Energy

Highlights US refiners will raise capacity-utilization rates as demand revives, which will keep crude oil inventories draining through 2H20. Early data indicate COVID-19-induced lockdowns pushed demand for gasoline, diesel, jet fuel and other products in the US down by a massive 31.9% vs. five-year average levels between March and end-April (Chart of the Week).1 Supply destruction in the US shales, a surge in crude exports, and an import collapse catalyzed by unintended inventory accumulation kept storage from breaching operational capacity outside Cushing, OK, where NYMEX WTI futures deliver. We continue to expect WTI to average ~ $37/bbl this year and ~ $65/bbl next year. Brent will trade ~ $3/bbl higher. Two-way price risk – to the upside and downside – remains high. Feature US refiners did an extraordinary job of balancing their systems in the wake of this demand collapse, which, with impelling alacrity, propelled similarly rapid adjustments in pipeline, storage and shipping markets.  Getting a fix on the actual demand destruction in oil markets wrought by the COVID-19 pandemic is exceedingly difficult. Few regional markets track fundamental data in anything close to a timely manner, except for the US, where the Energy Information Agency (EIA) publishes early estimates of crude and refined-product output, consumption, exports and imports on a weekly basis. Of course, these data are preliminary and will be revised – perhaps substantially – post-publication. However, they are invaluable for getting an early read on the effects of an exogenous shock like the COVID-19 pandemic in an advanced economy. While this experience cannot be translated directly to the rest of the world, the analysis is useful in getting a handle on the order of magnitude of demand destruction globally. These early data flows indicate that, between March and the end of April, US refined-product demand fell a stunning 31.9% vs. its five-year average, as shown in the Chart of the Week. The collapse in US product demand led OECD demand lower by a similar magnitude, which is unsurprising, given the US accounted for ~ 20% of the 100mm b/d or so of products consumed globally prior to the COVID-19 pandemic. An analysis of these early data indicate US refiners did an extraordinary job of balancing their systems in the wake of this demand collapse, which, with impelling alacrity, propelled similarly rapid adjustments in pipeline, storage and shipping markets. These adjustments now are being reflected in forward curves for WTI and Brent, as market participants discount them. Chart of the WeekUS Refined-Products Demand Collapse Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiner Adjustments Propel Re-Balancing Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully. - Samuel Johnson2 As the extent of the demand destruction became apparent in March, US refiners in PADDs 2 and 3 – the US Midwest and Gulf Coast, respectively, where ~ 75% of US refining capacity is situated – moved quickly to throttle back operations (Chart 2).3 Average utilization rates in both districts fell from a 1Q20 peak of 96.5% in January to 71.2% in April. In volumetric terms, this represented a decline of 4.1mm b/d in US refiner crude inputs (gross), leaving total inputs at 13.4mm b/d by the end of April (Chart 3). Chart 2US Refiners Quickly Ramped Down US Refiners Quickly Ramped Down US Refiners Quickly Ramped Down Chart 3US Refiners Throttle Back Run Rates As Product Demand Collapses US Refiners Throttle Back Run Rates As Product Demand Collapses US Refiners Throttle Back Run Rates As Product Demand Collapses Early data indicate pipelines and storage operators let it be known their systems were rapidly filling. This sudden ramping down in operations reduced refiners’ demand for flowing crude oil, leading to a sharp unintended accumulation of crude and product inventory in the US midcontinent and Gulf Coast, and the US East coast (PADD 1), which can receive more than 3mm b/d of refined product on the Colonial Pipeline, a 5,500-mile line running from Houston, TX, to the New York Harbor (Chart 4). With crude and product storage filling, anecdotal reports now confirmed in the early data indicate pipelines and storage operators let it be known their systems were rapidly filling, and that they soon would be denying access to their transportation and holding facilities. Word reached the US shale-oil basins, particularly the Permian and midcontinent fields in Oklahoma and North Dakota, where producers were forced to lay down rigs and choke back crude flows to reduce output (Chart 5).4 Chart 4Demand Collapse Leads To Unintended Inventory Accumulation Demand Collapse Leads To Unintended Inventory Accumulation Demand Collapse Leads To Unintended Inventory Accumulation Chart 5The Word Goes Out To Cut Production, As Pipelines and Storage Fill The Word Goes Out To Cut Production, As Pipelines and Storage Fill The Word Goes Out To Cut Production, As Pipelines and Storage Fill Additional data will be required to assess how quickly crude production ramped down in the US shales, but it appears the quick-response capability of this production allowed storage operators outside of Cushing, OK, to avoid even coming close to breaching the critical 80% operating capacity threshold of storage operators in these key districts. US Ramps Crude Exports, Slashes Imports Sharply lower refiner demand forced producers and traders to move crude oil out of the US as quickly as possible. In addition to sharply curtailing production, sharply lower refiner demand forced producers and traders to move crude oil out of the US as quickly as possible, which they did (Chart 6). US crude exports are up 26.9% y/y in 1H20, and likely will continue to remain strong. At the same time, US imports of crude oil have fallen 12.6% y/y as refiners continue to manage their own storage levels and system requirements. This will allow floating storage, particularly in the US Gulf, to be drawn down, as refiners return to normal utilization rates (Chart 7). Chart 6US Crude Exports Soar, Imports Collapse ... US Crude Exports Soar, Imports Collapse ... US Crude Exports Soar, Imports Collapse ... Chart 7… And Floating Storage Soars, Particularly In The US Gulf Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiners' Rapid Response Drives US Oil-Market Rebalancing The only outlier in all of this was Cushing, OK, where the NYMEX WTI futures contract delivers. Production curtailments in the shales, surging crude exports and sharply lower imports kept storage levels under control, for the most part, as refined-product demand was collapsing in the US. Indeed, EIA data indicate storage levels in PADDs 2 and 3 overall remained below 65% of working-storage capacity throughout March and April. The only outlier in all of this was Cushing, OK, where the NYMEX WTI futures contract delivers. Storage in Cushing breached 80% of capacity in the last two weeks of April before falling back to ~ 70% by mid-May (Chart 8). The proximate cause of this appears to be a disorderly termination of trading in the NYMEX WTI contract for May delivery in Cushing.5 Chart 8Storage In Cushing, OK, Breached 80% Of Capacity Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiners' Rapid Response Drives US Oil-Market Rebalancing US Product Demand Revival It’s still early days, but there are indications of demand reviving in the US. The Apple Mobility Index, which tracks consumer interest in travel, appears to move in line with US refined-product demand (Chart 9). Our expectation remains demand will revive in 2H20 and will increase sharply y/y in 2021, given the massive fiscal and monetary stimulus deployed in the US and globally. This, coupled with the massive supply cuts by OPEC 2.0 and producers outside the coalition, will allow prices to continue to rebound over this period.5 Brent prices likely will average $40/bbl this year and $68/bbl next year. We expect WTI to trade $2 - $4/bbl below Brent. That said, two-way price risk remains extremely high, as we have noted before. Output cuts by OPEC 2.0 and US shale-oil producers could overshoot, and take too much supply off the market as demand is recovering, while demand could once again collapse if a second wave of the COVID-19 pandemic emerges following the lifting of lockdowns globally. Chart 9US Interest In Travel Generally Appears To Be Picking Up US Interest In Travel Generally Appears To Be Picking Up US Interest In Travel Generally Appears To Be Picking Up     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight WTI prices increased 74% since beginning of May as economies gradually ease lockdown measures and global voluntary and involuntary supply cuts intensify. In the US, total oil rig count fell 73% to an 11-year low of 237 rigs, reflecting weak investment appetite by producers. The IEA expects investment in the oil and gas sector to fall by $400 billion this year, led by a 32% decline in oil and gas investment. In trading markets, speculators are returning to WTI markets in expectations lower supply and reviving demand will drain inventories and move prices significantly up (Chart 10). Fund managers now hold 8-to-1 long contracts in WTI vs. 2-to-1 for Brent. Base Metals: Neutral The LMEX rose 10% since bottoming on March 23. Copper, aluminum, zinc and nickel are up by 15%, 6%, 9% and 13%. Iron ore prices dropped ~$2/MT on Tuesday as ore exports from Brazil’s Vale increased by 1.5mm tons, easing concerns about COVID-19 induced supply disruption in the country, according to Fastmarkets MB. Precious Metals: Neutral Record economic policy uncertainty in the US – and globally – keeps safe assets – chiefly gold and the US dollar – well bid (Chart 11). We expect the dollar will weaken as economies reopen and uncertainty wanes. As this unfolds, the risk of a temporary pullback in gold prices remains elevated. Medium to long term, persistent accommodative global monetary policy will continue to support the yellow metal’s upward trend. Ags/Softs:  Underweight According to the USDA, private exporters reported sales of 258k MT of soybeans for delivery to China split between the current and next marketing year, which was supportive of soybean futures prices. A weaker USD also is supporting grains, and rallying corn futures. Wheat was slightly down, as a softer USD positive is being offset by favorable weather conditions in the Black Sea export regions that compete with the US. Chart 10Speculators Are Returning to WTI Speculators Are Returning to WTI Speculators Are Returning to WTI Chart 11USD Well Bid By High Uncertainty USD Well Bid By High Uncertainty USD Well Bid By High Uncertainty     Footnotes 1     “Product Supplied” is the US EIA’s measure of demand.  