Oil

Highlights This week, we provide one of our occasional updates on Commodities as an Asset class (CAAC), examining the strategic case for getting long commodity index exposure. Commodity index exposure is more highly correlated with inflation than equities or bond exposure, indicating commodities - and real assets generally - provide a better hedge against inflation than financial assets. A pure investment case for getting long broad commodity index exposure can be made if backwardation is expected in one or more of the components of a given index. Given our expectation for higher inflation, and our positioning for backwardation in the oil market, we recommend getting long the energy-heavy S&P GSCI index as a strategic portfolio position. Energy: Overweight. Deeper-than-expected production cuts from OPEC were reported by Reuters Tuesday, suggesting Cartel members are at 104% of pledged output reductions.1 Our $50/bbl vs. $55/bbl WTI calls spreads in Jul-Aug-Sep settled at an average of $3.06/bbl, and we are taking profits of 76.9%, per the upside $3.00/bbl stop we established for these positions on March 23/17. We also are taking profits on our Dec/17 vs. Dec/18 WTI backwardation trade basis tonight's close, after registering a gain of more than 700% when we marked to market earlier this week. We are keeping our long Dec/17 vs. short Dec/18 Brent backwardation spread open; it is up 426.3% since we recommended it on March 23/17. We are recommending a strategic long position in the energy-heavy S&P GSCI basis today's close. Given this commodity index's overweight to oil and refined products, we believe price appreciation will offset negative roll returns until crude markets go into backwardation later this year. We expect WTI and Brent to trade on either side of $60/bbl by year end. Base Metals: Neutral. Workers at Southern Copper's Toquepala and Cuajone mines struck Monday seeking higher wages and improved working conditions, according to Metal Report. Front-line copper on the COMEX has been chopping between ~ $2.50/lb and $2.70/lb since the beginning of the year through multiple strike actions. Precious Metals: Neutral. Gold rallied slightly, but our long volatility play still is down 14.7%. Markets do not appear to be overly concerned with Fed actions over the next couple of months. Feature There's a long-standing argument among equities investors as to whether they trade the stock market or a market of stocks. In the case of the former, getting long index exposure makes sense. In the case of the latter, stock pickers sensitive to the idiosyncratic risk of individual equities outperform the broad-exposure devotees. Sometimes, both are right at the same time. Commodities are no different. There are times when broad exposure to commodities is warranted - e.g., in the early stages of a global industrial rebound or when investors expect higher inflation. However, there are periods in which sensitivity to idiosyncratic risk reflecting different fundamental states for each market works best. And, as is the case with equities, there are times when both points of view can co-exist without contradiction. The relative performance of commodities vs. equities post-Global Financial Crisis (GFC) leaves much to be desired (Chart 1A and Chart 1B). The re-balancing of commodities generally, led by crude oil, but apparent in key base metals like copper, suggests the overall commodity down-cycle - with the exception of ags - has leveled out. Fundamentals - supply, demand and inventories - will be far more important for commodities going forward, particularly as the Fed pursues its rates-normalization policy and markets are slowly weaned off the excessive monetary accommodation they've seen in the post-GFC period. Chart 1ACommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Chart 1BCommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse Commodities Were Competitive Pre-GFC, Post-GFC Underperformance Will Reverse There are two global-macro considerations driving our expectation commodities will outperform the other major asset classes going forward, which we consider below. First, consistent with our House view and recent analysis from our Global Fixed Income Strategy (GFIS) service, we expect higher inflation, which already is being reflected in the forward CPI swaps markets. This could be exacerbated if oil supplies tighten on the back of massive capex cuts following the 2015 - 16 oil-price collapse, and if U.S. fiscal stimulus overheats an economy that already is at or near full capacity and full employment. Second, backwardation in crude oil markets will be a positive development for commodity index products generally, and the energy-heavy S&P GSCI in particular. Together, these fundamentals will provide investors portfolio diversification via non-correlated returns vis-à-vis the other asset classes. Higher Inflation Expectations Support Commodity Index Exposure We have been highlighting the inflationary "tail risks" in commodity markets for a number of months. These include the possibility of 1) higher oil prices after 2018, following the more-than-$1 trillion cuts in oil-and-gas capex in the wake of the 2015 - 16 oil price collapse; and 2) a large injection of fiscal stimulus to the U.S. economy from the Republican-controlled U.S. Congress working with President Trump's White House. The fiscal stimulus could become material next year, revving an economy that is at or near full employment and an output gap at or close to being closed.2 Our colleagues on BCA's GFIS desk note, "underlying U.S. inflation pressures remain strong, particularly given the evidence that conditions in the labor market are getting progressively tighter." While inflationary forces are a bit more subdued in Europe and Japan, our colleagues continue to favor being long CPI swaps in both markets (Chart 2).3 BCA's GFIS expects inflation expectations to rise to a level of ~ 2.5% p.a. on 10-year TIPS breakevens, which are priced off the CPI index. If markets do raise the odds of higher inflation over the medium term, it most likely will continue to show up in the 5-year 5-year (5y5y) CPI Swaps in the U.S. and Europe, which we have found to be cointegrated with 3-year forward WTI futures (Chart 3). The oil market will be especially sensitive to the supply-demand balances after 2018, and will move higher if it senses a supply squeeze from too-little investment in production following the massive cuts to supply-side capex. This will feed into the 5y5y CPI swaps markets, which, in turn, will drive TIPS yields higher. Chart 2Early Days Yet, But ##br##U.S. Inflation Pressures Are Building Early Days Yet, But U.S. Inflation Pressures Are Building Early Days Yet, But U.S. Inflation Pressures Are Building Chart 3Watch 3-Year Forward WTI Futures ##br##For Early Signs Of Higher Inflation Watch 3-Year Forward WTI Futures For Early Signs Of Higher Inflation Watch 3-Year Forward WTI Futures For Early Signs Of Higher Inflation Apart from active commodity positioning, commodity index exposure offers better inflation risk coverage than equities or bonds, as can be seen in Table 1.4 Chart 4 shows the out-performance of the commodity indices, the S&P GSCI in particular, in higher-inflation environments. Table 1Correlations Between Real And Financial Assets CAAC: Time To Get Long Commodity Index Exposure CAAC: Time To Get Long Commodity Index Exposure Our own modeling supports the academic findings. When we estimated the yoy S&P GSCI returns as a function of U.S. CPI yoy changes and the difference between 1st-nearby WTI futures (CL1) and 12th nearby WTI futures (CL12), we found this specification explained just over 84% of the commodity index's annual returns. Our model indicates the S&P GSCI can be expected to increase in value by close to 15bp for every 1% increase in U.S. CPI (Chart 5). This energy-heavy index - crude oil and refined products comprise more than half of the S&P GSCI - performs much better than the more evenly disbursed Bloomberg Commodity Index (BCI) as an inflation hedge. Chart 4Commodities Outperform In##br## Inflationary Markets Commodities Outperform In Inflationary Markets Commodities Outperform In Inflationary Markets Chart 5S&P GSCI Index Exposure ##br##Moves With Inflation S&P GSCI Index Exposure Moves With Inflation S&P GSCI Index Exposure Moves With Inflation Profiting From Backwardation Long-only commodity index products generate returns from three sources: Price appreciation; roll yield - the returns generated by selling and replacing futures contracts approaching their terminal trading date (the expiring contract in the index is sold and replaced by a contract with a deferred delivery); and on the collateral posted to carry positions. An investor with a strong view on prices can express it by getting long or short futures. When an investor wants to express a view on the structure of the market - chiefly the shape of the forward curve and whether it will be backwardated (prompt delivery costs more than deferred delivery), or in contango (prompt delivery costs less than deferred delivery) - they can do so either by trading spreads (buying prompt-delivered contracts vs. selling deferred-delivered contracts, and vice versa) or getting long commodity-index exposure such as the S&P GSCI or Bloomberg Commodity Index (BCI). Typically, long-only commodity-index products largest returns are generated via price appreciation and roll yield, which simply are returns generated by "rolling" the underlying futures contracts in the index as these contracts approach the termination of trading to a deferred month. In a backwardated market, prompt-delivered contracts are sold and replaced with lower-cost contracts. In contango markets the opposite occurs. Indexes with heavy concentrations in futures that are likely to be backwardated for a length of time are preferred to indexes with futures that, on a fundamental basis, are more likely to have a flat or contango term structure. We have been positioning for a backwardation in crude oil later this year for some time. We continue to expect backwardation in crude oil markets, and remain long Dec/17 Brent vs. short Dec/18 Brent to express this view. Given the very high concentration of energy exposure in the S&P GSCI index - more than half of the index is crude oil or refined products, according to S&P - this index is best-suited, in our estimation, to benefit from a backwardated oil market.5 Indeed, our modeling, shown in Chart 5, supports our view that backwardation would significantly boost performance in the S&P GSCI index: A 1% increase in the spread between 1st-nearby WTI vs. 12th-nearby WTI contracts likely would translate into gain in the index of slightly more than 1.14%. Bottom Line: We expect higher inflation and backwardation in the oil market later this year. For this reason, we are recommending a long exposure in the energy-heavy S&P GSCI index. Commodities outperform equities and bonds in inflationary markets. In addition, this index's overweight to crude oil and refined products suggests it will outperform when markets backwardate. Given we expect WTI and Brent prices to trade on either side of $60/bbl later this year, we believe price appreciation will offset minor roll-yield losses until markets backwardate. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Exclusive: OPEC futures show oil output cuts exceed pledge in March - sources" published by Reuters.com on April 11, 2017. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Gold's 'Known Unknowns' And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Please see BCA Research's Global Fixed Income Strategy weekly Report "The Song Remains The Same," dated April 11, 2017, available at gfis.bcaresearch.com. 4 Please see Bhardwaj, Geetesh, Gary Gorton and Geert Rouwenhorst (2015), "Facts and Fantasies about Commodity Futures Ten Years Later*" published by Yale University. This article updates earlier research and notes, "In the original study we found that commodities had historically offered a risk premium similar to equities, and at the same time would provide diversification to a traditional portfolio of stocks and bonds. What set commodities apart from these traditional assets was their positive correlation with inflation. (Emphasis added.) Here we provide 10 years of additional data. Although a decade is sometimes too short to draw firm conclusions, our-of-sample period is rich because it includes a global economic expansion led by the industrialization of China, a housing boom and bust in the United States, the largest financial crisis since the Great Depression, followed by a monetary policy stimulus response which has driven interest rates around the world towards zero. ... Many of the basic conclusions of the original study continue to hold." (p. 22) 5 Please see "WTI Crude Oil Remains On Top As S&P Dow Jones Indices Announces 2017 Weights For The S&P GSCI," at http://ca.spindices.com/indices/commodities/sp-gsci, website for the index. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016

Highlights WTI and Brent forward curves remain more or less backwardated beginning in 2018. On its face, this indicates hedgers and speculators are trading and positioning as if the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia in late 2016 will succeed in drawing inventories, leaving the market in a physical deficit this year. Over the short-term, this induced supply shock benefits producers generally. Longer term, KSA and Russia will have to continue to manage supplies if they are to exert any influence on oil prices. This is a three-level game, which now involves U.S. shale-oil producers as a permanent feature of the market. It will be difficult to manage. But the stakes are sufficiently high for KSA and Russia that we believe it has to be played. Energy: Overweight. We closed the first quarter on an up note, with our trade recommendations still open and closed in 2017Q1 up 420.75% on average. Base Metals: Neutral. Striking miners at Freeport McMoRan's Cerro Verde facility in Peru are back on the job, as are workers at BHP's Escondido mine in Chile. Export licensing difficulties at Freeport's Grasberg facility in Indonesia are close to being resolved.1 Precious Metals: Neutral. Our long volatility play in gold is down -32.8%, which, from a macro perspective, indicates markets are not fearful of a Fed-related surprise over the next couple of months. Ags/Softs: Underweight. U.S. farmers' corn planting intentions came in 1mm acres less than expected at 90mm; beans came in at 89.5mm acres, or 1.4mm over expectations; and wheat was up 100k acres at 46.1mm. Stocks remain high, and we remain bearish. Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart of the Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).2 Chart of the WeekEM Consumption Surge, Flat Production ##br##Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required##br## To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices, ##br##Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale ##br##Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.3 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.4 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged ##br##During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War Chart 8Global Oil Supply##br## Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.5 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock##br## Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year ##br##Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.6 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.7 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Workers to end strike at Peru's top copper mine Cerro Verde," published March 30, 2017, by miningweekly.com. 2 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 3 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 4 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 5 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 6 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 7 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016

Highlights Dear Client, In this analysis, my colleague Bob Ryan of the BCA Commodity & Energy Strategy argues that there is more upside to oil prices. First, Russia and OPEC will continue to coordinate their production for at least the rest of the year. Second, oil prices are too low to incentivize high cost, non-Gulf OPEC production, such as deep-water production. Third, the world lost roughly $1-trillion-plus of capex due to the oil-price collapse. Bob collaborates frequently with the Geopolitical Strategy team. As we controversially argued in February 2016, Saudi-Iranian tensions have peaked and created the geopolitical conditions for a renewal of OPEC production coordination. With oil prices plumbing decade lows in 2015-2016, both countries have set regional differences aside for the sake of domestic stability. I hope that you will enjoy Bob's note as much as I did. Many clients with whom I have met in person already know the view well, as it forms the core of Geopolitical Strategy's view on the Middle East. For those of you who are not subscribed to BCA's Commodity & Energy Strategy, and BCA's Energy Sector Strategy, I would recommend that you reach out to your account manager for a trial of both services. Kindest Regards, Marko Papic, Senior Vice President Geopolitical Strategy Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart Of The Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).1 Chart Of The WeekEM Consumption Surge, Flat Production##br## Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required ##br##To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices,##br## Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global##br## Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above 0/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale##br## Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.2 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.3 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged##br## During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War Chart 8Global Oil Supply ##br##Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.4 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock ##br##Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year##br## Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.5 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.6 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 2 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 3 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 4 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 5 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 6 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com.

Highlights The end game for the Kingdom of Saudi Arabia (KSA), Russia and their respective allies is fairly obvious: Remove enough production from the market to draw down storage and make the oil-supply curve, once again, more inelastic. This would allow these states to use forward guidance and small adjustments in production to influence prices, the sine qua non of petro-states desperate to maintain revenues and diversify away from near-complete dependence on hydrocarbon exports. We think the effort will succeed over the short run. Just how durable this pact will be remains to be seen, given oil is, once again, super-abundant. If production discipline breaks down, all bets are off. Energy: Overweight. We are now solidly positioned for backwardation in oil - long Dec/17 vs. short Dec/18 WTI and Brent; these positions are up 141.6% and 68.4%, respectively. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks: We are long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017; these positions are up 7.66% on average. Base Metals: Neutral. Workers at Chile's Escondida mine are back on the job, after a 44-day strike. The strike is estimated to have cost BHP Billiton some $1 billion, according to Reuters.1 Precious Metals: Neutral. Gold has rallied by 4.3% since the FOMC raised overnight rates. Our long volatility position - long a Jun/17 put and call spread for $21/oz - is down 30%. Ags/Softs: Underweight. The long-awaited and much-anticipated USDA planting intentions report is due out tomorrow. We remain bearish, expecting an early indication stocks-to-use ratios for grains and beans will remain elevated. Feature Chart of the WeekStorage Was Well On Its Way to Drawing##br## Before the Year-End Production Surge Storage Was Well On Its Way to Drawing Before the Year-End Production Surge Storage Was Well On Its Way to Drawing Before the Year-End Production Surge KSA and Russia have to make oil supply more inelastic in order to regain some control over where prices go and, consequently, where their revenues go. Their end game is obvious - i.e., remove the excess oil production that pushed inventories to historically high levels - but their execution has been, at best, halting. Prior to KSA and Russia delivering an historic production-management Agreement at the end of last year, oil markets were well on the way to removing the storage overhang by year-end 2017, as any Econ 101 text would have suggested. Low prices following OPEC's market-share war declaration destroyed supply and lifted demand, which was drawing down stocks. This is easily seen in the Chart of the Week showing inventories beginning to head south in mid-2016. Then came the KSA - Russia Agreement between OPEC and non-OPEC producers to cut output by some 1.8mm b/d. The goal of the deal was to accelerate the drawdown in record high storage levels. Even while the deal was being negotiated, it was apparent some producers in the know were getting a jump on shipping those last barrels out the door before they were obliged to cut. This produced the end-of-year production surge, which swelled global inventories. The year-end surge by OPEC and non-OPEC producers could be expected (Chart 2), but it came at a really bad time for the market, since 1Q17 also was when refiners took units down for maintenance. This is fairly routine, but in some key markets like the U.S. Gulf, the current maintenance season was busier than average, according to the EIA (Chart 3). This left a lot of crude in storage, as product inventories were being drawn. Chart 2Year-End Production Surge ##br##Powered The Storage Build Year-End Production Surge Powered The Storage Build Year-End Production Surge Powered The Storage Build Chart 3Maintenance Season In 1Q17 ##br##Exacerbated The Storage Build Maintenance Season In 1Q17 Exacerbated The Storage Build Maintenance Season In 1Q17 Exacerbated The Storage Build Where are we today? Most of the pre-Agreement production and export surge has been absorbed, and inventories in the U.S. are drawing a bit. Floating storage has been drained. But, in an interesting economic twist, OECD storage levels are likely to reach the targeted drawdown of 10% (300mm bbl) by year-end 2017, which is exactly what would have happened absent any action by KSA and Russia at the end of last year. It is difficult to resist reiterating that had nothing been done at the end of last year by KSA and Russia, and the market was left to do its necessary work of removing high-cost production and encouraging increased demand via lower prices, the market would have ended up in the exact same place it now finds itself. Trust But Verify Be that as it may, the really hard work of the KSA - Russia deal now begins. We expect OECD inventories to hit the 10% drawdown target by year end. However, if parties to the deal do not maintain production discipline markets will almost surely take prices lower. This could easily happen if prices start to percolate as we expect in 2Q17, and cash-strapped non-OPEC producers decide to see how far they can push KSA and its Gulf-state allies on their deal. Russia has been slow to deliver on its production commitment, while KSA has over-delivered (Chart 4). The same can be said for their respective allies (Chart 5). We believe markets will remain skittish, until evidence Russia and Iraq also are abiding by the end-2016 Agreement becomes incontrovertible. It is true Russian President Vladimir Putin personally involved himself in this deal, and helped close it on the non-OPEC side, but markets will want proof production actually is falling. Like former U.S. President Ronald Reagan, markets may be willing to trust, but they certainly will want to verify compliance. Chart 4KSA Over-Delivers On Its Cuts, ##br##Russia Is Slow To Deliver KSA Over-Delivers On Its Cuts, Russia Is Slow To Deliver KSA Over-Delivers On Its Cuts, Russia Is Slow To Deliver Chart 5KSA's Allies Are Delivering, ##br##Russia's Not So Much KSA’s Allies Are Delivering, Russia’s Not So Much KSA’s Allies Are Delivering, Russia’s Not So Much While not our base case, it is possible Russia and its fellow travelers could decide to risk keeping their production above agreed volumes under the Agreement, in the belief KSA is more in need of keeping prices above $50/bbl or so over the next 18 months, given the Kingdom wants a successful IPO of state-owned Saudi Aramco. Should this occur, markets would correct violently. At the end of the day, such a gamble likely would be ruinous for both, if it provoked KSA to abandon its commitment to keep production below 10mm b/d. Short-term goals - getting OECD storage levels down to five-year averages - would be sacrificed. Importantly, long-term goals we believe are driving KSA and Russia to cooperate in the first place, namely developing a modus operandi for containing U.S. shale-oil output, will become moot, possibly returning the market to the production free-for-all that motivated the KSA - Russia dialogue. The Quest For Relevance Chart 6Odds Favor Backwardated Markets ##br##As the Production Cuts Lead To Physical Deficits Odds Favor Backwardated Markets As the Production Cuts Lead To Physical Deficits Odds Favor Backwardated Markets As the Production Cuts Lead To Physical Deficits Our base case envisions a successful KSA - Russia Agreement in which production discipline is maintained, and the deal produces its desired result - drawing storage down by ~ 300mm bbls. Forward curves then backwardate (Chart 6). This sets the stage for deeper discussions among KSA, Russia and their respective allies re how they can work together going forward to contain U.S. shale-oil production. In effect, the parties to this deal have a choice to make: Either they figure out a way to make room for shale, which has catapulted the U.S. to major-producer status once again, or they leave this to the market. We are fairly confident these discussions already are ongoing, and will be well advanced by year-end. Next week, we will be publishing a theoretical piece on how the KSA - Russia pact could provide a platform that allows these petro-states - which we are taking the liberty of dubbing OPEC 2.0 - to re-gain a modicum of control over the rate at which U.S. shale-oil resources are developed. In earlier research, we advanced a theory that shale rig counts are highly sensitive not only to the level of prices at the front of the curve, but to the curve shape itself. We were able to demonstrate that contango markets - i.e., prices for promptly delivered crude are less than prices for deferred delivery material - favor shale producers, and, all else equal, incentivize them to hedge forward so as to lock in future revenues that maximize the number of rigs they deploy.2 In backwardated markets, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. This limits the rate at which the resource can be developed. Based on these theoretical results, we believe it is in the interest of the OPEC 2.0 states to keep the WTI forward curve in backwardation, so that, at the margin, the number of rigs deployed to the shales is contained. Our research suggests that the deeper the backwardation, the slower rig counts grow. So, if the ideal price level for KSA is, as has been reported in the media, $60/bbl for Brent, then, in the best of all worlds, the Kingdom, Russia and their respective allies target spot prices at this level and use production, storage and forward guidance to backwardate the WTI curve, which is used by shale producers to hedge.3 Such a strategy has numerous risks, particularly if OPEC 2.0 cannot react quickly enough to keep prices from rising above a level that keeps shale-oil producers restricted to their core production areas. This would allow higher-cost shale reserves to be brought on line, which would raise the likelihood of lower prices, and cost OPEC 2.0 market share.4 Such a strategy also would tempt OPEC 2.0 producers to free ride, raising production at the margin to increase their revenues. This also risks lower prices. Nonetheless, we believe such a strategy could benefit both KSA and Russia and their allies, which is why it likely will at least be considered and attempted.5 KSA would be able to IPO Aramco into a relatively stable higher-price market, which would allow it to invest in additional refinery capacity in Asia and elsewhere, and in alternative-energy resources like solar, to free up oil for export. Russia also is better off keeping prices at a level at which its economy can continue to work on diversifying its exposure away from its heavy dependence on oil and gas exports.6 We will present more of our thinking on this next week. In the meantime, we highly recommend BCA clients read Matt Conlan's article in this week's Energy Sector Strategy entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery."7 This is an excellent analysis of shale-oil economics. Bottom Line: We continue to expect crude and products storage to draw as production cuts become apparent and refiners bring units back up off maintenance. This will backwardate WTI and Brent forward curves. Based on our high level of conviction in this outcome, we added a long Brent Dec/17 vs. short Dec/18 Brent position to our recommended trades, along with a similar WTI position. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks, by being long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017. We continue to expect the U.S. benchmark WTI crude prices to average $55/bbl to 2020 and for WTI prices to trade most of the time between $45/bbl and $65/bbl. For 2018 and beyond, our conviction is lower: The massive capex cuts seen in the industry will place an enormous burden on shale producers and conventional oil producers - chiefly Gulf Arab producers and Russia - to offset natural decline-curve losses and meet increasing demand. For the international benchmark, Brent crude oil, we expect the spread between Brent and WTI prices to average $1.50/bbl (Brent over). Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Escondida outcome seen as disaster for BHP as workers return," published by Reuters.com on March 24, 2017. 2 We introduced this line of research in our February 16, 2017, issue of Commodity & Energy Strategy, in an article entitled "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," it is available at ces.bcaresearch.com. We continue to delve into this topic, and will be presenting out latest thinking next week. 3 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters February 28, 2017. Russia's budgeting assumption for 2017 to 2019 is $40/bbl, according to a Bloomberg report from March 24, 2017, entitled "OPEC Be Warned: Russia Prepares for Oil at $40." 4 It is not in KSA's, Russia's or their allies' interests to kill off shale production. The more-than-$1 trillion of capex for projects that would have been developed between 2015 and 2020, and would have translated into some 7mm b/d of oil-equivalent production will not be available to the market beginning later this decade. As we have noted, an enormous burden will be placed on shale production, Gulf OPEC producers and Russia to meet growing demand later this decade. 5 We also would note this would be a boon to long-only commodity index investors, whose returns are driven by roll yields that only exist in backwardated markets. More on that in subsequent research as well. 6 Russia's exports are dominated by oil and gas, while KSA's are dominated by crude oil and, increasingly, refined products. In 2015, the Carnegie Endowment for International Peace calculated close to 70% of Russia's economy is dependent on revenue from hydrocarbons - production, trade, investments in non-oil industries funded by oil revenues, and consumption made possible via oil and gas production and sales. We discuss this at length in the September 8, 2016, issue of Commodity & Energy Strategy, in an article entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." 7 Please see Energy Sector Strategy Weekly Report entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery," This article was published March 29, 2017, available at nrg.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

Highlights EM equity valuations are neutral. Relative to the U.S., EM share prices do offer some value, but this primarily reflects elevated valuations within the S&P 500. According to the cyclically-adjusted P/E ratio, EM stocks are cheap for investors with a long-term time horizon - longer than two to three years. Corporate profits are much more important than equity valuations in driving share prices in the next 12 months. Our outlook for EM EPS is downbeat for the next 12 months. Maintain a defensive posture and an underweight allocation in EM stocks versus DM. A new trade: go long Russian energy stocks / short global energy ones. Feature Chart I-1EM P/E Ratio And EPS EM P/E Ratio And EPS EM P/E Ratio And EPS There is ongoing debate in the investment community concerning whether emerging markets (EM) equities are or are not cheap, in both absolute terms and relative to developed markets (DM). In this week's report we review various equity valuation indicators and reiterate that EM stocks are neither cheap nor expensive in absolute terms. For example, the average of trailing and forward P/E ratios is slightly above its historical mean (Chart I-1, top panel). Relative to the U.S., EM share prices do offer value, but this reflects elevated valuations within the S&P 500. Despite this, we recommend underweighting EM vs U.S./DM because the cyclical growth dynamics is much better in DM than EM. EM stocks are cheap if one assumes a strong earnings recovery (Chart I-1, bottom panel). If earnings per share (EPS) begin contracting anew, as we expect, then the current rally will be reversed sooner than later. Overall, we continue to recommend a defensive posture for absolute-return investors and maintaining an underweight allocation in EM stocks versus DM for asset allocators. Valuation Perspectives Below we consider several valuation ratios: The equal-sector weighted trailing P/E ratio is 17.7 for EM (Chart I-2). Table I-1 displays equal-sector weighted P/E ratio, price-to-book value ratio and dividend yields for major equity markets globally. This is an apples-to-apples comparison, as it assigns equal weights to each of the 10 MSCI sectors - i.e., it removes sector biases. Chart I-2Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Table I-1Equal-Sector Weighted Valuation Ratios Across EM And DM EM Equity Valuations Revisited EM Equity Valuations Revisited Hence, on a comparable basis, EM equities are only slightly cheaper than DM stocks as is evident in Table I-1. Besides, the composite valuation indicator based on equal-sector weighted trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yield indicate that EM stocks are fairly valued (Chart I-3). The cyclically-adjusted P/E (CAPE) ratio. The CAPE ratio is a structural valuation measure, i.e. it matters in the long run. Importantly, it assumes that real (inflation-adjusted) EPS will revert to its historical mean or trend. In short, the CAPE ratio tells us what the P/E ratio would be if EPS were to revert to its historical trend. Chart I-4 illustrates the EM CAPE ratio. If EM EPS in inflation-adjusted U.S. dollar terms reaches its historical time trend, one can safely assume that EM stocks are cheap and currently worth buying. In a nutshell, the current CAPE ratio of 15 assumes that EM EPS should rise by about 30% in nominal U.S. dollar terms over an investor's time horizon. Chart I-3EM Equities Valuations Are Neutral bca.ems_wr_2017_03_29_s1_c3 bca.ems_wr_2017_03_29_s1_c3 Chart I-4EM CAPE Ratio EM CAPE Ratio EM CAPE Ratio Given that our time horizon is 12 months, the assumption that EM EPS will surge by about 30% in U.S. dollar terms is in our view ambitious. Therefore, we posit that EM share prices do not offer compelling value at all in the next 12 months. If one's investment horizon were two-to-three years or longer, the assumption that EPS will rise by 30% or more in U.S. dollar terms is much more plausible. In this sense we would concur that EM share prices offer decent value from a longer-term perspective. Our methodology of calculating the CAPE ratio for EM varies from the well-known Robert Shiller's CAPE ratio for the U.S.1 However, even when applying our CAPE methodology to U.S. equities, the resulting ratio is not very different from Shiller's CAPE (Chart I-5). Trimmed-mean equity valuation ratios. Chart 6 illustrates 20% trimmed-mean trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yields for the EM equity universe. A 20% trimmed-mean ratio excludes the top 10% and bottom 10% of industry groups, and then calculates the average. All calculations are based on 50 EM industry group data available from MSCI. Why look at trimmed-mean valuation ratios? Because by removing the top and bottom 10% of industry groups, this measure excludes outliers and provides a better perspective on valuation. A few observations are in order: First, according to the trimmed-mean valuation ratios, EM equities are not cheap. The trimmed-mean ratios are close to their historical mean (Chart I-6). Second, the trimmed-mean ratios are well above their market cap ones. This indicates that there are a few industry groups with large market caps that pull EM multiples lower. In other words, market-cap weighted multiples are skewed to the downside by a few large industry groups. There are reasons why some sectors and countries have low or high equity multiples. It makes sense to exclude them. Finally, the composite valuation indicator based on trimmed-mean trailing and forward P/Es, PBV and price-to-cash earnings ratios and dividend yield demonstrates that EM equity valuations are neutral (Chart I-7). Chart I-5U.S. CAPE Ratios U.S. CAPE Ratios U.S. CAPE Ratios Chart I-6EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value Chart I-7EM Equities Have Neutral Value bca.ems_wr_2017_03_29_s1_c7 bca.ems_wr_2017_03_29_s1_c7 Bottom Line: EM equities by and large command a neutral valuation. According to the CAPE ratio, EM equities are cheap for investors with a long-term time horizon, say two-to-three years or longer. Profits Hold The Key Valuations are not a good timing tool. For low equity valuations to be realized, i.e., to produce solid price gains, corporate profits should grow. The reverse is also true: for an overvalued market to decline, company earnings should contract, or at least disappoint. When valuations are neutral - as they currently are for the EM equity benchmark - a recovery in EPS should entail higher share prices, while EPS shrinkage should lead to a selloff. EM EPS will continue to recover in the next three to six months, given the rally in commodities prices in 2016, amelioration in China's business cycle and the technology sector boom in Asia. However, this moderate and short-lived EPS recovery is already priced in. For the market to rally further, EPS will need to expand beyond the next three to six months. Remarkably, there has been little improvement in EM ex-China domestic demand. Besides, the risk to bank loan growth remains to the downside both in China and EM ex-China. Slower loan growth and the need to recognize and provision for potentially large NPLs will pressure banks' profits in many EM countries. Finally, we expect oil and industrial metals prices to decline considerably over the course of this year. If and as this view plays out, energy and materials stocks will fall. Energy and materials share prices correlate not with their past or current profits but rather with underlying commodities prices. One area where we remain bullish is the technology sector. Even though tech share prices are overbought and could correct in absolute terms in the months ahead, they will continue to outperform the benchmark. Bottom Line: Corporate profits are much more important in driving share prices in the next 12 months than equity valuations. Our outlook for EM EPS is downbeat for the next 12 months or so, even though EPS will continue to recover in the next three to six months. Timing Reversal: Watch Credit Quality Spreads Chart I-8Credit Quality Spreads: ##br##A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Following are some of the indicators we are monitoring to gauge a reversal in EM share prices. EM corporate spreads have widened a notch relative to EM sovereign spreads (Chart I-8, top panel). Similarly, Chinese off-shore corporate spreads have widened versus Chinese sovereign spreads (Chart I-8, middle panel). Credit quality spreads - the gap between B- and BAA-grade corporate bonds - have widened slightly in the U.S. (Chart I-8, bottom panel). These moves are still very small, and do not constitute a definite sign of a major trend reversal. Nevertheless, such widening in credit quality spreads is an important development. If they persist, they will certainly sound the alarm for the reflation trade. Interestingly, this is the first time a simultaneous widening in credit quality spreads has occurred since the risk assets rally began in early 2016. Bottom Line: Major equity market selloffs will occur when lower quality credit begins to persistently underperform better quality credit. There have been budding signs of quality spread widening that are worth being monitored. Identifying Relative Value Within the EM equity universe, valuation ratios differ greatly. For example, banks trade at a trailing P/E of 9.7, while consumer staple stocks trade at 24.8. Table I-2 portrays the trailing P/E ratio and its historical mean as well as 12-month forward EPS growth and the forward P/E ratio for each sector - as well as average of trailing and forward P/E ratios. Table I-3 shows the same valuation measures but for EM countries. Table I-2Stock Valuation Snapshot: EM Sectors EM Equity Valuations Revisited EM Equity Valuations Revisited Table I-3Equity Valuation Snapshot: EM Countries EM Equity Valuations Revisited EM Equity Valuations Revisited It is difficult to draw any definitive conclusions from these tables. On a general level, a simplistic approach to investing based on trailing and forward P/E ratios would not have produced great outcomes in EM in recent years. When analyzing EM stock valuations, we prefer to use the trailing rather than forward P/E ratio because historically, EM forward EPS have had a very poor record forecasting actual EPS. One of our favorite ways to identify relative value is to compare the PBV ratio and return on equity (RoE) across countries/sectors. Chart I-9 plots RoE on the X-axis and the PBV ratio on the Y axis. Countries and sectors located in the bottom right corner (at the low end of the shaded area) have a low PBV ratio compared to their RoE. In contrast, in the north-west side of the distribution (at the upper end of the shaded zone), these have an elevated PBV ratio, taking into account their RoE. Chart I-9Searching For Relative Value EM Equity Valuations Revisited EM Equity Valuations Revisited Among countries, Korea, Russia, Hungary, the Czech Republic and China appear cheap, while Mexico, Brazil, South Africa, Colombia, Malaysia and Poland are on the expensive side. Chart I-10EMS's Recommended ##br##Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance Concerning equity sectors, utilities and financials/banks are cheap, yet consumer staples and consumer discretionary, health care, telecom and materials appear expensive in relative terms. Our recommended country equity allocation is based on a qualitative assessment of many variables including but not limited to valuation. Chart I-10 displays the performance of our fully invested EM Equity Portfolio Model versus the EM benchmark. Our overweights presently include: Korea, Taiwan, India, China, Thailand, Russia and central Europe. Our underweights are Brazil, Turkey, Indonesia, Malaysia and Peru. We are neutral on Mexico, Chile, Colombia, South Africa and the Philippines. The lists of our country allocation and other equity investment recommendations are presented each week at the end of our reports. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Bet On Russia's Non-Compliance With OPEC Odds of Russia's compliance with the OPEC agreement to cut oil output by 300k b/d in the next two months are low. This poses downside risk to oil prices. Russia has so far done only 120k b/d cuts. Hence, in the next two months it should reduce its output by 180k b/d which amounts to 1.6% of the nation's oil output. One way to bet on Russia's non-compliance, regardless the direction of oil prices, is to go long Russian energy stocks / short global energy ones (Chart II-1). There are a number of political, economic and financial motives why Russia might care less about lower oil prices than Saudi Arabia in the next 12-18 months or so. As a result, Russia might not cut as much as it is expected by the OPEC agreement. Russia is able to increase oil production due to a cheaper ruble and technology advances. BCA's Energy Sector Strategy team has been highlighting that there have been concerted efforts by Russia's largest producers to employ horizontal drilling and multi-zone hydraulic fracturing in Western Siberia.2 These have stemmed declines from those aging fields and allowed production to rise (Chart II-2). Chart II-1Long Russia Energy / ##br##Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Chart II-2Russian Oil ##br##Production Will Increase Russian Oil Production Will Increase Russian Oil Production Will Increase Russia will not shy away from being opportunistic and increase its market share when it can ramp up oil production. A rising global oil market share will allow Russian companies to outperform their global peers regardless the direction of oil prices. There are major cyclical divergences between Russian and Saudi economies. Russia's economy is gradually picking up while there is less certainty about Saudi's growth recovery. The reason is that Russia has allowed the ruble to depreciate and act as a shock absorber. Meanwhile, Sa­­­­udis have stuck to the currency peg. ­­­Oil prices are down by 27% from their top in rubles and 55% in Saudi riyals (Chart II-3). This has reflated Russia's fiscal revenues and the economy, while Saudi Arabia is still struggling with the consequences of low ­oil prices. On the fiscal front, Russia went through a notable fiscal squeeze and its budget deficit is projected to be 3.2% of GDP in 2017 (Chart II-4). In contrast, the Saudi Arabian fiscal deficit in 2016 reached an outstanding 17% of GDP, accounting for the drawdown in reserves by our estimates.3 Chart II-3Ruble's Depreciation ##br##In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Chart II-4Fiscal Deficit: Small In ##br##Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi More importantly, Russia's federal budget for 2017 was constructed on the oil price assumption of $40/bbl. The 2017 Saudi budget assumes oil price of $50/bbl.4 Therefore, Russia would not mind if oil prices drop toward or slightly below $40 in the second half of this year. Therefore, Saudis care much more about sustaining oil prices at a higher level than Russians do. Finally, Rosneft has already conducted its IPO while Aramco's IPO has not taken place yet. As such, the need for higher oil prices is much greater in Saudi Arabia - to justify a higher value of their oil giant - than in Russia. Bottom Line: Odds are considerable that Russia will not comply with the OPEC deal and this could cause oil prices to selloff more. Regardless of direction of oil prices, we expect the Russian energy sector to outperform their global peers due to Russia's rising market share in the global oil market. Go long Russian energy stocks / short global ones. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 For more detailed discussion on our methodology of CAPE, please refer to January 20, 2016 Emerging Markets Strategy Special Report titled "EM Equity Valuations: A CAPE Model", available at ems. bcaresearch.com 2 Please refer to the Energy Sector Strategy Weekly Report titled, "Russian Oil Production: Surpassing Expectation", dated December 14, 2016, available at nrg.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled, "Saudi Arabia: Short-Term Gain, Long-Term Pain", dated February 1, 2017, available at ems.bcaresearch.com 4 https://mof.gov.sa/en/budget2017/Documents/The_National_Budget.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, This week, we are sending you a piece written by my colleague Robert Ryan, Senior Vice-President for our Commodity & Energy sister service. This piece analyses dynamics in the oil markets and concludes that even if the U.S. dollar is indeed experiencing a cyclical bull market, oil prices could buck this trend. This gives us comfort on our more positive stance on the petro currencies within the commodity currency complex. Also, this week the Fed increased rates as was expected by the market. However, the tone of this hike was perceived as dovish, especially by the dollar: Four participants forecasted four hikes in 2017; one Fed president voted to keep rates unchanged, and the natural rate of unemployment estimate was downgraded to 4.7%, suggesting that the Fed perceives that the labor market is not as tight as it thought in December. Do these dynamics signal the end of the U.S. dollar cyclical bull market? No. The U.S. economy remains fundamentally strong. Various new orders surveys continue to hit record highs and capex should recover further. As a corollary, so will employment. Most crucially, the U-6 unemployment rate is now at 9.2%, a level at which wage growth significantly accelerated in 1997 and 2005. Thus, even if the U.S. economy tracks the now much-poorer Q1 GDP growth forecast of the Atlanta Fed, this soft patch will ultimately prove temporary. However, the U.S. dollar may continue to experience some short-term weakness against European currencies and the yen while forming a bottom against EM and commodity currencies. As we have argued in recent weeks, the global economy is very strong right now and it may prove difficult to sustain such a pace of growth in the industrial sector. As such, plays highly levered to the global industrial sector may experience a correction, a process that will boost the USD against EM and commodity currencies, but that will support the euro and the yen. Mathieu Savary, Vice President Mathieu@bcaresearch.com Highlights Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Chart 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less##br## Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue to Expect Backwardation##br## in Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 The greenback had an interesting reaction to the Fed rate hike. The FOMC's statement and forecasts disappointed markets and the DXY pared back most of its February gains, depreciating more than 1% following the hike. The Summary of Economic Projections confirmed two more hikes this year, for which the dates are uncertain, decreasing the perceived risk of four hikes in 2017. Moreover, the downgrade of the estimate for the structural unemployment rate suggests the Fed sees more labor market pressures than in December. Furthermore, FOMC board member, Neel Kashkari, voted against the hike, preferring instead to maintain the target rate at 0.5%-0.75%. February CPI numbers slowed slightly with core CPI falling to 2.2% from 2.3%, however, this was expected by the market. Additionally, headline CPI picked up to 2.7% from 2.5%, also as expected. The timing of the next up-leg in the dollar may now rest on the next clarifications of Trump's recent budget proposals. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 The euro minimally reacted to the Dutch elections, as its appreciation reflected the weak dollar. Regardless, the outcome for the elections was mainly market-positive as Euroskeptic Geert Wilders was defeated by Europhile party VVD. Also, Comments by ECB board member Nowotny gave the euro a further filip. Economic data, however, was not too strong: German CPI and HICP remained steady at 2.2%; ZEW Survey measures for the German Current Situation and the Economic Sentiment both underperformed expectations; Euro area industrial production declined annually; Euro area headline inflation held at 2%, and core also remained at 0.9%. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 In its monetary policy statement yesterday the BoJ reiterated its commitment to maintain its policy rate at -0.1% and to keep its yield curve control program, which leaves the rate of 10-year JGBs around 0%. Furthermore, the BoJ also recognized one theme that we have highlighted before: Japanese economic activity is improving and inflation, although still very weak, is improving. Evidence can be found in recent data: Industrial production yearly growth increased by 3.7% in January relative to a 3.2% growth in December Labor cash earnings grew by 0.5% from a year ago, outperforming expectations. Given that rates are anchored and inflation continues to improve, real rates Japanese rates should fall vis-à-vis the rest of the world, putting downward pressure on the yen on a cyclical basis. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 The pound rallied following the monetary policy statement of the BoE justifying why policy rate was left unchanged. In fact, the hawkish tone was enhanced by the dissent of one member who favored hiking. Furthermore the BoE also stated that "if aggregate demand stays resilient, monetary policy may need to be tightened sooner and to a greater degree". How likely is it that aggregate demand will stay resilient (and consequently that the pound gains)? Recent data paints a mixed picture in the short term: Industrial production growth and manufacturing production growth came in at 3.2% and 2.7%, underperforming expectations. However unemployment decreased to 4.7% and the goods trade balance continued to improve, beating expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 AUD/USD gained more than 1.5% this week on the back of a weak greenback and strong Chinese data. Industrial production in China increased by 6.3% in January, more than expected. We think this strength is temporary and will pass shortly: Inflation expectations released by the Melbourne Institute decreased to 4%; Unemployment rate increased by 0.2% to 5.9%, underperforming expectations; Employment decreased by 6,400. Part-time employment decreased by 33,500, while full-time employment increased by 27,100. Although this is an overall net decrease in employment, this may imply a tightening labor market as the full-time market strengthens relative to the part-time one. However, it is still too soon to tell. Monitoring labor market developments is important as they provide an important outlook for wage, and thus inflation, developments. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 The NZD has been the worst performer amongst the commodity currencies so far in 2017. This has been in part due to disappointing economic data such as the recent GDP numbers which came below expectations at 2.7% yearly growth. However the central bank has also been responsible for the poor performance of the NZD as it has been much less hawkish than anticipated. The RBNZ blamed low tradable-goods inflation and a worsening current account caused by a strong NZD as the main reasons behind its neutral bias. However the central bank may be falling behind the curve. Food inflation now stands at 2.2%, while the current account continues to close faster than expectations. This means that inflation might reach its target much before the RBNZ late 2018 projection, which could lift kiwi rates and the NZD as markets begin doubting the RBNZ's resolve. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 After a period of weakness due to a dovish rhetoric by the BoC and the recent surprise surge in oil inventories, CAD has rebounded against the greenback on the back of the USD's broad weakness. Within Canada, upbeat data has also contributed to this strength as the labor market has shown some improvements recently: The net change in employment was recorded at 15,300, beating expectations of 2,500; Unemployment came in at 6.6%. These developments took place despite a mild decrease in participation rate, suggesting the decrease in the unemployment rate was mostly driven by a stronger employment sector. The improvement in employment has manifested across the board, with employment among prime-age women increasing by 1.7% and among men aged 55 and above also increasing. Importantly, part-time employment actually fell by 90,000 while full-time employment rose by 105,000, potentially indicating a tightening in the labor market. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Yesterday, the SNB left its policy rate unchanged at -0.75%. Furthermore, as we expected, it stood by its commitment to intervene in the franc as the central bank still consider that the franc is "significantly overvalued". At the moment, EUR/CHF has risen from the implied floor of 1.065 set by the SNB, thanks to the overwhelming victory by the Europhile green party in the Dutch elections. This will take some pressure off the SNB, which last week was accumulating reserves at the fastest pace since December 2014. On the inflation front, the SNB upgraded its short term forecast and downgraded their long term forecast. We will continue to monitor how inflation develops in comparison to the SNB's forecast, as here lies the key to judging whether a break from the peg is possible or not. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 After skyrocketing following the surprising increase in oil inventories last week, USD/NOK has come down to earth, thanks to this week's draw in oil stocks. Additionally, the fall in the U.S. dollar following the "dovish Fed hike" has also put downward pressure on USD/NOK. Overall, oil prices should provide a tailwind, for the NOK, particularly against other commodity currencies, as oil is set to outperform base metals given that supply cuts by OPEC will ultimately results in draws in inventory. The domestic situation paints a more bearish picture. Core inflation plummeted from 2.1% to 1.6% from last month. Moreover, Norway continues to have an output gap of -2.5% and a negative credit impulse. All of these factors should support the Norges Bank dovish bias in an environment of rising U.S. rates, lifting USD/NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The Krona strengthened across the board as inflation numbers came in stronger than previously: monthly CPI came in at 0.7%, up from -0.7%; and yearly CPI was recorded at 1.8%, close to the Riksbank's 2% target. With capacity utilization above its historical average and the Riksbank's Resource Utilization indicator being at pre-crisis levels, this indicates that the economy could soon hit its inflation target. The labor market's tightness is apparent due to the low supply of workers relative to demand. Mismatch in terms of the supply and demand of labor are likely to put upward pressure on a substantial share of wage earners as firms find it difficult to fulfill vacancies. While both short-term and long-term dynamics paint an inflationary picture, the Riksbank is likely to lean to the dovish side for the remainder of the year: The Swedish central bank wants to prevent any build-up of a deflationary mindset and wants to mitigate any external risks to the economy. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Charts 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less Determinant ##br##For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue To Expect Backwardation ##br##In Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. 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

Highlights The Fed's evident desire to lift its policy rate next week - presumably to get out ahead of inflation that has yet to show up in its preferred gauge - will weigh on gold. Oil ... not so much. This is because fundamentals once again are asserting themselves in the evolution of oil prices, something that has been evident even before markets balanced last year. Gold, meanwhile, remains exquisitely sensitive to Fed policy expectations and their effects on the USD and real rates, as with other currencies. Energy: Overweight. We are looking to re-establish our long WTI Dec/17 vs. short Dec/18 spread if it trades in contango again, i.e., if Dec/17 is less than Dec/18. We believe the combination of OPEC and non-OPEC adherence to their production Agreement will remain high, and demand likely will remain stout. Base Metals: Neutral. Spot copper is down ~ $0.10/lb on COMEX over the past week. We expect transitory supply issues in Chile and Indonesia to be resolved, and reflationary stimulus in China to wane going into the 19th National Congress of the Communist Party in the autumn, and, with it, copper demand. We remain neutral. Precious Metals: Neutral. Gold is weakening as the Fed's March meeting approaches next week, given the overwhelming expectation for a 25bp rate hike. We remain long volatility, expecting fiscal-policy uncertainty in the U.S. to be resolved over the next few months, and Fed policy drivers to become more focused. Ags/Softs: Underweight. We are not expecting significant changes in the USDA's estimates of stocks globally, and therefore remain underweight. Feature The choreographed messaging of voting and non-voting FOMC members asserting the need for a policy-rate hike over the past two weeks succeeded in pushing markets' expectations for such action to 88.6% as of Tuesday's close, up from 44.6% at the end of February. This despite the fact that the Fed's preferred inflation gauge - core PCE - has yet to show any sign of pushing up and thru the Fed's target of 2% growth yoy (Chart of the Week). Nor, for that matter, has core PCE shown any tendency to remain above 2% yoy growth over the past two decades (Chart 2). Chart of the WeekThe Fed's Preferred Inflation ##br##Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent Chart 2Core PCE Has Been ##br##Quiescent For Decades Core PCE Has Been Quiescent For Decades Core PCE Has Been Quiescent For Decades Between mid-December 2016 and the end of last month, gold prices rallied ~11.3% largely on the expectation the Fed would not raise rates until at least June, and, even then, would be constrained by uncertainty over what Congress and the Trump Administration would offer up in terms of fiscal policy later this year. Now, with the Fed succeeding in raising the market's expectation of a March rate hike, gold markets are left to re-calibrate the number of hikes to expect this year, and the likely implications for the USD and real rates. We believe the Fed will execute three rate hikes this year, but this will be highly dependent on how markets react to the now fully priced-in hike markets expect next week. Synchronized Growth, Inflation And Feedback Loops It is likely the Fed feels confident accelerating its rates normalization because, for the first time since the Global Financial crisis, we are getting a globally synchronized recovery in GDP. All else equal, this will give the U.S. central bank a bit of headroom to experiment with an earlier-than-expected rate hike. This synchronized growth also will provide a positive backdrop for commodity demand this year and next (Chart 3). The possibility of highly stimulative - or even just moderately stimulative - fiscal policy in the U.S. at a time when the economy is apparently at or close to full employment, will be positive for aggregate demand, and could be inflationary if its principal result is to lift real wages in the U.S. In addition to synchronized growth, we also are seeing evidence of synchronized inflation in the largest economies in the world (Chart 4). Chart 3Synchronized Global Growth ##br##Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Chart 4Synchronized Inflation Globally ##br##Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention This synchronized growth and inflation is, we believe, important to the Fed, in that its effects constitute something of a global feedback loop. As we have noted in earlier research, the Fed is much more sensitive to how its policy actions affect other economies, given the deepening of global supply chains over the past two decades or so. Equally, policymakers are well aware the evolution of monetary policy and economic growth in other economies affects the U.S. growth and policy variables important to the Fed.1 Absent a policy shock in the U.S., Europe or China, the backdrop for EM growth should remain positive for at least 2017, even with reflationary stimulus waning in China, a left-tail risk to commodity prices that we identified in last week's publication.2 We expect the Fed's policy normalization to be tempered by continued monetary accommodation globally, which will be supportive of growth at the margin. This will keep global oil demand growth on track to average 1.50 - 1.60mm b/d this year and next, and, importantly for inflation and inflation expectations, keep EM oil demand growing. The income elasticity of per-capita oil consumption in EM economies typically is ~ 1.0, meaning a 1% increase in EM incomes is associated with a 1% increase in EM oil demand.3 EM growth accounts for close to 85% of the growth we expect in global oil demand this year. This is important, given EM oil demand, which we proxy with the U.S. EIA's non-OECD oil consumption time series, to be a common factor that explains the evolution of the CPI series shown above (Chart 5). EM oil demand is able to explain the synchronization of inflation in the three largest economies in the world is because incremental growth is occurring in the EM economies, and this is driving global growth. We continue to expect high compliance in the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia at the end of last year, which will, against the backdrop of continued global growth, cause inventories to fall and for markets to backwardate. We believe last week's increase in U.S. crude oil inventories to be the last big build, and expect the decline to begin later this month. On average vessels leaving the Persian Gulf destined for the U.S. have a 45- to 50-day sailing period depending on multiple factors such route, weather and sea conditions. Therefore, the recent increase in U.S. crude oil inventories can be linked to the arrival of the final fleet of vessels in concert with the pre-OPEC agreement production surge undertaken by the GCC. Evidence of this phenomenon is apparent in the ~500k b/d increase in U.S. crude oil imports (374k b/d coming from Iraq) over the prior week. We expect OECD oil stocks to start declining this month and fall some 300mm bbl before the end of 2017. This supply-demand dynamic will continue to dominate financial-market influences on oil prices, as we argued in last week's publication (Chart 6).4 Gold, on the other hand, will continue to take its cue from Fed policy and policy expectations, particularly as regards expectations for the USD, which should strengthen at the margin, given the Fed's new-found hawkishness, and real rates, which also should strengthen (Chart 7). Chart 5EM Oil Demand Continues##br## To Drive Inflation EM Oil Demand Continues To Drive Inflation EM Oil Demand Continues To Drive Inflation Chart 6IF KSA And Russia Can ##br##Coordinate Production... IF KSA And Russia Can Coordinate Production... IF KSA And Russia Can Coordinate Production... Chart 7Gold Will Continue To Take##br## Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Bottom Line: Oil prices will continue to be dominated by supply-demand-inventory fundamentals, with monetary policy effects on the evolution of prices taking a secondary role. Gold prices will continue to take their cue from Fed policy and policy expectations. We look to re-establish our long Dec/17 WTI vs. short Dec/18 WTI spread if it trades thru flat (i.e., $0.00/bbl). Given our gold view, we remain long volatility via the put spreads and call spreads we recommended February 23 - i.e., long Jun/17 $1,200/oz puts vs. short $1,150/oz puts, and long $1,275/oz calls vs. short $1,325/oz calls. The position was up 15% as of Tuesday's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Global Inflation and Commodity Markets," dated August 11, 2016, and "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Gold's Known Unknowns, And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Oil consumption frequently is employed to approximate EM income growth, given the income elasticity of demand for oil is ~ 1.0, meaning a 1% increase in income (GDP) produces an increase in demand for oil of approximately 1.0%. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Days Of Oil Future's Past: Mean Reversion," dated March 2, 2017, 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

Highlights Substituting certain imports with local production will ensure that Russia's inflation rate will become less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy. This is on top of the counter-cyclical fiscal policy emerging from the new fiscal rule. Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Continue overweighting Russian stocks, ruble, local fixed-income and credit relative to their EM counterparts. A new trade: Go long the ruble and short crude oil. Feature Russian equities and the ruble have been high-beta bets on oil prices. While the positive correlation between crude prices and Russian financial markets is unlikely to change soon, the country's stock market and currency will likely become low-beta within the EM universe. Sound macro policies and some import substitutions will make inflation less sensitive to the exchange rate. As such, the central bank will not need to hike interest rates amid falling oil prices. The key point is that fiscal and monetary policies are becoming less pro-cyclical. This will reduce volatility in the real economy, which in turn will warrant a lower risk premium on Russian assets, particularly within the EM aggregates. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Both Europe and the U.S. have lost appetite for direct confrontation. And while some of the exuberance immediately following Trump's victory will wear off, the U.S. and Russia are unlikely to revisit the 2014 nadir in relations. Orthodox Macro Policies... Russia has adhered to orthodox macro policies amid a severe recession over the past two years: On the fiscal front: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart I-1). The fiscal deficit is still large at 3.8% of GDP, but it typically lags oil prices (Chart I-2). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $/bbl 40 Urals. Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel ($40 oil price times 67 USD/RUB exchange rate) and sell foreign exchange when the oil price is below that level (Chart I-3). Chart I-1Russia Has Undergone ##br##Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart I-2...Which Is Now Over ...Which Is Now Over ...Which Is Now Over Chart I-3Oil Price Threshold For ##br##The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. With respect to monetary policy, Russia's central bank has been highly prudent. Unlike many other emerging countries, the central bank has refrained from injecting liquidity into the banking system (Chart I-4) and has maintained high real interest rates (Chart I-4, bottom panel). Chart I-5 demonstrates that the central bank's domestic assets have been flat, while the same measure has surged for many other EM central banks. Although this measure does not reflect central banks' net liquidity injections, it in general validates that Russia's monetary authorities have been more conservative than their counterparts in many developing countries. This is ultimately positive for the currency. Chart I-4Russian Central Bank: ##br##Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Chart I-5Russian Central Bank Has Been ##br##Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Furthermore, the central bank has been forcing banks to acknowledge non-performing loans (Chart I-6, top panel) and has been reducing the number of dysfunctional banks by removing their licenses (Chart I-6, bottom panel). This assures that the credit system has already gone through a cleansing process, and a gradual credit recovery will commence soon. This is also in stark contrast with many other EM banking systems, where credit-to-GDP ratios continue to rise. In brief, Russia is advanced on the path of deleveraging (Chart I-7), while many EM countries have not even begun the process. Chart I-6Russian Central Bank Has ##br##Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Chart I-7Russia Is Very Advanced ##br##In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Bottom Line: The new fiscal rule will reduce fluctuations in the ruble. The central bank's ongoing tight policy stance will also put a floor under the ruble. Even though we expect oil prices to drop meaningfully in the months ahead, any ruble depreciation will be moderate. ... Plus Some Imports Substitution... The dramatic currency devaluation in 2014-15 and sanctions imposed on Russia by the West have led to the substitution of some imported goods with locally produced ones. First, the most visible import substitution has occurred in the agriculture sector. Chart I-8 suggests that in agriculture import substitution has been broad-based and significant. Second, while there has been some import substitution in the industrial sector, it has been less pronounced. Demand for industrial goods and non-staples (autos and furniture, for example) has plunged significantly. Hence, local production has also collapsed, but less so than imports (Chart I-9). Chart I-8Russia: Import ##br##Substitution In Agriculture Russia: Import Substitution In Agriculture Russia: Import Substitution In Agriculture Chart I-9Some Import ##br##Substitution In Manufacturing Some Import Substitution In Manufacturing Some Import Substitution In Manufacturing As domestic demand recovers, manufacturing production of industrial goods will increase. However, it is not clear how much of this demand recovery will be met by rising imports versus domestic production. On one hand, the ruble is not expensive, and argues for more import substitution going forward - i.e. relying more on domestic production rather than imports. On the other hand, Russia is hamstrung by a lack of manufacturing productive capacity, technology and know-how in many sectors to produce competitive products. FDI by multinational companies will likely rise from extremely low levels (Chart I-10), yet it is unlikely to be sufficient to make a major difference in terms of Russia's competitiveness. Third, the ruble depreciation has helped Russia increase oil and natural gas production (Chart I-11). Chart I-10Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Chart I-11Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Finally, in an attempt to lessen dependence on foreigners, Russian President Vladimir Putin has been pushing the use of domestic technology. For example, Microsoft products will be replaced by locally developed software. Bottom Line: The combination of currency depreciation and trade sanctions has led to some import substitution. ...Will Make Inflation Less Sensitive To The Currency Chart I-12Russia: Unit Labor ##br##Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed The collapse of the ruble has drastically reduced labor costs in Russia's manufacturing sector (Chart I-12). A diminished share of imports in domestic consumption - import substitution - will ensure Russia's inflation rate becomes less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs instead. Tame wages and some improvement in productivity - as output recovers - will cap Russian unit labor costs and restrain inflation in the medium term. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy - i.e., hike interest rates when oil prices drop and the ruble depreciates. Less pro-cyclical monetary and fiscal policies will diminish fluctuations in the economy, and economic visibility will improve. This bodes well for the nation's financial assets. We do not mean to suggest that the central bank of Russia will immediately pursue counter-cyclical monetary policy - i.e., that it will be able to cut interest rates when oil prices fall. While this would be ideal for the national economy, it is not a practical option for now. Bottom Line: Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. The Growth Outlook The Russian economy is about to exit recession (Chart I-13, top panel), but growth recovery will be timid: Bank loans will recover after pronounced contraction over the past two years. The credit impulse - the change in bank loan growth - has already turned positive (Chart I-13, bottom panel). Retail sales volumes and auto sales have not yet recovered but manufacturing output growth is already positive (Chart I-14). Rising nominal and real wages argue for a pick-up in consumer spending (Chart I-14, bottom panel). Capital spending has collapsed both in absolute terms and relative to GDP (Chart I-15). Such an underinvested position and potential recovery in consumer spending warrant a pickup in investment outlays. The key difference between Brazil and Russia - the two economies that plunged into deep recession in the past 2-3 years - is public debt load and sustainability. Chart I-13Russia: Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart I-14Russia: Economic Conditions Russia: Economic Conditions Russia: Economic Conditions Chart I-15Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue The public debt-to-GDP ratio is 77% in Brazil and 16% in Russia, while fiscal deficits are 9% and 3.8% of GDP, respectively. Public debt could spiral out of control in Brazil1 in the next two years, while it is not an issue in Russia. Bottom Line: Russia is about to embark on a mild and gradual economic recovery, even if oil prices relapse. Russia Is In A Geopolitical Sweet Spot Geopolitical headwinds will continue to abate for Russia. We expect that some of the loftiest expectations of a U.S.-Russia détente will fail to materialize as the Trump Administration continues to face domestic pressures. However, the 2014 nadir in relations will not be revisited. Meanwhile, Russia will benefit from several geopolitical tailwinds: The path of least resistance for tensions between Russia and the West is down. The Trump administration is highly unlikely to increase sanctions against Russia. Congress is likely to open an investigation into allegations of Russian interference in the 2016 U.S. election, but we highly doubt that any genuine "smoking guns" linking the Kremlin to the election result will be found. As such, we expect the thaw in U.S.-Russia relations to continue, albeit haltingly and without any possibility that the two powers become allies. Washington has recently removed sanctions related to U.S. tech exports to Russia. While U.S. sanction can be easily removed by presidential decree, EU sanctions require a unanimous vote on behalf of the European council. A summary can be found bellow. Table I-1 Russia: Entering A Lower-Beta Paradigm Russia: Entering A Lower-Beta Paradigm Putin's support remains high (Chart I-16), giving him a sense of confidence that modest structural reforms and economic opening is possible without undermining his support base. Military intervention in Syria has largely been a success, from Moscow's point of view. Chart I-16Popularity Of Putin And Government Popularity Of Putin And Government Popularity Of Putin And Government None of the current candidates in the upcoming elections in Europe are overtly anti-Russia. In France, leading candidate Emmanuel Macron is mildly hawkish on Russia, but the other two candidates - Marine Le Pen and François Fillon are downright Russophile. In Germany, the historically sympathetic to Russia Socialist Democratic Party (SPD) has taken a lead against Angela Merkel's ruling party. Even if Angela Merkel retains her Chancellorship, it is likely that the Grand Coalition would have to give the SPD a greater role given their dramatic rise in polling. Despite two major diplomatic incidents between Turkey and Russia,2 relations between the two countries continue to improve. In fact, the Turkstream project - which will connect Russia with Turkey via the Black Sea - has been approved by both sides. This is a positive development for the Russian energy sector as the capacity of that pipeline is large, standing at 63 Bn cubic meters per year. In Syria, the two countries have gone from outright hostility to coordinating their military operations on the ground, a dramatic reversal. The Rosneft IPO was a success, a positive sign for foreign investments in Russia. While the issuance was conducted for budget reasons, it is a sign that Russia is willing to open itself to foreign investors. The caveat being that it will only do so selectively. Further evidence of this selective opening is the recent announcement by the head of the Finance Ministry debt department that the next Eurobond auction will be conducted privately. Past investments from western firms in Russia failed due to the fact that a large number of Western oil companies were complacent in their investment analysis and failed to do due diligence.3 Furthermore, foreign investments in Russia have often failed because it was caught in the cross fire between the Kremlin and the various oligarchs who brought in the foreign investment.4 Given that President Vladimir Putin has largely neutered oligarchs, FDI that arrives in the country will have full blessing of the government. Finally, we would expect western energy companies to be more selective in their foreign investments given the recent crash in oil prices. As BCA's Geopolitical Strategy has been warning since 2014, globalization is in a structural decline and protectionism may follow. The Trump administration has threatened to use tariffs against both geopolitical adversaries, like China, and allies, like Germany. The border adjustment tax, proposed by Republicans in Congress, is a protectionist measure that could launch a global trade war.5 Due to the fact that Russia exports commodities, we would expect Russia's export revenue stream to be unaffected compared to countries who export more elastic goods such as consumer products. Bottom Line: We expect geopolitical dynamics to play in Russia's favor going forward. These will mark a structural shift in how foreign investment is conducted in Russia and risk assets will continue re-pricing. Investment Conclusions Chart I-17Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Russian stocks will outperform the EM equity benchmark in the months ahead (Chart I-17). Stay overweight. Typically, the Russian bourse has outperformed the EM index during risk-on phases and underperformed in risk-off episodes - i.e., Russia has been a high-beta market. This will likely change, and we expect Russia to outperform in a falling market. Also, maintain the long Russian stocks and ruble / short Malaysian stocks and ringgit trades. Continue overweighting Russian sovereign and corporate credit within the EM credit universe. Continue overweighing local currency bonds within EM domestic bond portfolios. A new trade: Go long the ruble and short oil. When oil prices drop, as BCA's Emerging Markets Strategy team expects to happen in the months ahead, the ruble might weaken too. However, adjusted for the carry, the aggregate long ruble/short oil position will prove profitable. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 14. 2 Turkey shot down a Russian Sukhoi Su-24 on November 24th 2015 and Andrei Karlov, the Russian ambassador to Turkey got shot dead by a Turkish police officer in Ankara on December 19th 2016. 3 The BP and TNK deal failed for obvious reasons. BP and TNK had already come in confrontation when in the mid-1990's BP had bought a 10 percent stake in Sidanco only to see TNK strip the company of its asset. Furthermore, TNK was involved in other mergers inside Russia, making extremely confusing to understand what assets it actually owned. 4 Putin's campaign to sideline Khodorkovsky and Berezovsky for example sometimes came at odds with foreign investment in Russia. 5 Please see BCA Geopolitical Strategy Special Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com.

Highlights Crude-oil fundamentals stand out among commodities because of the active efforts by critical producers to rein in supply since the end of last year. This can be seen in even-higher compliance with the production accord - a supply shock in many ways - negotiated by the Kingdom of Saudi Arabia (KSA) and Russia: Last month, Reuters estimated 94% compliance on the 1.2mm b/d in cuts pledged by OPEC states. We expect compliance to remain high, which will strengthen the divergence between oil prices and the USD, as markets look toward the upcoming summer driving season in the Northern Hemisphere. Active supply management and robust demand growth wrought by lower prices could continue to overwhelm a strong USD's influence on oil prices, if this Agreement becomes a durable modus operandi for KSA and Russia going forward. We give a high probability to this outcome, even as the Fed leans into its interest-rate normalization. Energy: Overweight. This past Thursday, we closed our long WTI Dec/17 vs. short Dec/18 backwardation spread at +$0.96/bbl (Dec/17 over); it was initiated February 9 at -$0.11/bbl (Dec/17 under), resulting in a 972.7% gain. We also closed our Dec/19 short WTI vs. long Brent spread, elected February 6 at +$0.07/bbl (WTI over) at -$1.17/bbl (WTI under), for a gain of 1,771.4%. Base Metals: Neutral. Any demand uptick for base metals' coming from U.S. fiscal stimulus will not hit markets until 2H18 at the earliest. We remain neutral. Precious Metals: Neutral. Based on last week's analysis, we are tactically long a Jun/17 gold put spread (long the $1200/oz put vs. short the $1150/oz puts) and call spread (long the $1275/oz call vs. short the $1325/oz calls) at a net debit of $21/oz. Ags/Softs: Underweight. The USDA expects continued demand from China to keep soybeans relatively well bid versus corn and wheat in the 2017/18 crop year. Total planted area for these crops is expected to be the lowest since 2011, keeping ending stocks flat to lower. Feature Prior to the end of the 1990s, crude-oil prices were, to use one of the most popular catch-phrases in finance, mean-reverting: The price of crude oil imported to the U.S. averaged just over $19/bbl from Mar/83, when WTI futures began trading, to 1999 (Chart of the Week). This meant WTI traded at ~ $20/bbl on average over that period. Prices were volatile, but pretty much returned to $20ish/bbl, which allowed traders to take a view on how soon prices would revert to their mean. Whenever prices were too far removed from that level, markets expected producers - OPEC mostly - to adjust output to meet current and expected demand conditions. Since roughly 2000 - maybe a little earlier - oil prices have followed a random walk.1 During this time, oil prices have been negatively correlated with the broad trade-weighted index (TWI) for the USD. One striking characteristic of oil prices and the USD TWI during this time is both followed random walks, which "like the walk of a drunken sailor, wanders indefinitely far, listing with the wind," to borrow Paul Samuelson's well-turned metaphor (Chart 2).2 Chart of the WeekOil's Past As Prelude: ##br##A Return To Mean Reversion? Oil's Past As Prelude: A Return To Mean Reversion? Oil's Past As Prelude: A Return To Mean Reversion? Chart 2Oil Prices And The USD Followed ##br##A Common Long-term Trend Until 1Q16 Oil Prices And The USD Followed A Common Long-term Trend Until 1Q16 Oil Prices And The USD Followed A Common Long-term Trend Until 1Q16 We believe this was caused by OPEC's decision to become a price-taker at the end of the 1990s - shortly after Dec/98 or thereabouts - after years of unsuccessfully trying to manage oil prices via production adjustments. After the price of oil imports in the U.S. dropped below $10/bbl (nominal), it appears the Cartel took the decision to respond to prices set by market forces (supply, demand, inventories and exchange rates), and to abandon its price-management efforts. The long-term correlation between oil and the USD was due to the fact that while oil prices and the USD followed random walks, they followed a common long-term trend as they wandered indefinitely about. This held up to the end of 1Q16, when a massive sell-off in risky-asset markets globally took oil prices below $30/bbl (Chart 3).3 This came on the heels of a price collapse brought about by OPEC's Nov/14 decision to launch a market-share war. By no means did this high correlation mean oil and the USD were always moving in lock step. The collapse in oil prices at the end of the last century led to a production-cutting agreement among OPEC states, Norway and Mexico, which lifted U.S. import prices from less than $10/bbl at the end of 1998 to $30/bbl by Nov/00. Likewise, export disruptions in Venezuela in 2002 - 2003 and, to a lesser extent, hurricane losses in the U.S. Gulf in 2005 sharply curtailed supply and lifted oil prices above what could have been expected given the USD's level at the time, as the Chart of the Week shows.4 End Of Oil's Random Walk? The price collapse of 1Q16 marked the bottom of the price move begun a few months prior to the Nov/14 market-share war declaration. The subsequent divergence between oil prices and the USD since then has been remarkable (Chart 4). The market-share strategy, which essentially allowed Cartel members to produce full-out and grab as much market share as possible, was engineered by KSA, and, we believe, initially was directed at undermining Iran's efforts to restore oil production lost to nuclear-related sanctions. From time to time, it also appeared OPEC was trying to retard the continued growth of shale-oil production in the U.S., which, by 2014, was increasing at an annual rate of more than 1mm b/d, enough to replace the entire output of Libya. Chart 3Close-up Of USD vs. ##br##Brent Divergence Close-Up Of USD Vs. Brent Divergence Close-Up Of USD Vs. Brent Divergence Chart 4The Divergence Between ##br##Oil Prices And The USD Is Remarkable The Divergence Between Oil Prices And The USD Is Remarkable The Divergence Between Oil Prices And The USD Is Remarkable This strategy was a complete failure. The price collapse that ensued brought KSA and Russia - both highly dependent on oil revenues - to the brink of financial ruin, compelling them to find a way to work together.5 After several false starts in 2016, they succeeded late in the year with a negotiated production cut. OPEC pledged to reduce output by as much as 1.2mm b/d, and non-OPEC producers agreed to cut output by close to 600k b/d, half of which is expected to come from Russia. Recent tallies by Reuters indicate 94% of the cuts from OPEC states that signed on to the deal have actually been realized.6 Should KSA and Russia find a way to coordinate their and their allies' production in a way that maintains the backwardation we expect later this year - the result of production cuts (Chart 5), and robust demand growth (Chart 6) - we could see oil prices become mean-reverting once again. Chart 5If KSA And Russia Can ##br##Coordinate Production ... If KSA And Russia Can Coordinate Production ... If KSA And Russia Can Coordinate Production ... Chart 6... And Demand Continues To Grow, ##br##The Oil-Price Backwardation Could Persist ... And Demand Continues To Grow, The Oil-Price Backwardation Could Persist ... And Demand Continues To Grow, The Oil-Price Backwardation Could Persist This likely requires the forward curves for WTI and Brent to remain backwardated, so as to moderate the growth in shale production, and for prices to remain between $55/bbl and $65/bbl, so as not to set off another shale boom. Gulf sources have indicated KSA prefers prices this year of ~ $60/bbl, which, we believe would allow it to keep some control over the rate at which shale production revives.7 Chart 7Supply Destruction And Robust Growth ##br##Rallied Oil Despite A Strong USD Supply Destruction And Robust Growth Rallied Oil Despite A Strong USD Supply Destruction And Robust Growth Rallied Oil Despite A Strong USD Investment Implications We are not calling for a return to mean-reversion in oil prices just yet. We are, however, highlighting the possibility for such a sea-change in the market if all the supply-side pieces fall into place - i.e., KSA, Russia and their respective allies find a way to work together to moderate U.S. shale-oil production. That said, we will be watching closely to see whether the KSA - Russia Agreement becomes a durable modus operandi in the oil market, particularly as regards the management of inventories and production in the market generally. If these states are able to keep prices ~ $60/bbl, and gain some control over the forward curve's slope - i.e., literally manage their production for backwardation - then there is a chance oil prices could once again become mean-reverting. In a mean-reverting world with backwardated oil prices, commodity-index exposure is favored, since investors would, once again, earn positive roll yields as the indices are rebalanced monthly in the underlying futures markets. Bottom Line: The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. Since then, the combination of supply destruction and robust demand growth has allowed oil prices to rally despite a strong USD (Chart 7). If KSA and Russia can continue to cooperate in their production-management deal - i.e., find a way to manage production so that prices remain closer to $60/bbl than not - and Brent and WTI forward curves backwardate, markets could once again become mean-reverting. In such a world, commodity-index exposures are favored - particularly those heavy on crude-oil and refined-products price exposure - for their positive roll yield. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Technically, oil prices have been I(1) variables (integrated of order 1) since about 2000, meaning they are mean-reverting in first differences (e.g., today's price minus yesterday's price). Please see Geman, Helyette (2007), "Mean Reversion Versus Random Walk in Oil and Natural Gas Prices," pp. 219 - 228, in Advances in Mathematical Finance. Haidar, Imad and Rodney C. Wolff (2011) obtained similar results, reporting crude prices were mean-reverting from Jan/86 - Jan/98, then random-walking since then; please see pp. 3 - 4 of "Forecasting Crude Oil Price (revisited)," presented at the 30th USAEE/IAEE North American Conference in Washington, D.C., during October 2011. Our own research corroborates these results - we find WTI and Brent were mean-reverting from Mar/83, when WTI futures started trading, to Mar/98; and were random-walking I(1) variables after that. 2 Please see Samuelson, Paul A. (1965), "Proof That Properly Anticipated Prices Fluctuate Randomly," in Industrial Management Review, 6:2. 3 This is to say, these variables were cointegrated, and could be expressed in a linear combination using an error-correction model. 4 Our colleague, Mathieu Savary, who runs BCA Research's Foreign Exchange Strategy, addressed these oil-USD divergences in "Party Like It's 1999," published November 25, 2016. It is available at fes.bcareseach.com. 5 We discuss this at length in the feature article of Commodity & Energy Strategy published September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." Both states were burning through cash reserves, and were trying tap foreign markets for additional funds by selling interests in their most valuable holdings - via the IPO of, and via the sale of just under 20% of Rosneft held by the Russian government. Russia placed its Rosneft shares late last year with Glencore and Qatar's sovereign wealth fund, while KSA is expected to IPO Aramco in late 2018. 6 Please see "OPEC compliance with oil curbs rises to 94 percent in February: Reuters survey," published by the news service online February 28, 2017. 7 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters online February 28, 2016. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016