Oil

Highlights The EU’s €750 billion fiscal package, along with another round of US stimulus likely exceeding $1 trillion, will support global oil demand. On the supply side, OPEC 2.0’s production discipline likely holds, and US shale output will remain depressed. These fundamentals, along with a weakening USD, will continue to support Brent prices, which are up 129% from their lows in April. China’s record-setting crude-oil-import surge during the COVID-19 pandemic – averaging 12.7mm b/d in 1H20, up 28.5% y/y – is at risk of slowing in 2H20, as domestic storage fills. Supply-side risks are acute: Massive OPEC 2.0 spare capacity – which could exceed 6mm b/d into 2021 – will tempt producers eager to monetize these to boost revenue. On the demand side, COVID-19 infection rates are surging in the US. Progress on vaccines notwithstanding, politically intolerable public-health risks in big consuming markets could usher in demand-crushing lockdowns again. Economic policy uncertainty remains elevated globally, but the balance of risks continues to favor the upside: We expect 2H20 Brent prices to average $44/bbl, and 2021 prices to average $65/bbl, unchanged from last month’s forecast. Feature We are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June. Marginal improvements to preliminary supply and demand estimates earlier in the COVID-19 pandemic support the thesis that fundamentals will not derail the massive oil-price rally that lifted Brent 129% from its April 21 low of $19.30/bbl. A weakening US dollar, and the expectation this trend will continue, also is supportive to commodities in general, oil in particular. As a result, we are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June (Chart of the Week). The three principal oil-market data providers – the US EIA, IEA and OPEC – raised demand estimates at the margin for 1H20, particularly for 2Q20, the nadir for global oil consumption. The EIA’s estimate for 2Q20 demand shows an upward revision of 550k b/d from last month’s estimate. On the supply side, the EIA estimates global output fell -8.1mm b/d in 2Q20, a -300k b/d downward revision vs. its estimate from last month (Chart 2). Chart of the WeekOil Price Rally Remains Intact Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 2OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI. After accounting for this better-than-expected fundamental performance, we now expect global supply to fall 5.9mm b/d in 2020 and to increase 4.2mm b/d in 2021. On the demand side, we now expect 2020 demand to fall 8.1mm b/d vs. 8.9mm b/d last month, and for 2021 demand to rise 7.8mm b/d vs 8.5mm b/d in June (Chart 3). This will keep the physical deficit we’ve been forecasting for 2H20 and 2021 in place, allowing OECD storage to fall to 3,026mm barrels by year-end and to 2,766mm barrels by the end of next year (Chart 4). Chart 3Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Chart 4... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI (Chart 5). One caveat, though: We are watching floating storage levels closely, particularly in Asia: The current structure of the Brent forwards does not support carrying floating inventory, but it’s been slow moving lower (Chart 6). This could reflect a slowing in China’s crude-oil import surge, which hit record levels in May and June. Chart 5... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... Chart 6… Even As Floating Storage In Asia Remains Elevated Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside China’s Crude-Import Binge Ending? There is a non-trivial risk China’s crude-buying binge during the COVID-19 pandemic, which supported prices during the brief Saudi-Russian market-share war in March and the collapse in global demand in 2Q20, may have run its course (Chart 7).1 At the depths of the global pandemic in 2Q20, China’s year-on-year (y/y) crude imports surged 15%. According to Reuters, China’s crude oil imports totaled 12.9mm b/d in June, a record level for the second month in a row.2 Much of this was converted to refined products – chiefly gasoline and diesel fuel – as China’s demand recovered from the global pandemic (Chart 8). China’s 208 refineries can process 22.3mm b/d of crude, according to the Baker Institute at Rice University in Houston.3 Refinery runs in June were estimated at just over 14mm b/d by Reuters. Chart 7China's Crude Import Binge Stalls China's Crude Import Binge Stalls China's Crude Import Binge Stalls Chart 8China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. China imports its oil into 59 port facilities, which can process ~ 16mm b/d. Storage is comprised of 74 crude oil facilities holding ~ 706mm barrels, and 213 refined-product facilities with capacity to hold ~ 357mm barrels of products (Map 1). By Reuters’s count, ~ 2mm b/d of crude went into storage in the January-May period, while close to 2.8mm b/d was stored in June. Official storage data is a state secret, so it is not possible to determine whether China’s crude and product storage is full. However, if crude oil imports remain subdued – and floating storage in Asia remains elevated – we would surmise the Chinese storage facilities are close to full. Additionally, any sharp and sustained increase in refined product exports would indicate storage