2     From The Life of Samuel Johnson LL.D. Vol 3, by James Boswell. 3    PADD stands for Petroleum Administration for Defense Districts. 4    US Energy Secretary Dan Brouillette estimates as much as 2.2mm b/d of crude oil production has been shut in because of the COVID-19 pandemic. Please see US oil production shut-ins top 2.2 million b/d during pandemic: DOE chief published by S&P Global Platts May 21, 2020 5    Please see our April 30, 2020, report Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl, which examines the anomalous behavior of May-delivery WTI futures traded on the NYMEX last month, which may have contributed to this dramatic deviation from the rest of the US storage market. Markets will, at some point in the near future, be looking for a detailed post-mortem surrounding the events that occurred during the termination of trading of the NYMEX of futures delivering in May at Cushing, when WTI futures traded as low as -$40.32/bbl (i.e., negative $40.32/bbl). Part of the proximate cause of the anomaly appears to be a failure by the CME Group, which operates the NYMEX, and the US Commodity Futures Trading Commission (CFTC), which regulates US futures exchanges, to ensure an orderly termination of trading in May 2020 WTI futures contracts. See also Column: U.S. commodities watchdog issues blunt warning over oil volatility published by reuters.com May 14, 2020. In future research, we will explore the implications a non-trivial probability of negative prices in the future poses for the oil and gas markets, particularly in re capex and investment generally.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiners' Rapid Response Drives US Oil-Market Rebalancing Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Refiners' Rapid Response Drives US Oil-Market Rebalancing Refiners' Rapid Response Drives US Oil-Market Rebalancing

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control A Swift Policy Response Has Brought Spreads Under Control A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 3US IG: More Value In The Lower Tiers US IG: More Value In The Lower Tiers US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 5Euro Area IG: All Credit Buckets Are Attractive Euro Area IG: All Credit Buckets Are Attractive Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 7UK IG: Value In All Tiers Except Aaa UK IG: Value In All Tiers Except Aaa UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 9Canada IG: Great Value Across Tiers Canada IG: Great Value Across Tiers Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Australia IG: Favor A-Rated and Baa-Rated Credit Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Higher OPEC 2.0 production in 2H20 – likely beginning in 3Q20 – will be required to keep Brent prices below $50/bbl going into the US presidential elections, which arguably is the primary driver of prices in the 2020 post-COVID-19 recovery. Larger-than-expected OPEC 2.0 production cuts announced this month will force deeper inventory draws beginning in 3Q20. The re-opening of global economies and promising vaccine developments notwithstanding, we continue to expect an 8mm b/d hit to oil consumption this year, followed by an 8mm b/d recovery in demand next year. Brent prices likely will trade slightly higher than we forecast last month – $40/bbl this year, on average, vs. a $39/bbl forecast last month, and $68/bbl next year, $3/bbl above April’s forecast.  We expect WTI to trade $2 - $4/bbl below Brent (Chart of the Week). Two-way price risk is high: The likelihood demand will surprise to the upside cannot be ignored, but it could collapse with a second COVID-19 wave forcing lockdowns again.  On the supply side, the hurricane season is off to an early start in the US, with the first tropical storm, Arthur, named this week. Feature Chart of the WeekOil-Price Recovery In 2H20, 2021 Oil-Price Recovery In 2H20, 2021 Oil-Price Recovery In 2H20, 2021 Chart 2OPEC 2.0 Delivers Massive Production Cuts OPEC 2.0 Delivers Massive Production Cuts OPEC 2.0 Delivers Massive Production Cuts Political considerations – i.e., keeping crude oil prices below $50/bbl so as not to spike gasoline prices going into the US presidential elections – will drive the evolution of crude oil prices. The big driver of oil prices over the short term is what we know with the least uncertainty. Right now, that’s what's happening on the supply side over the next couple of months. Slightly further out – as November approaches, to be precise – the political economy of oil once again will dominate fundamentals. Political considerations – i.e., keeping crude oil prices below $50/bbl so as not to spike gasoline prices going into the US presidential elections – will drive the evolution of crude oil prices. That is why, we believe, the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies earlier this month – amounting to ~ 1.2mm b/d of cuts in addition to those agreed by OPEC 2.0 in April – are so important: The global inventory overhang produced by the COVID-19 pandemic, and the short-lived market-share war launched by Russia in March, has to be unwound as quickly as possible, before the US presidential elections kick into high gear. Holding to the schedule agreed in April would drain inventories, but not fast enough by September to prevent further distress for OPEC 2.0 member states as the year winds down.1 By then, additional cuts would be highly problematic, given US President Donald Trump almost surely will be demanding higher OPEC production to keep gasoline prices down as voters go to the polls in November. KSA announced plans to reduce production by ~ 4.5mm b/d vs. its April level of 12mm b/d starting in June, taking its output to ~ 7.5mm b/d. This cut is 1mm b/d more than what it agreed to last month to balance the oil market. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. Production cuts by OPEC 2.0 as a whole – led by KSA and Russia – begun in May and extending at least to the end of June will amount to ~ 9mm b/d, or close to 9% of global production (Chart 2). Chart 3US Shale-Oil Output Cuts... US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices Outside of the OPEC 2.0 production cuts, we expect US shale-oil output to fall sharply – down ~ 2mm b/d this year from its peak in December, 2019 (Chart 3). The shale-oil supply destruction will lead total US production down by 600k b/d y/y in 2020 (Chart 4). US production losses will account for the largest share of non-OPEC production losses globally. Along with losses from Canada, Brazil and Norway in the wake of the COVID-19 demand destruction, we expect global oil production to fall 12mm b/d y/y by the end of June. Chart 4... Lead US Production Sharply Lower ... Lead US Production Sharply Lower ... Lead US Production Sharply Lower Demand Could Come Back Stronger For the year as a whole, we are leaving our expected demand loss at 8mm b/d, with most of that loss occurring in 1H20. That said, demand could revive sooner than expected, if the anecdotal reports of stronger-than-expected recovery in China prove out – the level of demand there is believed to be close to 13mm b/d in May, after falling to ~ 11.25mm b/d in February and March.2 Kayrros, the oil-inventory tracking service, noted its satellite imagery indicates, “Oil demand losses appear far lower than the prevailing view in April. Measured crude oil builds are wholly inconsistent with prevailing views of a collapse in oil demand of nearly Biblical proportions.” Furthermore, “By early May, there were clear signs of robust recovery in Asian crude demand as well as earlier-stage recovery in US end-user product demand. In addition, steep, swift supply cuts helped rebalance the market, leading to surprisingly deep inventory draws. But demand had never plunged as low as widely believed in the first place.”3 Our estimate of oil-demand destruction is less than that of the major data-reporting agencies. If this performance is repeated globally in EM economies – the historical growth engine of commodity demand – markets could tighten faster than we expect (Chart 5). Our estimate of oil-demand destruction is less than that of the major data-reporting agencies. In their May updates, EIA expects 2020 demand to fall 8.1mm b/d y/y in 2020, vs. 5.2mm b/d last month; OPEC sees demand falling 9.1mm b/d y/y, vs. 6.9mm b/d last month; and the IEA has it at 8.6mm b/d y/y, vs. 9.3mm b/d last month. Chart 5EM Demand Could Revive Quickly EM Demand Could Revive Quickly EM Demand Could Revive Quickly Chart 6Massive Fiscal and Monetary Stimulus Will Boost Aggregate Demand Globally US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices By next year, we expect global demand will rise 8mm b/d y/y, driven by the massive monetary and fiscal stimulus that will continue to boost aggregate demand higher (Chart 6). In 2H20, we see demand recovering as flowing supplies fall (Chart 7), forcing onshore inventories to draw sharply in 2H20 and into 2021 (Chart 8), as well as floating storage (Chart 9). In addition, This will flatten the forward Brent and WTI curves in 2H20, and backwardate them next year, as storage draws continue (Chart 10). Chart 7Oil Supply Falls, Demand Rises ... Oil Supply Falls, Demand Rises ... Oil Supply Falls, Demand Rises ... Chart 8... Onshore Inventories Draw More Than Expected ... Onshore Inventories Draw More Than Expected ... Onshore Inventories Draw More Than Expected Chart 9Expect Floating Storage To Empty Rapidly US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices Chart 10Falling Storage Levels Will Push Forward Curves Into Backwardation Falling Storage Levels Will Push Forward Curves Into Backwardation Falling Storage Levels Will Push Forward Curves Into Backwardation Political Economy Drives Price Evolution The risk of higher gasoline prices as crude marches higher this summer is a risk President Trump already has shown he will not countenance. Following the massive production cuts being implemented this month and next by OPEC 2.0 and the large involuntary output losses outside the coalition, there is a risk prices could rise rapidly in 2H20. The fairly high likelihood demand surprises to the upside in 2H20 cannot be ignored, which would further fuel a price spike. This is a combustible political mix. The risk of higher gasoline prices as crude marches higher this summer is a risk President Trump already has shown he will not countenance, particularly not as an election looms. With this in mind, we iterated on the production required to keep Brent prices below $50/bbl in 2020 in our modeling, consistent with our view of the political economy considerations US elections impose (Table 1). Any additional volumes needed to keep Brent below $50/bbl can be returned to market fairly quickly out of OPEC 2.0 spare capacity. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices OPEC 2.0’s production cuts have sharply increased the group’s spare capacity to ~ 6.5mm b/d – 5.5mm b/d in OPEC and close to 1mm b/d in Russia and its allies – which means these states will be capable of modulating production quickly and with fairly high precision. The Return Of OPEC 2.0 Production Discipline The budgets of the OPEC 2.0 states have endured massive hits, which can only be repaired by higher oil-export revenues, given their dependence oil sales. After the US elections, OPEC 2.0 production discipline will have to be revived, given the massive fiscal constraints these states are facing. The budgets of the OPEC 2.0 states have endured massive hits, which can only be repaired by higher oil-export revenues, given their dependence oil sales. KSA will want to manage the rate at which prices increase, so that prices rise while global markets are awash in fiscal and monetary stimulus. We believe Russia will acquiesce on this point – i.e., it will not reprise its role as a price dove arguing for lower prices against KSA’s desire for higher prices – given the damage done to its economy from the price collapse in 1H20. That said, taking inventories from historically high levels back down to their 2010-14 average levels – the storage target pursued by OPEC 2.0 prior to the COVID-19-induced price collapse – likely will keep price volatility elevated (Chart 11). An upside demand surprise while production is being aggressively curtailed could sharply raise prices. Indeed, in our modeling of 2021 prices, we again iterated on production to keep Brent prices below $80/bbl, which we believe is the level both KSA and Russia can agree on for the short term. We also believe that the massive fiscal and monetary stimulus sloshing through EM and DM economies will make such prices bearable, provided they are not the result of a supply-side shock. Chart 11Oil Price Volatility Will Remain Elevated Oil Price Volatility Will Remain Elevated Oil Price Volatility Will Remain Elevated The level of uncertainty in the oil markets remains extraordinarily high. Bottom Line: Our price forecasts are premised on a resumption in global growth in 2H20 that lifts crude oil demand, and sharper-than-expected voluntary and involuntary production cuts taking supply significantly lower over the balance of the year and into next year. As the volatility chart above shows, however, the level of uncertainty in the oil markets remains extraordinarily high: A demand surprise to the upside cannot be ignored, but it also could collapse again with a second COVID-19 wave forcing another round of lockdowns. On the supply side, Tropical Storm Arthur launched the hurricane season weeks ahead of schedule. This elevates supply risk in the US Gulf until the end of November, when the season ends. We expect 2020 Brent prices to average $40/bbl and 2021 prices to average $68/bbl. WTI will trade $2-$4/bbl lower. Two-way risk – upside and downside – abounds.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight OPEC's May Monthly Oil Market Report noted Iraq failed to raise crude oil output in April amid the market-share war instigated by Russia’s refusal to back additional production cuts at OPEC 2.0’s March meeting. Saudi Arabia, Kuwait, and UAE managed to move their production up by 2.2mm b/d, 2.2mm b/d, and 330k, respectively. In our global oil balances, we assume Iraq will increase production along with core-OPEC 2.0 countries to balance oil markets once demand rebounds later this year. However, its declining production last month could signal Iraq’s ability to increase production is limited and that it will struggle to meet its increasing quota in 4Q20 and 2021. Base Metals: Neutral China’s policy-driven economic recovery continues. Last week’s data release provided evidence of a rebound in the manufacturing, infrastructure, and construction sectors (Chart 12). This will continue to support base metals – primarily copper and aluminum. Precious Metals: Neutral Chairman Powell’s comment that there is “no limit” to what the Fed can do with its emergency lending facilities supports our view that US real rates will remain depressed as inflation expectations move up ahead of nominal rates. Gold and silver are up 2% and 14% since last Tuesday. We believe silver slightly below its equilibrium price vs. gold and industrial metals (Chart 13). Silver could continue to temporarily outpace gold as it moves to equilibrium. Ags/Softs:  Underweight US corn planting for the 2020/2021 season is approaching the finish line, with 80% of the crop in the ground so far, as reported by the USDA on Monday. Although this figure was up 13 percentage points since last week, it didn’t meet analysts’ expectations of 82% to 84%, which provided support for corn prices. Furthermore, this week’s sharp rebound in oil prices also was positive for corn, which gained ¢2/bu since the beginning of the week. Chart 12Chinese Investment Tailwind for Base Metals Chinese Investment Tailwind for Base Metals Chinese Investment Tailwind for Base Metals Chart 13Silver Could Temporarily Outpace Gold Silver Could Temporarily Outpace Gold Silver Could Temporarily Outpace Gold   Footnotes 1    Please see US Storage Tightens, Pushing WTI Lower, our forecast published last month on April 16, 2020, which discussed the production cuts agreed by OPEC 2.0 in April.  It is available at ces.bcaresearch.com. 2    Please see Oil highest since March as Chinese demand reaches 13 MMbpd published May 18, 2020, by worldoil.com. 3    Please see Reassessing the Oil Demand Impact of COVID-19 published by Kayrros on medium.com May 19, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades US Politics Will Drive 2H20 Oil Prices US Politics Will Drive 2H20 Oil Prices

Highlights Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic (Chart of the Week). By 3Q20, the rebound in oil markets could be stronger than expected and surpass the base metals’ recovery, if the IMF’s latest EM GDP growth projections prove out. We examine a higher-growth scenario for non-OECD oil consumption – our proxy for EM demand – using the Fund’s projections. In it, EM oil consumption rises to 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Stronger EM consumption, coupled with global crude-oil production cuts would cause crude and product inventories to draw sooner and faster than expected, if these trends continue. Global policy uncertainty – economic and political – remains the critical risk to our metals and oil price outlooks, as it could retard a revival of growth and trade. The US and China appear to be on a collision course once again. Serious risks to global public health remain, particularly in light of a recently disclosed mutation to COVID-19. Feature Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic. Prices for base metals likely will continue rebounding from the global hit to GDP caused by COVID-19 and its associated lockdowns, recovering more of the ground lost to the pandemic in 2Q20 than crude oil prices. This is largely a reflection of China’s first-in-first-out recovery from the global pandemic and the aggregate demand destruction following in its wake. This is the signal coming from our updated market-driven indicators shown in the Chart of the Week.1 China accounts for ~ half of the demand for refined base metals worldwide, and a comparable share of the supply side for refined metals and steel (Chart 2). Chart of the WeekBase Metals Rebounding Faster Than Crude Oil Base Metals Rebounding Faster Than Crude Oil Base Metals Rebounding Faster Than Crude Oil We use principal components analysis to extract common factors driving industrial commodity prices in real time from trading markets, which allows us to get a preliminary estimate of the recovery in base metals and crude oil demand. The two indicators shown in the Chart of the Week use daily stock and commodity prices, and other daily economic data. These indicators are called the Metals Demand Component and the Oil Demand Component. The former is largely dependent on the recovery in China/EM industrial activity, and also affects all cyclical commodities, including oil. Chart 2China Dominates Base Metals Supply And Demand First Metals Then Crude First Metals Then Crude Chart 3Policy Stimulus Will Restore Profitability In China Policy Stimulus Will Restore Profitability In China Policy Stimulus Will Restore Profitability In China The base metals’ rebound likely will continue throughout 2H20 as China’s economic activity gradually normalizes, fiscal and monetary stimulus kick in, and firms’ profitability recovers (Chart 3). “China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3,” based on the analysis of our colleagues in BCA’s China Investment Strategy.2 A weaker USD will start showing up in stronger indications of global growth – particularly in the EM markets – which will reverse the downtrend in our data-driven indicators of economic activity (Chart 4). However, given the lags in the release of these data, this will take time. Currently, our Metals Demand Component suggests the trend in base metals demand is upward and established, while our Oil Demand Component is still quite volatile and not yet decisively upward. Nonetheless, our oil indicator does highlight what appears to be a bottom in oil demand. Chart 4A Weaker USD Will Reverse Lagging Indicators Of Activity A Weaker USD Will Reverse Lagging Indicators Of Activity A Weaker USD Will Reverse Lagging Indicators Of Activity EM Demand Surge Will Revive Oil Prices The EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Over the short term, oil prices could diverge from demand until storage builds are contained and the market moves into a deficit. The logistics of moving and storing oil remains the primary driver of its price over the very short term, especially for landlocked crudes. The drain in storage could occur earlier than we expected in our forecast last month, if the IMF’s global growth trajectory play out in line with its latest projections.3 Using the Fund’s projections for EM GDP, we examine a scenario in which non-OECD oil demand grows significantly more than we estimated last month. Indeed, the EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021 (Chart 5), if realized. EM growth is the critical variable for global oil-demand growth, accounting for ~ 80% of global consumption growth in the past five years. As we’ve noted for some time, the massive fiscal and monetary stimulus being deployed globally will fuel the recovery of commodity demand (Chart 6). The oil-demand scenario driven by the IMF’s latest GDP projections, and the EIA’s April forecast share a common view of a sharp recovery in the level of non-OECD demand, with the former seeing demand destruction reversed by September, and the latter expecting EM consumption to return to pre-COVID-19 levels toward the end of this year, slightly ahead of us.4 Chart 5EM Oil Demand Could Surge On The Back Of Massive Global Stimulus EM Oil Demand Could Surge On The Back Of Massive Global Stimulus EM Oil Demand Could Surge On The Back Of Massive Global Stimulus Chart 6Global Fiscal and Monetary Stimulus Will Surge In 2020 And 2021 First Metals Then Crude First Metals Then Crude A surge in EM oil-demand growth – should it play out as expected – will occur against the backdrop of sharply lower global production levels this year. OPEC 2.0 pledged to cut ~ 8mm b/d starting this month vs. its 1Q20 levels, with its putative leaders – KSA and Russia – accounting for ~ 1.5mm b/d and 2mm b/d, respectively, of the reductions. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to almost 10mm b/d for May-June, and 7.7mm b/d for 2H20).5 In addition, the US likely will lose close to 2.5mm b/d from involuntary cuts between now and the end of 2021 due to the global oil price collapse (Chart 7).6 Chart 7US Shale-Oil Output Could Fall ~ 2.5mm b/d US Shale-Oil Output Could Fall ~ 2.5mm b/d US Shale-Oil Output Could Fall ~ 2.5mm b/d OPEC 2.0 Might Have To Lift Production The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production. The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production, to keep prices from charging ahead too sharply in 2H20 and in 2021. The increase in the coalition’s spare capacity – consisting of the production taken off the market through production cuts and the 2.5mm b/d or so that it had prior to the COVID-19-induced demand destruction – will allow OPEC 2.0 to quickly meet any supply shortfalls as demand recovers before the US shale-oil producers can ramp production. All the same, the market could experience episodic volatility on the upside, if our EM demand calculations based on IMF GDP projections and those of the EIA are correct. It is highly likely, in our view, OPEC 2.0 will be the direct beneficiary of the massive fiscal and monetary stimulus of the DM and EM economies– oil being a derived demand that depends on the income available to firms and households. This means the odds of seeing $80/bbl Brent is more likely than not next year: Importantly, EM and DM consumers will be better equipped to absorb higher oil prices with the massive stimulus sloshing around the global economy next year. For now, we are maintaining our expectation of $65/bbl average prices for Brent next year, but we will continue to watch EM GDP growth in upcoming World Bank and IMF research (Chart 8). Chart 8Upside Risks in Oil Prices As GDP Growth Prospects Improve Upside Risks in Oil Prices As GDP Growth Prospects Improve Upside Risks in Oil Prices As GDP Growth Prospects Improve Oil Price Risks Abound An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. Two-way price risk abounds in the oil markets. Even if options volatility on the CBOE is considerably lower than its recent record-setting peak, it still is close to 100% on an annualized basis (Chart 9). On the upside, as we’ve discussed above, if EM GDP growth is in the neighborhood projected by the IMF, demand could surge, based on our calculations. We have no doubt OPEC 2.0 can cover any shortfall, but it can’t do it immediately, so we would expect episodic volatility this year and next. Chart 9Oil Price Risk Abounds Oil Price Risk Abounds Oil Price Risk Abounds On the downside, the COVID-19 pandemic could enter a second wave just as governments around the world are removing lockdown orders and phasing in a return to normal commerce. Of particular note in this regard is the emergence of a mutation of the original strain of the COVID-19 virus that is more contagious, and now constitutes the dominant strain in the world. The mutated form of the virus appeared in Europe and quickly spread to the US east coast, and then the rest of the planet.7 Also, the risk that “animal spirits” will not re-emerge in businesses and consumers globally remains elevated. Despite the large increase in global money supply, confidence needs to be restored for the money multiplier to move up. In addition to that, signs of another round in the Sino-US trade war in the offing could restrain growth and trade. Bottom Line: Our base case remains a resumption in global growth in 2H20, with base metals recovering most of their lost ground in 2Q20 and oil following in 3Q20. An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. However, serious risks to global public health remain, and trade tensions between the US and China once again are percolating.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Refinery runs in the US collapsed by 25% this year in the wake of the COVID-19-induced economic shutdown. Still, WTI prices rose 30% this week – from a very low level – as oil supply in the US – and globally – is adjusting rapidly to lower demand (Chart 10). Wells shut-ins are accelerating throughout North America. In the Bakken Basin, shut-ins reportedly reached 400k b/d this week.8 Moreover, the effect of the 50% YTD decline in US rig count will be visible over the coming weeks. The rig count is now well below the level necessary to keep production flat. Precious Metals: Neutral Gold prices remained above $1,700/oz as of Tuesday’s close, supported by elevated economic uncertainty. Virus-related uncertainty will gradually wane as economies reopen. This could pull gold down temporarily as safe-asset demand is reduced. Nonetheless, our Geopolitical team believes risk and uncertainty will partly shift to the geopolitical arena in the run-up of the US election.9 Additionally, the massive stimulus by the US Fed and Treasury will become an important driver of the yellow metal’s price going forward. Gold will trend higher as US rates remain stuck at zero, as it did in 2008 (Chart 11). Ags/Softs:  Underweight Following lockdown easing measures in different parts of the world, hopes of a rebound in ethanol demand helped push CBOT Corn futures 0.5% higher on Tuesday. Additionally, continuing drought conditions in Brazil will limit the country’s yields and support corn prices in the near term. Soybeans climbed 3¢/bu on Tuesday, backed by China’s booking of 378k tons of the oilseed as it seeks to fulfill the US trade deal obligations. Gains throughout corn and soybeans were mitigated by a strong planting progress as reported by the USDA. Wheat ended slightly higher after field assessments conducted by Oklahoma State University Extension projected the state harvest down by 13.5 Mn bushels year-on-year. Chart 10Crude Recouping Some Ground Crude Recouping Some Ground Crude Recouping Some Ground Chart 11Fed Rates Stuck At Zero Will Push Gold Higher Fed Rates Stuck At Zero Will Push Gold Higher Fed Rates Stuck At Zero Will Push Gold Higher   Footnotes 1     Given the importance of the daily prices in these indicators, we are explicitly assuming trading markets are continually processing fundamental information on supply, demand, inventories, and financial and economic conditions in industrial commodity markets and reflecting them in prices. This is especially important when an exogenous event like the COVID-19 pandemic hits global markets. Market participants have to work out the implications of the shock and its resolution in real time, which can make for exceptionally volatile prices. Lags in the economic data provided by the likes of the World Bank, the IMF, EIA, IEA and OPEC make the time series we typically rely on to model fundamentals and their expected evolution less effective in estimating the current state of commodity markets. Their forecasts, however, remain extremely useful, as they are developed by analysts with particular expertise in global macroeconomic forecasting, in the case of the World Bank and IMF, and oil markets, in the case of the EIA, IEA and OPEC. 2     Please see A Slow And Rocky Path To Recovery published by BCA Research’s China Investment Strategy April 29, 2020. It is available at cis.bcaresearch.com. 3    Please see US Storage Tightens, Pushing WTI Lower for our most recent supply-demand balances and oil price forecasts, which were published April 16, 2020. We use the global growth forecasts of the IMF and the World Bank as inputs to our fundamental modeling to estimate oil demand. In particular, we’ve found a parsimonious relationships between OECD, non-OECD and world oil demand and DM and EM GDP. Chapter 1 of the Fund’s advance forecast was published last month in its World Economic Outlook under the title “The Great Lockdown.” 4    Assuming the Fund’s projections of EM GDP are approximately correct, the impact on oil demand is quite large as can be seen in the comparisons shown in Chart 5. However, the IMF’s estimate for oil prices is sharply below our estimate, which was made last month assuming lower levels of EM oil demand. We expect Brent crude oil prices to average $39/bbl this year and $65/bbl next year, vs. the Fund’s estimate of $35.61/bbl in 2020 and $37.87/bbl in 2021. The EIA’s estimate of non-OECD demand is comparable to our, as seen in Chart 6, but its price forecasts for this year and next – $33/bbl and $46/bbl – also are below ours. 5    Please see US Storage Tightens, Pushing WTI Lower, where we outline OPEC 2.0’s cuts. 6    Please see our April 30 report entitled Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl for additional discussion. 7     Please see The coronavirus has mutated and appears to be more contagious now, new study finds published by cnbc.com May 5, 2020. 8    Please see 'Like watching a train wreck': The coronavirus effect on North Dakota shale oilfields published by reuters.com May 4, 2020. 9    Please see #WWIII published by BCA Research’s Geopolitical Strategy May 1, 2020. It is available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 First Metals Then Crude First Metals Then Crude Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades First Metals Then Crude First Metals Then Crude

Reinstate The Long S&P E&P/Short Global Gold Miners Trade Reinstate The Long S&P E&P/Short Global Gold Miners Trade Yesterday our 10% rolling stop got triggered on the long S&P oil & gas exploration & production (E&P)/short global gold miners pair trade. We are compelled to reinstate this intra-commodity pair trade, despite the explosive one week return, as neither the macro backdrop nor relative profit fundamentals changed. Importantly, the Fed’s determination to quash volatility is a powerful source of further gains in the relative share price ratio as the oil/gold ratio should regain its footing (volatility shown inverted, bottom panel). In addition, more and more states and a rising number of countries are setting the groundwork to reopen their economies. This should absorb some of the excess oil supply and also push real yields higher, both of which are a boon for relative share prices.  Bottom Line: While we locked in gains of 10% in a mere week on the long S&P E&P/short global gold miners pair trade, we are compelled to reinstate this intra-commodity pair trade. When it hits the 20% return mark anew, it will trigger a 10% rolling stop as a way to protect profits for our portfolio. For additional details please refer to the April 27th Weekly Report.  

Highlights WTI futures contracts delivering into Cushing, Oklahoma, in June could trade or go off the board below $0.00/bbl next month, just as the May contracts did this month, when they changed hands at a low of -$40.32/bbl last week.  Oil storage at this critical hub is approaching its practical limit of 80% full, raising the odds of sub-zero pricing (Chart of the Week). Pricing pressures will accelerate the rate of oil-supply destruction in the US, particularly in the prolific shale-oil basins.  We are revising our estimate of US production losses upward to 1.6mm b/d this year, and to 2.3mm b/d from January 2020 to December 2021. Retail speculation – in the US via ETFs and long-only index exposure, and in China via bank wealth-management products – is compounding WTI price volatility. The CME Group, which operates the NYMEX WTI futures and options markets, will be forced to address storage constraints in Cushing, and will have to better manage retail-spec positioning: These factors increase the probability of negative pricing and exacerbate price volatility as contracts go off the board. Feature The stunning -$40.32/bbl print for May 2020 WTI futures last week marks the first time this global oil benchmark has traded below $0.00/bbl. Negative prices are nothing new to non-storable commodities. In electricity markets, for example, wholesale prices go negative to force generation offline to balance supply and demand so that markets clear.1 Negative pricing also is seen in natural gas markets. It is occurring in the Permian basin with greater frequency, due to insufficient pipeline take-away capacity for all of the associated gas being produced there as oil output in the basin soars. This leaves no alternative to producers but to either shut in oil production or flare the associated gas. Indeed, forward natgas prices at the Waha Hub in Pecos County, Texas, recently have traded below zero for prolonged periods, owing to the surge in Permian oil production (Chart 2).2 Chart of the WeekCushing Approaches Crude Storage Limit Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Chart 2Lack Of Storage Pushes Natgas Prices Below Zero Lack Of Storage Pushes Natgas Prices Below Zero Lack Of Storage Pushes Natgas Prices Below Zero   Markets once again were reminded WTI futures are far more than electronic blips on computer screens: They are binding legal contracts to physically deliver light-sweet West Texas Intermediate (WTI) crude oil into the Cushing, Oklahoma, pipeline and storage hub. The stunning -$40.32/bbl print for May 2020 WTI futures last week marks the first time this global oil benchmark has traded below $0.00/bbl since the 1983 introduction of the NYMEX crude oil futures (Chart 3). Markets once again were reminded WTI futures are far more than electronic blips on computer screens: They are binding legal contracts to physically deliver light-sweet West Texas Intermediate (WTI) crude oil into the Cushing, Oklahoma, pipeline and storage hub. Going off the board long requires contract holders to take delivery into a pipeline or storage facility; going off short requires contract holders to make delivery. Chart 3WTI June Futures Could Go Below $0.00/bbl WTI June Futures Could Go Below $0.00/bbl WTI June Futures Could Go Below $0.00/bbl Owing to structural flaws in the delivery mechanism for WTI futures, and what appears to be a lapse in monitoring positions in the spot-month contract as May 2020 WTI was going off the board last week, the likelihood June 2020 WTI contracts pricing below $0.00/bbl is high. These flaws must be addressed by the CME Group’s NYMEX division and federal regulators, given the WTI futures contract’s importance to the global physical market and the capital at risk. Implications Of Negative WTI Prices Storage at Cushing is, for all