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April 24, 2020

Commodities Strategy | Metals Update

Metals Strategy: Macro Update for Metals

The list of once unthinkable occurrences becoming a reality has grown with a negative WTI print this week. That deserves further exploration because its brings to the forefront implications and arguments around un-derlying themes such the growing lack of zero bounds in assets, inflation vs deflation, liquidity or the percep-tion thereof, market structure & liquidity & product risk, etc. Some thoughts below on a range of pertinent themes we’re monitoring, and how they are expected to influence metals pricing & thinking.

Nicky Shiels Commodity Strategist (Metals 212-225-6724 Commodities Derivatives nicky.shiels@scotiabank.com

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Negative Oil print: YES, the contract was expiring soon and it is not representative of the whole curve / oil sector (large-cap energy remains indifferent to is-sues in crude futures/US0 ETF). There are also some logistical explanations related to market structure (over fundamentals, like the shortage of storage) be-hind this weeks negative print in May. However its never that simple, with many potential bigger picture implications worth considering.

• Oil vs Metals updated simulation table: its helpful to revisit the model-implied metals prices for Oil ranging from $0 (!) to $25/bbl (chart 1). The continu-ous statement energy repricing into distressed territory is a big deal for all metals that can’t be ignored. It simply lowers the cost of production floors across all (at various levels), but it also somewhat “de’brands” the commodity complex & is a deflationary headwind (without any reactionary stimulus from policy-makers). The takeaway is that MOST metals are still trading at a relatively higher ‘premium’ versus WTI at ~$17, either highlighting relatively tighter balanc-es or idiosyncratic supporting drivers. A sustained energy bounce will provide inflationary tailwinds across metals, especially for oversold ones like Aluminum (which have fallen through model-implied floors); for now its keeping would-be outperformers (liquidity assets like precious met-als) from outperforming, and ensures base metals remain in contained in ranges.

• Zero bound: there is none. Negative interest rates (Europe, Japan, soon in the US) are infiltrating commodities markets, and while negative prices aren’t unheard of in smaller/niche/byproduct commodities (e.g.: spot sulphuric acid), things get weird at the zero bound. The mantra in finance that “it cant go much lower” has been put to rest; prices can always push through fundamental (eg: costs of production) floors and well beyond rational / economic levels. Absurdly low (or negative) rates allow uneconomical companies to hide out, questioning the very essence of capitalism as markets battle to efficiently allo-cate capital/money. From a credit / risk perspective, models need to be retooled as the margin safety net has now been removed (e.g: the Black Scholes assumption is that prices cant trade below zero, no longer applies, creating potentially limitless losses/exposure in derivatives/puts). Fundamentally, su-per low interest rates allows higher cost producers to operate (inefficiently) for longer, which is accentuated by weaker EMFX trends & lower

input costs (energy) → structural headwinds for most industrial metals pricing, while it makes zero-yielding assets like Precious relatively at-tractive in the shorter-term.

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Commodities Strategy | Metals Update

Chart 1:

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Commodities Strategy | Metals Update

• Energy the leader → sentiment: sentiment from generalist investors was rightly spooked with a -$40 print and the cause for widespread derisking earlier this week across equities & commodities. The market has an uncanny ability to label and respect certain asset trends, and the energy complex is COVID-19s first responder (in contrast to the base metals complex which was the first responder/leader in the US/China trade war dispute). The reason Dr Copper has not fallen as much as crude – i.e.: well through cost of production floors and into distressed territory - is broadly twofold. 1) Copper has relatively tighter bal-ances (Cu deficits were expected for 2020 for 1st time in years, vs surpluses for crude which is evident in diverging inventory trends) 2) Crude demand takes a relatively larger hit due diminished air travel and impact on transportation (vs Copper / other base metals). Energy has been somewhat of a lead-ing indicator (despite the fact that idiosyncratic supply factors are complicating price trends), inflicting a deflationary overhang across most com-modities (pulling cost of production floors lower), the economy, and inducing the Fed to react. See note exploring connection between oil and metals here.

Chart 2:

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Commodities Strategy | Metals Update

• Inflation vs deflation: this deserves a standalone deeper dive, but for the purpose of this note, the thinking is that: 1) inflation follows deflation, usually, not

always, 2) low-negative interest rates spurs the supply-side and helps create zombie companies that produce <insert product here> forever at marginal cost of production, reinforcing deflationary trends that have persisted for decades (long-term chart 2 of energy & 10yr yields), 3) timing inflation is everything, and many (late) Gold bugs were burnt in 2009-2012 bullrun when inflation expectations rose, but inflation never reared its head, 4) Gold reacts to the FEAR of inflation that can persist for years (again, recall the largescale inflows 2009-2012 that was consensus, 1-sided, and drove gold from $800 to $1900), 5) defla-tion is bullish Gold ONLY if paired with (convincing) massive monetary stimulus AND the fear of future inflation.

• “Too big to fail” aggregators of liquidity & other products ‘at risk’? Exposure to paper products & derivatives, the disconnect between paper & physical and understanding the delivery mechanism, continues to be questioned. Metals are no stranger to these dislocations, which begun in palladium (~2 years ago), seen more recently in Gold (with perverse EFP moves/unwind into the April-June roll) and has now shifted to a marquee exchange product (“WTI”). What occurred in Gold (and Silver and then platinum) in March/April is the very opposite to Oil (the lack of physical metal in the right locations triggered an unwind of EFP positions driving futures > physical, while Oil is contending with a surplus of physical and lack of storage driving an exodus of paper longs willing to pay traders extra for storage, in a market short of storage). There are growing questions around exchanges’ credibility, which continue to be echoed by some investors warning about “gold substitutes” / paper gold (@TruthGundlach “I spoke about how physical gold is far better that “paper gold” for the opposite but related reason that tanked May WTI today. What if the “paper gold” vehicles wanted to take delivery of their futures and the counter party couldn’t deliver?”); that’s accentuated the deleveraging of paper positioning (Gold shorts & Oil longs both unwind) as some volumes either retreat completely (“lost’) or shift to other venues (OTC or other products). Similarly, issues around related commodity products & indices has arisen (e.g.: the risk that $4bn of ‘Oil’ in the USO ETF goes negative with June contract coming up; it has a record negative roll yield and the issue with contango with potential implications for further regulation/exchange intervention --> “the CME might have no other choice but to close out the ETFs positions…”). The USO ETF has essentially morphed into a closed-end active fund (from an open-end passive fund) in a week, and certainly has lessons for other commodity related ETFs if/when largescale dislocations within the market occur. Overall, dislocations within the commodity market are contingent not only supply/demand dynamics (supply hit vs demand hit) but also on transportation/logistical links which in turn is dependent on virus numbers & varying global policy deci-sions on opening up, that will fluctuate until a vaccine. That markedly impacts market structure (over fundamentals) which is are now increasing-ly a larger driver of (commodities, metals) price action. Traditionally, commodities react to a confluence of micro/fundamental, macro, and tech-nical / sentiment drivers, but one now needs to fully appreciate market structure and have intimate knowledge of how certain products are con-structed, as its impacts pricing, credit, liquidity and counterparty risk.

• Stimulus, liquidity risk and the perception of liquidity: while we have record fiscal and monetary stimulus that has started both earlier (than past crises)

and ramped up faster, the irony is that is not fully filtering down into financial markets (evidenced in overall participation rates, bid/ask spreads, volumes, etc). Positioning in most base metals (aggregate Open Interest across all exchanges) have plummeted to cyclical lows and future volumes in precious metals has fallen over the past month (vs average daily volumes seen 6mo or 1yr prior). While we don’t currently have any recent OTC/LBMA volumes to decipher whether precious activity has exited (due to market volatility) or been redirected (to other venues), we have compared the change in 1mo average daily vol-umes across precious metal and macro products (Eurodollar, SPX & 10yr futures) over peak VIX spikes now and in 2008 (Nov ’08). The takeaways are

(see table 1 and graphs 3-4) → 1) Post VIX peak, changes in participation rates (average daily volumes) in Silver, Palladium and US 10yrs (TYA) mirrors what was seen in 2H’2008 and isn’t extraordinary (volumes plummet post VIX spike and continue on a low base), 2) Participation rates in Gold, ED & ES futures and Platinum (especially!) have fallen relatively larger during and post COVID-crisis, versus the 2008-crisis

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Commodities Strategy | Metals Update

Charts 3 & 4:

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Commodities Strategy | Metals Update

Table 1:

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Commodities Strategy | Metals Update

• (Oil) Bail Out: OPEC cuts (which are largely expected to not match the demand halt) are set to begin on May 1st. The reaction function (that can be political-

ly driven) for higher energy prices is continued Middle/Iranian threats from Trump, injecting some geopolitical risk premium in the shorter term. However, structural industry reform is required (the Gold industry went through that painful process which takes a full cycle, several years). An alternative thinking is that with fundamentals playing a smaller part (because of lower interest rates mudding the picture & balances), whether asset classes ‘survive’ or not de-pends on Fed intervention; there is simply no incentive from CBs to save or support the commodities complex (from agriculture to energy) while there is some (indirect) incentive to keep financial conditions fluid (stocks higher, credit supported). The underappreciated windfall is that lower oil is also clearly a large added stimulus for consumers.

• COVID policy, growing public pressure & impact on risk: SPX bounced off its lows when the rate of infections slowed and rolled over; that is currently NOT driving sentiment and risk anymore, but when the economy opens up (and its likely to be happen in phases at different rates across different regions). Growing US protests and public pressure to open the economy is trending up, and its largely divided across political lines (the left want to hunker down for longer and save all lives, while the right wants the economy open now – there is no in-between). At some point it becomes too great to ignore, and the likeli-hood is that public opinion shifts faster (than policy) and the economy (informally) opens up, will be the 2

nd greenlight for risk to attempt a 2

nd leg higher.

That scenario - a short-lived V-shaped reflationary recovery into US elections as pent-up consumer demand is unleased, but is not sustained - will drag precious higher (all boats rise), but they will underperform higher beta oversold commodities.

