sub-sectors to overweight from neutral. At the same time, we are reducing the size of our prior overweights in Refining and Midstream to keep the overall Energy sector allocation to no more than two times that of the U.S. IG Energy index - a pure risk management move on our part. We are also upgrading some of our prior underweights in the Communications sectors to neutral (Media & Entertainment, Wirelines & Wireless) and to overweight (Cable & Satellite), given relatively attractive valuations in those areas. By the same token, we are cutting Other Industrials to underweight from neutral with valuations now looking unattractive. All of our U.S. sector changes result in an upgrade of our weighting to the broad Industrials grouping by 5 percentage points to 58.6%. We are reducing our large overweight to U.S. Banks by an equivalent amount to "fund" this new allocation within our 100% invested model IG portfolio. The net result of all these changes is that our U.S. IG portfolio has an overall DTS score of around 9, in line with that of the U.S. IG benchmark index. Thus, we are not making any changes to our aggregate recommended spread risk, in line with our top-down views on the overall level of credit spreads and curves, as described earlier. Bottom Line: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro Area Investment Grade: Not Much Value Left, Remain Underweight In Tables 2A and 2B, we show the output from our Euro Area IG sector valuation model. The scatter diagram showing the model residuals versus the individual sector DTS scores is shown in Chart 8. Chart Chart Chart 8 Finding value has become a problem in Europe, with only a few sectors (most notably, Metals & Mining, Oil Field Services, Life Insurance and P&C Insurance) showing a double-digit spread residual from our model. All those sectors also offer wider spreads than the overall Euro Area IG index, but the Insurers stand out as being much riskier from a DTS perspective. That is a function of the wide spread for the overall Insurance sector, which is nearly double that of the overall Euro Area IG index. We see no reason to change our existing allocations to those sectors in our model portfolio, keeping Metals & Mining and Oil Field Services at overweight and the Insurers at neutral (a prudent tradeoff between wide spreads and high risk). It would likely take a meaningful rise in European interest rates before any serious compression in Insurance spreads could unfold, given the struggles that industry faces from low yields on its fixed income investment assets. A rise in European bond yields could unfold later this year if the European Central Bank (ECB) signals that a tapering of its asset purchase program will begin next year. We see that scenario as increasingly likely, given the overall strength of the Euro Area recovery. The ECB will only shift its stance gradually, due to the lack of immediate inflation concerns. Any signal that that fewer bond purchases are in the offing, however, will pose a major risk for European corporates given the large ECB buying of that debt over the past year. We see very few necessary changes to our Euro Area allocations at the moment, as our overall portfolio DTS is in line with the IG benchmark index (around 6). We do recommend cutting Cable & Satellite and Utilities (Electric & Natural Gas) to underweight. Bottom Line: With corporate spreads at tight levels, and with few sectors showing compelling value, we are comfortable in remaining underweight Euro Area corporates, while keeping spread risk (i.e. DTS) close to index levels. Reduce Cable & Satellite, Electric Utilities and Natural Gas Utilities to underweight. U.K. Investment Grade: Stay Overweight, Focusing On Financials In Tables 3A and 3B, we present our update U.K. IG sector model, with the scatterplot of model residuals versus DTS scores shown in Chart 9. Not much has changed in terms of which sectors appear cheap in our model versus the late January levels. Financials, in general, have the cheapest spreads on an absolute basis, especially the Insurers. Although the cheap valuation on the Insurance debt mirrors the same problem highlighted above for the Euro Area insurers - interest rates that are too low to generate acceptable investment returns on the insurers' portfolios. Chart Chart Chart 9 We are maintaining our overall modest overweight allocation to U.K. IG, while keeping overall spread risk close to index levels. While the political and security risks within the U.K. are significant at the moment, there is no threat of the Bank of England moving to a less accommodative monetary policy anytime soon. A backdrop of churning economic growth, an undervalued British Pound and a central bank maintaining hyper-easy monetary policy is still a decent one for U.K. corporate debt. In terms of sector allocation changes based on our U.K. IG sector valuation model, we recommend upgrading Health Care and REITs to overweight, downgrading Other Industrials to neutral and cutting Tobacco to underweight. Bottom Line: Stay overweight U.K. IG but keep overall spread risk near index levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 Our valuation framework assesses the attractiveness of each IG sector within a cross-sectional analysis. The OAS for each sector is regressed against common risk factors (interest rate duration, credit quality) with the residual spread determining the valuation of each sector. Appendix Image Image Image