intents and purposes, full. Cushing accounts for ~ 15% of the total 653mm barrels of US crude oil storage, which was only at 60% of capacity in mid-April, based on the US EIA’s reckoning. However, Cushing is the delivery point of the physically settled WTI futures contracts traded on the NYMEX. With close to 80% of capacity filled – ~ 58mm barrels of the total capacity of ~ 76mm barrels – the operational limit of storage has been reached at Cushing. This is amply seen in the June-vs-July intermonth spread between futures, which, earlier this week, settled at more than $5/bbl – i.e., more than 10x the then-elevated 50 cents/bbl/month being charged to store oil in Cushing in March (Chart 4). Intermonth spreads are used as proxies for the cost of storage for physically delivered contract that actually can be stored, like oil. If physical surpluses cannot be moved out of regions where storage is full – and pipelines also are full – prices are forced lower and lower until enough production is shut in to allow storage to drain and inventories to return to normal levels. This is happening now in Oklahoma and the prolific Texas shale basins, and other shale basins in the US where horizontal rigs are being laid down and drilling crews are being laid off (Chart 5). Chart 4Intermonth-Spread Blow Out Indicates Full Cushing Storage Intermonth-Spread Blow Out Indicates Full Cushing Storage Intermonth-Spread Blow Out Indicates Full Cushing Storage Chart 5Texas Horizontal Rig Counts Collapse Texas Horizontal Rig Counts Collapse Texas Horizontal Rig Counts Collapse We are revising our estimate of US production losses upward for this year, and to 2.3mm b/d from January 2020 to December 2021. In our most recent modeling of US shale-oil production, we expect these pricing pressures to accelerate the rate of oil-supply destruction, particularly in the prolific shale-oil basins. In fact, we are revising our estimate of US production losses upward for this year, and to 2.3mm b/d from January 2020 to December 2021 (Chart 6). Depending on how long WTI prices stay depressed in the key producing basins, this supply destruction could be even more pronounced. The same is true of global storage: Kpler, the oil-storage tracker, last week estimated global onshore inventories were 85% full.3 Until sufficient supply destruction occurs to offset the COVID-19-induced demand destruction, inventories cannot draw. Floating storage also is surging, as the crude and product forward curves fall deeper into contango, and incentivize holding stocks on the water (Chart 7). Chart 6Lower Prices Will Push US Oil Output Lower Lower Prices Will Push US Oil Output Lower Lower Prices Will Push US Oil Output Lower Chart 7Floating Storage Volumes Surge Floating Storage Volumes Surge Floating Storage Volumes Surge Price will go low enough – negative if needs be – to clear surplus supply to rebalance markets. Storage acts as a shock absorber for physical commodities like crude oil – when there is more supply than demand, the physical surplus is moved to storage until it is needed, and vice versa when there is a physical deficit. When inventories fill in Cushing – arguably the most important crude-oil delivery hub in the world, given WTI is the most liquid crude oil futures contract in the world – it is as if there is no storage at all there. At this point, market for WTI behaves a lot like electricity, which cannot be stored (at least at utility scale), or natgas at Waha, where storage and pipeline takeaway capacity are in very short supply. In such circumstances, price will go low enough – negative if needs be – to clear surplus supply to rebalance markets. This appears to be what spooked markets last week when WTI futures for May delivery traded as low as -$40.32/bbl. Retail Specs Push WTI Volatility Higher Speculators perform a vital and necessary function in futures markets – they willingly accept risk hedgers want to shed. Natural longs – i.e., producers – do not want to sell when prices are low, which is when natural shorts want to buy. Likewise, natural shorts – i.e., consumers – don’t want to buy when prices are high, which is when natural longs want to sell. Speculators provide the liquidity that allows producers and consumers to hedge. When prices are relatively high, they can provide a bid to oil producers looking to hedge production – they may be short-term traders or have a view prices are going higher, or they may be getting out of short positions they put on earlier. When prices are low, speculators provide offers – selling futures because they are short-term traders, or have a view prices are going lower, or they are getting out of long positions. Speculators trade on information and typically never stand for delivery of futures like WTI, which means they typically are out of prompt-month contracts before they are getting ready to go off the board. At that point, only physical-market participants – producers, consumers and physical traders – are left in the market balancing their physical books. When speculators find themselves trading WTI futures as they are getting ready to go to delivery, something in their risk-management systems has gone terribly wrong. Not only do they not trade the physical oil, but they don’t know who to call to take them out of their risk. Something also has gone terribly wrong at the regulatory level: At the CME, which, as the operator of the NYMEX oil trading markets, and at the US Commodity Futures Trading Commission (CFTC) in Washington, D.C. The CME is the self-regulatory organization responsible for ensuring its rules are followed and markets trade in an orderly fashion, and, at the federal level, the CFTC exercises oversight and enforces laws and regulations. It appears Bank of China (BOC), the fourth largest bank in China and the world, has found itself holding long positions in WTI futures delivering in May on the last two days of trading last week. These contracts supported wealth-management products – known as “bao” or treasure – the state-owned bank offered its retail clients.4 Other banks in China also offer such products, but it appears BOC was the only one that did not roll out of its delivery exposure in a timely manner.5 The exposure BOC was trying to trade out of was not huge by normal standards, but after settling its open May futures at -$37.63/bbl, BOC clients apparently lost close to $1.3 billion.6 How the CME or the CFTC allowed a commercial bank with no capability to take delivery of WTI in Cushing against a long NYMEX WTI futures contract as it was going off the board is a mystery. Markets will have to wait for a detailed post-mortem to determine what exactly happened, and how. Retail Piles Into WTI Exposure The experience of BOC – and, most likely, the shock of such deeply negative WTI prices realized upon settlement of these contracts – and a change in US regulations on spot-month position limits for futures used by commodity-pool operators prompted a wholesale exodus from spot-month WTI futures – the June 2020-delivery WTI futures that deliver in Cushing – this week. As a result, the commodity-pool operator running the United States Oil Fund (USO) ETF and S&P Dow Jones, which designs and markets long-only commodity index products for investors – e.g., the S&P GSCI index – rolled their June WTI futures into July and later months in an effort to avoid holding length in the June contract out of fear these futures could trade negative.7 USO is geared to retail investors, and inflows are negatively correlated with front-month WTI futures prices – when prices tank retail investors pile into the ETF (Chart 8). This can dramatically increase the number of futures the fund has to buy to provide its product to retail investors. Chart 8Retail Piles Into WTI Futures Exposure Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Markets were exceptionally volatile early in the week as these fire sales were being executed. The $3.6 billion USO ETF, in particular, apparently was ordered to spread its spot-month exposure (June WTI) across the forward curve by the CME over the first three days of this week. This action was taken to keep the USO ETF from exceeding new position-limit levels in the spot-month contract, which go into effect May 1, and state no entity can have more than 25% of total open interest in the WTI spot contract.8 Markets were exceptionally volatile early in the week as these fire sales were being executed. This rolling out of June WTI exposures should reduce – but not eliminate – the selling pressure on front-month WTI futures contracts by providers of retail and institutional commodity exposure as June goes off the board next month. However, if storage at Cushing remains at tank tops, the rolling by these ETFs that source futures liquidity to hedge their exposures could again push spot prices below $0.00/bbl as the June WTI futures go off the board May 19.9 That said, it is difficult to ascertain exactly what exposure retail investors are getting now when they buy the USO ETF – its WTI futures now span contracts into next year, based on news reports. This could prompt investors to jettison positions, setting up another round of fire sales in WTI futures. Markets also will expect a post-mortem explaining how the CME and CFTC allowed this retail-focused fund could exceed position limits in spot-month WTI futures contracts so significantly at any point in time, let alone when Cushing infrastructure is so extraordinarily taxed. WTI Futures Contract Flaws Contribute To Volatility The CME has failed to find a way to ensure those holding futures that are going off the board are bona fide hedgers capable of making and taking delivery, as the BOC experience showed. The CME Group has not acquitted itself well in the termination of May 2020 futures trading. And, as researchers at the Oxford Institute for Energy Studies note, the past couple of weeks have exposed deep flaws in the WTI futures contracts’ physical-delivery mechanisms, which have been persistent.10 The lack of sufficient storage at Cushing to accommodate the volume of trading in WTI futures is not a new problem. In 2009, the Kingdom of Saudi Arabia changed its pricing benchmark for US sales to the Argus Sour Crude Index for its crudes sold into the US Gulf, because the WTI contract detached from fundamentals then owing to infrastructure constraints at Cushing. The CME has failed to find a way to ensure those holding futures that are going off the board are bona fide hedgers capable of making and taking delivery, as the BOC experience showed. In addition, the CME has shown it has no institutionalized automatic delivery procedures that kick in when Cushing storage is full – e.g., making and taking delivery, say, in the US Gulf using a WTI contract loaded for export, as the OIES researchers observe. Lastly, as of April 22, the CME is using an options-pricing model based on the original theory on random walks developed by the great Louis Bachelier in 1900, which assumes prices are normally distributed and can go below zero, vs. its previous methodology using Fischer Black’s commodity option pricing model, which assumes prices are log-normally distributed and have a lower boundary of zero.11 We’ll be exploring this in further research.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Exports from OPEC countries increased by more than 2mm b/d in April – led by Saudi Arabia and UAE – according to Petro-Logistics – a seaborne oil trade analytics company. This is flooding global markets while global demand is expected to drop to its lowest level since 2Q03 this month. Separately, we are revising up our Canadian oil sands shut-in estimates to ~ 800k b/d in 2Q20 from ~ 500k b/d, as US demand for Canadian oil will be hit more severely than we previously anticipated and local storage is filling rapidly. Rystad Energy now expects Canadian capex to fall 41% y/y in 2020. This will have a lasting impact on the industry’s production capacity. Base Metals: Neutral The LMEX rose 3% since the start of April – led by nickel and copper prices moving up by ~ 6%. Base metals – chiefly aluminum and copper – are poised to rebound in 2Q20 if China’s economy continues to improve and is not hit by a second wave of COVID-19 infections. According to BCA’s China Investment Strategy, the country’s fiscal response is now expected to reach 10% of its GDP this year. This will support further upside in base metals prices (Chart 9). Precious Metals: Neutral Despite the record fiscal and monetary stimulus deployed globally, consumer and market-based inflation expectations remain low, as markets focus on the deflationary effects of the COVID-19 shock and the uncertainty about the speed of the recovery (Chart 10). The low realized inflation post-GFC stimulus could influence investors’ expectations down. We see inflation risks as materially higher which will warrant larger protection in a diversified portfolio over the coming year. Inflation expectations will normalize later this year and next, boosting inflation hedges. Nominal bonds’ protection will remain expensive as rates in major DM countries are expected to stay low for a prolonged period. Chart 9 Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Chart 10 Inflation Expectations Remain Low Inflation Expectations Remain Low       Footnotes 1     Please see Bajwa, Maheen and Joseph Cavicchi, “Growing Evidence of Increased Frequency of Negative Electricity Prices in U.S. Wholesale Electricity Markets.” IAEE Energy Forum, 4th Quarter 2017. 2     Please see U.S. Gas Prices Turn Negative at Texas Waha Hub published by the Pipeline & Gas Journal March 3, 2020. The article notes, “The first swing to negative spot prices in almost seven months occurred due to pipeline constraints and as mild weather cut heating demand. Prices in the forward market have been trading below zero for weeks on expectations there will not be enough pipelines to transport record amounts of gas from the region’s shale oil fields. That gas that comes from oil wells, called associated gas in the industry, helped propel U.S. gas output to record highs, driving prices to their lowest in years as production outpaces demand for the fuel. Analysts expect gas prices in 2020 to fall to their lowest since 1999.” 3    Please see Oil prices sink as world runs low on storage capacity amid frail demand published by reuters.com April 28, 2020. The IEA estimates total onshore storage globally at close to 7 billion barrels, according to the Center for Strategic & International Studies in Washington, D.C. Please see The Oil Inventory Challenge published by the CSIS April 20, 2020, which notes the US has ~ 1.3 billion barrels of storage, while China has an estimated 1.5 billion barrels. Of that ~ 7 billion barrels of nameplate capacity, ~ 80%, or ~ 5.6 billion barrels, represents the operational limit. 4    Please see The world's 100 largest banks published by S&P Global Market Intelligence April 5, 2019. 5    Please see China's ICBC closes commodity-linked products to new investment published by reuters.com April 27, 2020. 6    Please see Bank of China says main investors to settle crude oil product at -$37 published by reuters.com on April 22, 2020. 7     Please see Futures contract moves endangering WTI prices again published by worldoil.com April 28, 2020. 8    Please see USO ETF pushes oil futures exposure out to June 2021 published by etfstrategy.com April 27, 2020. Earlier this month, the USO ETF has accounted for close to 30% of June WTI futures. Please see Biggest Oil ETF Shakes Up Structure published by etf.com April 17, 2020. 9    The USO ETF is not the only fund sourcing futures liquidity to provide retail exposure to WTI, but it is by far the largest. Please see Oil ETF roils already volatile crude markets published April 27, 2020, by investmentnews.com. 10   Please see Oil Benchmarks Under Stress published by OIES April 28, 2020. 11    Please see Davis, Mark, and Alison Etheridge. Louis Bachelier's Theory of Speculation: The Origins of Modern Finance. Princeton University Press, 2006; and Black, Fischer, “The Pricing of Commodity Contracts,” Journal of Financial Economics, Vol. 3, (1976), pp. 167-79, reprinted with permission in Interrelations Among Futures, Option, and Futures Option Markets (1992), the Board of Trade of the City of Chicago publisher.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl

Highlights Even as a net oil importer, China loses more than it gains when oil prices collapse. An oil price collapse generates a formidable deflationary force, which will further depress China’s industrial pricing power and profit growth in Q2. There are early signs that demand in some sectors is gaining traction in the first three weeks of April. A full removal of travel restrictions in late May in China should help speed up the return of domestic business activities. We maintain our view that China’s economic recovery will pick up momentum in H2, underpinning our cyclical overweight stance on Chinese risk assets. Feature The nosedive in oil futures last week was a rude awakening of the enormous and unpredictable impact the pandemic has on the global economy and financial markets. WTI futures for May 2020 delivery fell to -$40.40 per barrel on April 20, an unprecedented event.  The collapse in oil prices since March will generate substantial deflationary headwinds to China’s economy in the months ahead (Chart 1). Producer prices are already in contraction. An imported deflation from low oil prices will weaken industrial pricing power even more, pushing up real rates. China’s industrial profit growth also moves in lockstep with producer prices. A deepening in PPI contraction means industrial profit growth will remain underwater, underscoring our view that the near-term outlook for Chinese stocks is yet to turn sanguine (Chart 2). Chart 1Falling Oil Prices: A Substantial Deflationary Force Falling Oil Prices: A Substantial Deflationary Force Falling Oil Prices: A Substantial Deflationary Force Chart 2Deflation Weakens Industrial Profit Growth Deflation Weakens Industrial Profit Growth Deflation Weakens Industrial Profit Growth   Oil prices will likely rebound in Q3 when the global economy re-opens, oil supply cuts take hold and the US dollar peaks. Our Commodity and Energy strategist estimates that WTI spot prices will reach $38/barrel by end-2020.1 A modest recovery in oil prices alone will not be enough to lift Chinese producer prices back to positive. The substantial reflationary efforts from China’s policymakers since Q1 should start to have an impact on the real economy in H2. The exponential credit growth should effectively prop up investment and consumption growth, and reduce inventory overhang in the industrial sector. We expect industrial producer prices and profits to turn slightly positive in Q3/Q4, underpinning our constructive view on Chinese stocks in the next 6- to 12-months. Oil Price Collapse: A Bane, Not A