Please see our (energy) specialists take on pricing and the negative print here: Michael Loewen (Energy Strategist) , “Oil @ Zero: Tank Tops, Floating Storage, and Futures Curves”

Marc Desormeaux (Senior Economist) “Going Negative”

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April 24, 2020

Commodities Strategy | Metals Update

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9

April 24, 2020

Commodities Strategy | Metals Update

The information contained in this presentation is being provided for information and discussion purposes only. An investment decision should not be made solely on the basis of the contents of this

presentation. This presentation is being provided upon the express understanding that no representation or warranty, express or implied, is made, or responsibility of any kind accepted, by The Bank of

Nova Scotia, Scotiabank Europe plc, or any of their respective affiliates (“Scotiabank”TM), their directors, agents or employees with respect to the completeness or accuracy of the information, conclu-

sions and opinions provided herein, or as to the achievement or reasonableness of any projections, targets, estimates, or forecasts and nothing in this presentation should be relied upon as a promise

or representation as to the future. Past performance or simulated past performance is not a reliable indicator of future results. Forecasts are not a reliable indicator of future performance.. This presenta-

tion has not been prepared (i) by a member of the research department of Scotiabank, or (ii) in accordance with the legal requirements designed to promote the independence of investment research. It

is considered a marketing communication for regulatory purposes and is solely for the use of sophisticated institutional investors. This presentation does not constitute investment advice or any person-

al recommendation to invest in a financial instrument or “investment research” as defined by the UK Prudential Regulation Authority and the UK Financial Conduct Authority, and its content is not sub-

ject to any prohibition on dealing ahead of the dissemination of investment research.

The information contained in this presentation reflects prevailing conditions and our judgment as of the date of the presentation, all of which are subject to change or amendment without notice, and the

delivery of any such amended information at any time does not imply that the information (whether amended or not) contained in this presentation is correct as of any time subsequent to its date. Sco-

tiabank undertakes no obligation to update or correct any information contained herein or otherwise to advise as to any future change to it. Scotiabank does not provide any applicable tax, accounting

or legal advice and in all cases independent professional advice should be sought in those areas.

This presentation incorporates information which is either non-public, confidential or proprietary in nature, and is being furnished on the express basis that this information will not be used in a manner

inconsistent with its confidential nature or be disclosed to anyone other than as may be required by law or to those who have been informed of the confidential and proprietary nature of this presenta-

tion. This presentation and its contents are strictly confidential to the person to whom it is delivered and may not be copied or distributed in whole or in part or disclosed by such persons to any other

person without the prior written consent of Scotiabank. This presentation and the information contained herein remain the property of Scotiabank.

This presentation is not and shall not be construed as an offer, invitation, recommendation or solicitation to sell, issue, purchase or subscribe any securities or bank debt in any jurisdiction or to enter

into any transaction. Nothing in this document contains a commitment by Scotiabank to sell, issue, purchase or subscribe for financial instruments, or securities, to provide debt or to invest in any way

in any transaction described herein, or otherwise provide monies to any party. Any participation by Scotiabank in any transaction would only be provided in writing after satisfactory legal, financial, tax,

accounting and commercial due diligence, as well as being subject to internal approval processes. Any transaction implementing any proposal discussed in this document shall be exclusively upon the

terms and subject to the conditions set out in the definitive agreement related thereto.

This presentation is not directed to or intended for use by any person resident or located in any country where the distribution of such information is contrary to the laws of such country. Scotiabank, its

directors, officers, employees or clients may currently or from time to time own or hold interests in long or short positions in any securities referred to herein, and may at any time make purchases or

sales of these securities as principal or agent. Scotiabank may also have provided or may provide investment banking, capital markets or other services to the companies referred to in this presentation.

TM Trademark of The Bank of Nova Scotia. Used under license, where applicable. Scotiabank, together with "Global Banking and Markets", is a marketing name for the global corporate and investment

banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including Scotia Capital Inc., Scotia Capital (USA) Inc., Scotiabanc

Inc.; Citadel Hill Advisors L.L.C.; The Bank of Nova Scotia Trust Company of New York; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución

de Banca Múltiple, Scotia Inverlat Casa de Bolsa S.A. de C.V., Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank Group and authorized users of the mark. The Bank of Nova Sco-

tia is incorporated in Canada with limited liability. Scotia Capital Inc. is a member of CIPF. Scotia Capital (USA) Inc. is a registered broker-dealer with the SEC and is a member of the NASD and SIPC.

The Bank of Nova Scotia is authorised and regulated by the Office of the Superintendent of Financial Institutions of Canada. Scotia Capital Inc. is authorised and regulated by the Investment Industry

Regulatory Organization of Canada. The Bank of Nova Scotia and Scotiabank Europe plc. are authorised by the UK Prudential Regulation Authority. The Bank of Nova Scotia is subject to regulation by

the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Scotiabank Europe plc is regulated by the UK Financial Conduct Authority and the UK Prudential

Regulation Authority. Details about the extent of The Bank of Nova Scotia 's regulation by the UK Prudential Regulation Authority are available upon request. Scotiabank Inverlat, S.A., Scotia Inverlat

Casa de Bolsa, S.A. de C.V., and Scotia Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities.