Commodities & Energy Sector

Highlights The COVID-19-induced demand shock in China – and a stronger USD – will reduce growth in global crude oil consumption to just over 1mm b/d this year, vs. earlier expectations of ~ 1.4mm b/d. Significant fiscal and monetary stimulus from China will be required to put economic growth back on track over the critical 2020-21 interval. An accommodative monetary-policy backdrop globally also will support demand. On the supply side, OPEC 2.0 likely will cut output by an additional 600k b/d in 2Q20, which will remove 2.3mm b/d off member states’ official quotas. For 2H20, we expect the coalition to revert to its 1.7mm b/d in cuts to keep markets balanced. US shale-oil output growth will continue to slow under market-imposed capital discipline. We are revising our baseline price forecasts in 2020 lower to $62/bbl and $58/bbl for Brent and WTI, respectively (Chart of the Week). This is down $5/bbl vs our previous forecast. Price risk is to the upside, however. 2021 Brent and WTI forecasts remain at $70/bbl and $66/bbl, respectively, as we do not expect long-lived demand destruction from the COVID-19 outbreak. A growing consensus around policy stimulus and production cuts makes us leery. Feature Chart of the WeekCOVID-19 Knocks Oil Forecasts Lower COVID-19 continues to hammer Chinese oil demand, forcing refiners there to drastically reduce output. This crude oil is ending up in inventories, but, so far at least, overall storage capacity in China is not being maxed out by the unintended accumulations of crude and product inventories. Data are difficult to come by, but there are a few observations that provide some insight into the state of the refining market in China as the COVID-19 episode unfolds. Platt’s reported independent refiners in Shandong Province, which has ~ 3.4mm b/d of refining capacity, cut runs to a four-year low of ~ 40% of capacity this month, down from a January rate of 63.5%. Shandong refiners represent 50%-60% of China’s independent refining capacity.1 We estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. Ursa Space Systems’ radar satellite monitoring of inventories close to coastal refineries indicated Chinese oil storage at the beginning of the month was at 60% of capacity.2 This figure likely is higher, given refinery runs remain low, but it does not yet suggest storage capacity in China will be exhausted in the near future. In our modeling of the COVID-19 impact on oil demand, we estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. This leads us to believe EM oil demand will increase by 1mm b/d this year, down from our earlier expectation of 1.26mm b/d pre-COVID-19. For DM economies, demand growth also will disappoint, revised down by 100k b/d on the back of a warmer-than-expected winter and stop-and-go growth in manufacturing induced by COVID-19. Policy Stimulus Will Revive Chinese Demand The COVID-19 outbreak will result in a significant hit to China’s GDP, which will require substantial stimulus to put growth back on a 6% p.a. track this year. This growth rate is required for the Chinese Communist Party (CCP) to deliver on its pledge to double GDP and per-capita income over 2010-20, a pledge that was memorialized in writing following the Party’s 2012 Congress. In addition, next year marks the 100th anniversary of the founding of the CCP, and, we believe, it is an all-but-foregone conclusion the Party’s leadership will not want a faltering economy on display as it celebrates this important milestone. Given these considerations, the possibility policymakers will over-stimulate the economy to get it back on track is a non-trivial upside risk.3 We do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. Our baseline 2020 forecast envisions prices will falter somewhat versus our previous expectation – with Brent averaging $62/bbl this year, and WTI trading $4/bbl below that, vs. $67/bbl and $63/bbl previously. We are mindful of the impact Chinese policy stimulus can have on the global oil markets. The effects on GDP growth following demand shocks of past stimulus can be seen in the response of China’s GDP following the 2003 SARS outbreak; the 2008-09 GFC; the 2011-12 eurozone debt crisis; and even in China’s 2015-16 slowdown (Chart 2). For this reason, we do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. And it is for this reason that we believe price risk tilts to the upside this year. Our updated Ensemble price forecast includes two additional demand-side simulations to assess its sensitivity to changes in EM oil demand: Chart 2Chinese Stimulus Will Support Oil Demand Higher EM demand scenario (20% weight): We model the impact of the coronavirus as short-lived, with only a temporary impact on China’s economy. Consumer demand and industrial production in China converge to pre-COVID-19 levels rapidly in 2H20. Chinese policymakers overstimulate in 2Q20, over fears the virus could have severe long-term consequences on the economy. This scenario assumes EM demand increases by 100k b/d vs. our base case in 2020 and 2021. Lower EM demand scenario (10% weight): We model the impact of the coronavirus as a severe and long-lasting event. This triggers a negative feedback loop for EM oil demand; collapsing demand forces production lower, which reduces employment and pushes demand further down. This reverberates to other EM economies and affects global supply chains. This scenario assumes EM demand decreases by 240k b/d in 2020 and returns to our base case in 2021, supported by China stimulus. Oil-Demand Reduction (Not Destruction) The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). The COVID-19 outbreak in China caused us to reduce our expectation for global oil demand growth by ~ 360k b/d, taking 2020 year-on-year growth to ~ 1.04mm b/d, versus our earlier expectation of 1.4mm b/d. The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). Dollar strength produces a headwind for EM GDP growth, which suppresses oil-demand growth. The combination of the COVID-19-induced demand reduction and the stronger USD TWIB likely will compel OPEC 2.0 to maintain its production discipline until the global policy uncertainty abates and the USD TWIB retreats. Such a reversal in trend would become a tailwind for commodity demand (Chart 3). Chart 3Global Economic Uncertainty Keeps A Bid Under USD TWIB Global supply growth will continue to be constrained by demands from investors to return capital to shareholders. We expect the hit to global demand to be