Boon China, as a net oil importer, stands to lose more than gain in an oil price war. This is contrary to commonly held economic theory that net oil importing countries are winners from cheaper oil. In theory falling oil prices reduces import prices, improves net oil importers’ term of trade, and in turn contributes positively to their GDP growth. In reality oil prices rarely fall in isolation. A precipitous fall in oil prices is almost always triggered by a sharp decline in global demand, accompanied with a spike in the US dollar, and results in a turmoil in the global financial markets (Chart 3). Therefore, depending on where an economy is positioned in the global value chain, a net oil importer may lose even more than a net oil exporter when oil prices collapse. Chart 3Global Trade Remains Under Pressure Until Dollar Peaks Global Trade Remains Under Pressure Until Dollar Peaks Global Trade Remains Under Pressure Until Dollar Peaks Chart 4China Loses More From Falling Trade Than Gains From Falling Oil Prices China Loses More From Falling Trade Than Gains From Falling Oil Prices China Loses More From Falling Trade Than Gains From Falling Oil Prices At only 14% of world oil consumption, China’s demand for oil alone is not enough to support a price recovery. But as a global manufacturing powerhouse, the benefits China has gained from cheaper oil in the past cycles were often more than offset by the economic and financial shocks from an oil price collapse (Chart 4). The small positive contribution to China’s GDP growth via savings on oil import bills is further discounted by losses from China’s own oil and oil-product exports (Chart 4, middle panel). China’s oil and gas sector does not necessarily benefit from collapsing oil prices. The country’s domestic oil exploration becomes deeply unprofitable when international oil prices collapse. Falling domestic demand for finished oil products and rising competition in the industry when prices are low squeeze out any extra profits for oil refineries (Chart 5). Chart 5China’s Energy Sector Suffers Too In An Oil Bear Market China's Energy Sector Suffers Too In An Oil Bear Market China's Energy Sector Suffers Too In An Oil Bear Market Chart 6Energy Costs: A Small Part Of Chinese CPI Energy Costs: A Small Part Of Chinese CPI Energy Costs: A Small Part Of Chinese CPI Chart 7US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers Furthermore, unlike the US, Chinese household consumption does not get a boost from cheaper oil. Food prices, rather than energy, drive the overall consumer price inflation in China (Chart 6). In addition, China’s domestic petrol market is heavily regulated and retail prices for energy are set by the Chinese government. China does not pass on the entire benefit of an energy price decline to its consumers, a rigid policy that has not been changed since 2016.2 As such, the current reduction in oil prices will not have the same “tax cut” benefit as it does for US consumers (Chart 7). Bottom Line: Low oil prices, accompanied by a strong dollar and depressed global trade, create a self-feeding deflationary feedback loop to China’s industrial sector, reducing the effects of the existing reflationary measures on its economy. Budding Signs Of Reflation A modest recovery in oil prices in Q3 will not be enough to return China's PPI to positive territory. Even when the global economy re-opens, the initial recovery in business activities and demand will likely be gradual, a situation China has experienced in the past two months (Chart 8). Thus, China’s domestic demand will bear most of the brunt to shore up inflation in produced goods, by propping up investment and consumption growth. We expect China’s substantial reflationary measures to start filtering into the real economy in H2. China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3 (Chart 9). Chart 8China’s Export Growth Set To Decline Further In Q2 China's Export Growth Set To Decline Further In Q2 China's Export Growth Set To Decline Further In Q2 Chart 9Huge Credit Wave Should Start Lifting Industrial Profits In H2 Huge Credit Wave Should Start Lifting Industrial Profits In H2 Huge Credit Wave Should Start Lifting Industrial Profits In H2 High-frequency data point to some early signs of a rebound in China’s domestic demand. The annual growth in the transaction volume of rebar steel rebounded from an 8% decline in March to 4% growth in the first three weeks in April.3 The contraction in passenger car sales also narrowed from -38% in March to -7.3% so far in April.4 China is ramping up its COVID-19 antibody testing to prevent a second-wave outbreak and is preparing for the National People’s Congress (NPC), which may take place in mid-May. Inter-provincial travel restrictions have limited the speed of recovery in business operations, but we expect such cautionary measures to be fully lifted in late May. The removal of logistic restrictions will help to accelerate a return to normal in both domestic production and demand. As we noted in our last week’s report,5 the April 17 Politburo meeting confirmed a policy shift to maximum reflation. President Xi’s new slogan, “The Six Stabilities and The Six Guarantees,” sets the tone that the government will increase investments to ensure that China’s post-pandemic economic growth is strong enough to stabilize employment. Bottom Line: Chinese business activities continue to inch up.  The recovery in domestic demand should pick up momentum in H2 to offset imported deflationary pressures on China’s industrial profits.  Investment Conclusions In the near term, a strong US dollar is a key risk to the recovery of China’s industrial profits.  The greenback not only generates downward pressure on oil prices and global trade, but also puts the RMB in a poor position of depreciating against the dollar but at the same time appreciating against China’s export competitors (Chart 10). All are creating headwinds to China’s economic recovery. We recommend that investors stay on the sidelines in the near term until the dollar peaks and oil prices rebound, probably in Q3.  However, on a cyclical time horizon, as the global economy re-opens and demands slowly recovers in H2, the flood of stimulus including China's own reflation efforts should help to restore investors’ risk appetite and lift the prices of risk assets. Although Chinese stocks have passively outperformed global stocks this year, the strong rebound in the SPX in recent weeks has made Chinese stocks slightly less overbought in relative terms (Chart 11). Chart 10A Tough Combination For The RMB A Tough Combination For The RMB A Tough Combination For The RMB Chart 11Chinese Stocks: Slightly Less Overbought In Past Weeks Chinese Stocks: Slightly Less Overbought In Past Weeks Chinese Stocks: Slightly Less Overbought In Past Weeks We expect China’s corporate profit growth to outpace global earnings growth this year, even as other economies re-open and start to recover. This warrants an overweight stance on Chinese stocks after near-term risks and market gyrations subside.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Please see Commodity & Energy Strategy Weekly Report "USD Strength Restrains Commodity Recovery," dated April 23, 2020, available at ces.bcaresearch.com 2The floor for retail fuel prices is set at $40 a barrel to limit losses at China’s state-owned oil companies, which generally have average production costs in the range of $40-$50 per barrel. http://english.www.gov.cn/news/top_news/2016/01/13/content_281475271410529.htm 3Based on daily data from MySteel. 4Based on weekly data from China Passenger Car Association. 5Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1  Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market Negative Oil Didn't Shock The Bond Market Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1)   Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2)  Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Bond Market Priced For Deflation Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility The Zero Lower Bound Crushes Nominal Bond Yield Volatility The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields There's Value In Short-Maturity Real Yields There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3  Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Initiate Real Yield Curve Steepeners Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Chart 6BBa Spreads & Ratings Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Chart 7AB Spreads & VIX Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Chart 7BB Spreads & Ratings Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Chart 8ACaa Spreads & VIX Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Chart 8BCaa Spreads & Ratings Negative Oil, The Zero Lower Bound And The Fisher Equation Negative Oil, The Zero Lower Bound And The Fisher Equation Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers.  Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... Bank Bonds Are Defensive... Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt ...Except Subordinate Debt ...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Senior Bank Bond Valuation Senior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation Subordinate Bank Bond Valuation Subordinate Bank Bond Valuation ​​​​​​​Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on the Fed’s different emergency facilities please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification