Russia

Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... Chart 11...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Chart 16Likely No Majority In Congress Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Chart 18Mexico's Rising Political Plurality Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Chart 20A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Chart 22Abe Holding At Koizumi's Levels Of Support More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.

Highlights Solid fundamentals will keep the backwardation in the forward curves of the benchmark crude-oil streams - WTI and Brent - intact. If our long-held thesis is correct and OPEC 2.0 becomes a durable producer coalition, we believe it will maintain some level of production cuts in 2019.1 This will, in part, keep OECD commercial oil inventories close to their 2010 - 2014 levels, thus keeping oil forward curves backwardated beyond this year. Backwardation serves OPEC 2.0's interests by limiting the rate at which shale-oil production grows.2 It also drives returns from long-only commodity-index exposure, particularly the energy-heavy index exposure we favor, by maintaining an attractive roll yield for investors.3 We expect the S&P GSCI to return 10 - 20% this year. Energy: Overweight. Our recently concluded research shows commodity index exposure hedges portfolios against inflation risk. We remain long index exposure. Base Metals: Neutral. COMEX copper traded back through $3.00/lb on the back of strong official Chinese PMI data, indicating manufacturing activity continues to expand. It has since fallen back to ~ $3.00/lb, as U.S. - Sino trade-war fears grew. Precious Metals: Neutral. Gold remains range-bound, between $1,310 and $1,360/oz. Ags/Softs: Underweight. In a tit-for-tat fashion, Beijing announced on Wednesday that it would retaliate to the U.S. tariffs on $50 billion worth of Chinese imports. U.S. soybeans and beef are among the list of 106 items China plans to impose a 25% tariff on. Feature An unlikely commonality of interests unites the fates of OPEC 2.0 and long-only commodity index investors: The desire to see the crude-oil forward curves backwardated. Turns out, both interests benefit from the same configuration of the forward curves, in which prompt prices trade premium to deferred prices. Backwardation achieves a critical goal of OPEC 2.0 by making the prices most member states in the coalition receive on their crude oil sales - i.e., the spot price indexed in their term contracts - the highest point along the forward curve. A backwardated curve means the average price U.S. shale-oil producers realize over their hedging horizon - typically two years forward - is, perforce, lower than the spot price. We have shown rig counts are highly sensitive to the level and the shape of the WTI forward curve. A backwardated curve reduces the revenue that can be locked in by hedging. This reduces the number of rigs shale producers send to the field, which restrains - but does not quash - the rate at which they can grow their production (Chart of the Week). For commodity index investors - particularly those with exposure to the energy-heavy S&P GSCI index, where ~ 60% of the index is crude oil, refined products or natural gas - backwardation drives roll-yields, which are a critical component of the index's total returns. The steeper the backwardation, the higher the roll yield.4 Our balances modeling indicates oil markets will remain tight this year, given strong global growth in demand in excess of production growth, which will keep the market in a physical deficit (Chart 2). This will cause inventories to continue to draw this year (Chart 3), which will keep the crude-oil backwardation in place. This backwardation is one of the principal drivers of returns in the S&P GSCI. Chart of the WeekBackwardation Constrains##BR##Shale's Rate Of Growth Chart 2Balances Model Indicates##BR##Physical Deficit Persists This Year Chart 3Tighter Inventories Keep##BR##Backwardation In Place As for the other components of the S&P GSCI, we are neutral base and precious metals, expecting them to remain relatively well-balanced this year, and underweight ag markets, even though they appear to have bottomed, as the USDA indicated recently. As a result, we expect an energy-heavy commodity index exposure like the S&P GSCI will continue to perform for investors, driven largely by the stronger oil prices we expect this year, and the roll yields from backwardated energy futures. Any price upside from the other commodities will be a marginal contribution to returns, as energy price appreciation plus roll yields will be the primary driver of the long-index exposure. Can Crude Oil Backwardation Persist? Beyond 2018, reasonable doubts exist as to whether OPEC 2.0 can remain a durable coalition. These doubts arise from apparent differences in the long-term goals of OPEC 2.0's putative leaders, KSA and Russia. We believe that, over the short term (two years or so) KSA favors higher prices, and that the Kingdom's preferred range for Brent is $60 to $70/bbl, at least until the Saudi Aramco IPO is fully absorbed and trading in the market. Russia's apparent preference is for lower prices ($50 to $60/bbl), which will disincentivize U.S. shale producers from adding even more volume to the market and threaten its market share. How these goals are resolved within OPEC 2.0 as it negotiates its post-2018 structure will determine whether oil forward curves remain backwardated - the likely outcome if production cuts are extended into 2019 - or if OECD inventories start to rebuild and the backwardation returns to contango (i.e., deferred prices exceed prompt prices). This would happen if Russia and its allies decide they are uncomfortable with prices staying close to or above $70/bbl for too long, and therefore lift production and exports to bring them down. OPEC 2.0 Has Reconciled KSA's And Russia's Goals We believe OPEC 2.0 has reconciled KSA's desire for higher prices over the short term to allow a smooth IPO of Aramco. Both KSA and Russia share a longer-term goal of not overly incentivizing U.S. shale production, and production by others - e.g., Norway's Statoil - which also have significantly reduced their costs in order to remain competitive.5 If OPEC 2.0 is successful in achieving higher prices over the short term, it will have to offset them with lower prices further out the forward curve to reconcile KSA's and Russia's goals. This is the principal reason we believe backwardating the forward curve, and keeping it backwardated, achieves OPEC 2.0's short- and longer-term goals. After Aramco is IPO'd - something that, from time to time, seems doubtful - and the market's trading the stock, we believe KSA and Russia will want average prices to drift lower. KSA will, by that time, have lowered its fiscal break-even cost/barrel to $60 (they're at or below $70 now) and will be executing on its diversification strategy. But even with spot prices lower - we're assuming the target level would be ~ $60/bbl - the forward curve will have to remain backwardated to keep U.S. shale's growth somewhat contained. This can be done by keeping deferred contracts (2+ years out) close to $50/bbl using OPEC 2.0 production flexibility, global inventory holdings and forward guidance re production, export and inventory policies. By keeping the average price realization over the shale producers' hedging horizon in the low- to mid-$50s, OPEC 2.0 restrains rig deployment in the U.S. shales. Keeping the front of the forward curve closer to (or above) $60/bbl, means OPEC 2.0 member states get the high price on the forward curve, since their term contracts are indexed to spot prices. Once a persistent backwardation becomes a reliable feature of the forward curve, the short-term inelasticities of the global supply and demand curves - but mostly the supply curve - mean small changes by a production manager like OPEC 2.0 can readily change the price landscape and alter expectations along the forward curve covering the shale-oil producers' hedge horizon. OPEC 2.0 states already have lived through the alternative of not managing production to the best of their abilities during the 2014 - 2016 price collapse: A production free-for-all similar to what the market experienced then would again lead to massive unintended inventory accumulations globally. This would put the Brent and WTI forward curves into super-contangos, which occurred at the end of 2015 into early 2016. At that point, the market would, once again, begin pricing sub-$20/bbl oil as a global full-storage event becomes more probable. At that point, it's "game over" for OPEC 2.0 member states. The stakes remain sufficiently high for OPEC 2.0 member states to keep the coalition intact and to maintain production cuts to keep OECD inventories tight, and thus keep markets backwardated beyond 2018. Backwardation Works For Commodity Index Investors, Too We expect the S&P GSCI to continue to perform well this year - posting gains of 10 to 20% - given our expectation OPEC 2.0 will remain committed to maintaining production discipline. We've recently shown there is a close relationship between oil forward curves and oil inventories, expressed as the deviation of Days-Forward-Cover (DFC) from its 2- or 3-year average, and y/y percentage change (Chart 4).6 This analysis supports our view that - based on our expectation of a continuation of OECD commercial inventory decline - backwardation will continue throughout 2018 and early-2019. This tight relationship, allows us to include OECD commercial inventories as a proxy among our explanatory variables for the shape of the oil forward curves, when modeling and forecasting the GSCI total return. For 2018, we are modeling a continuation of the production cuts put in place at the beginning of 2017 to year end. At some point later this year, we expect the market to get forward guidance on what to expect in the way of OPEC 2.0 production levels for next year. In lieu of actual guidance, we've modelled three different scenarios for OPEC 2.0's production levels next year, leaving everything else affecting prices unchanged. This is a sensitivity analysis on OPEC 2.0's production only (Chart 5).7 Chart 4Oil Inventories, Spreads,##BR##DFC, Closely Related Chart 5BCA's 2019 Scenario Analysis##BR##For OPEC 2.0 Production Scenario 1: Our actual balances, most recently updated in our March 22, 2018, publication, with no production cuts in 2019; Scenario 2: An extension of the OPEC 2.0 production cuts to end-2019 at 100% of 2018 levels; Scenario 3: An extension of the OPEC 2.0 production cuts to end-2019 at 50% of 2018 levels. Under scenario 1, the GSCI's y/y returns slow in 2H18 and become negative in 3Q19. Returns peak in Feb/19 at 28%, and average 21% in 2018, and 9% in 2019. In scenario 2, y/y growth remains positive this year and next, peaking in Feb/19 at 30%, then falling to 13% in 2019. Average returns in 2018 are 21%, and in 2019 19%. In scenario 3, y/y growth remains positive in both years, and bottoms close to 0% but never turns negative. GSCI returns peak in Feb/19 at 29%, then fall to 3% in 2019. Average returns in 2018 are 21%, and in 2019 14%. Given the guidance already conveyed by KSA's oil minister Al-Falih, we would put a low weight on scenario 1, and attach a 50% probability to each of the 2019 simulations in scenarios 2 and 3. GSCI As An Inflation Hedge Our analysis shows the GSCI Total Return (TR) also is highly sensitive to the USD broad trade-weighted dollar (TWIB) and U.S. headline CPI inflation (Chart 6).8 This has powerful implications for the evolution of commodity-indices going forward. A decrease (increase) in the USD TWIB increases (decreases) USD-denominated commodity demand from buyers ex-U.S., thus raising prices, all else equal. An increase (decrease) in the U.S. CPI can lead to higher commodity costs, which are reflected in the GSCI, or to a positive (negative) net-inflow of cash into commodity-indices as a hedge against inflation risks. Importantly, we found the GSCI TR and U.S. CPI relationship to be bi-directional, enhancing the magnitude of the impact of a change in any of those variables. In other words, a rise in the GSCI TR causes inflation to rise which leads to a rise in the GSCI TR, and vice-versa until a new equilibrium is reached.9 Our colleagues at BCA's Global Fixed Income Strategy desk expect inflation pressures will continue to build this year. In particular, they note, "the global cyclical backdrop is boosting inflation."10 With 75% of OECD countries operating beyond full employment, capacity-utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 7, top panel). This closing of the global output gap likely will stoke inflation. Chart 6GSCI Highly Sensitive To USD, U.S. CPI Chart 7Inflation Risks Picking Up Consistent with our overweight view, we expect oil prices to move higher from current levels, as refiners come off 1Q18 maintenance turn-arounds and summer-driving-season demand picks up in the Northern Hemisphere (Chart 7, middle panel).11 Lastly, global export price inflation is showing no signs of slowing, suggesting that global headline inflation will continue moving higher (Chart 7, bottom panel). From the model shown in Chart 6, which captures ~ 82% of the variance in the y/y GSCI TR, we have high conviction that three of the four explanatory variables for the GSCI - crude spreads, DFC and U.S. CPI - will support the GSCI this year, leaving only a significant appreciation in USD TWIB as a potential risk to our view. Away from our modelling, other risks to our bullish oil case as a driver of GSCI returns remains a greater-than-expected economic deceleration in China arising from a policy error in Beijing as policymakers execute a managed slowdown, or a trade war with the U.S.12 These would affect our inflation and commodity-demand - hence commodity price - outlooks. Bottom Line: We expect persistent backwardation in the benchmark crude-oil forward curves- WTI and Brent - as OPEC 2.0 extends production cuts beyond 2018. This will achieve the goals of OPEC 2.0's leadership and underpin returns in the S&P GSCI, which we expect will post gains of 10 - 20% this year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Last month, the Kingdom of Saudi Arabia's (KSA) oil minister, Khalid Al-Falih, indicated OPEC 2.0 production cuts could be extended into 2019. Al-Falih suggested the level of the cuts could be at a reduced level. Please see "Saudi expects oil producers to extend output curbs into 2019," published by uk.reuters.com March 22, 2018. 2 OPEC 2.0 is the producer coalition led by KSA and Russia, which, at the end of 2016, agreed to remove 1.8mm b/d of production from the market. 3 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. For a primer on commodity index investing, please see "Convenience Yields, Term Structures & Volatility Across Commodity Markets," by Michael Lewis in An Investor Guide To Commodities (pp. 18 - 23), published by Deutsche Bank April 2005. 4 By way of a simplistic example, assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Please see "How we cut the break-even prices from USD 100 to USD 27 per barrel" on Statoil's website at https://www.statoil.com/en/magazine/achieving-lower-breakeven.html and "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018, where we discuss how KSA's and Russia's goals have been reconciled. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 7 This sensitivity analysis allows only for the path of OECD commercial inventories to vary while everything else is held constant. To obtain the forecasted values, we've combined the estimates of a set of different modelling techniques (i.e., a Markov switching model, threshold and break-OLS estimators). This increased the information and granularity obtained from the model and allowed us to capture time-varying characteristics in the global inventory/GSCI TR relationship. 8 We found there is two-way Granger-causality between the S&P GSCI and U.S. CPI y/y changes. This feedback loop indicates the GSCI will move with, and cause movement in, the CPI, as discussed herein. 9 This is supported statistically using Granger Causality tests in a VAR model of the GSCI TR and U.S. CPI inflation. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report titled "Nervous Complacency," published March 27, 2018. Available at gfis.bcaresearch.com. 11 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," for our latest oil price forecast. It was published March 22, 2018, and is available at ces.bcaresearch.com. 12 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," for a discussion of this risk. It was published March 29, 2018, and is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Russian equities are among the cheapest emerging markets, and among the cheapest in the world - a re-rating could be epic; Weak growth potential and poor governance present tremendous challenges; Yet macro fundamentals are sound and economic policy is orthodox - Russia should behave as a low-beta EM market going forward; The government is highly likely to build on recent micro-level improvements with reforms to improve human capital and infrastructure; Vladimir Putin's military adventurism has stalled, reducing geopolitical risk from high levels; Continue to overweight Russian assets within EM portfolios; go long Russian / short Brazilian local currency government bonds. Feature Russia has one of the cheapest equity markets in EM and in the world. With conflict in Ukraine frozen, a stalemate in Syria, and domestic politics stable (if not inspiring), could the country be on the verge of an epic re-rating? To answer this question, investors have to first understand why Russia is cheap. Shockingly, geopolitical adventures and the 2014 collapse in oil prices have nothing to do with the bargain prices! Russian P/E plummeted in 2011 because investors realized that President Vladimir Putin was here to stay for potentially another two decades (Chart 1). And that signaled that weak governance and an atrocious record on attracting foreign investment would persist for the long term. And yet, Russian equity outperformance amidst the most recent global volatility rout serves as an indication that Russian equities have the capacity to outperform (Chart 2). Is this a fluke, or the start of something more long-term?   This ... Is ... Sparta! Russia faces extreme challenges as a nation. It is an austere, isolated, and militaristic society - a modern-day Sparta compared to the West's Athens. Its few competitive wares are wheat, hydrocarbons, and guns. Its lack of openness toward immigration, foreign trade, services, technology, and human development tend to limit its productivity. To assess Russia's long-term economic potential, we should begin with the bad news. First, Russia has a disastrous population profile. Both labor force growth and the working age population are shrinking (Chart 3). The dependency ratio is high and rising at 45%. Though the fertility rate has notably perked up, it remains far below the replacement rate of 2.1 (Chart 4). Even given the current population, there is limited room to increase the labor participation rate, as it is already higher than in the U.S. and is not rising anymore.     Second, immigration is in decline. Most immigrants come from the Russian commonwealth, but in net terms, immigration has been drifting away since the global financial crisis, even more rapidly since the 2014 oil shock (Chart 5). Russia is rife with xenophobia and anti-immigrant politics. Even if policy were to become more inviting, the Russian-speaking sources of immigration are also seeing weak working-age population growth. And Russia is unlikely ever to become an all-weather migrant country (Chart 6).1     Third, labor productivity growth has only just begun to recover and is weaker than in the past. Russia has fallen behind its emerging European neighbors (Chart 7). The same can be said for total factor productivity growth, which is a very important indicator for economies that want to modernize - it currently stands at zero. Fourth, Russia suffers from chronically weak institutions and poor governance: Inequality is high and rising (Chart 8).   Governance indicators are deeply negative - worse than China's (Chart 9). Corruption is rampant - Russia ranks 135 out of 180 countries on the Corruption Perceptions Index, only very slightly improving since 2014. Corruption reduces economic efficiency and the effectiveness of public investments.2 For instance, despite the rise in spending on the judicial system in Russia, "rule of law" has declined, according to the World Bank's Worldwide Governance Indicators (Chart 9, bottom panel). Nationalization remains the government's modus operandi. Not only have privatization schemes failed, but new nationalizations have continued to occur - namely the electricity sector and most recently the banks (see Chart 14 below). State ownership has risen from 30% of GDP in 2000 to 70% today.3 Fifth, Russia's self-inflicted standoff with the western world has resulted in a closed economy that misses out on the benefits of human capital, technology transfer, and trade. The country's international competitiveness is clearly suffering: Russian exports have lost market share in the world and in the EU. Even in Eastern Europe and Central Asia, two areas where Russia has the biggest advantages and lacks geopolitical constraints, Russian exports have been lackluster. Crucially, Russia is gaining market share in East Asia, though even here with difficulty (Chart 10). Leaving aside commodities, Russia has failed to develop a competitive manufacturing sector.   Sixth, Russia's government spending priorities are heavily focused on national security and thus constrained from promoting economic productivity and improving governance. Total spending on national defense, state security, and diplomacy has risen to 6.4% of GDP and 31.7% of the government budget. This is twice as much as the U.S. and China at 3.2% and 2.8% of GDP, respectively. By contrast, total spending on social policy is 5.5% of GDP and 29% of the budget. Spending on education and healthcare, at 0.7% and 0.5% of GDP respectively, is well below European, American, and Chinese levels, and it has hardly increased as a share of government spending in recent years. Basic and applied research spending is tiny and falling. So far the most significant investments in social wellbeing have been limited to pensions. Yet it is a well-attested fact that increases to state pensions precede elections, as pensioners are a key political constituency for the ruling United Russia party. The spending tends to be fleeting and does not enhance productivity.4 Cutting military spending would give Russia more fiscal resources to address badly needed economic weaknesses. But it is not on the horizon, so economic reforms will face budgetary constraints. Bottom Line: Russia's long-term potential is stunted by population shrinkage, slow productivity growth, lack of openness and competitiveness, lack of diversification and complexity, weak institutions, and poor governance. Some Good News: Orthodox Macroeconomic Policy Now for the good news: Russia's economy has stabilized and its macroeconomic policy backdrop is sound and orthodox, especially relative to emerging markets. First and foremost, fiscal and monetary policies have become less pro-cyclical. This will reduce volatility in the real economy and ensure that the current cyclical recovery is sustainable (Chart 11). Fiscal policy has been tight and conservative. In fact, the government has only slightly let nominal expenditures grow since the oil crash, while spending has fallen considerably in real terms (Chart 12).   Consequently, the fiscal deficit has significantly narrowed. The conservative budget assumption of $40/bbl oil is still being upheld (Chart 12, bottom panel). Moreover, the new fiscal rule implemented by the Ministry of Finance last year has allowed Russia to rebuild its FX reserves (Chart 13). The rule stipulates that the Ministry of Finance will buy foreign currency when the price of oil rises above the set target level of 2,700 RUB per barrel (i.e. $40/bbl times 67 USD/RUB exchange rate), and sell foreign exchange when the oil price falls below that level. The objective is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Lastly, the public debt-to-GDP ratio is a mere 16% in Russia. On the monetary policy side, the Central Bank of Russia has been highly orthodox. Unlike many other EM central banks, it has refrained from injecting excess liquidity into the banking system and has maintained high real interest rates (Chart 13, bottom panels). All in all, Russia is much more advanced in its macroeconomic adjustment phase than other emerging markets: Commercial banks have been increasing provisions, even though the NPL ratio has begun to fall (Chart 14). Furthermore, the central bank has been reducing the number of dysfunctional banks by removing their licenses (Chart 14, bottom panel). Russia is further along in its deleveraging cycle than other EMs. Having gone through the pain of a massive currency devaluation followed by substantial increases in interest rates and bank restructuring, Russia can begin to re-leverage, which will be positive for consumption and investment. In fact, re-leveraging is already underway. Bank loans are expanding after a pronounced contraction. The credit impulse - i.e. the change in bank loan growth - continues to recover (Chart 15, top panel). Importantly, debt has room to grow, especially in the consumer sector where debt levels are low (Chart 15, bottom panel). Capital spending, which had collapsed both in absolute terms and relative to GDP, has started to recover. It is supported by a recovery in broad money supply (Chart 16). Starting from an extremely under-invested position, the recovery warrants major upside in investment outlays. Exposure to external risks is limited: External debt across private and public sectors remains extremely low, limiting the impact of potential foreign currency sell-offs (Chart 17).   Russia's foreign funding requirement - calculated by subtracting the current account balance from external debt servicing over the next 12 months - is the second-lowest in emerging markets after Thailand, making Russia's balance-of-payments position one of the least vulnerable in the EM universe. Furthermore, Russia is making clear improvements despite the dismal trends outlined above. On the margin these improvements could raise the country's long-term growth prospects: On the external side, the composition of exports is shifting away from commodity exports (Chart 18). Although commodity exports still account for the large majority of the export pool at 81%, a gradual shift towards other sectors will allow the economy to diversify its sources of revenue and employment. The allocation of government expenditures has marginally shifted towards addressing some of Russia's long-standing structural problems. Spending on infrastructure (transport and roads) has climbed steadily (Chart 19). This is critical as the road system in Russia is significantly underinvested and is a medium through which productivity can be efficiently increased.   In the private sector, employment for small and medium-sized enterprises (SMEs) has been rising (Chart 20). Importantly, this is happening in the peripheral districts as well as the economically more vibrant central federal district. Policy is becoming more supportive of SMEs, for instance via tax holidays. Allowing SMEs to gain a bigger share of the economy will hold the key to creating an environment where innovation and business confidence can start improving Russia's productivity prospects. Interestingly, the number of privately owned businesses being created is rising relative to the number of state-owned businesses. In addition, more state-owned businesses are being liquidated relative to privately owned ones (Chart 21), suggesting a willingness to accommodate "creative destruction."   The "Ease of Doing Business" has improved markedly under administrative reforms, easier land registration, and improved contract enforcement (Chart 22). "Regulatory quality," "control of corruption," and "absence of violence" are key governance indicators that are directly relevant for the corporate outlook and investors, and these are improving, albeit from a negative level (Chart 23).   In sum, while macro stability has been achieved, Russia needs to expand and sustain recent marginal developments on the micro level in order to improve its long-term economic and investment outlook. Bottom Line: The economy has stabilized and macroeconomic policy is orthodox. Marginal improvements in export composition, government spending allocations, and treatment of the private sector may not turn Russia into a high-productivity country overnight, but they do mark an inflection point that could arrest the downward trend of productivity. This is especially so if private and public initiatives are taken to further these initial developments. More Good News: Foreign Adventurism Has Stalled Russia's geopolitics are also unlikely to worsen from here, at least not in a way that is relevant to investors. President Putin's rhetoric reached peak bluster in his lengthy "State of the Nation" address to the Duma on March 1. Western media took the bait immediately, encapsulated best by The New Yorker headline, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War."5 Should investors dismiss Putin's slick, computer-generated images of Florida getting nuked by multiple warheads? It depends. On one hand, our Russian geopolitical risk indicator suggests that investors have been demanding an ever smaller premium on Russian assets (Chart 24).6 There is, therefore, considerable room for the market to be surprised in the future. On the other hand, Chart 24 also shows that the premium is still at elevated levels, at least compared to the era prior to Russia's invasion of Crimea. The main question for investors is whether a substantial increase in geopolitical risk could befall Russia over the short and medium term. We doubt it for three reasons: Stalemate in Syria: Russia got what it wanted in Syria. Embattled President Bashar el-Assad has survived, locking in Moscow's influence and allowing Putin to declare victory in late 2017.7 The Kremlin has already recalled most of its ground troops to Russia and has shied away from conflict with the U.S. since then.8 For example, when nine Russian mercenaries died in an attack against a U.S.-controlled base in Syria, the Russian government did not so much as protest.9 Stalemate in Ukraine: We controversially suggested in 2015 that the primary reason for Russia's intervention in Syria was to distract Putin's fired-up domestic constituency from the failures of Moscow's policy in Ukraine.10 The battle to carve out a substantive portion of Eastern Ukraine, where Russian speakers live, failed miserably. Out of the 13% of Ukrainian territory encompassing the Oblasts of Kharkiv, Luhansk, and Donetsk, Moscow-backed rebels stalled after conquering approximately 20% -- or in other words only 3% of Ukrainian territory as a whole (Map 1).11 What Else Is Left? Russia has shied away from directly confronting NATO member states. As such, Putin is unlikely to do anything in the Baltics and Scandinavia, two regions where NATO and Russia have recently arrayed forces against one another. There is always potential for Moscow to reignite conflict in the Caucasus, but it is unlikely that the market would care (they did not in 2008!). We therefore take a different view of Putin's latest aggressive military rhetoric. By stating that Russia no longer fears the U.S. ballistic missile defense system in Europe due to technological advancement, Putin is giving himself the maneuvering room to stand-down from a constant aggressive military posture. Three other factors suggest that Russia-West tensions have peaked for the current cycle: Energy: The EU is gradually diversifying its natural gas imports away from Russia (Chart 25), but the drop in the Russian share of European gas imports in 2017 is not firmly established. Europe as a whole still depends on Russia for 33% of its natural gas consumption. The threat from U.S. LNG shale imports is a decade-long theme that will only accelerate when Europeans commit to building more import terminals (like the new one in Lithuania). Moscow is not sitting still but has begun to counter this threat by becoming a far more compliant partner to the Europeans. It has even adopted the EU Commission's regulatory framework, which it had roundly rejected seven years ago. As the U.S. threat grows over the next decade, Russia will have to compete with Americans on more than just price. It will have to show Europe that it is a reliable geopolitical partner as well. As much as Europe relies on Russian natural gas exports, Moscow relies twice as much on European natural gas imports (Chart 26).     Putin's confidence: President Putin remains popular, with popular approval at 81%. His government has begun to lose support, however, with the spread between his approval and his government's approval widening to 39%, one of its highest levels. Given that Russia's president is largely in charge of foreign policy, the spread suggests that the population is largely content with the current geopolitical situation, but that the risks to Putin and his regime are domestic in nature. Given that Putin is a student of Russian history, he will remember that foreign adventures have collapsed almost every Russian regime over the past two centuries!12 Oil Prices: As we have repeatedly shown, low oil prices are a limiting factor to oil producers' ability to wage war (Chart 27). Political science research shows that the relationship is not spurious. Chart 28 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.13 While oil prices have recovered from their doldrums from two years ago, they are still a far cry from where they stood just before the invasions of Georgia and Ukraine. Bottom Line: Over the past decade, we have argued that Russia is aggressive not because it is playing offense but because it is playing defense. The military actions that Russia has taken since 2008 - Georgia, Ukraine, and Syria - have all focused on preserving its sphere of influence. With this sphere now largely secure - and with both Europe and the U.S. begrudgingly accepting Moscow's sphere - the probability of renewed conflict is likely overstated. Putin, Act IV Broadly, there are three different paths that Putin could take over the next six years, his fourth term in office. We review them below and give our subjective probabilities for them occurring: Détente with the West and liberalization - probability 5%. The only reason we consider this scenario an option is that the EU is gradually moving toward easing sanctions and increasing investment, while the U.S. Trump administration at least has the intention of improving ties with Putin, albeit mostly blocked by Congress. The risk remains that if Democrats take over the U.S. House of Representatives, meaningful new sanctions could be imposed on Russia. A new overseas military adventure - probability 20%. Moscow has proven to be unpredictable in the past. But while there is every reason to expect that Russia will maintain its standoff with the West, nevertheless relations are already at an extremely low level.14 Yes, Western governments will be on guard against Russian meddling in internal affairs. But the Kremlin has little interest in undermining the Trump administration, or Germany's Social Democratic Party, or Italy's Forza Italia.15 Some domestic reform while maintaining Far East strategy - probability 75%. This scenario consists of Putin attempting to augment the status quo with some substantive reforms and fiscal spending at home. At the same time, Moscow would continue to court East Asian trade and investment.16 Some normalization with the West may occur incidentally, but not as a condition of this scenario. Why do we assign such high probability to the domestic reform outlook? Credible opinion polling shows a clear majority demanding reform, with 83% of Russians wanting "change." The share of this group who want "decisive" change is slightly greater than those who want merely "incremental" change (Chart 29). This will motivate political leaders to push forward a reform agenda that increases popular support. The pressure for change is also clear in the aforementioned quality of life issues affecting the middle class, and the fact that the share of the population spending more than $20 per day has stopped growing in Russia (Chart 30). The middle class will increasingly have its ambitions frustrated if living standards are not improved. Recent elections already show worrisome trends for the regime, even within the rigged electoral system.17   What kind of change do the Russian people want? Primarily, more social spending. When asked what kind of change voters would like to see, living standards and social protections come first, and "great power status" comes dead last (Chart 31).18 Specifically, Russians want improved medical services, lower inflation, and better education, agriculture, and housing and utilities - not better relations with the West, fairer elections, free markets, or democratic rights (Chart 32). Russians do not want painful cuts in entitlements, partial privatization of public services, or a higher retirement age (Chart 33). And there is no fiscal need for these.   The Kremlin is already responding to the demand for more spending. The most intriguing part of Putin's State of the Nation speech was his emphasis on the need to reduce poverty, improve social wellbeing, and speed up economic development (Table 1). Table 1Putin's State Of The Nation Address Putin also claimed in the State of Nation address that the upcoming reforms would require "hard decisions" to be made. It seems he is willing to impose painful economic changes.19 Bottom Line: If we are right that Putin's conquests are largely finished, then he must decide whether to focus narrowly on preserving his regime, or on broadening its support for the future. Since Putin can easily rule for longer than his upcoming six-year term,20 it is too soon to expect him to pursue a retirement strategy that sidesteps the need for significant social improvement. Instead he will try to improve regime support through economic reforms. Investment Implications First, a short word on OPEC 2.0 production cuts.21 Russia is less leveraged to oil than in the past (due to its aforementioned ability to devalue the ruble and its tight budget controls). Hence it is less committed to the cartel than Saudi Arabia, and more concerned that this year's buoyant oil price outlook could challenge the new fiscal rule (which mediates oil pass-through to the ruble) and encourage U.S. shale production. So Russia's OPEC 2.0 compliance in 2019 and beyond is murky. Lower oil prices incentivize Russia's economic rebalance and further constrain its military adventurism, but too low will reduce the fiscal resources for its reforms. What about the implications for Russian financial assets? On the tactical level, Russian stocks should see some volatility. Looking at recent Russian history, the events that caused the biggest sell-offs in the succeeding 90 days were presidential elections and the devaluation of the ruble in 1998. Yet the biggest rallies occurred when Putin consolidated power over political enemies and when events suggested substantial reforms were on the way. While we cannot rule out another post-election correction if oil and EM risk assets sell off, we would expect the market to rally eventually as Putin's new policy trajectory becomes clear. On the strategic level, Russian stocks are making a major bottom formation relative to the EM benchmark and will outperform the EM equity benchmark in the coming years (Chart 34). Both BCA's Geopolitical Strategy and Emerging Markets Strategy recommend an overweight position. While the Russian bourse has historically tended to outperform the EM index during risk-on phases and underperformed in risk-off episodes, this has changed as a result of prudent macroeconomic policymaking. Namely, the decreased macroeconomic linkage between fluctuations in oil prices with the ruble and domestic interest rates. Consequently, we expect Russia to outperform in an EM risk-off phase. Another point that increases our level of conviction on overweighting Russia is that U.S. energy stocks relative to the S&P are currently at the bottom of a 60 year trend, perhaps marking an end to the structural underperformance of energy stocks (Chart 34, bottom panel). Emerging Markets Strategy recommends investors continue overweighting Russian sovereign and corporate credit within the EM credit universe, and maintain the following trades: Long Russian stocks and ruble / short Malaysian stocks an ringgit trades Long ruble / Short oil Within EM domestic bonds portfolios, Emerging Markets Strategy also recommends continuing to overweight Russian local currency bonds. Both Geopolitical Strategy and Emerging Markets Strategy recommend the following new trade: Long Russian / short Brazilian local currency government bonds. The public debt-to-GDP ratio in Brazil is 80% while it is only 16% in Russia. The fiscal deficit in Brazil stands at a large 8% of GDP, and interest payments on public debt are equal to 6 % of GDP. Meaning that without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. And public opinion is not favoring pro-market reformers. Adjusted for their respective cyclical, macro policies, currency and interest rate trends, Russian bonds offer better value than Brazilian ones and the best within the EM universe. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 See Sergey Aleksashenko, "The Russian Economy in 2050: Heading for Labor-Based Stagnation," Brookings, April 12, 2015, available at www.brookings.edu. 2 For instance, it is well known that corruption in the construction industry results in embezzlement and poor results in public infrastructure. If this is the case for roads, then it is all the more likely to be a problem with public administration and the judiciary, as more spending certainly does not mean more fairness and justice! 3 Federal Anti-Monopoly Service. Please see David Szakonyi, "Governing Business: The State and Business in Russia," Russian Political Economy Project, Foreign Policy Research Institute, January 2018, available at www.fpri.org. 4 Sarah Wilson Sokhey, "Buying Support? Putin's Popularity and the Russian Welfare State," Russian Political Economy Project, Foreign Policy Research Institute, February 2018, available at www.fpri.org. 5 Please see Geesen, Misha, The New Yorker, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War," dated March 2, 2018, available at www.newyorker.com. 6 We rarely put much stock in quantitative measures of geopolitical risk. However, the parsimony and track record of our Russian geopolitical risk indicator makes it a valuable tool. The Geopolitical Risk Premium is calculated based on USD/NOK exchange rate, Russia's CPI relative to the U.S.'s CPI, and a time trend. We chose Norway because it is a "riskless" oil producer. The USD/RUB exchange rate was adjusted according to the relative inflation in the U.S. and Russia. The deviation from the fair value after taking into account these factors is the risk premium. 7 Please see Nathan Hodge, "Putin Declares Victory In Surprise Stopover In Syria," dated December 11, 2017, available at www.wsj.com. 8 The most recent deployment of Russia's stealth air superiority fighter - the Sukhoi Su-57 - appears designed to give the newly built jet some time in combat zone and is not an escalation. 9 Although Russian media is replete with rumors that several hundreds of Russians died in the attack, the Kremlin's official line is that only nine Russian nationals died in the attack. Please see, Christoph Reuter, "The Truth About The Russian Deaths In Syria," Der Spiegel, dated March 2, 2018, available at www.spiegel.de. 10 Please see, BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 11 A quick note on our map: we include Kharkiv in our definition of Donbass. Most international observers do not, as there was no pro-Russian revolt in the Oblast. However, this is a heuristic error given that the majority Russian speaking population of Kharkiv made it a prime region for revolt against Kiev. That it did not revolt illustrates the limits of Russian capabilities and the paucity of its strategic effort in East Ukraine. Our estimate of 3% of Ukrainian territory is consistent with other estimates, for instance the 2.5% cited in Carl Bildt, "Is Peace In Donbas Possible?" European Council On Foreign Relations, dated October 12, 2017, available at www.ecfr.eu. 12 The idea that the Russian populace gives its leaders a blank check to pursue aggressive foreign policy is not rooted in historical evidence. In fact, Russia has a very spotty history when it comes to the popular backing of failed military campaigns: the Crimean War in the mid-nineteenth century, the 1904-1905 Russo-Japanese War, the First World War in 1917, Afghanistan in the 1980s, and the First Chechen War in the early 1990s. Each of these military losses and dragged-out campaigns led to popular backlash and domestic political crises (in some cases outright revolutions!), especially when complemented with economic pain. Putin is an astute reader of history and therefore we doubt he will commit himself to another lengthy military campaign. 13 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 14 The United States has (for now) backed away from considering imposing sanctions on the purchase of Russian sovereign debt; U.S. Treasury Secretary Steve Mnuchin issued a report against this possibility. So far U.S. sanctions have focused on limiting U.S. financing for Russian state-owned enterprises and energy and financial sectors more broadly. 15 The German Foreign Minister Sigmar Gabriel, a top leader in the SDP, is leaning on the new Grand Coalition to discuss an easing of Russian sanctions contingent on a UN peacekeeping role in Ukraine. 16 China's economy is a key support, but Xi wants to change that economy in a way that is broadly negative for Russia. And the Belt and Road Initiative is not enough for Russia's needs. Russia will thus look not only to China but to all of East Asia for markets and investment. Thus China's reform intensity, and Russo-Japanese peace negotiations, are our bellwethers for Russia's Far East and broader export success. 17 The ruling United Russia performed poorly in the 2012 elections, and fell from 83% to 79% of seats in regional elections last September. That same month, the Moscow municipal elections shocked the ruling elite due to extremely low voter turnout of 15%. Last year, anti-corruption activist and opposition leader Alexei Navalny ignited a surprising countrywide political network during his failed bid to become a presidential contender. And even Communist Party candidate Pavel Grudinin's presidential campaign reflects a yearning for change. We would not be surprised to see striking personnel reshuffles, such as the replacement of Prime Minister Dmitri Medvedev with a new "fresh faced" reformer. 18 Given this sentiment at home, Russian policymakers are unlikely to have missed the significance of the recent events in Iran, in which such sentiments helped mobilize significant anti-regime protests. 19 Examples of difficult policies in Putin's speech include: improving tax enforcement and increasing income tax rate; cutting spending to afford investments in human capital, cutting law enforcement spending and the audit office (no cuts to defense spending were on the menu); reducing the size of the state sector; selling off assets and privatizing the banking sector; keeping inflation in check (this is popular, but requires persistently hawkish monetary policy). 20 Article 81.3 of the Russian constitution can be amended fairly easily to allow Putin additional terms in office beyond 2024. 21 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices," dated February 22, 2018, available at ces.bcaresearch.com.

Special Report

Highlights Russian equities are among the cheapest emerging markets, and among the cheapest in the world - a re-rating could be epic; Weak growth potential and poor governance present tremendous challenges; Yet macro fundamentals are sound and economic policy is orthodox - Russia should behave as a low-beta EM market going forward; The government is highly likely to build on recent micro-level improvements with reforms to improve human capital and infrastructure; Vladimir Putin's military adventurism has stalled, reducing geopolitical risk from high levels; Continue to overweight Russian assets within EM portfolios; go long Russian / short Brazilian local currency government bonds. Feature Russia has one of the cheapest equity markets in EM and in the world. With conflict in Ukraine frozen, a stalemate in Syria, and domestic politics stable (if not inspiring), could the country be on the verge of an epic re-rating? To answer this question, investors have to first understand why Russia is cheap. Shockingly, geopolitical adventures and the 2014 collapse in oil prices have nothing to do with the bargain prices! Russian P/E plummeted in 2011 because investors realized that President Vladimir Putin was here to stay for potentially another two decades (Chart 1). And that signaled that weak governance and an atrocious record on attracting foreign investment would persist for the long term. And yet, Russian equity outperformance amidst the most recent global volatility rout serves as an indication that Russian equities have the capacity to outperform (Chart 2). Is this a fluke, or the start of something more long-term? Chart 1Russian Equities Are Cheap Chart 2Russia Outperformed In ##br##High Vol Environment This ... Is ... Sparta! Russia faces extreme challenges as a nation. It is an austere, isolated, and militaristic society - a modern-day Sparta compared to the West's Athens. Its few competitive wares are wheat, hydrocarbons, and guns. Its lack of openness toward immigration, foreign trade, services, technology, and human development tend to limit its productivity. To assess Russia's long-term economic potential, we should begin with the bad news. First, Russia has a disastrous population profile. Both labor force growth and the working age population are shrinking (Chart 3). The dependency ratio is high and rising at 45%. Though the fertility rate has notably perked up, it remains far below the replacement rate of 2.1 (Chart 4). Even given the current population, there is limited room to increase the labor participation rate, as it is already higher than in the U.S. and is not rising anymore. Chart 3Russia Loses Workers Chart 4Russian Fertility Beneath Replacement Rate Second, immigration is in decline. Most immigrants come from the Russian commonwealth, but in net terms, immigration has been drifting away since the global financial crisis, even more rapidly since the 2014 oil shock (Chart 5). Russia is rife with xenophobia and anti-immigrant politics. Even if policy were to become more inviting, the Russian-speaking sources of immigration are also seeing weak working-age population growth. And Russia is unlikely ever to become an all-weather migrant country (Chart 6).1 Chart 5Immigrants Not Welcome Chart 6Slow Growth In Immigration Sources Third, labor productivity growth has only just begun to recover and is weaker than in the past. Russia has fallen behind its emerging European neighbors (Chart 7). The same can be said for total factor productivity growth, which is a very important indicator for economies that want to modernize - it currently stands at zero. Fourth, Russia suffers from chronically weak institutions and poor governance: Inequality is high and rising (Chart 8). Chart 7Russian Productivity Has Fallen Chart 8Inequality Is On The Rise... Governance indicators are deeply negative - worse than China's (Chart 9). Corruption is rampant - Russia ranks 135 out of 180 countries on the Corruption Perceptions Index, only very slightly improving since 2014. Corruption reduces economic efficiency and the effectiveness of public investments.2 For instance, despite the rise in spending on the judicial system in Russia, "rule of law" has declined, according to the World Bank's Worldwide Governance Indicators (Chart 9, bottom panel). Nationalization remains the government's modus operandi. Not only have privatization schemes failed, but new nationalizations have continued to occur - namely the electricity sector and most recently the banks (see Chart 14 below). State ownership has risen from 30% of GDP in 2000 to 70% today.3 Fifth, Russia's self-inflicted standoff with the western world has resulted in a closed economy that misses out on the benefits of human capital, technology transfer, and trade. The country's international competitiveness is clearly suffering: Russian exports have lost market share in the world and in the EU. Even in Eastern Europe and Central Asia, two areas where Russia has the biggest advantages and lacks geopolitical constraints, Russian exports have been lackluster. Crucially, Russia is gaining market share in East Asia, though even here with difficulty (Chart 10). Leaving aside commodities, Russia has failed to develop a competitive manufacturing sector. Chart 9...And Governance Is Poor Char 10Lack Of Export Competitiveness Sixth, Russia's government spending priorities are heavily focused on national security and thus constrained from promoting economic productivity and improving governance. Total spending on national defense, state security, and diplomacy has risen to 6.4% of GDP and 31.7% of the government budget. This is twice as much as the U.S. and China at 3.2% and 2.8% of GDP, respectively. By contrast, total spending on social policy is 5.5% of GDP and 29% of the budget. Spending on education and healthcare, at 0.7% and 0.5% of GDP respectively, is well below European, American, and Chinese levels, and it has hardly increased as a share of government spending in recent years. Basic and applied research spending is tiny and falling. So far the most significant investments in social wellbeing have been limited to pensions. Yet it is a well-attested fact that increases to state pensions precede elections, as pensioners are a key political constituency for the ruling United Russia party. The spending tends to be fleeting and does not enhance productivity.4 Cutting military spending would give Russia more fiscal resources to address badly needed economic weaknesses. But it is not on the horizon, so economic reforms will face budgetary constraints. Bottom Line: Russia's long-term potential is stunted by population shrinkage, slow productivity growth, lack of openness and competitiveness, lack of diversification and complexity, weak institutions, and poor governance. Some Good News: Orthodox Macroeconomic Policy Now for the good news: Russia's economy has stabilized and its macroeconomic policy backdrop is sound and orthodox, especially relative to emerging markets. First and foremost, fiscal and monetary policies have become less pro-cyclical. This will reduce volatility in the real economy and ensure that the current cyclical recovery is sustainable (Chart 11). Fiscal policy has been tight and conservative. In fact, the government has only slightly let nominal expenditures grow since the oil crash, while spending has fallen considerably in real terms (Chart 12). Chart 11Russia Is Undergoing A Cyclical Recovery Chart 12Russia: Orthodox Fiscal Policy Consequently, the fiscal deficit has significantly narrowed. The conservative budget assumption of $40/bbl oil is still being upheld (Chart 12, bottom panel). Moreover, the new fiscal rule implemented by the Ministry of Finance last year has allowed Russia to rebuild its FX reserves (Chart 13). The rule stipulates that the Ministry of Finance will buy foreign currency when the price of oil rises above the set target level of 2,700 RUB per barrel (i.e. $40/bbl times 67 USD/RUB exchange rate), and sell foreign exchange when the oil price falls below that level. The objective is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Lastly, the public debt-to-GDP ratio is a mere 16% in Russia. On the monetary policy side, the Central Bank of Russia has been highly orthodox. Unlike many other EM central banks, it has refrained from injecting excess liquidity into the banking system and has maintained high real interest rates (Chart 13, bottom panels). All in all, Russia is much more advanced in its macroeconomic adjustment phase than other emerging markets: Commercial banks have been increasing provisions, even though the NPL ratio has begun to fall (Chart 14). Furthermore, the central bank has been reducing the number of dysfunctional banks by removing their licenses (Chart 14, bottom panel). Chart 13Russia: Orthodox Monetary Policy Chart 14Russian Banking Sector Underwent A Clean-Up Russia is further along in its deleveraging cycle than other EMs. Having gone through the pain of a massive currency devaluation followed by substantial increases in interest rates and bank restructuring, Russia can begin to re-leverage, which will be positive for consumption and investment. In fact, re-leveraging is already underway. Bank loans are expanding after a pronounced contraction. The credit impulse - i.e. the change in bank loan growth - continues to recover (Chart 15, top panel). Importantly, debt has room to grow, especially in the consumer sector where debt levels are low (Chart 15, bottom panel). Capital spending, which had collapsed both in absolute terms and relative to GDP, has started to recover. It is supported by a recovery in broad money supply (Chart 16). Starting from an extremely under-invested position, the recovery warrants major upside in investment outlays. Chart 15Russia: Re-leveraging ##br##Has Room To Continue Chart 16Russia: Capital Expenditures ##br##Will Rise From Low Level Exposure to external risks is limited: External debt across private and public sectors remains extremely low, limiting the impact of potential foreign currency sell-offs (Chart 17). Russia's foreign funding requirement - calculated by subtracting the current account balance from external debt servicing over the next 12 months - is the second-lowest in emerging markets after Thailand, making Russia's balance-of-payments position one of the least vulnerable in the EM universe. Furthermore, Russia is making clear improvements despite the dismal trends outlined above. On the margin these improvements could raise the country's long-term growth prospects: On the external side, the composition of exports is shifting away from commodity exports (Chart 18). Although commodity exports still account for the large majority of the export pool at 81%, a gradual shift towards other sectors will allow the economy to diversify its sources of revenue and employment. The allocation of government expenditures has marginally shifted towards addressing some of Russia's long-standing structural problems. Spending on infrastructure (transport and roads) has climbed steadily (Chart 19). This is critical as the road system in Russia is significantly underinvested and is a medium through which productivity can be efficiently increased. Chart 17Russia: External Debt Has Fallen And Is Low Chart 18Russia: Export Composition Is Improving In the private sector, employment for small and medium-sized enterprises (SMEs) has been rising (Chart 20). Importantly, this is happening in the peripheral districts as well as the economically more vibrant central federal district. Policy is becoming more supportive of SMEs, for instance via tax holidays. Allowing SMEs to gain a bigger share of the economy will hold the key to creating an environment where innovation and business confidence can start improving Russia's productivity prospects. Chart 19Russia: Road And Transport ##br##Expenditures Are Rising Chart 20Russia: SME Employment Is Rising Interestingly, the number of privately owned businesses being created is rising relative to the number of state-owned businesses. In addition, more state-owned businesses are being liquidated relative to privately owned ones (Chart 21), suggesting a willingness to accommodate "creative destruction." The "Ease of Doing Business" has improved markedly under administrative reforms, easier land registration, and improved contract enforcement (Chart 22). "Regulatory quality," "control of corruption," and "absence of violence" are key governance indicators that are directly relevant for the corporate outlook and investors, and these are improving, albeit from a negative level (Chart 23). Chart 21Russia: More Private, Less State-Owned Businesses Chart 22Easier To Do Business In Russia Chart 23Some Slight Governance Improvements In sum, while macro stability has been achieved, Russia needs to expand and sustain recent marginal developments on the micro level in order to improve its long-term economic and investment outlook. Bottom Line: The economy has stabilized and macroeconomic policy is orthodox. Marginal improvements in export composition, government spending allocations, and treatment of the private sector may not turn Russia into a high-productivity country overnight, but they do mark an inflection point that could arrest the downward trend of productivity. This is especially so if private and public initiatives are taken to further these initial developments. More Good News: Foreign Adventurism Has Stalled Russia's geopolitics are also unlikely to worsen from here, at least not in a way that is relevant to investors. President Putin's rhetoric reached peak bluster in his lengthy "State of the Nation" address to the Duma on March 1. Western media took the bait immediately, encapsulated best by The New Yorker headline, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War."5 Should investors dismiss Putin's slick, computer-generated images of Florida getting nuked by multiple warheads? It depends. On one hand, our Russian geopolitical risk indicator suggests that investors have been demanding an ever smaller premium on Russian assets (Chart 24).6 There is, therefore, considerable room for the market to be surprised in the future. On the other hand, Chart 24 also shows that the premium is still at elevated levels, at least compared to the era prior to Russia's invasion of Crimea. Chart 24Geopolitical Risk Is Falling The main question for investors is whether a substantial increase in geopolitical risk could befall Russia over the short and medium term. We doubt it for three reasons: Stalemate in Syria: Russia got what it wanted in Syria. Embattled President Bashar el-Assad has survived, locking in Moscow's influence and allowing Putin to declare victory in late 2017.7 The Kremlin has already recalled most of its ground troops to Russia and has shied away from conflict with the U.S. since then.8 For example, when nine Russian mercenaries died in an attack against a U.S.-controlled base in Syria, the Russian government did not so much as protest.9 Stalemate in Ukraine: We controversially suggested in 2015 that the primary reason for Russia's intervention in Syria was to distract Putin's fired-up domestic constituency from the failures of Moscow's policy in Ukraine.10 The battle to carve out a substantive portion of Eastern Ukraine, where Russian speakers live, failed miserably. Out of the 13% of Ukrainian territory encompassing the Oblasts of Kharkiv, Luhansk, and Donetsk, Moscow-backed rebels stalled after conquering approximately 20% -- or in other words only 3% of Ukrainian territory as a whole (Map 1).11 Map 1Ukraine Is A Stalemate What Else Is Left? Russia has shied away from directly confronting NATO member states. As such, Putin is unlikely to do anything in the Baltics and Scandinavia, two regions where NATO and Russia have recently arrayed forces against one another. There is always potential for Moscow to reignite conflict in the Caucasus, but it is unlikely that the market would care (they did not in 2008!). We therefore take a different view of Putin's latest aggressive military rhetoric. By stating that Russia no longer fears the U.S. ballistic missile defense system in Europe due to technological advancement, Putin is giving himself the maneuvering room to stand-down from a constant aggressive military posture. Three other factors suggest that Russia-West tensions have peaked for the current cycle: Energy: The EU is gradually diversifying its natural gas imports away from Russia (Chart 25), but the drop in the Russian share of European gas imports in 2017 is not firmly established. Europe as a whole still depends on Russia for 33% of its natural gas consumption. The threat from U.S. LNG shale imports is a decade-long theme that will only accelerate when Europeans commit to building more import terminals (like the new one in Lithuania). Moscow is not sitting still but has begun to counter this threat by becoming a far more compliant partner to the Europeans. It has even adopted the EU Commission's regulatory framework, which it had roundly rejected seven years ago. As the U.S. threat grows over the next decade, Russia will have to compete with Americans on more than just price. It will have to show Europe that it is a reliable geopolitical partner as well. As much as Europe relies on Russian natural gas exports, Moscow relies twice as much on European natural gas imports (Chart 26). Chart 25The EU Is Diversifying... Chart 26...But Both Sides Still Need Each Other Putin's confidence: President Putin remains popular, with popular approval at 81%. His government has begun to lose support, however, with the spread between his approval and his government's approval widening to 39%, one of its highest levels. Given that Russia's president is largely in charge of foreign policy, the spread suggests that the population is largely content with the current geopolitical situation, but that the risks to Putin and his regime are domestic in nature. Given that Putin is a student of Russian history, he will remember that foreign adventures have collapsed almost every Russian regime over the past two centuries!12 Oil Prices: As we have repeatedly shown, low oil prices are a limiting factor to oil producers' ability to wage war (Chart 27). Political science research shows that the relationship is not spurious. Chart 28 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.13 While oil prices have recovered from their doldrums from two years ago, they are still a far cry from where they stood just before the invasions of Georgia and Ukraine. Chart 27Low Oil Prices Discourage Oil States From Waging War Chart 28More Oil Revenue = More Aggression Bottom Line: Over the past decade, we have argued that Russia is aggressive not because it is playing offense but because it is playing defense. The military actions that Russia has taken since 2008 - Georgia, Ukraine, and Syria - have all focused on preserving its sphere of influence. With this sphere now largely secure - and with both Europe and the U.S. begrudgingly accepting Moscow's sphere - the probability of renewed conflict is likely overstated. Putin, Act IV Broadly, there are three different paths that Putin could take over the next six years, his fourth term in office. We review them below and give our subjective probabilities for them occurring: Détente with the West and liberalization - probability 5%. The only reason we consider this scenario an option is that the EU is gradually moving toward easing sanctions and increasing investment, while the U.S. Trump administration at least has the intention of improving ties with Putin, albeit mostly blocked by Congress. The risk remains that if Democrats take over the U.S. House of Representatives, meaningful new sanctions could be imposed on Russia. A new overseas military adventure - probability 20%. Moscow has proven to be unpredictable in the past. But while there is every reason to expect that Russia will maintain its standoff with the West, nevertheless relations are already at an extremely low level.14 Yes, Western governments will be on guard against Russian meddling in internal affairs. But the Kremlin has little interest in undermining the Trump administration, or Germany's Social Democratic Party, or Italy's Forza Italia.15 Some domestic reform while maintaining Far East strategy - probability 75%. This scenario consists of Putin attempting to augment the status quo with some substantive reforms and fiscal spending at home. At the same time, Moscow would continue to court East Asian trade and investment.16 Some normalization with the West may occur incidentally, but not as a condition of this scenario. Why do we assign such high probability to the domestic reform outlook? Credible opinion polling shows a clear majority demanding reform, with 83% of Russians wanting "change." The share of this group who want "decisive" change is slightly greater than those who want merely "incremental" change (Chart 29). This will motivate political leaders to push forward a reform agenda that increases popular support. The pressure for change is also clear in the aforementioned quality of life issues affecting the middle class, and the fact that the share of the population spending more than $20 per day has stopped growing in Russia (Chart 30). The middle class will increasingly have its ambitions frustrated if living standards are not improved. Recent elections already show worrisome trends for the regime, even within the rigged electoral system.17 Chart 29Russians Want Change Chart 30A Ceiling On Middle-Class Ambitions What kind of change do the Russian people want? Primarily, more social spending. When asked what kind of change voters would like to see, living standards and social protections come first, and "great power status" comes dead last (Chart 31).18 Specifically, Russians want improved medical services, lower inflation, and better education, agriculture, and housing and utilities - not better relations with the West, fairer elections, free markets, or democratic rights (Chart 32). Russians do not want painful cuts in entitlements, partial privatization of public services, or a higher retirement age (Chart 33). And there is no fiscal need for these. Chart 31Russians Want Social Spending... Chart 32...And Better Quality Of Life Chart 33Russians Oppose Any Cuts In Benefits The Kremlin is already responding to the demand for more spending. The most intriguing part of Putin's State of the Nation speech was his emphasis on the need to reduce poverty, improve social wellbeing, and speed up economic development (Table 1). Table 1Putin's State Of The Nation Address Putin also claimed in the State of Nation address that the upcoming reforms would require "hard decisions" to be made. It seems he is willing to impose painful economic changes.19 Bottom Line: If we are right that Putin's conquests are largely finished, then he must decide whether to focus narrowly on preserving his regime, or on broadening its support for the future. Since Putin can easily rule for longer than his upcoming six-year term,20 it is too soon to expect him to pursue a retirement strategy that sidesteps the need for significant social improvement. Instead he will try to improve regime support through economic reforms. Investment Implications First, a short word on OPEC 2.0 production cuts.21 Russia is less leveraged to oil than in the past (due to its aforementioned ability to devalue the ruble and its tight budget controls). Hence it is less committed to the cartel than Saudi Arabia, and more concerned that this year's buoyant oil price outlook could challenge the new fiscal rule (which mediates oil pass-through to the ruble) and encourage U.S. shale production. So Russia's OPEC 2.0 compliance in 2019 and beyond is murky. Lower oil prices incentivize Russia's economic rebalance and further constrain its military adventurism, but too low will reduce the fiscal resources for its reforms. What about the implications for Russian financial assets? On the tactical level, Russian stocks should see some volatility. Looking at recent Russian history, the events that caused the biggest sell-offs in the succeeding 90 days were presidential elections and the devaluation of the ruble in 1998. Yet the biggest rallies occurred when Putin consolidated power over political enemies and when events suggested substantial reforms were on the way. While we cannot rule out another post-election correction if oil and EM risk assets sell off, we would expect the market to rally eventually as Putin's new policy trajectory becomes clear. On the strategic level, Russian stocks are making a major bottom formation relative to the EM benchmark and will outperform the EM equity benchmark in the coming years (Chart 34). Both BCA's Geopolitical Strategy and Emerging Markets Strategy recommend an overweight position. Chart 34Russian And U.S. Energy ##br##Stocks Are Bottoming While the Russian bourse has historically tended to outperform the EM index during risk-on phases and underperformed in risk-off episodes, this has changed as a result of prudent macroeconomic policymaking. Namely, the decreased macroeconomic linkage between fluctuations in oil prices with the ruble and domestic interest rates. Consequently, we expect Russia to outperform in an EM risk-off phase. Another point that increases our level of conviction on overweighting Russia is that U.S. energy stocks relative to the S&P are currently at the bottom of a 60 year trend, perhaps marking an end to the structural underperformance of energy stocks (Chart 34, bottom panel). Emerging Markets Strategy recommends investors continue overweighting Russian sovereign and corporate credit within the EM credit universe, and maintain the following trades: Long Russian stocks and ruble / short Malaysian stocks an ringgit trades Long ruble / Short oil Within EM domestic bonds portfolios, Emerging Markets Strategy also recommends continuing to overweight Russian local currency bonds. Both Geopolitical Strategy and Emerging Markets Strategy recommend the following new trade: Long Russian / short Brazilian local currency government bonds. The public debt-to-GDP ratio in Brazil is 80% while it is only 16% in Russia. The fiscal deficit in Brazil stands at a large 8% of GDP, and interest payments on public debt are equal to 6 % of GDP. Meaning that without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. And public opinion is not favoring pro-market reformers. Adjusted for their respective cyclical, macro policies, currency and interest rate trends, Russian bonds offer better value than Brazilian ones and the best within the EM universe. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 See Sergey Aleksashenko, "The Russian Economy in 2050: Heading for Labor-Based Stagnation," Brookings, April 12, 2015, available at www.brookings.edu. 2 For instance, it is well known that corruption in the construction industry results in embezzlement and poor results in public infrastructure. If this is the case for roads, then it is all the more likely to be a problem with public administration and the judiciary, as more spending certainly does not mean more fairness and justice! 3 Federal Anti-Monopoly Service. Please see David Szakonyi, "Governing Business: The State and Business in Russia," Russian Political Economy Project, Foreign Policy Research Institute, January 2018, available at www.fpri.org. 4 Sarah Wilson Sokhey, "Buying Support? Putin's Popularity and the Russian Welfare State," Russian Political Economy Project, Foreign Policy Research Institute, February 2018, available at www.fpri.org. 5 Please see Geesen, Misha, The New Yorker, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War," dated March 2, 2018, available at www.newyorker.com. 6 We rarely put much stock in quantitative measures of geopolitical risk. However, the parsimony and track record of our Russian geopolitical risk indicator makes it a valuable tool. The Geopolitical Risk Premium is calculated based on USD/NOK exchange rate, Russia's CPI relative to the U.S.'s CPI, and a time trend. We chose Norway because it is a "riskless" oil producer. The USD/RUB exchange rate was adjusted according to the relative inflation in the U.S. and Russia. The deviation from the fair value after taking into account these factors is the risk premium. 7 Please see Nathan Hodge, "Putin Declares Victory In Surprise Stopover In Syria," dated December 11, 2017, available at www.wsj.com. 8 The most recent deployment of Russia's stealth air superiority fighter - the Sukhoi Su-57 - appears designed to give the newly built jet some time in combat zone and is not an escalation. 9 Although Russian media is replete with rumors that several hundreds of Russians died in the attack, the Kremlin's official line is that only nine Russian nationals died in the attack. Please see, Christoph Reuter, "The Truth About The Russian Deaths In Syria," Der Spiegel, dated March 2, 2018, available at www.spiegel.de. 10 Please see, BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 11 A quick note on our map: we include Kharkiv in our definition of Donbass. Most international observers do not, as there was no pro-Russian revolt in the Oblast. However, this is a heuristic error given that the majority Russian speaking population of Kharkiv made it a prime region for revolt against Kiev. That it did not revolt illustrates the limits of Russian capabilities and the paucity of its strategic effort in East Ukraine. Our estimate of 3% of Ukrainian territory is consistent with other estimates, for instance the 2.5% cited in Carl Bildt, "Is Peace In Donbas Possible?" European Council On Foreign Relations, dated October 12, 2017, available at www.ecfr.eu. 12 The idea that the Russian populace gives its leaders a blank check to pursue aggressive foreign policy is not rooted in historical evidence. In fact, Russia has a very spotty history when it comes to the popular backing of failed military campaigns: the Crimean War in the mid-nineteenth century, the 1904-1905 Russo-Japanese War, the First World War in 1917, Afghanistan in the 1980s, and the First Chechen War in the early 1990s. Each of these military losses and dragged-out campaigns led to popular backlash and domestic political crises (in some cases outright revolutions!), especially when complemented with economic pain. Putin is an astute reader of history and therefore we doubt he will commit himself to another lengthy military campaign. 13 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 14 The United States has (for now) backed away from considering imposing sanctions on the purchase of Russian sovereign debt; U.S. Treasury Secretary Steve Mnuchin issued a report against this possibility. So far U.S. sanctions have focused on limiting U.S. financing for Russian state-owned enterprises and energy and financial sectors more broadly. 15 The German Foreign Minister Sigmar Gabriel, a top leader in the SDP, is leaning on the new Grand Coalition to discuss an easing of Russian sanctions contingent on a UN peacekeeping role in Ukraine. 16 China's economy is a key support, but Xi wants to change that economy in a way that is broadly negative for Russia. And the Belt and Road Initiative is not enough for Russia's needs. Russia will thus look not only to China but to all of East Asia for markets and investment. Thus China's reform intensity, and Russo-Japanese peace negotiations, are our bellwethers for Russia's Far East and broader export success. 17 The ruling United Russia performed poorly in the 2012 elections, and fell from 83% to 79% of seats in regional elections last September. That same month, the Moscow municipal elections shocked the ruling elite due to extremely low voter turnout of 15%. Last year, anti-corruption activist and opposition leader Alexei Navalny ignited a surprising countrywide political network during his failed bid to become a presidential contender. And even Communist Party candidate Pavel Grudinin's presidential campaign reflects a yearning for change. We would not be surprised to see striking personnel reshuffles, such as the replacement of Prime Minister Dmitri Medvedev with a new "fresh faced" reformer. 18 Given this sentiment at home, Russian policymakers are unlikely to have missed the significance of the recent events in Iran, in which such sentiments helped mobilize significant anti-regime protests. 19 Examples of difficult policies in Putin's speech include: improving tax enforcement and increasing income tax rate; cutting spending to afford investments in human capital, cutting law enforcement spending and the audit office (no cuts to defense spending were on the menu); reducing the size of the state sector; selling off assets and privatizing the banking sector; keeping inflation in check (this is popular, but requires persistently hawkish monetary policy). 20 Article 81.3 of the Russian constitution can be amended fairly easily to allow Putin additional terms in office beyond 2024. 21 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices," dated February 22, 2018, available at ces.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights This past week, oil ministers from the Kingdom of Saudi Arabia (KSA) and Russia - OPEC 2.0's putative leaders - separately indicated increased comfort with higher prices over the next year or so.1 This suggests they are converging on a common production-management strategy, which accommodates KSA's need for higher prices over the short term to support the IPO of Saudi Aramco, and Russia's longer term desire to avoid reaching price levels where U.S. shale-oil production is massively incentivized to expand. We believe OPEC 2.0's production cuts will be extended to year-end, given signaling by Khalid Al-Falih, KSA's energy minister. As a result, we expect Brent and WTI crude oil prices to average $74 and $70/bbl this year, respectively (Chart Of The Week). These expectations are up from our previous estimates of $67 and $63/bbl, which were premised on curtailed production slowly being returned to market beginning in July. For next year, the extended cuts could lift Brent and WTI to $67 and $64/bbl, up from our previous expectations of $55 and $53/bbl, respectively. Extending OPEC 2.0's production cuts will accelerate OECD inventory draws, which have been faster than expected. Higher prices caused by maintaining the cuts will lift U.S. shale production more than our earlier estimates. Backwardations in both Brent and WTI forward curves will remain steep in this regime, muting the impact of Fed policy on oil prices. Energy: Overweight. We are getting long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls on the back of our updated price forecast. We also are taking profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, which were up 27.4% as of Tuesday's close. Base Metals: Neutral. The U.S. Commerce Department proposed "Section 232" tariffs and quotas on U.S. aluminum and steel imports, following national security reviews. President Trump has until mid-April to respond, and we expect him to go through with one of the three proposed options. Precious Metals: Gold remains range-bound around $1,350/oz, as markets wrestle with the likely evolution of the Fed's rate-hiking regimen. Ags/Softs: Underweight. USDA economists project grain and soybean prices to slowly rise over the next 10 years, according to agriculture.com. Feature Chart Of The WeekBCA Lifts Oil Price Forecasts Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with maintaining OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year, and possibly next. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0's leaders that the world economy can absorb higher prices without damaging demand over the short term is not clear. Markets have yet to receive what we could consider definitive forward guidance from OPEC 2.0 leadership, indicating that recent signaling could be foreshadowing the coalition's new policy. We are raising the odds that it is, and are moving our Brent and WTI forecasts higher for this year and next. Lifting 2018 Brent, WTI Forecasts To $74 And $70/bbl Maintaining OPEC 2.0's production cuts to end-2018 will lift average Brent and WTI crude oil prices to $74 and $70/bbl, respectively, this year, based on our updated supply-demand balances modeling (Chart Of The Week). This is not definitive OPEC 2.0 policy guidance: KSA's and Russia's oil ministers indicated they expect such an outcome in separate statements, and not, as has been the case with previous announcements, at a joint press conference.2 We are assuming the odds strongly favor such an outcome, and give an 80% weight to it. The remaining 20% reflects our previous expectation that OPEC 2.0's production cuts would cease at end-June, and curtailed volumes would slowly be restored over 2H18. Resolving this in favor of the former expectation would lift our price expectations to $76 and $73/bbl for Brent and WTI this year, and $70 and $68/bbl next year. These expectations are up from our previous estimates of $67 and $63/bbl for Brent and WTI prices this year, which were premised on curtailed OPEC 2.0 production slowly returning to market beginning in July, and a subsequent OECD inventory rebuilding. By maintaining production cuts to year-end, supply-demand balances remain tighter, which keeps inventories drawing for a longer period of time (Chart 2). Higher inventories would have increased the sensitivity of oil prices to the USD, which we showed in research on February 8th 2018. With OPEC 2.0's production cuts maintained throughout the year, OECD inventories will be more depleted by year-end (Chart 3). Extending OPEC 2.0's production cuts to end-2018 would result in an additional 130mm bbls reduction to OECD inventories versus our prior modeling. This means Brent and WTI forward curves will be more backwardated than they would have been had the barrels taken off the market at the beginning of 2017 been slowly restored starting in July of this year, as we earlier expected. Chart 2Fundamental Balances Remain In Deficit Longer Chart 3Maintaining Production Cuts Depletes Inventories Even More A steeper backwardation in oil forward curves - i.e., the front of the curve trades premium to the deferred contracts - reduces the USD effects on oil, all else equal. In other words, supply-demand fundamentals dominate the evolution of oil prices when forward curves are more backwardated, and the influence of financial variables -the USD in particular - is muted.3 For next year, we assume the volumes cut by OPEC 2.0 are slowly restored to the market over 1H19, lifting Brent and WTI to $67 and $64/bbl on average, up from our previous expectations of $55 and $53/bbl, respectively.4 Higher Shale Output, Strong Global Demand We expect U.S. shale production increases by 1.15mm b/d from December 2017 to December 2018, and another 1.3-1.4mm b/d during calendar 2019. This dominates non-OPEC production growth this year and next (Chart 4, top panel). Due to the supply response of the shales to higher prices in 2018, global production levels would see a net increase from March 2019 and beyond. Our assumption OPEC 2.0 production cuts will be maintained through 2018 puts our OPEC production assessment 0.14mm b/d below U.S. EIA's estimates (Chart 4, bottom panel). On the demand side, we continue to expect non-OECD (EM) growth to push global oil consumption up by 1.7mm b/d this year and 1.6mm b/d next year, respectively (Chart 5). Non-OECD demand is expected to account for 1.24mm b/d and 1.21mm b/d of this growth in 2018 and 2019, respectively (Table 1). Chart 4U.S. Shales Dominate Non-OPEC Supply Growth Chart 5Non-OECD Demand Growth Continues Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Aramco IPO Driving OPEC 2.0's Short-Term Agenda In previous research, we noted what appeared to be a relatively minor divergence between the goals of KSA and Russia when it comes to the level prices each would prefer over the short term. Recent press reports - unattributed, of course - suggest Saudi Aramco officials prefer a Brent price closer to $70/bbl further along the forward curve (two years out) to support their upcoming IPO.5 This obviously would bolster Aramco's oil-export revenues - some 7mm b/d of its 10mm b/d of production are exported - and income, which shareholders would welcome. However, until this past week, Russia's energy minister, Alexander Novak, was signaling a range of $50 to $60/bbl works better for his constituents, i.e., shareholder-owned Russian oil companies. Novak recently amended his range to $50 to $70/bbl for Brent.6 These positions are not irreconcilable. One is shorter term (2 years forward) and the other is longer term, attempting to balance competitive threats over a longer horizon - e.g., from U.S. shale-oil producers, electric vehicles, etc. This most recent indication the leadership of OPEC 2.0 is comfortable with higher prices over the short term is an indication - at least to us - that these issues are being dealt with in a way that allows markets to incorporate forward guidance into pricing of crude oil over the next two years. Beyond that, however, markets will need to hear an articulated strategy containing a post-Aramco IPO view of the world, so that capital can be efficiently allocated. KSA and Russia are in a global competition for foreign direct investment (FDI), and having a fully articulated strategy re how they will manage their production in fast-changing markets - where, for example, shale-oil approaches becoming a "just-in-time" supply option - will be critical. Signing a formal alliance by year-end would support this, but that, too, will require a level of cooperation that runs deeper than what OPEC 2.0 has so far demonstrated, impressive though it may be. Bottom Line: OPEC 2.0 leadership is signalling production cuts will be maintained for the entire year, not, as we expected, left to expire at end-June with curtailed barrels slowly returned to the market over 2H18. While this does not appear to be official policy of the producer coalition yet, we are revising our price expectations in line with tighter markets this year, lower OECD inventories and continued backwardation in Brent and WTI forward curves. OPEC 2.0's shorter-term agenda, driven by KSA's IPO of Saudi Aramco, and its longer-term agenda - maintaining oil's competitive edge and accommodating U.S. shale-oil production (but not too much) - appear to be getting reconciled. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com  1 OPEC 2.0 is the name we coined for OPEC/non-OPEC coalition led by KSA and Russia, has removed some 1.4 to 1.5mm b/d of oil production from the market beginning in 2017. 2 Please see, "Brent crude settles flat, U.S. oil up on short covering," published by reuters.com on February 15th 2018, in which KSA's oil minister Khalid Al-Falih indicated OPEC would maintain production cuts throughout 2018. See also, "On the air of the TV channel 'Russia 24' Alexander Novak summed up the participation in the work of the Russian investment forum 'Sochi-2018,'" published by Ministry of Energy of the Russian Federation on February 15th 2018. Lastly, please see "Saudi Arabia Is Taking a Harder Line on Oil Prices," published by bloomberg.com on February 19th 2018. 3 We discuss this in "OPEC 2.0 vs. The Fed," which was published on February 8th 2018 by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4 These expectations are highly conditional. Toward the end of this year, KSA and Russia are indicating the OPEC 2.0 coalition will become a more formal organization, with members signing a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "Oil producers to draft long-term alliance deal by end-2018: UAE minister," published by reuters.com on February 15th 2018. 5 Please see "For timing of Aramco IPO, watch forward oil price curve," published by reuters.com on February 19th 2018. 6 Please see reference in footnote 3 and "Russia's Novak says current oil price is acceptable," published by reuters.com on February 15th 2018. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2018 Summary Of Trades Closed In 2017

Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Chart I-7Slowdown In ##br##China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Slower global demand growth, coupled with surging production from the U.S. shales and higher OPEC 2.0 production, risks reversing the progress made in draining global commercial oil storage and tanking prices in 2019.1 Our updated balances modelling is in agreement with the backwardation in forward Brent and WTI curves, but, if anything, indicates the backwardation should be more pronounced: We are forecasting Brent and WTI prices next year will average $55 and $53/bbl, respectively, vs. $62.80/bbl and $57.40/bbl average prices for 2019's forward curves. For 2018, we are maintaining our $67 and $63/bbl expectation for Brent and WTI, although our modelling indicates higher prices are a distinct possibility, given our fundamental assumptions of falling supply and rising demand this year (Chart of the Week). Energy: Overweight. We liquidated our May and July Brent and WTI $55 vs. $60/bbl call spreads last week with gains of 110.1% and 129.0%. We will be liquidating our Dec/18 Brent and WTI $55 vs. $60/bbl call spreads at tonight's close; they were up 62.3% and 82.1% as of Tuesday. We remain long Jul/18 vs. Dec/18 WTI (up 47.4%), and long the S&P GSCI (up 8.5%), expecting backwardation. We will get long $55 Brent Puts vs. short $50 Brent Puts in 4Q19 at tonight's close. Base Metals: Neutral. We continue to expect base metals to remain well supported in 1H18 by environmental reforms in China, and supply uncertainty around contract renegotiations at the copper mines. The global expansion underpinning demand will compensate for slower Chinese growth in 2H18. Precious Metals: Neutral. Our long gold portfolio hedge is up 8.5% since inception in May/17. Ags/Softs: Underweight. Soybean markets rallied following last week's USDA WASDE report, but grains fell amid data indicating these markets will remain oversupplied. Feature If there is one truth in commodity markets it is this: The best cure for high prices is high prices, and vice versa. This is being dramatically demonstrated by OPEC 2.0 in its collective action to remove 1.8mm b/d of production from the market following disastrously low prices in 2015 - 16. Higher prices in 4Q17 and 1H18 oil futures are incentivizing a surge in U.S. shale output, and will give OPEC 2.0 comfort in slowly feeding output taken offline at the beginning of 2017 back into the market in 2H18 and 2019 (Chart 2). Higher prices and tightening monetary conditions globally will slow the rate of growth in demand next year (Chart 3). Chart of the WeekFundamentals##BR##Support Oil In 2018 Chart 2Non-OPEC Production##BR##Will Surge Chart 3Strong Consumption Growth In 2018,##BR##Tempered By Higher Prices In 2019 Given these fundamental inputs, we expect to see Brent averaging $55/bbl next year, and WTI averaging $53/bbl next year. Our forecast is highly uncertain, given the actual evolution of prices will, once again, depend on actions taken by OPEC 2.0 and the forward guidance provided by its leadership, KSA and Russia. Our forecast for 2018 - $67/bbl for Brent and $63/bbl for WTI - remains unchanged. If anything, our unconstrained models (Chart of the Week) have more upside risk than our forecast suggests, largely from falling production and surging demand - not to mention unplanned production outages. Looking to the end of 2019 from today, the backwardation we expect is greater than what is being priced into the Brent and WTI forward curves presently. Growth In U.S. Shales Dominates Non-OPEC Gains We are expecting U.S. crude oil production growth will dominate the increase in non-OPEC output in 2018 and 2019 (Chart 2, top panel). U.S. shale-oil output rises by 970k b/d and another 1.18mm b/d, respectively, this year and in 2019. By our reckoning, this will lift total U.S. crude oil production to 10.22mm b/d this year, a record level of output, and to 11.44mm b/d on average next year. Total U.S. crude and liquids output therefore rises from just under 17mm b/d in 2018 to 18.5mm b/d by the end of 2019. If our estimates are correct, the U.S. will join Russia in producing more than 11mm b/d of crude oil next year, and may even exceed it. Russia is expected to raise production slightly. As one of the putative leaders of OPEC 2.0, we expect Russia to maintain its 300k b/d production cut in 1H18, which will keep its overall liquids production steady at ~ 11.17mm b/d through June. In 2H18, Russia will gradually restore production to an average of 11.24mm b/d, reaching 11.4mm b/d by December. For 2019, we expect total Russian liquids production to average 11.35mm b/d, up ~ 140k b/d yoy. OPEC's return will be led by the Cartel's Gulf producers, which are expected to raise crude production 450k b/d this year and 350k b/d next year (Chart 2, bottom panel). Total production in Gulf OPEC states will reach 25.25mm b/d on average in 2019. This will, of course, be dominated by KSA, which we expect will lift crude production to ~ 10.36mm b/d in 2H18 after holding crude output steady at ~ 10mm b/d in 1H18 over-delivering vs. its quota under the OPEC 2.0 Agreement. For 2019, we expect KSA to maintain production above 10.1mm b/d.2 Non-Gulf OPEC producers, on the other hand, will see their production fall 140k b/d this year, and another 240k b/d next year, leaving it at 7.49mm b/d on average in 2019, in our estimation. The contribution of these states to the OPEC 2.0 production cuts has been "managing" their respective decline curves. It is highly unlikely they will see production surge following the expiration of the OPEC 2.0 agreement at the end of this year. Overall, we expect global crude and liquids production to reach 100mm b/d this year, and 102.2mm b/d next year (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Demand Surges This Year, But Slows In 2019 The global economic expansion will lift oil demand above 100mm b/d this year to 100.3mm b/d. This will be led, as always, by non-OECD growth, which we expect to increase 1.24mm b/d this year to 52.8mm b/d (Chart 3, top panel). DM demand - i.e., OECD consumption - will increase 440k b/d this year, to 47.5mm b/d, based on our estimates. Overall global demand rises 1.68mm b/d this year, by our reckoning (Chart 3). We expect tighter financial conditions this year and next will, with the lags typical of monetary policy, slow the rate of growth in oil demand next year. This will be delivered by tightening monetary policy, led by the U.S. Fed, and a mild recession next year, most likely in 2H19. We expect global demand to grow 1.57mm b/d next year, rising to just under 102mm b/d. EM demand will grow 1.21mm b/d, while DM demand will be up 360k b/d next year. Tightening Balances Will Reverse In 2H18 The yeoman effort put forth by OPEC 2.0 in reducing output and draining commercial inventories globally will reach its apotheosis by the end of 1H18 (Charts 4). Thereafter, as production grows and demand begins to slow, our balances indicate inventories will start to grow again (Chart 5). Chart 4Supply-Demand Balances##BR##No Longer Tightening In 2019 ... Chart 5... Leading To##BR##Inventory Accumulation Markets likely will start focusing on the implications of OPEC 2.0 returning production to the market and the surge in shale in 2H18 and during 2019. Non-forecastable events notwithstanding - e.g., a breakdown in Venezuela's production and exports - markets will be looking to OPEC 2.0 leadership for guidance on how the coalition will manage member-state production from 2H18 forward. If the OPEC 2.0 coalition is allowed to dissolve - something we do not expect - and a production free-for-all resumes similar to that of 2015 - 16, another round of supply destruction, brought about by lower prices, likely will ensue. This would greatly restrict E&P and services companies' access to capital, should it occur, and would, once again, imperil the economies of OPEC 2.0. In addition, because such volatility would discourage investment once again, it would set up a powerful price rally in the early 2020s following the attendant collapse in capex and E&P spending, as occurred in the previous down-cycle. We doubt this is the desired outcome of the OPEC 2.0 leadership, particularly KSA, as the Kingdom will be looking to IPO Saudi Aramco later this year to fund its Vision 2030 diversification efforts. We also doubt this is the desired outcome of Russia, given the economic pain it endured in the 2015 - 16 episode. More Frequent OPEC 2.0 Guidance Expected Given these considerations, we expect KSA and Russia to increase the frequency of forward guidance, directing market participants toward a preferred price band. Right now, this looks like a $50 to $60/bbl range - the 2018 forecast given by Russia's Energy Minister Alexander Novak earlier this week.3 It would be incumbent on OPEC 2.0 leadership to guide markets to expect production and inventory responses consistent with such guidance. We think the combination of OPEC 2.0 production restraint and the powerful synchronized global growth already in place puts Energy Minister Novak's guidance out of range for this year, and we are sticking with our forecasts for Brent and WTI. However, beginning in 2H18, a 2019 Brent forecast in Novak's range appears reasonable, based on the fundamentals discussed above. And, our WTI forecast of $53/bbl also is reasonable, given the average marginal cost of producing in the most prolific fields in the U.S. are at or below $50/bbl, according to the Dallas Fed's periodic Energy Survey.4 We believe the massive drawdown in global oil inventories to be the first step in a longer-term strategy by OPEC 2.0 countries. Lower OECD commercial inventory levels will diminish their shock-absorbing capacity, leading to a higher responsiveness of oil prices to supply-demand shocks. This will allow the coalition to exert greater control over oil prices via rapid, flexible storage adjustments and spare capacity management. Therefore, this year's out-of-range prices will be tolerated by Russia and KSA to achieve their optimal level of global inventories. A $50-to-$60/bbl Brent range for OPEC 2.0 would be consistent with a longer-term strategy to maximize the period of time hydrocarbons are the primary transportation fuel in the world. This is the only way to achieve the development goals set out by leaders of various oil-exporting states seeking to diversify the economic underpinnings of these economies. To do so, they have to keep oil-based transportation competitive for decades. Too much volatility - i.e., frequent excursions between very high and very low prices - will severely limit the access to capital these societies need to pull off this diversification. Managing production in a way that limits this volatility and keeps oil competitive in transport markets therefore is critical. Bottom Line: High prices will cause crude oil production to surge this year and next, particularly in the U.S. shales, and demand growth to slow. We expect Brent prices to average $67/bbl this year and $55/bbl next year. WTI prices will average $63/bbl this year and $53/bbl next year. We expect OPEC 2.0 to increase the frequency of its forward guidance - and to follow through on production and inventory adjustment in a manner that supports a desired price range for Brent prices in 2019 and into the 2020s. Right now, that range looks like $50 to $60/bbl. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is a name we coined to describe the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed at the end of 2016 to rein in out-of-control global oil production by cutting production some 1.4 to 1.5mm b/d last year (vs. a target of 1.8mm b/d). The coalition has been remarkably successful in maintaining production discipline in 2017 and extending their deal to the end of 2018 with an option to review quotas in June. We expect OPEC 2.0 to gradually return production taken off the market over the course of 2H18, which will, by next year, most likely reverse the draws seen in global inventories. 2 KSA's production should lift next year as pipeline repairs at its giant Manifa field are completed. Corrosion problems took some 300k of 900k b/d total production offline. In addition, there is another 500k b/d of capacity offline in the Neutral Zone shared with Kuwait. KSA's capacity likely will remain ~ 11.7mm b/d, versus its historical 12.5mm level, but as Energy Intelligence notes, it will have to balance actual production with spare capacity for the next year or so. Please see "A Headache for Aramco," published July 2017 by Energy Intelligence on its website. 3 Please see "CORRECTED-UPDATE 5-Brent oil falls by $1 but demand underpins near $70/barrel," published by uk.reuters.com on January 16, 2018. 4 In its December 2017 Dallas Fed Energy Survey, the Federal Reserve Bank of Dallas reported the WTI price shale operators needed to profitably drill a new well in Texas and Oklahoma averaged $49/bbl (simple, unweighted survey average). The lowest cost was in the Permian Midland formation ($46/bbl) and the highest costs was in so-called Other U.S. (shale) at $55/bbl. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in Summary of Trades Closed in

Special Report

Highlights The Arabic title of this Special Report is "Against Wasta." Wasta roughly translates as reciprocity in formal and informal dealings. It "indicates that there is a middleman or 'connection' between somebody who wants a job, a license or government service and somebody who is in a position to provide it."1 While it has been helpful, it also has led to profound corruption. Feature The political sandstorm ripping through the Kingdom of Saudi Arabia (KSA) - visible in the lifting of the ban on women driving cars earlier this year, and, most recently in the consolidation of military and political power by Crown Prince Mohammed bin Salman (often referred to as "MBS") over the past few weeks - must be seen as prelude to implementing Vision 2030, which will feature an ongoing battle against wasta in KSA. If successful, this could transform a feudal desert kingdom into a modern nation-state.2 When the storm passes, MBS will hold the military and political reins of power in the Kingdom. This will allow the Sudairi branch of the Saud family, led by MBS's father, King Salman, to execute on its Vision 2030 agenda to wean itself from an almost-complete dependence on oil-export revenues. To do so, the Kingdom's leadership must successfully navigate OPEC 2.0's production-cutting deal in the short term, and the IPO of Saudi Aramco in the long term.3 KSA's Leadership Is On A Mission Chart of the WeekMarkets Take KSA News In Stride It's fairly obvious KSA's leadership and Russian President Vladimir Putin are on the same page re extending OPEC 2.0's 1.8mm b/d production-cutting deal to end-2018, given the public statements of MBS and Putin supporting such a measure. While markets have been responsive to this messaging, Russian Energy Minister Alexander Novak is restraining a full-throttled embrace of this expectation, saying a decision to extend the deal might not come at OPEC's November 30 meeting, given the amount of data to be analyzed.4 Markets appear to be taking the recent news - particularly the headlines out of KSA - in stride, as the major safe-haven assets have been remarkably well-behaved (Chart of the Week). In our base case, we continue to expect the OPEC 2.0 deal to be extended to end-June, which will lift Brent and WTI prices to $65 and $63/bbl next year. If we do get an extension of the OPEC 2.0 deal to end-December - and the odds of this appear very high - our 2018 Brent and WTI average-price forecasts could increase by as much as $5/bbl.5 KSA, Russia Have A Transactional Relationship, Not An Alliance The public alignment of the views of the Saudi and Russian leaderships are important over the short term. However, this does not necessarily mean both states have achieved a general alignment of views on everything of common concern to them. The OPEC 2.0 coalition led by KSA and Russia - the two largest oil exporters in the world - is a transactional relationship, not an alliance. The coalition members negotiated a deal to remove 1.8mm b/d of oil from the market in order to drain global inventories, particularly in the OECD. This deal was negotiated under duress - Brent prices threatened to fall through the $20/bbl level at the beginning of 2016 in the wake of the market-share war declared by OPEC at the end of 2014.6 Such an outcome would have imperiled the very survival of the member states (Chart 2). The success of OPEC 2.0 has taken many by surprise: The overwhelming market consensus in the lead-up to the deal getting done was the coalition would never come about, and, if it did, it would never be able to maintain the discipline necessary to follow through on its goal to return OECD inventories to their five-year average. BCA was outside this consensus from the get-go.7 And we continue to expect OPEC 2.0's production discipline to be maintained into next year, with KSA and Russia leading by example (Chart 3). Chart 2Oil-Price Collapse Clobbered Reserves Chart 3OPEC 2.0 Production Discipline Holds As important as the management of OPEC 2.0 is to KSA, Russia and the oil markets, the Kingdom's leadership has a laser focus on its chief long-term goal: the Saudi Aramco IPO. In light of its Vision 2030 agenda, the most important decision the Kingdom's leadership will make will be whether to IPO Aramco on a Western bourse - e.g., the NY Stock Exchange - or whether the initial offering of KSA's crown jewel is placed directly with China's sovereign wealth fund (SWF) and two of that country's largest oil companies. KSA controls this evolution. Decisions made by its leaders will resound in the oil markets for years, if not decades, to come. KSA's Anti-Corruption Campaign And The Aramco Offering The recent arrest of Saudi royals and consolidation of power by the Sudairi branch of the Saud royal family - led by King Salman and his son, MBS - appear to be part and parcel of an anti-corruption campaign laid out in the Vision 2030 document last year. This campaign, like the formation of OPEC 2.0, is being undertaken to support the IPO of Saudi Aramco next year. Proceeds from the IPO will support KSA's diversification away from being almost wholly dependent on oil exports.8 King Salman, MBS and their closest advisors have concluded they must reform the system of wasta if the Kingdom is to offer anything resembling a prosperous future full of opportunity to its restive population, most of which - more than 50% - are members of MBS's 30-something demographic cohort (Chart 4). Chart 4KSA's Under-30 Cohort Needs Jobs The wasta system in the Middle East - like the "old-boy" networks in the West - can be positive, in that it can "lower transaction costs and reduce the problem of asymmetric information if, for example, the use of such connections can place disadvantaged groups or individuals into the workforce who might otherwise not have the same opportunity as others," according to Prof. Ramady. However, such a system can, and has, become corrosive to the evolution of society, and can stunt the evolution toward an innovative, dynamic society and economy. Prof. Ramady notes, "Fighting negative wasta is important for the countries that seek to truly implement a more equal opportunity and entrepreneurial knowledge-based economic base." This discontent with the status quo post-Arab Spring was apparent in 2016, when BCA's Geopolitical Strategy noted KSA was in the early stages of such reforms.9 From everything King Salman and MBS have said and done to date, this appears to be the agenda that is being enacted. The lifting of the ban on women driving in KSA to take effect next year; hosting investors and entrepreneurs in Riyadh in September - the so-called Davos in the Desert presentations; even the recent mass arrests and consolidation of power are part and parcel of this reform.10 Early indications of this agenda could be seen in April 2015, when KSA lowered the value of projects requiring approval by the Council of Ministers to SR100 million from SR300 million ($27 million from $80 million). The collapse in oil prices from more than $100/bbl in 2014 likely drove this decision, but, as Prof. Ramady notes, "the intention of the Saudi government was clear: that even 'small' projects (by Saudi standards) could now be scrutinised to avoid 'hidden costs' and corruption." Following the April 2015 reforms, King Salman told the Kingdom's Anti-Corruption Committee "that his government would have zero tolerance for corruption in the country and that he and other members of the royal family are not above the law and that any citizen can file a lawsuit against the king, crown prince or other members of the royal family. These were some of the strongest statements to be made by a Saudi monarch on the issue of combating corruption and nepotism." (Emphasis added.)11 The Aramco IPO The way KSA monetizes its crown jewel will have a profound effect on the evolution of the country's institutions and the oil markets. MBS's implementation of the anti-corruption campaign laid out by his father, King Salman, suggests an IPO on a western bourse is in the offing. Such a listing would impose regulatory and transparency requirements on Aramco that are fully consistent with the royal family's words and deeds since King Salman took power in January 2015. Monetizing 5% of what could potentially be the largest oil-producing and -refining enterprise in the world - the only asset capable of funding the transformation of an entire country of 32mm people - on a bourse that requires even a minimal level of transparency for investors means the government of KSA could demand similar transparency from every other firm and individual in the Kingdom. It gives the government license, so to speak, to develop and enforce the rule of law, consistent with King Salman's remarks to the Anti-Corruption Committee. This will resonate with the younger KSA elites, many of whom are tech-savvy, educated in the West and in MBS's 30-something cohort. This would be a huge gamble on the future and the Kingdom's ability to transform itself into an open monarchy. Success would transform a feudal kingdom into a modern nation-state with an enfranchised population that can advance based on entrepreneurial innovation and merit. The rule of law and transparency in business and governmental dealings would replace wasta, privilege and corruption. It also could expose the royal family to a palace coup, as Marko Papic, BCA's Chief Geopolitical strategist, notes in his most recent report "The Middle East: Separating The Signal From The Noise," which we cite above. The stakes couldn't be higher. Listing on a Western bourse also would position Saudi Aramco squarely in the market and central to it, executing on its plan to become the dominant global oil refiner, and funding the Kingdom's diversification away from near-total dependence on oil exports. Lastly, it would allow KSA to retain its geopolitical optionality - playing competing global interests off each other when negotiating alliances and commercial deals. Implications Of An Aramco Private Placement If the Aramco shares are privately placed with China's SWF and the country's two largest oil companies, the pressure to reform likely would be lessened, as the Chinese government typically does not make reform demands on governments of resource-rich countries in which it is investing.12 Assuming China's SWF and/or the oil companies participating in its bidding consortium received a seat(s) on the Aramco board, China certainly would gain greater assurance over its crude oil and refined product supplies going forward. This is a critical concern with domestic production falling and demand for crude oil increasing (Chart 5). And it would give China an eventual interest in using military power to protect its investments in KSA, thus advancing and supporting its long-term evolution as a superpower.13 It also would, in all likelihood, expand the membership of the club trading oil in yuan, which now includes Russia and Iran, to KSA and its GCC allies and Iraq by 2020, if not sooner. This would represent ~ 39mm b/d of production (Chart 6), and 23mm b/d of exports. BP estimates just over 42mm b/d of crude oil are traded globally, meaning this petro-yuan producing coalition would account for 55% of total exports.14 Chart 5China Needs To Offset Declining Production Chart 6A Petro-yuan Would Be Formidable At some 9mm b/d, China accounts for ~ 21% of global crude oil imports. The combination of OPEC 2.0's crude production and exports with China's import volumes could make the OPEC 2.0 + 1 - the "+1" being China - the most potent force in the oil trading markets, if such a coalition can find a way to balance the competing interests of the world's largest exporters (KSA and Russia) with those of the world's largest importer (China). It also would put the petro-yuan bloc firmly in China's geopolitical orbit, allowing it to expand its sphere of influence deeply into the Persian Gulf, and the global oil market. Bottom Line: The recent turmoil in KSA must be seen as the opening moves in the transformation of a feudal desert kingdom into a modern nation-state. The evolution of the transformation is critically dependent on decisions made by KSA's leadership. How this breaks will profoundly affect the global oil markets and the Kingdom itself particularly in regard to how oil is priced - USD vs. yuan - and the effect new trading blocs have on market structure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Ramady, Mohamed A., ed. (2016), "The Political Economy of Wasta: Use and Abuse of Social Capital Networking," Springer International Publishing Switzerland. Ramady is a professor of Finance and Economics at King Fahd in Dhahran, Saudi Arabia. The introduction of the book starts by quoting the proverb: To accept a benefit is to sell one's freedom. 2 Please see "The Middle East: Separating The Signal From The Noise," published November 15, 2017, in BCA Research's Geopolitical Strategy, for a full analysis of these issues. 3 OPEC 2.0 is our moniker for the OPEC and non-OPEC coalition of oil producers led by KSA and Russia, which agreed to remove 1.8mm b/d of oil production from the market at the end of last year. 4 Please see "Russia's Novak: Oil cut pact extension decision not necessarily at Nov meeting," published November 2, 2017, by reuters.com. Elevating the level of uncertainty as to when the OPEC 2.0 pact will be unwound is exactly the sort of forward guidance OPEC 2.0 leaders would need to convey to markets in order to backwardate the forward oil-price curve - i.e., keep longer-dated prices below prompt prices. A backwardated forward curve means U.S. shale producers realize lower prices on longer-dated hedges, which restrains the number of rigs they can deploy in the field. On Wednesday, Reuters also reported as spokesman for Rosneft, Russia's largest oil company, foresees difficulty in the wind-down of OPEC 2.0's production cuts - and the return to unrestrained production. Mikhail Leontyev said, "Speaking about the company's concerns, first of all it was about how to prepare for suspending measures to restrict production. This is a serious question. Sooner or later, of course, these measures will be lifted," Leontyev said. "Now or later, that's a separate question. It's a serious challenge, for which one needs to prepare." Roseneft is responsible for 40% of Russia's oil output; it is 50% owned by the Russian government. Please see "Russia's Rosneft says managing exit from OPEC+ deal is a serious challenge," published by reuters.com on November 15, 2017. 5 Please see "Oil Forecast Lifted As Markets Tighten," published by BCA Research's Commodity & Energy Strategy, October 19, 2017. It is available at ces.bcaresearch.com. Worth noting is the fact that should OPEC 2.0 not extend the expiry of the production-cutting deal markets likely would sell off quickly. This is because the leadership of the coalition - MBS and President Putin - have publicly embraced such a move; not doing so would be a disappointment to markets. Our modelling in the article cited here indicates the cuts have to be extended at least to end-June 2018, if the OPEC 2.0 goal of reducing OECD commercial oil inventories to their 5-year average levels is to be achieved. Also worth noting, if we do see the OPEC 2.0 cuts extended to end-2018, we likely will be widening our implied Brent vs. WTI spread to $4/bbl, given the transportation bottlenecks that are likely to emerge in the event of a further lift in U.S. prices: Pipeline infrastructure in the most productive shales, particularly the Permian Basin, cannot get oil to export facilities as quickly as it is produced. Please see "Transportation constraints and export costs widen the Brent-WTI price spread," published in the U.S. EIA's This Week in Petroleum series November 8, 2017. 6 We discuss this at length in our 2017 outlook. Please see "2017 Commodity Outlook: Energy," published by BCA Research's Commodity & Energy Strategy December 8, 2016. See also our "2016 Commodity Outlook: Neutral Across the Board," published December 17, 2016, for a detailed discussion of pricing dynamics as this time. Both are available at ces.bcaresearch.com. 7 Please see the 2017 Outlook referenced above in footnote 6. 8 KSA officials believe the company is worth $2 trillion, based on their expectation a 5% IPO of the company would generate $100 billion. 9 Please see "Saudi Arabia's Choice: Modernity Or Bust," the May 2016 issue of BCA Research's Geopolitical Strategy. It is available at gps.bacresearch.com. 10 Please see "Saudi Arabia plans to build futuristic city for innovators," published October 24, 2017, by phys.org. 11 Please see footnote 1, p. ix. 12 Please see "Exclusive - China offers to buy 5 percent of Saudi Aramco directly: sources," published by reuters.com October 16, 2017. 13 We examined this in depth in our report entitled "OPEC 2.0: Fear and Loathing in Oil Markets," published by BCA Research's Commodity & Energy Strategy on April 27, 2017. It is available at ces.bcaresearch.com. 14 Please see https://www.bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy/oil/oil-trade-movements.html. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016