アメリカ合衆国

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Highlights Bad news is still looming in the trade war. Public opinion polling in the U.S. gives President Trump more leeway to push the envelope on tariffs and sanctions against China than the consensus recognizes. Trump’s tendency to push the envelope is forcing China into a corner in which structural concessions become too risky. Unrest in Hong Kong reveals the city-state’s political woes as well as the tail-risk of a geopolitical incident in Taiwan. Tariffs on Mexico are still possible. Close long MXN/BRL. Maintain tactical safe-haven plays. Feature Judging by the S&P 500, the Federal Reserve has cut interest rates and the G20 summit between Presidents Donald Trump and Xi Jinping has been a success (Chart 1). Chart 1Trade War? Who Cares! The problem is that there is not yet a compelling, positive, political catalyst on the trade front. And the Fed has an incentive to wait until after the June 28-29 G20 to make its decision on any cut. At least in the case of the December 1 G20 summit in Buenos Aires there was significant diplomatic preparation ahead of time. That is not yet the case for the summit in Osaka, Japan. And even Buenos Aires ended up being a flop given the subsequent tariff escalation. We are maintaining our tactical safe-haven recommendations – long gold, Swiss bonds, and Japanese yen – until we see a clearer pathway for the risk-on phase to resume amid a summer loaded with fair-probability geopolitical risks: Trump’s aggressive foreign policy, the Democratic primary, China’s domestic policy, the U.S. immigration crisis, and Brexit. Beyond this near-term caution, we agree with BCA’s House View in remaining overweight equities on a cyclical basis (12 months). China’s economic stimulus is likely to pick up further this summer and it still has the capacity to deliver positive surprises. Preparing For The G20 Over the course of this year we have argued for a 50% chance and then 40% chance that the U.S. and China would conclude a trade deal by the G20 summit. However, Commerce Secretary Wilbur Ross and other administration officials, including Chief of Staff Mick Mulvaney, have recently indicated that the best case at the G20 is for the leaders to have dinner and agree to a new timetable that aims to close the negotiations in the coming months. The Trump-Xi summit itself remains unconfirmed as we go to press. This suggests that we were too optimistic about even a barebones trade deal at the G20. We are now extending our time frame to the November 2020 election -- the only deadline that really matters. Diagram 1 presents a cogent and conservative decision tree that results in a 41% chance of a major, Cold War-style escalation in tensions; a 27% chance of a minor escalation that is contained but without a final trade agreement; and a 28% chance of a tenuous or short-term deal. It gives only a 4% chance of a “grand compromise” that initiates a new phase of re-engagement between the two economies. These outcomes clearly represent a large downside risk given where equities are positioned today. Diagram 1Trade War Decision Tree (Updated June 13, 2019) Why such gloom when the two sides may be on the brink of a new tariff ceasefire? First, delaying the talks beyond the G20 is disadvantageous for Trump and will make him angry sooner or later. The Trump administration, unlike its predecessors, has made a point of opposing China’s traditional playbook of drawing out negotiations. China benefits in talks over the long run because it gains economic and strategic leverage. This has been the case in every major round of dialogue since the 1980s and it is specifically the case today, as China gradually stimulates its way out of the slowdown that afflicted it at the time of the last G20 (Chart 2). Chart 2China's Bargaining Leverage To Improve On Stimulus Trump would not have called a ceasefire on Dec. 1, 2018 if the stock market had held up amid Fed rate hikes and the Sept. 24 implementation of the 10% tariff on $200 billion. This year the U.S. equity market has bounced back and the Fed has paused, but China’s economy has not yet fully recovered. This gives Trump an advantage that may not last if the talks extend through the rest of the year. And this reasoning explains why Trump raised the tariff rate and blacklisted China’s tech companies in May – to try to clinch a deal by the end of June. He is also threatening to impose tariffs on the remaining $300 billion worth of imports if Xi snubs him in Osaka. If the G20 fails to produce progress, we would bet that Trump will proceed with a sweeping tariff on the remaining $300 billion worth of Chinese imports, whether immediately after the summit or at some later point when he decides that the Chinese are indeed playing for time. How can we be confident of this? After all, Trump’s approval rating has fallen since he escalated the trade war in May and it remains well beneath the average post-World War II presidents at this stage in their first terms, including President Obama’s rating in the summer of 2011 (Chart 3). Recent opinion polls suggest that voters are getting wise to the negative impact of tariffs on their pocketbooks. The financial and political constraints on Trump are not very pressing. We are confident because the financial and political constraints on Trump are not very pressing, at least not at the moment. First, the stock market has risen despite the tariff hikes, so Trump is likely emboldened. Second, Trump is less constrained in the use of tariffs than in other areas. He is bogged down with a Democratic Congress, investigations, and scandals at home. He cannot pursue policy through legislation – he shifted to the threat of tariffs on Mexico because he could not build his border wall. By turbo-charging his trade policy and foreign policy – against China, Iran, Mexico, Russia, most recently Germany … basically everyone except North Korea – he creates the option of turning 2020 into a “foreign policy election” rather than an election about the economy or social policy. A strong economy has not enabled him to break through his ceiling in public opinion thus far and he will lose a social policy election easily (see health care). The risk of his aggressive foreign policy is that it triggers an international crisis. But that would likely benefit him in the polls, given the natural inclination to defend America against foreign enemies. See George W. Bush, 2004 (Chart 4). Third, popular opposition to Trump’s trade war is not clear-cut – voters are ambivalent. In the past we have shown that President Trump’s 2020 run still depends on his ability to increase voter turnout among whites, specifically white males, low-income whites, and whites without college degrees. Recent polls suggest that voters have turned against tariffs and the trade war – namely the Quinnipiac and Monmouth University polls released in late May after the latest tariff hike. But it is essential to dig beneath the surface. These polls reveal that the key voting groups look more favorably than the rest of the country upon Trump’s policies on both trade and China (Chart 5). These voters’ assessment of Trump’s performance overall, across a range of policies, is not disapproving, despite all of the unorthodox and disruptive decisions that Trump has made in his presidency thus far (Chart 6). American voters are neither as enthusiastic about free trade nor as appalled by protectionism as the headline polling suggests. For instance, take the Monmouth University poll, which asked very specific questions about trade, tariffs, and retaliation. If we combine the group of voters who are clearly protectionist with those who are “not sure” or think the answer “depends,” the results do not suggest that Trump is heavily constrained (Table 1). Table 1Americans Are Not As Pro-Free Trade As It Seems In swing counties 51% of voters think that free trade is either a bad idea or are undecided. And even 57% percent of voters in counties that voted for Hillary Clinton by more than a 10% margin are in favor of tariffs or unsure. And a majority of voters in the most relevant categories – independents, moderates, non-college graduates, low-income earners – believe that Trump’s tariffs will bring manufacturing back, a highly relevant point for an election that will likely swing on the Rust Belt yet again. This includes Clinton’s most secure districts (Chart 7)! The point is not that Trump lacks political constraints on the trade war – after all, these voters are on the borderline in many cases and concerned about all-out trade war with China. Rather, his aggressive trade tactics enable him to reconnect with and energize his voter base at a time when his other signature policies are tied down. This is critical because his reelection prospects, which we have pegged at 55%, are in great peril, at least judging by his lag in the head-to-head polling against the top Democrats in swing states. Bottom Line: Going forward, Trump has more room to push the envelope than investors realize. A failed G20 summit poses the risk of another selloff in global equities. We are maintaining our tactical safe-haven trades.   What About Xi Jinping’s Constraints? Xi is president for life and must be attentive to long-term ramifications. Chart 8Xi Jinping's Immediate Constraint If Trump is tempted to continue pushing the envelope, will President Xi back down? While not constrained by the stock market or elections, he does face the prospect of instability in the manufacturing sector and large-scale unemployment (Chart 8), which Beijing has not had to deal with for 20 years. The point is not to claim that laid-off Chinese workers will turn around and protest against their own country in the face of gunboat diplomacy by capitalist imperialists – on the 70th anniversary of the regime, no less. Rather, Xi is president for life and must be attentive to the long-term ramifications of a disruptive transition in the excessively large manufacturing sector. This would cause economic and, yes, ultimately socio-political problems for him down the road. If Trump continues to move toward his 2016 campaign pledge of a 45% tariff on all Chinese imports, as the 2020 election approaches, China’s leaders have far less incentive to put their careers (and lives) on the line to produce structural concessions. A tariff covering all Chinese goods is an absolutist position that China can only address by doubling down on its demand for full tariff rollback. Yet Trump needs to retain some tariffs to enforce the implementation of any agreement. Thus slapping tariffs on all Chinese imports is almost, but not quite, an irreversible step. This is captured in Diagram 1 via the 29% chance that tensions are contained even if a deal falls through. Tensions are even less likely to be contained if the Trump administration follows through on its threats against China’s tech sector. On August 19, the Commerce Department will decide whether to renew the license for U.S. companies to sell key components to Huawei and other blacklisted companies. If the administration denies the license – and moves further ahead with export controls on emerging and foundational technologies – then Beijing faces an outright technological blockade. It will retaliate against U.S. companies – a process already beginning1 – and will likely act on other threats such as a rare earths embargo. In this case strategic tensions will escalate dramatically, including saber-rattling in the air, in cyberspace, or on the high seas. At the moment political frictions in Hong Kong are exacerbating U.S.-China distrust. Bottom Line: Since President Xi’s constraints are longer-term, he has the ability to deny structural concessions to Trump. But Trump’s ability to push the trade war further and further risks forcing China to a point of no return. There is not a clear basis for the geopolitical risk affecting the global trade and growth outlook to fall. Hong Kong: A New Front In The U.S.-China Struggle The large-scale protests that have erupted in Hong Kong – first on April 28 and most recently on June 9 –are important for several reasons: they highlight the immense geopolitical pressure in East Asia emanating from China’s “New Era” under Xi Jinping; they are rapidly becoming entangled in U.S.-China tensions, particularly over technological acquisition; and they foreshadow the political instability on the horizon in Taiwan. Tensions have been rising between Hong Kong and mainland China since the Great Recession and the shock to capitalist financial centers around the world. The tensions are symptomatic of the dramatic change in China over the past decade; the decline of the post-Cold War status quo; and the broader decline of the western world order (e.g. the British Empire). After all, the West is lacking tools to preserve the rights and privileges that Hong Kong was supposed to be guaranteed when the transfer of sovereignty occurred in 1997. More immediately, the current protests are part of a process going back to 2012 in which the disaffected and marginalized parts of Hong Kong society began speaking up against the political establishment. This emerged because of high income inequality (Chart 9), shortcomings in quality of life, excessive property prices (Chart 10), and the mainland’s reassertion of Communist Party rule and encroachments on Hong Kong’s autonomy. Chart 10Another Source Of Hong Kong's Unrest A simple comparison with Singapore, the other major East Asian city-state, shows that Hong Kong has trailed in GDP per capita and wage gains, while property price inflation has soared ahead (Chart 11). These structural economic factors contributed to the emergence of the “Occupy Central” protests in 2014, which were smaller than today’s protests but signaled the abrupt shift in the political sphere toward disenchantment and activism. Chart 11Why Hong Kong Is Not As Quiet As Singapore The 2016 elections for the Legislative Council (LegCo) resulted in a fiasco by which a number of pro-democracy activists, known as “localists,” were squeezed out of the legislature through a combination of juvenile mistakes and heavy-handed intervention by Beijing and the pro-mainland Hong Kong authorities (Chart 12 A&B). Beijing exploited the occasion to extend its legal writ over Hong Kong society and curb some of the city’s freedoms.2 The democratic opposition and dissidents have been sidelined or repressed — and now they face the prospect of being extradited, given that the LegCo is highly likely to pass the “Fugitive Offenders and Mutual Legal Assistance in Criminal Matters” bill that sparked the protests this year. The exclusion of the localists from power runs the risk of radicalizing them and increasing disaffection, making mass protests likely to recur both in the near term and in future. Hong Kongers are losing confidence in the “One Country, Two Systems” arrangement (Chart 13). They are similarly becoming more disillusioned with mainland China, adding fuel to the fire over time (Chart 14). However, in the specific case of the city-state, there is no alternative to Beijing’s ultimate say – and the older generations will continue to support the political establishment. Nevertheless Hong Kong’s discontents will become entangled in the broader Cold War emerging between the U.S. and China. Beijing is accusing the protesters of being lackeys of foreign powers. The U.S. Congress, on both sides of the aisle, is threatening to declare that Hong Kong is no longer sufficiently autonomous from Beijing and therefore no longer eligible for special privileges. Hong Kong faces rising political dependency on China and the potential for special relations with the United States to decline. Part of Washington’s concern lies with Beijing’s aggressive technological acquisition program. Hong Kong has been able to import advanced dual-use technology products from the United States without Beijing’s restrictions. This is not apparent from the proportion of exports but it is important on the technological level (Chart 15). It introduces a backdoor for China to acquire these goods and has prompted a rethink in Washington. Hong Kong is also accused of facilitating the circumventing of sanctions on U.S. enemies. It thus faces rising political dependency on China and the potential for special relations with the United States to decline. These pressures also highlight why we view Taiwan as a potential “Black Swan.” Similar political fissures are emerging as Beijing expands its economic and military dominance over Taiwan. Of course, the political backlash against Beijing has recently been receding in Taiwanese opinion, due to the fact that the nominally pro-independence Democratic Progressive Party has lost most of the momentum it gained after the large-scale “Sunflower” student protests of 2014 (Chart 16). But there are still several reasons that the January 2020 election could become a geopolitical flashpoint: namely the developments in Hong Kong, China’s handling of them, Beijing’s tensions with Washington, and the Trump administration’s temptation to achieve some key goals with the Tsai Ing-wen administration before it leaves office (including arms sales). Even if the Taiwanese political winds shift to become less confrontational toward Beijing after January, the time between now and then is ripe for an “incident” of some kind. Beyond that, the pro-independence opposition will begin activating and marching against the next government if it proves obsequious to the mainland. Chart 16Taiwan: Pro-Mainland Forces Revive Over the long run, Taiwan is far more autonomous than Hong Kong, harder for Beijing to control, and much more attractive for Beijing’s enemies to defend – namely the U.S. and Japan. Moreover, as the tech conflict with Washington heats up, Taiwan becomes vital for China’s technological self-sufficiency, putting it at higher risk (Chart 17). Beijing will also frown upon the role of Taiwanese companies like FoxConn for taking early steps to diversify the supply chain away from China. This regional strategic reality is not conducive to U.S.-China trade negotiations. And even aside from the U.S., Beijing’s growing power generates resistance from its periphery. This is true of Chinese ally North Korea, which is trying to broaden its options, as well as a historic enemy like Vietnam. Other countries at a bit more of a distance are trying to accommodate both Beijing and Washington, but are increasingly seeing their regimes vacillate based on their orientation toward China – this is true of Thailand in 2014, the Philippines in 2015, South Korea in 2017, and Malaysia in 2018. These changes inject economic policy uncertainty on the country level. Over the long run we see Southeast Asia as a beneficiary of the relocation of supply chains out of China. But at the moment, with the trade war escalating and unresolved and with China taking a heavier hand, we are only recommending holding relatively insulated countries like Thailand. Bottom Line: Our theme of U.S.-China conflict is intertwined with our theme of geopolitical risk rotation to East Asia. States that have domestic-oriented economies, limited exposure to China, or greater U.S. support – including Japan, Thailand, South Korea, Indonesia, and Malaysia – face less geopolitical risk than those heavily exposed to China (Taiwan) or that lack U.S. security guarantees (Hong Kong, Vietnam). Investment Recommendations In addition to our safe-haven tactical trades – long spot gold, long Swiss bonds, and long JPY-USD – we are maintaining our long recommendation for a basket of companies in the MVIS global rare earth and strategic metals index. The basket includes companies not based in mainland China that have seen their stock prices appreciate this year yet have a P/E ratio under 35 (Chart 18). Chart 18Go Long Rare Earth Firms Ex-China We remain short the CNY-USD on the expectation that trade tensions will encourage Beijing to use depreciation as a countervailing tool, despite our expectation of increasing fiscal-and-credit stimulus. Over the long run, we would observe that trade escalation between the U.S. and China bodes poorly for China’s long-term productivity and efficiency. The basis for a reduction in trade tensions is a recommitment to the liberal structural reform agenda that Chinese state economists outlined at the beginning of Xi Jinping’s term in 2012-13. The current trajectory of “the New Long March,” in which Beijing pursues personalized power and uses stimulus to improve self-sufficiency and import-substitution, goes the opposite direction. It is not a pathway for innovation, openness, and technological progress. A simple comparison of China’s long-term equity total return highlights the market’s lack of enthusiasm about the current administration’s approach (Chart 19). The contexts were different, but the earlier outperformance grew from painful structural reforms and a grand compromise with the United States in the late 1990s and early 2000s. Chart 19The Market Wants Reforms And Trade Deal We are closing our long MXN / short BRL trade for a gain of 4.6%. This trade has bounced back from the U.S.-Mexico deal to avert tariffs. The agreement was not entirely hollow compared to earlier agreements: it calls for Mexico to accelerate the deployment of the National Guard to stem the flow of refugees from Guatemala and central America and expand the Migrant Protection Protocols across the southern border. Trump’s reversal – under Senate pressure, entirely unlike the China dynamic – gave the peso a boost, benefiting our trade. However, one of the fundamental reasons for this trade – the improvement in Mexico’s relative current account balance – has now rolled over (Chart 20) and the tariff threat will reemerge if Mexico proves unable or unwilling to stem the inflow of asylum seekers into the United States (Chart 21). Chart 20Peso Has Outperformed The Real   As we go to press, the attacks on tankers in Oman highlight our view that oil prices will witness policy-induced volatility and a rising geopolitical risk premium as “fire and fury” shifts to the U.S. and Iran in the near-term. Our expectation of increasing Chinese stimulus helps underpin the constructive view on oil and energy-producing emerging markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The American Chamber of Commerce in China and Shanghai released a survey on May 22, 2019 revealing that while 53% of companies have not yet experienced “non-tariff” retaliation by Chinese authorities, 47% had experienced it: 20.1% through increased inspections; 19.7% through slower customs clearance; 14.2% through slow license approvals; another 14.2% through bureaucratic and regulatory complications; and smaller numbers dealing with problems associated with American employees’ visas, increased difficulty closing investment deals, products rejected by customs, and rejections of licenses and applications. 2 We noted at the time, “Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.” See BCA Geopolitical Strategy, “Strategic Outlook 2017: We Are All Geopolitical Strategists Now,” December 14, 2016, available at www.bcaresearch.com.

Neutral In the context of further de-risking the portfolio, we downgraded the S&P tech hardware storage & peripherals index (THS&P) to neutral in our most recent Weekly Report. Four reasons underpin our downgrade of this index that comprises almost 1/5 of the S&P tech market cap. First, index heavyweight Apple has 20% foreign sales exposure to the Greater China region. While we doubt the Chinese will directly retaliate to the U.S. restriction on Huawei by directly targeting Apple, it is still a risk. Moreover, recent news of the FTC and the DOJ targeting GOOGL and FB pose a risk to Apple, especially given its App Store dominance. Any negative news on either front would take a bite out of the sector’s profits. Second, the S&P THS&P index’s internationally sourced revenues are near the 60% mark, and computer exports are also flirting with the zero line. Worryingly, deflating EM Asian currencies are sapping consumer purchasing power and are weighing on industry exports (bottom panel). For the other two reasons that compelled us to downgrade the S&P THS&P index, please refer to our most recent Weekly Report. Bottom Line: Downgrade the S&P THS&P index to neutral for a modest relative loss of 1.0% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CMPE – AAPL, HPQ, HPE, NTAP, STX, WDC, XRX.  

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Highlights Few issues in the global oil and gas markets are as closely followed as the development of the U.S. shales. In this Special Report, we examine the extent to which the growth of oil and gas production in the shales will be constrained by capital discipline in the U.S. – something unheard of in years past. For the E&P companies large and small comprising this sector, success will depend on their ability to manage investors’ expectations for competitive returns – not their ability to grow production simply for the sake of growing production. We see early signs these companies – majors and independents alike – are behaving like capital-constrained firms that must provide a return greater than their cost of capital to attract and retain the funding necessary to ensure their growth and survival (Chart of the Week). Feature Since the 2014-15 global oil-price collapse, U.S. shale production has been driving non-OPEC liquid fuels production growth, expanding by an annual average ~ 1.13mm b/d vs. 0.61mm b/d for the other non-OPEC producers.1 We expect U.S. shale to remain the main vehicle of production growth over the next 2 years (Chart 2, panel 1). Our latest expectations for global supply – demand balances remain positive for the U.S. shale-oil producers. We have U.S. lower 48 production expanding by 1.3mm b/d in 2019, and 0.9mm b/d in 2020, led by shale production. This is slightly above the EIA and OPEC forecasts (Chart 2, panel 2). We have consistently exceeded the EIA’s and IEA’s production estimates for U.S. onshore production since August 2016 (Chart 3). This is not to say we believe the E&Ps will once again recklessly expand production in excess of the ability of their free cash flow (FCF) to support. In the past, we have tended to fade the independent E&Ps’ declarations of capital-discipline – e.g. in 2017 – 2018. We’ve staunchly maintained higher oil prices would compel the E&Ps to grow production beyond the ability of their FCF to support it. Nonetheless, this time could be different. Chart 2U.S. Shales Vs. Non-OPEC Production In point of fact, we now believe the independent E&P model is transitioning to a mature business model – i.e., these companies will, over time, look more like firms in other industries that seek to maximize shareholder value in order to retain their access to capital to grow and invest (Charst 4A &  4B). If the sector evolves in this direction, we could witness a sea change in the development of the U.S. shales, which leads to lower production growth. Chart 4AMajors Sensitive To Shareholder Concerns ... Chart 4B... As Are Independent E&Ps In this 2-part Special Report, we review our forecasting methodology for U.S. shale production, assess whether capital discipline demands by investors will affect current production forecasts, and explore ongoing logistical constraints in the Permian Basin and the U.S. Gulf Coast. E&Ps Transitioning To A Mature Business Model Historically, the U.S. E&P model prioritized sharp production growth above all else, making these companies highly dependent on external capital to finance that growth. In fact, since 2011, public E&Ps outspent their operating cash flow by ~ 40% on average, using a mix of debt, asset sales and equity financing (Chart 5).2 Efficiency gains allowed producers to be almost as profitable in 2018, with oil prices hovering around $65/bbl, as they were in 2014 with prices above $100/bbl. Since 2016, equity financing and asset sales have supported most of the over-spending. The equity financing window appears to have closed in 2018, as a large part of the equity issuance of smaller E&Ps was forced on them by banks to reduce leverage following their semi-annual credit re-determinations. Still, most E&Ps stock prices have remained depressed during the 32% surge in WTI prices in 1Q19 (Chart 6, panel 1). Investors remain skeptical about the E&P model, and are demanding proof this sector is moving toward a business model that can withstand the oil-price volatility that is endemic to these markets. This has – and will continue to – limited E&Ps’ ability to easily source funding from Wall Street via equity and debt financing. In fact, investors are demanding a higher premium to hold high-yield energy debt (Chart 6, panel 2), in the wake of the recent exceptional volatility oil markets have experienced. Chart 6Equities, Oil Prices Disconnected Ideally, the independent E&P cohort’s behavior would move closer to that of the Majors – i.e. spend less on capex than is generated via operating cash flow (OCF), using this margin to support dividends, and return of capital to shareholders via share buybacks. We expect most U.S. E&Ps to meet investors’ expectations, and to register positive FCF growth this year.3 Efficiency gains allowed producers to be almost as profitable in 2018, with oil prices hovering around $65/bbl, as they were in 2014 with prices above $100/bbl (Chart 7). Chart 7Efficiency Gains Drive EBIT E&P 2019 Production And Spending Guidance The last time BCA examined E&Ps’ finances – and their ability to sustain profitable growth – was in April 2018. At that time, we identified a sharp divergence in production vs. capex intentions. We argued then that these numbers were incompatible, and that E&Ps’ capital expenditures would have to increase above guidance to sustain the large production increases these firms were projecting. Actual 2018 numbers confirmed our thesis: E&P capex grew by ~ 16% y/y. Nonetheless, despite outspending their 2018 guidance, these producers needed only a limited amount of external capital. Most of the additional capex was financed from higher-than-expected operational cash flow, due mostly to higher WTI prices, cost reductions and productivity gains. Output per well slipped, all the same, while rig turnover increased, resulting in higher overall production (Chart 8). Our updated analysis for 2019 shows our group of producers is guiding toward ~ 14% y/y increase in production, and ~ 17% y/y decrease in capex. Again, these expectations are inconsistent, in our estimation. We calculate E&Ps’ production guidance is in line with our 15% y/y shale production growth forecasts. Achieving this growth will require flat to higher capex. Chart 8Well Output Down; Rig Turnover Up We estimate the exploration and development cost of adding a new barrel of oil-equivalent production in 2018 was around $32,100 for our group of 41 E&P companies (ex-property purchase and other expenses)(Chart 9). Assuming ~ 5-10% cost-inflation  and an estimate of property purchase for 2019, the ~ 1.7mm b/d of new production expected from our group – including the replacement of legacy production declines (more on this below) – would cost > $60 billion. This is above the companies’ current guidance. Achieving this would require further efficiency gains from technology improvement and geology high-grading – i.e., producers would have to focus their drilling activity on their best geologies to increase production per well, while reducing overall activity/expenditure in second-tier regions. We doubt this can happen. Our concerns about new wells’ productivity are increasing. The spacing of new wells appears to interfere with nearby older wells’ output, decreasing the overall pressure and productivity for both the newer and older wells. This often is referred to as the “parent-child” problem. The jury is still out re whether the industry has reached a tipping point in terms of well proximity that lies at the heart of this problem. However, reverting to wider spacing between wells would effectively reduce available drilling acreage in E&Ps’ tier-1 locations. Based on the most recent U.S. EIA Drilling Productivity Report (DPR) data, we cannot entirely substantiate these concerns – it is too early to detect a tipping point in the data (Chart 10). Nonetheless, we believe efficiency gains will be limited from here on, as the inventory of tier-1 wells has been decreasing in the past few year, and lateral and proppant growth slows. Importantly, this means the accelerating decline rates of U.S. production, as the share of new oil production coming from shale increases, will require more drilling and capex as new wells risk being less productive. Even in the prolific Permian Basin, new production per new well appears to have peaked in 2018. Moreover, there are growing risks of logistical bottlenecks in U.S. Gulf Coast exporting facilities that could further limit growth, a subject we will address in next week’s report. Chart 10Tipping Point For Productivity? Increasing Decline Rates Require More Capex With tight-oil production as a share of total production increasing, overall production decline rates are increasing – i.e. the downhole pressure which pushes the oil out of the well against the force of gravity dissipates much faster in shale oil wells.4 This is an underappreciated aspect of E&P production forecasts. In our view, attaining the production levels E&Ps currently are guiding toward, while accounting for massive production decline rates, will require capex to surprise to the upside and grow y/y.  Shale technology does allow for a more elastic oil supply, as it can be brought on line quickly in response to rising prices. However, the associated production declines can exceed 70% in the first year – i.e., production at a specific well (in b/d) will fall by 70% from its peak in the first year of operation – and another ~ 30% in the second year, compared to an average <10% for conventional onshore wells. This as large consequences for rig count in the U.S. Our updated decline-curve estimates show U.S. shale production will fall by ~ 37% in the next 12 months (Chart 11). This implies ~ 2mm b/d will be lost by the end of 2019. Hence, maintaining a flat level of production would require 750 rigs on average per month – given current well-per-rig and new-production-per-well rates. Accounting for the 14% y/y growth based on production guidance, this implies a total of 3.3mm b/d of new onshore U.S. production (Chart 12). In our view, attaining the production levels E&Ps currently are guiding toward, while accounting for massive production decline rates, will require capex to surprise to the upside and grow y/y. Chart 12Higher Rig Counts Needed Producers Will Remain Profitable, And Within OCF We expect U.S. E&P spending to remain within the limits of the operating cash flow. This will allow E&Ps to deliver on investors’ expectations of higher FCF and return on capital employed (ROCE). Two points support this expectation: (1) higher WTI prices, and (2) a higher inventory of Drilled-but-Uncompleted (DUCs) wells. Higher WTI prices. Our most recent oil price forecast sees WTI prices averaging $66/bbl in 2019, and $72/bbl in 2020, vs. $65/bbl in 2018.5 Most public E&Ps base their capex projection on a $50 - $55/bbl WTI price. The higher prices we expect will allow capex to increase above guidance while remaining within the limits of cash flow. Assuming no efficiency gains, this alone would increase OCF by ~ 20% compared with a $55/bbl price – depending on each company's hedging program. Including the expected 14% y/y volumes increase in 2019 adds another 14% to OCF. Hence, we believe there is room for an additional ~ $10 billion capex increase by our group of producers vs. last year solely based on our oil price and production projections. This outcome is highly contingent on our prices forecast. If prices remain in the low $50s/bbl, most producers’ cash flow will fall below the capex required to achieve current production growth forecasts. In this scenario, smaller shale producers would scramble to raise external funding to cover their expenses. As mentioned above, debt and equity financing will remain scares this year as investors demand financial discipline. This would either result in lower production growth or additional asset sales and increasing drilling partnerships. DUCs completion. Since mid-2018, Permian production has been constrained by a lack of pipeline takeaway capacity to move increasing oil production out of the basin. This put pressure on Midland, TX, prices, and incentivized additional truck and rail transportation (Chart 13, panel 1). Not unexpectedly, this led to a slowdown in completions relative to drilling activity (Chart 13, panel 2), and increased the number of DUCs. As a result, Permian producers built an inventory of excess DUCs awaiting pipeline expansions (Chart 13, panel 3). The process of drilling and completing wells produces a normal inventory of uncompleted wells, because of the time lag between the moment wells are drilled and the time they are completed. The development of multi-well pad drilling in U.S. shale basins structurally increased the time lag between drilling and completion to ~ 5 months. This implies a normal level of DUC inventory that corresponds to ~ 5 - 6 months’ worth of drilling activity. We define any DUC above our estimate of normal as an excess DUC well. It also implies that, as rig count expands, the normal level of DUCs will rise accordingly. Hence, simply looking at the absolute level of DUCs can be misleading. DUCs should be analyzed in relation to drilling. Chart 13Expect More From DUCs We estimate current excess DUCs to be ~ 1,700 in the top five shale basins, and 1,100 in the Permian alone. If completed, this represents a potential 1mm b/d and 700k b/d of additional production in top five basins and the Permian, respectively – at current well productivity. On average, completion accounts for ~ 65% of the total well costs. This implies adding new production from the 1mm b/d inventory of DUCs would require a 35% lower capital expenditure. This will support our expectation of higher E&P production while keeping expenses within OCF. In our projections, we include a monthly increase of 40k b/d of oil production from DUC completions from October 2019 to end-2020, given the 1.8mm b/d of additional pipeline capacity from the Permian to Gulf Coast that will be built before the end of the year, along with another 1.5mm b/d of new pipe that will be operational by 2021 (Chart 14). Additionally, 2mm b/d of additional takeaway capacity projected to be built from Cushing to the Gulf by 2021. This will completely relieve the transportation constraint and allow the > 900k b/d of additional production we expect by December 2020 to be moved toward export facilities. Beyond 2020, our group of E&P companies could be forced to raise external financing, as a large portion of their long-term debt will need to be paid off, or re-financed (Chart 15). This alone could capture more than 50% of E&Ps’ FCF, leaving little room to expand production within cash flow from operations. Permian Natgas Bottlenecks Remain A Risk To Oil Production Growth The exceptional growth in Permian tight oil production was mirrored by a glut in the volume of associated gas output (Chart 16, panel 1). While oil-takeaway investment has proceeded apace to get those molecules out of the Basin, supporting infrastructure development failed to produce the necessary natural-gas pipeline-takeaway capacity. This pushed gas supply above local demand and pipeline capacity, forcing natgas prices at Waha Hub lower – at times, to less than zero (e.g., in April and May 2019) (Chart 16, panel 2). In other words, producers are willing to pay midstream companies to move their gas out of the Permian. Delays in pipeline completion in Mexico led to an under-utilization of the current capacity from the Waha Hub to the Mexican border via the Trans-Pecos, Comanche Trail and Roadrunner pipelines (Chart 17). Chart 16Associated Gas Production Soars The completion of the Fermaca pipelines carrying gas toward central Mexico; and gas pipelines from the Permian to the U.S. Gulf Coast are expected to start coming on line in 2H19, which ultimately will bring an additional 9.8 Bcf/d of takeaway capacity to this market by 4Q20. This lack of capacity forced oil producers either to flare their additional gas or to reduce oil production – thereby reducing associated gas production. Most producers chose the former. As a result, flaring in the Permian reached ~ 610 MMcf/d in 4Q18 and a record high of 661 MMcf/d in 1Q19.6 By comparison, total residential natgas consumption in the entire state of Texas averaged 544 MMcf/d over the 2010 – 17 period, according to the U.S. EIA.7 When accounting for flaring and low Mexican pipelines utilization, we expect a marked supply-surplus until the end of the year, which will keep downward pressure on Waha prices (Chart 17, panel 2-3). Over the next 12 months, additional natgas pipeline takeaway will allow more gas to be shipped out of the Permian Basin: The completion of the Fermaca pipelines carrying gas toward central Mexico; and gas pipelines from the Permian to the U.S. Gulf Coast are expected to start coming on line in 2H19, which ultimately will bring an additional 9.8 Bcf/d of takeaway capacity to this market by 4Q20. This will provide the required feedstock for the ongoing Gulf Coast LNG buildout centered around Corpus Christi, TX. We expect > 5 Bcf/d of export capacity will be completed by end-2021. Nonetheless, the resumption of tight-oil production in the Permian in 2H19 is expected to build before the natgas system takeaway capacity comes on line. This will once again pressure natgas prices, and could stymie the growth in oil production in the Permian at the margin, given this would require additional flaring. How these issues are resolved partly depends on the Texas Rail Road Commission’s (RRC), which will have to rule on exemptions from the state’s Rule 32. Operators in Texas are allowed to flare gas while drilling, and for up to 10 days after completion. After this, each well’s owner must apply for a 45-day flare permit, and prove it is necessary for it to flare gas at specific wells. Texas RRC staff can issue these permits for a maximum of 180 days, beyond which an extension has to be approved via a Commission Final Order.8 Despite this strict process, YTD, none of the more than 20 requests for exception to Rule 32 in the main Permian Districts (7C, 08 and 8A) have been rejected.9 In general, the lack of existing pipeline capacity has been treated as a reasonable cause to grant exceptions to Rule 32. As long as the RRC allows these exceptions, oil production growth in the Permian will be primarily restrained by oil-pipeline takeaway constraints in the Basin, and export constraints in the Gulf. Nonetheless, these abnormal levels of flaring and venting are already gaining exposure in the media. The public opinion could switch rapidly and environmental protests could emerge, demanding the RRC enforces Rule 32 to E&P companies. This remains a risk to monitor. Bottom Line: The growth in U.S. shale-oil production could be slowing as E&P companies exercise greater capital discipline, and productivity gains begin to level off. It is still early days on the capital-discipline front – we have been here before – but we believe E&Ps are behaving in a manner consistent with that of other capital-constrained companies, and are prioritizing shareholder interests over their desire to increase production. The next big step in this evolution will be demonstrating to investors that lower-risk plays like the Permian Basin can provide the long-term returns necessary to sustain E&Ps access to capital. This will be critical as decline curves steepen in the Permian Basin and the other big U.S. shale plays.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com  Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      U.S. shale production denotes the sum of Anadarko, Bakken, Eagle Ford, Permian and Niobrara crude oil production. In this analysis, non-OPEC liquid fuels production excludes Russia, as it jointly leads the producer coalition we’ve dubbed OPEC 2.0, which was formed at the end of 2016 to manage global oil production and drain the unintended inventory accumulation resulting from OPEC’s 2014 – 16 market-share war. 2      Our analysis is based on a group of 41 public U.S. E&P companies. As a group, these companies represent ~3.3mm b/d of production (or around 38% of U.S. onshore production). 3      Not all E&Ps will perform similarly. Well-capitalized shale producers are on track to reach positive FCF by year-end. However, smaller companies with weak fundamentals will continue to face increasing default risk as external funds from Wall Street dry up. Indeed, a management premium – well-run vs. poorly run firms – almost surely will be a defining feature of the E&P market. 4      This downhole pressure is crucial for oil production. In general, wells are not abandoned when oil is completely depleted, but when pressure reaches levels so low that almost no oil is naturally pushed up the wellbore. Pass this point, artificial lifts or re-pressurization methods are needed to continue extraction from this well, requiring additional capex. 5      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Oil Market Volatility Reflects Recession Fears,” dated June 6, 2019, available at ces.bcaresearch.com. 6       Please see Permian "Natural Gas Flaring And Venting Reaching All-Time High," published by rystadenergy.com, June 4, 2019. 7      Based on EIA data, https://www.eia.gov/dnav/ng/NG_CONS_SUM_DCU_STX_A.htm. 8      Please see Texas Railroad Commission's flaring regulation, https://www.rrc.state.tx.us/about-us/resource-center/faqs/oil-gas-faqs/faq-flaring-regulation/. 9      Based on Texas Railroad Commission data, https://www.rrc.state.tx.us/hearings/dockets/oil-gas-proposals-for-decision-and-orders/index-for-332/.

We are compelled to put the S&P tech sector on our downgrade watch list as President Trump’s hawkish trade talk and actions since May 5 warn that tech revenues (60% export exposure) and profits will likely remain under intense downward pressure. Our tech EPS model is also flashing red on the back of sinking capex and an appreciating U.S. dollar (bottom panel). We will be downgrading the tech sector to underweight via the S&P software index, the tech sector’s largest industry group on a market cap basis. A downgrade to neutral in the S&P software index would push our S&P tech sector weight to a below benchmark allocation. Thus, we are initiating a stop near the 10% relative return mark on the S&P software high-conviction overweight call since the December 3, 2018 inception. We also lift the stop to 27% from 17% relative return on the cyclical overweight we have on the S&P software index since the November 27, 2017 inception. Bottom Line: We are compelled to put the tech sector on our downgrade watch list. We will execute the S&P tech sector downgrade to underweight when the S&P software index’s stops are triggered. This would push the S&P software index to neutral from currently overweight.

As we highlighted in our most recent Weekly Report, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the S&P 500 hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Using the NY Fed’s yield curve-derived recession probability forecast is revealing. This recession gauge has been an excellent leading indicator of S&P 500 momentum since the S&L crisis induced recession and its current message corroborates U.S. Equity Strategy’s cautious cyclical equity market view (recession gauge shown inverted, see chart). For additional details, please refer to the most recent Weekly Report.