Investors honeymoon with OPEC falters as shale drilling booms

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1 FEBRUARY 2017 The analysis of Thierry Masset Earnings could offer antidote to political uncertainty France s election is making Europe s bond market nervous Investors honeymoon with OPEC falters as shale drilling booms The good and the bad peripheral debt When is a surprise profit warning not a surprise? Linkers are still looking attractive OTHER ASSET CLASSES Investors honeymoon with OPEC falters as shale drilling booms Commodities have confirmed their spectacular comeback (+15% in euro) and their strength should continue in 2017 as global economic growth picks up and the oversupply that has dogged markets finally dissipates. Crude oil has traded mostly between $50 and $55 a barrel (a 17-month high) for the last three months. After unprecedented optimism that OPEC, which has decided to lower its total output, for six months starting January 1, by 1.2 million barrels a day to about 32.5 million barrels, will manage to ease a global supply glut, the increase in U.S. output is keeping prices in a tight range at the moment (more comment in the oil section). Gold has posted more gains this year (+4.5% in euro) as U.S. President Donald Trump s unorthodox approach to governing unnerves investors and concerns mount about more political upheaval in Europe. Industrial metals, the best performer of last year (+21%), trade at the highest level in more than a year on a rising wave of optimism that a recovery in global demand is underway and signs that production gluts are finally set to ease. Investors have also piled into industrial commodities in the past months on expectations for sustained demand from the U.S. and China, the world s two biggest economies, as President-elect Donald Trump plans to cut taxes and add fiscal stimulus, while China s leader Xi Jinping seeks to sustain growth before an important leadership transition next year. Donald Trump s promise to revive American infrastructure means commodities used to build everything from airports to bridges, such as zinc or nickel, will benefit under his presidency. China is moving safely away from a feared hard landing, helping boost metals. Data indicated a pickup in China s service industries. The nation s official factory gauge matched a post-2012 high. The appetite for raw materials in the world s biggest consumer keeps getting bigger. China s imports of crude oil and iron ore rose to records in 2016, while coal buying expanded for the first time in three years. While the commodities rally seems a bit overdone on Trump s pledge to boost spending on infrastructure and while there is probably too much expectation on how much Donald Trump can reflate the economy, the metal-recovery momentum is likely to continue in 2017 and 2016 may mark multiyear lows for industrial metals. Beaten up more than precious metals in the past few years, they should have the most to gain if the global economic recovery picks up. The election of Donald Trump as U.S. president may mark a performance pass from precious to industrial. Outlook on gold remains mixed. While fiscal and geopolitical uncertainty, as well as potential inflationary fiscal spending and import tariffs, may be positive for bullion, stronger growth could be bearish as three interest-rate hikes by the Federal Reserve are still expected in The movement of commodities prices as a whole, up or down in 2017, could have strong global macroeconomic implications as the path to global market normalization may be found through potential bottoms in commodities and bond yields. If the 2016 recovery rally is sustained, it would be a global reflation signal - say goodbye to negative rates as bond yields potentially reach bottom - perhaps the reciprocal of the peak 35 years ago. And if the rally stumbles, that would signal a trip back to the bad old days of increasingly aggressive central bank stimulus to help reignite inflation. The positive momentum on industrial metals encourage us to adopt a more positive positioning in commodities, as the traditional reasons for allocating to commodities - portfolio diversification, low to negative correlation to stocks and bonds, inflation hedging, event risk protection - are returning to the forefront. A recovery in commodity prices following the multiyear decline may coincide with some inflation and pullback of stock/bond market rallies that have been elongated by aggressive central bank stimulus. It is true that a strength of the dollar should pressure commodities as the inverse relationship between commodities and

2 the dollar is more prominent since the global crisis. But this relationship may be shifting back to historic trends. Commodities' monthly beta relative to the U.S. Dollar index has grown to -1.3 since 2008 from -0.3 for Furthermore, the majority of commodities are moving away from steep contango conditions predominant at the end of 2015 (the futures curve is flattening), indicating improving negative roll yields and tightening supply/demand conditions. 3.1 Gold: neutral Gold gained the most in five years in 2016 as the Federal Reserve delayed interest-rate increases and the U.K. s vote to leave the European Union boosted demand. The metal has posted more gains this year as U.S. President Donald Trump s unorthodox approach to governing unnerves investors and concerns mount about more political upheaval in Europe. Fueling the bullish outlook for gold, which rallied in January and February to its highest level in three months (+4.5% in euro), is the risk of chaos on multiple fronts: a possible trade war from America s fraying relationship with China, the increasing specter of cyber warfare, the U.K. s complicated exit from the European Union, and elections slated in France, Germany and the Netherlands that may see a rise of nationalist groups. And then there are Trump s frequent Twitter posts. 140 characters of unfiltered Trump is likely to create tensions with America s largest trading partners and push investors to see gold as a safe-haven bid. While the prospect for higher rates and a strong US dollar mean enthusiasm for gold is questionable (total net long non-commercial positions in gold futures and options fell by almost 50% during the last months of 2016), the strong investment demand since the beginning of 2016 helped to make gold one of the best performing assets. The geopolitical issues have driven some inflows into gold-backed ETFs this year (+ 40 tons). Furthermore, demand for gold is still supported by low real interest rates (yields minus inflation). Gold, even at a yield of 0%, may prove to be a higher yield relative to other assets during a time when interest rates are eroding capital globally. Investors turn to gold when faith in their currencies and financial systems is shaken.

3 3.2 Crude oil (Brent): neutral As the U.S. and European oil benchmarks (WTI and Brent) have traded mostly between $50 and $55 a barrel for the last three months, we can conclude that there are limits to investors love affair with the Organization of Petroleum Exporting Countries (OPEC). After unprecedented optimism that OPEC, which has decided to lower its total output, for six months starting January 1, by 1.2 million barrels a day to about 32.5 million barrels, will manage to ease a global supply glut, the increase in U.S. output is keeping prices in a tight range at the moment. While OPEC and other major exporters are pumping less crude, U.S. inventories and production are on the rise, and shale drillers keep adding rigs. OPEC achieved the best compliance rate in its history at the outset of its Algiers accord to cut production (OPEC implemented 90% of promised output cuts in January, the first month of its agreement), according to the International Energy Agency. This is important because OPEC had often struggled in the past to fully deliver promised cuts due to a reluctance to lose income and market share! Meanwhile, U.S. producers extended the biggest surge in oil drilling in more than four years as the prolific shale plays of Texas and Oklahoma lure investment from Exxon Mobil and Continental Resources. U.S. crude output climbed to 8.98 million barrels a day in the week ended February 3, according to the Energy Information Administration. That is an increase of about half a million barrels a day from last year s low, and the agency expects production to keep climbing to reach 9.53 million a day next year, the most since Does that mean that the OPEC production cuts are fully priced into the market and that the oil bulls are vulnerable to bearish news? It is possible because, as they boost output, U.S. oil producers are hedging their price risk for this year and Producers short positions, protecting against a drop in prices, increased to 707,498 futures and options, the most since August 2007, according to the CFTC. Furthermore, the U.S. oil supply glut is still failing to clear. The issue is that once prices go up, American drillers start to produce more. Natural gas and oil drilling is effectively coming back in a big way: the Federal Reserve oil & gas-drilling index has surged almost 47% since end June. A cohort of shale producers are ready to boost output when prices rise could cap any recovery at about $60 a barrel for the next couple of years, regardless of any OPEC moves to cut production. According to the EIA, U.S. oil output will grow by 110,000 barrels a day this year and will be higher on an annual basis by April.

4 For OPEC, there is thus cause for both celebration and concern. After a two-year war downturn that wreaked economic havoc in several member countries, oil is trading near the highest level in more than a year and the prospect of a return to $30 or lower seems remote. While the group can claim that it has successfully set a floor for prices, the resilience of its rivals means the ceiling may not be too far away. With more shale supplies ready to enter the market, the best that OPEC can reasonably hope for is to stabilize prices in the $50 to $60 range. 3.3 Industrial metals: overweight Less than a year after a commodities slump brought the mining industry to its knees, major producers of metals and minerals are so flush with cash (by 2016, diversified miners generated a total of $12.9 billion of spare cash, from just $153 million two years before, according to UBS) that they are starting to share more with investors. Not only have shares surged with the rebound in price, but asset sales and cost-cutting prompted by the downturn have left some companies more streamlined and profitable. Analysts are adjusting earnings estimates for next year (+9%) amid a dizzying rally in industrial metals. The cash bonanza will allow mine owners to focus on reducing debt, but will also leave plenty for potential share buybacks and higher dividends was all about survival and recovery is cash flow and capital returns. It is going to be the theme in the industry. One gauge of leverage among mining and energy companies is starting to decrease: their net debt/earnings before interest, tax, debt and amortization is 65% lower than in September While it s tempting for mining companies to take advantage of the higher prices by boosting supply, they will be wary of repeating past mistakes. Rio Tinto Chief Executive Officer Jean Sebastien Jacques told investors in December the company would demonstrate relentless capital discipline. BHP CEO Andrew Mackenzie has said cutting debt remains a priority in the short term. All they want to do is repair balance sheets and restore and maintain dividends. After three years of losses, an index of industrial metals has rallied 22% (in euro) last year. Demand has stabilized in China, one of the world s biggest consumers, and prospects for raw-materials got a boost with the election last month of U.S. President-elect Donald Trump, who pledged to invest in infrastructure and revitalize the economy. The rally brings copper s advance last year to 21% (in euro), narrowing the gap with zinc (+63%) and tin (+50%), even if a stronger U.S. dollar is normally negative for them.

5 At the same time, mine closures during the slump have curbed supply and left the industry in better shape to benefit from the rebound. After expansions earlier in the decade led to soaring debt just as prices fell and cash flow weakened, many companies aren t eager to resume investments in new supply. Since 2014, miners have shed more than $80 billion in assets while trimming costs, according to Bloomberg. While we see capital expenditure remaining lower than at the height of commodities boom (BHP s annual spend peaked at about $21 billion in fiscal 2013), the world s two largest mining companies are planning to raise capital expenditure from decade lows as a rebound in commodity prices and the improved cash flow outlook pave the way for at least $12 billion of growth projects. BHP Billiton, the No. 1 miner, expects to raise spending by 15% in fiscal 2018, while Rio Tinto forecasts it will boost expenditure from next calendar year. Mining executives are placing more confidence in China s ability to support economic expansion, a factor that has lifted demand and commodities prices. 3.4 USD (positive), Yen (neutral) and GBP (negative) There is no end in sight to the impact of Brexit and Trump, twin themes which have dominated foreign exchange markets this year and last. Politics dominated again global markets last three months as the dollar weakened after the president-elect called the U.S. currency too strong and the pound rallied on British Prime Minister Theresa May s plans to leave the European Union. Scarred perhaps by U.K. and U.S. elections last year when many opinion polls and investors got the result dead wrong currency traders are also bidding down the price of the euro against the dollar in anticipation of the French election. The greenback fell against most peers (-3%) after Donald Trump told the Wall Street Journal its value is too high in part because China holds down its own currency. But we would put dollar weakness down to noise rather than a structural shift. If Trump wants to become as growth-generative as he is planning to be and if we don t have the same fiscal push coming from the rest of the world, then it is a question of where does the capital flow to. If the dollar was the big winner of the last three months of 2016 (the Bloomberg Dollar Correlation Weighted index gained 8%, the most since September 2011) there are mainly two reasons for that: Donald Trump s election gave way to optimism that its plans for fiscal stimulus and spending as much as $1 trillion over a decade to rebuild U.S. infrastructure will provide a boost to the U.S. economy. The Federal Reserve raised borrowing costs in December and signaled up to three rate increases in If Trump follows through with spending pledges, the Federal Reserve may indeed need to raise interest rates quickly to control inflation. A perspective that runs the risk of curbing the yield allure of developing world currencies and of the yen which recorded at the end of last year its biggest drop since 1988 (-12%). The parliamentary approval for the Brexit deal added to the pound s momentum: the sterling posted its biggest rally since the global financial crisis (+2.5%). The move probably also reflects greater clarity about the British government s position, though the sterling remains dwarfed by the collapse since the Brexit vote (-15%). In other words, investors still have a dim view of Britain s economic prospects outside the single market the challenge ahead for May and her Government is a significant one. The euro is in the middle of the pack with a 4% loss (versus the G10 currencies) since end September 2016, as investors see the euro as the best way to express concern about the stability of the European Union and the populist mood, while the ECB keeps its accommodative stance.

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