Oil

Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Waiting For The Turn Waiting For The Turn Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months Wages Have Accelerated Over Past Three Months Wages Have Accelerated Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data No Slowdown In ECI Data No Slowdown In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation Labor Market Tight Enough To Push Up Inflation Labor Market Tight Enough To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small Caps Are Not Great Market Prognosticators Small Caps Are Not Great Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. 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 "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Odds the leaders of the OPEC 2.0 petro-states will be forced to back up last month's "whatever it takes" declaration - perhaps deepening and extending the 1.8mm b/d production cuts agreed at the end of last year - are not yet overwhelming. All the same, they will continue to increase, if markets do not see sustained draws in visible storage. Our updated supply-demand balances indicate global crude inventories will continue to draw, and that these draws will accelerate. This will keep global storage levels on track to normalize later this year or in 1Q18. We continue to expect Brent to trade to $60/bbl by December, with WTI ~ $2/bbl under that. Energy: Overweight. Our low-risk call spread initiated last week - long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls - is down 18.9%, following continued selling. We are adding to the position with the same Dec/17 strikes in Brent at tonight's close. These are strategic positions. Base Metals: Neutral. SHFE copper inventories fell on the back of increased demand for collateral to support financing deals in China. Tightening credit conditions are beginning to bite as the government pushes deleveraging policies, according to Metal Bulletin. Precious Metals: Neutral. We remain long gold, despite the hawkish rhetoric being thrown around by Fed officials, particularly William Dudley, head of the NY Fed. Our long gold portfolio hedge is up 1.1% since it was put on May 4, 2017. Ags/Softs: Underweight. Chicago and KC winter wheat remain bid, as concerns over drought-induced damage to the crop continue to weigh on markets. Feature Chart of the WeekUpdated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Insomuch as such things can ever be "official," crude oil officially entered a bear market - down 20% or more from recent highs - with the unexpected arrival of WTI futures below the lower end of our long-time $45-to-$65/bbl trading range this week.1 The proximate causes of this turn of events are persistently sticky inventory levels - most visible in the high-frequency data from the U.S. - and growing fears increasing Libyan and U.S. shale-oil production will undermine OPEC 2.0's 1.8mm b/d production cuts. We are hard-pressed to see the case for such fears, even though the market is consistently trading in a manner that is more aligned with supply cuts being far less than advertised by OPEC 2.0, or demand slowing considerably more than any agency or data service has yet picked up on. We will never be able to confirm sovereign hedging - e.g., Mexico or Iraq hedging oil-production revenues - until after the fact. However, this cannot be dismissed out of hand. Based on our latest supply-demand analysis, OPEC 2.0 - the coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia - will have removed some 1.4mm b/d of production on average from the market between January 2017 and end-March 2018 vs. peak production in November of last year (Chart of the Week). This will be diluted somewhat by the Libyan and U.S. production gains, but this increased production will not be sufficient to counter the OPEC 2.0 cuts entirely. Global Oil Supply Contracting Sharply Chart 2OECD Storage Draws On Track OECD Storage Draws On Track OECD Storage Draws On Track Against peak production in November 2016, we see just over 1.2mm b/d of crude oil production being cut by OPEC between January and end-March-2018.2 Throw in another 200 - 300k b/d or so from the non-OPEC members of the OPEC 2.0 coalition - mostly Russia - and we get to 1.4 to 1.5mm b/d of production taken off the market in the Jan/17 - Mar/18, interval in our modeling. This will leave the highly visible OECD storage levels being targeted by OPEC 2.0 at ~ 2.70 billion barrels by the end of the year, or some time close to the start of next year (Chart 2). In our modeling, we do not agree with the implied 1.9mm b/d of production cuts that follow from the reported OPEC 2.0 compliance statistics in the press. These reports indicate OPEC 2.0 coalition members are at 106% compliance. This is remarkably high, even if reports of this compliance rely on anonymous sources speaking to reporters following the coalition's technical committee meeting in Vienna earlier this week.3 If the production discipline attested to is true, we will raise our estimate of how quickly inventories will draw this year, and lower our expected global inventory levels for the end of March 2018. As for U.S. crude production, while we do have Dec/17 production 1.1mm b/d over Dec/16, we expect America's contribution to yoy global production growth to be only ~ 340k b/d on average over the course of 2017. The U.S. gains will be driven by shale-oil production, which we expect to grow ~ 410k b/d to 5.2mm b/d this year (Chart 3). Libya's production recently surged to 900k b/d, according to press reports, but, so far this year, it is averaging just under 700k b/d (Chart 4). This is slightly higher than the level we've been modeling in our balances for this year. The 300k b/d yoy increase in Libya's production is impressive, but it does not overwhelm OPEC 2.0's cuts. Even if Libyan production were to average 1mm b/d in 2H17, its net contribution to global production this year would be ~ 840k b/d, an increase of ~ 400k b/d over 2016's levels. We also note that as production and revenue increase the likelihood of renewed violence in Libya also increases.4 Chart 3U.S. Shale-Oil##BR##Growth Could Slow U.S. Shale-Oil Growth Could Slow U.S. Shale-Oil Growth Could Slow Chart 4Libya's Recover Is Impressive,##BR##But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Between them, combined growth in U.S. and Libyan production looks like it will be a touch under 650k b/d yoy (on average). Meanwhile, OPEC 2.0's production cuts - assessed against peak output for 2016 - are on track to exceed targets set at the outset of the agreement last December. Net, on a yoy basis, we expect to register inventory draws of close to 900k b/d this year. This should lead to cumulative draws in global storage levels of at least 400mm bbls by end-March. Demand Remains Strong The EIA revised its liquids demand estimates in its most recent Short-term Energy Outlook (STEO), and now has 2015 global consumption up 300k b/d from previous estimates at 95.4mm b/d, and 2016 consumption up 180k b/d at 96.9mm b/d. Our expected growth in global demand for this year and next is in line with the EIA's average estimate of ~ 1.6mm b/d, which will put 2017 demand at 98.5mm b/d and 2018 at 100.1mm b/d, respectively. Growth this year and next is expected to be slightly higher than last year's level (Chart 5). Once again, we expect EM demand - proxied by non-OECD liquids consumption - to lead global growth this year and next. Concern over apparent slowing in U.S. refined-product demand - particularly gasoline - is, we believe, overdone. Growth this year is being compared to stellar rates last year (Chart 6), which still leaves the level of demand above 20mm b/d. Growth in gasoline demand specifically also has slowed, but, again, this is occurring in a market where the level of demand remains high, pushing toward 10mm b/d, which is a mere 2.5% below record demand set in August of last year (Chart 7). Chart 5Expect Global Demand##BR##To Remain Stout Expect Global Demand to Remain Stout Expect Global Demand to Remain Stout Chart 6The Level Of U.S. Product##BR##Demand Remains High The Level Of U.S. Product Demand Remains High The Level Of U.S. Product Demand Remains High Chart 7U.S. Gasoline Demand##BR##Also Remains Stout U.S. Gasoline Demand Also Remains Stout U.S. Gasoline Demand Also Remains Stout 2018 Getting Foggy Uncertainty surrounding the evolution of the oil market next year is growing. The EIA believes markets will tighten in 3Q17, but then get progressively looser going into 2018, apparently disregarding OPEC 2.0's efforts to date, and the high likelihood - in our view - that the coalition will maintain production discipline for the most part (Chart 8). Combined with the robust demand growth BCA and the EIA expect, we get a fairly balanced market next year (Chart of the Week). U.S. shale-oil production, once again, will dictate just how tight markets become next year. Presently, we have average 2018 U.S. shale production in the Big 4 basins - Bakken, Eagle Ford, Niobrara, and the Permian - coming in more than 1mm b/d over 2017 levels. However, the recent sell-off that took WTI into bear-market territory this week could have a profound effect on shale-drilling activity next year, if it persists. Recent econometric work we've done confirms rig counts in the Big 4 plays are highly sensitive to WTI price. A prolonged stretch below $45/bbl could reduce rig counts by as much as 40% next year, especially if private-equity-backed companies cut spending. With hedging levels down, this is not a trivial concern (Chart 9).5 If prices stay depressed for any length of time for whatever reason - an outcome we do not expect - U.S. shale drilling activity could once again plummet. Chart 8EIA Fades OPEC 2.0's Resolve,##BR##BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not Chart 9Weak Prices Could##BR##Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts In addition, low prices also increase fiscal stress levels in petro-state revenues. This is of particular concern for KSA and Russia. The former is almost wholly dependent on oil revenues to fund its budgets, and will be looking to IPO its state-owned oil company, Aramco, next year. The latter is heavily dependent on oil and gas revenues, and will be holding an election in mid-March, just ahead of the expiry of the OPEC 2.0 production-cut extensions. The benchmark Russian crude, Urals, trades ~ $1.00 to $1.25/bbl under Brent, and any prolonged excursion into the low-$40s by Brent would stress the state's revenues. This is not our base case, but it is worthwhile considering. This mutual dependence on oil prices to support their respective economies is what compels strong compliance with the OPEC 2.0 production deal. Bottom Line: Our updated balances modeling continues to support our view global oil storage will draw, with OECD inventories likely falling below five-year average levels by year-end or early next year. Self-reported compliance with OPEC 2.0's production-cutting agreement exceeds 100%, implying the coalition is tracking to a 1.9mm b/d reduction in crude-oil output at present. On the demand side, even after upward revisions to 2015 and 2016 demand figures by the U.S. EIA, liquids consumption still is expected to grow on average ~ 1.6mm b/d this year and next. Cuts in production by OPEC 2.0 this year are more than sufficient to offset increases in Libyan and U.S. production, leaving overall production below consumption globally by close to 900k b/d, which will ensure inventories draw. For next year, after storage draws have abated, we expect supply and demand to be roughly balanced. We continue to expect Brent prices to trade to $60/bbl by year-end, and, on that basis, are recommending a long Dec/17 $50/bbl Brent call vs. short a Dec/17 $55/bbl Brent call. Longer term, our central tendency for price remains $55/bbl, with a range of $45 to $65/bbl prevailing most of the time. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We are using the front-line WTI futures contract, which hit its recent high on Feb. 23 at $54.45/bbl (last price) and traded down to $43.23/bbl on June 20, registering a drop of 20.6%. First-line Brent has yet to fall more than 20% from its recent high of $57.10/bbl on Jan. 6 to $46.02/bbl on June 20 (a 19.4% drop). 2 Measuring against peak production - rather than the October levels referenced by OPEC 2.0 coalition members - is an inherently more conservative way of assessing the effect of the production cuts. 3 Please see "OPEC, non-OPEC compliance with oil cuts hits highest in May: source," published by reuters.com on June 21, 2017. 4 An uptick in Nigerian production also is cited by some observers as a cause for concern vis-à-vis slowing the normalization of global storage levels. However, as Chart 4 illustrates, that country's production remains on either side of 1.5mm b/d, more than 500k b/d below recent steady-state levels. 5 Looking at rig-count sensitivity to prices and rig productivity, we find a 1% increase (decrease) in nearby prices translates into a roughly 70bp increase (decrease) in rig counts, while a 1% increase (decrease) in lagged, deferred WTI futures prices (out to 3 years forward) translates into a 2% change in the same direction. The R2 coefficients of determination for the models we estimated average ~ 0.95. 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 Time For "Whatever It Takes" In Oil? Time For "Whatever It Takes" In Oil?

Highlights The sharp downturn in oil prices triggered last week by an unexpected jump in weekly U.S. oil inventories, along with word Mexico's finance ministry had begun soliciting offers for its 2018 oil-revenue hedge, will be reversed by strong fundamentals in the next few weeks. On the data side, we believe markets simply over-reacted to high-frequency U.S. statistics. Taking a slightly broader view of the data suggests the trend in U.S. oil markets is continued tightening, as the northern hemisphere enters the summer driving season. Globally, we expect the OPEC 2.0 production-cut extension and continued strong EM demand to lead to a normalization of global storage levels by end-2017. We continue to expect Brent to trade to $60/bbl in 4Q17, with WTI trailing by ~ $2/bbl. Energy: Overweight. We were stopped out of our long Dec/17 vs. short Dec/18 WTI and Brent spreads by last week's sell-off. We continue to favor long front-to-back exposure, but will wait to re-establish these positions. We will, however, take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Base Metals: Neutral. Copper's brief rally stalled, taking front-month COMEX prices below $2.60/lb this week. The IMF's upgrade of China's growth prospects likely will support copper prices. Precious Metals: Neutral. Spot gold's chart has formed a bullish inverted head-and-shoulders pattern, which could take prices into a gap that opened in the continuation chart at $1,292/oz in the aftermath of November 2016's price plunge. We remain long spot gold. Ags/Softs: Underweight. The USDA's WASDE report did little to temper expectations for another record harvest - or something close enough to it. Even so, given recent U.S. Midwest weather, we would close any shorts. Feature This past week in the oil markets amply demonstrates that the old adage "One week does not a trend make" is more honored in the breach than in the observance. Events we view as transitory - the unexpected 3.3mm bbl jump in weekly U.S. crude-oil inventories, along with news Mexico's finance ministry began lining up offers on crude-oil put options for its 2018 revenue hedge - conspired to shave close to 6% from Brent prices in less than a week. From just over $51/bbl at the beginning of the month, when the Mexican finance ministry reportedly began soliciting offers on crude-oil put options, to the end of last week, Brent prices had fallen ~ $3/bbl. Front-month Brent continued to languish around that level as we went to press.1 Stronger fundamental data, particularly from the U.S., where last week's inventory shock hammered prices, will reverse these transitory effects going into 2H17. Chart of the WeekU.S. Refinery Runs At Record Levels U.S. Refinery Runs At Record Levels U.S. Refinery Runs At Record Levels U.S. Fundamental Strength Will Reverse Weak Crude Prices Third-quarter refining - typically a high-activity period in the U.S. - is opening on a very strong note: U.S. refining runs are at record highs, with net crude inputs posting a four-week average 17.3mm b/d run rate at June 2, 2017 (Chart of the Week). U.S. demand is reviving and now is back over 20mm b/d (Chart 2). We expect low product prices, particularly for gasoline, to boost demand going into the summer driving season. In addition, surging refined-product exports, particularly into Latin American markets, will keep U.S. refiners' appetite for crude high, allowing storage levels to drain (Chart 3). Note the end-2016/early-2017 surge and the ongoing strength in product exports year to date - exports are seasonally strong, even if they dipped a bit. The resumption in export growth after a short-lived downturn will continue to pull total crude and product net imports down in the U.S. (Chart 4). Chart 2U.S. Product Demand Back##BR##Over 20mm b/d U.S. Product Demand Back Over 20mm b/d U.S. Product Demand Back Over 20mm b/d Chart 3U.S. Product Exports##BR##Are Surging U.S. Product Exports Are Surging U.S. Product Exports Are Surging Chart 4U.S. Crude And Product Export Growth##BR##Continues To Lower Net Import Levels U.S. Crude And Product Export Growth Continues To Lower Net Import Levels U.S. Crude And Product Export Growth Continues To Lower Net Import Levels On the supply side, U.S. crude-oil production is up sharply after bottoming yoy with a decline of ~ 850k b/d last September, and stood at ~9.20mm b/d at the beginning of June, based on monthly production data from the EIA (Chart 5). This is up 330k b/d yoy. Much of this is being consumed domestically, but export volumes continue to increase, after hitting a recent high of close to 1mm b/d on a four-week-moving-average basis in March (Chart 6). Given the reception U.S. light crude is receiving in Asian markets, we expect continued growth, which will support the build-out of export-related facilities along the Gulf. Chart 5U.S. Crude Production Is Recovering Smartly ... U.S. Crude Production Is Recovering Smartly ... U.S. Crude Production Is Recovering Smartly ... Chart 6... And U.S. Crude Exports Are Surging ... And U.S. Crude Exports Are Surging ... And U.S. Crude Exports Are Surging Strong product demand and exports will allow crude inventories to continue to draw in the U.S. (Chart 7), particularly in the critically important Cushing storage market, where the NYMEX WTI futures contract delivers (Chart 8). Note that using 4-week-moving-average data shows yoy crude and product storage levels down an average 2.4mm bbl/week over the past eight weeks even with the unexpected surge in stocks reported last week. Cushing storage has become increasingly integrated with U.S. Gulf storage, which supports the strong refining activity there. Chart 7Strong Demand And Exports Allow##BR##U.S. Crude And Product Stocks To Draw Strong Demand And Exports Allow U.S. Crude And Product Stocks To Draw Strong Demand And Exports Allow U.S. Crude And Product Stocks To Draw Chart 8Cushing Crude Storage##BR##Continues To Draw Cushing Crude Storage Continues To Draw Cushing Crude Storage Continues To Draw Mexico's Revenue Hedge Is A Transitory Event Earlier this month, Mexico's Ministry of Finance reportedly began soliciting market-makers for offers on put options, signalling its annual revenue hedge will be forthcoming in the not-too-distant future. Reportedly, the finance ministry began lining up offer indications at the beginning of June, and by the end of last week the news was on the wire services.2 By purchasing puts, the finance ministry secures the right - but not the obligation - to sell oil at the strike price of the options. This puts a floor on the revenue realized by the ministry, since, if oil prices move higher next year, they will be able to sell into the market at the higher market-clearing price. However, if prices go below the strike price of the options, the market-makers - typically banks and, last year, for the first time, the trading arm of a major oil company - have to pay the difference between the puts' strike price and the market price. These hedges paid out $6.4 billion in 2015 and $2.7 billion last year, according to Bloomberg. The Mexican finance ministry's program, which can hedge up to 300mm bbl worth of production revenue, will keep markets leery for a couple of weeks. This is because the market-makers writing the puts for Mexico's ministry of finance will soak up available liquidity by hitting bids across the WTI, Brent, and refined products futures and swaps forward curves. The market-makers typically try to trade out of the exposure they've taken on by providing the hedge to the ministry, because, at the end of the day, they do not want to be made long oil if the options go into the money. This is what would happen if oil prices were to fall below the strike price of the puts purchased by the ministry, when the options approach their monthly expiry dates and their value is determined. To hedge themselves against this potential risk, the market-makers will sell volumes into the futures and swaps markets that are determined by the output of an option-pricing model. The lower prices go, the more they sell forward, and vice versa. More than likely, market-makers will be selling into rallies, so, at least while this hedge is moving through the market, any rally likely to be short-lived, as market-makers hedge themselves. However, once this activity is out of the way and refinery demand for crude kicks into high gear, we expect the physical reality of crude and product draws to take prices higher and backwardate WTI and Brent curves later this year. As an aside, we would expect lower prices will accelerate the draws at the margin, as we approach the peak of the northern hemisphere's summer driving season, as noted above. Strong Demand, Lower Supply Will Draw Stocks And Lift Prices Chart 9OPEC Really Is Cutting ~1.0mm b/d##BR##For More Than 400 Days OPEC Really Is Cutting ~1.0mm b/d For More Than 400 Days OPEC Really Is Cutting ~1.0mm b/d For More Than 400 Days The extension of OPEC 2.0's production cuts to the end of 1Q18 means that - for more than 400 days from January 2017 to March 2018 - OPEC producers with the ability to hold production at relatively high levels, and to even increase it, will have removed more than 1mm b/d from global flows (Chart 9). This will be supplemented by some 300k b/d of cuts from Russia and sundry non-OPEC producers.3 On the demand side, we continue to expect robust growth, given the behavior of EM global trade volumes and non-OECD oil demand strength, led by continued growth in China and India (Chart 10).4 We will be updating our balances next week, but we see no reason to lower our expectation that global demand will grow by more than 1.5mm b/d this year, especially following the IMF's upgrade of China's expected GDP growth this year to 6.7% from 6.6% on the back of "policy support, especially expansionary credit and public investment."5 This is the third upward revision to China's GDP growth made by the Fund this year. We continue to expect lower supply and robust demand this year and into early 2018 to draw visible inventories down to more normal levels (Chart 11), lift prices and backwardate the Brent and WTI forward curves. Given our analysis, we expect Brent to trade to $60/bbl later this year, with WTI trailing it by ~ $2/bbl. Chart 10 Chart 11... And Inventories Will Normalize ... And Inventories Will Normalize ... And Inventories Will Normalize Bottom Line: Markets appear to have extrapolated the weekly data into a trend that would reverse - or at least materially slow - the normalization of inventories, despite the extension of OPEC 2.0's 1.8mm b/d production cuts to the end of 1Q18, and continued strength in EM oil demand, which is driven by continued strength in China's and India's economies. Net, we believe Mexico's revenue hedge and the one-week surge in U.S. inventories are transitory events, which will be reversed in the weeks ahead. Despite being stopped out of our long Dec/17 vs. short Dec/18 Brent and WTI recommendations following last week's sell-off we still are inclined to keep this exposure. However, we will wait for the market to process Mexico's revenue hedge and to work through the IEA's subdued 2017 demand forecast before re-establishing these positions. In the meantime, we will take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Mexico Said to Take First Steps in Annual Oil Hedging Program," published by bloomberg.com on June 9, 2017. 2 Please see footnote 1. 3 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", published June 1, 2017, for an in-depth analysis of OPEC 2.0's production cuts. It is available at ces.bcaresearch.com. 4 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017. It is available at ces.bcaresearch.com. 5 Please see "IMF Staff Completes 2017 Article IV Mission to China," published June 14, 2017, on the IMF's website imf.org. 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 U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing

Highlights Crude oil prices will find support from stronger EM trade volumes, which broke out of an extended low-growth period at the end of last year and finished 1Q17 on a very strong note. Sustained growth in EM trade volumes will boost inflation at the consumer level in the U.S. and Europe, and will lift the Fed's preferred inflation gauge, provided the Fed does not constrict the growth of money supply this year and next. Energy: Overweight. We remain long Dec/17 WTI and Brent vs. short Dec/18 WTI and Brent, expecting the extended OPEC 2.0 production cuts and stronger oil demand to drain inventories this year. Base Metals: Neutral. China's Caixin manufacturing PMI for May fell below 50, indicating the manufacturing sector may be contracting. We will wait to see if this is confirmed this month and next, but for now this keeps us neutral with a negative tilt on the base metals complex. Precious Metals: Neutral. A weaker USD, and market expectations the Fed will be constrained in lifting interest rates later this year is supporting our strategic gold portfolio hedge, which is up 5.1% since it was initiated May 4, 2017. Ags/Softs: Underweight. Front-month corn is trading through the top of the $3.55 to $3.75/bushel range it has occupied since the beginning of the year. We are not inclined to play the momentum. Feature EM import and export volumes moved sharply higher in 1Q17 after breaking out of an extended low-growth funk late last year (Chart of the Week). The year-on-year (yoy) increase in the volume of imports and exports for EM economies reported by the CPB World Trade Monitor were up on average 8.74% and 5.29% in 1Q17, respectively, versus 12-month moving average levels of 2.2% and 2.5%.1 EM trade volumes are highly correlated with EM oil demand (Chart 2), particularly in the post-Global Financial Crisis (GFC) era, when EM import and export growth made significant gains relative to DM trade volumes (Chart 3).2 Indeed, EM imports and exports both grew at twice the rate of DM trade between the end of 2010 and the end of 1Q17: EM import volumes grew 22% vs. DM growth of 10% over the period, while EM export volumes grew 21% vs. DM growth of 11%. Chart of the WeekEM Imports And Exports##BR##Surge In 1Q17 EM Imports And Exports Surge In 1Q17 EM Imports And Exports Surge In 1Q17 Chart 2EM Oil Demand Closely##BR##Tracks Trade Volumes EM Oil Demand Closely Tracks Trade Volumes EM Oil Demand Closely Tracks Trade Volumes Chart 3EM Trade-Volume Growth##BR##Surpasses DM Growth EM Trade-Volume Growth Surpasses DM Growth EM Trade-Volume Growth Surpasses DM Growth We expect EM demand will account for some 80% of ~1.53mm b/d of global oil demand growth this year. If the strong 1Q17 performance in EM trade were to carry into 2Q, we will be raising our estimated oil-demand growth for the year significantly. We will be updating our global supply-demand balances next week. Coupled with the extension to end-March 2018 of the 1.8mm-barrel-per-day crude-oil production cuts recently agreed by the OPEC 2.0, the strong EM oil-demand growth could accelerate the draw-down in global storage levels, putting the WTI and Brent forward curves into backwardation sooner than the late-2017/early-2018 timeframe we currently expect.3 EM Trade Growth Will Stoke Oil Prices And Inflation Because EM demand is the driving force of global oil-demand growth, a continuation of the strong trade performance from this sector will support oil prices going forward, and likely will lift inflation as the year progresses. In the post-GFC period, we would expect a 1% increase in EM import and export volumes to boost oil prices by a little more than 2%, and vice versa.4 This is almost twice the effect an increase in trade produces in estimates beginning pre-GFC in 2000; most likely, it reflects the increase in EM trade volumes relative to DM trade volumes post-GFC.5 Our modeling confirms key inflation gauges - particularly the Fed's preferred gauge, the core PCE; the U.S. CPI; and EMU Harmonized CPI - all are highly sensitive to EM oil demand, as expected, and, no surprise, to EM trade volumes.6 In the post-GFC period, a 1% increase (decrease) in EM oil demand can be expected to lift (drop) core PCE and the U.S. CPI by a little more than 50bps; for the EMU CPI, a 40bps increase (decrease) can be expected.7 In addition, we have found the EM trade data also is a highly explanatory variable for these inflation gauges. Imports explain ~ 84%, 91% and 89% of core PCE (Chart 4), U.S. CPI (Chart 5), and EMU CPI (Chart 6), respectively, in the post-GFC period, while exports explain 94%, 93% and 81% of these inflation gauges. The elasticities for the U.S. gauges is ~ 50bps, similar to the EM oil demand estimates, and ~35bps for the EMU CPI. Chart 4Core PCE Is Highly Sensitive To EM Trade Volumes... Core PCE Is Highly Sensitive To EM Trade Volumes... Core PCE Is Highly Sensitive To EM Trade Volumes... Chart 5...As Is U.S. CPI... ... As Is U.S. CPI ... ... As Is U.S. CPI ... Chart 6...And EMU CPI ... And EMU CPI ... And EMU CPI A continued expansion of EM trading volumes this year can be expected to lift inflation in the U.S. and Europe. We also would expect this to hold for China as well, given the results of our earlier research.8 Fed Could Kill The Party Chart 7U.S. M2 Is Important To EM Trade Volumes U.S. M2 Is Important To EM Trade Volumes U.S. M2 Is Important To EM Trade Volumes One variable we are watching closely is U.S. money supply, M2 in particular, vis-à-vis EM trade volumes (Chart 7). We find that in the post-GFC world, EM trade volumes are highly sensitive to M2, with M2 explaining 92% of EM exports and 82% of imports. This relationship did not exist in the pre-GFC world, or in estimates starting pre-GFC and extending to the present day. This no doubt is related to massive monetary accommodation and QE experiments post-GFC, but, as of this writing, we are not at all sure how this relationship will evolve going forward. Bottom Line: EM trade volumes have broken out of a long-term funk, which will be supportive of crude oil prices and will lift inflation going forward. Strong EM trade growth at the pace at which it ended 1Q17 would cause us to lift our expectation for global oil demand significantly for this year. This, combined with the extension of the OPEC 2.0 production cuts to March 2018 could normalize global inventories faster than markets currently expect. EM trade is, importantly, highly exposed to U.S. monetary policy, particularly to what happens to U.S. M2 money supply. This is a feature of the global trade picture that was not present pre-GFC. Our research affirms our conviction on the bullish oil exposure we have on - chiefly the long Dec/17 Brent and WTI vs. short Dec/18 Brent and WTI backwardation trades. Our results also support remaining long gold as a strategic portfolio hedge against inflation and geopolitical risk, and remaining long commodity-index exposure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for EM imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports was changing so as to better see how the relative shares of EM and DM are evolving. 2 EM export and import volumes are cointegrated with non-OECD oil consumption, our proxy for EM oil demand, in regressions starting pre- and post-GFC, meaning they share a common trend and are in a long-term equilibrium. The adjusted R2 coefficient of determination for EM oil demand as a function of EM export volumes is 0.91 for estimates starting in 2003 and 2010 (the pre- and post-GFC periods); for EM imports, it is 0.84 post-GFC, and 0.90 pre-GFC. Post-GFC, we estimate a 1% increase (decrease) in EM import and export volumes translates to an 88bp and 85bp gain (decline) in EM oil demand. The read-through on this is EM trade volumes are closely tied to income growth, given the income-elasticity of demand for oil is ~ 1.0 in non-OECD economies, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. 3 Please see our discussion of this production-cut extension in the joint report we did with BCA Research's Energy Sector Strategy on June 1, 2017, entitled "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories." It is available at ces.bcaresearch.com. 4 The R2 coefficients of determination for the cointegrating regressions of Brent prices on EM export and import volumes are 0.90 and 0.93, respectively, for post-GFC estimates. For estimates beginning in 2000, the R2 coefficients are 0.88, while the elasticities are ~1.20 for the EM trade variables. These models also include a parameter for the broad trade-weighted USD, which, post-GFC, has become more important to the evolution of Brent prices: A 1% increase in the currency parameter translates to a price decline of more than 5%, which is approximately twice the value of the estimates starting pre-GFC. 5 Our estimates for WTI produce similar results for the pre- and post-GFC periods. 6 We examined this in our August 4 and 11, 2016, in "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," and "Global Inflation And Commodity Markets." Both are available at ces.bcaresearch.com. 7 The R2 coefficients of determination for the core PCE, U.S. CPI and EMU CPI estimates as a function of EM oil demand are 0.97, 0.94 and 0.85, respectively. It is interesting to observe that prompt measures of inflation are not correlated to oil prices, but that 5-year 5-year CPI swaps remain highly correlated with oil prices, the 3-year forward WTI futures contract in particular; the R2 for the estimate of the 5y5y CPI swap as a function of the 3-year WTI contract is 75%. 8 In the August 11, 2016, article "Global Inflation And Commodity Markets," we found Chinese inflation to be equally sensitive to EM oil demand. We will be exploring this further when we look at base metals demand vis-à-vis EM trading volumes in forthcoming research. 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 Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil

Highlights Will Trump's trade rhetoric damage the U.S. service sector's abilities to generate a trade surplus and create high-paying jobs? Our assessment of the latest Beige Book via the BCA Beige Book Monitor supports the Fed's view that Q1 weakness was an anomaly and inflation is headed higher. This will keep the Fed on track to tighten in June and again later this year. GDP growth in 2017 is poised to exceed the Fed's forecast for the first time in seven years if the recent pattern of 2H GDP beating 1H GDP growth is repeated. Global oil inventories are set to move lower and drive oil prices higher. The odds of a recession remain low even with the economy at full employment. Feature The May employment report fell short of expectations, but the average gain of 121,000 jobs per month over the past 3 months and the drop in the unemployment rate are still enough to tighten the labor market and keep the Fed on track to tighten later this month. The unemployment rate dipped to 4.3% in May and is now 0.4% below the Fed's view of full employment. Wage growth remains stagnant despite the state of health of the labor market, as year-over-year average hourly earnings growth remained at just 2.5% in May (Chart 1). Chart 1Labor Market Still Tightening##BR##Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Taking a broader view, the job picture in the service sector remains robust and wages in the export-oriented service industries remain well above wages in the goods sector. In this week's report we examine the impact of trade on the labor market and highlight areas where Trump's rhetoric may hurt trade-related job growth. Trump At Your Service The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market. Trump campaigned on his ability to create high paying manufacturing jobs, but his America First rhetoric is threatening jobs in the high paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side. U.S. imported goods exceeded exports by $1.3 trillion in 2016. Service exports totaled an all-time high of $778 billion in 2016, $270 billion more than imports. Exports of services have increased by 7% per year on average since 2000, which is nearly twice as fast as nominal GDP (Charts 2A & 2B). Chart 2AThe U.S. Runs Trade##BR##Surplus In Services... The U.S. Runs Trade Surplus In Services... The U.S. Runs Trade Surplus In Services... Chart 2B...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods The trade surplus in services added 0.07% to GDP in Q1 2017, 0.04% in 2016, and has consistently added to GDP growth over the past few decades, although it is swamped by the large drag on GDP as a result of the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is more than seven times faster than in industries where the U.S. runs a deficit. In addition, median wages ($29 as of April 2017) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24) where there is a trade deficit, even though wages are rising quicker in the goods-producing sector in the past year (Chart 3). U.S. service sector exports tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast of a 10% rise in the next 6-12 months (Chart 4). Chart 3Wages In Export Led Service Industries##BR##20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Chart 4Service Sector Export Orders##BR##At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar However, Trump's trade policies may threaten to reduce the U.S.'s global dominance in services. The U.S. has the largest trade surpluses in travel (which includes education), intellectual property, financial services, and legal, accounting and consulting services (Table 1). The U.S. also runs a large surplus in areas such as intellectual property, software and advertising. In 2015, foreigners spent $92 billion more to travel to, vacation in and be educated in America compared with what U.S. residents spent for those services overseas. Anecdotal reports note that travel to the U.S. is down by as much as 15% since the start of the year, and that 40% of U.S. colleges and universities have seen a decline in foreign applications, putting the nearly $100 billion trade surplus at risk. Other Trump policies, such as the proposed travel ban and some of his "America First" campaign-style rhetoric, could jeopardize the trade surpluses in financial services ($77 billion), software services ($30 billion), TV and film right ($13 billion), architectural services ($10 billion) and advertising ($8) billion. Table 1Key Components Of U.S. Trade Surplus In Services Can The Service Sector Save The Day? Can The Service Sector Save The Day? Trump's trade rhetoric potentially threatens U.S. service exports to NAFTA countries (Canada and Mexico), the Eurozone and the emerging markets. President Trump campaigned on renegotiating NAFTA, supporting Brexit and pulling the U.S. out of the Trans Pacific Partnership (TPP). Trade in services are key to all of those treaties, although trade in goods gets more attention. At $56 billion in 2015, Canada is the U.S.'s second largest service export market, and Mexico is a top 10 destination ($31 billion). Forty percent of U.S. service exports go to Europe, and at $66 billion in 2015, the U.K. is the single largest market for U.S. service exports. The U.S. sends half of its service exports to EM nations, with markets in Asia accounting for just under 30% of all U.S. service exports. Thus investors should carefully monitor the progress of all three of these trade deals to help better assess the impact on U.S. trade and jobs in the service sector. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth as long as there is no retaliation from its trading partners (which is unlikely). But any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. Beige Book Backs The Fed For the Fed, policymakers are treating any potential changes to trade and fiscal policy as risks to their outlook. At the moment, they are judging the need for tighter policy based on the evolution of the labor market and inflation. The Beige Book released on May 31 confirmed the FOMC's base-case outlook. It keeps the Fed on track to tighten in June and then again later this year as it begins to trim its balance sheet. Our quantitative assessment of the qualitative Beige Book that we introduced in April 17 found that the economy had rebounded from a weak Q1 and that inflation was in an uptrend despite recent soft readings.1 The dollar seems to have faded as a key concern for small businesses and bankers. Business uncertainty around government policy (fiscal, regulatory and health) remained elevated. Our analysis of the Beige Book also shows that commercial and residential real estate, the former a surprise source of strength in Q1 GDP, remains stout more than halfway through Q2. Chart 5 shows that the BCA Beige Book Monitor ticked up to 71% in May 2017 from 64% in April. The metric is in line with its cycle highs recorded in mid-2014 as oil prices peaked. "Inflation" words in the Beige Book hit a new peak in May and are in sharp contrast to the recent soft readings on CPI and the PCE deflator. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may be turning up soon. Chart 5May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 In Chart 5, panel 4 we track mentions of "strong dollar" in the report. The May Beige Book saw the same number of references to a strong dollar as the May 2016 report. This suggests that the dollar is not as big a concern for business owners as it was from early 2015 through early 2016. Housing added 0.5 percentage points to growth in Q1, and business spending on structures added 0.7 percentage points. The latest Beige Book suggests that both sectors remain robust here in Q2 (Chart not shown). The implication is that the U.S. economy is poised to clear the low hurdle in 2017 set for it by the FOMC in late 2016. The Fed's economic growth target for 2017 (set at the December 2016 FOMC meeting) was just 2.1%, the lowest year ahead forecast since 2009. The projection incorporates the Fed's lowered trajectory for potential output, but may also reflect the fact that actual GDP growth has not exceeded the Fed's forecast every year since 2009 (Chart 6). GDP growth in 1H 2017 is tracking between 2% and 2.5% despite the weak start to the year. In late May, Q1 GDP growth was revised to +1.2% from the 0.7% reading reported in late April. Based on the Atlanta Fed's GDP Now, the NY Fed's Nowcast and readings on ISM, vehicle sales and the Beige Book, GDP in Q2 is tracking to near 3%. If the economy rebounds from the lackluster first quarter as we expect, then real output will be on course to match or exceed the Fed's forecast for the first time since the recession. We expect an acceleration for fundamental reasons and due to poor seasonal adjustment. In 5 of the past 7 years, real GDP growth in Q3 and Q4 was the same or stronger than the pace of expansion in the first half of the year (Table 2). During that period, 2H output growth averaged 2.4%, while 1H growth was an anemic 1.8%. In the years when Q1 GDP was weak,2 as it was this year, real economic output in the second half of the year accelerated from 1H growth nearly every time. Chart 6 Table 2GDP Growth In 2H Has Met Or Exceeded 1H Growth In 5 Of Past 7 Years Can The Service Sector Save The Day? Can The Service Sector Save The Day? Bottom Line: The latest Beige Book (prepared for the June 13-14 FOMC meeting) confirms policymakers' assessment that the weak growth in Q1 was transitory and inflation is in an uptrend. The economy remains on target to hit or exceed the Fed's growth objectives. The FOMC is poised to raise rates in June and one more time by year end. This view is not discounted in the bond market, implying that Treasury yields are too low. Equity prices could be undermined by higher yields and the dollar, but this will be offset by rising growth (and profit) expectations if our base-case view pans out. Oil Prices: Fade The Recent Weakness A pickup in U.S. growth will also be positive for oil prices, although it is OPEC's efforts to curtail excess inventories that is the main driver of our bullish view. Our commodity strategists believe that OPEC 2.0's recent production cut extension will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating).3 Shale production is bouncing back quickly. OPEC's November 2016 agreement signaled to the world that OPEC (and Russia) would abandon Saudi Arabia's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers to pour money into vastly increased drilling programs. Nonetheless, global oil demand continues to grow robustly. Moreover, production is eroding for oil producers outside of (Middle East) OPEC, Russia and U.S. Shale, which collectively supply half the market. The cumulative effects of spending constraints during 2015-18 will result in falling output in the coming years for this group of producers. Adding it all up, we expect demand to exceed supply for the remainder of 2017, which will result in a significant drawdown in oil inventories (Chart 7). Our strategists think the inventory adjustment will push the price of oil up to US$60 by year end. They expect a trading range of US$45-65 to hold between now and 2020. Chart 8 shows a simple model for oil prices, based on global industrial production, oil production, OECD oil inventories and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, the model implies that oil prices will surge by more than US$10! The coefficient on oil inventories in the model is probably overly influenced by the one major swing in inventories we have seen in the last couple of decades, suggesting that we must take the results with a grain of salt. Nonetheless, our point is that oil prices have significant upside potential if the excessive inventory problem is solved. Chart 7Significant Drawdown##BR##In Inventories Is Coming Significant Drawdown In Inventories Is Coming Significant Drawdown In Inventories Is Coming Chart 8Upside Potential For Oil##BR##If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Bottom Line: The extension of OPEC 2.0 production cuts reinforces our bullish view for oil prices. Revisiting The Odds Of A Recession It seems odd at first glance to be discussing recession risks at a time when growth is poised to accelerate. Nonetheless, BCA's Global Investment Strategy service recently noted that investors should be on watch for recession now that the economy has reached full employment.4 Historically, once the unemployment rate reached estimates of full employment, the odds of a recession in the subsequent 12 months increased four-fold. In last week's report, we maintained that the lack of progress on fiscal policy by the Trump administration may actually be positive for risk assets in the medium term because it would stretch out the cycle and thus lower recession risks.5 The economic data have disappointed so far this year, as highlighted by the economic surprise index (Chart 9). Despite this, there is not much talk of recession in the news media and various models also show slim chances of recession this year (Chart 10). Only one of eight components in our BCA model is flashing recession: the three-year moving average of the Fed funds rate is rising because the Fed rate hike cycle began in late 2015. Chart 9Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Chart 10Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low In a prior report we dismissed the rollover in commodity prices as a recessionary signal and noted that Trump's political woes would only slow the GOP's legislative agenda. Nonetheless, even without fiscal stimulus, the U.S. economy will still grow above its long-term potential, tighten the labor market and push up wages and inflation in the coming quarters. Bottom Line: The odds of recession remain low despite the U.S. economy being at full employment. The delay in Trumponomics' will prolong the expansion and will support risk assets over the next 6-12 months. 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, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 3 Please see Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", dated June 1, 2017, available at ces.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight", dated May 26, 2017, available at gis.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Corporate Earnings Versus Trump Turbulence", dated May 29, 2017, available at usis.bcaresearch.com.

Feature Table 1 Monthly Portfolio Update Monthly Portfolio Update Growth And Its Implications We still see little on the horizon to undermine a continued rally in risk assets over the next 12 months. U.S. economic growth will be propelled by an acceleration in both consumption and capex - leading indicators for both point to further upside (Chart 1). The weak U.S. GDP growth in Q1, just 1.2% annualized, was dragged down by two, less meaningful elements: inventories (which fell, deducting 1 ppt from growth) and imports (which rose, deducting 0.6 ppt). Regional Fed GDP "nowcasts" are pointing to 2.2-3.8% growth in Q2. Corporate earnings had their best quarter in five years in Q1, with S&P500 sales up 8% and EPS up 14% - but, despite this, analysts have barely revised up their calendar year EPS growth forecast, which stands at 10%. In Europe, loan growth has picked up to 2.5% YoY, with the credit impulse indicating that GDP growth is likely to remain above trend at around the 2% it achieved in Q1 (Chart 2). But the stronger growth has implications. It suggests the market is too complacent about the probability of Fed tightening. Futures are pricing a hike on June 14 as a near certainty but, after that, imply little more than one further 25bp rise by end-2019 (Chart 3). We expect two hikes before the end of 2017. Not least, the Fed will be cognizant of how financial conditions have recently eased, not tightened, despite its raising rates in December and March (Chart 4) and will want to put in place insurance against inflation rising sharply in 12 months' time, especially given that it may wish to hold back from hikes early next year as it begins to reduce its balance-sheet. Chart 1Consumption And Capex On Track to Rebound Consumption And Capex On Track to Rebound Consumption And Capex On Track to Rebound Chart 2Euro Credit Growth Looks Good For GDP Euro Credit Growth Looks Good For GDP Euro Credit Growth Looks Good For GDP Chart 3 Will The Fed Really Be This Slow? Will The Fed Really Be This Slow? Will The Fed Really Be This Slow? As a result, 10-year U.S. Treasury bond yields are likely to move back up. The 40bp fall from the peak of 2.6% in March was caused partly by softer growth and inflation data, but also reflected a correction after the excessive pace at which rates had run up - the fastest in 30 years (Chart 5). The combination of stronger growth, a 50bp higher Fed Funds Rate, and a moderate acceleration of inflation as wages begin to pick up again, should push the 10-year yield to above 3% by year-end. Chart 4Fed Must Worry About Easing Conditions Fed Must Worry About Easing Conditions Fed Must Worry About Easing Conditions Chart 5Rates Couldn't Keep Rising This Fast Rates Couldn't Keep Rising This Fast Rates Couldn't Keep Rising This Fast Momentum for risk assets over the coming months is likely to slow a little. Global PMIs have probably peaked for now (Chart 6) and investors should not expect to repeat the 19% total return from global equities they have enjoyed over the past 12 months. And there are potential pitfalls: China could continue to slow, and European politics could come into focus again (with early Austrian and Italian parliamentary elections looking increasingly possible for the fall). Investors may also worry about the chaotic state of the Trump White House. However, we never believed the U.S. presidential election had much impact on markets (the S&P500 has risen by 2% a month since then, whereas it had risen by 4% a month over the previous nine months). If anything, there could still be a positive catalyst if Congress is able to pass a tax cut before year-end - which we see as likely - since this is no longer priced in (Chart 7). Chart 6Momentum For Equities Will Slow A Little Momentum For Equities Will Slow A Little Momentum For Equities Will Slow A Little Chart 7No One Expects A Corporate Tax Cut No One Expects A Corporate Tax Cut No One Expects A Corporate Tax Cut On balance, then, we continue to see equities outperforming bonds comfortably over the next 12 months, and so keep an overweight on equities within our asset class recommendations. We also maintain the generally pro-cyclical, pro-risk and higher-beta tilts within our multi-asset global portfolio. Equities: The combination of cyclical economic growth, accelerating earnings, and easy monetary conditions represents a positive environment for global equities. Valuations are not particularly stretched: forward PE for the MSCI All Country World Index is 15.9x, almost in line with the 30-year average of 15.7x (Chart 8). The Vix (30-day implied volatility on S&P500 options) may look low - famously it dipped below 10 last month, raising fears of complacency - but the Vix term structure is fairly steep, implying that investors are hedging exposure three and six months out (Chart 9). Within equities, our preference remains for DM over EM. The latter will be hurt by the slowdown in China (Chart 10), a rising dollar, the ongoing slowdown in credit growth in most EM economies, and continual political disappointments (most recent example: Brazil). We like euro zone equities, on the grounds of their high beta and greater cyclicality of earnings. We are overweight Japan (with a currency hedge), since rising global rates will weaken the yen and boost earnings. Chart 8Global Equity Valuations Are Not So High Global Equity Valuations Are Not So High Global Equity Valuations Are Not So High Chart 9 Chart 10China's Slowdown Should Hurt EM China's Slowdown Should Hurt EM China's Slowdown Should Hurt EM Fixed Income: As described above, we expect the U.S. 10-year Treasury yield to reach 3% by year-end. This should mean a negative return from global sovereign bonds for the year as a whole, for the first time since 1994. Accordingly, we remain underweight duration and prefer inflation-linked over nominal bonds in most markets. In this positive cyclical environment, we continue to overweight credit, with a preference for U.S investment grade (which trades at a 100 bp spread over Treasuries) over high-yield bonds (where valuations are not as attractive) and euro area credit (which will be hurt when the ECB starts to taper its bond purchases). Currencies: The temporary softness in the dollar has probably run its course. Interest rate differentials between the U.S. and other G7 countries point to further dollar appreciation (Chart 11). At the same time as we expect the Fed to tighten more quickly than the market is pricing in, we see the ECB setting monetary policy for the euro periphery (especially Italy) which, given weak fundamentals (Chart 12), cannot bear much tightening. The Bank of Japan, too, will stick to its yield curve control policy which, as global rates rise, ought to significantly weaken the yen. Chart 11Interest Differentials Point To Stronger USD Interest Differentials Point To Stronger USD Interest Differentials Point To Stronger USD Chart 12Italy Can Not Bear A Rate Hike Italy Can Not Bear A Rate Hike Italy Can Not Bear A Rate Hike Chart 13OPEC Cut Agreement Showing Through OPEC Cut Agreement Showing Through OPEC Cut Agreement Showing Through Commodities: The recently agreed extension of the OPEC agreement should push crude oil prices up to around $60 a barrel in the second half. OPEC production has already fallen noticeably since the start of the year, but the response from non-OPEC producers - including North American shale - to boost output has so far been subdued (Chart 13). Metals prices have fallen sharply over the past two months (iron ore, for example, by 36% since March) as Chinese growth slowed as a result of moderate fiscal and monetary tightening. They could have further to fall. But China, with its key five-year Party Congress scheduled for the fall, is likely to take measures to boost activity if economic growth slows much further, which would help commodities prices stabilize. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation

Highlights This week, Commodity & Energy Strategy is publishing a joint report with our colleagues at BCA's Energy Sector Strategy. Driven by the leadership of the Kingdom of Saudi Arabia (KSA) and Russia, OPEC 2.0 formalized the well-telegraphed decision to extend its production cuts for another nine months, carrying the cuts through the seasonally weak demand period of Q1 2018. The extension is will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating) setting in later this year. Energy: Overweight. We are getting long Dec/17 WTI vs. short Dec/18 WTI at tonight's close, given our expectation OPEC 2.0's extension of production cuts, and lower exports by KSA to the U.S., will cause the U.S. crude-oil benchmark to backwardate. Base Metals: Neutral. Despite "catastrophic flooding" in March, 1Q17 copper output in Peru grew almost 10% yoy to close to 564k MT, according to Metal Bulletin. This occurred despite strikes at Freeport-McMoRan's Cerro Verde mine, where production was down 20.5% yoy in March. Precious Metals: Neutral. Our strategic gold portfolio hedge is up 2.61% since it was initiated on May 4, 2017. Ags/Softs: Underweight. The USDA's Crop Progress report indicates plantings are close to five-year averages, despite harsh weather in some regions. We remain bearish. Feature Chart 1Real OPEC Cuts Of ~1.0 MMb/d##BR##For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days OPEC 2.0's drive to normalize inventories by early 2018 will be accomplished with last week's agreement to extend current production cuts through March 2018. In total, OPEC has agreed to remove over 1 MMb/d of producible OPEC oil from the market for over 400 days (Chart 1), supplemented by an additional 200,000-300,000 b/d of voluntary restrictions of non-OPEC oil through Q3 2017 at least, perhaps longer if Russia can resist the temptation to cheat after oil prices start to respond. Many of the participants in the cut, from both OPEC and non-OPEC, are not actually reducing output voluntarily, but have had quotas set for them that merely reflect the natural decline of their productive capacity, limitations that will be even more pronounced in H2 2017 than in H1 2017. With production restricted by the OPEC 2.0 cuts, global demand growth will outpace supply expansion by another wide margin in 2017, just as it did last year (Chart 2). As shown in Chart 3, steady demand expansion and the slowdown in supply growth allowed oil markets to move from oversupplied in 2015 to balanced during 2016; demand growth will increasingly outpace production growth in 2017, creating sharp inventory draws (Chart 4) that bring stocks down to normalized levels by the end of 2017 (Chart 5). Chart 2 Chart 3Production Cuts And Demand##BR##Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Chart 4Higher Global Inventory##BR##Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Chart 5OECD Inventories To Be##BR##Reduced To Normal OECD Inventories To Be Reduced To Normal OECD Inventories To Be Reduced To Normal The extension of the cut through Q1 2018 will help prevent a premature refilling of inventories during the seasonally weak first quarter next year. The return of OPEC 2.0's production to full capacity in Q2 2018 will drive total production growth above total demand growth for 2018, returning oil markets from deliberately undersupplied during 2017 to roughly balanced markets in 2018, with stable inventory levels that are below the rolling five-year average. 2018 inventory levels will still be 5-10% above the average from 2010-2014, in line with the ~7% demand growth between 2014 and 2018. Compliance Assessment: Only A Few Players Matter In OPEC 2.0 OPEC's compliance with the cuts announced in November 2016 has been quite good, with KSA anchoring the cuts by surpassing its 468,000 b/d cut commitment. In addition to KSA, OPEC is getting strong voluntary compliance from the other Middle Eastern producers (except Iraq), while producers outside the Middle East lack the ability to meaningfully exceed their quotas in any case. OPEC's Core Four Remain Solid. The core of the OPEC 2.0 agreement has delivered strong compliance with their announced cuts. Within OPEC, the core Middle East countries Kingdom of Saudi Arabia, Kuwait, Qatar, and UAE have delivered over 100% compliance of their 800,000 b/d agreed-to cuts. We expect these countries to continue to show strong solidarity with the voluntary cuts through March 2018 (Chart 6). Iraq And Iran Make Small/No Sacrifices. Iraq and Iran were not officially excluded from cuts, but they were not asked to make significant sacrifices either. We estimate Iran has little-to-no capability to materially raise production in 2017 anyhow, and KSA is leaning on Iraq to better comply with its small cuts. Chart 7 shows our projections for Iran and Iraq production levels through 2018. Chart 6KSA, Kuwait, Qatar & UAE Carrying##BR##The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts Chart 7Iran And Iraq Production##BR##Near Full Capacity Iran And Iraq Production Near Full Capacity Iran And Iraq Production Near Full Capacity Iraq surged its production above 4.6 MMb/d for two months between OPEC's September 2016 indication that a cut would be coming and the late-November formalization of the cut. Iraq's quota of 4.35 MMb/d is nominally a 210,000 b/d cut from its surged November reference level, but is essentially equal to the country's production for the first nine months of 2016, implying not much of a real cut. Despite the low level of required sacrifice, Iraq has produced about 100,000 b/d above its quota so far in 2017 at a level we estimate is near/at its capacity anyway. KSA and others in OPEC are not pleased with Iraq's overproduction and have pressured it to comply with the agreement. We forecast Iraq will continue producing at 4.45 MMb/d. Iran's quota represented an allowed increase in production, reflecting the country's continued recovery from years of economic sanctions. We project Iran will continue to slowly expand production, but since the country is almost back up to pre-sanction levels, there is little remaining easily-achievable recovery potential. South American & African OPEC Capacity Eroding On Its Own. Chart 8 clearly shows how production levels in Venezuela, Angola and Algeria started to deteriorate well before OPEC formalized its production cuts, with productive capacity eroded by lack of reinvestment rather than voluntary restrictions. The quotas for these three countries (as well as for small producers Ecuador and Gabon) are counted as ~258,000 b/d of "cuts" in OPEC's agreement, but they merely represent the declines in production that should be expected anyway. With capacity deteriorating and no ability to ramp up anyway, these OPEC nations will deliver improving "compliance" (i.e. under-producing their quotas) in H2 2017, and are happy to have the higher oil prices created by the extension of production cuts by the core producers within OPEC 2.0. Libya and Nigeria Exclusions Unlikely To Result In Big Production Gains. Both Libyan and Nigerian production levels have been constrained by above-ground interference. Libyan production has been held below 1.0 MMb/d since 2013 principally by chronic factional fighting for control of export terminals, while Nigerian production--on a steady natural decline since 2010--has been further limited by militants sabotaging pipelines in 2016-2017. While each country has ebbs and flows to the amount of oil they are able to produce, we view both countries' problems as persistent risks that will continue to keep production below full potential (Chart 9). Chart 8 Chart 9Libya And Nigeria Production Could Go Higher##BR##Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances For Nigeria, we estimate the country's crude productive capacity has eroded to about 1.8 MMb/d from 2.0 MMb/d five years ago due to aging fields and a substantial reduction in drilling (offshore drilling is down ~70% since 2013). Within another year or two, this capacity will dwindle to 1.7 MMb/d or below. On top of this natural decline, we have projected continued sabotage / militant obstruction will limit actual crude output to an average of 1.55 MMb/d for the foreseeable future. Libyan production averaged just 420,000 b/d for 2014-2016, a far cry from the 1.65 MMb/d produced prior to the 2011 Libyan Revolution that ousted strongman Muammar Gaddafi. Since Gaddafi was deposed and executed, factional strife and conflict has persisted. Each faction wants control over oil export revenues and, just as importantly, wants to deny the opposition those revenues, resulting in a chronic state of conflict that has limited production and exports. If a détente were reached, we expect Libyan oil production could quickly rise to about 1.0 MMb/d of production within six months; however, we put the odds of a sustainable détente at less than 30%. As such, we forecast Libyan crude production will continue to struggle, averaging about 600,000 b/d in 2017-2018. Non-OPEC Cuts Hang On Russia In November, ten non-OPEC countries nominally agreed to restrict production by a total of 558,000 b/d, but Russia--with 300,000 b/d of pledged cuts--is the big fish that KSA and OPEC are relying on. Mexico's (and several others') agreements are window dressing, reframing natural production declines as voluntary action to rebalance markets. Through H1 2017, Russia has delivered on about 60-70% of its cut agreement, with compliance growing in Q2 (near 100%) versus Q1 (under 50%). From the start, Russia indicated it would require some time to work through the physical technicalities of lowering production to its committed levels, implying that now that production has been lowered, Russia could deliver greater compliance over H2 2017 than it delivered in H1 2017. We are a little more skeptical, expecting some weakening in Russia's compliance by Q4, especially if the extended cuts deliver the expected results of bringing down OECD inventories and lifting prices. Russia surprised us with stronger-than-expected production during 2016. Some of the outperformance was clearly due to a lower currency and improved shale-like drilling results in Western Siberia, but it is unclear whether producers also pulled too hard on their fields to compensate for lower prices, and are using the OPEC 2.0 cut as a way to rest their fields a bit. We have estimated Russian production returning to 11.3 MMb/d by Q4 2017 (50,000 b/d higher than 2016 average production) and holding there through 2018 (Chart 10), but actual volumes could deviate from this level by as much as 100,000-200,000 b/d. Mexico, the second largest non-OPEC "cutter," is in a position similar to Angola, Algeria, and Venezuela. Mexican production has been falling for years (Chart 11), and the nation's pledge to produce 100,000 b/d less in H1 2017 than in Q4 2016 is merely a reflection of this involuntary decline. As it has happened, Mexican production has declined by only ~60,000 b/d below its official reference level, but continues to deteriorate, promising higher "compliance" with their production pledge in H2 2017. Chart 10Russia Expected##BR##To Cheat By Q4 Russia Expected To Cheat By Q4 Russia Expected To Cheat By Q4 Chart 11Mexican Production Deterioration##BR##Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Kazakhstan and Azerbaijan are not complying with any cuts, and we don't expect them to. Despite modest pledges of 55,000 b/d cuts combined, the two countries have produced ~80,000 b/d more during H1 2017 than they did in November 2016. We don't expect any voluntary contributions from these nations in the cut extension, but Azerbaijan's production is expected to wane naturally (Chart 12). While contributing only a small cut of 45,000 b/d, Oman has diligently adhered to its promised cuts, supporting its OPEC and Gulf Cooperation Council (GCC) neighbors. We expect Oman's excellent compliance will be faithfully continued through the nine-month extension (Chart 13). Chart 12Kazakhstan And Azerbaijan Not Expected##BR##To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Chart 13Oman Has Faithfully Complied##BR##With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date OPEC Extension Will Continue To Support Increased Shale Drilling Energy Sector Strategy believed OPEC's original cut announced in November 2016 was a strategic mistake for the cartel, as it would accelerate the production recovery from U.S. shales in return for "only" six months of modestly-higher OPEC revenue. As we cautioned at the time, the promise of an OPEC-supported price floor was foolish for them to make; instead, OPEC should have let the risk of low prices continue to restrain shale and non-Persian Gulf investment, allowing oil markets to rebalance more naturally. However, despite our unfavorable opinion of the strategic value of the original cut, since the cut has not delivered the type of OECD inventory reductions expected (seemingly due to a larger-than-expected transfer of non-OECD inventories into OECD storage), we view the extension of the cut as a necessary, and logical, next step. OPEC 2.0's November 2016 cut agreement signaled to the world that OPEC (and Russia) would abandon KSA's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers (and supporting capital markets) to pour money into vastly increased drilling programs. Now that the shale investment genie has already been let out of the bottle, extending the cuts is unlikely to have nearly the same stimulative impact on shale spending as the original paradigm-changing cut created. The shale drilling and production response has been even greater than we estimated six months ago, and surely greater than OPEC's expectations. The current horizontal (& directional) oil rig count of 657 rigs is nearly twice the 2016 average of 356 rigs, is 60% higher than the level of November 2016 (immediately before the cut announcement), and is still rising at a rate of 25-30 rigs per month (Chart 14). The momentum of these expenditures will carry U.S. production higher through YE 2017 even if oil prices were allowed to crash today. Immediately following OPEC's cut, we estimated 2017 U.S. onshore production could increase by 100,000 - 200,000 b/d over levels estimated prior to the cut, back-end weighted to H2 2017, with a greater 300,000-400,000 b/d uplift to 2018 production levels. Drilling activity has roared back so much faster than we had expected, indicative of the flooding of the industry with external capital, that we have raised our 2017 production estimate by 500,000 b/d over our December estimate, and raised our 2018 production growth estimate to 1.0 MMb/d (Chart 15). Chart 14Rig Count Recovery Dominated##BR##By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Chart 15Onshore U.S. Production##BR##Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Other Guys' Decline Requires Greater Growth From OPEC, Shales, And Russia We've written before about "the Other Guys' in the oil market, defined as all producers outside of the expanding triumvirate of 1) U.S. shales, 2) Russia, and 3) Middle East OPEC. While the growers receive the vast majority of investors' focus, the Other Guys comprise nearly half of global production and have struggled to keep production flat over the past several years (Chart 16). Chart 17 shows the largest offshore basins in the world, which should suffer accelerated declines in 2019-2020 (and likely beyond) as the cumulative effects of spending constraints during 2015-2018 (and likely beyond) result in an insufficient level of projects coming online. This outlook requires increasing growth from OPEC, Russia and/or the shales to offset the shrinkage of the Other Guys and simultaneously meet continued demand growth. Chart 16The Other Guys' Production##BR##Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat Chart 17 Risks To Rebalancing Our expectation global oil inventories will draw, and that prices will, as a result, migrate toward $60/bbl by year-end is premised on the continued observance of production discipline by OPEC 2.0. GCC OPEC - KSA, Kuwait, Qatar, and the UAE - Russia and Oman are expected to observe their pledged output reduction, but we are modeling some compliance "fatigue" all the same. Even so, this will not prevent visible OECD oil inventories from falling to their five-year average levels by year-end or early next year. Obviously, none of this can be taken for granted. We have consistently highlighted the upside and downside risks to our longer term central tendency of $55/bbl for Brent crude, with an expected trading range of $45 to $65/bbl out to 2020. Below, we reprise these concerns and our thoughts concerning OPEC 2.0's future. Major Upside Risks Chief among the upside risks remains a sudden loss of supply from a critical producer and exporter like Venezuela or Nigeria, which, respectively, we expect will account for 1.9 and 1.5 MMb/d of production over the 2017-18 period. Losing either of these exporters would sharply rally prices above $65/bbl as markets adjusted and brought new supply on line. Other states - notably Algeria and Iraq - highlight the risk of sustained production losses due to a combination of internal strife and lack of FDI due to civil unrest. Algeria already appears to have entered into a declining production phase, while Iraq - despite its enormous potential - remains dogged by persistent internal conflict. We are modeling a sustained, slow decline in Algeria's output this year and next, which takes its output from 1.1 MMb/d in 2015 down to slightly more than 1 MMb/d on average this year and next. For Iraq, where we expect a flattening of production at ~ 4.4 MMb/d this year and a slight uptick to ~ 4.45 MMb/d in 2018, continued violence arising from dispersed terrorism in that country in the wake of a defeat of ISIS as an organized force, will remain an ongoing threat to production. Longer term - i.e., beyond 2018 - we remain concerned the massive $1-trillion-plus cutbacks in capex for projects that would have come online between 2015 and 2020 brought on by the oil-price collapse in 2015-16 will force prices higher to encourage the development of new supplies. The practical implication of this is some 7 MMb/d of oil-equivalent production the market will need, as this decade winds down, will have to be supplied by U.S. shales, Gulf OPEC and Russia, as noted above. Big, long-lead-time deep-water projects requiring years to develop cannot be brought on fast enough to make up for supply that, for whatever reason, fails to materialize from these sources. In addition, as shales account for more of global oil supplies and "The Other Guys" continue to lose production to higher depletion rates, more and more shale - in the U.S. and, perhaps, Russia - and conventional Persian Gulf production will have to be brought on line simply to make up for accelerating declines. This evolution of the supply side is significantly different from what oil and capital markets have been accustomed to in previous cycles. Because of this, these markets do not have much historical experience on which to base their expectations vis-à-vis global supply adjustment and the capacity these sources of supply have for meeting increasing demand and depletion rates. Lower-Cost Production, Demand Worries On The Downside Downside risks, in our estimation, are dominated by higher production risks. Here, we believe the U.S. shales and Russia are the principal risk factors, as the oil industry in both states is, to varying degrees, privately held. Because firms in these states answer to shareholders, it must be assumed they will operate for the benefit of these interests. So, if their marginal costs are less than the market-clearing price of oil, we can expect them to increase production up to the point at which marginal cost is equal to marginal revenue. The very real possibility firms in these countries move the market-clearing price to their marginal cost level cannot be overlooked. For the U.S., this level is below $53/bbl or so for shale producers. For Russian producers, this level likely is lower, given their production costs are largely incurred in rubles, and revenues on sales into the global market are realized in USD; however, given the variability of the ruble, this cost likely is a moving target. While a sharp increase in unconventional production presently not foreseen either in the U.S. or Russian shales will remain a downside price risk, an increase in conventional output - chiefly in Libya - remains possible. As discussed above, we believe this is a low risk to prices at present; however, if an accommodation with insurgent forces in the country can be achieved, output in Libya could double from the 600k b/d of production we estimate for this year and next. We reiterate this is a low-risk probability (less than 25%), but, in the event, would prove to be significant additions to global balances over the short term requiring a response from OPEC 2.0 to keep Brent prices above $50/bbl. Also on the downside, an unexpected drop in demand remains at the top of many lists. This is a near-continual worry for markets, which can be occasioned by fears of weakening EM oil-demand growth from, e.g., a hard landing in China, or slower-than-expected growth in India. These are the two most important states in the world in terms of oil-demand growth, accounting for more than one-third of global growth this year and next. We do not expect either to meaningfully slow; however, we continue to monitor growth in both closely.1 In addition, we continue to expect robust global oil-demand growth, averaging 1.56 MMb/d y/y growth in 2017 and 2018. This compares with 1.6 MMb/d growth last year. OPEC 2.0's Next Move Knowing the OPEC 2.0 production cuts will be extended to March 2018 does not give markets any direction for what to expect after this extension expires. Once the deal expires, we expect production to continue to increase from the U.S. shales, and for the key OPEC states to resume pre-cut production levels. Along with continued growth from Russia, this will be necessary to meet growing demand and increasing depletion rates from U.S. shales and "The Other Guys." Yet to be determined is whether OPEC 2.0 needs to remain in place after global inventories return to long-term average levels, or whether its formation and joint efforts were a one-off that markets will not require in the future. Over the short term immediately following the expiration of the production-cutting deal next year, OPEC 2.0 may have to find a way to manage its production to accommodate U.S. shales without imperiling their own revenues. This would require a strategy that keeps the front of the WTI and Brent forward curves at or below $60/bbl - KSA's fiscal breakeven price and $20/bbl above Russia's budget price - and the back of the curve backwardated, in order to exert some control over the rate at which shale rigs return to the field.2 As we've mentioned in the past, we have no doubt the principal negotiators in OPEC 2.0 continue to discuss this. Toward the end of this decade, such concerns might be moot, if growing demand and accelerating decline curves require production from all sources be stepped up. Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see the May 18, 2017, issue of BCA Research's Commodity & Energy Strategy article entitled "Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts," in which we discuss the outlook for China's and India's growth. Together, these states account for more than 570k b/d of the 1.56 MMb/d growth we expect this year and next. The article is available at ces.bcaresearch.com. 2 A backwardated forward curve is characterized by prompt prices exceeding deferred prices. Our research indicates a backwardated forward curve results in fewer rigs returning to the field than a flat or positively sloped forward curve. We explored this strategy in depth in the April 6, 2017, issue of BCA Research's Commodity & Energy Strategy, in an article entitled "The Game's Afoot In Oil, But Which One?" It is available at ces.bcaresearch.com. 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 Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories

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