China

Highlights Our leading indicator for China’s “old economy” remains weak, and the beneficial trade front-running effect that has supported some of China’s macro data over the past year is beginning to wane. Our "earnings recession" model for Chinese investable stocks suggests that a trade deal alone is not enough to prevent a contraction in earnings growth over the coming year. A meaningful rebound in credit relative to GDP would also be required, one that would retrace roughly 50% of the decline that has occurred since late-2017. An overweight cyclical stance (i.e. over a 6-12 month period) towards Chinese stocks versus their global peers remains premature. The equity market is conceptually supported until the beginning of March if trade talks continue to make progress, but will face (potentially severe) headwinds thereafter until credit durably accelerates at some point in the second half of the year. Feature China’s macro data remains at the forefront of investor attention, and December’s updates did not provide market participants with much comfort. Our leading indicator for China’s “old economy” deteriorated anew in December after a shallow three-month rise (Chart 1), driven by a currency-driven retracement in monetary conditions, as well as slowing growth in both M3 and adjusted total social financing (TSF). The flow of adjusted TSF relative to GDP technically ticked higher in December, but only because of a material slowdown in nominal GDP growth from 9.6% in Q3 to 8.1% in Q4 (Chart 2). This decline in nominal GDP means that it has retraced 70% of its rise from 2015 to 2017. Chart 1A Relapse In Our Leading Indicator For China's Old Economy Chart 2A 70% Retracement In Chinese Nominal GDP Growth On the housing front, sales volume growth ticked slightly higher but remains negative (and well below the pace of construction growth), and pledged supplementary lending from the PBOC, a factor that we have identified as a core driver of China’s housing market since 2015,1 decelerated further. Finally, December’s trade data was uniformly negative, with import and export growth decelerating 6-7 percentage points even on a smoothed basis, depending on whether measured in U.S. dollars or local currency. Revisiting The Measurement Of China’s “Old Economy” One notable exception to the weak data was the Bloomberg Li Keqiang index (LKI) itself, which rose from 8.4 in November to 9.3 in December. Our alternative LKI rose to exactly the same level, closing the gap with Bloomberg’s measure that had existed earlier this year (Chart 3). Chart 3Our Coincident Measures Of The Old Economy Are Trending Higher... In fact, the LKI has been providing a different message than our LKI leading indicator for several months, and the apparent uptrend in the series raises the question of whether the Chinese economy is actually strengthening rather than weakening. With high conviction, our answer to this question is no. As we have highlighted in previous reports, our view is that the gap can be explained by the (anomalous and only temporary) positive impact that the trade war has had on economic activity since March last year, as Chinese exporters rushed to front-load the production and shipment of goods to the U.S. in advance of the imposition of tariffs. Panel 1 of Chart 4 makes this point explicitly, by showing the percentile rank of the two most cyclical components of the LKI. From 2010 to early-2018, electricity production and railway freight volume moved closely together, with the former leading the latter somewhat from 2017 to early-2018. While the trade war-driven bounce in electricity production has since rolled off, railway cargo volume remains elevated and is only now rolling over. December’s extremely poor trade data suggests that a material further decline is likely in Q1 of this year. Chart 4...Because Of A (Temporarily) Beneficial Trade War Effect Panel 2 shows that bank lending, the third component of the LKI, has begun to pick up over the past few months. However, this reflects, at least in part, the goal of policymakers to shrink the size of shadow banking in the economy and reorient the provision of credit back to traditional financial institutions (Chart 5). A sustainable rise in bank loan growth that overwhelms a shrinking shadow banking sector will almost certainly show up in our preferred measure of aggregate credit growth (adjusted total social financing), which for now remains in a clear downtrend. From a bigger picture perspective, it is worth revisiting why we focus on the LKI at all. Our use of the index to represent China’s investment-relevant economic activity dates back to a November 2017 Special Report,2 in which we noted that it correlated well with China’s nominal import growth and led the growth in earnings for the MSCI China index ex-technology. Real GDP growth, by contrast, has shown barely any cyclicality over the past four years in the face of large changes in Chinese import growth and the prices of China-related assets (Chart 6). This underscores that aggregate Chinese real GDP is not, by and large, investment-relevant. Chart 5A Stunning Collapse In Shadow Banking Activity Chart 6Chinese Real GDP Growth Is Not Relevant For Investors What can we infer about the trend in China’s old economy if the LKI is combined with other closely correlated measures of investment-relevant economic activity? Panel 1 of Chart 7 answers this question by presenting the standardized LKI alongside standardized nominal import growth and nominal manufacturing output, the measure of Chinese coincident activity preferred by BCA’s Emerging Markets Strategy service. Panel 2 of the chart shows an equally-weighted average of all three measures alongside our leading indicator for the LKI. We note four key observations from Chart 7: Chart 7China's Investment-Relevant Economic Activity Is Trending Lower Since 2010, the primary trend in the LKI, nominal import growth, and nominal manufacturing output has been the same The modest uptrend in the LKI since early-2018 is not corroborated by imports or manufacturing output Economic activity in China has been stronger over the past year than our leading indicator would have suggested, even after abstracting from the anomalous uptrend in the LKI The gap between our leading indicator and China’s actual economic activity is now beginning to close. These observations support the conclusion that we reached when analyzing the components of the LKI itself: a temporary boost from trade front-running has masked an underlying slowdown over the past year. But this boost has now begun to wane, implying that actual activity will continue to slow in the coming months. Is A Trade Deal Enough To Prevent An Earnings Contraction? While most global investors would acknowledge that China’s domestic economy is slowing, the performance of China-related assets over the past year highlights that the market views the trade war with the U.S. as being at least equally important as slowing Chinese money & credit growth. Chart 8 highlights that our market-based China growth indicator did not break down until the second quarter of 2018, when the threat of tariffs from the Trump administration became a reality. The indicator’s prior resilience was in contrast to a steady deterioration in our LKI leading indicator, which peaked at the beginning of 2017. Chart 8Investors Are Largely Focused On The U.S./China Trade War The surge in the indicator since early-December underscores that investor expectations of a trade deal with the U.S. have materially improved sentiment about China’s growth profile, despite the fact that Chinese money & credit growth have yet to meaningfully improve. Given that our geopolitical strategy team assigns odds as high as 45% of a framework deal emerging by the March 1 deadline,3 how can investors gauge the net impact of an improving external outlook and still-weak domestic demand? Chart 9 illustrates one method of approaching this question, using a model of Chinese investable earnings growth that we introduced in our January 16 Special Report.4 The model is designed to predict the likelihood of a serious investable earnings contraction over the coming 12-months, and includes data on credit, trade, and forward earnings momentum as predictors. The chart shows what would have to happen to the flow of adjusted total social financing as a share of GDP in a trade deal scenario, calibrated in a way that the odds of a major earnings contraction fall to 33% (the highest historical reading of the model that did not correspond to a major earnings decline). Chart 9A Trade Deal Is Not Enough To Avoid An Earnings Recession In China The chart shows that a meaningful rebound in credit flow to GDP would be required, one that would retrace roughly 50% of the decline that has occurred since late-2017. In short, our analysis shows that a trade deal alone is likely not enough to prevent a contraction in Chinese earnings growth over the coming year. Importantly, Chart 10 shows what this would imply for the volume of credit that would need to be created over the coming several months in order for the scenario shown in Chart 9 to come to pass (assuming an 8% growth rate in nominal GDP). The chart highlights that China would need to create approximately RMB 26 trillion in new credit over the coming 12 months (nearly US$ 4 trillion at current exchange rates), which would exceed the prior high set in late-2017 by a non-trivial amount. While this goal looks on its way to being achieved based on a 6-month annualized rate of change (panel 2), this largely reflects a one-month surge in local government bond issuance in September. Over the past 3-months, the annualized pace of credit creation has fallen well below the RMB 26 trillion mark, implying that either traditional credit growth, shadow credit, or local government bond issuance will have to pick up significantly over the coming several months in order for the domestic demand situation to stabilize. We expect this to occur, but it has not occurred yet. Chart 10China Needs To Create 26 Trillion RMB In Credit In 2019 Investment Conclusions The key conclusion of our analysis above is that an overweight cyclical stance (i.e. over a 6-12 month period) towards Chinese stocks versus their global peers remains premature. We noted in our December 5 weekly report that a tactical (0-3 month) overweight was probably warranted due to the prospect of a framework trade deal with the U.S. on March 1, but Chart 9 makes it clear that an improving external demand outlook is not a sufficient basis to expect that Chinese stocks will avoid an earnings recession. In this regard, investors should conceptualize the absence of a significant pickup in the volume of credit as a “gap” in a bridge representing the market support for Chinese stocks over the course of the calendar year (Chart 11). Assuming leaks from the negotiations continue and are consistent with the agreement of a framework deal, the market is conceptually supported until the beginning of March. However, following March 1, a gap in support emerges until credit durably accelerates at some point in the second half of the year. In our view, investors who go long Chinese stocks today with a 6-12 month time horizon are betting not only on the success of trade negotiations, but that this gap will close by the time that a deal is announced. This is a risky gamble given the still-relevant desire of policymakers to avoid another major credit overshoot, and as such our cyclical recommendation remains unchanged: wait. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Special Report “China's Property Market: Where Will It Go From Here?”, dated September 13, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report “The Data Lab: Testing The Predictability Of China's Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see Geopolitical Strategy and China Investment Strategy Special Report “Is China Already Isolated?”, dated January 23, 2019, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks”, dated January 16, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Dear Client, I will be meeting clients in Europe next week. Instead of our usual weekly bulletin, I will be sending you a Special Report discussing how “The Most Important Trend In The World” – a trend that has been around for thousands of years and accounts for all of the economic growth the world has ever experienced – has recently reversed, and what this means for your investment decisions. This is one report you will not want to miss. Best regards, Peter Berezin, Chief Global Strategist Highlights China’s debt problem is a symptom of a deeper ailment: The country’s excessively high saving rate. While the authorities are taking steps to boost consumption, this is likely to be a drawn-out process. In the meantime, the economy will have to continue recycling savings into fixed-asset investment. Now that credit growth has fallen close to nominal GDP growth, the need to further suppress credit growth has abated. The 6-month credit impulse is already moving higher, and the 12-month impulse should follow suit by the middle of the year. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. Feature Global Growth Worries Weigh On Risk Sentiment Global growth is clearly slowing (Chart 1). Our tactical MacroQuant model, which did an exemplary job of flagging the Q4 selloff in stocks, is flashing amber again, after having turned more constructive in late December (Chart 2). Chart 1Growth Is Slowing   As we discussed last week, the world economy should stabilize by mid-year, paving the way for global equities to rise further from current levels.1 Until then, volatility will remain elevated. Many factors will influence the trajectory of global growth over next 12 months, but perhaps none more important than what happens to China. In this week’s report, we focus on one of the most critical problems facing the Chinese economy – a problem that surprisingly gets very little attention from market participants. China’s Savings Problem Saving is usually considered a virtue. At the individual level, that is certainly true. However, at the economy-wide level, saving can be a vice if it leads to a shortfall of spending, resulting in higher unemployment. This is precisely the problem that China confronts today. Simply put, the country consumes too little of what it produces. The result is a national saving rate of 45% of GDP, higher than any other major economy in the world (Chart 3). Chart 3China Saves A Lot The reasons for China’s high saving rate are long and varied. Just as the Great Depression instilled a sense of thrift among Americans who came of age in the 1930s, memories of the abject poverty that many older Chinese citizens endured during the Cultural Revolution have restrained the desire to spend needlessly. While the younger generation is more willing to live it up, it also faces severe constraints to spending more. The labor market remains challenging, even for those with a university degree. Sky-high property prices require young people to save a large fraction of their incomes in order to have any hope of owning a home. Looking out, there is little reason to expect China’s saving rate to fall rapidly. While the number of people entering retirement is steadily increasing, the share of the population in their prime savings years – ages 30-to-59 – has yet to peak (Chart 4). Chart 4China: Share Of Population In Its High Savings Years Has Yet To Peak In addition, an increasingly skewed male-female sex ratio has created an "arms race" of sorts among Chinese bachelors hoping to accumulate enough wealth to find a bride. One academic study concluded that this factor accounts for half of the increase in the household saving rate since the late-1970s.2 Unfortunately, China’s gender imbalance is only likely to worsen, given that the ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 – a proxy for gender imbalances in the marriage market – is projected to rise from 1.06 in 2011 to 1.34 by the middle of the next decade (Chart 5). Chart 5Not Enough Chinese Brides What To Do With Excess Savings? By definition, a country’s savings are either recycled into domestic investment or exported abroad via a current account surplus. The latter strategy served China well in the years leading up to the Great Recession, when the country’s current account surplus reached a whopping 10% of GDP (Chart 6). Just like Germany today, China was able to export its excess production with the help of a highly undervalued currency. Chart 6China: No Longer Exporting Savings Abroad Unfortunately for China, as its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being singled out by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment (see Box 1). This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded (Chart 7). Chart 7China: From Exporting Savings To Investing Domestically (And Building Up Debt) This strategy was feasible when China did not have a lot of debt and needed more factories, housing, and public infrastructure. But those days are long gone. The rate of return on assets among state-owned enterprises has now fallen below their borrowing costs (Chart 8). Our EM team estimates that 15%-to-20% of apartments in China are sitting vacant.3 Chart 8Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs How To Boost Consumption There is only one long-term solution to China’s excess savings problem: Tackle it head-on by taking steps to increase consumption. The good news is that there is some scope to do so. The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 9). A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply since the 1980s (Chart 10). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 10China: Inequality Has Risen In The Past Two Decades As a share of GDP, public-sector spending in China on education, health care, and pensions is close to half of the OECD average (Chart 11). If the government were to finance the increase in social spending by running larger budget deficits, this would help reduce overall national savings both by increasing the budget deficit and by discouraging precautionary household savings. Unlike in most countries, the poor in China are net savers, largely because they cannot rely on a publicly-funded social safety net (Chart 12). Recent tax changes, including an increase in the threshold at which income begins to be taxed and an expansion of deductions for childhood education, medical costs, and home loan interest and rent, are steps in the right direction. More Financial Repression? Over a longer-term horizon, the Chinese authorities are also likely to step up efforts to discourage savings by driving down real interest rates into negative territory. Since nominal interest rates are already low in China, the only way to reduce real rates is to raise inflation. The added benefit of higher inflation is that it would boost nominal GDP growth, thus putting downward pressure on the debt-to-GDP ratio. The catch is that negative real rates could destabilize the currency, fueling capital outflows. Negative real rates could also inflate asset bubbles, especially in the property market. The only way to square the circle is to tighten administrative controls, such as those relating to property speculation and capital flows, in order to preserve the benefits of negative real rates, while attenuating the costs. This suggests that hopes that the RMB will become an international reserve currency anytime soon are likely to be dashed. China Will Continue To Back Off From Its Deleveraging Campaign Realistically, the measures to boost consumption listed above will take time to implement. In the meantime, China’s economy continues to slow. Not only does a weaker economy endanger domestic stability, it also puts the Chinese government in a weaker negotiating position with the Trump administration over trade matters. This suggests that the government will continue to ease off its deleveraging campaign at least until growth recovers. Granted, one could have said the same thing last year. That is correct, but here is the thing: last year, credit growth was running at a much faster pace than today. Total social financing increased by only 11% year-over-year in December, not much higher than trend nominal GDP growth. On all three occasions over the past ten years when credit growth has fallen back towards nominal GDP growth, the government has allowed credit growth to accelerate (Chart 13). Chart 13China: Credit Growth Versus GDP Growth We do not expect growth to surge this time around. However, if monthly credit growth simply stabilizes at current levels, the credit impulse, which is just the change in credit growth, will turn positive. Chart 14 shows that the 6-month impulse is already moving higher. The 12-month impulse is still trending down, but if credit growth remains constant at its current pace, it will start hooking up this summer (Chart 15). Chart 14Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals   Chart 15The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes Importantly, the Li Keqiang index, a broad real-time measure of economic growth in China, is highly correlated with the 12-month credit impulse. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. My colleague, Arthur Budaghyan, BCA’s chief emerging markets strategist, remains bearish on EM equities in both relative and absolute terms. While this publication does not have a strong view on the relative performance of EM versus DM shares, we do expect EM stocks to rise in absolute terms over the remainder of the year. Accordingly, we sold our March-2019 EEM put on January 3rd for a gain of 104%, and are now outright long the ETF as one of our recommended trades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   BOX 1 Do Banks Create Money Out Of “Thin Air”? Strictly speaking, banks can create deposits by issuing new loans without the need for economic savings (which economists define as the difference between what an economy produces and consumes). In that sense, banks can create money out of “thin air.” However, this does not mean, as is sometimes claimed, that economic savings are irrelevant to credit creation or that there is no effective limit on the volume of loans that banks can originate. Even if one ignores the presence of legal capital requirements, the public must still be willing to hold whatever deposits banks create. Just like the number of apples a society wishes to consume is simultaneously determined by the number of apples farmers wish to produce and the number of apples people wish to eat (with the price of apples equilibrating supply and demand), the answer to the question of whether loans create deposits or deposits create loans is always “both.” The aggregate volume of deposits that people wish to hold depends, among other things, on the level and distribution of net worth across society, as well as the rate of return that bank deposits offer compared to competing financial instruments (including cash, which pays nothing). A country’s net worth tends to be closely correlated with the value of its capital stock. Both are mainly determined by accumulated economic savings. Real interest rates are also largely determined by economic savings, especially at the global level, where rates adjust to ensure that world savings equals investment. The distribution of savings also matters. When some people wish to spend more than they earn, while others wish to do the opposite, debt levels will rise. The same is true for individual sectors of the economy. If there are some sectors that save a lot (such as households in China) and other sectors that borrow a lot (Chinese state-owned companies and local governments), debt levels will go up. Debt levels will also rise when people purchase assets using credit. Fresh economic savings are not necessary to finance the purchase of existing assets, but with the exception of undeveloped land and natural resources, economic savings are needed to create those assets (such as when a home is constructed or a factory is built). In China, a perfect trifecta of sky-high property prices, a high and uneven distribution of savings throughout the economy, and a financial sector that has been willing to intermediate savings without much regard for credit quality, have all contributed to the elevated debt levels we see today. Footnotes 1      Please see Global Investment Strategy Weekly Report, "Patient Jay," dated January 18, 2019. 2      Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 3      Please see Emerging Markets Strategy Special Report, “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

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