Commodities & Energy Sector

Highlights EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS. BCA's Emerging Markets Strategy team has a more pessimistic outlook than the BCA house view, which is upbeat on the prospects for China's capex growth and commodity prices. The ongoing liquidity tightening in China amid lingering credit excesses is bound to produce major negative growth surprises. The authorities will reverse the ongoing monetary tightening only if the pain on the ground becomes visible or the economic data deteriorates significantly. Financial markets will sell off considerably in advance. In Chile, take profits on the receiving 3-year swap rate trade; stay neutral on this bourse within an EM equity portfolio. Feature EM Profit Recovery: How Enduring? EM equities have not only advanced in absolute terms but have also outperformed developed market (DM) share prices considerably since early this year. This outperformance has been rationalized by a recovery in EM earnings per share (EPS). Indeed, EM EPS has revived briskly in recent months (Chart I-1A). Chart I-1AEM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) Chart I-1BEM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) For this rally to continue, EM EPS would need to continue to expand further. We do not expect this. On the contrary, our bet is that EM EPS growth will slow considerably later this year and most likely contract in early 2018. Our basis is that the growth (first derivative) and impulse (second derivative) of EM & Chinese narrow money (M1) has in the past led their respective profit cycle (Chart I-1A and Chart I-1B). If these relationships hold and EM EPS growth dwindles later this year, EM share prices should begin to sense it now, and start falling back very soon. Interestingly, EM EPS net revisions have failed to rise above the zero line despite the recent rebound in profits (Chart I-2, top panel). This is in contrast to DM EPS net revisions, which have surged well above zero (Chart I-2, middle panel). As a result, recent EM relative outperformance against their DM peers has occurred despite the drop in relative net EPS revisions (Chart I-2, bottom panel). This presages EM equity analysts are not revising upward their forward estimates for EM EPS, despite the ongoing rally in share prices. This is extremely puzzling (and rare) and may be a reflection of recent weakness in commodities prices - or the fact that expectations for EM EPS growth were already elevated. We do not place much emphasis on analysts' EPS revisions because the latter swing with stock prices - they have zero forecasting power for share prices. We highlight this fact simply to counter the common market narrative that EM corporate earnings growth expectations are improving, driving EM bourses higher. Bottom Line: EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS nine months ahead. Importantly, EM equity prices relative to DM shares are at a major technical juncture (Chart I-3). A decisive breakout would be a very bullish technical signal, whereas a failure to break out would be an important warning sign. We continue to bet on the latter. Chart I-2EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM Chart I-3Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM China's Credit Cycle And Commodities Redux Our overarching theme has been and remains that China is tightening liquidity amid a lingering credit bubble. This cannot end well for financial markets that are exposed China's growth. Here we revisit our rationale for a credit slowdown in China and its impact on EM. Chinese interest rates have risen dramatically since last November across the entire yield curve. The 3-month interbank rate and AA- on-shore corporate bond yields both have risen by about 200 basis points since November 1, 2016. Monetary policy works with a time lag, and higher interest rates warrant a slowdown in credit growth (Chart I-4). In turn, it takes only a deceleration in credit growth for the credit impulse - the second derivative of outstanding credit - to turn negative. The falling credit and fiscal impulse will consequently lead to a relapse in Chinese import volumes and EM EPS (Chart 5), in turn weighing on commodity prices and non-commodity producing countries like Korea and partially Taiwan. Mainland import volumes contracted mildly in the second half of 2015, as demonstrated in Chart I-5. De facto, from the perspective of the rest of the world, China was in mild recession in late 2015. Not surprisingly, global risk assets in general, and particularly those exposed to China, tumbled. Chart I-4China: Higher Rates Point To##br## Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse Chart I-5China's Credit Impulse Heralds ##br##Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports We expect China import volumes to shrink again by the end of this year or early next. Some sort of replay of 2015 is a real possibility. The broad-based yet mild selloff in commodities since early this year (Chart I-6) amid weakness in the U.S. dollar exchange rate gives us confidence in our view. Chart I-6ABroad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Chart I-6BBroad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Our colleagues at BCA have attributed the selloff in commodities this year to deleveraging in China's shadow banking system, and to traders worldwide closing their long positions. They expect an improving commodities supply-demand balance to support prices going forward. It makes sense to us to explain the selloff in commodities as having been caused by deleveraging in China's shadow banking system. Yet to be consistent, we should also acknowledge that the rally in commodities last year was to a large extent driven by the same forces in reverse: non-commercial buyers (investors) buying commodities both in China and elsewhere. In short, this signifies there was little improvement in worldwide commodities demand last year. In 2016, rising commodities prices provided a significant boost to commodity-producing countries and underlying corporate profits - and ultimately EM risk assets. The drop in commodities prices this year, if sustained, should lead to the opposite dynamic: income/profits among commodities countries/companies will drop. As such, falling commodities prices amid diminishing investor demand for commodities is bearish for EM risk assets. Where we differ from the majority of our colleagues at BCA is that we expect Chinese credit growth to decelerate, thereby weighing on its capital spending and depressing demand for commodities (please refer to Chart I-5). We have written extensively1 on this topic and will not fully rehash our view that China's annual credit growth will decelerate from the current 12% to somewhere around 8% in the next 12-18 months. In short, China's corporate and household credit-to-GDP ratio cannot rise indefinitely from an already high level of 225% of GDP. Credit growth will likely downshift to a level of sustainable nominal GDP growth, which is probably around 8%. Our main disagreement with our colleagues on structural issues is as follows: we believe China's credit excesses are not a natural outcome of the nation's high savings rate but rather the outcome of a speculative credit boom driven by high-risk behavior among creditors and debtors.2 Tightening liquidity amid such speculative excesses creates a very bearish backdrop for risk assets exposed to China's credit cycle. The bullish camp on China has recently pointed to a strong recovery in mainland nominal GDP growth, which in their view suggests that double-digit credit growth in China is not excessive (Chart I-7). However, such a surge in nominal GDP growth has been due to the GDP deflator rising from zero in the fourth quarter of 2015 to 5% in the first quarter of this year. Importantly, the swings in the GDP deflator almost perfectly correlate with the fluctuation in commodities prices (Chart I-8). This proves how much China's economy is exposed to commodities cycles and how much of nominal GDP swings are stipulated by resource price swings. Chart I-7China: Credit And ##br##Nominal GDP Growth China: Credit And Nominal GDP Growth China: Credit And Nominal GDP Growth Chart I-8China's GDP Deflator Is Very Sensitive##br## To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices As commodities prices decline, China's GDP deflator, producer prices and nominal GDP growth will all dwindle. Thereby, China's underlying steady state nominal GDP growth is probably around 8% at best (5.5-6% real growth), with inflation of 2-2.5% (assuming flat commodities prices). If this is indeed the case, corporate and household credit growth of 12% entails a further build-up of leverage and an escalating non-public credit-to-GDP ratio, which already stands at 225% of GDP: corporate debt is 180% and household debt is at 45% of GDP. Bank loans account for 70%, while shadow (non-bank) funding channels (corporate bonds, trust products, entrusted loans, and banker's acceptance) constitute 30% of outstanding non-public credit or 65% of GDP. Both are growing at an annual rate of 11-12.5% (Chart I-9). On the whole, the share of shadow banking is non-trivial and its current growth pace is unsustainable amid ongoing regulatory tightening and rising interest rates. Furthermore, banks are themselves exposed to shadow banking as their claims on non-depository financial institutions have risen exponentially from RMB 3 trillion to RMB 27 trillion over the past five years. In regard to non-standard credit assets,3 our estimates are that banks' off-balance-sheet exposure is RMB 10 trillion compared with RMB 18.3 trillion of their balance-sheet non-standard credit assets. The off-balance-sheet credit exposure to non-standard credit assets is much larger for medium and small banks than the largest five (Table I-1). We discussed these issues in greater detail in our June 15, 2016 Special Report titled "Chinese Banks' Ominous Shadow". Chart I-9Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Chart I- With banks being forced by regulators to bring off-balance-sheet assets onto their balance sheets, their capital adequacy ratios will drop and their ability to sustain double-digit credit growth will be curtailed. Chart I-10Stay With Short Small / Long Large ##br##Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade The risks to medium and small banks is greater than to the large five banks. That is why we reiterate our recommendation from October 26, 2016 to short small banks versus large ones (Chart I-10). As a final note, we are often asked whether the government will provide a bail out if things deteriorate. Yes, we concur that policymakers will step in and backstop a financial system to preclude a systemic crisis. However, they are tightening now, and like the rest of us have little visibility. The authorities will meaningfully reverse the ongoing monetary tightening only if the pain on ground becomes visible or economic data deteriorate considerably. Financial markets will sell off materially in advance. Bottom Line: Investors should not be long China-plays, commodities and EM risk assets when mainland policy tightening is occurring amid lingering speculative credit excesses. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Strategy For Chilean Markets We recommended receiving 3-year swap rates on November 2, 2016 and this position has panned out with rates dropping by 30 basis points. We now recommend booking profits. The following has led us to conclude that the risk-reward profile of this position is no longer attractive: The improvement in narrow money (M1) growth points in a bottom in the economic activity indicator (Chart II-1). Mining production plunged amid the strikes in the world's largest copper producer Codelco (Chart II-2, top panel) and manufacturing production has also been contracting (Chart II-2, bottom panel). A period of improvement in mining and manufacturing output from a very low base is likely. Chart II-1Book Profits On Receiving ##br##3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Chart II-2Chile: Money And Economic##br## Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out This will ameliorate overall business conditions and cause the central bank, at least for the time being, to halt the easing cycle. The pace of expansion in employment, wage growth, and consumer credit remains decent (Chart II-3). This will put a floor under household spending growth for now. Odds are that copper prices will decline meaningfully in the next nine months or so, which will cause the Chilean peso to depreciate. Although a depreciating currency will not to lead to materially higher interest rates in Chile, it will limit downside in local rate expectations. Finally, local 3-year swap rates and their spread over U.S. 3-year bond yields are extremely low from a historical perspective (Chart II-4). At this point, there is little value left in Chilean local rates. Chart II-3Chile's Mining And Manufacturing ##br##A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chart II-4Chile: Consumer Spending##br## Is Holding Up Chile: Consumer Spending Is Holding Up Chile: Consumer Spending Is Holding Up Investment Conclusions Chart II-5Chilean Local Rates Spreads Over ##br##U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left We do not expect the central bank to hike but the downside in local rates is limited for the time being. Take profits on the receiving 3-year swap rate trade. As to equities, the outlook for relative performance is balanced; we continue recommending a benchmark weight in Chile for dedicated EM equity portfolios. For absolute return investors, the risk-reward profile is not attractive because our profit margin proxy points to a relapse in corporate earnings (Chart II-5). Unit labor costs are rising faster than the core inflation rate, producing a profit margin squeeze (Chart II-5, bottom panel). Finally, we continue shorting the peso versus the U.S. dollar as a bet on lower copper prices. 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports titled, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?", dated March 23, 2017, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, "Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 3 Non-standard credit assets are banks' claims on corporates that are not classified as loans. For more details please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominous Shadow", dated June 15, 2016, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. Profit growth has accelerated at a faster pace than our top-down model had projected and we expect growth to accelerate further into year end. We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth over rest of 2017. Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge. Feature The S&P 500 is attempting to break through the 2400 barrier as we go to press. This is impressive given that the flagging relative performance of infrastructure stocks and highly-taxed companies suggests that investors have given up hope of ever seeing significant tax cuts, infrastructure spending and incentives for capital spending. As we discuss below, disappointment on the policy front has thankfully been offset by solid corporate earnings figures. We believe that investors have gone too far in pricing out tax reform. True, the growing number of White House scandals will serve to delay the GOP's market-friendly policy agenda. Nonetheless, the President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans are on the same page. Capital spending is the part of the economy that could benefit the most from tax reform. Surprising Support From Capex Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. The post-election rollover in C&I loan growth worried investors that rising rates and election-related uncertainty had cut the flow of credit to the business sector, thus putting capex at risk (Chart 1, top panel). That concern was overdone, as we pointed out in a recent report.1 Business expenditures on plant, equipment and software were a surprising source of strength in first-quarter GDP, and bank lending has stabilized in the past six weeks. The FOMC minutes of the May 2-3 meeting noted that "financing conditions for large nonfinancial firms stayed accommodative." The minutes also stated that, while there was weaker demand for C&I loans in April, the weakness "pertained to customers' reduced needs for financing." The reduced need likely reflected a preference to issue corporate bonds. Chart 1Outlook For Capex Looks Solid Outlook For Capex Looks Solid Outlook For Capex Looks Solid Our BCA Capex indicator for business investment points to solid business spending in the next few quarters. (Chart 1, bottom panel) Our past research shows that sustainable capital spending cycles only get underway when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were quite soft (+0.3% annualized gain) in Q1, our view is that the weakness was transitory.2 This view was confirmed by the FOMC minutes. A rebound in consumer spending in the second quarter will boost CEO confidence that increased capital spending will be justified in terms of future sales. Our base case is that at least some tax cuts will be enacted by year end, but the risk is that political turmoil further delays a fiscal package or even totally derails the GOP legislative agenda. This scenario would be negative for stocks temporarily, but could end up being positive over the medium term by extending the expansion in the economy and corporate profits. U.S. Profits, Beats And Misses Profit growth has accelerated at a faster pace than our top-down model had projected earlier this year (Chart 2). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at just under 20%, before moderating in 2018. The favorable profit picture reflects two key factors. First, profits are rebounding from a poor showing in 2016, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart 3). Earnings are of course leveraged to corporate sales, helping to explain why profits are highly correlated with industrial production in the major countries. BCA's U.S. Equity Strategy service estimates that operating leverage for the S&P 500 is 1.4x.3 Chart 2Impact Of Stronger Dollar Is Fading Impact Of Stronger Dollar Is Fading Impact Of Stronger Dollar Is Fading Chart 3IP On The Rebound Globally IP On The Rebound Globally IP On The Rebound Globally Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row. Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.4 The hiatus of wage pressure may not last long, but for now our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). What About The Dollar? We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth of about one percentage point for the remainder of this year, assuming no change in the dollar from today's level (Chart 2, second and third panels). However, our base case remains that the dollar will appreciate by another 10% in trade-weighted terms. A 10% appreciation would trim EPS growth by roughly 2½ percentage points, although most of this would occur in 2018 due to lagged effects. The key point is that another upleg in the dollar, on its own, should not provide a major headwind for the stock market. Indeed, the dollar would only be rising in the context of robust U.S. economic growth and an expanding corporate top line. Even though the message from our EPS model is upbeat, it still falls short of bottom-up estimates for 2017. Is this a risk for the equity market, especially since valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table 1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in 2008, which was a recession year. But even outside of the recession, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart 4 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years considered. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the direction of 12-month forward estimates (which remains up at the moment). Table 1Bottom Up Estimates Are##BR##Always Too Optimistic Corporate Earnings Versus Trump Turbulence Corporate Earnings Versus Trump Turbulence Chart 4Oil Related##BR##Dip In 2015 Oil Related Dip In 2015 Oil Related Dip In 2015 The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. Gold Update Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge against rising inflation and inflation expectations, geopolitical risk and increased equity volatility.5 Chart 5A shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel that it has been in since early 2012 (Chart 5B). There has been a big gap between the model value and the actual price of gold for the past three years. The real price of gold remains elevated despite the fact that inflation has been well contained.6 Chart 5AModel Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Chart 5BIn A Downward Channel Since 2012 In A Downward Channel Since 2012 In A Downward Channel Since 2012 Our 6-12 month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year end, just enough to keep the Fed on track this year as it begins to shrink its balance sheet and raise rates two more times. Thus, we do not see a great need to hold gold as a hedge against inflation over the next year. Nonetheless, for those investors concerned about a pullback that turns into a correction or a bear market, we mention that gold has a 33% weight in our Protector Portfolio.7 Chart 6Core Inflation To Stay Near##BR##Fed's Target This Year Core Inflation To Stay Near Fed's Target This Year Core Inflation To Stay Near Fed's Target This Year Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, the yellow metal may have value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Earnings Rebound Will Earn Some Respect", April 10, 2017. Available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation And The Fed", May 8, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," published April 17, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?," published April 24, 2017. Available at usis.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report, "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017. Available at ces.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "Gold: The Asset Allocation Dilemma," published August 1, 2011. Available at usis.bcaresearch.com. 7 Please see U.S. Investment Strategy Weekly Report, "Still Awaiting The Next Pullback," published May 15, 2017. Available at usis.bcaresearch.com.

Highlights This week, we are reprising and updating "The Other Guys In The Oil Market" from our sister service Energy Sector Strategy (NRG), because it so well captures the state of oil production outside the U.S. shales, Middle East OPEC and Russia. "The Other Guys" account for ~ half of global supply. Next week, we'll publish a joint report with NRG analyzing today's OPEC meeting. The aptly named "Other Guys" account for ~ 42mm b/d of production, which they are struggling to maintain at current levels, let alone increase. These producers supply nearly half of global production, and have been stuck in a pattern of slow decline for years despite high oil prices. Beginning in 2019, we expect production declines to accelerate. This will put enormous pressure on the three primary growth regions, which markets likely will start pricing in toward the end of next year. Energy: Overweight. OPEC 2.0 is expected to extend its 1.8mm b/d of production cuts to the end of 1Q18 at its meeting in Vienna today. Going into the meeting, markets were being guided to expect even deeper cuts. Our long Dec/17 Brent $65/bbl calls vs. short $45/bbl puts, and our long Dec/17 vs. Dec/18 Brent positions are up 75.0% and 509.5% respectively, following their initiation on May 11, 2017. Base Metals: Neutral. Steel and iron-ore prices are getting a boost from China's anti-pollution campaign, which is expected to run through the end of this month. This was launched ahead of the anti-pollution campaign we expected after the Communist Party Congress in the fall. Iron ore delivered to Qingdao is up 3.1% since May 9, when Reuters reported the campaign began.1 Precious Metals: Neutral. Gold was well bid earlier in the week on the back of a weaker USD. Our long gold position is up 1.9%, while our long volatility trade, which we will unwind at tonight's close, is down 98.5%. Ags/Softs: Underweight. The weaker USD takes some pressure off wheat and beans over the short term, and might prompt a short-covering rally. We remain bearish, however, as the USD likely will bottom in the near future.2 Feature U.S. Onshore, Middle East OPEC (ME OPEC), and Russia combine to produce ~43 MMb/d of oil plus another ~11 MMb/d of other liquids (NGLs, biofuels, refinery gains, etc.). Combined, these producers increased crude production by 5 MMb/d plus another 1 MMb/d of other liquids production over the past three years (2014-2016), creating the oversupply that crashed prices. We expect these producers to add another 1.60 MMb/d of oil plus 1.14 MMb/d of other liquids by 2018 (over 2016 levels), dominated by nearly 2.0 MMb/d of oil and NGLs from the U.S. shales. Oil production from the other 100+ global oil producers also represents about ~42 MMb/d, but on balance has been slowly eroding since 2010, failing to grow even when oil prices were $100+/bbl. Despite some 2017 recovery from Libya, we expect total production to continue to fall in both 2017 and 2018. The few recently expanding producers among the Other Guys are running out of growth. Canada, Brazil, North Sea and GOM account for ~13 MMb/d of oil production in 2016, adding ~1.5 MMb/d over the past three years (2014-2016). North Sea production is projected to resume declines starting in 2017; GOM will reach it peak production sometime in 2017 or 2018, then start to ebb; large new Canadian oil sands projects will add ~310k b/d in 2017-2018, but scarce additions are scheduled beyond that; and Brazil's once-lofty growth plans have slowed to a crawl in 2016-2018. Global deepwater drilling activity and exploration spending have collapsed, lowering the reserve base, and undermining the stability of current production levels. Outside Of Just Three Regions, Oil Supply Picture Looks Worrisome Often overlooked in our discussions about world oil markets are the supply contributions of over 100 geographic regions. This collection of suppliers (which we will call the "Other Guys") is defined as all producing regions in the world other than: 1) U.S. Onshore (shales, specifically), 2) OPEC's six Middle East members, and 3) Russia. The Other Guys deliver nearly half of global production, try to maximize production every day (even OPEC nations among the Other Guys have not had production constrained by quotas), and still have endured consistent, albeit modest, production declines over the past six years. Chart 1Outside Of A Very Few Regions,##BR##Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled At the end of 1Q17, oilfield-services leader Schlumberger voiced sharp concerns regarding stability of supplies from these ignored producers, warning that aggregate capital expenditures within these regions will sustain an unprecedented third straight year of decline in 2017, with total spending only about half of 2014 levels. Chart 1 shows the divergent production histories of the three growing regions versus the rest of the world. Chart 1 also shows production of the Other Guys excluding the especially dramatic declines/volatility of Libyan production. Even though these producers benefitted from the same incentives and profitability from high oil prices as the three growing regions, as a group, they have been unable to expand production. As oil prices have plunged, drilling activity in these nations has also plummeted, raising concerns that production declines could start accelerating in the near future. Chart 2 shows that oil-directed drilling activity among the international components of the Other Guys (Chart 2 excludes GOM and highly-seasonal Alaska and Canada) has crashed by ~40%, from an average of over 800 rigs during the five-year period of 2010-2014 to under 500 rigs for the past year. Offshore drilling has collapsed even a little more sharply for these producers than overall oil-directed drilling, falling ~43% from an average of over 280 rigs to only 160 today (Chart 3, excludes GOM). Chart 2Other Guys' Drilling##BR##Has Collapsed 40% Other Guys' Drilling Has Collapsed 40% Other Guys' Drilling Has Collapsed 40% Chart 3International Offshore Drilling Is Down Over 40%,##BR##Boding Poorly For The Stability Of Future Production International Offshore Drilling Is Down Over 40%, Boding Poorly For The Stability Of Future Production International Offshore Drilling Is Down Over 40%, Boding Poorly For The Stability Of Future Production Offshore Production Declines To Accelerate Chart 4Other Guys' Offshore Drilling Has Collapsed Other Guys' Offshore Drilling Has Collapsed Other Guys' Offshore Drilling Has Collapsed As a particularly worrisome trend for the Other Guys' production stability, offshore drilling activity has collapsed in some of the most important offshore oil producing regions in the world, including the GOM, North Sea, West Africa, and Brazil (Chart 4). Considering the multi-year lag between drilling activity and the start of oil production, and the large well size and quick declines associated with offshore wells, the oil production impacts of this drilling collapse that started two years ago have not really been felt yet. When these regions get past the wave of new production from 2015-2017 project additions (projects started during 2011-2014), they will face a dearth of new projects maturing in 2018-2022 due to this collapse in drilling, with new production likely to be inadequate to offset the declines of legacy production. Brazil, the North Sea, West Africa, and GOM together account for about 12 MMb/d of oil production (Chart 5). These four offshore regions have benefitted from intense investment from 2010-2015 as shown by the surging rig counts during that period in Chart 4. This investment/drilling drove 1.1 MMb/d of oil production growth in Brazil, the GOM, and the North Sea from 2013 to 2016, without which total production from the Other Guys would have declined by 1.4 MMb/d rather than just 0.3 MMb/d. Despite strong investment, production in West Africa merely held flat outside of Nigeria during 2013-2016 while falling by 0.4 MMb/d within Nigeria (mostly in 2016 due to pipeline disruptions from saboteurs). Chart 5Offshore Production Will Stop Expanding, Then Decline The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux Brazil offshore drilling activity over the past year is less than half of levels during 2010-2013. As a result, production growth will moderate significantly over the next few years, expanding far less (250k b/d in 2018 vs. 2016, based on our balances data) than the rapid 470,000 b/d step-up in production during 2013-2014. While Brazil still has a rich endowment of pre-salt reserves, marshalling capital and the International Oil Companies' (IOCs) focus to resurrect development activity will take years. We expect no growth during 2019-2020. The North Sea has seen production cut in half from the time of peak production in 1999 until 2013. Production declines were briefly halted and re-expanded by ~300,000 b/d during 2014-2016 due to a concerted drilling effort and brownfield maintenance program incentivized and financed by $100/bbl oil prices. Drilling has since declined 35% from average 2010-2014 levels, and production is expected to resume its downward trend in 2017-2018. Overall oil-directed offshore drilling in the GOM has been cut by over 50% from 2013-2014 levels. Based on our field-by-field analysis published in January, we estimate GOM oil production will hit a peak in a year and a half or less and then will succumb to declines due to lack of new drilling. West Africa has suffered production declines for the past several years due to both geologic challenges as well as more recent (2016-2017) political/sabotage related disruptions in Nigeria. With offshore drilling activity plummeting 70%-80%, we expect production declines will accelerate and it will take years of increased drilling to yield new production that can stem the declines. The collapse in Nigerian drilling, from 10 rigs in 2010-2013 to only 2-3 rigs over the past year, likely means that Nigerian production is incapable of returning to 2015 levels even if its recent sabotage issues are resolved. In aggregate, as shown in Chart 5, we expect production from these four offshore regions to stagnate during 2017-2018 (North Sea and West Africa decline while Brazil and GOM expand) before declining by ~0.5 MMb/d in each 2019-2020 due to the dramatic curtailment of investment during 2015-2017. SLB Talks Its Book, But Makes A Strong Point At an industry conference at the end of March, Schlumberger (again) railed against the inadequacy of the cash flow-negative U.S. shale industry to single-handedly supply enough production growth to satisfy continuing global demand growth, especially once the Other Guys start seeing more pronounced negative production effects from the sharply reduced investments over 2015-2017. "The 2017 E&P spend for this part of the global production base...is expected to be down 50% compared to 2014. At no other time in the past 50 years has our industry experienced cuts of this magnitude and this duration." - Paal Kibsgaard, CEO of SLB. SLB highlighted an analysis of depletion rates constructed with data from Energy Aspects. (The March 27 presentation can be found at www.slb.com). Annual depletion rates (annual production/proved developed reserves) in the GOM had spiked to over 20% in 2016 from a long-term level of only ~10% during 2000-2013. Similarly, depletion rates in the U.K. and Norwegian sectors of the North Sea also surged from ~10% to ~15% over the past three years. In both the GOM and the North Sea, oil production had recently been expanded, but proved developed reserves declined. Due to such low drilling investments during 2015-2016, producers have replaced only about half of the oil reserves that they've produced in the GOM and North Sea over the past three years (2014-2016). Eventually, this lack of investment in cultivating tomorrow's resources will catch up to the industry, and production will decline. Investors must take SLB's commentary with a grain of salt, as they could be construed as sour grapes. The immense pull of new capital spending to the U.S. shales has substantially benefitted SLB's primary competitors more than it has benefitted SLB (SLB is much more focused on international and offshore projects). Still, investors are too complacent about the stability of non-U.S. production. SLB's analysis and warnings of accelerating production declines should not be ignored. Bottom Line: Outside of the three regions of sharply growing production (U.S. onshore, ME OPEC and Russia) that investors are focused on, the other half of global production has been stagnant to declining despite high oil prices and high levels of drilling during 2010-2015. Now that drilling and capex in these regions has declined by 40%-50%, production declines should accelerate in coming years. Offshore production, especially, has not seen enough drilling to replace reserves, and is poised to decline within the next 2-3 years. The accelerating declines of the "Other Guys" will allow more room for growth from U.S. shales, ME OPEC and Russia. Matt Conlan, Senior Vice President, Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see "China steel hits nine-week peak amid crackdown, lifts iron ore," published by reuters.com May 22, 2017. 2 Please see the feature article in last week's edition of BCA Research's Foreign Exchange Strategy entitled "Bloody Potomac," in which our colleague Mathieu Savary lays out the case for an imminent USD rebound. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux

Dear Client, In addition to this Special Report, I am sending you our usual Weekly Report focusing on the market implications from the brewing crisis in the Trump White House. Best regards, Peter Berezin, Chief Global Strategist Highlights Chart 1Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year. Concerns over the Chinese economy, a withdrawal of speculative demand, and strong supply growth have all weighed on commodity prices. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. Stick with it. The cyclical recovery in commodity prices will benefit DM commodity currencies such as the CAD, AUD, and NOK. Go short EUR/CAD. Feature What's Been Weighing On Commodities? Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year (Chart 1). We see three reasons why commodities have struggled to gain traction over the past few months: Fears that the Chinese economy is losing growth momentum have intensified. Traders have soured on the commodity complex, causing speculative demand to fizzle. Skepticism about OPEC's ability to maintain production discipline has been running high. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. Global Growth: An Uneven Picture After a strong end to 2016, global growth so far this year has been mixed. The euro area has continued to hum along, with real GDP increasing by 2% in Q1 on an annualized basis. Japanese growth clocked in at 2.2% in Q1. This marked the fifth consecutive quarter of positive growth - the first time this has happened in 11 years! In contrast, U.K. growth slowed to 1.2% in Q1, while the U.S. registered a disappointing 0.7% growth print. As discussed in the Weekly Report that accompanies this Special Report, the U.S. economy is likely to bounce back over the remainder of the year, notwithstanding the ongoing soap opera that has become the Trump presidency. However, even if that happens, traders have become increasingly concerned that stronger U.S. growth will be offset by weaker growth in China. China Growth Risks Back In Focus All four Chinese purchasing manager indices fell in April (Chart 2). This week's data releases saw below-consensus growth in industrial production, retail sales, and fixed asset investment. Tighter financial conditions have contributed to the recent growth shortfall (Chart 3). The PBoC has drained excess liquidity over the past few months, causing overnight rates to rise. Corporate bond yields have surged while Chinese small cap stocks have taken it on the chin. The slowdown in Chinese growth is a cause for concern, but some perspective is in order. The economy began the year on a strong footing. Nominal GDP increased by 11.8% in Q1, compared with 9.6% in Q4 of 2016. Real GDP rose by 6.9% in the first quarter, comfortably above the government's target of 6.5%. A modest slowdown from these levels is not surprising. Most indicators point to an economy that is still expanding at a decent clip. Export growth is accelerating and our China team's model suggests that this will remain the case, thanks to solid global demand and a competitive RMB (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output. Chart 2China: PMIs Falling Across The Board China: PMIs Falling Across The Board China: PMIs Falling Across The Board Chart 3Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Chart 4China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue Meanwhile, fixed investment is benefiting from an upturn in the profit cycle. Chart 5 shows that excavator sales, railway freight traffic, and the PBoC's Entrepreneur Confidence Index - all leading indicators for Chinese capex - are surging. Even the housing market is well positioned to withstand some policy tightening. Land purchases by developers have rebounded and the most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the first quarter (Chart 6). Chart 5Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Chart 6...And The Housing Market ...And The Housing Market ...And The Housing Market Efforts Focused On Containing Financial Risk Most of the government's tightening measures have been designed to reduce financial sector risks while inflicting as little collateral damage on the economy as possible. So far, this strategy appears to be working: While broad credit growth has slowed from a high of 25.7% in January 2016 to 15.5% in April of 2017, almost all of that was due to a deceleration in borrowing by non-bank financial institutions. The pace of lending to nonfinancial private borrowers and the government - the so-called "real economy" - has barely fallen from last year. In fact, medium- and long-term loans to the corporate sector, a key driver of overall capital spending, have accelerated (Chart 7). The inversion of the Chinese yield curve largely reflects these macroprudential measures. The spread between 10-year and 5-year government bond yields turned negative last week, the first time this has ever happened (Chart 8). Chart 7China: Credit Growth To The Real EconomyBarely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures Chart 8Chinese Yield Curve Inversion Chinese Yield Curve Inversion Chinese Yield Curve Inversion Some pundits have interpreted this development as an omen of a coming recession. However, there is a less dramatic explanation: Up until recently, non-bank financial institutions have been issuing so-called wealth management products like crazy. According to Moody's, the outstanding value of these products soared from U.S. $72 billion in 2007 to $4.2 trillion in the first quarter of 2017. The crackdown on shadow banking has forced many participants to liquidate their positions which, in many cases, included substantial leveraged holdings of government bonds. Since 5-year bonds are less liquid than their 10-year counterparts, yields on the former have increased more than on the latter. The Commodity Connection While the data is sketchy, it appears that Chinese non-bank financial institutions have been major players in the commodities market. As funding to these institutions - and their clients - dried up, panic selling of commodity futures contracts ensued. This withdrawal of Chinese investment demand for commodity markets began at time when, globally, long speculative positions were highly elevated. Chart 9 shows that net long spec positions as a share of open interest for energy and industrial commodities reached the highest levels in over a decade earlier this year. Today, speculative positioning has returned to more normal levels. This reduces the risk of a further downdraft in commodity prices. At the same time, the Chinese authorities appear to be relaxing some of their earlier tightening measures. The PBoC re-started its Medium-Term Lending Facility (MLF) earlier this week. It also made the largest one-day cash injection into the financial system in nearly four months on Tuesday. This follows the release of stronger-than-expected credit numbers for April, as well as Premier Li Keqiang's call over the weekend for "striking a balance" between enhancing financial stability and maintaining growth. Adding to the newfound easing bias, general government fiscal spending is now recovering (Chart 10). Chart 9Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 10China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend Oil Supply Should Tighten Chart 11Oil Inventories Should Decline Oil Inventories Should Decline Oil Inventories Should Decline Tighter supply conditions in various parts of the commodity complex should reinforce the upward pressure on prices stemming from firming demand. This is especially true for crude oil. Saudi Arabia and Russia announced earlier this week that they will support an extension of output cuts through to March 2018. Despite a sharp recovery in shale output, BCA's energy strategists expect global production to increase by only 0.5 MMB/d in 2017 compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. Inventory draws will continue through 2018, albeit at a slower pace than in 2017 (Chart 11). Larger-than-expected declines in U.S. oil inventories over the past two weeks, along with a steep reduction in the volume of oil held in tanker ships (so-called "floating storage"), suggest that this trend has already begun. Some Investment Implications Fading fears about a China slowdown and a tighter supply picture will lift commodity prices over the remainder of the year. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. We are targeting a further 10% in upside from current levels. The cyclical recovery in commodity prices will benefit the stocks and bonds of companies within the resource sector. It will also benefit DM commodity currencies such as the CAD, AUD, and NOK. In addition, rising commodity prices will provide a tailwind to emerging markets, although Fed rate hikes and the occasional political scandal (here's looking at you, Brazil!) will take some bloom off the rose. The prospect of higher commodity prices supports our recommendation to be overweight euro area stocks relative to U.S. equities. The IMF estimates that the European economy is three-times more sensitive to changes in EM growth than the U.S. (Chart 12).1 If higher commodity prices give emerging markets a boost, this will help Europe's large industrial exporting companies. Calculations by JP Morgan suggest that petrostate sovereign wealth funds hold five times more European equities than U.S. stocks, even though European stocks account for less than half the global market capitalization of U.S. stocks.2 These funds are especially exposed to European financials and consumer discretionary names. Higher oil prices would give them greater scope to add to their favorite positions. What about EUR/USD? The run-up in the euro over the past few weeks was partly driven by the unwinding of sizable short hedges that traders put on in the lead up to the French elections. At this point, euro positioning has moved from being highly bearish to broadly neutral. Going forward, fundamentals will play the dominant role. On the one hand, an outperforming euro area equity market should attract foreign capital into the region, giving the common currency a boost. On the other hand, interest rate differentials will continue to move in favor of the dollar. As we discussed last week, the Fed is likely to raise rates by more than the 38 basis points that markets are currently pricing in over the next 12 months.3 In contrast, the ECB is likely to stand pat, given that the rate of labor underutilization is still 18% in the euro area, 3.5 percentage points higher than in 2008 (Chart 13). If anything, rising inflation expectations in the euro area could cause real short-term rates to decline, putting downward pressure on the euro. Chart 12Europe Is More Sensitive To EM The Signal From Commodities The Signal From Commodities Chart 13Labor Market Slack In The Euro Area Remains High The Signal From Commodities The Signal From Commodities Our research indicates that real interest rate differentials are by far the most important drivers of currency returns over cyclical horizons of around 12 months. The decline in the dollar over the past few weeks has occurred alongside an increase in real rate differentials between the U.S. and its trading partners. Notably, two-year real rate differentials have widened by 47 basis points versus the euro area since the end of March, even though the dollar has actually weakened against the euro over this timeframe (Chart 14). Thus, a period of "catch-up strength" for the dollar is in order. We continue to expect EUR/USD to reach parity by the end of the year. With all this in mind, we are opening a new trade today: Short EUR/CAD (Chart 15). Chart 14Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 15Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "IMF Multilateral Policy issue Report: 2014 Spillover Report," IMF, dated July 29, 2014. 2 Nikolaos Panigirtzoglou, Nandini Srivastava, Jigar Vakharia, and Mika Inkinen, "Flows & Liquidity," J.P.Morgan Global Asset Allocation (January 29, 2016). 3 Please see Global Investment Strategy Weekly Report, "The Fed's Dilemma," dated May 12, 2017, available at gis.bcaresearch.com.

Highlights Unsurprisingly, OPEC 2.0's leadership agreed on the need to extend the coalition's 1.8mm b/d production-cutting agreement to end-March 2018. Leaders of the coalition - the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia - will recommend as much when the coalition meets next week in Vienna. Meanwhile, sequential production in U.S. shales during the first four months of the year is up just under 100k b/d, based on the EIA's latest estimates. This was led by surging Permian production. We expect shale-oil production growth to continue, and are revising our year-end 2017 light-tight-oil (LTO) production estimate for the four main shale-oil plays to 5.66mm b/d, up from our earlier assessment of 5.39mm b/d. We also are lifting our year-end 2018 estimate of shale production to 6.64mm b/d. This means December-to-December LTO production will increase ~ 1mm b/d by Dec/17 and by another ~1mm b/d by Dec/18. Energy: Overweight. As of last Thursday's close, we are long Dec/17 Brent $65/bbl calls vs. $45/bbl puts at -$1.16/bbl, and long Dec/17 vs. Dec/18 Brent at -$0.21/bbl. These positions were up 16.4% and 242.9%, respectively. Base Metals: Neutral. The physical deficit in zinc appears to be widening slightly, based on supply-demand estimates from the International Zinc Study Group. Usage totaled 2.282mm MT in Jan-Feb 2017 vs. refined production of 2.28mm MT. For 2016, usage was 13.89mm MT vs. supply of 12.67mm MT. Precious Metals: Neutral. Metal refiner Johnson Matthey expects a 790k oz. palladium deficit this year, up from a little over 160k oz. last year. Separately, the World Platinum Investment Council expects platinum supply to fall 2% this year to 7.33mm oz. Ags/Softs: Underweight. The USDA reported corn planting stood at 71% for the week ended May 14, vs. an average of 70% over the 2012 - 16 period. We remain bearish. Feature The determination of the leaders of OPEC 2.0 to clear the storage overhang could not have been made more clear, following comments earlier this week from KSA's and Russia's energy ministers the coalition's 1.8mm b/d production-cutting agreement would be extended to end-March 2018. This is three months beyond earlier speculation the deal would be extended to year-end 2017. Chart of the WeekBalances Chart Balances Chart Balances Chart Still, when dealing with a political organization of any sort - and OPEC 2.0 is nothing if not a political entity - our bias is to assume less-than-complete compliance with production cuts, and an earlier return to pre-agreement production levels than proffered by the leadership of the coalition. Hence, in our updated balances model (Chart of the Week), in addition to assuming higher U.S. production out of the shales, we have Russian production returning to a level just below 11.30mm b/d by October 2017, up roughly 150k b/d from the 11.15mm b/d we assume they'll be producing until the end of September. We also assume Iraq's production will move up to 4.45mm b/d (up 50k b/d) beginning in January, and that Iran will be steadily, yet slowly, increasing production by 5-10k b/d per month beginning this month. The only assumption we're making for staunch compliance to the OPEC 2.0 accord after our assumed extension to year-end 2017 at next week's Vienna meeting is that KSA and its GCC allies - Kuwait, Qatar, and the UAE - will continue to abide by their voluntary production cuts. This group has maintained solidarity on past production-management deals, we expect them to do so again in this round. Of course, the other members of the coalition could vote against this proposal next week, and instead decide to end the production deal in June under its original conditions. Or, they could agree to extend the deal, but only until year-end 2017. Regardless of whichever policy decisions are agreed to during next week's meeting, come November, when OPEC meets again, they might tweak/change those agreements to reflect their updated outlook at that time. Given this uncertainty, we believe the assumptions we've made are realistic, but we will be monitoring conditions closely so that we can modify our view quickly. Shale Coming On Strong Part of OPEC 2.0's desire to extend its deal likely is the improvement in the performance of shale-oil producers in the U.S. In its latest Drilling Productivity Report (DPR), the EIA noted that sequential production in the first four months of the year has risen ~ 100k b/d per month in the U.S. shales. This surge was led by higher Permian production, which accounted for ~ three-quarters of the increased output (Chart 2). Interestingly, rig-weighted production per rig dropped for the first time in April 2017, but it still is high at 732 b/d, down from 735 b/d in March. We will be watching this closely to see if it is the beginning of a trend of stagnating productivity amid a rapid expansion of industry activity. The resurgence in the shales can be seen in the year-on-year (yoy) growth in total production in the seven basins the EIA tracks, which broke back above 5.0mm b/d in February and crossed into positive yoy growth in March (Chart 3). Net, we expect 2017 global supply to average 97.65mm b/d, for an increase 610k b/d this year, and for demand to average 98.3mm b/d, for an increase of 1.5mm b/d. EM demand, which we proxy using non-OECD consumption, accounts for 1.27mm b/d of this year's global demand growth, and continues to lead overall growth in oil demand (Chart 4, panel 2). Of this, China and India account for 350k and 210k b/d, respectively, of the growth in EM demand. Chart 2Permian Basin Leads##br##U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Chart 3Year-On-Year LTO Production##br##Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Chart 4EM Growth Continues##br##To Lead Global Demand EM Growth Continues To Lead Global Demand EM Growth Continues To Lead Global Demand China, India Lead EM Oil Consumption Non-OECD countries represent more than 50% of global oil consumption. Indeed, within the ~1.6mm b/d global oil demand growth we expect for 2017 and again in 2018, slightly more than 87% of it comes from EM economies. Table 1 below shows the average yoy growth by year for different regions - DM and EM - and countries from 2011 to 2018. Over this period, almost all of the world's oil-demand growth comes from non-OECD countries. From 2011-2018, the average p.a. demand growth for non-OECD countries is 2.79%, while for OECD countries it is only 0.12%. Table 1EM Leads Oil-Demand Growth Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Looking more closely at the composition of the EM economies, we see that, on average, between 2010 and 2018 Chinese oil consumption accounts for 24% of non-OECD demand, while the Indian oil consumption represents 8.3%, for a combined total of 32.37% of non-OECD average consumption. These two countries alone contributed on average to around 50% of the world oil consumption growth from 2010 to 2018. China has been the fastest-growing oil market in the world since the early 2000s. However, since 2015, when it emerged as an important growth market on the world stage, India's consumption has been increasing at a faster pace than China's. One of the reasons for this likely is the desire of the Chinese government to resume its pivot to a more service-oriented economy, which is less commodity-intensive than the export-oriented economy dominated by heavy industry. India, meanwhile, is looking to increase its manufacturing output, lifting it from the low-teens to 25% of GDP by 2022 under Prime Minister Narendra Modi's "Make in India" campaign. This change in the composition of global oil-demand growth is reducing demand for residual fuel oil and distillates. Indeed, IEA data continues to show a steady decline in yoy consumption for these two types of fuel in China, with residual fuel oil consumption down 26.5% yoy in 2016, and gasoil and diesel (distillates) consumption down close to 3% yoy. By contrast, gasoline consumption, is up more than 8% yoy along with jet fuel and kerosene. LPG demand (propane and butane, along with other light ends) and ethane demand (a petrochemical feedstock) is surging, up 24% in 2016, according to the IEA. In relative terms, China will remain the main driver of global oil consumption. At ~ 12.5mm b/d, China's oil demand is close to three times as high than India's. However, India likely will surpass China in terms of its contribution to global oil demand growth in coming years. A combination of structural and policy-driven factors points toward a possible sustainable growth path for Indian oil consumption for the coming years (oil consumption per capita is increasing, as is vehicle usage, particularly motorcycles (Chart 5); and, the government's desire to increase the share of the manufacturing to 25% of GDP by 2022 will boost oil demand growth as well). Chart 5India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring Recent studies assessing the "take-off" of an economy look at its per capita oil consumption in transportation, in particular, given that this sector accounts for more than half of the world's oil consumption (63% according to IEA Energy Statistics 2014). The theory boils down to the following: As income grows, a larger share of the population becomes vehicle owners. This is referred to as the "motorization" of an economy. In India, the transportation sector represents around 40% of total oil consumption.1 According to Sen and Sen (2016), the level of vehicle-ownership per capita is still low in India compared to other economies that have experienced similar take-offs. The government's targeted increase in manufacturing as a share of GDP to 25% under the "Make In India" program (from a current level of ~ 15%) would, according to the Sen and Sen (2016) formulation, lead to an increase in oil consumption. The "Make in India" campaign was launched in 2014 by Prime Minister Narendra Modi and aims to transform the country's manufacturing sector into a powerhouse for growth and employment. Other key objectives of this campaign include a target of 12-14% annual growth in the manufacturing sector, and the creation of 100 million new jobs by 2020 in the sector.2 In 2017Q1, India's liquid fuels consumption declined by 3% yoy. This decline was, for the most part, caused by the government's "demonetization" program, which was designed to streamline the economy and reduce rampant black-market transactions. The government chose to invalidate the 500- and the 1,000-rupee banknotes, the most-used currency denominations in the economy (around 86% of the total value of currency in circulation). This represented a huge shock to the average citizen, since it limited the purchasing power of a large part of the consumer economy for an extended period of time and impacted India's overall economic activity. Recent data show Indian oil and liquids consumption up 3% in April (yoy), and its money supply is almost back to its pre-demonetization levels, according to the EIA. This suggests economic activity and liquid-fuel consumption will get back to their previous levels. Bottom Line: We believe OPEC 2.0's deal will be extended at next week's Vienna meeting to March 2018. However, after September, we are expecting compliance to fall off meaningfully, leaving KSA and its allies as the only producers adhering to their voluntary cuts past year-end 2017. Even so, we expect the storage overhang to be worked off - mostly this year - but also into next. Even though U.S. shale production is surprising on the upside, the commitment of a majority of OPEC 2.0 to production cutbacks at least through September of this year will force the storage overhang to draw down by year end. KSA and its core allies will maintain production discipline to March 2018, which will keep storage from refilling too quickly during the seasonally weak consumption period in the first quarter next year. We continue to expect oil forward curves to backwardate by December 2017, and remain long Dec/17 Brent vs. short Dec/18 Brent. In addition, we remain long Dec/17 Brent $65/bbl calls vs. short Dec/17 Brent $45/bbl puts, expecting prices to rally toward $60/bbl by the time Brent delivers in December. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Sen, Amrita; Anupama Sen (2016), "India's Oil Demand: On the Verge of 'Take-Off'?". Oxford Institute for Energy Studies. 2 Some of the recent policies to enhance the manufacturing growth include: Government subsidies of up to 25% for specific manufacturing sub-sectors; area-based incentives to increase the manufacturing development in key regions; allowances for companies that invest a predetermined amount in new plant and machinery; deductions for additional wages paid to new regular employees; deductions for R&D expenditures; and other incentives aimed at promoting the manufacturing sector and improving the India's ease of doing business to attract foreign direct investments. Please see http://www.makeinindia.com/article/-/v/direct-foreign-investment-towards-india-s-growth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended Commodity Bull Market Ended Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. Image Image The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Image Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression A Hyperflationary Depression A Hyperflationary Depression Image Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Official Forex Devaluations Official Forex Devaluations Chart 15Domestic Demand Collapses Domestic Demand Collapses Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chinese Demand Is Limited Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Public And Private Consumption Shrink Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... External Debt Soars... External Debt Soars... Chart 19...While Forex Reserves Dwindle ...While Forex Reserves Dwindle ...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. Image In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Image Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Highlights The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. Although it has been well over a year since the last 10% pullback, the U.S. equity market is not "due" for a correction. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction. What is Dr. Copper's diagnosis? We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a correction. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. We disagree. Feature U.S. stock prices remain within striking distance of their all-time highs and many investors continue to worry about the next correction. The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. The market has all but ignored the recent political turmoil in Washington. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction, while others note that it's been more than 15 months since the last 10%+ correction and that we are "due" for one. But is Dr. Copper still a reliable indicator of equity market tops? And if a correction is at hand, which assets would hold up best on the way down? We also review yet another disconnect between the Fed and the market: average hourly earnings. Geopolitical Risk Continues To Fade As A Market Concern Emmanuel Macron's victory was a resounding one as French voters rejected Le Pen's anti-Europe message in last week's election. Removing the possibility of a French President that is dedicated to exiting the eurozone is obviously positive for European stocks and investor risk appetite the world over. Next up are the two rounds of legislative elections in June. Polls are sparse, but they support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. A Macron presidency supported by Les Republicains in the National Assembly would be a bullish outcome for investors, according to our geopolitical strategists. On the international stage - where the president has few constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Republicains. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. The presidential election result in South Korea last week was exactly what the market expected, and should help to reduce tensions on the Korean peninsula. For now, the situation in Washington around President Trump's firing of FBI Director Comey has not had a major impact on markets. If the Democrats win the House of Representatives in 2018, our geopolitical team believes that impeachment proceedings will begin against Trump. On one hand, this means that polarization in the U.S. is about to reach record-high levels. On the other, it should motivate the GOP to get tax reform done before it is too late. Bottom Line: Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, but that is a risk for 2018. We expect market-friendly policies emerging from Washington this year, although the Comey affair highlights that the road will be anything but smooth. Corrections And Pullbacks In Context Geopolitical risk appear to have faded for now, but with U.S. equities at or close to all-time highs, talk of a correction is hard to avoid. We continue to favor stocks over bonds this year and suggest that any sell-off in equities will be bought not sold. A hard landing in China, major disappointment on the Trump legislative agenda, a prolonged spell of weakness in the U.S. economic data1, and an overly aggressive Fed in 2017 may all serve as catalysts for a pullback. Above average PE ratios and measures of market volatility that are at cycle lows have only added to the chorus of those saying we are "due" for a correction. History suggests otherwise. From the end of WWII through 2009, the S&P 500 has experienced, on average, two 10% corrections and 10 corrections of 5% of more during equity bull markets. Since the start of the current bull market in March 2009 we've had 22 pullbacks of 5% or more and six corrections of more than 10% (using market closing prices) Table 1. This suggests that the market has seen its fair share of pullbacks and corrections since 2009, and isn't really "due". Chart 1 takes a different approach, but reaches the same conclusion. At 15 months (325 days) since the end of the last 10% correction, the current bull market is right of the middle of the pack of all bull markets since 1932. Table 1Six S&P 500 Corrections Of 10% Or More Since March 2009: We're Not "Due" Still Awaiting The Next Pullback Still Awaiting The Next Pullback Chart 1Current Equity Bull Market Is Not Long In The Tooth Still Awaiting The Next Pullback Still Awaiting The Next Pullback Our view remains that any pullback in U.S. equities will be bought, not sold, and we favor stocks over bonds in 2017. There are few notable imbalances in the U.S. or global economies and we see an acceleration in both over the remainder of 2017. The Fed will raise rates gradually this year, and there is general agreement between the Fed and the market on the pace of hikes at least for 2017. The Fed and the market remain far apart on hikes in 2018. Our view of the economy and labor market suggests that the market will ultimately move toward the Fed's view. The U.S. corporate earnings outlook remains solid, after a very good Q1 earnings season and favorable guidance for Q2 2017 and beyond. Bottom Line: Equity pullbacks - even during bull markets - are normal and healthy. We do not believe that the market is especially "overdue" for a pullback, but when the inevitable pullback or correction occurs, we expect that investors will take the opportunity to add to equity positions and not turn the pullback into a bear market. Dr. Copper? Chart 2Metals Prices Are Rolling Over...##BR##But Is It A Signal? Metals Prices Are Rolling Over... But Is It A Signal? Metals Prices Are Rolling Over... But Is It A Signal? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 20% on a year-ago basis, but has fallen by 8% since February (Chart 2). From their respective peaks earlier this year, zinc and copper are down about 10%, nickel has dropped by 22% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Some of our global leading economic indicators have edged lower this year, as we have discussed in recent Weekly Reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart 3). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over (annual growth is shown on a 12-month moving-average basis in Chart 4 because of the extreme volatility in the series). Both the PMI and housing starts are correlated with commodity prices. Chart 3China is The Main Story##BR##For Base Metals Demand China is The Main Story For Base Metals Demand China is The Main Story For Base Metals Demand Chart 4Direct Fiscal Spending And Infrastructure##BR##Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: Chart 5Dr. Copper Is Not Signaling##BR##A Slowdown in Global Growth Dr. Copper Is Not Signaling A Slowdown in Global Growth Dr. Copper Is Not Signaling A Slowdown in Global Growth There is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Moreover, both direct fiscal spending and infrastructure investment have picked up noticeably in recent months (Chart 4). Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. This all adds up to a fairly benign outlook for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. We intend to update our view on oil prices in the May 22, 2017 edition of this report. Bottom Line: From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Chart 5 highlights that the LMEX base metals index has a high positive correlation with the U.S. stock-to-bond total return ratio on a daily change basis. However, in terms of trends and turning points, base metals are far from a reliable indicator for the stock-to-bond ratio. Where To Hide In A Stock Market Correction Over the past several years, BCA's U.S. Investment Strategy service has periodically recommended that investors add a variety of investments as portfolio "insurance" to help guard against the possibility of a material correction in equities. More recently, we have highlighted two specific forms of insurance: our yield and protector portfolios. We last discussed the protector portfolio in the October 17, 2016 and November 7, 2016 Weekly Reports2, and in today's report we revisit the issue by comparing both portfolios to a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. Charts 6, 7, and 8 show a breakdown of the relative performance of S&P 500 defensives along with our yield and protector portfolios. Panels 2 and 3 of Charts 6, 7 and 8 present the rolling 1-year beta and alpha of each strategy vs. the S&P 500. Here, we present alpha as the difference between the actual year-over-year excess return of the portfolio (vs. short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is sometimes referred to as "Jensen's alpha". Chart 6A Modestly Low-Beta Option A Modestly Low-Beta Option A Modestly Low-Beta Option Chart 7A Lower Beta Than Defensives A Lower Beta Than Defensives A Lower Beta Than Defensives Chart 8A Negative Beta, And Positive Alpha A Negative Beta, And Positive Alpha A Negative Beta, And Positive Alpha There are several noteworthy observations from the charts: Based on the historical beta of the three portfolios vs. the S&P 500, defensive stocks are the most correlated with the overall equity market. Our protector portfolio has a negative correlation to the broad market, and our yield portfolio is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 2); with our protector portfolio composed entirely of non-equity assets. Table 2A Breakdown Of Three##BR##Portfolio Insurance Options Still Awaiting The Next Pullback Still Awaiting The Next Pullback After accounting for their lower beta, all three portfolios have tended to outperform the S&P in risk-adjusted terms since the onset of the global economic recovery. But this outperformance has been more significant for our yield and protector portfolios: the top panel of Charts 7 and 8 highlight that both portfolios have generated essentially the same return as equities have since the end of the recession (since the relative profile has been flat), despite exhibiting considerably less volatility than stocks. All three portfolios have experienced a relative decline vs. the S&P 500 since the election, but this has largely occurred due to passive rather than active underperformance. In other words, they have underperformed due to a failure to keep up with the S&P 500 rather than because of losses in absolute terms. There are two important conclusions from Charts 6, 7 and 8 for U.S. multi-asset investors. First, the lower beta of our yield and protector portfolios compared with S&P defensives means that the former represent a better insurance bet against a sell-off in the equity market than the latter. Second, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets over the past few years, which is likely to persist over the coming 6-12 months. But investors should also recognize that this preference could eventually be subject to a reversal if the long-term economic outlook significantly improves, an event that could be catalyzed either by organic economic developments or policy decisions by the Trump administration. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. But our analysis suggests that clients who anticipate the need for portfolio insurance over the coming year should favor our yield and protector portfolios over a defensive sector allocation within an equity portfolio, and we are likely to recommend an allocation to these portfolios for all clients were we to see any material progression towards the sell-off triggers that we identified earlier in the report. Bottom Line: Investors seeking some protection against a potential equity market sell-off should favor our yield and protector portfolios over defensive sector positioning. We do not currently recommend these portfolios for all clients, but we are likely to do so if our key sell-off trigger "red lines" are breached. What's Up With Wage Growth? On the surface, the April jobs report-released in early May seemed to send mixed signals to investors and the Fed about the health of the labor market3. Our view remains that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation, which will lead the Fed to raise rates twice more in 2017. But even though the economy is very close to full employment and the output gap has nearly closed, patience is required. Although it's a close call, the next hike is likely to come next month. Markets remain somewhat skeptical of this view, and have only priced in 39 bps of tightening by the end of the year, and have not yet fully priced in a June rate hike. The lack of wage growth (up just 2.5% year-over-year in April according to average hourly earnings (AHE)) remains a key source of the market's skepticism about the pace and timing of Fed rate hikes. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. Does the Fed see something the market does not? Or is it the other way around? Markets tend to focus on data that are timely. That requirement certainly fits the AHE. The monthly wage measure is the most timely data point on labor compensation. While timeliness is an important factor when assessing the health of the labor market, it is also critically important to watch what the Fed watches. Investors should note that the AHE data is only one of at least four measures of labor compensation the Fed mentions in its Semi Annual Monetary Report to Congress. Since Fed Chair Yellen took office in 2014, the Fed has specifically referenced (and charted together) three measures of labor compensation in the report: Average hourly earnings Employment Cost Index and Compensation per Hour in the nonfarm business sector, and Chart 9The Fed Tracks All Four Of##BR##These Compensation Measures The Fed Tracks All Four Of These Compensation Measures The Fed Tracks All Four Of These Compensation Measures The Atlanta Fed's Wage Tracker was mentioned in the June 2016 Monetary Policy Report, and the Fed added it to the chart of the other three metrics in the most recent report, released in February 2017. As Chart 9 shows, all have moved higher in recent years, although it is clear that AHE has lagged the others. Given the attention it receives in the financial news media on and just after "Employment Friday" each month, it may surprise investors to learn that neither AHE nor wages were directly mentioned in any of the FOMC statements since Yellen took charge. However, wage growth (or lack thereof) has been a topic of discussion at all but a few of the 13 post FOMC press conferences Yellen has held. When asked about wages, she is careful to note that the Fed watches a wide range of indicators of labor compensation, but has lamented the lack of progress on wages. In her most recent press conference, Yellen noted that "I would describe some measures of wage growth as having moved up some. Some measures haven't moved up, but there's some evidence that wage growth is gradually moving up, which is also suggestive of a strengthening labor market." Average hourly earnings are routinely mentioned in the FOMC minutes, but only alongside mentions of the other metrics noted above. On balance, average hourly earnings are viewed by the Fed - and therefore should be viewed by the market - as one of several indicators of the health of the labor market, but not the only indicator. Chart 10 shows that only a third of industries have seen an acceleration in wage increases over the past year, which supports the market's view that the economy is not growing quickly enough to push up wages and inflation. A recent report by the Kansas City Fed4 takes a different view. Using a bottom-up approach, the author points out that only a few industries (mostly in the goods producing sector of the economy) have accounted for much of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail trade, professional and business services and leisure and hospitality - all service sector industries - have been the laggards. The study done by the economists at the Kansas City Fed shows that although earnings growth has lagged in those more service-oriented industries since 2015, hours worked have seen faster growth than in the mainly goods producing sector (chart not shown). This suggests to the author - and we concur - that labor demand has been strong in the past few years in areas that have not seen much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience may be required. Chart 11 shows that it takes two to three years after a bottom in the output gap for a decisive turn higher in ECI or AHE. While this cycle has seen a more shallow recovery - especially in AHE - both have moved higher since the output gap bottomed out in 2009/2010. Chart 10Only 33% Of Industries Have Seen##BR##Wage Acceleration Over The Past 12 Months Only 33% Of Industries Have Seen Wage Acceleration Over The Past 12 Months Only 33% Of Industries Have Seen Wage Acceleration Over The Past 12 Months Chart 11Measures Of Labor Compensation Move##BR##Higher After Output Gap Bottoms Out Measures Of Labor Compensation Move Higher After Output Gap Bottoms Out Measures Of Labor Compensation Move Higher After Output Gap Bottoms Out Bottom Line: Investors are always wise to watch what the Fed watches. The evolution of wage growth will be critical to FOMC policymakers, because a clear acceleration will confirm that the economy is truly at full employment and, thus, at risk of overheating. We do not expect a surge in wages, but a steady upward trend will keep the Fed on a gradual tightening path. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Reports "Portfolio Insurance: What, How, When?", dated October 17, 2016 and "Policy, Polls, Probability", dated November 7, 2016, both available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed" dated May 8, 2017, available at usis.bcaresearch.com. 4 See "Wage Leaders and Laggards; Decomposing the Growth in Average Hourly Earnings" The Macro Bulletin, February 15, 2017; Federal Reserve Bank of Kansas City.

Highlight Once-ebullient oil markets are overwrought. Fears that an economic slowdown in China will spill over into EM - the engine of global commodity demand growth - along with a very weak 1Q17 U.S. GDP performance, will keep oil markets focused on downside risks to prices. On the supply side, high-frequency inventory data from the U.S. suggests visible OECD stocks remain high, seemingly impervious to OPEC 2.0's best efforts to drain them. Steadily rising U.S. shale output also weighs on prices. Markets appear to be looking right through the choreographed comments on production cuts from leaders of OPEC 2.0, which suggest these cuts will definitely be extended to year-end 2017, and possibly into 2018. We doubt the demand picture is anywhere close to a fundamental downshift, expecting, instead, continued robust demand. We also expect the extension of OPEC 2.0's production cutbacks to year-end 2017 to significantly drain storage, even as shale output continues to grow. If anything, recent market action has presented an opportunity re-establish length, and to position for backwardation toward year-end. Energy: Overweight. The stop-loss on our Dec/17 Brent $45/bbl puts vs. $65/bbl calls was elected May 4/17, leaving us with a loss of $1.54/bbl (-327.7%). We are reinstating the position as of tonight's close, anticipating Brent will reach $60/bbl by year-end. We also stopped out of our Dec/17 Brent long vs. Dec/18 Brent short on May 4/17, with a $0.50/bbl loss (-263.2%). We will re-establish this position as well basis tonight's close. Base Metals: Neutral. LME and COMEX stock builds are keeping copper under pressure, offsetting possible renewed labor unrest. This is keeping us neutral. Precious Metals: Neutral. We were made long spot gold at $1230.25/oz basis last Thursday's close as a hedge against inflation risk, and a possible equities correction. Ags/Softs: Underweight. USDA data indicate a favorable start to the grain planting season. We remain bearish. Feature Softer Chinese PMIs spooked commodity markets, coming as they did on the heels of a very visible and much-reported weakening of base metals and iron ore prices emanating from Chinese markets (Chart of the Week).1 Financial markets fear weaker Chinese growth could presage weaker EM growth, which is the engine of commodity growth generally.2 With U.S. GDP coming in weak as well - registering a paltry growth of 0.7% in 1Q17 - markets started re-calibrating oil demand estimates for this year in light of still-high inventory levels. Adding to the market's agita, visible oil inventories in the OECD remain stubbornly high, thwarting OPEC 2.0's best efforts to drain them via their closely followed production cuts. By Wednesday of this week, this potent combination shaved some 9.6% off 1Q17 average prices, taking international benchmarks Brent and WTI below $50/bbl. Dubai prices have largely been spared similar carnage, as Gulf OPEC states continue to reduce supplies of heavier sour crude availabilities (Chart 2). Chart of the WeekChina PMIs Weaken As Monetary##BR##Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly Chart 2Oil Prices##BR##In Retreat Oil Prices In Retreat Oil Prices In Retreat OPEC 2.0 Responds To Weaker Prices OPEC 2.0 - our moniker for the producer group comprised of OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia - was not oblivious to these concerns. Indeed, earlier this week KSA Oil Minister Khalid al-Falih said the group would "do whatever it takes" to drain stocks and normalize global inventories (Chart 3). The OPEC 2.0 leadership is well aware that failure to do so would again expose these petro-states to the risk of a price collapse, as, absent production discipline, oil inventories once again would fill. This would force prices through producers' cash costs until enough production was knocked off-line to drain the storage overhang.3 Comments by leaders of OPEC 2.0 regarding the extension of its 1.8mm b/d production cuts this year and into next year are consistent with a strategy we laid out earlier, part of which includes the use of forward guidance to convince markets the supply side will tighten in the future.4 The other critical part of the strategy is for OPEC 2.0 to keep the front of the Brent curve at or below $60/bbl, using their own production, spare capacity and storage, and guiding to higher supply in the future, which would keep markets backwardated in 2018 once visible storage returns to five-year average levels. A persistent and deep backwardation - on the order of 10% p.a. - would, based on our modelling, slow the return of rigs to U.S. shale fields. In addition, the combination of a front-end forward curve capped at $60/bbl and persistent backwardation would keep depletion rates elevated, as cash-strapped producers - e.g., non-Gulf OPEC producers with high fiscal breakeven oil prices - are forced to forego maintenance capex. Taken together, this would give OPEC 2.0 a stronger hand in guiding prices - provided the coalition can hold together and maintain production discipline. We continue to expect an extension of the 1.8mm b/d OPEC 2.0 cuts will backwardate markets once inventories normalize later this year, even with strong growth from U.S. shales.5 Indeed, we expect this combination of fundamentals will clear the storage overhang by end-2017, and produce draws of more than 1mm b/d on average from April - December (Chart 4). Chart 3OPEC 2.0 Leaders KSA,##BR##Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" Chart 4Steady Demand,##BR##Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Wobbly Oil Demand Is Transitory The 1Q17 demand-side scares emanating from China and the U.S. are transitory. Chart 5Fiscal And Infrastructure Spending##BR##Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Following their return from the mainland, our colleagues on BCA's China Investment Strategy desk note that monetary conditions still are fairly stimulative, and are unlikely to cause the economy to roll over.6 Most of the deterioration in economic growth results from a slowing in the depreciation of China's trade-weighted RMB, following a years-long appreciation from 2012 to 2015, which did dampen growth. In addition, while fiscal stimulus was reduced at the end of 2016, the government "quickly reversed course" as direct spending and investment in infrastructure picked up substantially (Chart 5). Our China Investment Strategy colleagues note China's fiscal spending is pro-cyclical - it increases as the economy improves and tax revenues increase. The government shows no sign of wanting to wind this down: "China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant." The impact of Chinese demand on global oil demand is increasing, based on econometric work we've recently completed. From 2000 to end-April 2017, a 1% increase in Chinese oil demand has translated into a 0.64% ncrease in Brent prompt prices. During this period, the impact of non-OECD demand ex China was more than two times that of China's - a 1% increase there could be expected to lead to a 1.3% increase in Brent prices. China's impact on Brent prices in the post-GFC world more than doubled, while the impact of non-OECD demand ex-China increased marginally. Since the Global Financial Crisis, a 1% increase in China's oil consumption has produced a 1.4% increase in Brent prices, while a similar increase in EM ex-China has translated into a 1.8% increase in Brent prices.7 Turning to the U.S., we believe, along with the Fed, the weak patch in GDP in 1Q17 is transitory. Following the report on the quarter's weak 0.7% GDP growth, the U.S. Bureau of Labor Statistics surprised markets with a reading of 4.4% unemployment (U3 measure), and an equally impressive U6 measure of 8.6%, which takes it almost to pre-GFC levels. We expect robust U.S. labor-market conditions will keep demand for refined products in the U.S. robust, which will support oil prices there going forward. Globally, the U.S. EIA expects oil consumption will grow 1.6mm b/d this year - unchanged from last year. This is above our 1.4mm b/d estimate for the year. If the EIA's demand estimate is accurate, we can expect a sharper draw (+200k b/d) in global inventories than the average 860k b/d we currently are projecting, all else equal (Chart 4). This would lead to a sharper and earlier backwardation in prices that we currently expect. We will be re-estimating our balances model next week. Investment Implications We continue to expect the global storage overhang to clear by year-end, given the extension of OPEC 2.0's production cuts to at least year-end 2017. Wobbly demand is a transitory phenomenon, and we expect a recovery in the balance of the year. Given our expectation, we are re-establishing our long year-end Brent exposure, and are going short a $45/bbl Dec/17 Brent put vs. long a $65/bbl Dec/17 Brent call at tonight's close. We had a -$1.00/bbl stop-loss on this position, which was elected May 4/17 and resulted in a 1.54/bbl loss (-327.7%). We stopped out of our long Brent front-to-back position - long Dec/17 Brent vs. short Dec/18 Brent - in anticipation of backwardation. We also will be looking to re-establishing this position at tonight's closing levels, and for a good entry point to re-establish the same position in WTI. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Iron-ore (62% Fe) prices are down 33.5% after peaking this year at close to $91/MT in March. The LMEX base metals index is down 7.7% from its 2017 peak in February. Regular readers of Commodity & Energy Strategy will recall we've been bearish iron ore and steel for months, and have remained neutral base metals. Please see "China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals," and "Copper's Price Supports Are Fading," in the January 19, and March 23, 2017, issues of Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 2 In the May 5, 2017, issue of BCA Research's Foreign Exchange Strategy, our colleague Mathieu Savary notes, "The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing." Please see "The Achilles Heel of Commodity Currencies" in the May 5 FES, available at fes.bcaresearch.com. 3 Please see "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," published by BCA Research's Commodity & Energy Strategy April 20, 2017, for a further discussion of the logic behind these cuts. 4 This aligns with a strategy we laid out last month, which uses forward guidance to convince markets to anticipate tighter supply further out the curve. By leading markets to anticipate lower crude oil availabilities in the future - while storage is drawing - OPEC 2.0 is setting the stage for forward curves to remain backwardated. Please see "The Game's Afoot In Oil, But Which One?" published April 6, 2017, in BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 5 "Backwardation" refers to a futures forward-price curve in which contracts for prompt delivery are higher than prices for deferred delivery. This indicates merchants and refiners are willing to pay more for a commodity delivered close in time versus in the future. It is the opposite of a "contango" curve, in which deferred prices exceed prompt prices. 6 Please see "Has China's Cyclical Recovery Peaked?" in BCA Research's China Investment Strategy Weekly Report published May 5, 2017. It is available at cis.bcaresearch.com. 7 These coefficients are all significant at less than 0.01. R2 coefficients of determination for these cointegrating regressions, which include the USD broad trade-weighted index (TWIB) all exceed 0.90, indicating that the USD TWIB and Brent prices share a common long-term trend, and that FX effects remain important in assessing oil prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong

Please note that we are publishing a Special Report today titled "EM Local Bonds: Looking At Hedged Yields". Feature Commodities prices have plunged lately, even though the U.S. dollar, up until this past week, has been weak versus European currencies. Hence, the recent selloff in the commodities complex cannot be attributable to U.S. dollar strength. Something else has been at work. Furthermore, EM share prices and currencies have decoupled from both commodities prices and DM commodities currencies such as the AUD, NZD and the CAD (Chart I-1). Chart I-1Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Is this time different, and are we entering a new era in EM investing? We do not think so. This divergence is unsustainable and reflects irrational exuberance and fund flows into EM. The decoupling is already overstretched - although it could last another several weeks, it will not continue for much longer. We have the following observations: The commodities selloff has been very broad-based, and has been especially intense in commodities that are trading in China as well as those that are leveraged to Chinese growth (Chart I-2A & Chart I-2B). Such a simultaneous gap down in various commodities prices can be explained either by a decline in speculative long positions in commodities or weakness in real demand. It cannot be attributed to supply because the selloff has transpired at the same time across various commodities. Commodities' supply dynamics are idiosyncratic. China's central bank has been tightening liquidity, forcing deleveraging in the financial system. It is very plausible that this has led to an unwinding of long positions in commodities trading in China. Chart I-2AWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities Chart I-2BWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities China bulls would correctly argue that the selloff in commodities is indicative of a reduction in speculative trading activities - not in final demand. However, to be consistent, we should also accept that that the commodities rally in 2016 was not entirely due to demand improvement in China. Instead, it was at least partially due to speculative investment demand. It is impossible to quantify the magnitude of speculative activity in China's commodities markets, yet it has probably been a non-trivial force supercharging both last year's rally as well as the latest selloff. In regard to commodities demand from the real economy, China's growth has not yet turned decisively down. That said, the growth outlook is downbeat as credit growth downshifts in response to the ongoing policy tightening. Chart I-3 illustrates that the annual growth in the number and value of newly started projects has recently contracted. This heralds weaker demand for commodities, materials and capital goods in the months ahead. The surge in new projects launched last year marked the beginning of an upturn in industrial activity, and could well be indicative of a budding downtrend now. Besides, Chinese imports of industrial metals (excluding iron ore) has by and large been flat since 2010 (Chart I-4). The mainland's iron ore imports have been strong because inefficient/expensive domestic production has been shut down, leading to an increase in imports. Chart I-3China: Capital Spending To Slump Again China: Capital Spending To Slump Again China: Capital Spending To Slump Again Chart I-4China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports Although China's oil imports have been strong (Chart I-5, top panel), underlying final demand has been weaker as there is evidence that the country has used imports of crude to increase inventories (Chart I-5, bottom panel). Provided that inventories are mean-reverting, such a large build-up in crude inventories poses a risk to China's oil demand and oil prices in the months ahead. Remarkably, the Brazilian real and South African rand have recently decoupled from the overall commodities price index and platinum prices, respectively (Chart I-6). These divergences represent a substantial departure from historical correlations. We cannot find any explanation other than the ongoing irrational exuberance in EM financial markets. Finally, signposts of potential growth deceleration are not only limited to the commodities complex. For example, Taiwanese narrow money (M1) impulse has decisively rolled over; it typically leads Taiwanese exports and correlates well with the equity market (Chart I-7). Chart I-5China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy Chart I-6EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices Chart I-7Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Bottom Line: The recent decoupling between commodities prices and EM risk assets is unsustainable. This divergence reflects irrational exuberance that typically transpires around a major market top. While not chasing this rally has been painful, there is no point in doing so at current levels. We recommend investors maintain a negative stance on EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations