Energy

Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation

The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners. This high-octane trade would benefit most from the handoff of global liquidity to economic growth (top and middle panels). Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago1 - pans out in the coming months, then relative share prices should reverse. Our relative EPS models do an excellent job in capturing the different macro forces that drive this trade; at the current juncture, they emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (bottom panel). Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. 1 Please see August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?", available at uses.bcaresearch.com.

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Feature The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Chart 2AExcellent Leading Properties Chart 2BAll Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Chart 5Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Chart 10Unloved ##br##And Oversold Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (Chart 12). Chart 11Reflation Trade Chart 12U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Chart 16Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Table 2Safe-Haven Demand Rises During Crises, Continued Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Chart 6BAsset Class Returns During Crises We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The Kingdom of Saudi Arabia (KSA) is taking a well-timed tactical decision to make room for increased Libyan and Nigerian output, by reducing allocations to refiners by more than 500k b/d in September. The bulk of these reductions will be directed at U.S. refiners, which are running their units at close to record output, while reducing their crude imports and boosting product exports. This will keep the year-on-year (yoy) reductions in OECD commercial oil stocks now showing up in the data on track, driven by continued sharp draws in U.S. inventories. Most importantly, these reductions will occur in the highly visible, high-frequency data produced by the U.S. every week. Energy: Overweight. Reports of foreign workers being pulled from Venezuelan oil fields will keep markets on edge. We remain long Dec/17 $50/bbl calls and short $55/bbl calls in Brent and WTI, which are up 127% and 74% since inception on June 22 and June 15, respectively. Base Metals: Neutral. Aluminum rallied on the back of news reports China's Shandong province ordered more than 3.2mm MT/yr of capacity shuttered by end-July. While surprising, such actions are not inconsistent with the stricter enforcement of environmental regulations in China we expect going forward. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. Recent geopolitical tensions between the U.S. and North Korea are supporting this position, which is up 2.1% since inception on May 4, 2017. Ags/Softs: Underweight. Grains were treading water ahead of today's WASDE. We remain bearish, but continue to avoid shorting the complex. Feature Chart of the WeekU.S. Refiners Running At Close To Record Rates KSA's decision to reduce crude oil allocations to refiners in September, particularly in the U.S., is a well-timed tactical move.1 U.S. refinery net crude inputs hit record levels in early June at 17.3mm b/d, and remain close to that level (Chart of the Week). U.S. product exports continue at near-record levels, while imports have been trending lower (Chart 2). Crude oil exports from the U.S. are running close to record levels, and imports are trending lower (Chart 3). U.S. exports of crude and products hit a record in January at 5.9mm b/d - 5.24mm b/d of products, and just under 650k b/d for crude exports. At the end of July, total exports of crude and products stood at 5.44mm b/d, or 7.4% below the record set in January. U.S. product exports fell to 4.6mm b/d, while crude exports stood at 845k b/d. It is worthwhile pointing out that, in terms of total oil and products exports, the U.S. ranks among the top exporters in the world: KSA exports ~ 7mm b/d of crude, while Russia exports ~ 5mm b/d of crude. Chart 2U.S. Product Export Remain Strong,##BR##While Imports Continue Trending Lower ... Chart 3... While U.S. Crude Exports Remain High,##BR##And Imports Are Moderating With net U.S. crude and product imports declining (Chart 4), we expect U.S. commercial oil inventories - crude and products - to continue to draw sharply, which, since they account for close to 45% of OECD inventories, will draw down total DM stock levels as well (Chart 5). Indeed, U.S. commercial inventories drew close to 4% yoy in July, based on EIA historical data, the second month in a row the yoy comparisons came in negative in America. For the OECD as a whole, July marked the first month this year that the yoy percent change in stock levels was negative (-1.8%). Thus, as the summer driving season - and peak refiner crude demand - reaches its denouement next month, KSA's well-timed move to reduce shipments to U.S. refiners will push inventories lower and advance OPEC 2.0's agenda to clear out surplus OECD commercial oil inventories over the short term (Chart 6). Chart 4U.S. Net Crude And##BR##Product Imports Are Falling ... Chart 5... Which Will Support Continued Draws In##BR##Commercial Oil Stocks (Crude And Products) Chart 6KSA Will Continue Reducing##BR##Shipments To U.S. Refiners The OPEC 2.0 Agreement Is Holding ... On Average ... KSA is following through on Energy Minister Khalid al-Falih's "whatever it takes" assertion and making room for Libya and Nigeria, which together have added some 750k b/d of production to the market vs. April's level - 470k b/d for Libya and 280k b/d for Nigeria. April happens to be the month during which OPEC's producers recorded their largest production cuts vs. October's levels (1.12mm b/d), based on the EIA's historical tallies. OPEC 2.0 benchmarks to October 2016 production levels. Among OPEC members, neither Libya nor Nigeria were bound by the historic OPEC 2.0 Production Agreement. However, for those states that did obligate themselves to the agreement, compliance has been fairly high on average. OPEC member states that are party to the 2.0 deal have overproduced relative to their agreed production volumes by some 20k b/d over the January - July period on average.2 So, relative to the deal the OPEC members agreed, they've managed to cut 800k b/d of crude production on average versus their October 2016 production levels.3 During this period, Iraq stands out for its overproduction, having pumped 100k b/d on average over its agreed OPEC 2.0 volume of 4.35mm b/d (Chart 7). Among the non-OPEC members of the OPEC 2.0 coalition, Russia's compliance appears to be holding up, at close to 300k b/d below its October levels of crude and liquids production in 2Q17 and July (Chart 8). Oman produced ~ 980k b/d, over the first seven months of the deal vs. 1.02mm b/d in October, while Kazakhstan has faltered, with production averaging 1.88mm b/d in Jan - July, versus 1.79mm b/d in October. Chart 7Iraq Stands Out For Overproduction;##BR##Libya, Nigeria Not Covered In OPEC 2.0 Deal Chart 8Russia And KSA##BR##Continue To Lead OPEC 2.0 ... But Markets Await Articulated Strategy We continue to expect compliance with the OPEC 2.0 deal to remain relatively high to March 2018, which will draw OECD storage down to five-year average levels. We also are maintaining our expectation Brent prices will trade to $60/bbl by year end, with WTI trading ~ $58/bbl. Nonetheless, when we update our balances this month, we will continue to model for "compliance fatigue" among the OPEC 2.0 coalition. The fact that KSA and Russia are able to keep their rapport strong and compliance levels among OPEC and non-OPEC states relatively high, is a necessary condition for keeping OPEC 2.0 a viable coalition. However, the sufficient condition remains articulating a position on managing production via OPEC 2.0 that all these states can buy into, and support with concrete action. If, once the deal expires, the parties to the OPEC 2.0 coalition are left to go their own way and resume a production free-for-all, prices almost surely will fall, as the battle for market share is resumed. The ironic outcome of all this likely would be further destruction of capex budgets, which will set up another violent price surge that kills demand. We have no doubt the principal negotiators in OPEC 2.0 continue to discuss this, and that they are working on guidance. Bottom Line: KSA's tactical move to reduce exports to the U.S. likely will accelerate the commercial oil storage drawdown now apparent in OECD inventories, if current U.S. trends hold up - i.e., refinery runs remain high, exports of crude and products remain strong, and imports continue to fall yoy. Strategically, OPEC 2.0 still needs to convince markets there is a longer-term game plan for managing its output, short of a production free-for-all. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This tactical move was reported by Reuters earlier this week. Please see "Saudi Arabia cuts crude oil allocations in September by more than its OPEC pledge," which was published by reuters.com August 8, 2017. 2 We are using the production levels specified by the Cartel in its "OPEC Bulletin 11 - 12/16" on p. 35. 3 This likely overstates the actual production available for export by KSA, since the Kingdom typically consumes some 500 - 600k b/d of crude domestically over the June - September period as direct-burn fuel to power generation producing electricity for air conditioners. So the reported data likely are noisy at this time of year. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Reduced demand in oil-exporting countries and higher supplies from distressed states is whittling down the amount of oil being removed from the market this year, based on our latest supply-demand balances. As a result, even though OECD inventories will be drawn down to their five-year average levels by year end, this average will be a higher end-point than we projected last month. The Kingdom of Saudi Arabia (KSA) continues to reassure markets through anonymous media leaks it will cut production further to accommodate higher Libyan and Nigerian production. This is not unexpected, but it still is speculative. Ecuador's opting out of OPEC 2.0's production cuts raises the odds other financially distressed non-Gulf producers also will head for the exits. Energy: Overweight. Crude oil prices remain supported by actual production cuts, and the promise of further reductions by KSA and possibly other OPEC 2.0 members. Base Metals: Neutral. Labor and management at the Zaldívar copper mine in Chile are negotiating, according to Metal Bulletin. Separately, a three-year deal was agreed at the Centinela copper mine in Chile last week. Precious Metals: Neutral. Gold rallied on the back of lower inflation readings in the U.S., which suggested the Fed will back off aggressively pursuing its rates normalization policy. This would leave real rates low. Our strategic long portfolio hedge is up 1.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. We maintain our bearish view on grains. Fears that extreme heat in the U.S. Midwest and Plains will not be sufficient to counter the still-high ending-stocks expectations published in the USDA's WASDE last week. Feature Higher oil production is seeping into global balances. Lower prices, which are stimulating demand in oil-importing markets, are reducing incomes and demand in oil-exporting provinces. As a result, the rate at which inventories will draw this year is slowing. Our latest supply - demand balances shown in Table 1 indicate the net 900k b/d physical deficit we expected for 2017 has been whittled down to just under 500k b/d, as a result of production increases in Libya and Nigeria, and slower demand growth in oil exporters generally (Chart of the Week). Table 1BCA Global Oil Supply -##BR##Demand Balances (mm b/d) Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Ecuador, a small-ish OPEC member producing about 550k b/d, opted out of the Agreement negotiated by KSA and Russia to remove some 1.8mm b/d of production from the markets. This indicates weaker states that are party to the OPEC 2.0 Agreement are finding it impossible to maintain compliance with the cuts they've obliged themselves to undertake in the face of lower oil prices. As a result, they are compelled to increase production in an attempt to recover lost revenue (R), by increasing their quantity (Q) sold when prices (P) are weak, so as to maximize P*Q = R while they can. This only works if they are alone in increasing production while others - notably KSA, other Gulf states and Russia - restrict output to revive prices. Otherwise, if all the distressed states in the OPEC 2.0 coalition took the same action, markets would be flooded with oil. This was demonstrated in the mid-1980s during KSA's netback-pricing regime, when the Kingdom priced its oil as a function of prices received by refiners. This collapsed prices, and, eventually, reined in free-riding on KSA's production cuts.1 While few of these states, mostly outside the Gulf, are capable of significantly increasing production, at the margin, they can have an impact. Production Increases In OPEC, U.S. Partly Counter OPEC 2.0's Best Efforts Year-to-date to June, Iran and Libya have added 110k and 140k b/d of production to the market vs. their respective Oct/16 benchmark levels of 3.7mm and 550k b/d against which the OPEC 2.0 deal is being assessed. June production for these states was up 120k and 300k b/d for Iran and Libya, respectively, vs. October levels, while Nigeria's output was up 90k b/d (Chart 2). Libya and Nigeria are not parties to the OPEC 2.0 deal. Nonetheless, these states together with Iran added close to 500k b/d vs. their Oct/16 output levels in June, without an offsetting decline from members of the OPEC 2.0 coalition. Gulf OPEC ex Iran production is down some 850k b/d on average at 24.6mm b/d in 1H17 vs. Oct/16 levels, while non-Gulf OPEC production is down 215k b/d at 7.5mm b/d. We still see OPEC 2.0's production significantly below the EIA's estimate to March 2018 (Chart 3), which drives our view of inventory behavior. U.S. production also was higher in 1H17, as WTI prices rallied in response to the OPEC 2.0 production-cutting deal (Chart 4). For 1H17, U.S. crude oil production was up 230k b/d vs. 4Q16 levels, at 9.04mm b/d, led by higher shale-oil output. Chart 2Almost 500k b/d Added To Oct/16 Output##BR##By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 Slower Demand Growth Reduces Storage Draw On the demand side, we've lowered our estimate of demand growth this year to close to 1.37mm b/d, down nearly 110k b/d vs. our earlier May estimate. This results from lower consumption in oil exporting states. The combination of stronger supply growth and weaker demand growth reduces our estimated physical deficit for this year to 470k b/d from close to 900k b/d in our May balances estimates. These revised supply - demand estimates still produce enough of a physical deficit to allow storage to fall to five-year average levels (Chart 5). However, with the drawdowns prolonged by slower supply losses and reduced demand, inventories are now projected to remain above 2.8 billion bbls versus our earlier estimate of inventories declining to ~2.75 billion barrels by end-2017 or early 2018. Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Net, at the end of this drawdown, storage will be higher than expected, even if it does make it to five-year average levels. This will leave less room for OPEC 2.0 members to implement a strategy to backwardate the forward WTI curve so as to slow the rate at which shale-oil rigs return to the field, which we've discussed in previous research.2 More Cuts Required By OPEC 2.0 Going into its St. Petersburg meetings next week, there are clearly defined issues to be addressed by OPEC 2.0. The foregoing suggests additional cuts will be needed to empty storage sufficiently by yearend for OPEC 2.0 to be able to move to the next phase of its plan to regain some influence over the evolution of oil prices, particularly the U.S. benchmark WTI price, which drives hedging and profitability of U.S. shale producers. Over the short term, this effort likely will be clearly supported by KSA's stated intention to reduce exports to the U.S. market (Chart 6). All else equal, this will result in sharper draws in the high-frequency U.S. weekly inventory data, by augmenting reduced shipments to the U.S. from OPEC overall (Chart 7). Chart 6KSA's To Reduce##BR##Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments More substantive price-support and inventory-draining measures, as noted at the top of this article, will have to involve further production cuts by OPEC 2.0. KSA again is signaling it is open to additional production cuts, in order to normalize oil inventories.3 We have no doubt the Kingdom's Gulf allies - particularly Kuwait and the UAE - will support KSA in this effort. We also expect Russia to be supportive of this effort. The size of the cuts likely will exceed 500k b/d, so as to offset the production gains of Libya and Nigeria. Iran's higher production discussed herein, and Iraq's recent assertiveness in claiming "the right" to increase its production given the size of its reserves, suggests a short and a long game for the leadership of OPEC 2.0. In the short-term, Iran, Iraq, Libya and Nigeria will be constrained by lack of funds to significantly increase production. Thus, OPEC 2.0 - mostly KSA and its allies - can cut production without triggering an immediate response from these states, which will allow storage to resume drawing at a faster rate. For OPEC 2.0 to have a meaningful effect on U.S. shale production, the stronger storage draws in the near term would have to be accompanied by forward guidance from KSA, Russia and their allies that production will be increased in the medium term - 6 months or so out - so that continued demand growth can be accommodated by higher supplies. This would require storage and production flexibility by OPEC 2.0's leaders. Should all of this fall in place, we would expect a backwardation to develop toward yearend, which would be the first step in a longer-term strategy by OPEC 2.0 to slow the rate at which horizontal rigs return to drilling in the shale fields. Bottom Line: Higher oil production from Libya, Iran and Nigeria, coupled with a slight downgrade in demand growth, will reduce the physical deficit we expected this year. This will, all else equal, reduce the rate at which OECD storage draws, and raise the level of five-year average inventory levels by yearend. We do not believe this is a favorable outcome for OPEC 2.0, particularly KSA and Russia, if they are intent on regaining some influence over the evolution of oil prices. For this reason, we believe KSA and its Gulf Arab allies will reduce production further to put the inventory draws back on track. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes - and will look for opportunities to gain upside exposure once we get clear signaling from OPEC 2.0 leadership. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA's Commodity & Energy Strategy Weekly Report "Sideshow In Vienna," published October 23, 2014, for a review of netback pricing by KSA. It is available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Reports of April 6, 2017, entitled "The Game's Afoot In Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil" for a discussion of this strategy. Both are available at ces.bcaresearch.com. 3 Please see "Saudi Arabia still aims to reduce supply; weighs Nigerian, Libyan barrels," published by reuters.com on July 18, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been re-established; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (middle panel). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone (bottom panel). Overall, we are upgrading to an above benchmark allocation in the S&P energy index.

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map Chart 4Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Chart 12...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Chart 14Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective Chart 16Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016