is brimming. Map 1Baker Institute China Oil Map Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. We expect the latter condition to obtain, in line with our expectation of a global recovery in demand, even though China remains out of sync with the rest of the world presently. China was the first state to confront the pandemic and first to emerge out of it; its trading partners still are in various stages of recovery (Chart 9). Chart 9China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy OPEC 2.0’s Remains Sensitive To Demand Fluctuations OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months. The asynchronous recovery in global oil demand poses a unique problem for OPEC 2.0 this year and next. OPEC 2.0 will be easing production curtailments to 7.7mm b/d beginning in August from 9.6mm b/d in July, on the advice of its Joint Ministerial Monitoring Committee (JMMC). This is a decision that will be closely monitored, amid rising concern over the speed of demand recovery in the US and EM economies, due to mounting COVID-19 cases (Chart 10). The surge in US infections relative to its trading partners is of particular concern, given the size of US oil demand (Chart 11). In 2H20, we expect US demand will account for close to 20% of global demand, much the same level it was prior to the pandemic (Table 1). Chart 10COVID-19 Infections Surge In The US Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Chart 11US COVID-19 Infections Are A Risk To Global Commodity Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months, bringing the actual increase in production closer to 1-1.5mm b/d. Together, Iraq, Nigeria, Kazakhstan, and Angola, over-produced versus their May and June targets by ~ 760k b/d. In our balances estimates, as is our normal practice, we haircut these estimates and use a lower compliance level that those stated in the official OPEC 2.0 agreement. In the case of these producers, we assume they will compensate for ~ 70% of their overproduction, bringing the adjusted cuts to ~ 8.3mm b/d. This should be sufficient to maintain the current supply deficit in oil markets that continues to support Brent prices above $40/bbl. However, the reliance on laggards’ extra cuts to balance markets adds instability. There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The JMMC is continually assessing supply-demand balances and remains focused on making sure the totality of the cuts does not fall on a small group of countries. It reiterated its position that “achieving 100% conformity from all participating Countries is not only fair, but vital for the ongoing rebalancing efforts and to help deliver long term oil market stability.” In June, OPEC 2.0’s overall compliance was 107% – mostly reflecting over-compliance from KSA, the UAE, and Kuwait.4 There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The US EIA estimates that within the original OPEC cartel spare capacity will average close to 6mm b/d this year, the first time since 2002 that it has exceeded 5mm b/d. On top of this, there’s the looming downside risk of a new Iran deal if Democrats win the White House and Congress in US elections in November, and a possible restart of Libyan exports this year. Watch The DUCs In The US With WTI prices averaging $41/bbl so far in July, we continue to expect part of previously shut-in US production to come back on line in July, August and September. Nonetheless, the negative effect of the multi-year low rig count will be felt heavily in 4Q20 and 1Q21 and will push production lower. The rig count appears to be bottoming but is not expected to increase meaningfully until WTI prices move closer to $45-50/bbl. On average it takes somewhere between 9-12 months for the signal from higher prices to result in new oil production flowing to market in the US. As the rig count moves back up in 2021, its effect on production will be apparent only in late-2021. However, the massive inventory of drilled-but-uncompleted (DUC) wells in the main US tight-oil basins will provide a source of cheaper new supply, if WTI prices remain above $40/bbl. DUCs are 30-40% cheaper to complete compared to drilling a new well from start. We expect DUCs completion will begin adding to US crude output in 1Q21, and that this will continue to be a source of supply beyond 2021. Bottom line: Global economic policy uncertainty remains elevated, albeit off its recent highs (Chart 12). We expect this uncertainty to continue to wane, which will allow the USD to continue to weaken. This will spur global oil demand, and will augment the fiscal and monetary stimulus to the COVID-19 pandemic undertaken globally. Chart 12Global Policy Uncertainty Remains High, Which Could Support USD Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Nonetheless, the global recovery remains out of sync, which complicates OPEC 2.0’s production management, and markets’ estimation of supply-demand balances. Uneven success in combating the pandemic keeps the risk of lockdowns on the radar in the US. Policy is driving oil production at present, and, given the temptation to monetize spare capacity, the supply side remains a risk to prices. We continue to see upside risk dominating the evolution of prices and are maintaining our expectation Brent prices will average $44/bbl in 2H20 – lifting the overall 2020 average to $43/bbl – and $65/bbl next year. Our expectation WTI will trade $2-$4/bbl below Brent also remains intact.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight Canadian oil production averaged 4.6mm b/d in 2Q20 vs. 5.5mm b/d in 2Q19, based on EIA estimates. The lack of demand from US refiners – crude imports from Canada fell by 420k b/d y/y during the quarter – and close to maxed-out local storage facilities pushed prices below cash costs, forcing the shut-ins of more than 1mm b/d of crude production. Canadian energy companies started releasing their 2Q20 earnings this week and analysts expect the results to be one of the worst ever recorded, reflecting the extent of the pain producers felt during the COVID-19 shock. Base Metals: Neutral High-grade iron ore prices (65% Fe) were trading above $120/MT this week, on the back of forward guidance from the commodity’s top exporter, Brazilian miner Vale, which suggested exports will be lower than had been previously estimated this year, according to Fastmarkets MB, a sister service of BCA Research. This is in line with an Australian Department of Industry, Science, Energy and Resources analysis in June, which noted, “The COVID-19 pandemic appears to have affected both sides of the iron ore market: demand disruptions have run up against supply problems localised in Brazil, where COVID-19-related lockdowns have derailed efforts to recover from shutdowns in the wake of the Brumadinho tailings dam collapse” (Chart 13). Precious Metals: Neutral Our long silver position is up 17.5% since it was recommended July 2. We are placing a stop-loss on the position at $21/oz, our earlier target, given the metal was trading ~ $22/oz as we went to press. The factors supporting gold prices – chiefly low real rates in the US, a weakening dollar and global monetary accommodation, also support silver prices. However, silver also will benefit from the recovery in industrial activity and incomes we anticipate in the wake of global fiscal and monetary stimulus, which will drive demand for consumer products (Chart 14). Ags/Softs:  Underweight Lumber prices have more than doubled since April lows. The uncertainty brought by the COVID-19 health emergency altered the perception of future housing demand and, by extension, lumber demand, to the point that mills responded by substantially decreasing capacity utilization rates. However, in the wake of global monetary and fiscal stimulus, housing weathered the storm better than expected. Furthermore, a surge in DIY projects from individuals working from home at a time of reduced supply contributed to the current state of market shortage. Chart 13Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Chart 14Silver Favored Over Gold Silver Favored Over Gold Silver Favored Over Gold         Footnotes 1     In our reckoning, a non-trivial risk is something greater than Russian roulette odds – i.e., a 1-in-6 chance of an event occuring. Re the ever-so-brief Saudi-Russian market-share war, please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020. It is available at ces.bcaresearch.com. 2     Please see COLUMN-China's record crude oil storage flies under the radar: Russell published by reuters.com July 20, 2020. 3    The Baker Institute’s Open-Source Mapping of China's Oil Infrastructure was last updated in March 2020. The map is “a beta version and is likely missing some pieces of existing infrastructure. The challenge of China’s geographic expanse — it is roughly the same area as the U.S. Lower 48 — is compounded by a lack of transparency on the part of China’s government,” according to the Baker Institute. 4    In our supply-side estimates, we used IEA estimates of cuts for June this month. This doesn’t change the overall estimate of cuts from our earlier analysis; however, it slightly changes how the 9.7mm b/d was split between OPEC 2.0 members. the official eased cuts are 7.7mm b/d from 9.7mm b/d in May-June-July, but it actually is closer to 8.3mm b/d accounting for the compensation from the countries mentioned above.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside

Highlights Falling volatility in oil-trading markets will remain suspect while the massive economic uncertainty plaguing global markets persists. Geopolitical risk also will remain high, as the US and China return to loggerheads and India and China move closer to war. Positive consumer and employment data in the US could presage a sharp recovery in demand generally; however, it is immediately countered with fears of a second COVID-19 wave, which now is the baseline scenario of our global investment strategists. Despite lower EM oil-demand growth this year – spurred by weaker GDP growth – deeper production cuts by OPEC 2.0 will keep oil markets on track to rebalance beginning in 3Q20. Massive fiscal and monetary stimulus will bridge global economic activity to a return to normal next year, provided the second wave of the COVID-19 pandemic does not result in renewed lockdown measures. Our updated supply-demand balances keep our expectation for Brent prices at $40/bbl this year and put next year’s average price at $65/bbl, $3/bbl below last month’s forecast. We continue to expect WTI to trade $2-$4/bbl lower than Brent. Feature As the OPEC 2.0 Joint Ministerial Monitoring Committee convenes today, members will be attempting to sort out the appropriate supply response to a highly uncertain oil-demand evolution over the balance of this year and next. Indeed, global economic policy uncertainty is scaling heights unimagined even in the depths of the Global Financial Crisis (GFC) of 2007-09 or the European sovereign-debt crisis of 2010-12, which followed in the GFC’s wake (Chart of the Week). This uncertainty is driving the policy responses of central banks and governments around the world, as they attempt to bridge COVID-19-induced demand destruction and the return to normality they seek in re-opening their economies. The data informing policy are suspect, as are the responses of firms and households to the stimulus they provide. This reflects the near-complete uncertainty in re current economic conditions. This translates directly to estimates of fundamental supply and demand variables, particularly in oil, which has been hardest-hit among the major commodities (Chart 2). Chart of the WeekEconomic Uncertainty Plagues Oil Markets Economic Uncertainty Plagues Oil Markets Economic Uncertainty Plagues Oil Markets Chart 2Oil Hardest Hit Commodity In 2020 COVID-19 Pandemic Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Demand To Weaken More Than Expected In 2020 OPEC 2.0’s agreement earlier this month to extend its 9.7mm b/d production cuts into July likely were informed by weaker physical demand. Our updated oil-demand model – driven by World Bank estimates of DM and EM GDP growth – indicates global oil consumption will fall by close to 9mm b/d this year, or ~ 1mm b/d more than we estimated last month.1 For next year, we expect a stronger rebound – 8.5mm b/d vs. last month’s estimate of 8mm b/d – off a lower base this year. This change is driven by the Bank’s more pessimistic assessment of EM GDP growth for 2020 than the IMF growth estimates we used in last month’s forecast (Chart 3). DM demand will take a harder hit than EM, given the extent of the lockdowns in major systematically important economies. This will set up a stronger rebound in oil demand next year, which, among many things spawned by the COVID-19 pandemic, is rarely seen. Chart 3EM Oil Demand Growth Estimate Lowered EM Oil Demand Growth Estimate Lowered EM Oil Demand Growth Estimate Lowered OPEC 2.0’s agreement earlier this month to extend its 9.7mm b/d production cuts into July likely were informed by weaker physical demand – appearing as unintended inventory accumulation – reflecting slower GDP growth. Global Oil Supply Expansion Required In our updated balances, we expect OPEC 2.0 supply to contract 3.2mm b/d y/y in 2Q20, and to increase in 2H20 and 2021 to keep prices from overshooting in the event the global demand response to fiscal and monetary stimulus is underestimated. We expect US shales to contract 600k b/d this year to 9.3mm b/d of production, and to gradually rebound in 2021 (Chart 4).2 The contraction in US shales will lead non-OPEC 2.0 supply losses in our estimation (Table 1). Chart 4Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks The combination of reduced supply and higher demand growth beginning next month will produce a physical deficit in 2H20 and in 2021 (Chart 5). This will be apparent in falling storage levels (Chart 6) and in a further flattening and eventual backwardating of the Brent and WTI forward curves (Chart 7). Chart 5Physical Markets Will Tighten Physical Markets Will Tighten Physical Markets Will Tighten Chart 6... Causing Storage to Drain ... ... Causing Storage to Drain ... ... Causing Storage to Drain ... Chart 7... And Forward Curves To Flatten, Then Backwardate ... And Forward Curves To Flatten, Then Backwardate ... And Forward Curves To Flatten, Then Backwardate Chart 8Massive Stimulus Flooding Global Economy Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Upside Favored, But Uncertainty Dominates We reckon even a second wave of the pandemic – now our Global Investment Strategy’s base case – will not derail a recovery in commodity demand. We continue to maintain a bias toward the upside price risk prevailing over the downside – driven by our expectation the massive fiscal and monetary stimulus unleashed globally will serve as an effective bridge from the COVID-19 pandemic to normal economic activity (Chart 8). This is being picked up in BCA Research's Global Nowcast, which closely tracks current economic conditions in leading manufacturing economies (Chart 9). We reckon even a second wave of the pandemic – now our Global Investment Strategy’s base case – will not derail a recovery in commodity demand.3 But the balance could tip the other way, with downside risk dominating the upside. The unprecedented uncertainty now dominating markets makes falling price volatility in oil markets – as measured by the implied volatility of Brent crude oil options’ implied volatility – highly suspect (Chart 10). We continue to emphasize two-way price risk in commodities remains pronounced despite the decline in the implied volatility of traded crude-oil options.4 Chart 9Global Economic Activity Turning Higher Global Economic Activity Turning Higher Global Economic Activity Turning Higher Chart 10Falling Vol Does Not Mean Lower Uncertainty Falling Vol Does Not Mean Lower Uncertainty Falling Vol Does Not Mean Lower Uncertainty Investment Implications The dynamics laid out above continue to point to a tightening physical oil market this year and next and higher prices. However, that does not come without substantial two-way risk. Indeed, the evolution of supply-demand information alone can trigger sharp adjustments in prices, as data revisions – to be expected, given the uncertainty prevailing at present – upend earlier preliminary estimates. We are leaving our 2020 forecast for Brent at $40/bbl and expect 2021 prices to average $65/bbl, $3/bbl below last month’s forecast. We continue to expect WTI to trade $2-$4/bbl lower than Brent (Chart 11). We also expect forward curves to flatten and return to backwardation in Brent and WTI, as the underlying physical markets tighten and inventories draw. Chart 11Brent To Average /bbl In 2021 Brent To Average $65/bbl In 2021 Brent To Average $65/bbl In 2021     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices are recovering from the dual supply and demand shocks delivered by the COVID-19 pandemic and the short-lived OPEC 2.0 internal market-share war. Brent price are now down 42% ytd vs. -72% two months ago. The contango in the Brent futures curve continues to narrow as voluntary and involuntary production cuts take effect and lockdown measures are relaxed in major economies. Continued production losses and demand recovery will force inventories lower, flattening the oil forward curves and ultimately backwardating them. Base Metals: Neutral As of Tuesday’s close, the LMEX index was up 17% since bottoming in March, 2ppt lower than the level reached last week. Positive data out of China – fueled by stimulative fiscal and monetary policies – indicates demand for industrial metals will grow: Year-on-year industrial production, infrastructure spending, and steel production grew by 4.4%, 10.9%, and 4.2%, respectively, in May (Chart 12). Moreover, y/y floor space started and sold moved up to positive territory. As government support continues to reach the economy, these sectors will encourage base metal consumption, providing further upside to the LME index. Still, fresh outbreaks of COVID-19 cases in Beijing – and associated lockdown measures – illustrate the fragility of the recovery over the short-term. Precious Metals: Neutral Gold prices remain range-bound at ~ $1,700/oz, mimicking movements in US real rates. Going forward, both the Fed and market participants expect US interest rates will remain pinned near zero through the end of 2022 (Chart 13). Our US Investment strategists expect the Fed will err to the side of providing too much accommodation as it navigates the uncertain consequences of the current economic shock. A gradual rebound in inflation next year could push real rates deeper in negative territories, which will be supportive for gold. Ags/Softs:  Underweight July soybean prices are up more than 3% since the beginning of the month. Strong export prospects going forward contributed to the strength in prices this past week. On June 4th the USDA reported new sales of soybeans of 1.21 MM MT, a huge week-on-week jump, which brought outstanding sales for the next marketing season to 4.1 MM MT. China was responsible for close to half of these sales and private exporters have since reported a little over an additional 1 million MT of exports to China. Chart 12Chinese Infrastructure Investment Rising Chinese Infrastructure Investment Rising Chinese Infrastructure Investment Rising Chart 13US Rates Expected To Remain Near Zero Until End 2022 US Rates Expected To Remain Near Zero Until End 2022 US Rates Expected To Remain Near Zero Until End 2022       Footnotes 1     Please see p. 3 of the World Bank’s June 2020 Global Economic Prospects. 2     We proxy US shales using the sum of crude production from the top 5 tight oil basins (i.e. Anadarko, Bakken, Eagle Ford, Niobrara, and Permian). Recent news reports suggest as much as 500k b/d of previously shut-in production will be back on line by the end of the month as a consequence of higher prices. This is slightly above our estimates shown in Chart 4. Please see US shale companies to boost oil output by 500,000 bpd by month-end published June 17, 2020, by reuters.com. 3    Please see A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) published by BCA Research’s Global Investment Strategy June 12, 2020. It is available at gis.bcaresearch.com. 4    For a discussion of how options markets price risk – i.e., known economic and political factors with outcomes that can be assigned probabilities – please see Ryan, Bob and Tancred Lidderdale (2009), Energy Price Volatility and Forecast Uncertainty, published by the US EIA October 2009. Risk can be thought of a “known unknowns” that can be measured across time and assigned a probability (conditional or otherwise), while uncertainty literally consists of unknown unknowns that cannot be measured.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks

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 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

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