Oil

Highlights Dear Client, We will not be publishing next week, as BCA Research's Investment Conference is being held in New York City. We will be back the following week with a Special Report on global agricultural markets, and a recap on the performance of our 3Q17 recommendations. Kind regards, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Our new supply-demand balances indicate OPEC 2.0 will have to extend its production cuts to June 2018 to meaningfully reduce global oil inventories, even with demand growth exceeding 1.60mm b/d this year and 1.70mm b/d next year. This will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. We continue to expect Brent to trade to $60/bbl by year-end 2017, and for WTI to trade ~ $3.00/bbl under that. Higher prices will incentivize higher production from U.S. shale operators. This is a risk OPEC 2.0 will have to manage, as it develops a modus operandi that allows it to co-exist with shale and still maintain adequate revenues for its member states. Energy: Overweight. We are taking profit on our Brent options positions at today's close, since December options will have only three weeks to trade when we return. These positions, recommended in May and June, were up 116.3% on average by Tuesday's close. We will initiate positions in May and December 2018 Brent call spreads, going long the $55/bbl strike vs. short the $60/bbl strike at tonight's close. Base Metals: Neutral. Our tactical COMEX copper short is up 5.5% since inception on September 7. Precious Metals: Neutral. Our long COMEX Gold hedge is up 6.2% since it was initiated May 4, 2017. We are retaining the position as a strategic portfolio hedge. Ags/Softs: Underweight. Corn is having a tough time holding a bid following last week's USDA's Crop Report, which called for higher production and ending stocks, and lower prices. We will be updating our global ags assessment in a Special Report October 5. Feature OPEC 2.0 will have to extend its 1.8mm b/d production cuts to end-June 2018, in order to bring global inventories closer to levels it considered necessary to clear the market when it embarked on its 1.8mm b/d production-cutting Agreement at the end of last year, based on our most recent supply-demand balances modeling (Chart of the Week). Chart of the WeekOPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories As a result, our base case for balances reflects the OPEC 2.0 Agreement being extended to end-June (Chart 2). As we noted in our assessment last week, compliance with the OPEC 2.0 production-cutting Agreement remains high.1 All told, we see global production growing 0.83mm b/d this year, and 2.13mm b/d next year, based on our expectation of the OPEC 2.0 Agreement being extended to end-June. On the demand side, our most recent assessment of global demand leads us to expect growth of 1.62mm b/d this year and 1.72mm b/d in 2018 (Table 1). Chart 2Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Table 1BCA Global Oil Supply - Demand Balances (mm b/d) OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Fundamentals Point To Higher Oil Prices Based on our latest assessment of the global oil market, we believe OPEC 2.0 will fall short of reducing visible inventories back to their 5-year average levels if the coalition's production-cutting agreement expires at end-March 2018 (Chart of the Week, top panel). In fact, we believe that the Agreement will have to be extended to at least June 2018 - assuming no change in OPEC 2.0 country-specific production quotas - in order to draw OECD inventories down to their 5-year average levels (Chart of the Week, middle panel). An extension of the cuts to December 2018 would push OECD commercial inventories closer to levels originally targeted by OPEC 2.0 when its Agreement was reached at the end of last year. There is a higher risk prices will exceed the upper end of the range we assume WTI will trade in - $45/bbl to $65/bbl - with greater frequency next year, given we expect WTI prices will average slightly less than $57.50/bbl and Brent prices will average just under $59.00/bbl. Given the draws we expect in global inventories, the likelihood the WTI forward curve trades in backwardation next year also is elevated. We expect Brent to continue to trade in backwardation next year, which we believe will benefit OPEC 2.0 member states, since it allows them to realize higher spot prices - against which term contracts mostly are written - and will limit the volume of hedging U.S. shale producers can effect. Given our updated balances, we re-estimated our oil fundamentals models, accounting for the higher demand we expect (Chart 3), and continued production restraint by OPEC 2.0 on the supply side (Chart 4). These are markedly different to the EIA's estimates. Chart 3BCA Expecting Stronger Oil Demand Than EIA BCA Expecting Stronger Oil Demand Than EIA BCA Expecting Stronger Oil Demand Than EIA Chart 4Oil Supply Evolution Under Different Scenarios Oil Supply Evolution Under Different Scenarios Oil Supply Evolution Under Different Scenarios Using these fundamental inputs, we derived forecasts for the WTI and Brent prices.2 The four scenarios we analyzed are: Expiry of OPEC 2.0 Agreement in March 2018; Expiry of OPEC 2.0 Agreement in June 2018; Expiry of OPEC 2.0 Agreement in December 2018; The U.S. EIA Short-term Energy Outlook (STEO) supply-demand assumptions. The estimated results are presented in Table 2 and Chart 5. Table 2Fundamentally Derived##BR##Price Expectations OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Chart 5Oil Prices Will Lift As OPEC 2.0##BR##Agreement Restricts Supply Oil Prices Will Lift As OPEC 2.0 Agreement Restricts Supply Oil Prices Will Lift As OPEC 2.0 Agreement Restricts Supply Interestingly, the 4Q17 WTI futures curve appears to be priced much closer to Scenario No. 4, the EIA's assumptions. This is something we have observed in the past - i.e., the market has a tendency to price to the EIA's supply-demand balances, in the short term. As far as we can tell, the EIA's estimates assume less steep cuts than we do, and appear to be projecting visible inventories will begin to rise starting next month - (Chart 6). Chart 6EIA Assumes OECD Inventories Will Rise EIA Assumes OECD Inventories Will Rise EIA Assumes OECD Inventories Will Rise Under the EIA scenario, the average WTI futures price for 4Q17 is $50.40/bbl. Under BCA Base Case Scenario, which assumes the OPEC 2.0 Agreement will be extended to end-June, we estimated WTI prices would average $54.00/bbl over the same period. For 2018, the divergence between the EIA and BCA base cases is even more dramatic: Under the EIA's assumptions, our fundamental model estimates WTI prices will average $45.55/bbl in 2018, while under our new base case scenario, which projects the OPEC 2.0 deal will be extended through June, we estimate WTI prices will average $57.44/bbl next year. In its September Short-Term Energy Outlook (STEO), the EIA substantially lowered its U.S. shale production growth estimates for this year. Our colleagues at BCA's Energy Sector Strategy highlight this revision in this week's report, noting that 3Q17 U.S. onshore production levels will be 540k b/d higher yoy, versus an earlier expectation of a 730k b/d increase. This represents a ~ 25% reduction in the yoy growth rate. In addition, EIA's forecasted 3Q17 quarter-on-quarter oil production growth was cut by 40%, with sequential production growth now estimated at 197k b/d.3 The EIA's estimate now is more in line with BCA's assessment. These revisions will be supportive of prices, once market participants realize the EIA's scaling back on its growth expectations. BCA Lifts Estimate Of Demand Growth In our revised supply-demand balances, we expect 2017 global oil consumption will increase 1.62mm b/d, while 2018 demand will be up 1.72mm b/d. This reflects the strong growth reported by the OECD, which we noted last week, and the IMF.4 Strong growth momentum also can be seen in the continued performance of world trade volumes (Chart 7). The trade expansion is led by EM economies, with EM Asia, Latin America and Central Europe all posting yoy growth of ~ 10% at mid-year. EM also drives most of global oil-demand growth (Chart 8).5 Chart 7Global Growth Reflected##BR##In Increased Trade Volumes Global Growth Reflected In Increased Trade Volumes Global Growth Reflected In Increased Trade Volumes Chart 8EM Import Volumes##BR##Remain Strong EM Import Volumes Remain Strong EM Import Volumes Remain Strong Our expectation is EM oil demand will grow 1.20mm b/d this year and 1.30mm next year, accounting for the bulk of the 1.62mm and 1.72mm of overall demand growth we expect in 2017 and 2018, respectively. We will continue to follow demand trends in EM closely, particularly China and India, given its importance to overall global oil demand growth. Backwardation Will Persist In Brent, Arrive Sooner In WTI The direct implication of our results is backwardation will become more pronounced going forward. In the Brent market, the forward curve is backwardated to the end of 1Q18 then pretty much flattens out, based on mid-week settlements. In the WTI curve forwards, WTI futures carry to June 2018 then backwardate slightly to the beginning of 4Q19. We expect both to backwardate next year as storage draws and markets tighten. We have maintained OPEC 2.0 member states would benefit from a strategy under which they manage production and storage in such a way as to backwardate Brent and WTI curves. This would allow member states to realize higher revenues from spot prices, which are referenced in long-term supply contracts and are received on outright spot sales, and limit the amount of hedging U.S. shale producers can do: Lower deferred prices are not as profitable for producers, since they result in less revenue per barrel hedge in the future. Upward-sloping forward curves - i.e., contango market structures - allow producers to hedged at higher prices in the future, providing higher revenues, assuming the starting point is the same as in a backwardated market. We expect that as 2017 winds down and we approach the end of 1Q18, it will become apparent to OPEC 2.0's leadership their production-cutting agreement needs to be extended in order to drain global storage and get prices to lift. This is particularly true for the Kingdom of Saudi Arabia (KSA), which most likely will IPO Saudi Aramco, the state-owned oil company toward the end of next year. If OPEC 2.0's production-management agreement is not extended and inventories do not draw sufficiently to lift prices and backwardate the Brent forward curve, KSA most likely will have to push its IPO into 2019. Given the country's keen desire to raise funds to support its diversification away from its oil dependency, we believe its leaders would prefer to get the funds raised by the IPO in the door and begin allocating them. Bottom Line: OPEC 2.0 will extend the expiry of its production-cutting agreement from end-March to end-June 2018. This will force global inventories to fall to levels closer to those expected when the coalition agreed to jointly manage production at the end of last year. Demand growth will exceed 1.60mm b/d this year and 1.70mm b/d next year. This, along with the extension of the OPEC 2.0 cuts to end-June, will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. 2 We estimate WTI and Brent prices for the balance of 2017 and 2018 with respect to their fundamentals. The adjusted R2 for the WTI and the Brent regressions are 0.89 and 0.92, respectively. 3 Please see BCA Research's Energy Sector Strategy Weekly Report "A Funny Thing Happened On The Way To The "Shalepocalypse," published September 20, 2017. It is available at nrg.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. See also "A Firming Recovery," in the IMF's World Economic Outlook Update published July 24, 2017. We use IMF global GDP growth estimates as an input to our oil-demand modelling. 5 We have found EM imports to be a good explanatory variable for oil and base metals demand, as well as inflation in the U.S. and EU. Please see, e.g., BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published July 27, 2017. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights U.S. Treasury yields should continue to rise as investors price-out doomsday risk; Tensions surrounding North Korea will continue, but there are signs that negotiations have started and that China is playing ball on sanctions; Meanwhile, our view that tax cuts are coming is finally coming to fruition; Fade renewed European risks regarding Brexit and Catalan independence; But the independence push by Kurds in Iraq could have market impact. Feature Early in the second quarter, BCA's Geopolitical Strategy made two predictions. First, we said that summer would be a time to stay invested in U.S. equities and largely ignore domestic politics.1 Second, that North Korea would become an investment-relevant risk and buoy safe-haven plays but would not lead to a full-scale war (and hence not cause a global correction).2 The summer proved lucrative for both risk-on and risk-off trades, best emblemized by solid returns for both the S&P 500 and 10-year U.S. Treasury (Chart 1 A & B). Chart 1ARisk Assets Have Rallied... Risk Assets Have Rallied... Risk Assets Have Rallied... Chart 1B...At The Same Time As Safe Havens ...At The Same Time As Safe Havens ...At The Same Time As Safe Havens Can this continue? We do not think so. Geopolitics can influence the 10-year Treasury yield via two mechanisms: safe-haven flows and fiscal policy. On both fronts, we see movements that should support a pickup in yields over the rest of the year, a view corroborated by our colleagues on the fixed-income team. First, investors finally have progress on tax legislation that we have been forecasting since President Trump's election. Given the markets' collective pessimism on corporate tax reform (Chart 2), we expect any good news to change the current narrative. While it is still difficult to envision tax legislation that massively stimulates the economy, it is also difficult to imagine tax legislation that is revenue-neutral. As such, fiscal policy in the U.S. should be at least mildly stimulative in 2018, supporting higher yields. Second, we remain concerned that North Korea could escalate the ongoing tensions in East Asia.3 However, Pyongyang is constrained by its military capacity, which limits what it can realistically do to threaten its neighbors. As we discuss below, there are emerging signs of both diplomatic negotiations and Chinese pressure, key signposts that we have passed the peak on our "Arc of Diplomacy." As such, investors should prepare for the bond rally to reverse and the broader risk-on phase to extend through the end of the year. We expect the "Trump reflation trade" - USD appreciation, yield-curve steepening, and small-cap outperformance (Chart 3) - to restart if our views on the U.S. legislative agenda and North Korean tensions hold. Chart 2Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Chart 3...And On Trump's Policy In General ...And On Trump's Policy In General ...And On Trump's Policy In General U.S. Treasuries: Fade The Doomsday Trade Our colleagues at BCA's fixed-income desk have shown that flows into safe havens over the summer have widened the disconnect between global yields and economic fundamentals (Chart 4).4 Chief Fixed-Income Strategist Rob Robis points out that BCA's own valuation model for the 10-year U.S. Treasury yield indicates that "fair value" sits at 2.67%, nearly 55bps higher than current market levels (Chart 5).5 This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Rob believes that the summer bond rally is about safe-haven demand, depressed investor sentiment, and underwhelming inflation, in that order. It is certainly not about growth expectations, which remain buoyant (Chart 6). Chart 4Falling Yields Reflect Save Haven Demand,##br## Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Chart 5U.S. Treasuries ##br##Are Overvalued U.S. Treasuries Are Overvalued U.S. Treasuries Are Overvalued Chart 6Global Growth##br## Remains Buoyant Global Growth Remains Buoyant Global Growth Remains Buoyant To prove that underwhelming inflation has not spurred the latest rally in Treasuries, Rob decomposes developed market bond yield changes since the July 7 peak in U.S. yields. The benchmark 10-year U.S. Treasury yield has risen 20bps off those September lows as investors have priced out doomsday risk. Table 1 shows that yields declined everywhere but Canada (where the central bank has been hiking interest rates). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations, which have actually stabilized over the summer. This has also occurred via a bull-flattening move in government bond yield curves, which suggests it is risk-aversion that has driven yields lower. Table 1Changes In DM Bond Yields Over The Summer (From July 7th Peak In U.S. Treasury Yields) Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? The conclusion of our fixed-income team is that there is now considerable upside risk in global yields. We agree. While North Korea could retaliate against the just-imposed UN sanctions in various ways, it is difficult to see the market reacting with the same vigor as it did in July and August. Investors are becoming desensitized to North Korean provocations, especially as the latter remain confined to "expected and accepted" forms of belligerence, even in the current context of heightened tensions. Future North Korean safe-haven rallies will be of shorter amplitude and duration. The September 15 missile launch over Japan (the fourth time this has happened) has shown this to be the case. Chart 7Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Bottom Line: BCA's bond team remains short duration, a position that our political analysis supports. We will keep our 2-year/30-year Treasury curve-steepener trade open, despite it being in the red by 34.3bps. In addition, we are closing our short Fed Funds January 2018 futures position (for a gain of 0.51bps) and opening a new short Fed Funds December 2018 position. Any sign of emerging bipartisanship should also favor higher fiscal spending, as policymakers almost always come together to spend money rather than cut spending. In addition, we are recommending that our clients put on a U.S. Treasury-German Bund spread widening trade.6 Rob has pointed out that this is a way to profit directly from higher fiscal spending in the U.S., particularly since there is no sign that Germany will change its government spending following its unremarkable election campaign. The data also supports a tactical widening of the Treasury-Bund spread, which is correlated with the relative data surprises (Chart 7). U.S. Politics: From Impeachable To Ingenious The crucial moment for the Trump presidency was the White House purge of the "Breitbart clique" following the social unrest in Charlottesville, Virginia on August 11-12.7 That move has made headway for upcoming tax legislation and resolution of the debt ceiling imbroglio. While some investors saw the racially motivated rioting in Virginia as a harbinger of a major risk-off episode, we saw it essentially as a "Peak Stupid" moment in U.S. politics. We may not know precisely what goes on in President Trump's mind, but we know that he likes polls. And his polling with Republican voters suffered appreciably following the Charlottesville fiasco (Chart 8). Strong Republican support for President Trump is the main source of his political capital. He can use it to cajole and influence Republicans in Congress via the upcoming Republican primary process ahead of the midterm elections. If he loses that support, his political capital will erode and he could become the earliest "lame duck" president in recent U.S. history. Worse, if support among Republicans were to fall below 70%, Trump could embark upon a Nixonian trajectory that could indeed lead to impeachment (Chart 9). Chart 8Trump's Support With GOP Voters Suffered... Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 9... But Remains Well Above Nixonian Levels Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Many clients have asked us about the debt ceiling deal that President Trump made with Democrats and whether it signals a radical shift towards bipartisanship. We do not think so. In fact, we think the deal is mostly irrelevant. As we argued throughout the summer, the idea that there would be another debt ceiling crisis this year was always a figment of the media's imagination. There was never any evidence that a sufficient number of members of the House of Representatives wanted to play brinkmanship with the debt ceiling. First, Democrats in both houses of Congress have been clear throughout the year that they would not play politics with the debt ceiling. Second, investors and the media continuously overestimate the strength of the Freedom Caucus, the fiscally conservative grouping of Tea Party-linked representatives. There are 41 members of the Freedom Caucus, whereas 55 Republicans in the House sit in districts that are at least theoretically vulnerable to a Democratic challenge (Table 2).8 The danger for House Speaker Paul Ryan is not that the Freedom Caucus abandons the establishment line, but that the 55 Republicans listed in Table 2 abandon the Republican line. This, in fact, happened throughout the Obama presidency, with centrist Republicans voting with Democrats in the House on a number of key legislative bills (Chart 10). Table 2Plenty Of Vulnerable Republican Representatives Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 10The Obama Years: A Governing 'Grand Coalition' Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? This is why Speaker Paul Ryan largely ignored the Freedom Caucus and proposed an eighteen-month extension of the debt ceiling. He was never going to allow the Freedom Caucus to play brinkmanship. That President Trump picked the shorter Democrat version is significant only in so far as it signaled that he was willing to work with Democrats. In other words, the move was a "shot across the bow" of Republicans, a message that they had better get started on tax legislation, or else ... What should investors watch now? There are three main issues to follow: Tax legislation outline: House Speaker Paul Ryan has set the week of September 25 as the deadline for Republicans to outline their tax policy plan. The good news for investors is that the outline will supposedly include an already agreed-upon framework by both the House Ways and Means Committee - Chaired by Representative Kevin Brady (R, TX) - and the Senate Finance Committee - Chaired by Senator Orin Hatch (R-UT). Brady and Hatch are serious players and their comments on tax policy should be followed closely. Both favor legislation that would be retroactively applied to FY 2017, even if the bill is actually passed in 2018. They are also part of the Republican "Big Six" group on tax policy, along with Speaker Ryan, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin, and National Economic Council Director Gary Cohn. Reconciliation instructions: The House Budget Committee passed a FY 2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. These instructions allow Republicans to use the reconciliation procedure - a process that allows the Senate to pass legislation without needing 60 votes.9 However, the House version of the budget resolution also included over $200 billion of spending cuts, which is unlikely to pass in the Senate. As such, investors have to carefully watch for the House and Senate Republicans to pass a final budget resolution in order to kick off the reconciliation process. This process will likely happen in October, after the tax legislation package is presented by the Big Six. At that point, the Freedom Caucus will have the ability to extract concessions from establishment Republicans as their votes are needed to pass the budget resolution. We suspect that no Democrats will support the budget resolution given that they have not been involved in the tax policy process thus far. Trump's involvement: President Ronald Reagan's personal support and lobbying for the 1986 tax reform proved critical in getting the bill through Congress.10 President Trump's focus and energy will have to be on par with that of Reagan's if he plans to accomplish the same. A headwind for Trump is the lack of legislative experience in his White House (Chart 11). However, since the appointment of Chief of Staff General John F. Kelly, there has been a clear shift of focus on the legislative process. Chart 11Trump Administration Is On The Low End Of Congressional Experience Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Bottom Line: We expect investors to start gleaning the outlines of tax policy by late September, with the budget resolution containing reconciliation instructions being passed by both houses of Congress by the end of November. It may be too much to ask Congress to have an actual bill ready to pass by the end of the year, as we originally expected,11 particularly as there is now a potential immigration deal to negotiate with Democrats and last-minute effort to repeal and replace Obamacare. As such, we still think that it will take until the end of Q1 2018 for tax legislation to pass Congress (Q2 in the worst-case scenario for Republicans). Investors, however, will begin to price in a higher probability of tax policy as soon as the outline of the bill emerges in October. As such, we are reiterating our recommendation that investors go long U.S. small caps relative to large caps. Tax policy should overwhelmingly benefit small caps, which actually pay the 35% corporate tax rate. In addition, we would expect the USD to arrest its decline and rally by the end of the year. North Korea: At The Apogee Of "The Arc Of Diplomacy" To illustrate the current North Korean predicament to readers, we have referred to an "arc of diplomacy" (Chart 12), which we illustrate by referencing the rise and fall of U.S. tensions with Iran from 2010-15. The pattern is for the U.S. to increase tensions deliberately in order to convince its enemy that the military option is "on the table." Only once a "credible threat" of war has been established can the negotiations begin in earnest. Chart 12A Lesson From Iran: Tensions Ramp Up As Nuclear Negotiations Begin Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? We are at or near the peak of this process. First: what is the worst-case scenario for markets if the North causes a crisis short of a devastating war? Using our short list of geopolitical crises (Table 3),12 our colleague Anastasios Avgeriou, chief strategist of BCA's U.S. Equity Strategy, notes that while the average peak-to-trough drop of a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis. To illustrate the trend, Anastasios has constructed an S&P 500 profile of the average geopolitical crisis, and the picture is encouraging (Chart 13). It shows that the market is likely to grind higher even if North Korea does something truly out of the box. Table 3Geopolitical Crises And SPX Returns Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Nor is a geopolitical incident (again, short of total war) likely to cause a U.S. or global recession. Aside from direct shocks to oil, such as in 1973 and 1990, only the U.S. Civil War (that is, a war waged on U.S. turf) caused a recession at the outset. Other major wars (WWI, WWII, the Korean War) caused recessions when they concluded because of the sharp drop in federal spending as a result of reduced military spending. What makes us think we are at or near the peak of North Korea's belligerent threats? China appears to be enforcing sanctions: at least according to China's official statistics (Chart 14). There is no doubt there are discrepancies and black market activity, but it makes sense for China to dial up the pressure (while never imposing crippling sanctions) and that appears to be occurring. China and Russia agreed to reduce fuel supplies. Both sides agreed to new UN sanctions on September 11 that would partially cut off North Korean fuel. This is a significant step, given that Chart 14 indicates China is already moving in this direction. The U.S. and North Korea have begun diplomatic talks. According to Japan's NHK press on September 14, former U.S. diplomat Evans Revere met with Choe Kang-Il, the deputy director general of the North American bureau of North Korea's foreign ministry in Switzerland over the past week. The U.S. State Department spokeswoman Heather Nauert all but confirmed that some kind of communication is underway, and Secretary of State Rex Tillerson has described his diplomatic initiative as highly active. The last efforts at negotiations, via the longstanding New York channel, were discontinued in June after the death of a U.S. prisoner in North Korea. Those were focused on retrieving U.S. citizens, whereas the new talks allegedly centered on the latest UN sanctions, i.e. a crux of the relationship. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. South Korea is offering aid. South Korea's new government is looking to give the North humanitarian aid, as expected, and will decide on September 21 about a special package for pregnant women and infants. It is suggesting that such aid has no conditionality on the North's behavior. At the same time, the U.S. administration is talking down Trump's recent threat to discontinue the U.S.-South Korean free trade agreement - meaning that the U.S. may even condone the South Korean administration's more diplomatic approach to the North. Chart 13Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Chart 14Is China Finally Playing Ball? Is China Finally Playing Ball? Is China Finally Playing Ball? At the same time, North Korea is running out of options for provocations that it can commit without provoking a costly response from the U.S. and its allies. The September 15 missile test over Japan was essentially the fourth of its kind, and the market shrugged it off. Here are some options, drawn from our list of scenarios and probabilities (Table 4): Table 4North Korean Scenarios Over The Next Year Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? More of the same: Nuclear and missile tests could continue, or be conducted at higher frequencies or simultaneously. While technical advances may become apparent, they will not change the game. U.S. Territory: The North could create a bigger risk-off move than we saw in July-August if it shot ICBMs toward Guam, or other U.S. territories, as it has suggested it might do. This is especially risky because the U.S. Secretary of Defense James Mattis has repeated Trump's warning to North Korea to not even threaten the United States. However, as long as no such missile actually strikes U.S. territory, the U.S. is unlikely to respond with an attack, and thus such a scare seems likely to fade like the others. Attacking South Koreans: The North has a history of state-backed terrorist actions and military actions. An attack limited to South Korea will cause a shock, in the current context, but the military consequences are still likely to be contained given the extensive history of such attacks. If it is an attack against South Korean civilians in a non-disputed territory, it will leave a bigger mark than it otherwise would, but the South is still likely either to retaliate in strict proportionality, or to refrain from action and use the event as a way of galvanizing international sanctions. Attacking Americans or U.S. allies: The true danger in the current climate is an attack that kills U.S. citizens, or U.S. allies who are not as, shall we say, understanding as the South Koreans (such as the Japanese). This could cause the U.S. or Japan or another ally to take a retaliatory action. Even if limited, this could cause a deep correction in the market. The U.S. response would likely still be limited and proportional. Then the question would be whether the North Koreans can afford to escalate. They can't. The military asymmetry is excessive. This is not the case of the Japanese in 1941, who believed they had the potential of defeating the U.S. if they acted quickly enough and the U.S. was distracted in Europe (Diagram 1). Diagram 1North Korea Crisis: A Decision Tree Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? As the foregoing demonstrates, there could still be big ups and downs between now and the resumption of formal international negotiations, let alone a satisfactory diplomatic accord. The tensions could yet reach another peak. Nevertheless, our sense is that the pieces are falling into place for the North to moderate its behavior, sending the signal that it is ready to engage in real negotiations. Since the U.S. has consistently shown its readiness to talk directly with the North - coming from both Trump and Tillerson - we think we could see shuttle diplomacy taking place as early as this winter. Here are some dates and events to watch: Military exercises: Will the U.S., South Korea, and Japan stop or slow down the pace of military exercises? This could open space for North Korea to offer an olive branch in return. October 10 - anniversary of the Worker's Party of Korea: The North may take an extraordinary action, no action, or familiar actions like missile tests. October 11-25 - China's party congress: The North could fall silent ahead of the big event, or could attempt to disrupt it. China, in turn, could take action around this time (particularly afterwards) to send a signal to the North to tone down the belligerence. In previous periods of tension, China has reputedly drawn a harder line on North Korea in the month of December, when end-of-year quotas made certain trade measures more convenient. Late October - Japanese snap election? Rumor has it that Shinzo Abe is thinking of calling a snap election as early as this month. We normally dismiss such rumors but this time there is a certain logic: two North Korean missiles have flown over Hokkaido in as many months, while the Japanese opposition is in total disarray. If Abe calls early polls, it suggests that he thinks Korean fears are peaking. If he delays, and exploits these fears by pushing constitutional revisions through the Diet (our base case), then he may provoke a North Korean response, given that the revisions pave the way for Japan to "re-militarize." November 1 - APEC and Trump's visit to China: Trump is supposed to head to Vietnam for the APEC summit and to China to visit President Xi Jinping. Xi has recently shown his sensitivity to such summits by concluding the Doklam dispute with India just days ahead of the BRICS summit in Xiamen, China in order to ensure that Indian President Narendra Modi would attend. Xi may have also wanted to advertise his ability to negotiate solutions to international showdowns for the world (and U.S.) to see. Thus, progress on North Korea before or after Trump's arrival could improve Xi's authority both with Trump and the rest of the world. November 23 - U.S. Thanksgiving: North Korea likes to be "cute," so we cannot rule out attempts to unsettle the Americans on Thanksgiving or Christmas Day, as with the July 4 ICBM launch. Trump's visit is very consequential and it is more likely under the circumstances that China will receive him warmly, like Nixon, rather than coldly, like Obama last year. Trump is holding serious trade negotiations (via Commerce Secretary Wilbur Ross) and at the same time threatening to sanction Chinese companies and imports (via Treasury Secretary Steve Mnuchin). There are many reasons for Beijing to cooperate on North Korea in order to get advantageous treatment on the economic front. Bottom Line: The market is already discounting North Korea. We may be wrong temporarily if the North ups the ante yet again, but we are very near the peak of the latest round of tensions. The North is running out of options short of instigating a fight it would lose, while China is enforcing sanctions more seriously (including fuel), and Washington has apparently opened direct talks with Pyongyang. We will maintain our portfolio hedge of Swiss bonds and gold, for now. We are also re-opening our long CBOE China ETF volatility index to account for potential rising political uncertainty surrounding the coming October Party Congress and possibly for further North Korea related risks. However, we are closing our short KRW / THB trade for a gain of 5.33%. Europe: More Red Herrings Brexit is no longer market-relevant. Its economic effect was fully priced in when Prime Minister Theresa May announced on January 17 that the U.K. would not seek membership in the Common Market. Since then, the pound has effectively bottomed against both the dollar and the euro, as we argued it would (Chart 15).13 This does not mean that investors should necessarily go long the pound. Rather, we are pointing out that the moves in the U.K. currency have ceased to be Brexit-related since we called its bottom in January. Going forward, investors should make bets on the pound based on macroeconomic fundamentals, not on the U.K.-EU negotiations. The one political risk to the pound going forward is the potential for the Labour Party, headed by opposition leader Jeremy Corbyn, to come to power in the U.K. in the near term. Corbyn is the most left-of-center leader of a developed world economy since French president François Mitterrand in 1981. And he symbolizes a leftward shift on economic policy by the median voter. Nevertheless, the risks to PM May are overstated, for now. A key test for the Prime Minister, the EU (Withdrawal) Bill, passed its first parliamentary hurdle in Westminster on September 12. No Conservatives rebelled, with seven Labour politicians defying Corbyn's instructions to vote against the bill. The bill still faces several days of amendments, but it largely gives May a free hand to negotiate with Europe going forward. Bremain-leaning Tory backbenchers could have posed problems for May had they decided to obstruct the bill. That they did not tells us that nobody wants to challenge May and that she will likely remain the prime minister until the eventual deal with the EU is reached. Our clients often balk at our dismissal of Brexit as an investment-relevant geopolitical event. However, the crucial question post-Brexit was whether any other EU member states would follow the U.K. out of the bloc. We answered this question in the negative, with high conviction, the day of the U.K. referendum.14 Not only did no country follow U.K.'s lead, but the effect of Brexit was in fact the exact opposite of the conventional wisdom, with a slew of defeats for populists around Europe following the referendum. For the U.K. economy and assets, the key two Brexit-related questions were whether the economy's service sector would have unfettered access to the European market via membership in the Common Market (Chart 16); and whether the labor market would have access to the European labor pool (Chart 17). Both questions were answered by May during her January 17 speech in the negative, which is why we continue to cite that moment as the date when U.K. assets fully priced in Brexit. Chart 15Is Brexit##br## Still Relevant? Is Brexit Still Relevant? Is Brexit Still Relevant? Chart 16U.K. Needs A Free Services Agreement##br## With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! Chart 17Intra-EU Migration Boosts ##br##Labor Force Growth Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? What could change our forecast? We would need to see the negotiations with Europe become a lot more acrimonious. Disputes over the amount of the "exit bill" or the status of the Irish border simply do not count as acrimony. We need to see the threat of a "Brexit cliff" - where the EU-U.K. trade relationship reverts to "WTO rules" - emerge due to a conflict between the two powers. However, this is unlikely to happen as the EU greatly values its trade relationship with the U.K. And London's demand for an FTA actually plays to the EU's strengths, since FTAs normally privilege trade in goods (where Europe is competitive) relative to trade in services (where the U.K. has an advantage). Bear in mind, as well, that the U.K. and EU are negotiating an FTA from a starting point of a high degree of economic integration: this is not the equivalent of two separate economies pursuing an FTA for the first time. Similarly overstated as a risk is the upcoming Catalan independence referendum. As we argued this February, the referendum is a non-event.15 Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 18). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.16 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.17 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). Chart 18Catalans Do Not Want Independence Catalans Do Not Want Independence Catalans Do Not Want Independence We expect the turnout of the upcoming referendum to be low. Given that Madrid will not recognize it, the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. What does that mean precisely? The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to be willing to take up arms in order for its referendum to be relevant to the markets. Without recognition from Spain, and with no support for independence from fellow EU and NATO peers, Catalonia cannot win independence at the ballot box. Bottom Line: Fade Brexit and Catalonia risks. Iraq: An Emergent Risk In 2014, we wrote the following about the future of Iraq:18 "Furthermore, the recent Kurdish occupation of Kirkuk - nominally to secure it from ISIS, in reality to (re)claim it for the Kurdish Regional Government (KRG) - will not be acceptable to Baghdad. In our conversations with clients, too much optimism exists over the stability of Kurdistan and its expected oil output. While we are broadly positive on the KRG, there are many challenges. First, three-quarters of Iraqi production is, in fact, located in the Southern part of the country, far from Iraqi Kurdistan. Second, Kirkuk and its associated geography has the potential to boost production, but the Kurds (and their ally Turkey) will eventually have to face-off against Baghdad (and its ally Iran) for control over this territory. Just because the KRG secured Kirkuk today does not mean that it will stay in their control in the future. We are fairly certain that once ISIS is defeated, Baghdad will ask for Kirkuk back." In 2016, we followed up again on the situation in Iraq by pointing out that a series of defeats for the Islamic State were raising the probability that a reckoning was coming between Baghdad and Iraqi Kurds.19 Now that the Islamic State threat is in the rear-view mirror, our forecast is coming to fruition. On September 25, Kurds in Iraq will hold an independence referendum. Opposition to the referendum is uniform across the region, with the U.S. - Kurds' strongest ally - requesting that it not take place. Why should investors care? First, there is the issue of oil production. There are no reliable figures regarding KRG production, but it is thought to be around 550,000 bpd, although KRG officials have themselves downplayed their production. This figure includes production from the Kurdish-controlled Bai Hassan and Avana fields in the Kirkuk province, which is not formally part of the KRG territory but which Kurds nominally control due to their 2014 anti-ISIS intervention. A conflict over Kurdish independence could impact this production, particularly if war breaks out over Kirkuk. However, the bigger risk to global oil supply is what it would do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production. Second, there are problematic regional dynamics. There are about six million Kurds in Iraq, about 20% of the total population. The Kurdish Regional Government controls the northeast corner of Iraq, but fighting against the Islamic State has allowed the Kurds to extend their control further south and almost double their territory (Map 1). Turkey has largely supported the KRG over the years, as the ruling party in the autonomous province is relatively hostile to the Kurdistan Workers' Party (PKK), which Turkey considers a terrorist organization. However, Turkey is opposed to the independence of the KRG due to fears that it would start the ball rolling on the independence of Kurds in Syria and potentially one day in Turkey as well. Also opposed to KRG secession are Iran (Baghdad's closest ally) and Syria (which is dealing with its own Kurdish question). Map 1Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? On the other hand, the KRG does have international support. Russia just recently concluded a major oil deal with KRG, promising to buy Kurdish oil and refine it in Germany. Moscow will also invest US $3 billion in KRG territory. Russia also supplied the KRG Peshmerga - armed forces - with weapons during their fight against the Islamic State. From Russia's perspective, any conflict in the Middle East is a boon. It stalls investment in the region, curbs its oil production, and potentially adds a risk premium to oil prices. In addition, a close alliance with the KRG would allow Russia to gain another ally in the region. Bottom Line: While it is difficult to see how the independence referendum will play out in the short term, we have had a high-conviction view that Iraq's stability will not improve with the fall of the Islamic State. For investors, rising tensions in Iraq are significant because they could curb investment in the long term and potentially even impact production in the short term. Unlike the Islamic State, which never threatened oil production in the Middle East in any significant way, Iraq and the KRG are both oil producers. In fact, their main conflict is over an oil-producing region centered on Kirkuk. Tensions in the region support BCA Commodity & Energy Strategy's bullish view on oil prices.20 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017; "North Korea: No Longer A Red Herring" in BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017; and "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 5 BCA Global Fixed Income Strategy 10-year Treasury yield model only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Duration 'Hot Potato' Shifts Back To The U.S.," dated August 8, 2017, available at gfis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Is The 'Trump Put' Over?" dated August 23, 2017, available at gps.bcaresearch.com. 8 We use the Cook Political Report for their assessment of how U.S. electoral districts lean. Charlie Cook is Washington's foremost election handicapper with a long record of accomplishment. Anyone interested in closely following the U.S. midterm elections should consider his research, which is found on http://www.cookpolitical.com/ 9 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 10 Please see Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see footnote 3 above. 13 The GBP/USD bottomed then and there. The GBP/EUR has recently hit a new low, for reasons other than Brexit. This bottom is only slightly below its previous lows in October 2016, when May confirmed that her government would seek to leave the EU in accordance with the referendum result, and in January 2017, when May admitted what the GBP/EUR had already reflected, that this meant leaving the Common Market. Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World," dated January 25, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, and Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 16 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 17 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat 18 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 20 Please see BCA Commodity & Energy Strategy Weekly Report, "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," dated September 14, 2017, available at ces.bcaresearch.com.

Highlights Finally, an upside surprise on inflation. Recent significant developments reinforce BCA's bullish view on crude oil. Investors should consider the Monthly Report on personal income and spending, and not the quarterly GDP data, to gauge hurricanes' impact on economy. While the Fed will consider impact of Harvey and Irma, policy will ultimately be made on health of underlying economy. Feature Chart 1Rally For Risk Assets##BR##A Week Before The FOMC Rally For Risk Assets A Week Before The FOMC Rally For Risk Assets A Week Before The FOMC Risk assets and oil prices rose last week along with Treasury yields ahead of this week's FOMC meeting. Both the S&P 500 and the Dow hit new highs last week as the dollar moved lower. The stock-to-bond ratio also climbed, approaching the highs it reached earlier this year (Chart 1). All of this occurred amid an absence of any meaningful news on corporate earnings, aside from Apple's launch of the latest iPhone. Q3 earnings season is still a month away. Our base case projects stocks outperforming cash and bonds over the next 6-12 months, but in early September we recommended that clients be prudent, pare back any overweight positions and hold some safe-haven assets within diversified portfolios. The most significant movement in assets prices last week came in the U.S. Treasury market. Aided by hints of some progress on tax cuts in Washington less damage than initially feared from Hurricane Irma's impact on Florida, and despite another rocket launch by North Korea, the 10-year Treasury yield moved from near 2.0% in the first week of September to 2.20% on September 15. BCA's U.S. Bond Strategy service notes1 that bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Finally A Surprise On Inflation Chart 2Does One Month Make A Trend? Does One Month Make A Trend? Does One Month Make A Trend? After five months of downside surprises, U.S. core CPI met expectations in August. It is still too soon say that this is enough for the Fed to raise rates again this year. To get a better sense of the underlying trends, we like to break core CPI into three sub-groups: shelter, core goods and core services ex-shelter and medical care. Shelter, which accounts for over 40% of core CPI, rose 0.4% m/m in August. This was the biggest contributor to core CPI during the month. Our shelter model suggests that this strength is unlikely to persist. On the flip-side, core goods prices (25% of core CPI) fell 0.1% m/m. Given the weakness in the dollar, core goods prices should soon begin to rise. To some degree, a slowdown in shelter and a pick-up in core goods could offset each other over the coming months (Chart 2). Therefore, a sustained pick-up in overall core inflation requires an upturn in core services ex-shelter and medical. This sub-component of core CPI is the most tightly correlated with wage inflation. There was a slight tick higher in annual core services ex-shelter and medical inflation in August. However, it is still near a 25-year low of just 1.1%. Bottom Line: Following five months of persistent downside surprises, the 0.2% m/m increase in core CPI during August was a welcomed change for the Fed. However, one month does not make a trend and Fed will need to see more evidence of inflation turning the corner before raising interest rates again. Any rise in oil prices would also give inflation a lift, although it would affect the headline more than the core inflation rate. Bullish Oil Supply And Demand Recent significant developments reinforce BCA's bullish view on crude oil. The International Energy Agency (IEA) revised its forecasts for global oil demand. Oil consumption will be 100,000 bpd higher this year than the IEA's previous projection. Furthermore, renewed turmoil in Libya curbed production by 300,000 bpd from a 4-year high of more than 1 million bpd. BCA's Commodity & Energy Strategy service states that while predicting OPEC compliance is tricky, little to no cheating will occur. At worst, Saudi Arabia will step in and curtail production if Libya and/or Iraq begins to pump oil above quota. Finally, the Energy Information Administration (EIA) in the U.S. lowered its estimated shale oil output by 200,000 bpd for this year's third quarter. The decreased estimation confirms BCA's assertion that the EIA has overestimated the pace of the shale production response during 2017. Chart 3Drawdown In Global Oil##BR##Inventories Is Underway Drawdown In Global Oil Inventories Is Underway Drawdown In Global Oil Inventories Is Underway Taken together, these factors will help to improve the global net demand/supply balance by 600,000 bpd, if the current situation remains unchanged. As a result, global oil inventories will continue to be drawn down (Chart 3). Severe weather in the U.S. has temporarily distorted the energy markets. Crack spreads have widened in the U.S. as product inventories have declined along with Brent - WTI spreads. Nonetheless, BCA's commodity strategists remain bullish on crude oil, forecasting a rise in WTI to over $55/bbl and Brent to $60/bbl by year-end. Looking to next year, crude prices could go higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. A sudden jump in the U.S. dollar could risk BCA's bullish view. Bottom Line: There is a disagreement between the market's view of the fundamentals of the global oil balance, which is guided by the EIA data, and BCA's view that is driven by the OPEC 2.0 framework.2 Oil prices could spike higher if the market adheres to the OPEC framework. BCA's Equity Trading Strategy service recommends an overweight to the S&P 500 Energy Sector and initiated an overweight in the Oil and Gas Refining and Marketing sub-group on September 11, 2017.3 Hurricane Redux Turning to the U.S. hurricane destruction, history shows that natural disasters have only a passing effect on the U.S. economy, the financial markets and the Fed.4 Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the storms on Houston, Florida and nearby southern states. The U.S. data gathering agencies (BEA, BLS and Census) have processes to ensure that the storm's sway is reflected in the economic data. In the past, all three have produced post-disaster evaluations and will likely release the same type of information in the months ahead. Most of the storms' effects will be felt in the September data, but have already affected the initial claims data for the last week in August and the first week of September. The storms will also buffet the Q3 GDP (due out in late October). However, GDP data may not provide a comprehensive picture; GDP is not directly affected by natural disaster losses involving property, plants, equipment and structures. However, GDP can take a direct hit from the loss of productive capacity linked to a storm. The BEA notes that "while GDP may be affected by the actions that consumers, businesses, and governments take in response to a disaster, these responses are generally not separately identifiable, and they may be spread out over a long period of time." Investors should consider the monthly report on personal income and spending, and even more, the regional accounts by state, and not the quarterly GDP data, for details on the storms' economic fallout. Only hurricanes Katrina and Rita warranted a mention in the Q3 2005 GDP release, and none of the other major storms since that time have been noted by the agency. On the other hand, the personal income and spending reports released after all the major hurricanes since 2005 have provided key specifics on incomes. For example, the BEA stated that "work interruptions" linked to Hurricane Sandy reduced wages by $18 billion in October 2012 when the storm hit the northeastern U.S. The Bureau of Economic Analysis (BEA) also tends to note a storm's influence on other primary income categories including personal rental incomes, proprietors' incomes, and other current transfer receipts (i.e. insurance payments received). Table 1Total Federal Spending And Total Economic Damage For Selected Hurricanes, 2000 To 2015 Stormy FOMC Meeting This Week Stormy FOMC Meeting This Week A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP growth (Table 1). CBO notes that most of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart 4). Chart 4Federal Government Outlays For Hurricane Relief Stormy FOMC Meeting This Week Stormy FOMC Meeting This Week The severe weather in the U.S. has raised the odds that the Trump administration and Congress will make progress on fiscal policy this fall. We think that the outlines of a tax bill will emerge in the next month or so, and while the probability of passing legislation this year is still low, BCA's Geopolitical Strategy service expects the market to react when it sees the bill. The implication for investors is that the President Trump trades (Chart 5) that have unwound since the start of the year may soon become profitable again. The recent agreement between Trump and the Democrats to extend the debt ceiling and avoid a government shutdown support our stance. Chart 5Trump Trades Making A Comeback? Trump Trades Making A Comeback? Trump Trades Making A Comeback? Bottom Line: The hurricanes may have a bearing on the economic data for the next few months. Investors should closely monitor the input data to GDP, but not GDP itself. However, we do not anticipate that any economic disruptions from the storms will have a meaningful influence on near-term Fed monetary policy. Disasters And The Fed The hurricanes will probably play a supporting role in the Fed's outlook on the economy, inflation and labor market at this week's meeting. The FOMC statement will mention the storms and Fed Chair Yellen may include them in her opening remarks. Moreover, the news conference will provide another opportunity to discuss the issue. For example, the FOMC statement released in mid-December 2012, six weeks after Sandy, stated that "economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions". Fed staff noted that manufacturing production was held down by Sandy and that household spending, notably vehicle sales, declined in October due to the storm (Table 2). Similarly, the wrath of Hurricanes Katrina and Rita was noted in FOMC statements and minutes in the fall and early winter of 2005. For example, in the statement released at the meeting after Katrina hit in August 2005, the FOMC observed: "The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term." Fed policymakers made similar observations in the aftermath of other natural and man-made disasters in the past 25 years (Table 2). Table 2FOMC Reaction To Disasters, Natural And Man Made Stormy FOMC Meeting This Week Stormy FOMC Meeting This Week Bottom Line: Fed officials will consider the disruptions to the economy and economic data caused by Hurricanes Harvey and Irma, but ultimately make policy decisions based on the underlying strength of the economy, labor market and inflation. FOMC Preview The FOMC will initiate shrinking its balance sheet at this week's meeting, but neither BCA nor the market anticipate that the Fed will bump up rates. Moreover, the Fed will need more evidence that inflation, inflation expectations and/or inflation surprise has turned higher before resuming its rate hike regime. Furthermore, there is still a significant disconnect between the market and the Fed concerning rates for the next 12 months, and how that gap closes could be crucial for the financial markets, especially the bond market. At 43 basis points, the gap between the June dot plots and the market on the Fed funds rate in the next 12 months remains near its widest level of the year. The market is currently predicting only 30 bps in increases in the next 12 months. However, an uptick in inflation could quickly change that view (Chart 6). Despite the disagreement on rates, the Fed and the market are mostly aligned on the economy, the labor market and inflation, at least in 2017. For the first time, the FOMC will provide projections for 2020 at this week's meeting. At 4.4% in August, the unemployment rate is a mere tenth above the Fed's end-2017 forecast, but it is 0.2% below the central bank's latest estimate of full employment (4.6%). The Fed's measure of full employment has declined in recent years and we would not be shocked to see a drop again this week. The consensus outlook for the unemployment rate matches the Fed's path through the end of 2018 (Chart 7 and Chart 8). Chart 6Big Disagreement Between The Fed ##br##And The Market On Rates Big Disagreement Between The Fed And The Market On Rates Big Disagreement Between The Fed And The Market On Rates Chart 7The Fed Vs. The Market The Fed Vs. The Market The Fed Vs. The Market Chart 8The FOMC's "Long Run"##BR##Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 The economy is on pace this year to grow at the Fed's 2.2% projection but is running above the FOMCs long-run calculation of 1.8%, which is the low point since the Fed started publishing these long-run projections in 2009. The consensus forecast for GDP in 2018 and 2019 is slightly above the upper end of the Fed's range set in June (Chart 7 and Chart 8). The Fed and the market are relatively close on inflation this year, but there is still a wide gap in 2018 and beyond. In June, the Fed lowered its inflation forecast for 2017 to 1.6% from 1.9% in March. PCE inflation is at only 1.4% (year-to-date in 2017), so there is not much disagreement in this regard. The market does not agree with the Fed's view that inflation will return to 2.0%, and this is a key reason why the 10-year Treasury yield recently touched a new post-election low at 2.0%, although geopolitical tensions also played a role. The central bank's view of inflation in the long run has not deviated from 2.0% since 2012. Bloomberg consensus estimates for core inflation for this year and next are below the low end of the Fed's forecast range (Chart 7 and Chart 8). Market participants and some Fed officials are still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with an unemployment rate that is below the Fed's estimate of full employment. (Please see a BCA Special Report, "Did Amazon Kill The Phillips Curve?").5 Who Will Be The Next Fed Chair? As some investors consider the Fed's next policy move, others are taking a longer view and thinking about Fed Chair Yellen's replacement. Yellen's term as Chair will end in February 2018, and the markets have not yet shown any concerns about her potential replacement. Until last month, the frontrunner to replace Yellen was Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others.6 Several new names have emerged as possible Fed nominees as Cohn fell out of favor in the White House in early September. Kevin Warsh, Glen Hubbard and John Taylor, are all high-profile economists with links to the GOP, but Warsh stands out because he served on Trump's Strategic and Policy forum before it disbanded in August, and was a Fed Governor in the early 2000s (Table 3). Hubbard, who is currently an academic, was President George W. Bush's chief economist. However, he has not worked with Trump and has no Fed experience. John Taylor is well known in monetary policy circles, but has no Fed or government background, nor has he served with Trump. Taylor advocates for rules-based monetary policy.7 Another possible name, Larry Lindsey, an advisor to George W. Bush's campaign in 2000, a Fed Governor in the 1990s, and worked in the Reagan White House but he has no connection to Trump. He has recently spoken in favor of the House tax plan. Table 3Characteristics Of Fed Chairs Since 1970 Stormy FOMC Meeting This Week Stormy FOMC Meeting This Week The other two names under consideration - Richard Davis and John Allison - may have difficulty winning confirmations by the Senate. Both men were CEOs at major banks although neither have directly served Trump, nor been at the Fed or in government. Allison, a former president of the Libertarian Cato Institute, has argued that the Fed should be abolished and blamed the Fed for the financial crisis. The timing of Trump's announcement on Yellen's replacement may be critical. As a reminder, names floated by the Obama White House in the summer of 2013 were mainly rejected by the markets. Yellen's official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. As we noted in the sections above, there is already a wide discrepancy between the Fed and the market over the pace and timing of rate hikes in the coming year. BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) currently places fair value at 2.67%.8 Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68%. Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Bottom Line: Markets will be increasingly concerned in the next six weeks about the next Fed Chair and his or her policies. While the reappointment of Fed Chair Yellen for another term would please the markets, several other possible successors would not. We anticipate that the President will make a choice within the next month. Taking a longer view, the next Fed chair will oversee the policy response to the next recession and its aftermath. Investors should understand how the next Chair views the Fed's role in the business cycle. Economy Focus: Some Good News From The Quarterly Services Survey Even with the increasingly dominant role of the service sector's contribution to the economy (~69% of GDP), most of the high-frequency data are related to the manufacturing sector (~12% of GDP) (Chart 9, top panel). However, the Quarterly Services Survey (QSS), initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the services sector of the economy, including companies of all sizes (small- and medium-sized). It produces the most timely revenue data, on a quarterly basis, within the flourishing service sector. The dataset is used primarily by the BEA to estimate a more accurate picture of the national accounts, notably personal consumption and the intellectual property segment of private fixed investment. The survey is also essential for FOMC policymakers as it is very useful to track current economic performance. Even more, during the financial crisis, the BEA "aggressively responded to policymakers' needs for data on financial services". The QSS is a significant source of revisions to real GDP, as about 42% of the quarterly estimates of PCE for services is now based on QSS data. The "key services statistics" include information services; health care services; professional, scientific, and technical services; administrative and support and waste management and remediation services (Chart 9). For the first half of 2017, upward revisions to second and third estimates to real GDP stemmed from revisions to PCE services and nonresidential fixed investment, namely: health care services, financial & insurance services and intellectual property products (specifically software) and other services accounted for by cellular telephone services. The most recent QSS for 2017Q2 showed U.S. selected services total revenue rising by 3.2% over the last quarter and 6.2% over the last four quarters (in nominal terms and non-seasonally adjusted data only available). The strongest growth came from revenues of Other Services (9.4% QoQ% and 18.4% YoY) followed by Arts, Entertainment & Recreation and Administration, Support & Waste Management. Sales in Finance & Insurance and Health Care & Social Assistance, which make up about 50% of total service revenues, are advancing at a sturdy pace, as is revenue in Information services (Chart 9). Chart 9Growth For Service Sector##BR##Industries Is Broad-Based Growth For Service Sector Industries Is Broad-Based Growth For Service Sector Industries Is Broad-Based Chart 10QSS Survey Heralds Some##BR##Upward Revision To Real GDP QSS Survey Heralds Some Upward Revision To Real GDP QSS Survey Heralds Some Upward Revision To Real GDP Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see some upward revision to real consumer spending for services for the third estimate of real GDP next week (Chart 10). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report "Open Mouth Operations", published September 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance", published September 14, 2017. Available at ces.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report "Still Goldilocks", published September 11, 2017. Available at uses.bcaresearch.com. 4 Please see BCA U.S. Investment Strategy Weekly Report "Shelter From The Storm", published September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report "Did Amazon Kill The Phillips Curve?", published August 31, 2017. Available at bca.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", published July 17, 2017. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report "Trump And The Fed", published March 6, 2017. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report "The Cyclical Sweet Spot Rolls On", published September 5, 2017. Available at usbs.bcaresearch.com.

Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Bonds As A Safe Haven: Global bond yields have been driven lower by safe haven buying, despite ample evidence of faster global growth and central bankers that are still biased to shift to a less easy policy stance. There is now considerable upside risk for global bond yields over the next 6-12 months from these current depressed levels. ECB: The ECB is giving strong indications that a decision on tapering its asset purchase program will be made next month. With the Euro Area economy growing at a solid pace, and with inflation creeping higher, a reduction in the pace of bond buying in 2018 is highly probable. Canada: The Bank of Canada will continue to deliver on rate hikes without decisive signs that the current booming Canadian economy is slowing down, which leading indicators do not suggest is imminent. Stay underweight Canadian government debt, with a curve flattening bias. Feature Fade The Doomsday Trade Investors have had a lot of depressing news to process over the past several weeks. From threats of nuclear war with North Korea, to fears of a U.S. government shutdown over the debt ceiling, to the potential of Biblical flooding from hurricanes in Texas and Florida, the environment has not been conducive to risk-taking. This has triggered a flight into safe-haven assets like gold and U.S. Treasuries as investors have looked to protect portfolios from "existential" risks (Chart of the Week). Yet despite this rapid run-up in the value of save-havens, risky assets like equities and corporate credit have performed relatively well since the most recent peak in bond yields in early July (Table 1). Chart of the WeekFalling Yields Reflect Save Haven Demand,##BR##Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Table 1Changes In Risk Assets Since##BR##U.S. Treasury Yields Peaked On July 7th Have Bond Yields Peaked For The Cycle? No. Have Bond Yields Peaked For The Cycle? No. This move toward safety and risk aversion has widened the disconnect between global bond yields and economic fundamentals - specifically, growth momentum and central bank guidance - to extreme levels. Investors are now underestimating the potential for additional rate hikes in the U.S. in 2018, and are not fully appreciating the likelihood that the European Central Bank (ECB) will slow the pace of its asset purchases next year. Investors plowing money into government bonds now can only be rewarded if global monetary policy was set to ease, which would only be the case if global growth was slowing. That is not happening right now, even in the U.S. where the most apocalyptic headlines have been occurring. While the impact of Hurricanes Harvey and Irma will likely weigh on U.S. growth in the next few months, the underlying trend remains one of steady above-potential growth that is boosting both corporate profits and household incomes. More globally, depressed investor sentiment, indicated by measures such as the global ZEW survey, has helped drive bond yields lower despite the steady upturn in leading economic indicators (Chart 2). When looking at indicators of actual economic activity, like manufacturing PMIs, the growth story looks far stronger. As a sign of how much this "sentiment versus reality" divergence has distorted bond yields, look no further than our own valuation model for the 10-year U.S. Treasury yield. This model, which only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs, indicates that the current "fair value" of the 10-year Treasury yield is 2.67%, nearly 60bps higher than market levels seen as this publication went to press (Chart 3). This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Chart 2Bond Investors Are##BR##Ignoring Strong Growth Bond Investors Are Ignoring Strong Growth Bond Investors Are Ignoring Strong Growth Chart 3U.S. Treasuries Are##BR##Now Extremely Overvalued U.S. Treasuries Are Now Extremely Overvalued U.S. Treasuries Are Now Extremely Overvalued In Table 2, we present a decomposition of the 10-year yield changes in the major Developed Markets since that recent peak in U.S. Treasury yields on July 7th. As can be seen in the first two columns of the table, yields declined everywhere but Canada where the central bank has been hiking interest rates (as we discuss later in this report). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations. This has also occurred via a bull-flattening move in government bond yield curves (again, ex-Canada where the curve has bear-flattened), which suggests it is risk-aversion that has driven yields lower. Table 2Developed Market Bond Yield Changes Since U.S. Treasury Yields Peaked On July 7th Have Bond Yields Peaked For The Cycle? No. Have Bond Yields Peaked For The Cycle? No. The relative lack of movement in inflation expectations is a bit surprising given how strongly global oil prices have risen, denominated in any currency (see the final column of Table 2). When plotting the Brent oil price (in local currency terms) vs. the 10-year market-based inflation expectations (from inflation-linked bonds or CPI swaps), some notable divergences stand out. Inflation expectations in the U.S., U.K., Australia and even Japan look around 10-20bps too low relative to where they were the last time oil prices were at current levels (Charts 4 & 5). Meanwhile, inflation expectations are largely in lines with levels implied by oil and currency levels in the Euro Area and Canada. Most importantly, expectations are depressed in all countries, largely because actual inflation has stayed stubbornly low. Chart 4Inflation Expectations Vs. Oil Prices (1) Inflation Expectations Vs Oil Prices (1) Inflation Expectations Vs Oil Prices (1) Chart 5Inflation Expectations Vs. Oil Prices (2) Inflation Expectations Vs Oil Prices (2) Inflation Expectations Vs Oil Prices (2) The lack of realized inflation in places with allegedly "full employment" economies like the U.S. has led to questions over the usefulness of frameworks like the NAIRU (non-accelerating inflation rate of unemployment) in predicting inflation. A reduced link between the NAIRU and inflation does appear in many countries, but not necessarily in all countries when viewed in aggregate. Chart 6The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet In Chart 6, we present an indicator that shows the percentage of OECD economies (34 in total) that have an unemployment rate below the NAIRU rate. Currently, there are 67% of the countries in this list with unemployment rates under the OECD estimate of NAIRU, which is back to levels seen before the 2009 Great Recession. During that pre-crisis period, global inflation rates were accelerating for both goods and services inflation (bottom two panels). While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. This may be a sign that there is a "global NAIRU level" (or global output gap) that is more important in determining global inflation rates than individual country NAIRU measures. Or put more simply, investors are downplaying the NAIRU concept just at the time when it could be expected to strengthen. If that were the case, inflation expectations around the world would be too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that in bond yields. In the meantime, markets have become even too pessimistic on growth prospects and the implications for bond yields. Investors have driven down rate hike expectations in the U.S. and U.K. (and, to a lesser extent, the Euro Area) during this latest bond market rally, dragging longer-term bond yields down with them (Chart 7). Yet growth in the developing world is showing little signs of slowing down outside of the U.K., with leading economic indicators still pointing to a continued steady expansion (Chart 8). Even if central bankers are starting to question how fast their economies can grow before inflation pressures pick up in a meaningful way, they are unlikely to stand by and see faster growth prints without responding with less stimulative monetary policies. Chart 7Not Much Tightening Priced##BR##(Except For Canada)... Not Much Tightening Priced (except for Canada)... Not Much Tightening Priced (except for Canada)... Chart 8...Despite Improving Growth##BR##In Most Countries ...Despite Improving Growth In Most Countries ...Despite Improving Growth In Most Countries Net-net, bond markets are now discounting too pessimistic of an outcome for both global growth and inflation. We continue to see more upside risks for global yields on a 6-12 month horizon, although it will take some signs of faster global inflation (not just growth) before bond yields respond. Bottom Line: Global bond yields have been driven lower by safe haven buying, despite ample evidence of faster global growth and central bankers that are still biased to shift to a less easy policy stance. There is now considerable upside risk for global bond yields over the next 6-12 months from these current depressed levels. September ECB Meeting: All Systems Go For A 2018 Taper Last week's ECB meeting provided no changes on interest rates or the size of asset purchases, but plenty of clues on the central bank's next move. A reduction in the size of the ECB's asset purchase program in 2018, to be announced next month, is now highly probable - even with a strengthening euro. The ECB's GDP forecast for 2017 was revised higher from the June forecasts (2.2% vs. 1.9%), while the projections for 2018 (1.8%) and 2019 (1.7%) were unchanged. Meanwhile, the inflation forecast for 2017 was left unchanged at 1.5% and the forecasts for the next two years were only revised slightly lower (2018: 1.2% vs. 1.3%, 2019: 1.5% vs. 1.6%). The fact that the 14% rise in euro versus the U.S. dollar seen so far in 2017 was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. That makes sense when looking at the euro rally more broadly, as the currency has only gone up 6% in trade-weighted terms year-to-date. Simply put, the ECB does not yet seem overly worried that the strengthening euro represent a serious threat to the economy that could cause a more prolonged medium-term undershoot in Euro Area inflation. ECB President Mario Draghi did make references to currency volatility as being something that should be closely monitored with regards to the growth and inflation outlook. Right now, the realized volatility of the euro has been quite subdued, even as the currency has steadily appreciated (Chart 9). At the same time, our Months-to-Hike indicator has also fallen as the market has pulled forward the date of the next ECB rate hike. That hike is still not expected until late 2019 - pricing that we agree with. However, the fact that the euro can appreciate with such low volatility alongside a slightly-more-hawkish repricing of ECB rate expectations suggests that the market thinks that a move towards reduced monetary stimulus in the Euro Area is credible. That will remain true until the rising euro starts to become a meaningful drag on the economy or inflation, which is not evident in the broad Euro Area data at the moment (Chart 10). Chart 9A "Credibly Hawkish" ECB? A "Credibly Hawkish" ECB? A "Credibly Hawkish" ECB? Chart 10No Impact (Yet) From A Stronger Euro No Impact (Yet) From A Stronger Euro No Impact (Yet) From A Stronger Euro Draghi did note that the "bulk of decisions" regarding the ECB's asset purchase program would likely take place in October. That means a reduction in the size of the monthly purchases starting in January of next year, but without any changes in short-term interest rates (the ECB reiterated that rates will stay at current levels until after the end of the asset purchase program). Nonetheless, the ECB is incrementally moving towards a less accommodative policy stance that will continue to put upward pressure on the euro and, eventually, trigger a move toward higher longer-term Euro Area bond yields. Bottom Line: The ECB is giving strong indications that a decision on tapering its asset purchase program will be made next month. With the Euro Area economy growing at a solid pace, and with inflation creeping higher, a reduction in the pace of bond buying in 2018 is highly probable. Maintain an underweight medium-term stance on Euro Area government debt. Bank Of Canada: Shock Hawks The Bank of Canada (BoC) continues to confound investors with a surprisingly hawkish policy bias. Another 25bp rate hike was delivered at last week's monetary policy meeting, a move that was not fully discounted by the market, bringing the BoC Overnight Rate up to 1%. The Bank cited the impressive strength of the Canadian economy, as well as the more synchronous global expansion that was supporting higher industrial commodity prices, as reasons for the rate hike. With Canadian real GDP growth surging to a 3.7% year-over-year pace in the 2nd quarter, in a broad-based fashion across all components, perhaps policymakers can be forgiven for feeling that interest rate settings are still too stimulative for an economy with a potential growth rate of only 1.4% (the most recent BoC estimate). In the statement announcing the rate hike, it was noted that the level of Canadian GDP was now higher than the BoC had been expecting after the last Monetary Policy Statement (MPS) published in July. The BoC was already projecting that the output gap in Canada would be closed by the end of 2017. Thus, a higher realized level of GDP suggests an output gap that will be closed even sooner than the BoC was forecasting. This alone would be enough to move sooner on rate hikes for a central bank that focuses so much on its own measures of the output gap when making inflation projections. However, at the moment, there is not much inflation for the central bank to worry about. Chart 11The Great White North The Great White North The Great White North Headline CPI inflation sits at 1.2%, well below the midpoint of the BoC's 1-3% target band, while the various measures of core inflation that the BoC monitors are between 1.3% and 1.7%. Annual wage growth accelerated to the faster growth rate of the year in August, but still only sits at 1.7% even with the unemployment rate now down to a nine-year low of 6.2%. Meanwhile, the Canadian dollar has appreciated 13% vs. the U.S. dollar, and 10% on a trade-weighted basis, since bottoming out in early May. This move has been supported by growth and interest rate differentials that favor Canada. This is especially true versus the U.S. where the 2-year gap between Overnight Index Swap (OIS) rates is now positive at +21bps - the highest level since January 2015 (Chart 11). The BoC acknowledged this in last week's policy statement, suggesting acceptance of a strong loonie as a reflection of a robust Canadian economy that requires higher interest rates. The strength in the Canadian dollar will likely weigh on import price inflation in the coming months, and act as a drag on overall inflation. This will not trigger any move by the BoC to back off from its hawkishness unless there is also some weakness in the Canadian economic data. For a central bank that focuses so much on the output gap in its assessment of its own policy stance, the inflationary impact from a booming economy will far outweigh the disinflationary effects of a stronger currency. It remains to be seen if the BoC will be proven right on delivering actual rate hikes with inflation well below target. This is a problem that many central banks are facing at the moment, but the robust Canadian economy is forcing the BoC's hand. An appreciating currency may limit the number of rate hikes that the BoC eventually undertakes, but given its own assessment that that terminal interest rate is around 3%, there are plenty of additional hikes that the BoC can deliver before getting anywhere close to "neutral". The key risk will come from the spillover effects on the overheated Canadian housing market from the interest rate increases. Already, house prices are coming off the boil in the most overheated markets like Toronto, where median home values are down 20% since April due to regulatory changes aimed at reducing leveraged speculation in Canadian housing. It remains to be seen how much the BoC hikes will exacerbate the latest downturn in house price inflation and, potentially, have spillover effects on consumer confidence given high levels of household indebtedness. For now, we do not recommend fighting the BoC, with Canadian leading economic indicators still accelerating and the BoC's own business surveys showing that the economy is likely to remain strong. While there are already 50bps of rate hikes priced next twelve months, this would only take the Overnight Rate to 1.5% - still a stimulative level in the eyes of the central bank. This could also create additional strength in the loonie, although that impact should be lessened if the Fed comes back into play and delivers additional rate hikes in 2018, as we expect. We continue to recommend a below-benchmark duration stance on Canadian government bonds, with yields likely to surpass the relatively modest increases currently priced into the forwards (Chart 12, top panel). We also continue to advise an underweight allocation to Canadian government bonds in hedged global fixed income portfolios (middle panel). We also are staying with our winning Canadian trades in our Tactical Overlay portfolio, where are positioned for wider Canada-U.S. bond spreads and a flatter Canadian yield curve (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Bonds Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds Chart 13Sticking With Our Tactical##BR##Canadian Bond Trades Sticking With Our Tactical Canadian Bond Trades Sticking With Our Tactical Canadian Bond Trades Bottom Line: The Bank of Canada will continue to deliver on rate hikes without decisive signs that the current booming Canadian economy is slowing down, which leading indicators do not suggest is imminent. Maintain an underweight stance on Canadian government debt, with a curve flattening bias. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Have Bond Yields Peaked For The Cycle? No. Have Bond Yields Peaked For The Cycle? No. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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 Monthly Portfolio Update Monthly Portfolio Update Chart 2Earnings Continue To Accelerate Earnings Continue To Accelerate Earnings 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? Inflation To Pick Up? Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Financial Condition: Easy In The U.S., Tight In Europe Financial 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 Rates Lag Behind Global Growth Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM bca.gaa_mu_2017_09_01_c6 bca.gaa_mu_2017_09_01_c6 Chart 7EM Domestic Growth Anemic EM Domestic Growth Anemic EM 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% U.S. Rate Fair Value Is Around 2.6% U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Monthly Portfolio Update Monthly Portfolio Update 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 There Are A Lot Of Euro Bulls There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Euro Is No Longer Undervalued Euro 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

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 U.S. Refiners Running At Close To Record Rates U.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 ... U.S. Product Export Remain Strong, While Imports Continue Trending Lower ... U.S. Product Export Remain Strong, While Imports Continue Trending Lower ... Chart 3... While U.S. Crude Exports Remain High,##BR##And Imports Are Moderating ... While U.S. Crude Exports Remain High, And Imports Are Moderating ... While U.S. Crude Exports Remain High, 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 ... U.S. Net Crude And Product Imports Are Falling ... U.S. Net Crude And Product Imports Are Falling ... Chart 5... Which Will Support Continued Draws In##BR##Commercial Oil Stocks (Crude And Products) ... Which Will Support Continued Draws In Commercial Oil Stocks (Crude And Products) ... Which Will Support Continued Draws In Commercial Oil Stocks (Crude And Products) Chart 6KSA Will Continue Reducing##BR##Shipments To U.S. Refiners KSA Will Continue Reducing Shipments To U.S. Refiners KSA Will Continue Reducing 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 Iraq Stands Out For Overproduction; Libya, Nigeria Not Covered In OPEC 2.0 Deal Iraq Stands Out For Overproduction; Libya, Nigeria Not Covered In OPEC 2.0 Deal Chart 8Russia And KSA##BR##Continue To Lead OPEC 2.0 Russia And KSA Continue To Lead OPEC 2.0 Russia And KSA 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 KSA's Tactics Advance OPEC 2.0's Agenda KSA's Tactics Advance OPEC 2.0's Agenda Commodity Prices and Plays Reference Table KSA's Tactics Advance OPEC 2.0's Agenda KSA's Tactics Advance OPEC 2.0's Agenda 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) Odds Continue To Favor Lower Oil Inventories Odds Continue To Favor Lower Oil Inventories Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Higher Production And Lower Demand Reduce Physical Deficits Versus Last Month's Projections Higher Production And Lower Demand Reduce 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 Almost 500k b/d Added To Oct/16 Output By Iran, Libya, And Nigeria In June Almost 500k b/d Added To Oct/16 Output By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws OPEC 2.0 Cuts Drive Inventory Draws OPEC 2.0 Cuts Drive Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 U.S. Crude Production Grows In 1H17 U.S. Crude Production 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 Odds Continue To Favor Lower Oil Inventories Odds Continue To Favor Lower Oil Inventories Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher OECD 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. KSA's To Reduce Exports To The U.S. KSA's To Reduce Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments OPEC Exports To The U.S. To Fall Further When KSA Reduces Shipments OPEC Exports To The U.S. To Fall Further 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 Odds Continue To Favor Lower Oil Inventories Odds Continue To Favor Lower Oil Inventories Commodity Prices and Plays Reference Table Odds Continue To Favor Lower Oil Inventories Odds Continue To Favor Lower Oil Inventories 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 Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Libya's Resurgence Clobbers Benchmark Prices Libya's Resurgence Clobbers 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 Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, 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 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! 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 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

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 Crude Oil Prices Rally, Despite Reports Of Higher Production Crude Oil Prices Rally, 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 OPEC Inventory Transfer Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Surge In 2H16 OPEC Production 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 OPEC Exports To The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High U.S. Refinery Runs And Exports Remain High U.S. Refinery Runs And Exports Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq Libya, Nigeria Increase Production, 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 OPEC's Oil Inventory Shift Winding Down OPEC's Oil Inventory Shift Winding Down Summary of Trades Closed in 2016