offset by increased production cuts from OPEC 2.0, which will be agreed next month. OPEC 2.0 production also will be impacted by continued output losses in Iran and Venezuela, which have seen y/y production fall by ~ 1.8mm b/d in 2019. Global supply growth will continue to be constrained by demands from investors to return capital to shareholders – via stock buybacks – and for steady and increasing dividends to make their equity competitive with alternative sectors (e.g., tech). These capital-market pressures – in addition to growing pressure from Environmental, Social and Governance (ESG) investors – will continue to have a profound effect on capital availability for oil and gas E+P companies for decades to come. This is a theme we will return to often in future research. We summarize these supply-demand dynamics in Chart 4. For OPEC 2.0, the 1.7mm b/d reduction in output the coalition agreed for 1Q20 remains in place, as do losses from Iran and Venezuela. For 2Q20, we assume the coalition adds another 600k b/d of production cuts. After that, we assume OPEC 2.0 reverts to its earlier production cuts of 1.7mm b/d for 2H20. In 2021, we assume OPEC 2.0 takes production cuts back down to 1.2mm b/d in January 2021, then gradually increases its production over 1H21 to balance the market and to avoid spiking prices. We also expect the Kingdom of Saudi Arabia (KSA) to remove 300k b/d of overcompliance next year, as markets tighten. In 2H21, we see OPEC 2.0 production levels remaining flat at ~ 44.8mm b/d (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4Supply-Demand Balances Chart 5Global Oil Inventories Will Resume Drawing For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. For the US, we reduced our Lower 48 production assumptions, and now have 740k b/d growth in 2020 and 300k b/d in 2021. Shales account for almost all of this increase. We also include a scenario in which US production comes in lower in our ensemble forecast. These fundamentals combine to put global oil inventories back on a downward trajectory in 2H20 (Chart 5). That said, there is an important caveat going into 2H20: If the US Economic Policy Uncertainty Index starts rising in 2H20 on the back of US election risks, markets will continue to price in a stronger USD in 2020 vs. what we now expect. For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. Odds favor a return to the pre-COVID-19 price trajectory for oil next year, with continued upside risk from Chinese fiscal and monetary stimulus, and a globally accommodative monetary-policy backdrop. Higher Spare Capacity Reduces Risk Premium The market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. The risk premium in oil prices evaporated following the drop in demand and the increase in spare capacity due to the large OPEC 2.0 cuts. When China’s economy resumes its normal activity, demand will pick up and the market will balance, increasing the impact of possible supply disruptions. However, the market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. In addition, if production capacity of ~ 300k-500k b/d in the Neutral Zone shared by KSA and Kuwait is restored, the risk premium could drop even lower, given this production is expected to be retained as spare capacity. If this is the case we could have lower prices in 2020 vs. our current forecast (down to ~ $60/bbl). We will be exploring the changes in OPEC 2.0 spare capacity and the consequences for overall production in future research. Bottom Line: Assisted by Chinese policy stimulus, oil demand will recover this year from the COVID-19-induced demand shock. On the supply side, the combination of deeper OPEC 2.0 production cuts – which we expect will be settled at the upcoming March meeting – and capital-market-imposed reduction in US oil production will push oil markets to a supply deficit. The ongoing demand shock forces us to reduce our 2020 Brent price forecast to $62/bbl from $67/bbl previously. For 2021, we maintain our $70/bbl target. Risks to our view are mounting. Three crucial pieces to our 2020 and 2021 expectations remain uncertain: The duration and magnitude of the impact of the coronavirus shock, The level of production cuts by OPEC 2.0 and the degree of compliance by all members, and The trajectory of the US dollar – if global economic policy uncertainty remains elevated the USD could remain well bid, which would continue to pressure EM GDP growth – and commodity demand – at the margin. Our base case remains that prices will rise from here, but our conviction level is slightly lower. One reason for this is the apparent consensus emerging around the likelihood of Chinese stimulus and OPEC 2.0 production cuts. If either of these assumptions prove wrong, oil prices likely would move lower.   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 As of Tuesday’s close, Brent prices were up 8% from their Feb 10 low of $53.27/bbl, supported by receding COVID-19 fears and rising expectations OPEC 2.0 will deepen its production cuts at its March meeting. Earlier this week, oil prices received an additional lift from the newly-imposed US sanctions on Rosneft Trading SA – a subsidiary of Russia’s state-own company – for its activities with Venezuela’s PDVSA. Rosneft Trading intensified its involvement in Venezuela’s oil sector and now handles the majority of the country’s crude exports, providing vital support to the Maduro government. The US restrictions include a 90-day wind-down period for companies to end their activities with Rosneft Trading. Base Metals: Neutral Chinese steel consumption – which accounts for ~50% of global demand – has been hit hard by the coronavirus outbreak. Steel and iron ore prices in China plunged 11% and 3% YTD (Chart 6). Steel mills’ inventories increased to record levels, reaching full capacity. Mills are now forced to export their surplus at reduced prices – flooding seaborne steel markets – or to cut output. Accordingly, more than 33% of steel mills are considering cutting steel production, according to a recent Platts survey. Margins at producing mills are declining and could harm high-grade iron ore prices. This is a short-term risk to our view. Precious Metals: Neutral Gold prices surged past $1,600/oz on Tuesday – overlooking positive manufacturing data in the US. Silver shadowed gold’s movement, closing at $18.13/oz. Precious metals are bought as insurance against risks of a wider-than-expected spread of the coronavirus and should remain well bid until uncertainty dissipates. Gold is somewhat overbought based on sentiment, momentum and technical indicators (Chart 7). If, as we expect, the daily increase in confirmed cases ex-Hubei slows meaningfully over the coming months, gold and silver prices will lose some steam. Ags/Softs:  Underweight CBOT March wheat futures surged 4.4% on Tuesday after Australia’s government sharply lowered its estimate of the country’s wheat harvest as severe drought affected crops. The Australian agricultural agency said the crop totaled 15.17 mm MT, the lowest since 2008, paving the way for stronger US exports. Corn also moved higher, with the prompt contract gaining 1.26% on the back of a new round of Chinese tariff exemptions on US goods. A USDA report showed US soybean export inspections bound for China were still half of last year's volumes. Soybeans futures closed 1.25 cents lower at $8.915/bu as markets await large Chinese purchases of US soybeans. Chart 6Increasing Inventories Pressure Steel and Iron ore Prices Chart 7Gold Technical Indicators Signal Overbought Market     footnotes 1     Please see China's Shandong independent refiners cut run rates to 4-year low of 40% in Feb, published by S&P Global Platts February 13, 2020. 2     Please see Oil demand falls on coronavirus: how much will inventories rise? posted by Ursa Space Systems February 7, 2020. 3     Please see Iron Ore, Steel Poised For Rally, published January 13, 2020, for a discussion of the significance of 2020 vis-à-vis the Communist Party’s pledge to double GDP and per-capita income vs. 2010 levels, memorialized by the CCP at its 2012 Peoples Congress.  We also discuss the 100th anniversary of the Party’s founding next year, which also will be a significant milestone for the CCP – and another reason the Party will not want the Chinese economy faltering as it is celebrated.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Special Report

Highlights Geopolitical sparks in the Mediterranean point to the revival of realism or realpolitik in places where it has long been dormant. Europe is wary of Russia but will keep buying more of its natural gas. This will be a source of tension with the United States. Turkey is wary of Russia but will continue choosing pragmatic deals with Moscow that fly in the face of Europe and the United States. Turkey’s intervention in Libya is small but symbolic. Increases in foreign policy aggressiveness are negative signs for Turkey as they stem from domestic economic and political instability. Short Turkish currency, equities, and local government bonds. The recent increase in immigration into Europe will fuel another bout of populism if it goes unchecked. Feature “Multipolarity,” or competition among multiple powerful nations, is our overarching geopolitical theme at BCA Research. The collapse of the Soviet Union did not lead to the United States establishing a global empire, which might in theory have provided a stable and predictable trade and investment regime. The United States lashed out when attacked but otherwise became consumed by internal struggles: financial crisis and political polarization. Under two administrations the American public has demanded a reduced commitment to international affairs. Europe is even less likely to project power abroad – particularly after being thrown on the defensive by the Syrian and Libyan revolutions and ineffectual EU responses. Turkey’s aggressive foreign policy is a symptom of global multipolarity – which makes the world less predictable for investors. Emerging markets have risen in economic and military power relative to their developed counterparts. They demand a redistribution of global political power to set aright historical grievances and address immediate concerns, such as supply line insecurities, which increase alongside a rapidly growing economy. Multipolarity is apparent in Russia’s resurgence: pushing back on its borders with Europe and NATO, seeking a greater role in the Middle East and North Africa, interfering in US politics, and cementing its partnership with China. Multipolarity is equally evident when medium-sized powers – especially those that used to take orders from the US and Europe – seek to establish an independent foreign policy and throw off the shackles of the past. Turkey is just such a middle power. Strongman President Recep Tayyip Erdogan initially sought to lead Turkey into a new era of regional ascendancy. The Great Recession and Arab Spring intervened. Domestic economic vulnerabilities and regional instability have driven him to pursue increasingly populist and unorthodox policies that threaten the credit of the nation and security of the currency. A coup attempt in 2016 and domestic political losses in 2019 drove Erdogan further down this path, which includes aggressive foreign policy as well as domestic economic stimulus. The Anatolian peninsula has always stood at the crossroads of Europe and Asia, as well as Russia and Africa. Turkey’s efforts to change the regional status quo to its favor, increase leverage over its neighbors in Europe and the Middle East, and deal with Russia’s Vladimir Putin from a position of strength, are causing the geopolitics of the Mediterranean to heat up. It has now intervened in the Libyan civil war. In this special report, we focus on this trend and ask what it means for global investors. Unfinished Business In Libya Chart 1Haftar Is Weaponizing Libya’s Oil As the Libyan conflict enters its sixth year this spring, the battle for control of the western bastion of Tripoli rages. Multiple efforts to mediate the conflict between Field Marshal Khalifa Haftar of the Libyan National Army (LNA) and Prime Minister Fayez al-Sarraj of the UN-recognized Government of National Accord (GNA) have failed. Ceasefire talks in Moscow, Rome, and Berlin have fizzled. Instead, fighting has finally hit oil production, with the state-run National Oil Corp (NOC) declaring force majeure on supplies on January 18. Tribal leaders who support Haftar have blockaded eastern ports (Chart 1). Previously the mutual dependence of the rival factions on oil revenues ensured production and exports went mostly undisturbed. LNA forces control nearly all key oil pipelines, fields, ports, and terminals in Libya. The exceptions are the Zawiyya and Mellitah terminals and offshore fields (Map 1). However the National Oil Company (NOC), headquartered in the GNA-controlled Tripoli, is the sole entity controlling operations and the sole marketer of Libyan oil. Map 1Libya’s Oil And Natural Gas Infrastructure: Monopolized By Haftar General Haftar’s blockade – which has ground oil production to a halt – displays his ability to weaponize oil to obtain concessions from the Tripoli-based government. Tribal leaders behind the blockade are calling for a larger share of oil revenues, for which they are at the mercy of the LNA and NOC. With little progress in Haftar’s push to gain control of Tripoli, and Libya more generally, the conflict has reached a stalemate. Not one to back down, Haftar’s decision to cut off oil sales from the Tripoli government, which also cuts off revenues to his own parallel administration, is a brute attempt to force a settlement. Haftar’s gambit follows Turkey’s decision to intervene in Libya on behalf of Sarraj and the GNA. Turkey has deployed roughly 2,000 Syrian fighters, as well as 35 Turkish soldiers in an advisory capacity. Turkey apparently feared that Haftar, who has substantial backing from Egypt and the Gulf Arabs as well as Russia and France, was about to triumph, or at least force a settlement detrimental to Turkish interests. Bottom Line: Turkey’s decision to intervene in the Libyan civil war – while limited in magnitude thus far – raises the stakes of the conflict, which involves the EU, Russia, and the Arab states. It is a clear signal of the geopolitical multipolarity in the region – and a political risk that is flying under the radar amid higher profile risks in other parts of the world. Political Interests: Islamist Democracy Versus Arab Dictatorship The Libyan civil war is a proxy war between foreign nations motivated by conflicting economic and strategic interests in North Africa and the Mediterranean. But there is an ideological and political structure to the conflict that explains the alignment of the nations: Turkey is exporting democracy while the Arab states try to preserve their dictatorships. Haftar’s primary supporters include Egypt, the United Arab Emirates (UAE), and Saudi Arabia. These states see monarchy as the way to maintain stability in a region constantly on the edge of chaos. Islamist democracy movements, such as Egypt’s Muslim Brotherhood, pose a threat to their long-term authority and security. They try to suppress these movements and contain regimes that promote them or their militant allies. They are willing to achieve one-man rule by force and thus support military strongmen like Egypt’s Abdel Fattah el-Sisi and Libya’s General Haftar. On the other side of the conflict stand the backers of the GNA – Turkey and Qatar – which support political Islam and party politics (Chart 2). Turkey’s Erdogan and his Justice and Development Party (AKP) are sympathetic to Hamas in the Palestinian territories and Egypt’s Muslim Brotherhood. They want to ensure a lasting role for Islamic parties in the region, which strengthens their legitimacy. They do not want Libya’s Islamists to suffer the same fate as their affiliates in the Muslim Brotherhood – removal via a military coup. Chart 2Turkey Sees A Place For Political Islam Chart 3Turkey Steps In Amid Qatar Embargo The political conflict is mirrored in the Persian Gulf in the form of the air, land, and sea embargo imposed on Qatar in 2017 at the hands of the Saudis, Egyptians, and Emiratis. The Qatar crisis followed a 2014 diplomatic rift and the 2011 Arab Spring, when Qatar supported protesters and democracy movements against neighboring regimes. The embargo strengthened Turkey-Qatar relations, as Turkey stepped in to ensure that Qataris – who are heavily dependent on imports – would continue to receive essentials (Chart 3). Bottom Line: The alliances forged in the Libyan conflict reflect differing responses to powerful forces of change in the region. Established monarchies and dictatorships are struggling to maintain control of large youth populations and rapidly modernizing economies. Their response is to fortify the existing regime, suppress dissent, and launch gradual reforms through the central government. Their fear of Islamist movements makes them suspicious of Tripoli and the various Islamist groups allied with the GNA, and aligns them with Khalifa Haftar’s attempt to impose a new secular dictatorship in Libya. Meanwhile Turkey, with an active Islamist democracy, is seeking to export its political model, and Muslim Brotherhood-esque political participation, to gain influence across the region, including in Libya and North Africa. Economic Interests: The Scramble For Energy Sources Chart 4Europe Addicted To Russian Gas The Libyan proxy war is also about natural resources, for all the powers involved. Turkey’s intervention reflects its supply insecurity and desire to carve a larger role for itself in the east Mediterranean economy. Turkey needs to secure cheap energy supplies, and also wants to make itself central to any emerging east Mediterranean natural gas hub that aims to serve Europe. Europe’s increasing dependency on natural gas imports to meet its energy demand, and Russia’s outsized role – supplying the EU with 40% of its needs – have encouraged a search for alternative suppliers (Chart 4). Israel is attempting to fill that role with resources discovered offshore in the eastern Mediterranean. Given its strategic location, Turkey hopes to become an energy hub. First, it is cooperating with the Russians. Presidents Putin and Erdogan inaugurated the Turkish Stream pipeline (TurkStream) at a ceremony in Istanbul on January 8. The pipeline will transport 15.75 billion cubic meters (Bcm) of Russian natural gas to Europe via Turkey. This is part of Russia’s attempt, along with the Nord Stream 2 pipeline, to bypass Ukraine and increase export capacity, strengthening its dominance over Europe’s natural gas market (Map 2). Map 2Russia’s Latest Pipelines Bypass Ukraine Europe and its allies are wary of Russian influence, but the EU is not really willing to halt business with Russia, which is a low-cost and long-term provider free from the turmoil of the Middle East. Despite the significant growth in US natural gas supplies, the relatively higher cost makes Russian supplies comparatively more attractive (Chart 5). Chart 5Russian Gas Is Competitive In European Markets … Chart 6… As US Attempts To Gain Market Share The result will be tensions with the United States, which expects the Europeans to honor the security relationship by buying American LNG (Chart 6) and will always abhor anything resembling a Russo-European alliance. American legislation signed on December 20 would impose sanctions on firms that lay pipes for Nord Stream 2 and TurkStream. Second, Turkey wants to become central to eastern Mediterranean energy development. A series of offshore discoveries in recent decades has sparked talk of cooperation among potential suppliers (Table 1). There is a huge constraint on developing the fields quickly, as there is no export route currently available for the volumes that will be produced. While the reserves are not significant on a global scale, their location so close to Europe, and growing needs in the Middle East, has generated some interest. Table 1Recent East Mediterranean Discoveries Are Relatively Small, But Geopolitically Attractive However, Europe and Israel – the status quo powers – threaten to marginalize Turkey in this process: A meeting of the energy ministers of Egypt, Cyprus, Greece, Israel, Italy, the Palestinian territories, and Jordan in Cairo last July resulted in the creation of the Eastern Mediterranean Gas Forum to promote regional energy cooperation. Turkey – along with Lebanon and Syria – was excluded. Turkey seeks access to natural resources – and to prevent Israel, Egypt, and Europe from excluding it. The EastMed Pipeline deal – signed by Greece, Cyprus, and Israel on January 2 – envisages a nearly 2,000 km subsea pipeline transporting gas from Israeli and Cypriot offshore fields to Cyprus, Crete and Greece, supplying Europe with 9-12 Bcm per year (Map 3). The project enjoys the support of the European Commission and the US as an attempt to diversify Europe’s gas supplies and boost its energy security.1 But it would also be an alternative to an overland pipeline on Turkish territory. Map 3The Proposed EastMed Pipeline Would Marginalize Turkey Egypt has two underutilized liquefied natural gas plants – in Idku and Damietta – and has benefited from the 2015 discovery of the Zohr gas field. Egypt has recently become a net exporter of natural gas (Chart 7). It signed a deal with Israel to purchase 85.3 Bcm – $19.5 billion – of gas from Leviathan and Tamar fields over 15 years. Egypt sees itself as an energy hub if it can re-export Israeli supplies economically. Note that Russia and Turkey have some overlapping interests here. Russia does not want Europe to diversify, while Turkey does not want to allow alternatives to Russia that exclude Turkey. Thus maintaining the current trajectory of natural gas projects is not only useful for Russia’s economy (Chart 8) but also for Turkey’s strategic ambitions. Chart 7Egypt Also Aims To Become East Mediterranean Gas Hub Of course, while Russian pipes are actually getting built, the EastMed pipeline is not – for economic as well as geopolitical reasons. Europe is currently well supplied and energy prices are low. At an estimated $7 billion, the cost of constructing the EastMed pipeline is exorbitant. Chart 8Maintaining Energy Dominance Advances Russia’s Strategic Ambitions Too Still, Turkey must make its influence known now, as energy development and pipelines are necessarily long-term projects. The chaos in Libya presents an opportunity. Seizing on the Libyan GNA’s weakness, Turkey signed an agreement to provide for offshore maritime boundaries and energy cooperation as well as military aid. The EastMed pipeline, of course, would need to cross through Turkish and Libyan economic zones (see Map 3 above).2 Turkey is incapable of asserting its will militarily in the Mediterranean against powerful western naval forces. But short of war, it is capable of expanding its claims and leverage over regional energy and forcing the Israelis and Europeans to deal with it pragmatically and realistically rather than exclude it from their plans. Part of Turkey’s goal is to cement an alliance with Libya – at least a partitioned western Libyan government in any ceasefire brokered with Haftar and the Russians. Bottom Line: While Turkey and Russia support opposing sides in the Libyan conflict, both benefit from dealing directly with each other – bypassing the western powers, which are frustrated and ineffectual in Libya. Both would gain some direct energy leverage over Europe and both would gain some influence over any future eastern Mediterranean routes to Europe. In Libya, if either side triumphs and unites the country, it will grant its allies oil and gas contracts almost exclusively. But if the different foreign actors can build up leverage on opposing sides, they can hope to secure at least some of their interests in a final settlement. Turkey Needs Foreign Distractions The foregoing would imply that Turkey is playing the game well, except that its foreign adventures are in great part driven by domestic economic and political instability. After all, Turkey’s maritime claims are useless if they cannot be enforced, and offshore development and pipeline-building are at a low level given weak energy prices and slowing global demand. Economically, in true populist fashion, Erdogan has repeatedly employed money creation and fiscal spending to juice nominal GDP growth. The result is a wage-price spiral, currency depreciation, and current account deficits that exacerbate the problem. The poor economy has mobilized political opposition. Over the past year, for the first time since Erdogan rose to power in 2002, his Justice and Development Party is fracturing. Former Turkish deputy prime minister Ali Babacan, a founding member of the AKP, as well as former prime minister Ahmet Davutoglu, have both announced breakaway political parties that threaten to erode support for the AKP. Local elections in 2019 resulted in a popular rebuke in Istanbul. Thus Erdogan is distracting the public with hawkish or nationalist stances abroad that are popular at home. Turkey has taken a strident stance against the US and Europe, symbolized by its threats to loose Syrian refugees into Europe and its purchase of S400 missile defense from Russia despite being a NATO member. Military incursions in Syria aim to relocate refugees back to Syria (Chart 9). Chart 9Erdogan Is Distracting Turks With Popular Foreign Stances Chart 10No Love Lost Toward The West Turkish public opinion encourages close cooperation with Russia and a more aggressive stance against the West (Chart 10). This is a basis for Russia and Turkey to continue cutting transactional deals despite falling on opposite sides of conflicts in Syria, Libya, Iran, and elsewhere. Erdogan’s pretensions of reviving Ottoman grandeur in the Mediterranean fall in this context. Elections are not until 2023, but we expect Erdogan to continue using foreign policy as a distraction. The opposition is trying to unite behind a single candidate, which could jeopardize Erdogan’s grip on power. The insistence on stimulus at all costs means that Erdogan is not allowing the economic reckoning to occur now, three years before the election. He is trying to delay it indefinitely, which may fail. Libya may not get resolved, however. Allies of Haftar’s LNA – specifically Egypt, Saudi Arabia, and the UAE – will be motivated to intensify their support of him for fear that a loss would revive domestic interest in political Islam. Egypt especially fears militant proxies being unleashed from any base of operations there. The LNA currently serves as a buffer between Egypt and the militant actors in Libya. If Haftar is defeated, Egypt’s porous western border would provoke a harsh reaction from Cairo. The threat of a revival of Islamic State in Libya has united the Egyptian people – a critical variable in the administration’s vision of a stable country. That has provided Egypt’s Sisi an excuse to flex his muscles through military exercises. Neither Russia nor NATO will be moved to bring a decisive finish to the conflict, as neither wishes to invest too heavily in it. Bottom Line: Erdogan has doubled down on populism at home and abroad. His assertive foreign policy in Syria and now Libya may end up exacerbating economic and political pressures on the ruling party. What Is The Endgame In Libya? There are three possible scenarios to end the current stalemate between the Haftar’s forces and the internationally recognized GNA: Military: An outright military victory by either Haftar or Sarraj is highly unlikely. While Haftar’s forces enjoy military and financial support from the UAE, he lacks popular support in Tripoli – which has proved to be challenging to takeover. Similarly, Sarraj’s army is not strong enough to confront the eastern forces and reunify the country. The merely limited involvement of foreign actors – including Turkey – makes a military solution all the more elusive. The most likely path to a quick military victory comes if foreign actors disengage. This will only occur if they are punished for their involvement, and thus it requires a major neutral power, perhaps the United States, to change the calculus of countries involved. But the US is eschewing involvement and the Europeans have shown no appetite for a heavy commitment. Diplomatic: A negotiated settlement is eventually likely, given the loss of oil revenues. A ceasefire would assign some autonomy to each side of the country. Given Haftar’s ambitions of conquering the capital and becoming a strongman for the country as a whole, the diplomatic route will be challenging unless his Gulf backers grow tired of subsidizing him. Financial: Haftar could win by breaking the NOC’s monopoly on oil. In the past, the LNA failed at selling the oil extracted from infrastructure under its control. If Haftar manages to market the oil without the aid of the NOC then he will be able to guarantee a stream of revenue for his forces and at the same time starve the Tripoli government of financing. This would pose an existential risk for the GNA. The key challenge in this scenario is to obtain international backing for LNA sales of Libyan crude supplies. Libya’s partition into two de facto states is the likeliest outcome. Bottom Line: Unless one of the constraints on a military, diplomatic, or financial end to the conflict is broken, the current stalemate in the Libyan conflict will endure. A partition of Libya will be the practical consequence. Turkey hopes to boost its regional influence through Tripoli, and thus increase its leverage over Europe, but a heavy investment could result in fiscal losses or spiral into a broader regional confrontation. Investment Implications While it is not clear how long the current blockade on Libyan ports will last – or the associated over 1 million barrels per day loss of production – oil supplies will remain at risk so long as the conflict endures. However, unlike supplies in the Gulf or in Venezuela, Libyan crude is of the light sweet grade. There is enough global spare capacity – from US shales – to make up for the Libyan loss, at least over the short term. The fall in Libyan supplies is occurring against the backdrop of oil markets that have been beaten down by the decline in demand on the back of the coronavirus impact (Chart 11). The OPEC 2.0 technical panel recommended additional output cuts of 600 thousand barrels per day last week, and is waiting on a final decision by Russia. We expect the cartel to tighten supplies to shore up prices. The instability in Libya could also affect Europe through immigration. The conflict re-routes migrants through the western route and thus could result in an increased flow to Spain and Portugal, rather than Italy which was previously their landing pad (Chart 12). A meaningful pick up would have a negative impact on European domestic political stability, especially with Germany in the midst of a succession crisis and incapable of taking a lead role. Chart 11Libyan Blockade Comes Amid Demand Shock Chart 12Refugees Will Favor Western Route Across The Mediterranean Erdogan’s foreign adventurism, and aggression against the West, poses a risk for Turkish markets. We remain underweight Turkish currency and risk assets. Our Emerging Markets strategists expect foreign capital outflows from EM to weigh on Turkey’s currency, local fixed-income and sovereign credit relative to EM benchmarks. Go short the Turkish lira relative to the US dollar. Bottom Line: Historically, the Mediterranean was the world’s most important waterway. It was the “life line” of the British empire. The US succeeded the British as the guarantor of Suez and corralled both Turkey and Greece into a single alliance under the Truman Doctrine. This status quo held until the twenty-first century. Since 2000, Russia has revived, US foreign policy in the Middle East has become erratic, and the Europeans have lost clout. Turkey is seeking to carve a space for itself and challenge the settlements of the past, all the way back to the 1923 Treaty of Lausanne. Yet in the wake of the Great Recession its economy is unstable and its populist leaders are taking greater risks abroad. The result will be greater friction with Europe, or the Arab states, or both. Given Turkey’s mismanagement at home, and limited gains to be made in Syria or Libya, Turkish assets will be the first to suffer from negative surprises.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 The Eastern Mediterranean Security and Energy Partnership Act of 2019 is an American bi-partisan bill the lends full support for the East Med pipelines and greater security cooperation with Israel, Cyprus, and Greece. The US Senate also passed an amendment to the National Defense Authorization Act last June which ended the arms embargo on Cyprus. 2 Turkey has also been engaging in drilling activities in disputed waters near Cyprus – which Ankara argues it is undertaking in order to protect Turkish-Cypriot claims – motivating EU economic sanctions in the form of travel bans and asset freezes on two Turkish nationals.

Highlights Bulk commodity markets – chiefly iron ore and steel – could see sharp rallies once Chinese authorities give the all-clear on COVID-19 (the WHO’s official name for the coronavirus). These markets rallied sharply Tuesday, as President Xi vowed China would achieve its growth targets this year, which, all else equal, likely will require additional monetary and fiscal stimulus. China accounts for ~ 70% of the global trade in iron ore, and ~ 50% of global steel supply and demand. COVID-19-induced losses have hit Chinese demand for steel hard, forcing blast furnaces to sharply reduce output. However, this partly is being countered by transitory weather- and COVID-19-related disruptions that are reducing iron ore exports from Brazil and delaying Australian shipments. Iron ore inventories could be drawn hard in 2Q and 2H20 to meet demand as steelmakers rebuild stocks and construction and infrastructure projects restart (Chart of the Week). The Chinese Communist Party celebrates its 100th anniversary next year. To offset the COVID-19-induced drag on domestic growth this year, which could take GDP growth below 5%, and a weak GDP performance next year additional stimulus is an all-but-foregone conclusion. Feature When policymakers really want to jumpstart GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. There is a compelling case a strong rally in iron ore and steel will accompany the containment of COVID-19, reversing the 14% and 4% declines in both since the start of the year (Chart 2). Chief among the drivers of the rally will be the increase in fiscal and monetary stimulus required to restore Chinese GDP growth disrupted by the COVID-19 outbreak, which could reduce annual growth closer to 5% than the ~ 6% rate policymakers were targeting. Chart of the WeekLow Iron Ore Stocks Setting Up A Rally Chart 2Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices There are a number of reasons for expecting this. 2020 marks the terminus of the decade-long policy evolution that was supposed to end with the realization of the “Chinese Dream.” Chief among the goals that were to be realized by the end of this year – which will usher in the 100th anniversary of the founding of the Chinese Communist Party in 2021 – are a doubling of per capita income and of GDP.1 The Communist Party in China has numerous policy levers it can pull to respond to worse-than-expected growth and economic shocks. These policies consume a lot of bulk commodities and base metals. When policymakers really want to jump-start GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. This was clearly seen following the Global Financial Crisis (GFC) in 2008-09 (Chart 3). Even before the COVID-19 outbreak, policymakers made it clear they wanted to stabilize growth following the Sino-US trade war at the conclusion of the Central Economic Work Conference (CEWC) in December. Nominal wages and per capita income growth had been falling since 3Q18, imperilling one of the principal goals of the “Chinese Dream.” Chart 3Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q- 4Q20 if their goal is simply to achieve 6% p.a. growth this year. Following that CEWC meeting, our colleagues at BCA’s China Investment Strategy (CIS) anticipated policymakers would announce growth targets at the National People’s Congress (NPC) meeting next month in the range of 5.8 and 6.2% p.a. growth, noting, “the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms.”2 The growth rate required to put the economy on track to deliver on the “Chinese Dream” is now much higher following the COVID-19 outbreak, which could shave ~1% or more off China’s growth this year alone. This suggests policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q-4Q20 if their goal is simply to achieve 6% p.a. growth this year. This predisposes us to expect significant monetary and fiscal stimulus this year after the all-clear is sounded and the economy can return to its day-to-day activities. In addition – and by no means least of the concerns driving policymakers’ decisions – the 100th anniversary of the founding of the CCP will be celebrated next year, something policymakers at all levels have been looking forward to showcase the success of their revolution. A Boon For Bulks As monetary policy eases, the construction growth trajectory should pick up smartly. China accounts for ~ 70% of the global trade in iron ore. It is expected to import ~ 1.1 billion MT this year and next, based on estimates published by the Australian government’s Department of Industry, Innovation and Science in its December 2019 quarterly assessment (Chart 4). China will account for ~ 50% of global steel supply and demand, or roughly 900mm MT/yr in 2020 and 2021. The COVID-19 outbreak reduced utilization rates at the close to 250 steel mills monitored by Mysteel Global in China to 78%, a drop of 2.3pp.3 Platts estimates refined steel production could fall by 43mm MT by the end of February.4 Most of China’s steel output goes into commercial and residential construction (~ 35%), infrastructure (~20%), machinery (~ 20%), and automobile production (~ 7%), based on S&P Global Platts estimates.5 Residential construction began to recover last year, and residential housing inventories were declining relative to sales (Chart 5). In our view, once the COVID-19 infection rate falls outside Hubei Province – the epicenter of the outbreak – markets will begin pricing in a revival of commercial and residential construction in China. As monetary policy eases, the construction growth trajectory should pick up smartly (Chart 6). Chart 4China Dominates Iron Ore, Steel Markets   Chart 5Resumption Of Construction Will Lift Demand For Bulks Chart 6Easier Money And Credit Policy Will Revive Construction Infrastructure spending already was on track to increase prior to the COVID-19 outbreak, based on our CIS colleagues’ reading of the CEWC statement issued in December, which “suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year.”6 This fiscal push will be supported by additional spending at the local government level, and by the issuance of special-purpose bonds by these governments with proceeds earmarked for infrastructure development (Chart 7). “A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019,” according to our CIS colleagues. Chart 7Pump Priming Will Boost Infrastructure Spending Bottom Line: Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Whether it rises at double-digit growth rates remains to be seen, however. Expect Chinese Consumers To Come Out Spending Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Prior to the outbreak of COVID-19, consumer confidence was running high (Chart 8), and employment prospects have bottomed and turned higher, although they still indicate contraction. (Chart 9). This boded well for consumer-spending expectations, particularly for autos (Chart 10). Chart 8Consumer Confidence Was High Prior to COVID-19 Outbreak ... Chart 9... And Job Prospects Were Improving ... At ~ 7%, China’s automobile production remains a marginal contributor to overall steel consumption. Nonetheless, a meaningful pickup in automobile production following the depressed growth rate of the past 15 months would move steel demand upward. China’s share of world auto sales is ~30% (Chart 11). Chart 10... Thus Lifting Prospects For Chinese Auto Sales   Chart 11Policy Stimulus Will Revive Chinese Auto Sector Accommodative monetary and fiscal policies in China point toward higher growth for the auto sector. However, it is important to note the revival in auto production needs to be driven by consumer demand – if it is led simply by restocking, the rebound will not be sustainable. The recovery we are expecting will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. Bottom Line: Auto consumption and production were recovering in late 2019; however, the strength of the recovery did not match previous stimulus programs (2009 and 2016). The recovery we are expecting this year will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. If these other sectors remain constructive for metal demand (or at least are not contracting or slowing drastically), the boost from the auto sector will meaningfully contribute to higher iron ore and steel prices.   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 Oil prices halted their decline and rose 1% on Tuesday as the number of daily confirmed cases of the Wuhan coronavirus decelerated in China. As of Tuesday, the daily growth in cases dropped to 5%, down from 6% the previous day. Investors will closely monitor this number for any sign of a durable slowdown in daily confirmed cases. Separately, the US Energy Information Administration revised down its global demand growth estimates for 2020 to 1.0mm b/d from 1.3mm b/d last month, reflecting the effects of the coronavirus and warmer-than-expected January temperatures in the northern hemisphere. We will be updating our global oil balances next week. Base Metals: Neutral Iron ore prices fell 14% since the COVID-2019 outbreak in January. Investors are assessing how the iron ore market will balance weaker demand expectations in China amid lower supply – largely a result of falling Brazilian ore exports. Brazil’s total iron ore exports fell ~19% y/y in January due to heavy rainfall and lower production at Brazilian miner Vale. The company’s output never fully recovered from the 2019 dam incident and remains a risk to iron ore supply in 1Q20. Vale lowered its March sales guidance by 2mm MT. Low Chinese port inventories raise prices’ vulnerability to supply disruptions (Chart 12). Precious Metals: Neutral Gold remains well bid despite a strong US dollar, fueled by safe-haven demand. The yellow metal’s price fell slightly on Tuesday as investors’ concerns over the coronavirus eased. Based on our fair-value model, prices averaged $55/oz above our estimate in January. Investors – i.e. global ETF holders and net speculative positions reported by the US CFTC – have been important contributors to the latest gold rally. Investors’ total holding of gold reached a record high 113mm oz last week. Nonetheless, we believe there is still opportunity for this group to further support prices: the share of gold allocation vs. world equity-market capitalization is still low at 0.24%, vs. its peak of 0.42% in 2012 (Chart 13). Ags/Softs:  Underweight March wheat futures were down 1.8% at Tuesday’s close, settling at the lowest level of the year after the USDA called for ‘stable supplies’ of the grain for the 2019/2020 U.S. marketing year. For corn, ending stocks were unchanged relative to the January projection, while world production was revised slightly upwards. March corn futures finished 2¢ lower at $3.7975/bu. The USDA also estimated higher soybean exports on the back of increased sales to China. However, soybean price gains were limited by higher production and ending stocks abroad. Chart 12Low Iron Ore Inventory Raises Exposure To Supply Disruptions Chart 13A Higher Share Of Gold Holdings Could Support Prices Further   Footnotes 1     The “Chinese Dream” is a phrase coined by President Xi Jinping, following the 18th Party Congress of the Chinese Communist Party in 2012, when the overarching goal of transforming China into a “moderately well-off society” was memorialized in writing. These goals were crystalized in terms of progress expected in per capita income and GDP, both of which were to be doubled in the decade ending this year. Please see Why 2020 Is a Make-or-Break Year for China published by thediplomat.com February 13, 2015. 2     Please see A Year-End Tactical Upgrade, published by BCA Research’s China Investment Strategy December 18, 2019, for an in-depth analysis of policy guidance coming out of the Economic Work Conference last December. It is available at cis.bcaresearch.com. 3    Please see WEEKLY: China’s blast furnace capacity use drops to 78% published by Mysteel Global February 10, 2020. 4    Please see China steel consumption to plunge by up to 43 mil mt in February due to coronavirus published February 6, 2020, by S&P Global Platts. 5    Please see China Macro & Metals: Steel output falls, but property creates bright spots published by S&P Global Platts December 6, 2019. 6    Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades