Commodities & Energy Sector

Venezuela’s stability is deteriorating rapidly along the lines of our projections in recent years. Regime failure is at this point a high probability and poses immediate risks to global oil production. Our conviction is high because of the unprecedented combination of internal and external factors working against the regime: Economic collapse: Economic collapse has translated into total social collapse, as indicated by the large-scale emigration from the country (Chart 1). The current mass protests are the largest ever and are gaining momentum, while the opposition movement is coalescing into a single force against the regime as a whole for the first time. Political illegitimacy: What remained of the Maduro administration’s political legitimacy has eroded with his decision to ignore the results of the 2015 election and rig the election of 2018. The President of the National Assembly, Juan Guaidó, has declared himself President of the Republic based on an interpretation of the Venezuelan constitution and his leadership of the democratically elected National Assembly.1 International opposition: The erosion of Maduro’s legitimacy is reinforced by a rapidly changing international environment, with several countries becoming more assertive in opposing the regime. The United States and Colombia, on January 23, formally recognized Guaidó as president. They are joined by Canada and several other Latin American states, including Brazil, which is taking a more confrontational posture under the newly inaugurated President Jair Bolsonaro. This marks a rare coordination of North and South American states in pursuing a harder policy toward Venezuela. U.S. intervention: The United States, in particular, is taking a more interventionist stance through tighter sanctions. Indeed a limited U.S. military intervention is one of our top five geopolitical “Black Swans” for this year. Such an intervention could be further motivated by President Donald Trump’s need to distract from his domestic woes (Chart 2). His weak popular approval is comparable to that of President Ronald Reagan at this stage in Reagan’s first term, when he intervened in the small island state of Grenada. Venezuela is not Grenada, but the U.S. is also not considering outright invasion. Trump is facing a serious risk of becoming a “lame duck” due to the fall in his popularity amid the government shutdown and gridlock in Congress. A foreign policy response to a humanitarian crisis is an obvious way for him to try to increase his influence over the remainder of his term. Moreover, the U.S. diplomatic and defense establishment may agree on the need to reinforce the Monroe Doctrine against anti-democratic politics and growing Chinese (and Russian) influence in Venezuela. Chart 1 Chart 2Trump May Distract From His Woes Trump May Distract From His Woes Trump May Distract From His Woes What remains is to see whether the U.S. adds force (tougher sanctions) to its more aggressive diplomatic posture, and whether the Venezuelan opposition remains mobilized and unified in rejecting anything except a transition to a new government. The U.S. is already considering expanding sanctions, including a likely deathblow that would involve sanctioning Venezuelan oil imports and the export of diluents necessary to process Venezuela’s heavy sour crude. Within Venezuela, the opposition’s momentum and the role of the National Bolivarian Armed Forces will be decisive: so far there are small signs of fracture (Table 1), but no sign of a substantial turn against the Maduro regime.Sufficient popular pressure can create a “tipping point,” however, after which the military and security forces are no longer effective in executing the government’s writ and the socio-political situation declines beyond the ability of the regime to stay in power. Persistent large-scale protests concentrating on Maduro’s departure and/or a split in the security forces could precipitate the final stage of transition to a new interim government in the short to medium term. Table 1Military Insurgencies Have Been Small And Unsuccessful … So Far Venezuelan Production Near Collapse Venezuelan Production Near Collapse Impact On The Oil Market In this context, we are raising the likelihood of a collapse of that state to an 80% probability, from our prior assessment (33%). We use the word “collapse” to stand for Venezuela’s production falling to 250k b/d to feed domestic refineries, from ~ 1mm b/d at present. In our simulation of how a collapse could affect oil prices, we make the following assumptions based on recent history – i.e., the run-up to the re-imposition of U.S. sanctions against Iranian oil exports. These assumptions are driven by our prior belief that the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which we’ve dubbed OPEC 2.0, and the Trump administration will attempt to hold Brent crude oil prices at or below $80/bbl in the event of a collapse in Venezuela’s oil production. Here are our assumptions: Venezuela collapses next month; OPEC 2.0 responds with a one-month lag, and increases production by 500k b/d in March 2019. If Brent spot prices trade to $85/bbl, OPEC 2.0 raises production an additional 100k b/d. If prices continue to rise toward $100/bbl, OPEC 2.0 adds another 300k b/d to global supply. Further increases lead to the U.S. Strategic Petroleum Reserve (SPR) releasing 100k b/d as needed to reduce Brent prices to $80/bbl or less. If spot Brent prices rise toward $100/bbl, we assume there will be 200k b/d of demand destruction globally. Chart 3 shows how Brent and WTI prices would evolve per these assumptions. Because Venezuela’s production has fallen so much, we believe the collapse of that country’s oil industry can be managed by OPEC 2.0, and, if necessary, via U.S. SPR releases. Of course, a similar trajectory likely would occur in the event Venezuela’s oil industry collapses later.2 Chart 3A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses In our simulation, the Brent spot price trades to $85/bbl in December 2019, and OPEC 2.0 adds an additional 100k b/d to global supply. Prices continue to rise, and we assume OPEC 2.0 member states release a combined 300k b/d in March 2020. The U.S. release 100k b/d of SPR in 2020. In addition, we do see demand destruction of 200k b/d in 2020, as prices reach close to $100/bbl. With all of this, prices are contained and start decreasing in mid-2020. Of course, whether these surges can be maintained indefinitely – i.e., until Venezuela comes back on line, or comparable crude grades can be shipped south from Canada – is an open question. Even so, there is no doubt that the leaders of OPEC 2.0 silenced more than a few critics by means of their 4Q18 production surge. KSA stands out in this regard, taking its November 2018 production over 11mm b/d from ~ 10mm b/d in 1H18 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Venezuelan Production Near Collapse Venezuelan Production Near Collapse As a practical matter, we have no way of knowing how OPEC 2.0 or the U.S. SPR would respond to a collapse in Venezuela’s oil industry. In these simulations, we’re making a call on how and when OPEC 2.0 might choose to release its spare capacity once again, as they did in the run-up to the U.S.’s Iran oil export sanctions last year (Chart 4). Chart 4 As the members of OPEC 2.0 – mostly KSA, when it’s all said and done – dig deeper into spare capacity, less is available to meet another unplanned outage – e.g., Libya or Nigeria lose significant barrels to civil unrest. That is, we are sure, a discussion OPEC 2.0 is and will be having among its members, and with the U.S. SPR. The global oil market still is exposed to a sharp loss of Iranian barrels on top of the loss of Venezuela’s supplies in the event that country’s oil industry collapses. This argues strongly for an extension of the waivers granted by the Trump administration in November for anywhere from 90 to 180 days, depending on how the Venezuela situation evolves. These waivers expire at the end of May. This would require us to change our balances assessment, should it occur.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1 Please see Articles 233, 333, 350 of the Venezuelan constitution. The domestic and international legal debate is beside the point: the effective power of the people, the security forces, and the international community will determine the outcome. 2 For more information on global supply and demand balances, and our most recent oil price forecasts, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy today. It is available at ces.bcaresearch.com.  

OPEC 2.0 is building physical optionality, to deal with different possible moves the U.S. can make on Iranian oil export sanctions and waivers. This comes despite an apparent break in the sense of urgency Saudi Arabia and Russia feel re production cuts. The coalition’s market monitoring committee meets in April, followed by a full gathering in May, when U.S. waivers expire. If the U.S. extends waivers, OPEC 2.0 can extend production cuts; if it doesn’t, it can add supply as needed.1 On the demand side, markets appear to be overly concerned about a sharper-than-expected slowdown in China, which, if borne out, would restrain EM growth. We believe these fears are overdone, and expect a slight improvement in EM demand generally this year and next. In our new balances estimates, we see the OECD commercial oil inventory overhang clearing in 1H19, on the back of resilient demand, OPEC 2.0 discipline, and a more moderate level of growth in U.S. shale oil output. This keeps Brent on track to average $80/bbl this year and $85/bbl next year, with WTI trading $74/bbl this year, and $82/bbl next year. Highlights Energy: Overweight. Mandatory cuts of 325k b/d, coupled with additional exports of ~ 190k b/d due to additional train and pipeline capacity out of Canada, will drain the 35mm barrels of excess crude oil inventories targeted by the Alberta government in December by 1H19. The WCS – WTI spread narrowed to -$10/bbl from -$50/bbl on these mandatory cuts. By 2H19, we expect Canadian production cuts to average 95k b/d. Base Metals: Neutral. Aluminum output in China surged 11.3% y/y in December, hitting 3.05mm MT, according to Metal Bulletin. Total output for 2018 was 35.8mm MT, a 7.4% y/y increase. Precious Metals: Neutral. Gold is holding its recent gains, as markets become more comfortable with the Fed pausing on its rates-normalization policy until 2H19. Agriculture: Underweight. Hot and dry weather in Brazil is threatening crop yields there. The unfavorable weather is expected to affect three-quarters of cotton-growing regions, half of sugar areas, a third of first-crop corn acreage, and a quarter of soy regions. Feature The first signs of fraying in the relationship between the putative leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA), which cut production ~ 450k b/d m/m in December, and Russia, which raised output – are emerging, as world leaders meet in Davos. While this casts doubt on the leadership’s carefully cultivated amity, and their shared willingness to abide by the recently agreed output cuts, we do not believe it signals the end of the historic cooperation between these states. Total OPEC output – estimated by production-tracking sources outside the Cartel – stood at 31.6mm b/d in December, a prodigious 751k b/d reduction m/m. We expect continued oil production cuts from core OPEC states and decline-curve losses among non-Gulf OPEC and non-OPEC states within the coalition this year to remove at least 1.2mm b/d from the market, per the quotas agreed by members in December (Chart of the Week, Table 1). On top of this, mandatory Canadian production cuts of 325k b/d in 1H19 and 95k b/d in 2H19 will keep average production cuts at ~ 1.4mm b/d this year. Chart of the WeekOPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts Table 1OPEC 2.0 Production Cuts Could Exceed Quotas OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC 2.0’s cuts could persist into 2020, depending on how the U.S. deals with Iranian oil-export sanctions and waivers. Even though KSA and Russia apparently do not share the same sense of urgency re production cuts right now, we believe OPEC 2.0 is committed to draining oil inventories, particularly in the OECD.2 To do so, they’re increasing their operational flexibility – creating physical options, in a manner of speaking – to deal with a range of uncertain outcomes when U.S. waivers on Iranian export sanctions expire in May. Sanctions And OPEC 2.0’s Physical Options Despite the waivers granted to its eight top consumers shortly after U.S. sanctions took effect in November, Iranian exports plunged below 0.5mm b/d in December. As of December, China had substituted almost all of its Iranian imports for alternative barrels.3 This coincided with a production surge by OPEC 2.0 at the behest of the U.S. leading up to the November sanctions deadline of November 4, 2018, which swelled OECD inventories and took them above their rolling 5-year average level (Chart 2). India retained 30% of its May import levels from Iran, while Europe complied at 100% with U.S. sanctions (Table 2). Chart 3 shows the decrease in exports in preparation for the sanctions over the course of 2018. Chart 2OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In Table 2Iran Exports By Destination 2018 (‘000 b/d) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Chart 3 Whether or not the waivers are extended is anyone’s guess. It is possible waivers will be extended for 90 or 180 days, as a way to counter OPEC 2.0 production cuts, and to offset the lag between filling new pipeline takeaway capacity in the Permian. We expect importers to queue up for Iranian barrels as the market tightens in 1H19. OPEC 2.0’s market monitoring committee will meet in April, followed by a ministerial meeting in May, just ahead of the expiration of the waivers.4 If the U.S. extends them, OPEC 2.0 can extend production cuts after it meets in May; if waivers are not extended, the Cartel can calibrate an appropriate supply response. Either way, we expect OPEC 2.0 will closely align its production schedule with any U.S. action on the sanctions and waivers. This will, we believe, keep change in the overall market’s supply side relatively constant, except for the month or two required to adjust OPEC 2.0 output. Permian Will Drive OPEC 2.0 Policy The larger issue for OPEC 2.0 comes in 4Q19, when ~ 2mm b/d of new pipeline takeaway capacity comes on line in the Permian Basin in West Texas. With additional takeaway capacity due to come on in 2020, the Cartel will have its work cut out for it next year.5 Our models show a slight decrease then flattening in U.S. rig counts over the coming months, as a result of the 4Q18 sell-off in WTI, with a rebound around mid-year (Chart 4). This is because rig count lags oil prices by ~4 months. Chart 4U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) We are expecting production in the Big 5 shale basins to average 8.4mm b/d in 2019 and 9.0mm b/d next year, a somewhat higher level than projected by the EIA. Growth in the shales accounts for close to 80% of the 2.3mm b/d of growth in the U.S. over 2019 – 2020. Globally, U.S. shales will continue to provide the bulk of y/y crude oil production growth, accounting for 73% of the 2.5mm b/d of growth we will see over the next two years. Given the near-death experience OPEC 2.0 member states had in the price collapse of 2014 – 2016, we remain convinced OPEC 2.0 member states will once again have to embark on a strategy to backwardate the Brent forward curve as they did in 1H18, to moderate the growth of shale-oil production in the U.S. (Chart 5). Reducing production in the short term will force refiners to draw inventories to supply their units and produce products like gasoline, diesel, jet fuel and a wide range of petrochemicals. Chart 5OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards This will backwardate the Brent forward curve – i.e., prompt-delivery barrels will be more expensive than deferred-delivery barrels. A backwardated forward curve means OPEC 2.0 member states with term contracts indexed to spot prices receive higher prices for their oil than shale producers hedging 2 years forward, all else equal. The trick for OPEC 2.0 will be to keep the Brent forwards backwardated when the Permian takeaway capacity starts to fill, and exports from the U.S. rise in the early 2020s, as deep-water harbors are brought on line. If OPEC 2.0 is successful in keeping the Brent forwards in backwardation, this will, over time, moderate the growth of shale production: Hedgers’ revenue is constrained by lower forward prices.6 We would not be surprised if OPEC 2.0 states started announcing final investment decisions on select investments in spare capacity to augment existing resources, so they are able to quickly bring production to market in the event of unplanned outages that could lift the entire forward curve and incentivize hedging at higher prices. Demand Still Looks Good Oil markets continue to fret over a possible hard landing in China – resulting either from an internal policy error or a ratcheting up of tensions in the Sino – U.S. trade war. This is causing markets to extrapolate into the wider EM space, and take oil-demand projections lower on an almost-daily basis. In a word, markets are overwrought. Chinese policymakers are sensitive to the tight financial conditions that prevailed in 2H18, which, along with the trade war with the U.S., slowed growth and fostered uncertainty among households and firms in China. We agree with our Geopolitical Strategy and China Investment Strategy groups that presidents Trump and Xi are pragmatists dealing with restive populations, and want to deliver a deal ahead of U.S. elections and the 100th anniversary of the founding of the Chinese Communist Party in 2021.7 We’ve been expecting the government to deploy a modest amount of stimulus in 1H19, which will begin having an effect on the Chinese economy in the second half of this year. Toward the end of the year and into 2020, we expect the larger stimulus to be deployed in the run-up to put a bid under industrial commodities – oil, base metals and bulks in particular. Overall, we are seeing signs global growth may be reviving over the next few months via an apparent bottoming in our Global LEI Diffusion index (Chart 6). The diffusion index measures the proportion of countries where Leading Economic Indicators (LEIs) are rising relative to those in which LEIs are falling. As is apparent in Chart 6, the diffusion index suggests the downturn in the global LEI has bottomed. The index leads the global LEI by a few months. Chart 6BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming In our latest supply-demand balances, we are expecting Chinese oil demand to average 14.3mm b/d this year, and 14.8mm b/d next year. Along with India – expected to consume 5.0mm b/d this year, and 5.2mm b/d next year – these two states account for 36% of the total 54.3mm b/d of EM demand we expect in 2019 and 2020 (Table 3).8 Table 3BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Overall EM demand, the powerhouse of global oil-demand growth led by China and India, is expected to increase 1.1mm b/d this year – slightly more than we estimated last month – and 1.3mm b/d in 2020. DM demand growth, as always, comes in lower, at 390k b/d this year and 280k b/d next year. Oil Supply-Demand Balances Will Tighten We expect global oil production to average 100.9mm b/d this year and 102.9mm b/d in 2020. Consumption is expected to average 101.8mm b/d this year and 103.4mm b/d next year, respectively (Chart 7). This puts OECD inventories back on a downward trajectory, as storage draws resume (Chart 2). Chart 7Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening On the back of these estimates, we expect Brent to average $80/bbl this year and $85/bbl next year, with WTI averaging $74/bbl and $82/bbl, respectively. Given our expectation for higher prices in Brent and WTI, we continue to favor being long crude oil exposure. We are long outright WTI spot futures; long July 2019 Brent vs. short July 2020 Brent; long call spreads along the 2019 forward Brent curve, and long the S&P GSCI. Bottom Line: Markets will continue to tighten as a combination of lower supply growth and rising consumption allows OECD commercial oil inventories to resume their downward trajectory. The apparent lack of a shared sense of urgency by OPEC 2.0’s leaders – KSA and Russia – will be resolved, in our view. OPEC 2.0 will once again focus on backwardating the Brent forward curve, in order to gain some control over the rate at which U.S. shale oil production grows. We continue to favor long exposures to the crude oil futures.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      In last week’s Commodity & Energy Strategy we noted these upcoming meetings, and OPEC 2.0’s resolve to drain the market.  Please see “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. 2      Bloomberg reported this week KSA’s and Russia’s oil ministers cancelled a planned meeting in Davos, following al-Falih’s criticism of the pace at which Russian oil production is being cut.  Please see “Saudi, Russian Energy Ministers Cancel Planned Davos Meeting,” published by bloomberg.com January 22, 2019.  KSA cut its crude oil output 450k b/d m/m in December to 10.64mm b/d from 11.09mm b/d in November.  Russia increased crude and liquids production to a record 11.65mm b/d in December, an 80k b/d increase m/m, according to OPEC Monthly Oil Market Report published January 17, 2019.  OPEC expects Russian oil output to average 11.47mm b/d in 1H19, and 11.49mm b/d in 2019.  We are carrying something close to this in our balances (11.51mm b/d) for 2019 and 2020. 3      China imported 10.3mm b/d of crude oil in December after posting a record 10.4mm b/d of imports in November 2018, just as sanctions were kicking in. 4      In our base case estimate, we assume Iran’s crude oil output will average ~ 2.8mm b/d, down ~ 1.0mm b/d from its 3.8mm b/d production level in 1H18, which was prior to the U.S.’s announcement it intended to re-impose export sanctions.  One way or another, we expect OPEC 2.0 to adjust production to compensate for whatever production is lost due to sanctions.  5      Please see “Permian tracker: Production growth slowing as pipeline race still on,” published by S&P Global Platts July 2, 2018, for a discussion of the new takeaway capacity planned for the Permian Basin by midstream companies in 2019 and 2020. 6      The Permian basin is closely tied to hedging activity in the WTI futures market.  It is the only basin for which WTI commercial short open interest is an explanatory variable for rig counts in our modeling.  Commercial short open interest in the WTI futures also Granger causes Permian rig counts. 7      Please see the Special Report entitled “Is China Already Isolated,” published by BCA Research’s Geopolitical Strategy and China Investment Strategy January 23, 2019.  It is available at gps.bcaresearch.com and cis.bcaresearch.com. 8      Our EM demand assumptions are driven by the IMF and World Bank EM GDP forecasts. This week the IMF lowered its global growth forecast for 2019 and 2020 by 0.2 and 0.1 percentage points to 3.5% and 3.6%, respectively. This is only slightly down from our lower estimate last month, but still above the World Bank’s expectation. We are using these variables directly in regressions to estimate prices and EM consumption. This replaced our earlier income-elasticity models used to calculate EM oil consumption.  We proxy EM demand with non-OECD oil consumption. We discuss this in “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4q18 Image Commodity Prices and Plays Reference Table Insert table images here Summary Of Trades Closed In 2018 Image

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Chart 1 Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring ...Sending Multiples Soaring ...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... A Utilities Proxy No More... A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead ...An Energy Proxy Instead ...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7). Chart 7   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations... Cheap Valuations... Cheap Valuations...   Chart 10...Amid Recovering Profit Margins ...Amid Recovering Profit Margins ...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Chart 11 Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe MLPs: Not Your Typical Yield Play MLPs: Not Your Typical Yield Play Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale. Chart 13   Chart 14   Chart 15 Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

The Fed’s near-term capitulation on its rates-normalization policy highlighted by our fixed-income desks will provide a tailwind for EM oil demand this year by weakening the USD. This will reduce refined-products’ costs in local-currency terms ex-U.S., as it buoys EM growth prospects.1 If, as we expect, Chinese policymakers also deploy modest stimulus, global oil demand still will remain on track to grow 1.4mm b/d this year, per our forecast. We are mindful of potential upside surprises on the demand side, particularly, if, as we noted in our last balances update, the 100th anniversary of the Chinese Communist Party in 2021 provokes policymakers to deploy large-scale stimulus in 2H19 or 2020.2 The odds of this occurring before 2H19 are low, and we are not yet raising our demand estimates. A partial defusing of the Sino – U.S. trade war is possible, as the 90-day negotiating window agreed at the December G20 meeting starts to close next month. This could trigger a short-term rally in commodities, but, absent durable agreements on the technology front, this potential thawing will be transitory. Highlights Energy: Overweight. China’s crude oil imports surged 30% y/y in December 2018, which helped lift total 2018 imports by 10% vs. 2017 levels. This partly was the result of independent refiners scrambling to use up 2018 import quotas at year-end, so that they could retain those levels this year, according to S&P Global’s Platts.3 Base Metals: Neutral. China’s copper ore and concentrate imports were down 11.5% y/y in December – the largest y/y decline since May 2017 – in line with slowing growth there. Precious Metals: Neutral. We expect gold to continue to rally over the next 3 – 6 months on the back of a weaker USD in 1H19, as the Fed likely pauses on its rate-hiking schedule. Ags/Softs: Underweight. Grains likely will get a short-term price lift as the Fed dials back its rates-normalization policy. Feature For the moment, the Fed’s apparent capitulation on its rates-normalization policy reduces the risk the U.S. central bank will err on the side of being overly aggressive, which would have thrown a spanner into EM growth prospects this year. An easier Fed monetary policy will buoy EM GDP and weaken the USD over the short term, which will, support oil prices via stronger demand (Chart of the Week). Chart of the WeekEM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track On the supply side, we remain convinced OPEC 2.0 is resolved to drain the global inventory overhang as quickly as possible. This unintended inventory accumulation resulted from OPEC 2.0’s production surge and the granting of waivers on U.S. export sanctions against Iran by the Trump administration in November (Chart 2). This conviction was strengthened earlier this week, following the announcement of a proposed earlier-than-expected meeting of the coalition’s market monitoring committee in Baku, Azerbaijan, in mid-March to assess global supply and demand conditions. This could be followed by a full OPEC 2.0 meeting in Vienna in mid-April, following up on their December meeting in Vienna, according to S&P Global Platts.4 Chart 2OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang Pieces Of The Price Puzzle Falling Into Place The Fed is signaling it has put its rates normalization policy on hold, given indications global economic growth is slowing in a manner similar to what occurred in 2014 – 15. Then, the U.S. central bank was attempting to escape the zero lower bound of its monetary policy, following the end of its QE program. In the event, the Fed only raised rates once in December 2015, as the slowdown in growth stayed its hand. Our colleagues at BCA’s Global Fixed Income Strategy note, “the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) … reached levels last seen after that 2014/15 episode” as 2019 unfolded (Chart 3).5 The slowdown in global growth could stabilize, as the LEI diffusion index suggests, but the Fed, at least for now, appears to be comfortable waiting for clear evidence this is the case. Chart 3Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint In and of itself, the Fed’s near-term capitulation to the market will not be sufficient to reverse the “darkening prospects” foreseen by the World Bank in its most recent forecast, but it will be supportive of oil prices.6 On the back of our expectation the Fed will take a break from its rate-normalization, we are expecting a weaker USD over the short term, which will support oil demand and EM GDP growth. All else equal, this will create a tailwind for oil prices, given EM is the main driver of demand growth (Chart 4). Chart 4USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices The Chart of the Week introduces a new model we developed to understand the effect of EM GDP growth on oil prices. The level of EM demand is mean reverting to a linear trend, and anchors other variables – oil prices and FX rates, for example – that oscillate randomly with the arrival of new information to the market. Our modeling indicates Brent and WTI prices can be expected to increase (decrease) 94bp and 73bp for every 1 percent increase (decrease) in EM GDP, assuming the broad trade-weighted index (TWIB) for the USD remains unchanged. A 1 percent decrease (increase) in the USD TWIB (holding EM GDP constant) translates into an increase (decrease) in Brent and WTI prices of ~ 4.0% and 3.6%, respectively. We have found EM GDP levels to be as useful an explanatory variable for Brent and WTI prices as non-OECD oil consumption, our proxy for EM demand. Indeed, it is perhaps even cleaner, since using it directly in our models does not require us to estimate an income elasticity of demand for EM economies, in order to forecast prices.7 We are not raising our expectation for demand growth on the back of the Fed’s apparent moderation in its rates policy. We are keeping our 2019 demand growth estimate at 1.4mm b/d, with 1.0mm b/d of that coming from EM and the remainder from DM. Should the Fed signal a further pause in its rates-normalization policy – extending perhaps deep into 2H19 – we would be inclined to raise our demand-growth estimates. Additional Stimulus Coming From China? China is not the be-all and end-all of EM growth. All the same, next to the U.S., it is the second-largest consumer in the world, accounting for ~ 14% of the 103.75mm b/d of global demand we expect this year. Next in line is India, which accounts for ~ 5% of global demand. The news coming out of China at the moment is confusing. While the Xi administration prosecutes its “Three Tough Battles” – i.e., deleveraging, pollution and poverty – it also is pulling policy levers to counter the economic damage inflicted by its trade war with the U.S.8 Government policymakers are signaling fiscal and monetary stimulus will be forthcoming via tax cuts and bond issuance this year, to counter these headwinds.9 However, we do not expect a massive deployment of stimulus. More than likely, the big stimulative measures arrive in 2H19 or next year. The key target dates for policymakers are further in the future, and are focused on the upcoming 100th Anniversary of the Communist Party in 2021. By 2020, the Xi administration is targeting a doubling of real GDP vs. 2010 levels, and a doubling of rural and urban incomes (Chart 5). Chart 5China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" So the real stimulus out of China likely comes later this year or next year. As our Geopolitical Strategy service notes: “If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021.” There is, as we noted in our last balances update, a low-probability chance stimulus could surprise to the upside if growth – particularly employment – falls precipitously. For now, we are comfortable with our House view that the more extensive fiscal and monetary stimulus will be saved for later this year or next in the run-up to the Communist Party’s anniversary.10 Bottom Line: The Fed appears to have capitulated to markets in the short term, and likely will hold off on another rate hike in 1H19. All else equal, this will weaken the USD and buoy EM GDP over the short term. Together, these effects will keep oil demand on track to growth 1.4mm b/d, per our forecast. Markets are reacting to news of fiscal and monetary stimulus coming out of China. We have been expecting modest stimulus to be deployed this year, most likely in 2H19. We continue to expect a larger package of fiscal and monetary stimulus later in the year and next year in the run-up to the Communist Party’s 100th anniversary.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see “Enough With the Gloom: Upgrade Global Corporates On A Tactical Basis,” published January 15, 2019, by BCA Research’s Global Fixed Income Strategy. It is available at gfis.bcaresearch.com. See also “Buy Corporate Credit,” published by BCA’s U.S. Bond Strategy January 15, 2019. It is available at usbs.bcaresearch.com. 2      Please see “Oil Volatility Will Persist; 2019 Brent Forecast Lowered to $80/bbl,” published January 3, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see “China’s 2018 crude oil imports rise 10% to 9.28 mil b/d,” published by S&P Global Platts January 14, 2019, online. 4      OPEC 2.0 ministerial meetings usually are held in May/June and again November/December. Please see “OPEC eyes mid-March monitoring committee meeting, mid-April full ministerial,” published by S&P Platts Global January 14, 2019. The cartel also will meet in early February to put the finishing touches on a charter formalizing the coalition. We will be delving deeper into the supply side next week, when we update our balances. 5      Please see footnote 1 above. 6      The World Bank’s most recent forecast can be found in its Global Economic Prospects, published January 8, 2019. The lead article is entitled “Darkening Skies.” 7      We use forecasts of EM GDP and GDP growth published by the World Bank and IMF in our modeling. This is useful for us for a number of reasons, particularly since it is calculated externally by well-regarded global institutions tasked with this function. Like other estimates and projections – e.g., the EIA’s, IEA’s and OPEC’s supply/demand estimates – we can take a view on these data relative to our House view or our own Commodity & Energy Strategy view. NB: Because these are cointegrated systems, regressions in levels is appropriate. 8      This campaign is discussed in depth in “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 9      Please see “China signals more stimulus as economic slowdown deepens,” published by uk.reuters.com January 15, 2019. 10     Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018 Image

The oil rout that began in October appears to have run its course, based on positioning, sentiment and technicals. All the same, several cross-market gauges we designed to assess investors’ conviction on global macro conditions continue to support a cautious view over the short term. This dichotomy in the markets’ internal dynamics supports our view volatility will remain elevated over the next month or two. After that, we expect clear evidence the global oil market is tightening, as strong OPEC 2.0 compliance with production cuts and robust demand – albeit weaker than that of the past two years – drains inventories in 1H19. This is the basis of our $80/bbl Brent forecast for this year. Highlights Energy: Overweight. Our oil recommendations made last week in the wake of the oil-price vs. fundamentals disconnect – long spot WTI and long July 2019 Brent vs. short July 2020 Brent spread – are up 5.7% and 0.7%. Base Metals: Neutral. Asia trade-volume growth likely will move lower in the short term, even if Sino – U.S. trade talks are fruitful. With or without such an outcome, precautionary inventories built on both sides will have to be drawn down, an outcome we believe is priced into base metals prices. A rapprochement would be supportive for these markets, but these inventories still have to be worked through. Precious Metals: Neutral. Gold’s rally is intact, as markets gain conviction the Fed will deliver one rate hike this year. We are aligned with our House view calling for three hikes, which would present a headwind. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Insiders report China made three large purchases of soybeans from the U.S. over the past month, as trade negotiators met in Beijing this week. Optimism on the trade front is buoying optimism in ag markets.1 Feature The rout in oil prices over the course of 4Q18 appears to have run its course, based on a composite indicator we created to assess technical and sentiment information in the crude oil market, and other metrics designed to gauge internal market dynamics (Chart of the Week). Chart of the WeekBCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude The individual components of the composite at the end of last year all had taken a sharp down leg, indicating investors were seriously concerned about a global slowdown and perhaps even an unexpectedly early recession (Chart 2).2 This concern also was noted by the World Bank, which this week revised its EM growth outlook – the key driver of commodity demand – for 2018 lower, and shaved its global 2019 growth estimate as well.3 Chart 2Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Ordinarily, there is not a lot of econometric support for technical indicators. Nonetheless, we found this composite indicator does a good job of explaining y/y changes of Brent crude oil prices, and vice versa. That’s right: there is two-way Granger-causality between the BCA WTI Composite indicator and y/y crude prices (Chart 3).4 Chart 3Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Given this two-way relationship, it is plausible speculative positioning, investor sentiment and price momentum can help forecast short-term price movements. In turn, the movement in prices feeds back to the components of our composite indicator, and can help anticipate positioning, sentiment and momentum. Indeed, it is likely the fundamental supply-side shock arising from the higher-than-expected waivers on Iranian imports granted by the Trump administration in November – separate and apart from the selling pressure in October – set off one of these feedback loops. Given the paucity of data at the time, market participants had to guess the extent of the physical surplus arising from the waivers as OPEC 2.0 rapidly increased production and filled inventories ahead of U.S. sanctions, and at the same time fears over the strength of demand were becoming more pronounced.5 As we noted last week, we do not think the oil price rout was evidence of an as-yet undetected collapse in demand or run-away supply. OPEC 2.0 and Canadian producers will cut ~ 1.4mm b/d of production; decline-curve losses of ~ 200k b/d from states that cannot maintain or increase their supply will persist, and slower U.S. shale growth resulting from price-induced capex declines will reduce output growth there. These supply cuts, plus still-strong demand growth of 1.4mm b/d, are driving our forecast the physical oil overhang will clear in 1H19, and that Brent prices will average $80/bbl this year, with WTI trading $6/bbl below that.6 Based on the most recent “oversold” reading of the BCA WTI Composite indicator, we believe the oil rout has run its course, given the indicator is in deeply oversold territory. By now, we think the negative sentiment and spec positioning components of prices have been exhausted. Unless we see a fundamental shock – a truly unexpected collapse in demand, e.g., or a complete breakdown in OPEC 2.0 production discipline – it is difficult to foresee another sell-off.  As the uncertainty clears and inventory starts to draw, speculators will re-enter the market (allowing producers to hedge), and sentiment will turn more bullish as visible evidence of lower inventories continues to be reported in weekly and monthly data. Some Indicators Still Urge Caution While the case can be made the oil rout has run its course, there still are cautionary signals flashing in our other indicators that assess internal market dynamics within and across EM and commodities. This likely will keep volatility high over the short term (Chart 4). Chart 4Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated BCA’s Emerging Market strategists’ Risk-on vs. Safe-Haven currency ratio has rolled over. This ratio picked up the degradation of demand expectations and rise in recession fears, which then spilled into global bond yields. With the benefit of hindsight, the case can be made this presaged a rise in global risk aversion in currency markets (Chart 5).7 Chart 5Warning Signs Flashing bca.ces_wr_2019_01_10_c5 bca.ces_wr_2019_01_10_c5 In addition, our gold ratios, which serve as growth-versus-safe-haven indicators – i.e., the copper/gold and oil/gold ratios – sagged, as industrial commodities weakened and gold rallied by 7% since November 2018.8 Together, these indicate markets were revising down their growth expectations, and reducing their risk in 4Q18. Even with the recent pick up in EM trade volume – a proxy for EM income growth – our short-term models suggest this likely will not be sustained, and that import volume growth will contract in 2H19 (Chart 6). Chart 6Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Our EM trade-volume models are driven by the broad trade-weighted USD (TWIB) and other FX and financial variables.9 The USD had been rallying as the U.S. domestic economy outperformed the rest of the world, and markets remained concerned over the Fed’s rates-normalization policy, which was pressuring expectations for EM trade growth lower. With the oil-price collapse of 4Q18 in the rear-view mirror, it is not inconceivable the Fed will not feel compelled to raise rates in 1H19, as inflation expectations are re-calibrated in the wake of this most important expectations driver. If this takes some of the steam out of the USD, or even causes it to retreat from its recent highs, oil – and commodities generally – will rally on the tailwind. Indeed, a depreciation in the USD of 5% from current levels could lift prices by ~18%, holding everything else constant (Chart 7). Chart 7USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance Bottom Line: Our intra- and inter-market indicators are throwing off conflicting signals regarding the current state of global oil markets. On the one hand, our WTI Composite indicator shows oil is oversold, which supports our bullish outlook. On the other hand, markets currently are signaling a larger decline in global growth than we currently have in our oil forecast models. A larger-than-expected slowdown in oil demand growth – e.g., an additional loss of 200k b/d that took growth to 1.2mm b/d – would push our Brent forecasts down by ~ $4/bbl to $76/bbl this year. Nevertheless, uncertainty about the future path of oil supply and demand is elevated, and the distribution of possible price outcomes is wide, as our most recent forecast illustrates (Chart 8). We believe the combination of OPEC 2.0 production discipline and robust demand support a rebound in oil prices in 2019. We are keeping our 2019 Brent price target at $80/bbl. Chart 8Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “China buys more U.S. soy as officials meet for trade talks,” published by reuters.com January 7, 2019.com. 2      Each of the individual components is standardized to create the WTI composite indicator. We lack CFTC open-interest data to update the open-interest series, due to the U.S. government’s shutdown. 3      This is in line with our expectation, which is contained in our most recent balances and forecast update published last week.  Please see “Oil Volatility will Persist; 2019 Brent Forecast Lowered to $80/bbl.”  It is available at ces.bcaresearch.com.  The World Bank’s latest forecast can be found in its Global Economic Prospects, which is titled “Darkening Skies.”  It can be found at http://www.worldbank.org/en/publication/global-economic-prospects. 4      Clive Granger used standard statistics to show information contained in past realizations of one variable can be used to predict another variable’s value. Two-way causality indicates lagged values of both variables contain statistically significant information that allows past realizations of both to be used to predict the other’s value.  There is a huge literature on this topic.  For an excellent intuitive explanation of Granger causality, please see the discussion beginning on p. 365 of “Time Series Analysis, Cointegration, and Applications,” Clive Granger’s Nobel lecture delivered December 8, 2003 (https://www.nobelprize.org/uploads/2018/06/granger-lecture.pdf). 5      Please see “All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  It is available at ces.bcaresearch.com. 6      We would not be at all surprised if OPEC 2.0 overdelivered on production cuts, as it did in 2017 – 1H18. 7      Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 8      These gold ratios are discussed in detail in “Gold Ratios Wave Off ‘Red October’ … Iran Export Waivers Highlight Tight Market,” published by BCA Research’s Commodity & Energy Strategy November 8, 2018.  It is available at ces.bcaresearch.com. 9      For in-depth discussions of these models and our general approach to modeling EM trade volumes, please see “Trade, Dollars, Oil & Metals … Assessing Downside Risk,” published by BCA Research’s Commodity & Energy Strategy August 23, 2018.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2018 Image ​​​​​​​

Getting right to the point: Oil fundamentals are, and could remain, disconnected from benchmark prices, as they were in the waning days of 2018, when markets were forced to recalibrate global supply-demand balances in the dark. Four factors will drive this disconnect and keep volatility elevated (Chart of the Week): Chart of the WeekPrice-Fundamentals Disconnect Will Persist Price-Fundamentals Disconnect Will Persist Price-Fundamentals Disconnect Will Persist Continuing uncertainty over how much oil Iran will export this year; A lack of precise information about individual production cuts from OPEC 2.0; Uncertainty over EM demand; and Illiquid markets, brought about by a diminution of speculators’ risk-bearing capacity, which is largely the result of the price-fundamentals disconnect. Nonetheless, we do not believe markets are responding to an as-yet undetected collapse in demand or run-away supply, which recent price action would suggest. To the contrary, we expect OPEC 2.0 and Canadian production cuts of ~ 1.4mm b/d, continued decline-curve losses and slower U.S. shale growth resulting from price-induced capex declines, will face off against stout demand to rebalance markets in 1H19. We are, therefore, getting long spot WTI, and long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close. Highlights Energy: Overweight. We ended 2018 with an average gain of 24% on recommendations we closed or were stopped out of. Open positions going into 2019 – mostly Brent call spreads with stop-losses of -$1.00/bbl – were down 49%. Base Metals: Neutral. Chile’s national statistics agency INE reported copper output was 5.3mm MT over the January – November 2018 period, its highest level since December 2005, and 6% higher than year-ago levels.1 Precious Metals: Neutral. Gold markets appear to be pricing less than the four rate hikes we’re expecting this year from the Fed. We remain long as a portfolio hedge. Ags/Softs: Underweight. U.S. negotiators head to Beijing next week to continue trade talks. We remain bearish soybeans all the same, given our expectation the current crop year will end with record-high stocks-to-use ratios worldwide. Feature The last time WTI oil futures traded this close to $40/bbl, OECD crude and products inventories stood at ~ 3.1 billion barrels, and OPEC 2.0 had just begun its output cuts in Jan17 (Chart 2). OECD inventories now stand under 2.9 billion barrels, and are on course to fall to ~ 2.5 billion by year-end, as the physical surplus is drained by a combination of falling production and still-strong demand (Chart 3). Chart 2OECD Inventories Will Draw, Taking Crude Prices Higher OECD Inventories Will Draw, Taking Crude Prices Higher OECD Inventories Will Draw, Taking Crude Prices Higher Chart 3Supply Cuts, Demand Strength Will Rebalance Markets Supply Cuts, Demand Strength Will Rebalance Markets Supply Cuts, Demand Strength Will Rebalance Markets Brent and WTI prices have fallen 39% and 41% from their October 2018 highs, following the about-face by the U.S. on Iranian oil-export sanctions in November. On the back of this, we expect OPEC 2.0 to follow through on its 1.2mm b/d production cuts – possibly even exceed them, as they did over the 2017 – 1H18 period. OPEC 2.0’s track record on production discipline is strong, hence our expectation the group’s 2019 output will fall to 31.14mm b/d vs. 2018’s 32.40mm b/d level.2 The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as unlikely the administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and expect they will be extended at least for 90 days. We expect Iranian production to fall from ~ 2.80mm b/d in 1H19 to an average 2.60mm b/d from June – December 2019, resulting in the loss of 1.25mm b/d of exports. We expect Saudi Arabia to raise production from 10.15mm b/d to 10.30mm b/d to offset most of this incremental loss of Iranian production. Government-mandated production cuts of 325k b/d in Alberta, Canada – undertaken to drain a persistent inventory overhang and loosen the flow of oil pipeline-transport-constrained production – also will remove actual production from the market this year.3 In addition, we continue to model the loss of 190k b/d of decline-curve losses in OPEC 2.0 member states that are incapable of maintaining or lifting output due to low prices and a lack of investment (Chart 4). The contribution of these states to the OPEC 2.0 cuts is to “manage” their depletion rates per their November 2016 accord (Table 1). Chart 4Production Outside Gulf OPEC Continues Decline, Led By Venezuela Production Outside Gulf OPEC Continues Decline, Led By Venezuela Production Outside Gulf OPEC Continues Decline, Led By Venezuela Table 1Table 1 BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Oil Volatility Will Persist; 2019 Brent Forecast Lowered To $80/bbl Oil Volatility Will Persist; 2019 Brent Forecast Lowered To $80/bbl Net, we have world supply growth at 0.5mm b/d this year vs. the 1.4mm b/d estimated by the EIA. Most of this again comes from the U.S., where we expect 1.3mm b/d growth. Due to the price rout following Iranian import waivers, we lowered our rig count projections – the main input of our U.S. production forecast – which took our Lower 48 U.S. (i.e., ex GOM) production growth to 1.2mm b/d from the 1.4mm b/d rate we estimated last month. Despite pipeline bottlenecks in the Permian Basin, which will be fully alleviated by 4Q19 when the last of ~ 2mm b/d of new takeaway capacity comes on line, U.S. shales still account for most of the net growth in U.S. ouput (Chart 5).4 If WTI prices remain in the mid- to low-$40/bbl range, however, rig counts will be driven lower, which will, all else equal, lower U.S. shale-oil output this year. Chart 5Lower WTI Prices Slow U.S. Shale Growth Lower WTI Prices Slow U.S. Shale Growth Lower WTI Prices Slow U.S. Shale Growth Lower Prices Will Support Demand The price collapse since October will keep global oil demand from breaking down, leading us to expect consumption to grow ~ 1.40mm b/d this year. This is down slightly from our previous estimate of 1.45mm b/d of growth, and falls 200k b/d short of the ~ 1.6mm b/d of growth we expect for 2018.5 Forecasting demand is notoriously difficult. This is particularly true for forecasting EM demand, the source of most of the growth in the world. We have non-OECD demand – our proxy for EM oil consumption – growing 1.0mm b/d this year, down from 2018’s rate of 1.2mm b/d. This reflects our expectation the IMF will lower its growth expectation for EM GDP to 4.6% this year, from its October 2018 estimate of 4.7% growth. This will take global GDP growth to 3.6% to 3.7% previously estimated. EM demand continues to be led by China and India, which we expect will grow 450k b/d and 210k b/d, respectively, this year, again accounting for more than half of EM growth. China’s oil consumption is expected to average 14.3mm b/d, while India’s will average just over 5mm b/d. We continue to expect modest stimulus coming from China in 2H19, which will support oil demand and consumer spending. However, this could surprise to the upside, with the 100th anniversary of the Chinese Communist Party coming up in 2021. Our colleagues at BCA Research’s Geopolitical Strategy (GPS) noted that if China’s government is to launch another large-scale stimulus package (not a foregone conclusion), then the likeliest time frame is 2H19 or 2020. Indeed, this is more probable than anytime earlier, due to the desire of Chinese policymakers to dispel any doubts about stability in 2021 for the Party’s centenary. GPS’s Matt Gertken observed the average gap between the bottom of China’s credit impulse and the top of nominal GDP growth is ~ 1.5 to 2 years. Policymakers will not want to stimulate too aggressively in early 2019 and risk having a flagging economy in the midst of 2021 celebration.6 Investment Implications Over the short term, oil prices could remain disconnected from market fundamentals, which we believe remain broadly supportive. Indeed, the balance of risks still favors the upside, despite the epic volatility over the past 3 months brought about by the larger-than-expected waivers to importers of Iranian oil just before U.S.-imposed sanctions were due to kick in in November (Chart 6). Chart 62019 Brent, WTI Price Forecasts: Slightly Lower at And /bbl 2019 Brent, WTI Price Forecasts: Slightly Lower at $80 And $74/bbl 2019 Brent, WTI Price Forecasts: Slightly Lower at $80 And $74/bbl We have lowered our average 2019 Brent forecast to $80 this year from $82/bbl, and our WTI forecast to $74 from $76/bbl, given our assessments of production and consumption.7 Markets continue to re-calibrate supply and demand balances largely in the dark, and will continue to do so until greater clarity is gained on actual OPEC 2.0 production cuts and the state of EM demand. On the supply side, we expect sharp production cuts from OPEC 2.0 and Canadian producers of ~ 1.4mm b/d; falling output in non-Gulf OPEC states from continuing decline-curve losses; and slower U.S. shale growth resulting from lower capex in the wake of the price collapse. On the demand side, we lowered our EM growth estimate slightly ahead of an expected downgrade of EM growth this year, but we still expect consumption to show relatively strong growth of 1.4mm b/d. Net, the combination of supply cuts plus still-strong demand will remove the current global surplus, and rebalance the market by the end of 1H19. Thus, in our view, the balance of risks – as seen in our ensemble scenarios – still is to the upside (Chart 7). Chart 7Balance of Risks Favors Upside Balance of Risks Favors Upside Balance of Risks Favors Upside In line with our expectation for higher prices, we are getting long spot WTI, believing prices in the low- to mid-$40s extending beyond 1Q19 will cause a 5 – 10% slowdown in U.S. production growth later this year, which will set up a rally later in the year. We also are getting long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close, in the expectation of a return to backwardation by the end of 1H19, as OECD inventories draw. We have touched on 3 of the 4 drivers of volatility in this week’s research. Next week we will examine the effect of this volatility on speculators’ risk-bearing capacity, and the implications for price discovery. Contrary to popular and received political opinion, speculation is a necessary and vital activity for the efficient functioning of commodity markets, particularly those used by commercial participants to hedge untoward price risks.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1      Please see “UPDATE 1-Chile monthly copper output highest in 13 years,” published December 31, 2018, by reuters.com. 2      Our estimates include continued production declines ex OPEC Gulf states and in other non-OPEC members like Mexico that are covered by the OPEC 2.0 agreement (Table 1). Under the production-cutting accord agreed at OPEC 2.0’s December meeting in Vienna, October 2018 is the benchmark against which new quotas – yet to by made public – are assessed. We note here that OPEC 2.0 has not published any official quota schedule following its December 2018 meeting, where it agreed to the 1.2mm b/d of production cuts.  Our supply estimates use data from the U.S. EIA, IEA and OPEC, along with trade press reports. 3      We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the Alberta government is attempting to draw down by its action over the course of 2019 at a rate of ~ 96k b/d.  4      By year-end, we expect U.S. crude oil production of 12.6mm b/d, which will keep the U.S. the largest crude oil producer in the world. U.S. crude oil exports can be expected to continue to grow as a result, after hitting 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data. U.S. product exports likely will run ~ 6mm b/d this year. 5      The IEA and OPEC are expecting 2019 demand growth of 1.3mm and 1.29mm b/d, respectively, while the U.S. EIA is expecting consumption will grow 1.5mm b/d. 6      Please see “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 7      This puts us above the consensus Brent forecast of $69.13/bbl reported by Reuters. Please see “Oversupply, faltering growth to weigh on oil prices in 2019: Reuters poll,” published by reuters.com December 31, 2018. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 3Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017 Image