Energy

  Overweight For the better part of this decade, the rise and fall of WTI has been the fundamental driver of the fortunes of the S&P oil & gas exploration & production (E&P) index, as it should be. However, starting in 2017, WTI began a pronounced recovery that was not matched by the relative performance of E&P stocks; this divergence has grown excessive (top panel). Such a divergence would be logical if domestic production had not matched the recovery in oil prices though, as shown in the second panel, this is not the case. Forward earnings projections too have been moving upward at a pace broadly similar to the underlying commodity, which we think marks conservatism on the part of sell-side analysts who are still stinging from being caught offside in 2014. Typically, we would expect increasing fixed cost absorption to drive multiplicative returns to profit growth as the price of oil increases. Nevertheless, forward earnings have been rising much faster than share prices, meaning valuations have collapsed to the normal range before the 2014 oil price decline (bottom panel). We reiterate our overweight recommendation on the S&P oil & gas E&P index and our high-conviction overweight recommendation on the broader S&P energy index. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX.  

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations

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Highlights The pace of "de-capacity" reforms in China will continue to diminish, with declining shutdowns of inefficient capacity and rising advanced capacity over the next 12-15 months. Coal prices may have less downside than steel prices due to more resilient domestic demand, and lower production growth for the former than the latter. Meanwhile, iron ore prices may have limited downside and could outperform steel prices due to increasing shutdowns of domestic iron ore mines. Go long September 2019 thermal coal and iron ore futures versus September 2019 steel rebar futures. Chinese coal producers' shares may outperform Chinese steel producers' shares. Feature This April, our Special Report titled, "Revisiting China's 'De-Capacity' Reforms," painted a negative picture for steel and coal prices over 2018 and 2019 on diminishing pace of "de-capacity" reforms and rising steel and coal output.1 So far, our call has not yet played out. Both steel and coal prices have been firm over the past five months (Chart 1A). Meanwhile, iron ore and coking coal have also rebounded (Chart 1B). Chart 1ASteel And Coal Prices: More Upside Ahead? Chart 1BIron Ore And Coking Coal Prices: Following Steel And Coal Prices? In this report, we return to the analysis we laid out back in April, with the goal of identifying whether or not the rally in steel and coal prices will continue. Another major question to answer is why share prices of coal and steel companies have continued to plunge, even though coal and steel prices have held up well. In brief, our research findings still suggest that steel and coal prices are likely to fall over the next 12-15 months on a diminishing pace of de-capacity (less shutdowns of old capacity) and rising advanced capacity. We also reckon that coal prices may have less downside than steel prices over the next 12-15 months due to more resilient domestic demand and smaller production growth compared to steel; we conclude by outlining a long/short trade opportunity tied to this view. Understanding The Recent Price Rally The recent strength in both steel and coal prices has been due to a tighter supply-demand balance than we expected: Steel Falling steel product output and still-solid steel demand growth have pushed up steel prices this year. While crude steel production has had strong growth so far this year (9% year-on-year and 50 million tons in volume), total output of steel product has actually declined by 20 million tons (2.7%) year-on-year during the same period (Chart 2). Steel products, including rebars, wire rods, sheets and other items, are made from crude steel and consumed in end consumption. Tianjin province - a city very close to Beijing - accounted for more than 100% of the reduction of steel product output, as 40% of the province's operating capacity was shut down due to the city's "de-capacity" policy and increasingly stringent environmental regulations. In addition, Chinese steel products production had already experienced huge cut last year by nearly 100 million due to the government's "Ditiaogang" de-capacity policy.2 As a result, strong crude steel output growth this year has not been able to lift steel product production from contraction, creating a shortage in Chinese steel product supply. To put it in perspective, total steel products production for the first eight months of this year is at a five-year low. Chart 2Falling Steel Product Output Amid Strong Crude Steel Production Growth Chart 3Steel Demand Has Been Robust As Well Meanwhile, massive pledged supplementary lending (PSL) injections - the People's Bank of China's direct lending to the real estate market - had extended property sales and starts beyond what appeared to be a sustainable trajectory, thereby lifting steel demand to some extent3 (Chart 3). Hence, weaker-than-expected steel products supply combined with slightly better demand than we anticipated have tightened the Chinese domestic steel market further, and underpinned high steel prices. Coal Similarly, the rebound in coal prices has also been due to declining output and strong demand growth. Chinese coal output turned out to be much weaker than we expected due to extremely stringent and frequent environmental and safety inspections on coal output (Chart 4). Back in mid-2017, in order to curb pollution, China demanded that coal mines plant trees, boost efficiency, cut down noise and seal off facilities from the outside world as part of a new "green mining" plan. This year's inspection have been even more stringent. Operations among coal mines, coal-washing plants and coal storage facilities were halted immediately if inspection teams found they failed to meet the related standards. As a result, Chinese coal production contracted 1% for the first eight months of this year. Chart 4Weaker-Than-Expected Coal Output Chart 5Resilient Thermal Coal Demand On the demand side, electricity generation from thermal power has remained quite robust at 7% (Chart 5). Again, coal prices have rebounded as the domestic coal supply-demand balance has tightened. Will Steel And Coal Prices Continue To Rise? The short answer is no. Many of the drivers underpinning the recent rally in steel and coal prices are set to fade over the next 12-15 months: Steel Steel prices will likely weaken in 2019 on rising steel product output and faltering steel demand growth. First, production of both crude steel and steel products will rise considerably next year, as the steel sector's de-capacity target is almost reached and new advanced capacity will come on stream faster to replace old or inefficient capacity that has already exited the market. Table 1 showed the 82% of this year's steel de-capacity target was already achieved by the end of July, leaving not much in the way of additional de-capacity cuts needed through the remainder of 2018. If this year's de-capacity cut target of 30 million tons is fulfilled over the next two months, there will be no need for any more capacity cuts in 2019, as the high end of the 2016-2020 de-capacity target (150 million tons) will be fully met this year. Table 1Supply-Side Reform - Capacity Reduction Target And Actual Achievement Record-high profit margins that Chinese steel producers are currently enjoying will also help boost steel production (Chart 6). This was the main driver behind this year's strong growth in crude steel output, despite more stringent environmental policies and ongoing de-capacity efforts. In addition, falling graphite electrode prices and increasing graphite electrode production will facilitate the expansion of cleaner electric furnace (EF) steel capacity and production in China (Chart 7). Chart 6Steel Producers' Profit Margin: At A Record High Chart 7Rising Graphite Electrode Supply Will Facilitate EF Steel Output EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. The availability of graphite electrode has been one major bottleneck for the development of EF capacity. As of late 2017, there were about 524,000 tons of new graphite electrode capacity under construction, most of which will be completed within the next two years. This will nearly double the current capacity of 590,000 tons. As this capacity gradually enters into the market, graphite electrode prices will drop further, encouraging more EF steel projects. In 2017, newly added EF steel capacity was about 30 million tons, and EF steel production increased by about 24 million tons (47% year-on-year). With rising graphite electrode supply, EF capacity this year is expected to add 40 million tons, resulting in about a 25-30 million ton increase in EF steel output. In 2019, based on the government's goal of 15% of total steel production being EF steel by 2020, we expect another 25-30 million tons new EF capacity to come online. This alone would translate into 3-4% rise in steel product production in 2019. Second, while steel supply is rising, the demand outlook seems more pessimistic. Our September 13 Special Report titled, "China's Property Market: Where Will It Go From Here?" concluded that the Chinese property market is facing increasing downside risks. Diminishing PSL direct financing from the central bank and shrinking funding sources for Chinese real estate developers point to a considerable slowdown in property starts and construction, which will eventually lead to faltering demand for steel. Chinese auto output growth is weak, with the three-month moving average growth registering a 6% contraction this September. The government has boosted infrastructure projects. This will support steel demand to some extent, but it is unlikely to offset demand weakness from the down-trending property market. The property market is the biggest steel-consuming sector, accounting for 38% of total Chinese steel consumption - much higher than the 23% share from the infrastructure sector. Bottom Line: Steel prices may stay high over the next two or three months due to low inventories and heating-season production controls within the steel industry. Nonetheless, steel prices are vulnerable to the downside over the next 12-15 months on rising steel product output and faltering steel demand growth. Coal Coal prices will likely decline over the next 12-15 months, but the price downside may be less than that of steel. First, on the supply side, coal output will rise only moderately (i.e., 2-3%) in 2019. There are three drivers pushing up Chinese coal output. The government in May asked domestic coal producers to ramp up coal output, as current coal market supply has been tight this year. Particularly, the National Development and Reform Commission (NDRC) demanded that the top three coal produce provinces (Shanxi, Shaanxi, and Inner Mongolia) increase their aggregated coal output by at least 300,000 tons per day as soon as possible. However, the June-July environmental inspections within the major producing province of Mongolia resulted in a 14 million ton year-on-year drop in the province's coal output. If the 300,000 ton per day increase is realized in 2019, it will be equivalent to nearly 100 million tons of new coal supply next year, which is about 2.8% growth from 2017's output of 3.52 billion tons. Based on government data, 660 million tons of capacity is currently under construction, which includes new technologically advanced capacity that has already been built and ready to use but has not yet received government approval. If 30% of the under-construction capacity comes to market in 2019 and runs at a capacity utilization rate of 70%, it will translate into about 140 million tons of new coal supply next year, which is about 4% growth from last year. Due to too-strict production policies during the winter heating season, there was a coal supply crisis last winter. This year, the government is likely to implement a less stringent production policy for coal. In this case, coal producers will likely produce more to take advantage of seven-year-high profit margins (Chart 8). Chart 8Coal Producers' Profit Margin: At A Multi-Year High However, at the same time there are also two drivers dragging down coal output. Table 1 above shows that at the end of July, only 53% of this year's coal de-capacity target and 65% of the government's 2016-2020 coal capacity reduction target had been achieved. This implies that Chinese coal producers still need to cut 70 million tons of old coal capacity through the remainder of 2018 and another 210 million tons of inefficient capacity in the coming two years (2019 and 2020) - possibly 105 million tons of cuts in each year. Similar to steel, coal de-capacity reforms are also diminishing (e.g. a 150-million ton reduction target in 2018 versus a 105 million-ton reduction target in 2019). However, different from steel, the remaining de-capacity target for coal is still quite significant. With continuing the implementation of its de-capacity plan, excluding the three major producing provinces, the remaining provinces that in general have smaller-scale coal mines may face further cuts in their coal production. For the first eight months of this year, 13 out of the 22 non-top-three coal-producing provinces registered a contraction in coal output. Environmental policies will likely remain strict, given the country seems determined to improve its air quality. More frequent inspection and/or stricter policies will further curb coal production. On balance, we still expect overall coal output to increase moderately (i.e., 2-3%) next year. Second, on the demand side, coal demand growth will weaken only slightly due to robust thermal coal consumption for thermal power generation (Chart 5 above). We expect Chinese electricity consumption to grow at 5-6% next year - a touch lower than this year - on strong demand from both the residential and service sectors. Most of the growth will likely be supplied by thermal power, as some 72% of total electricity generation is currently thermal power. In addition, the government has limited hydropower and nuclear power projects coming onstream next year. In the meantime, coal consumption for heating will likely be replaced by natural gas or electricity, and coking coal demand may fall due to EF steel expansion and more use of scrap steel in blast furnaces. Bottom Line: Coal prices are likely to head south on rising supply and weakening demand growth next year. In addition, we expect coal prices to fall less than steel prices over the next 12-15 months on a tighter supply-demand balance for the former than the latter. What About The Iron Ore Market? The outlook for iron ore prices is becoming less downbeat. Iron ore prices may have limited downside and could outperform steel prices over the next 12-15 months - due to increasing shutdowns of mainland iron ore mines. Government data show that Chinese domestic iron ore output contracted 40% year-on-year in the first eight months of this year (Chart 9). About 60% of the decline was from Hebei - the province that has probably imposed the strictest environmental policies among all the provinces targeting ferrous- and coal- related industries - due to its proximity to the capital, Beijing. Chart 9Significant Drop In Domestic Iron Ore Output Profit margins for iron ore miners has tanked to a 15-year low due to rising production costs on environmental protections. The number of loss-making enterprises as a share of the total number of iron ore companies has reached a record high (Chart 10). Although EF steel capacity additions will contribute to most of the growth in crude steel output next year, non-EF crude steel capacity, which uses iron ore as its main input, will also increase to some extent. This will also lift iron ore demand, which will lead to further declines in port inventories and rising imports (Chart 11). Chart 10Iron Ore Producers' Profit Margin: At A 15-Year Low Chart 11Chinese Iron Ore Imports Are Likely To Go Up Bottom Line: We are less bearish on iron ore prices and expect them to outperform steel prices. Chinese iron ore imports will likely grow again. Investment Implications Three main investment implications can be drawn from our analysis. Price ratios of thermal coal/steel rebar and iron ore/steel rebar have fallen to record low levels (Chart 12). As we expect thermal coal and iron ore prices to outperform steel, we recommend going long September 2019 thermal coal futures/short September 2019 steel rebar futures and going long September 2019 iron ore futures/short September 2019 steel rebar futures on Chinese exchanges in RMB. Chinese coal imports including both thermal coal and coking coal could remain strong, which would at a margin be positive news for Chinese major coal importers Australia, Indonesia, Russia and Mongolia. In the meantime, Chinese iron ore imports are likely to rebound in 2019 as well. This will be positive news for producers in Australia, Brazil and South Africa. Chart 12Both Thermal Coal And Iron Ore Will Likely Outperform Steel Chart 13Coal Producers' Shares May Outperform Steel Producers' Stocks Despite stubbornly high coal and steel prices, Chinese share prices of coal producers and steel producers have still plunged (Chart 13, top and middle panel). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of their peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. Based on our analysis, Chinese steel producers' share prices are still at risk of falling steel prices, while coal-producing companies may benefit from rising production and limited downside in coal prices. Hence, Chinese coal producers' shares may continue to outperform steel producers' shares with the price ratio of the former versus the latter just rebounding from three-year lows (Chart 13, bottom panel). Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease see Emerging Markets Strategy Special Reports "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, and "Revisiting China's De-Capacity Reforms", dated April 26, 2018, available at ems.bcaresearch.com. 2 Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality and also lead to environmental degradation. As "Ditiaogang" is illegal in China, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Consequently, last year's significant removal of "Ditiaogang" and statistical issues have caused the big divergence between crude steel production expansion and steel products output contraction since then. 3 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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Highlights A supply-driven spike in oil prices in early 2019 is now a highly likely scenario. This represents a potential risk to our current high-conviction view that global bond yields will continue to rise over the next year. Oil prices north of $100/bbl would have negative implications for global growth, especially with a rising U.S. dollar likely to magnify the inflationary impact outside the U.S. A spike in oil prices could alter the recent positive correlation between global bond yields and oil (through higher inflation expectations), even turning into a negative correlation (through weaker expected economic growth). The most reliable historical correlations suggests that more volatile oil prices will lead to greater volatility for both bond yields and corporate credit spreads. Feature The BCA house view remains unequivocally bond bearish, led by additional upside potential for U.S. Treasury yields. The Fed will continue to deliver a steady pace of rate hikes over at least the next year in response to a strong U.S. economy that is fueled by fiscal stimulus and operating well beyond full employment. U.S. bond markets are not discounting enough potential tightening and inflation expectations remain below levels consistent with the Fed's 2% inflation target, so Treasury yields have room to rise further. While we are comfortable with our high-conviction bearish view on government bonds, we recognize that it is prudent to look for potential scenarios that could derail our base-case scenario. Especially since our once out-of-consensus expectation of higher global yields is now a widely-held view among investors, with Treasury yields breaking out to new cyclical highs in recent weeks. One such risk could come from a spike in oil prices in early 2019, and its potential aftermath. A confluence of geopolitical (Iran, Venezuela) and monetary policy risks (Fed tightening, rising U.S. dollar) will likely stoke oil price volatility next year. This will eventually lead to higher bond market volatility both in developed markets (DM) and emerging markets (EM) - a relationship that has had a far more reliable correlation over time than the direct relationship between oil prices and yields (Chart 1). Chart 1Oil Vol & Bond Vol Are Linked In this joint Special Report, BCA's Commodity & Energy Strategy and Global Fixed Income Strategy services explore how a changing relationship between oil and interest rates could affect the future behavior of global bond markets and, by association, returns to fixed income portfolios. Growing Odds Of A 2019 Oil Price Spike Global oil markets are tightening. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. U.S. sanctions against the former, and the unabated collapse in the latter's economy will together remove some 2mm barrels/day (b/d) of supply from an already tight market next year. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage even in a minor oil-exporting state. The confluence of these factors is setting the global oil market up for a supply shock, which could take prices to $100/bbl in 1Q19 (Chart 2).1 Those high prices are likely to be sustained, and we expect Brent crude oil, the global benchmark, to trade at $95/bbl on average over the course of next year. Chart 2Get Ready For $100/bbl Oil In Q1 2019 Against this physical reality, the Fed remains set to continue normalizing interest rates. With other major central banks remaining relatively accommodative, widening rate differentials (Chart 3) will continue to support the U.S. dollar (USD). This will, all else equal, increase the cost of oil in local currency terms outside the U.S., hitting EM economies particularly hard if the price move is both as large, and as rapid, as we expect. Chart 3Rate Differentials Will Remain USD-Supportive It is important here to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by pushing up the inflation expectations components of global bond yields at a time when strong economic growth is also pushing up real bond yields. An oil price spike, however, can eventually produce a DIS-inflationary impulse by depressing real economic growth and destroying oil demand, which ultimately lowers oil prices, inflation expectations and real yields. The IMF, in its most recent World Economic Outlook, highlighted a scenario for 2019 where a big enough rise in oil prices could even cause the Fed to reverse its rates-normalization policies.2 While this is not BCA's base case view, a period of sharply higher oil prices in 1Q19 followed by lower prices in 2H19 would whipsaw global oil markets and raise oil price volatility. History suggests that bond price volatility is likely to also increase in the process, both for government bonds (through more uncertainty over the future path of inflation and policy rates) and corporate bonds (though more uncertainty over future economic growth). Expect Higher Bond Volatility As Oil Volatility Rises Since the end of the Global Financial Crisis (GFC), oil volatility has strongly influenced volatility in DM and EM bond markets. Indeed, we find all grades of corporate and junk bonds grouped together are highly correlated with oil volatility in the post-GFC period. We expect this to continue going forward, as oil inventories are drawn down globally to meet consumer demand for refined petroleum products like gasoline, diesel fuel, chemicals and plastics. The drawdown in global inventories shows up in a backwardated oil-price forward curve, which reflects the increasing inelasticity of supply.3 This means prices have to adjust more frequently and sharply to equilibrate available supply with demand, producing higher volatility in oil prices (Chart 4). Chart 4Implied Volatilities Will Rise As OECD Storage Falls Using principal components analysis (PCA), we find a high pairwise correlation between oil and bond volatility since 2010. The first principal component (PC) of all grades of corporate and junk bonds grouped together varies strongly with oil volatility, with a correlation of 0.80. Importantly, this component explains 91% of the variability in the group (Chart 5).4 EM bond spreads for smaller issuers like Chile, Peru, Hungary, Poland, Turkey, Indonesia, Mexico, Colombia, and Malaysia are also heavily influenced by greater variability of oil prices, with the first PC of this group highly correlated with oil volatility. Chart 5Oil Volatility Leads To Bond Volatility It comes as no surprise that our U.S. Bond Strategy group, headed by Ryan Swift, has found that lower-quality corporate bonds (i.e., junk) have a high correlation with oil volatility, as do lower-quality corporate spreads (Chart 6). As Ryan noted in a recent report: "there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa. ... The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads."5 Chart 6Higher Oil Vol = Wider Junk Spreads Oil Volatility Leads To Credit Spread Widening Thus, the oil price spike that we are expecting in 2019 should make corporate bond investors more cautious on the outlook for credit spread and expected returns. BCA's bond strategists have already been expecting to shift to an underweight stance on U.S. corporate debt sometime in 2019 as the Fed moves to a restrictive monetary stance and investors begin to cut U.S. growth expectations and anticipate increased future credit downgrades and defaults. A sharp upward move in oil prices in 1Q19 may prove to be the trigger for that shift to a more bearish outlook on credit. Could An Oil Price Spike Change The Fed's Current Thinking? The combination of an oil price spike and a stronger USD that we anticipate would present a considerable headwind to EM economic growth. Econometric modelling work done by BCA Commodity & Energy Strategy shows that there is a strong correlation between EM growth and U.S. inflation (see Box 1).6 Correlation is not causation, of course, but there is a plausible mechanism for that correlation through the USD, which impacts both EM growth and U.S. inflation. Box 1 Modeling The Links Between The USD, EM & Inflation The two risks we highlight in this Special Report - an oil-price shock in 1Q19 that occurs while the Fed is tightening - have profound implications for EM economies, which makes them particularly important for fixed-income markets globally.7 The near-term effects of an oil-supply shock that quickly sent prices above $100/bbl will hit EM consumers particularly hard. Many governments relaxed or removed fuel subsidies shielding consumers from high oil prices following the OPEC-engineered oil-price collapse of 2014 - 16, which saw Brent crude oil prices - the global benchmark - fall from more than $110/bbl in 1H14 to close to $25/bbl in early 2016.8 An oil-price spike would consume a far larger share of EM households' disposable income now, and would reduce aggregate demand. The second risk - tightening of the Fed's monetary policy - is more complicated. The U.S. economy separated itself from the rest of the world with strong growth this year, partly aided by fiscal stimulus. As a result, the U.S. economy is operating beyond full employment, and wages are growing smartly. This growth allows the Fed to tighten monetary policy, which likely produces four policy-rate rate hikes this year, and, per our House view, four next year. On the back of the Fed's rates-normalization policy, the U.S. trade-weighted dollar appreciated ~ 8% this year. We expect continued strength next year. As the dollar strengthens, EM trade volumes slow. This is partly a result of rising local-currency costs ex U.S., as most commodities are priced in USD. Trade volumes - particularly imports - are closely tied to EM incomes: The World Bank estimates the income elasticity of trade in EM economies averaged 1.5% from 2000-07 p.a., and 1.2% from 2010-17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period.9 Falling trade volumes correspond with weakening or falling income in EM economies. Part of this likely is explained by the expansion and deepening of Global Supply Chains (GSCs) over the past two decades, which fueled the rapid rise in trade of intermediate goods globally, and EM incomes in the process.10 To examine the impact of a rising dollar on EM income, we estimated a regression for the level of EM import volumes using an ensemble of models for the broad trade-weighted index (TWIB) USD as an explanatory variable.11 Our modeling indicates that a 1% increase in our USD TWIB ensemble translates into a 0.33% decline in EM import volumes (Chart 7).12 Chart 7Strong Dollar Dampens EM Trade Volumes Downward Trend In EM Trade Will Continue As USD Strengthens ... Next, we wanted to take these results and have a closer look at inflation, since, as noted above, wage and price pressures have been transmitted globally through GSCs for the better part of the 21st century. This is a phenomenon that accelerates as GSCs are broadened and deepened. More precisely, we wanted to examine the global aspects of local inflation in DM and EM economies.13 To do this, we look at the level of the U.S. Consumer Price Index (CPI) as a function of EM import volumes. Our modeling indicates that a 1% change in the level of EM import volumes as a function of the USD TWIB translates to a change (in the same direction) in the level of U.S. CPI of between 0.15% and 0.25% - estimated over the post-GFC period (2010 to now). This reflects both the direct and indirect effects of EM incomes on domestic inflation in the U.S. (Chart 8): Chart 8U.S. CPI Vs EM Import Volumes U.S. CPI Vs EM Import Volumes A stronger USD lowers expected U.S. inflation by reducing the cost of imports. EM disposable income growth slows as the USD rises, because the local-currency costs of imports rise and consumes more of available household budgets. Our modeling isolates the common deterministic trend between the U.S. CPI and EM import volumes from the cyclical variations. In fact, these two variables expressed in levels exhibit a strong and stable common trend.14 The U.S. trade-weighted dollar index has already appreciated 8% this year, with more upside likely in the next 6-12 months (Chart 9).15 This would widen the existing sharp divergence between a strong U.S. economy and weaker non-U.S. growth, putting even more upward pressure on the USD. This would represent an additional tightening of U.S. monetary conditions on top of the Fed rate hikes that have already occurred since late 2015. Chart 9Expect Continued USD Appreciation BCA's bond strategy services have described a concept known as the "Fed Policy Loop" to explain the link between global growth divergences, a rising USD, financial market volatility and eventual shifts in the Fed's hawkish bias. Such a move occurred in late 2015/early 2016, when the Fed had to delay additional increases beyond the initial 25bp rate hike of the current tightening cycle because of a soaring USD and global financial market instability (Chart 10). Chart 10Is The Fed Policy Loop: Watch U.S. Credit Spreads The current backdrop shares some characteristics with that episode, in terms of growth divergences (top panel), USD strength and wider EM credit spreads (second panel). The missing piece today is a large widening of U.S. credit spreads, and U.S. credit market underperformance versus Treasuries (third panel). The U.S. economy is in a much healthier place now compared to three years ago, which is why credit spreads have remained much better behaved in 2018. The global backdrop is also far less disinflationary, with the global output gap now closed and inflation expectations drifting back towards pre-crisis levels consistent with central bank inflation targets (Chart 11). Investors should focus on U.S. corporate bond spreads for signs that a stronger USD is starting to impact U.S. corporate profits and future U.S. growth expectations. This would be the most likely potential trigger for the Fed to pause on its current tightening path, as occurred in early 2016 (bottom panel). Importantly, we firmly believe that the Fed's hurdle for backing off the rate hikes from a tightening of financial conditions is much higher now because the U.S. economy is stronger today. A "garden variety" equity market correction, without much widening of corporate spreads, will not be enough. Investment Implications What we have laid out in this report is a risk to the current BCA house views on global duration exposure (stay below-benchmark) and global credit exposure (stay neutral, but favoring the U.S. over Europe and EM) - a supply-driven spike in oil prices, combined with additional increases in the USD fueled by Fed tightening. The potential trigger for that oil spike is largely geopolitical, stemming from the likely loss of oil supply from Iran via U.S. sanctions and Venezuela through economic collapse. The timing of either outcome is difficult to pin down precisely, but sometime in the first quarter of 2019 is our current best guess for when oil prices reach $100/bbl. The key variables to watch will be the U.S. dollar. If it stays stable, then the impacts on global growth and U.S. inflation from the oil spike could be more modest. If the USD surges higher, then the negative impact on non-U.S. growth will eventually spill back into the U.S. economy. The combination of more volatile oil prices and a stronger USD would be a likely trigger for a surge in U.S. bond volatility and wider corporate bond spreads. Eventually, this could move the Fed to pause on its rate hike cycle and, at least temporarily, end the current bond bear market. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Our full oil-price forecast is available in the September 20, 2018, issue of BCA Commodity & Energy Strategy, in a report titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. We will be updating our oil-price forecast next week. 2 Please see the IMF's World Economic Outlook for October 2018, which can be found here https://www.imf.org/en/Publications/WEO/ 3 Backwardation is a term of art in commodity markets used to describe an inverted forward curve - i.e., prompt prices for commodities delivered in the very near future trade higher than prices for commodities delivered further out in time. This is the market's way of signaling supplies are tight; storage holders are being incentivized to release oil in inventory via higher prices for prompt delivery. The opposite of this is referred to as a contango market (prompt prices are lower than deferred prices). Contango markets reflect well-supplied markets, as supply that cannot be immediately used must be stored for later use. In recent research, we were able to extend findings from academic studies that showed a non-linear relationship between oil volatility and the slope of the forward curve - highly backwardated and contango forward curves are accompanied by higher volatility in oil prices, due to the physical constraints on storage in such markets. 4 Principal components analysis (PCA) is a statistical technique used to reduce the most important information contained in a large number of correlated variables into a smaller number of common factors that explains the larger set. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk," dated October 9, 2018, available at usbs.bcaresearch.com. 6 EM trade volumes - particularly imports - are a key variable we use to track EM income levels. The World Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. Please see "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 10 of the 11 post-WW2 recessions in the U.S. were preceded by an oil-price spike. Since 1970, the combination of an oil-price spike and a Fed rate-hiking cycle resulted in recession. Please see "Oil-Supply Shock, Risking U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy on September 13, 2018. It is available at ces.bcaresearch.com. 8 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse." 9 We discuss this in "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Global value chains and the increasingly global nature of inflation," by Raphael Auer, Claudio Borio, Andrew Filardo, published online April 28, 2017, by VOX, the CEPR Policy Portal. 11 We average estimates from five different USD regressions using monetary policy variables, commodity prices and momentum indicators. The period covered is the post-GFC (2010 to now). 12 The regression we estimate includes a trend variable, which allows us to separate out the cyclical aspects of trade (i.e., imports) alone. 13 Please see "The globalisation of inflation: the growing importance of global value chains," by Raphael Auer, Claudio Borio and Andrew Filardo, which was published by the Bank For International Settlements in January 2017. 14 We believe this reflects "hidden variables" that simultaneously drive U.S. inflation and EM incomes such as global growth and global money/credit growth. The coefficient range we report - 0.15% to 0.25% - controls for this. For a discussion of "hidden variables," please see Clive Granger's 2003 Nobel Lecture entitled "Time Series Analysis, Cointegration, and Applications." 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ...Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com.

特別レポート

Highlights This Special Report was written with our colleagues in BCA Research's Geopolitical Strategy, led by Marko Papic. In it, we explore the evolution of Russia's role in European natural gas markets vis-a-vis the fast-growing U.S. natural gas production and Liquefied Natural Gas (LNG) export capabilities. So what? Rise of U.S. LNG exports to Europe will benefit gas producers and LNG merchants with access to U.S. supplies. Russia will grow ever-more dependent on China, while retaining a market share in Europe. Why? Exports of U.S. LNG to Europe are set to surge over the next decade. Russia will not be completely displaced, as American LNG fills the gap in European natural gas production. But U.S. LNG will lead to the end of oil-indexing of long-term natural gas contracts, hurting Russian state coffers on the margin... ... And forcing Russia further into the arms of China. Also... A tighter Trans-Atlantic partnership - soon to involve a deep energy relationship - and a budding Sino-Russian alliance will further divide the world into two camps, producing a Bifurcated Capitalism that may define this century. Feature Russia's obituaries have been written and re-written many times since the end of the Cold War. And yet, Moscow continues to play an outsized role in global affairs that is belied by quantitative measures of its power (Chart 1). Chart 1From Bipolarity To Multipolarity How so? The fall of the Soviet Union was precipitated by the country's sclerotic managed economy, its failure to escape the middle income trap, and its disastrous military campaign in Afghanistan. But before it died, the Soviet Union sowed the seeds for its resurrection. The $100-130 billion (in 2018 USD) spent on building a natural gas pipeline infrastructure into Western Europe was the elixir that revived Russian power. Just as Russia emerged from its lost decade in the 1990s, it caught a break. Western Europe's natural gas demand rose. At the same time, China's epic industrialization created a once-in-a-century commodity bull market (Chart 2). With demand for its resources buoyed on both sides of the Eurasian landmass, Russia once again saw revenue fill its coffers (Chart 3). With material wealth came the ability to rebuild its hard power and put up a fight against an expansionary Western alliance encroaching on its sphere of influence. Chart 2Chinese Industrialization... Chart 3...Filled Russian Coffers Is there an existential risk to Russia's business model looming in the form of surging U.S. liquefied natural gas (LNG) export capability (Chart 4)? Not yet. Thanks to a massive drop in European domestic production, U.S. LNG exports will fill a growing supply gap, but will not replace Russia's natural gas exports in the medium term. All the same, the once-lucrative European market no longer holds as much promise as it once did with the arrival of the U.S. LNG supplies. Chart 4U.S. LNG Exports Will Surge In order for Russian natural gas exports to Europe to be permanently displaced, Europe would have to build out new LNG capacity beyond 2020, restart domestic production by incentivizing shale development, or turn to alternative energy sources with large base-load potential, such as nuclear power. None of these are on the horizon. With ~15% of its government revenue sourced from natural gas sales, Russia is as much of a one-trick pony as there is in macroeconomics. While we do not foresee that pony heading off to the glue factory, Russia will face some considerable risks in the future, starting with the shift away from the rigid oil-indexed contracts it favors (which lock the price of natural gas to that of oil). As such, the risk to Russia is not that it loses market share in Europe's energy market, but that this market share yields much smaller income in the future, as gas-on-gas pricing competition increases. The U.S. Shale Revolution Goes Global Our commodity team has presented a compelling case for why investors should expect an increase in U.S. LNG exports beyond the current EIA forecast.1 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so as not to curtail oil production, will drive a large part of the expected growth in LNG exports. Our commodity team expects that a major LNG export center will be developed in south Texas, in Corpus Christi, over the next five years, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.2 At the same time, global LNG demand is expected to rise at an impressive 1.7% annual rate to 2040 (Chart 5). A few key markets will lead this trend (Chart 6). Based on BCA Commodity & Energy Strategy calculations, world LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7). The majority of the new capacity (53%) will come from the U.S., while 18% will come from Australia and 15% from Russia. Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally Chart 7LNG Export Capacity Growth The pickup in Australian export capacity is already impressive. While being a relatively small natural gas producer - the eighth largest, accounting for 3% of world output - it has already become the second largest LNG exporting country in the world with over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019. Most of Australia's LNG trade lies with Asia, given its geography. The U.S., whose LNG export terminals will be located in the Gulf of Mexico, only has 3 Bcf/d of liquefaction capacity today. Most of its LNG exports also go to Asia (Table 1), but that may change as the current capacity expansion will see exports rise to just over 9 Bcf/d in 2020.3 Furthermore, American gas will compete with surging Australian LNG exports and a build-up of Russian pipeline export capacity to China, which is set to start delivering gas to the country in 2019. Table 1U.S. LNG Exports By Country Europe, on the other hand, has massive regasification capacity slack and thus requires only minimal capex to begin importing large volumes of U.S. LNG. Europe has 23 Bcf/d regasification capacity, with a very low utilization rate of just 27%. This means that it has ~ 16 Bcf/d capacity available, more than enough to absorb all of expectant U.S. ~ 6-7 Bcf/d exports in the next couple of years.4 Bottom Line: The U.S. shale revolution is going global, with U.S. LNG exports set to surge over the next 5-10 years. While some of that capacity will find its way to Asia, those markets will also be flooded with Australian LNG and Russian piped natural gas. Europe, on the other hand, is filing just a quarter of its LNG import capacity, making a Trans-Atlantic gas alliance a match made in heaven. From Cold War To Gas War? If half of the currently proposed, pre-FID, LNG export projects were built in the U.S., American capacity would grow to potentially ~26 Bcf/d by 2030. Europe would need only one or two extra LNG import terminals to build over the next two decades to absorb this volume, as its current capacity is able to import nearly every molecule coming out of North America (Chart 8). Chart 8Europe Has Plenty Of Regasification Capacity Will this new U.S. LNG displace Europe's imports of Russian natural gas? The short answer is no. By 2030, Europe's supply-gap (i.e. domestic supply minus domestic consumption) is estimated to reach 36 Bcf/d. The U.S. could cover a large part of this gap if only half of the proposed pre-FID projects are constructed. However, if Europe's demand remains stable over this period, Europe will still import roughly 20 Bcf/d of Russian natural gas, which in 2017 amounted to 35% of Europe's natural gas consumption. If the U.S. fills 100% of the increase in Europe's supply-gap, it means new Russian natural gas production (the IEA and BP expect Russian production to keep increasing until 2030) will not be sent to Europe. Hence, even if it does not displace old Russian exports, it will limit Russia's ability to export its new natural gas. Europe's demand for natural gas is not likely to be stable. Despite sclerotic growth and generally weak population growth, European governments have tried to incentivize natural gas consumption due to its low emission of CO2 (Table 2). As such, investors should expect further displacement of coal and nuclear power generation in favor of natural gas. Table 2Natgas Emits Less CO2 Thus, U.S. exports will simply replace Europe's domestic production, which is facing considerable declines. The U.K. North Sea production will decrease 5% annually due to the lack of capex and the large number of fields reaching a mature state. Meanwhile, the Netherlands is phasing-out its Groningen field by 2030. Finally, Norwegian gas production is likely to stagnate after reaching record levels in 2017. The second reason that Europe will not be able to sever its relationship with Russia is that its LNG import terminals are largely located in countries that are not massively dependent on Russian imports (Map 1). The two major LNG terminals serving Central and Eastern Europe are the Swinoujscie terminal in Poland - finished in 2015 - and the Adria project in Croatia, to be completed in 2020. Map 1European Natural Gas Geography The Polish LNG terminal will do little to alleviate the dependency of countries further East - Belarus, Ukraine, Bulgaria, Hungary, and Slovakia - from Russia as it currently satisfies only one third of Poland's natural gas needs, and is projected to reach 50% by 2022 once the expansion is completed. This could significantly cut Russian exports to Poland, but not completely end them.5 The Croatian LNG terminal will likely make a very small dent in the overall reliance of the Balkans on Russian natural gas, as once it satisfied Croatian demand, little will be left over for the rest of the region. Beyond these two terminals, Europe will have to invest in pipeline infrastructure in order to reverse the flow of pipelines currently taking gas from the East to the West. At some point in the distant future, we could see a scenario where American natural gas flows even through Cold War era, Soviet-built pipelines deep into Central and Eastern Europe. But given the steep declines in West European natural gas production, this day will come after 2030. Bottom Line: Dreams of displacing Russian natural gas in Europe with American are overstated. European imports of U.S. LNG are likely to skyrocket, but that will merely replace the massive decline in West European and North Sea production. What does that mean for geopolitics? It means that Russia will continue to have a role to play in Europe, but its share of European imports will decline. As such, Europe will have options. If it builds more LNG import terminals, it could expand those options beyond American LNG imports. However, Russian geopolitical influence will not be displaced completely. Russian Coffers Will Take A Hit Although Russian natural gas will continue to course through Europe's veins, its state coffers are nonetheless going to take a hit. European governments are actively diversifying away from Russia via U.S. LNG imports, and buyers generally are shortening the tenor of contracts as they seek more flexible pricing.6 The growth in the global LNG market, fueled by surging U.S. production, will ultimately allow Asian and European markets to diversify away from oil-indexed pricing - which tends to be priced higher than gas-on-gas pricing - and expand access to U.S. supplies.7 The EU has co-financed or committed to co-finance LNG infrastructure projects valued at ~ 640mm euros to secure U.S. LNG. Ultimately, as more and more U.S. LNG moves toward Europe, markets will move toward short- and long-term contracts priced in USD/MMBtu (indexed to Henry Hub, LA, prices), much like Brent crude oil priced in USD/bbl. European markets have already seen this shift, as illustrated in Chart 9. Chart 9European Gas-On-Gas Pricing Is Rising The totality of U.S. export prices is determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. These contracts are without the restrictions found in many oil-indexed contracts. In the U.S., the presence of a deep futures market delivering natural gas to Henry Hub, LA, allows flexible long-term financing and short- and long-term contracting that can be hedged by buyers and sellers. According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply. While in Europe the share of LNG spot and short-term deals is small relative to the overall market, it is growing (Chart 10). With U.S. LNG volumes becoming increasingly available in Europe, market participants will be inclined to turn to the LNG spot market to buy or sell outside contracted volumes. This will deepen the development of European natgas markets: in any fully developed market, spot trading is followed by forward contracting, then futures trading using contracts settling against a spot price.8 Chart 10Expect More LNG Spot Trading Russia is a low-cost gas producer in Europe and will be committed to maintaining its market in Europe. However, with U.S. LNG export capacity potentially reaching ~14 Bcf/d by 2025, from ~3 Bcf/d today, it is entirely likely that Russia will find itself in a price war defending existing market share in Europe at lower prices. Its preferred way of doing business, via oil price indexed contracts, will be challenged overnight by a surge in U.S. LNG imports. Bottom line: The EU and its member states are actively diversifying gas supply sources away from Russia via U.S. LNG purchases. This will lower the marginal price of all gas bought and sold in Europe, all else equal, resulting in lower margins for all sellers of gas and better prices for consumers. Ultimately, the European natural gas market will resemble every other fully developed commodity market, operating on razor-thin margins. This means whatever rents were available in this market will be dissipated as competition increases. Investment And Geopolitical Implications The immediate investment implication of these developments is that gas producers and LNG merchants with access to U.S. shale-gas supplies, processing trading, and risk-management capabilities should be favored in this evolving market. Beyond the short term, however, we expect several ongoing geopolitical developments to be ossified by the flood of American LNG steaming towards European shores: Sino-Russian alliance deepens: As Russian natural gas exports to Europe stagnate, its pipeline infrastructure build-out will increase its exports to China to 3.8 Bcf/d by 2019. China will become the growth market for Russian energy producers, deepening the move between the two former Cold War foes to stabilize their relationship. Although it may seem obvious that Russia would retain leverage in such a relationship - given that it can "turn off the lights" to Beijing at whim - we actually think that Beijing will hold all the cards.9 Europe will have an incentive to keep diversifying its natural gas supplies. Meanwhile, Chinese demand is likely to keep growing. As such, China will become Russia's main option for revenue growth. And as the old adage goes, the customer is always right. Trans-Atlantic alliance deepens: Despite the fears that the "Trump Doctrine" would lead to American isolationism - fears that we shared in 2017 - the growing U.S.-European LNG connection will ensure that the Trans-Atlantic alliance - forged 70 years ago in blood - will be saved via brisk energy trade.10 A growing European energy deficit with the U.S. will also resolve - or at least alleviate - the main source of marital problems in the relationship: Europe's trade surplus. Bifurcation of capitalism: A key theme of BCA's Geopolitical Strategy is that the age of globalization will yield to the world's segmentation into spheres of influence.11 A deepening Trans-Atlantic alliance, when combined with a budding Sino-Russian relationship, will lead to a Bifurcated Capitalism system where the Trans-Atlantic West faces off against the Eurasian East. What would such a Bifurcated Capitalism mean for investors? Time will tell. But it may mean that thirty years of global capitalism (1985 to roughly today) may give way to something more common in human history: a world dissected into spheres of influence where flows of capital, goods, and people within spheres are relatively smooth and unencumbered, yet flows between the spheres are heavily impeded. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Pavel Bilyk, Research Associate Commodity & Energy Strategy pavelb@bcaresearch.com 1 Please see "U.S. Set To Disrupt Global LNG Market," published by BCA Research's Commodity & Energy Strategy October 4, 2018. It is available at ces.bcaresearch.com. 2 Please see "The Price of Permian Gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 3 Following a two-year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized. Therefore, final decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. 4 Cheniere Energy, the largest U.S. LNG exporter, expects ~ 50% of its exports to go to Europe, according to S&P Global Platts. Please see "US LNG vs Pipeline Gas: European Market Share War?" published April 2017 by Platts. 5 Additionally, if the Baltic Pipe Project, moving gas from Norway to Poland, reaches FID in 2019, this would help Poland diversify its energy supply from Russia, as the country would cover close to all its domestic demand via its production + LNG and new pipeline imports. 6 Please see "US and Russia step up fight to supply Europe's gas," published by the Financial Times August 3, 2017. See also "Russia's gas still a potent weapon," also published by the FT, re the so-called collateral damage suffered by Europe when Russia cut off gas supplies to Ukraine in January 2009. 7 For the EU, supply diversification is a particularly important goal. On July 25, 2018, the European Commission and the U.S. issued a joint statement, in which the EU agreed to import more LNG from the U.S. "to diversify and render its energy supply more secure. The EU and the U.S. will therefore work to facilitate trade in liquefied natural gas," according to a press release issued August 9, 2018, by the Commission. Re Japan's diversification strategy, please see "Feature: US LNG sources fit with Japan's desire for route diversity: minister," published by S&P Global Platts September 27, 2018. 8 Please see Darrell Duffie, Futures Markets (1988), Prentice-Hall; and Jeffrey C. Williams, The Economic Function of Futures Markets (1986), Cambridge University Press. Longer-term deals already are being signed under flexible Henry Hub futures-based indexing terms in the U.S. This is occurring because the U.S. LNG market is able to tap into futures liquidity that supports hedging by natgas producers and consumers. Please see "Vitol-Cheniere Pact Shows Long-Term LNG Deals Aren't Dead," published by bloomberg.com September 17, 2018. 9 Please see BCA Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com.

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart of the WeekIncreasing Gas-On-Gas Pricing Will Disrupt Global LNG Markets Growth in the global Liquefied Natural Gas (LNG) market will be fuelled by surging U.S. natural gas production, which will allow consumers in Asian and European markets to diversify away from oil-indexed pricing - with its attendant geopolitical risks - and falling European gas production. As a result, markets will move toward short- and long-term contracts priced in USD/MMBtu (Chart of the Week). This will favor gas producers and LNG merchants with access to U.S. shale-gas supplies, where production is growing at double-digit p.a. rates (Chart 2). Well-developed trading and risk-management markets in the U.S. - centered on Henry Hub, LA - will incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. These markets allow producers and merchants to offer short- and long-term contracts that meet consumer preferences. As the global LNG market grows, shipping companies, along with producers and merchants with worldwide trading and transport capabilities - or access to such capabilities - will grow market share at the expense of exporters tied to the more rigid oil-indexing regime (Chart 3). Energy: Overweight. We remain long call spreads along the Brent forward curve over February - August; these positions are up an average 88.4% since inception, basis Tuesday's close. The long S&P GSCI position we recommended in December is up 21.8%, on the back of higher oil prices and backwardated crude-oil forward curves. Base Metals: Neutral. Copper is holding on to recent gains - up ~ 11% from its mid-August trough, following oil higher. Precious Metals: Neutral. Gold hovers around $1,200/oz, following the Fed's meeting last week, which resulted in a 25bp increase in fed funds to 2.25%. Ags/Softs: Underweight. The trade agreement to be signed by U.S. officials at the end of November with their counterparts in Mexico and Canada removes some of the uncertainty weighing on ag markets. Upward revisions to 2017 carry-out estimates by the USDA continue to pressure corn and beans. Chart 2Surging Production, Market Depth Favor U.S. Gas Producers And Merchants Chart 3Growing LNG Imports Will Favor Shippers, Producers And Merchants Feature Surging U.S. natural gas production will continue to find its way to global LNG markets over the next decade. The persistence of oil-indexing in Asian LNG contracts will fuel the growth of U.S. exports, given the arbitrage between cheaper natural gas - priced basis supply-demand fundamentals for gas - and more expensive oil-indexed contracts.1 Added to this cost advantage, U.S. exports can be linked to hedgeable futures prices, using NYMEX Henry Hub, LA, contracts. These stability-of-supply and pricing advantages also allow LNG buyers in Asia and Europe to diversify away from oil-production disruption risks, which can send prices sharply higher, and being overly reliant on Russian imports. Chart 4U.S. LNG Exports Will Surge This will give global consumers an incentive to continue shortening the tenor of more rigid oil-indexed LNG contracts, and to replace them with hedgeable contracts referencing Henry Hub, LA, futures contracts priced in USD/MMBtu. While a fairly stout increase of U.S. LNG exports already is expected by the EIA and IEA, we believe this dynamic likely results in export volumes that are higher than the ~ 10 Bcf/d expected by 2023, and close to 15 Bcf/d toward the end of the 2020s (Chart 4).2 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so that it does not curtail oil production, will drive a large part of this growth. We expect a significant LNG export center to be developed in South Texas in Corpus Christi over the next five years or so, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.3 Flexible pricing of LNG contracts basis Henry Hub already is supporting the buildout of Gulf Coast exports via take-or-cancel contracts. These contracts are replacing the more restrictive take-or-pay contracts still used in Asia.4 This will continue to evolve, allowing supply development to be hedged via Henry Hub natgas futures. Consumers ultimately benefit from cheaper supplies and hedgeable risks. This is not to say other benchmarks will fall away. There is always room for regional benchmarks - even oil-based benchmarks such as the Japan Crude Cocktail (JCC), or the spot- and swaps-market reference Japan/Korea Marker (JKM).5 The global crude oil market accommodates such regional benchmarks: WTI crude oil futures are the benchmark for oil markets in the Americas, while Brent crude oil futures serve as the benchmark for global markets. Crude oils with different chemical properties can be priced relative to these benchmarks for delivery anywhere in the world. The global LNG market could retain an Asian benchmark, but a lot of work needs to be done in terms of building the supporting infrastructure - pipelines, regasification facilities, deep futures markets, etc. - to make that happen.6 We are inclined to believe the build-out of U.S. LNG export capacity will occur before these pieces fall into place: Scale has never been an issue in the U.S. oil and gas patch. Global Supply - Demand Overview Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations Global LNG demand is expected to rise at an impressive 1.7% p.a. out to 2040 (Chart 5). However, local supply and demand levels are increasingly unbalanced, implying that cross-border pipeline and LNG imports will need to increase as gas demand rises.7 A few key markets lead this trend, as seen in Chart 6, which illustrates the supply-gap in major consuming countries. Supply gaps are poised to grow in Emerging Asia and Europe, due to elevated demand growth in the former and lack of supply growth in the latter. World LNG demand grew by 10% last year, with Europe and Emerging Asia accounting for more than 95% of this increase. However, last year's stellar growth numbers should not be considered as the baseline growth forecast.8 The latest projections show demand increasing by 21 Bcf/d by 2025 - taking LNG imports from 38 Bcf/d at present to 58 Bcf/d by then. This implies a lower annualized growth rate of 5.5%. Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally LNG Supply On Growth Trajectory World LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7), with 53% of the additional capacity coming from the U.S., 18% from Australia, and 15% from Russia.9 Chart 7LNG Export Capacity Growth Our baseline forecast for the LNG market foresees a short-term supply surplus in 2020 (Chart 8), followed by a catch-up in demand and new waves of projects between 2024 and 2030. Among the supply-side developments we are following: Chart 8New LNG Projects In The Pipeline The Australian LNG market has undergone massive change in the last five years. While being a relatively small natural gas producer (8th largest producer, accounting for ~ 3% of world output), in 2015, the country became the second largest LNG exporting country in the world with now over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019 with the completion of new trains at the Wheatstone, Prelude Floating and Ichthys LNG facilities.10 This will bring Australian total LNG export capacity to over 10 Bcf/d. Importantly, most of Australia's LNG trade is with Emerging Asian countries. This region still relies mostly on oil-linked, long-term, and fixed-destination contracts. Absent the OPEC market-share war of 2014 - 2016, when oil prices collapsed, Australia's LNG prices are subject to oil price risks and volatility (Chart 9). Chart 9Asian Oil-Indexed Contracts Trade Above Spot LNG The U.S. currently has ~ 3 Bcf/d liquefaction capacity and is increasingly exporting to Asian countries (Table 1). The present wave of projects under-construction will push capacity to ~ 9 Bcf/d in 2020. Following a two year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized; therefore, final investment decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. If a majority of these projects goes through, U.S. capacity risks being overbuilt for the next decade (Chart 10). Table 1U.S. LNG Exports By Country Chart 10U.S. LNG Capacity Risks Becoming Overbuilt Importantly, U.S. LNG exports already have had a massive impact on the global LNG market. The totality of U.S. export prices are determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. Just as importantly, these contracts are without destination restrictions found in many oil-indexed contacts. In the U.S., the presence of a deep futures market allows flexible long-term contracting.11 According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply.12 An overbuilt U.S. market would increase spot LNG trading. Our own calculations based on EIA data indicate the U.S. could have too much capacity relative to demand in 2018 - 19, but goes into balance in 2020 - 2022.13 Russia's natural gas production is projected to increase from 66.7 Bcf/d in 2017 to 70.1 Bcf/d in 2023. However, the bulk of this increase will cover new pipeline exports. The country's LNG capacity is expected to grow by ~ 2.5 Bcf/d with the completion of trains at the Yamal, Vysotsk and Portovaya export facilities. Despite its low LNG capacity, Russia remains a key player in the LNG market. Its rising pipeline capacity connected to China - the fastest growing market in the world - competes directly with global LNG supplies. For Russia, the rise of natural gas availability on a global basis - in the form of LNG - shakes its foreign relationships and policies to the core. In loosening the once-tight relationship between buyers and sellers, the rise of spot LNG supplies will favor consumers and energy security, and foster the development of longer-term contracting.14 Global LNG Demand Could Outpace Supply By our reckoning, some 62% of additional global gas demand of 160 Bcf/d will be covered by rising domestic production, 12% by rising trans-national pipeline capacity, and the remaining 26% by LNG imports.15 Longer-term, we expect LNG and natural gas demand to keep rising as industry demand expands and major coal consumers build up their natural gas and renewables usage. As a result, LNG consumption will increase at a rate of ~ 3% p.a. until 2040, as overall gas demand grows ~ 1.7%.16 Key demand-side developments: Table 2Natgas Emits Less CO2 China's environmental reforms, supply-side industrial policies and continued economic growth will be the engine of global natural gas and LNG growth in the next decade. The Middle Kingdom's natural gas demand grew 15% to 23 Bcf/d in 2017, of which 54% came from additional LNG. This short-term growth surge required spot and short-term LNG imports, which pushed up North Asian LNG spot prices. Despite our expectation that China will continue leading global LNG growth, we believe 2017 to be an outlier. Two factors contributed to the rise in spot prices: To tackle its massive pollution without significantly altering economic development and growth, China's environmental policies favor natural gas as a bridge to a low-carbon economy, since natgas contains half the carbon content of coal (Table 2). China's supply-side reforms and winter capacity cut led to a spike in spot LNG demand, which had to be covered in global LNG markets. China has an extremely low level of storage to deal with seasonal natgas consumption fluctuations; this forces the country to rely on spot LNG to meet short-term peaks in gas demand (Chart 11). Chart 11China's Minimal Natgas Storage Forces It To Rely On Spot Markets While these factors still dominate Chinese markets, new Russian pipeline capacity is expected to start delivering gas in 2019, the ~ 247 bcf of additional domestic storage capacity and the rise in spot LNG supply will mitigate the effect. In addition, China is limited in its regasification capacity. Data re projects under construction and demand forecasts indicate the average utilization would rise to ~ 90% in 2020. Winter usage would push this to ~ 100% rapidly, constraining its ability to meet winter demand with spot LNG. As a result, we expect Asian spot LNG prices to rise above contracted oil-indexed prices next winter, but less so in 2020 and 2021. Longer term, China's gas consumption is expected to grow 4.6% p.a., outpacing the 4.0% p.a. domestic production growth. Some 23% of the gap will come from Russian and Turkmenistan pipeline imports. Europe's supply-gap rose in the past 3 years, and is expected to continue to widen. Unlike the rest of the world, this gap is growing because of supply depletion instead of strong demand growth. In fact, demand is expected to remain flat, based on the IEA's forecast of Europe's long-term growth. On the other hand, total European gas supply has decreased by 16% since 2010, and is expected to continue decreasing at a similar pace, reaching 21 Bcf/d in 2023 from 25 Bcf/d in 2017. These declines in European natgas supply are due to: The phase-out by 2030 of Netherlands' Groningen field. Continued concerns about the impact of natural gas production on earthquakes in nearby communities pushed the Dutch government to adopt, in March 2018, a plan to gradually stop gas extraction at the Groningen field. Production has been decreasing since 2013 and is expected to decrease by around three quarters between now and end-2023. U.K. natural gas production will decrease by 5% p.a. due to the lack of capex and the large number of fields reaching a mature state. Stagnation in Norway's gas production following its record production level in 2017. Europe's regasification capacity has considerable slack, which will allow it to expand its import volumes. Europe currently has 23 Bcf/d regas capacity, with a very low 27% utilization in 2017. This means it has ~16 Bcf/d capacity available. With the U.S. is expected to raise its exports by ~ 6 - 7 Bcf/d in the next couple of years, Europe could potentially absorb the entire U.S. LNG exports if it desires to diversify its source of energy supply. Pressure Builds For Competitive LNG Markets Chart 12Expect More LNG Spot Trading The movement toward an integrated global market - similar in structure to current oil markets - will be driven by sharply increased U.S. LNG exports, and more competitive pricing of LNG as a function of gas supply-demand fundamentals. This latter effort likely will find support from Japanese and EU regulators. In addition, U.S. exporters already are using futures-based pricing - using Henry Hub contracts - which provide greater flexibility for producers, consumers and merchants to hedge their risk. Either Asian markets will develop viable regional benchmarks, or the global market will increasingly adopt Henry Hub indexing. Again, this is a typical commodity-market evolution: wheat can be priced for delivery anywhere on the planet using Chicago Board of Trade indexing. Asia lacks an integrated pipeline network. Market-based pricing of gas as gas - i.e., based on regional supply-demand gas fundamentals - also has not fully developed. LNG-on-LNG competition is considered a way to promote market-based pricing. Thus, the rise in spot and short-term contracts priced on the basis of natural gas fundamentals in the region already visible in the data likely will continue (Chart 12). In addition, if we see the oil price spike we expect in 1Q19 - driven by the loss of Iranian exports due to U.S. sanctions, continuing losses in Venezuelan exports due to economic collapse, and still-strong global oil demand - LNG priced on gas fundamentals will become even more attractive.17 LNG consumers' exposure to oil prices - via oil-indexed supply contracts - is a disadvantage to consumers with super-abundant natural gas supplies (Chart 13).18 That said, the U.S. export capacity remains limited, thus it cannot completely substitute for the global trade being done basis oil-indexed LNG contracts. Still, higher oil prices will incentivize a shift to contracts with prices determined by natgas fundamentals, which favors continued growth in U.S. exports. If anything, it will push for a faster-than-expected expansion of U.S. LNG export capacity. Chart 13LNG Buyers Will Resist Oil-Indexed Exposure Bottom Line: Growth in global LNG markets likely will be faster than expected, as the U.S. develops its export capacity and continues to offer futures-based pricing. This will further reduce the attractiveness of rigid oil-indexed contracts. Gas producers and LNG merchants with access to U.S. shale-gas supplies, possessing trading and risk-management capabilities that allow them to offer flexible contracts globally, are favored in this quickly evolving market. Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com Pavel Bilyk, Research Associate pavelb@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The LNG cost structure is complex. A recent paper from the Oxford Institute For Energy Studies estimates U.S. breakeven costs for new LNG projects are roughly $7/MMBtu delivered, or ~ $4/MMBtu over current Henry Hub, LA, spot prices. This includes liquefaction costs, and transportation costs from the U.S. Gulf to Asia of ~ $1.50/MMBtu, and ~ $0.70/MMBtu from the U.S. Gulf to northwest Europe. Regasification charges and entry fees likely add ~ $0.70 to $1/MMBtu. Please see "The LNG Shipping Forecast: costs rebounding, outlook uncertain," published by the Oxford Institute For Energy Studies, March 2018. Transport costs are variable, and are only one part of the LNG pricing equation. The benefits of diversifying supplies cannot be overlooked, nor can the benefit of gas-on-gas pricing in a high-priced crude oil market. See also see "US powerhouse in the making," published June 14, 2018, by petroleum-economist.com. 2 Please see the International Energy Agency's Gas 2018 report published in March, particularly the discussion of supply beginning on p. 67. 3 Please see "The Price of Permian gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 4 Take-or-cancel contracts employ option-like features - e.g., cancelation payments that function as an option premium - that give buyer and seller flexibility in cancelling a contract or delivery in a manner that allows the seller to cover fixed costs, not unlike a tolling contact. This is possible because of the hedging latitude provided by the NYMEX natural gas futures market, which has Henry Hub, LA, as its delivery point. Please see "The Shift Away from Take-or-Pay Contracts in LNG," published by the Atlanta-based law firm King & Spalding on its Energy Law Exchange blog September 13, 2017. 5 Platts' JKM spot assessment for November was $11.35/MMBtu, which was down 6% from October assessments. Please see "Platts JKM: Asia November LNG spot prices fall on thin demand," published by S&P Global Platts September 21, 2018. The NYMEX JKM forward curve peaks at $13.50/MMBtu for January 2019 deliveries, and backwardates thereafter. 6 Big LNG consumers' antitrust regulators are increasing pressure on overly restrictive contracts, which could open these markets to further competition over the next three years. Japan's Fair Trade Commission (JFTC) in 2017 concluded a review of term LNG contracts, which raised the possibility heretofore standard term contract features - e.g., limits on destinations and diversions, and take-or-pay provisions - could run counter to its antimonopoly laws. Japan is the largest importer of LNG in the world, taking ~ 11 Bcf/d. Meanwhile, in June of this year, the European Commission opened an investigation into long-term LNG contracts between its member states and Qatar Petroleum. Akin Gump Strauss Hauer & Feld, the Washington, D.C., law firm, expects a ruling on destination and profit-sharing clauses that severely limit re-trading of LNG by purchasers. Akin Gump expects a ruling in the course of the next 3 years. While Japan's FTC did not specify remedies, it is possible buyers gain rights to re-sell and re-direct cargoes, following these reviews. This would make markets more competitive, although indexing the price of LNG to oil-based formulas likely will hinder this process. Please see "Revisiting LNG Resale Restrictions - Implications of Recent EU Decisions," published on the firm's website August 2, 2018. 7 Natural gas demand grew by 16% since 2010, according to the BP 2018 Statistical Review of World Energy, and is expected to grow by a cumulative 47% (1.6% p.a.) by 2040. 8 Many idiosyncratic factors helped Chinese LNG imports reach such an exceptional growth rate, mostly weather-related: China's environmental policy is resulting in widespread substitution of coal for natural gas for space-heating purposes, which, in colder-than-expected winters, results in surging demand. We do not believe this will be a long-term seasonal influence: Physical facilities are being built out to accommodate higher supply and demand. 9 World liquefaction capacity will rise to ~ 61 Bcf/d in 2022, based on our calculations of projects under construction. The bulk of additional capacity will come from the U.S., Australia and Russia. 10 Capacity of 0.6, 0.5 and 1.2 Bcf/d, respectively. 11 Please see U.S. Department of Energy, office of Oil & Natural Gas, LNG Monthly. 12 Like most globally traded commodities, LNG can be traded in USD/MMBtu. The global financial and clearing system already is set up to accommodate commodity transactions denominated in USD, therefore we do not see any impediments to extending it further into the LNG market. 13 Please see Chart 10 footnote for details. 14 We will be exploring the geopolitical dimension of LNG next week in a Special Report written with our colleagues in BCA Research's Geopolitical Strategy. Please see Meghan L. O'Sullivan, Windfall: How the new energy abundance upends global politics and Strengthens America's Power (New York: Simon & Schuster, 2012). 15 From 2017 to 2040, based on BP projections. The bulk of additional pipeline capacity will come from Russia with 12 Bcf/d destined to China and Europe expected to come on line in 2019. 16 Please see the International Energy Agency's GAS 2018 report published in March, BP's BP Statistical Review Of World Energy 2018 report published in June, Shell's Shell LNG Outlook 2018 report published in February, and U.S. the Energy Information Administration's International Energy Outlook 2017 report published in September. 17 Please see our most recent assessment of global oil fundamentals, published September 27, 2018, entitled "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," and our updated forecast, "Odds Of Oil-Price Spike In 1h19 rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published September 20, 2018. 18 Asia LNG prices are usually linked to the JCC according to predetermined formulae. However, the exact formula remains opaque and varies with each contract. Based on our calculations, we concluded that since 2010, the average formula uses a slope of ~14% on JCC prices lagged 4 months, with very low s-curve components and a constant. 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