Energy

Highlights The COVID-19-induced demand shock in China – and a stronger USD – will reduce growth in global crude oil consumption to just over 1mm b/d this year, vs. earlier expectations of ~ 1.4mm b/d. Significant fiscal and monetary stimulus from China will be required to put economic growth back on track over the critical 2020-21 interval. An accommodative monetary-policy backdrop globally also will support demand. On the supply side, OPEC 2.0 likely will cut output by an additional 600k b/d in 2Q20, which will remove 2.3mm b/d off member states’ official quotas. For 2H20, we expect the coalition to revert to its 1.7mm b/d in cuts to keep markets balanced. US shale-oil output growth will continue to slow under market-imposed capital discipline. We are revising our baseline price forecasts in 2020 lower to $62/bbl and $58/bbl for Brent and WTI, respectively (Chart of the Week). This is down $5/bbl vs our previous forecast. Price risk is to the upside, however. 2021 Brent and WTI forecasts remain at $70/bbl and $66/bbl, respectively, as we do not expect long-lived demand destruction from the COVID-19 outbreak. A growing consensus around policy stimulus and production cuts makes us leery. Feature Chart of the WeekCOVID-19 Knocks Oil Forecasts Lower COVID-19 continues to hammer Chinese oil demand, forcing refiners there to drastically reduce output. This crude oil is ending up in inventories, but, so far at least, overall storage capacity in China is not being maxed out by the unintended accumulations of crude and product inventories. Data are difficult to come by, but there are a few observations that provide some insight into the state of the refining market in China as the COVID-19 episode unfolds. Platt’s reported independent refiners in Shandong Province, which has ~ 3.4mm b/d of refining capacity, cut runs to a four-year low of ~ 40% of capacity this month, down from a January rate of 63.5%. Shandong refiners represent 50%-60% of China’s independent refining capacity.1 We estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. Ursa Space Systems’ radar satellite monitoring of inventories close to coastal refineries indicated Chinese oil storage at the beginning of the month was at 60% of capacity.2 This figure likely is higher, given refinery runs remain low, but it does not yet suggest storage capacity in China will be exhausted in the near future. In our modeling of the COVID-19 impact on oil demand, we estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. This leads us to believe EM oil demand will increase by 1mm b/d this year, down from our earlier expectation of 1.26mm b/d pre-COVID-19. For DM economies, demand growth also will disappoint, revised down by 100k b/d on the back of a warmer-than-expected winter and stop-and-go growth in manufacturing induced by COVID-19. Policy Stimulus Will Revive Chinese Demand The COVID-19 outbreak will result in a significant hit to China’s GDP, which will require substantial stimulus to put growth back on a 6% p.a. track this year. This growth rate is required for the Chinese Communist Party (CCP) to deliver on its pledge to double GDP and per-capita income over 2010-20, a pledge that was memorialized in writing following the Party’s 2012 Congress. In addition, next year marks the 100th anniversary of the founding of the CCP, and, we believe, it is an all-but-foregone conclusion the Party’s leadership will not want a faltering economy on display as it celebrates this important milestone. Given these considerations, the possibility policymakers will over-stimulate the economy to get it back on track is a non-trivial upside risk.3 We do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. Our baseline 2020 forecast envisions prices will falter somewhat versus our previous expectation – with Brent averaging $62/bbl this year, and WTI trading $4/bbl below that, vs. $67/bbl and $63/bbl previously. We are mindful of the impact Chinese policy stimulus can have on the global oil markets. The effects on GDP growth following demand shocks of past stimulus can be seen in the response of China’s GDP following the 2003 SARS outbreak; the 2008-09 GFC; the 2011-12 eurozone debt crisis; and even in China’s 2015-16 slowdown (Chart 2). For this reason, we do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. And it is for this reason that we believe price risk tilts to the upside this year. Our updated Ensemble price forecast includes two additional demand-side simulations to assess its sensitivity to changes in EM oil demand: Chart 2Chinese Stimulus Will Support Oil Demand Higher EM demand scenario (20% weight): We model the impact of the coronavirus as short-lived, with only a temporary impact on China’s economy. Consumer demand and industrial production in China converge to pre-COVID-19 levels rapidly in 2H20. Chinese policymakers overstimulate in 2Q20, over fears the virus could have severe long-term consequences on the economy. This scenario assumes EM demand increases by 100k b/d vs. our base case in 2020 and 2021. Lower EM demand scenario (10% weight): We model the impact of the coronavirus as a severe and long-lasting event. This triggers a negative feedback loop for EM oil demand; collapsing demand forces production lower, which reduces employment and pushes demand further down. This reverberates to other EM economies and affects global supply chains. This scenario assumes EM demand decreases by 240k b/d in 2020 and returns to our base case in 2021, supported by China stimulus. Oil-Demand Reduction (Not Destruction) The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). The COVID-19 outbreak in China caused us to reduce our expectation for global oil demand growth by ~ 360k b/d, taking 2020 year-on-year growth to ~ 1.04mm b/d, versus our earlier expectation of 1.4mm b/d. The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). Dollar strength produces a headwind for EM GDP growth, which suppresses oil-demand growth. The combination of the COVID-19-induced demand reduction and the stronger USD TWIB likely will compel OPEC 2.0 to maintain its production discipline until the global policy uncertainty abates and the USD TWIB retreats. Such a reversal in trend would become a tailwind for commodity demand (Chart 3). Chart 3Global Economic Uncertainty Keeps A Bid Under USD TWIB Global supply growth will continue to be constrained by demands from investors to return capital to shareholders. We expect the hit to global demand to be offset by increased production cuts from OPEC 2.0, which will be agreed next month. OPEC 2.0 production also will be impacted by continued output losses in Iran and Venezuela, which have seen y/y production fall by ~ 1.8mm b/d in 2019. Global supply growth will continue to be constrained by demands from investors to return capital to shareholders – via stock buybacks – and for steady and increasing dividends to make their equity competitive with alternative sectors (e.g., tech). These capital-market pressures – in addition to growing pressure from Environmental, Social and Governance (ESG) investors – will continue to have a profound effect on capital availability for oil and gas E+P companies for decades to come. This is a theme we will return to often in future research. We summarize these supply-demand dynamics in Chart 4. For OPEC 2.0, the 1.7mm b/d reduction in output the coalition agreed for 1Q20 remains in place, as do losses from Iran and Venezuela. For 2Q20, we assume the coalition adds another 600k b/d of production cuts. After that, we assume OPEC 2.0 reverts to its earlier production cuts of 1.7mm b/d for 2H20. In 2021, we assume OPEC 2.0 takes production cuts back down to 1.2mm b/d in January 2021, then gradually increases its production over 1H21 to balance the market and to avoid spiking prices. We also expect the Kingdom of Saudi Arabia (KSA) to remove 300k b/d of overcompliance next year, as markets tighten. In 2H21, we see OPEC 2.0 production levels remaining flat at ~ 44.8mm b/d (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4Supply-Demand Balances Chart 5Global Oil Inventories Will Resume Drawing For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. For the US, we reduced our Lower 48 production assumptions, and now have 740k b/d growth in 2020 and 300k b/d in 2021. Shales account for almost all of this increase. We also include a scenario in which US production comes in lower in our ensemble forecast. These fundamentals combine to put global oil inventories back on a downward trajectory in 2H20 (Chart 5). That said, there is an important caveat going into 2H20: If the US Economic Policy Uncertainty Index starts rising in 2H20 on the back of US election risks, markets will continue to price in a stronger USD in 2020 vs. what we now expect. For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. Odds favor a return to the pre-COVID-19 price trajectory for oil next year, with continued upside risk from Chinese fiscal and monetary stimulus, and a globally accommodative monetary-policy backdrop. Higher Spare Capacity Reduces Risk Premium The market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. The risk premium in oil prices evaporated following the drop in demand and the increase in spare capacity due to the large OPEC 2.0 cuts. When China’s economy resumes its normal activity, demand will pick up and the market will balance, increasing the impact of possible supply disruptions. However, the market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. In addition, if production capacity of ~ 300k-500k b/d in the Neutral Zone shared by KSA and Kuwait is restored, the risk premium could drop even lower, given this production is expected to be retained as spare capacity. If this is the case we could have lower prices in 2020 vs. our current forecast (down to ~ $60/bbl). We will be exploring the changes in OPEC 2.0 spare capacity and the consequences for overall production in future research. Bottom Line: Assisted by Chinese policy stimulus, oil demand will recover this year from the COVID-19-induced demand shock. On the supply side, the combination of deeper OPEC 2.0 production cuts – which we expect will be settled at the upcoming March meeting – and capital-market-imposed reduction in US oil production will push oil markets to a supply deficit. The ongoing demand shock forces us to reduce our 2020 Brent price forecast to $62/bbl from $67/bbl previously. For 2021, we maintain our $70/bbl target. Risks to our view are mounting. Three crucial pieces to our 2020 and 2021 expectations remain uncertain: The duration and magnitude of the impact of the coronavirus shock, The level of production cuts by OPEC 2.0 and the degree of compliance by all members, and The trajectory of the US dollar – if global economic policy uncertainty remains elevated the USD could remain well bid, which would continue to pressure EM GDP growth – and commodity demand – at the margin. Our base case remains that prices will rise from here, but our conviction level is slightly lower. One reason for this is the apparent consensus emerging around the likelihood of Chinese stimulus and OPEC 2.0 production cuts. If either of these assumptions prove wrong, oil prices likely would move lower.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight As of Tuesday’s close, Brent prices were up 8% from their Feb 10 low of $53.27/bbl, supported by receding COVID-19 fears and rising expectations OPEC 2.0 will deepen its production cuts at its March meeting. Earlier this week, oil prices received an additional lift from the newly-imposed US sanctions on Rosneft Trading SA – a subsidiary of Russia’s state-own company – for its activities with Venezuela’s PDVSA. Rosneft Trading intensified its involvement in Venezuela’s oil sector and now handles the majority of the country’s crude exports, providing vital support to the Maduro government. The US restrictions include a 90-day wind-down period for companies to end their activities with Rosneft Trading. Base Metals: Neutral Chinese steel consumption – which accounts for ~50% of global demand – has been hit hard by the coronavirus outbreak. Steel and iron ore prices in China plunged 11% and 3% YTD (Chart 6). Steel mills’ inventories increased to record levels, reaching full capacity. Mills are now forced to export their surplus at reduced prices – flooding seaborne steel markets – or to cut output. Accordingly, more than 33% of steel mills are considering cutting steel production, according to a recent Platts survey. Margins at producing mills are declining and could harm high-grade iron ore prices. This is a short-term risk to our view. Precious Metals: Neutral Gold prices surged past $1,600/oz on Tuesday – overlooking positive manufacturing data in the US. Silver shadowed gold’s movement, closing at $18.13/oz. Precious metals are bought as insurance against risks of a wider-than-expected spread of the coronavirus and should remain well bid until uncertainty dissipates. Gold is somewhat overbought based on sentiment, momentum and technical indicators (Chart 7). If, as we expect, the daily increase in confirmed cases ex-Hubei slows meaningfully over the coming months, gold and silver prices will lose some steam. Ags/Softs:  Underweight CBOT March wheat futures surged 4.4% on Tuesday after Australia’s government sharply lowered its estimate of the country’s wheat harvest as severe drought affected crops. The Australian agricultural agency said the crop totaled 15.17 mm MT, the lowest since 2008, paving the way for stronger US exports. Corn also moved higher, with the prompt contract gaining 1.26% on the back of a new round of Chinese tariff exemptions on US goods. A USDA report showed US soybean export inspections bound for China were still half of last year's volumes. Soybeans futures closed 1.25 cents lower at $8.915/bu as markets await large Chinese purchases of US soybeans. Chart 6Increasing Inventories Pressure Steel and Iron ore Prices Chart 7Gold Technical Indicators Signal Overbought Market     footnotes 1     Please see China's Shandong independent refiners cut run rates to 4-year low of 40% in Feb, published by S&P Global Platts February 13, 2020. 2     Please see Oil demand falls on coronavirus: how much will inventories rise? posted by Ursa Space Systems February 7, 2020. 3     Please see Iron Ore, Steel Poised For Rally, published January 13, 2020, for a discussion of the significance of 2020 vis-à-vis the Communist Party’s pledge to double GDP and per-capita income vs. 2010 levels, memorialized by the CCP at its 2012 Peoples Congress.  We also discuss the 100th anniversary of the Party’s founding next year, which also will be a significant milestone for the CCP – and another reason the Party will not want the Chinese economy faltering as it is celebrated.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Special Report

Highlights Geopolitical sparks in the Mediterranean point to the revival of realism or realpolitik in places where it has long been dormant. Europe is wary of Russia but will keep buying more of its natural gas. This will be a source of tension with the United States. Turkey is wary of Russia but will continue choosing pragmatic deals with Moscow that fly in the face of Europe and the United States. Turkey’s intervention in Libya is small but symbolic. Increases in foreign policy aggressiveness are negative signs for Turkey as they stem from domestic economic and political instability. Short Turkish currency, equities, and local government bonds. The recent increase in immigration into Europe will fuel another bout of populism if it goes unchecked. Feature “Multipolarity,” or competition among multiple powerful nations, is our overarching geopolitical theme at BCA Research. The collapse of the Soviet Union did not lead to the United States establishing a global empire, which might in theory have provided a stable and predictable trade and investment regime. The United States lashed out when attacked but otherwise became consumed by internal struggles: financial crisis and political polarization. Under two administrations the American public has demanded a reduced commitment to international affairs. Europe is even less likely to project power abroad – particularly after being thrown on the defensive by the Syrian and Libyan revolutions and ineffectual EU responses. Turkey’s aggressive foreign policy is a symptom of global multipolarity – which makes the world less predictable for investors. Emerging markets have risen in economic and military power relative to their developed counterparts. They demand a redistribution of global political power to set aright historical grievances and address immediate concerns, such as supply line insecurities, which increase alongside a rapidly growing economy. Multipolarity is apparent in Russia’s resurgence: pushing back on its borders with Europe and NATO, seeking a greater role in the Middle East and North Africa, interfering in US politics, and cementing its partnership with China. Multipolarity is equally evident when medium-sized powers – especially those that used to take orders from the US and Europe – seek to establish an independent foreign policy and throw off the shackles of the past. Turkey is just such a middle power. Strongman President Recep Tayyip Erdogan initially sought to lead Turkey into a new era of regional ascendancy. The Great Recession and Arab Spring intervened. Domestic economic vulnerabilities and regional instability have driven him to pursue increasingly populist and unorthodox policies that threaten the credit of the nation and security of the currency. A coup attempt in 2016 and domestic political losses in 2019 drove Erdogan further down this path, which includes aggressive foreign policy as well as domestic economic stimulus. The Anatolian peninsula has always stood at the crossroads of Europe and Asia, as well as Russia and Africa. Turkey’s efforts to change the regional status quo to its favor, increase leverage over its neighbors in Europe and the Middle East, and deal with Russia’s Vladimir Putin from a position of strength, are causing the geopolitics of the Mediterranean to heat up. It has now intervened in the Libyan civil war. In this special report, we focus on this trend and ask what it means for global investors. Unfinished Business In Libya Chart 1Haftar Is Weaponizing Libya’s Oil As the Libyan conflict enters its sixth year this spring, the battle for control of the western bastion of Tripoli rages. Multiple efforts to mediate the conflict between Field Marshal Khalifa Haftar of the Libyan National Army (LNA) and Prime Minister Fayez al-Sarraj of the UN-recognized Government of National Accord (GNA) have failed. Ceasefire talks in Moscow, Rome, and Berlin have fizzled. Instead, fighting has finally hit oil production, with the state-run National Oil Corp (NOC) declaring force majeure on supplies on January 18. Tribal leaders who support Haftar have blockaded eastern ports (Chart 1). Previously the mutual dependence of the rival factions on oil revenues ensured production and exports went mostly undisturbed. LNA forces control nearly all key oil pipelines, fields, ports, and terminals in Libya. The exceptions are the Zawiyya and Mellitah terminals and offshore fields (Map 1). However the National Oil Company (NOC), headquartered in the GNA-controlled Tripoli, is the sole entity controlling operations and the sole marketer of Libyan oil. Map 1Libya’s Oil And Natural Gas Infrastructure: Monopolized By Haftar General Haftar’s blockade – which has ground oil production to a halt – displays his ability to weaponize oil to obtain concessions from the Tripoli-based government. Tribal leaders behind the blockade are calling for a larger share of oil revenues, for which they are at the mercy of the LNA and NOC. With little progress in Haftar’s push to gain control of Tripoli, and Libya more generally, the conflict has reached a stalemate. Not one to back down, Haftar’s decision to cut off oil sales from the Tripoli government, which also cuts off revenues to his own parallel administration, is a brute attempt to force a settlement. Haftar’s gambit follows Turkey’s decision to intervene in Libya on behalf of Sarraj and the GNA. Turkey has deployed roughly 2,000 Syrian fighters, as well as 35 Turkish soldiers in an advisory capacity. Turkey apparently feared that Haftar, who has substantial backing from Egypt and the Gulf Arabs as well as Russia and France, was about to triumph, or at least force a settlement detrimental to Turkish interests. Bottom Line: Turkey’s decision to intervene in the Libyan civil war – while limited in magnitude thus far – raises the stakes of the conflict, which involves the EU, Russia, and the Arab states. It is a clear signal of the geopolitical multipolarity in the region – and a political risk that is flying under the radar amid higher profile risks in other parts of the world. Political Interests: Islamist Democracy Versus Arab Dictatorship The Libyan civil war is a proxy war between foreign nations motivated by conflicting economic and strategic interests in North Africa and the Mediterranean. But there is an ideological and political structure to the conflict that explains the alignment of the nations: Turkey is exporting democracy while the Arab states try to preserve their dictatorships. Haftar’s primary supporters include Egypt, the United Arab Emirates (UAE), and Saudi Arabia. These states see monarchy as the way to maintain stability in a region constantly on the edge of chaos. Islamist democracy movements, such as Egypt’s Muslim Brotherhood, pose a threat to their long-term authority and security. They try to suppress these movements and contain regimes that promote them or their militant allies. They are willing to achieve one-man rule by force and thus support military strongmen like Egypt’s Abdel Fattah el-Sisi and Libya’s General Haftar. On the other side of the conflict stand the backers of the GNA – Turkey and Qatar – which support political Islam and party politics (Chart 2). Turkey’s Erdogan and his Justice and Development Party (AKP) are sympathetic to Hamas in the Palestinian territories and Egypt’s Muslim Brotherhood. They want to ensure a lasting role for Islamic parties in the region, which strengthens their legitimacy. They do not want Libya’s Islamists to suffer the same fate as their affiliates in the Muslim Brotherhood – removal via a military coup. Chart 2Turkey Sees A Place For Political Islam Chart 3Turkey Steps In Amid Qatar Embargo The political conflict is mirrored in the Persian Gulf in the form of the air, land, and sea embargo imposed on Qatar in 2017 at the hands of the Saudis, Egyptians, and Emiratis. The Qatar crisis followed a 2014 diplomatic rift and the 2011 Arab Spring, when Qatar supported protesters and democracy movements against neighboring regimes. The embargo strengthened Turkey-Qatar relations, as Turkey stepped in to ensure that Qataris – who are heavily dependent on imports – would continue to receive essentials (Chart 3). Bottom Line: The alliances forged in the Libyan conflict reflect differing responses to powerful forces of change in the region. Established monarchies and dictatorships are struggling to maintain control of large youth populations and rapidly modernizing economies. Their response is to fortify the existing regime, suppress dissent, and launch gradual reforms through the central government. Their fear of Islamist movements makes them suspicious of Tripoli and the various Islamist groups allied with the GNA, and aligns them with Khalifa Haftar’s attempt to impose a new secular dictatorship in Libya. Meanwhile Turkey, with an active Islamist democracy, is seeking to export its political model, and Muslim Brotherhood-esque political participation, to gain influence across the region, including in Libya and North Africa. Economic Interests: The Scramble For Energy Sources Chart 4Europe Addicted To Russian Gas The Libyan proxy war is also about natural resources, for all the powers involved. Turkey’s intervention reflects its supply insecurity and desire to carve a larger role for itself in the east Mediterranean economy. Turkey needs to secure cheap energy supplies, and also wants to make itself central to any emerging east Mediterranean natural gas hub that aims to serve Europe. Europe’s increasing dependency on natural gas imports to meet its energy demand, and Russia’s outsized role – supplying the EU with 40% of its needs – have encouraged a search for alternative suppliers (Chart 4). Israel is attempting to fill that role with resources discovered offshore in the eastern Mediterranean. Given its strategic location, Turkey hopes to become an energy hub. First, it is cooperating with the Russians. Presidents Putin and Erdogan inaugurated the Turkish Stream pipeline (TurkStream) at a ceremony in Istanbul on January 8. The pipeline will transport 15.75 billion cubic meters (Bcm) of Russian natural gas to Europe via Turkey. This is part of Russia’s attempt, along with the Nord Stream 2 pipeline, to bypass Ukraine and increase export capacity, strengthening its dominance over Europe’s natural gas market (Map 2). Map 2Russia’s Latest Pipelines Bypass Ukraine Europe and its allies are wary of Russian influence, but the EU is not really willing to halt business with Russia, which is a low-cost and long-term provider free from the turmoil of the Middle East. Despite the significant growth in US natural gas supplies, the relatively higher cost makes Russian supplies comparatively more attractive (Chart 5). Chart 5Russian Gas Is Competitive In European Markets … Chart 6… As US Attempts To Gain Market Share The result will be tensions with the United States, which expects the Europeans to honor the security relationship by buying American LNG (Chart 6) and will always abhor anything resembling a Russo-European alliance. American legislation signed on December 20 would impose sanctions on firms that lay pipes for Nord Stream 2 and TurkStream. Second, Turkey wants to become central to eastern Mediterranean energy development. A series of offshore discoveries in recent decades has sparked talk of cooperation among potential suppliers (Table 1). There is a huge constraint on developing the fields quickly, as there is no export route currently available for the volumes that will be produced. While the reserves are not significant on a global scale, their location so close to Europe, and growing needs in the Middle East, has generated some interest. Table 1Recent East Mediterranean Discoveries Are Relatively Small, But Geopolitically Attractive However, Europe and Israel – the status quo powers – threaten to marginalize Turkey in this process: A meeting of the energy ministers of Egypt, Cyprus, Greece, Israel, Italy, the Palestinian territories, and Jordan in Cairo last July resulted in the creation of the Eastern Mediterranean Gas Forum to promote regional energy cooperation. Turkey – along with Lebanon and Syria – was excluded. Turkey seeks access to natural resources – and to prevent Israel, Egypt, and Europe from excluding it. The EastMed Pipeline deal – signed by Greece, Cyprus, and Israel on January 2 – envisages a nearly 2,000 km subsea pipeline transporting gas from Israeli and Cypriot offshore fields to Cyprus, Crete and Greece, supplying Europe with 9-12 Bcm per year (Map 3). The project enjoys the support of the European Commission and the US as an attempt to diversify Europe’s gas supplies and boost its energy security.1 But it would also be an alternative to an overland pipeline on Turkish territory. Map 3The Proposed EastMed Pipeline Would Marginalize Turkey Egypt has two underutilized liquefied natural gas plants – in Idku and Damietta – and has benefited from the 2015 discovery of the Zohr gas field. Egypt has recently become a net exporter of natural gas (Chart 7). It signed a deal with Israel to purchase 85.3 Bcm – $19.5 billion – of gas from Leviathan and Tamar fields over 15 years. Egypt sees itself as an energy hub if it can re-export Israeli supplies economically. Note that Russia and Turkey have some overlapping interests here. Russia does not want Europe to diversify, while Turkey does not want to allow alternatives to Russia that exclude Turkey. Thus maintaining the current trajectory of natural gas projects is not only useful for Russia’s economy (Chart 8) but also for Turkey’s strategic ambitions. Chart 7Egypt Also Aims To Become East Mediterranean Gas Hub Of course, while Russian pipes are actually getting built, the EastMed pipeline is not – for economic as well as geopolitical reasons. Europe is currently well supplied and energy prices are low. At an estimated $7 billion, the cost of constructing the EastMed pipeline is exorbitant. Chart 8Maintaining Energy Dominance Advances Russia’s Strategic Ambitions Too Still, Turkey must make its influence known now, as energy development and pipelines are necessarily long-term projects. The chaos in Libya presents an opportunity. Seizing on the Libyan GNA’s weakness, Turkey signed an agreement to provide for offshore maritime boundaries and energy cooperation as well as military aid. The EastMed pipeline, of course, would need to cross through Turkish and Libyan economic zones (see Map 3 above).2 Turkey is incapable of asserting its will militarily in the Mediterranean against powerful western naval forces. But short of war, it is capable of expanding its claims and leverage over regional energy and forcing the Israelis and Europeans to deal with it pragmatically and realistically rather than exclude it from their plans. Part of Turkey’s goal is to cement an alliance with Libya – at least a partitioned western Libyan government in any ceasefire brokered with Haftar and the Russians. Bottom Line: While Turkey and Russia support opposing sides in the Libyan conflict, both benefit from dealing directly with each other – bypassing the western powers, which are frustrated and ineffectual in Libya. Both would gain some direct energy leverage over Europe and both would gain some influence over any future eastern Mediterranean routes to Europe. In Libya, if either side triumphs and unites the country, it will grant its allies oil and gas contracts almost exclusively. But if the different foreign actors can build up leverage on opposing sides, they can hope to secure at least some of their interests in a final settlement. Turkey Needs Foreign Distractions The foregoing would imply that Turkey is playing the game well, except that its foreign adventures are in great part driven by domestic economic and political instability. After all, Turkey’s maritime claims are useless if they cannot be enforced, and offshore development and pipeline-building are at a low level given weak energy prices and slowing global demand. Economically, in true populist fashion, Erdogan has repeatedly employed money creation and fiscal spending to juice nominal GDP growth. The result is a wage-price spiral, currency depreciation, and current account deficits that exacerbate the problem. The poor economy has mobilized political opposition. Over the past year, for the first time since Erdogan rose to power in 2002, his Justice and Development Party is fracturing. Former Turkish deputy prime minister Ali Babacan, a founding member of the AKP, as well as former prime minister Ahmet Davutoglu, have both announced breakaway political parties that threaten to erode support for the AKP. Local elections in 2019 resulted in a popular rebuke in Istanbul. Thus Erdogan is distracting the public with hawkish or nationalist stances abroad that are popular at home. Turkey has taken a strident stance against the US and Europe, symbolized by its threats to loose Syrian refugees into Europe and its purchase of S400 missile defense from Russia despite being a NATO member. Military incursions in Syria aim to relocate refugees back to Syria (Chart 9). Chart 9Erdogan Is Distracting Turks With Popular Foreign Stances Chart 10No Love Lost Toward The West Turkish public opinion encourages close cooperation with Russia and a more aggressive stance against the West (Chart 10). This is a basis for Russia and Turkey to continue cutting transactional deals despite falling on opposite sides of conflicts in Syria, Libya, Iran, and elsewhere. Erdogan’s pretensions of reviving Ottoman grandeur in the Mediterranean fall in this context. Elections are not until 2023, but we expect Erdogan to continue using foreign policy as a distraction. The opposition is trying to unite behind a single candidate, which could jeopardize Erdogan’s grip on power. The insistence on stimulus at all costs means that Erdogan is not allowing the economic reckoning to occur now, three years before the election. He is trying to delay it indefinitely, which may fail. Libya may not get resolved, however. Allies of Haftar’s LNA – specifically Egypt, Saudi Arabia, and the UAE – will be motivated to intensify their support of him for fear that a loss would revive domestic interest in political Islam. Egypt especially fears militant proxies being unleashed from any base of operations there. The LNA currently serves as a buffer between Egypt and the militant actors in Libya. If Haftar is defeated, Egypt’s porous western border would provoke a harsh reaction from Cairo. The threat of a revival of Islamic State in Libya has united the Egyptian people – a critical variable in the administration’s vision of a stable country. That has provided Egypt’s Sisi an excuse to flex his muscles through military exercises. Neither Russia nor NATO will be moved to bring a decisive finish to the conflict, as neither wishes to invest too heavily in it. Bottom Line: Erdogan has doubled down on populism at home and abroad. His assertive foreign policy in Syria and now Libya may end up exacerbating economic and political pressures on the ruling party. What Is The Endgame In Libya? There are three possible scenarios to end the current stalemate between the Haftar’s forces and the internationally recognized GNA: Military: An outright military victory by either Haftar or Sarraj is highly unlikely. While Haftar’s forces enjoy military and financial support from the UAE, he lacks popular support in Tripoli – which has proved to be challenging to takeover. Similarly, Sarraj’s army is not strong enough to confront the eastern forces and reunify the country. The merely limited involvement of foreign actors – including Turkey – makes a military solution all the more elusive. The most likely path to a quick military victory comes if foreign actors disengage. This will only occur if they are punished for their involvement, and thus it requires a major neutral power, perhaps the United States, to change the calculus of countries involved. But the US is eschewing involvement and the Europeans have shown no appetite for a heavy commitment. Diplomatic: A negotiated settlement is eventually likely, given the loss of oil revenues. A ceasefire would assign some autonomy to each side of the country. Given Haftar’s ambitions of conquering the capital and becoming a strongman for the country as a whole, the diplomatic route will be challenging unless his Gulf backers grow tired of subsidizing him. Financial: Haftar could win by breaking the NOC’s monopoly on oil. In the past, the LNA failed at selling the oil extracted from infrastructure under its control. If Haftar manages to market the oil without the aid of the NOC then he will be able to guarantee a stream of revenue for his forces and at the same time starve the Tripoli government of financing. This would pose an existential risk for the GNA. The key challenge in this scenario is to obtain international backing for LNA sales of Libyan crude supplies. Libya’s partition into two de facto states is the likeliest outcome. Bottom Line: Unless one of the constraints on a military, diplomatic, or financial end to the conflict is broken, the current stalemate in the Libyan conflict will endure. A partition of Libya will be the practical consequence. Turkey hopes to boost its regional influence through Tripoli, and thus increase its leverage over Europe, but a heavy investment could result in fiscal losses or spiral into a broader regional confrontation. Investment Implications While it is not clear how long the current blockade on Libyan ports will last – or the associated over 1 million barrels per day loss of production – oil supplies will remain at risk so long as the conflict endures. However, unlike supplies in the Gulf or in Venezuela, Libyan crude is of the light sweet grade. There is enough global spare capacity – from US shales – to make up for the Libyan loss, at least over the short term. The fall in Libyan supplies is occurring against the backdrop of oil markets that have been beaten down by the decline in demand on the back of the coronavirus impact (Chart 11). The OPEC 2.0 technical panel recommended additional output cuts of 600 thousand barrels per day last week, and is waiting on a final decision by Russia. We expect the cartel to tighten supplies to shore up prices. The instability in Libya could also affect Europe through immigration. The conflict re-routes migrants through the western route and thus could result in an increased flow to Spain and Portugal, rather than Italy which was previously their landing pad (Chart 12). A meaningful pick up would have a negative impact on European domestic political stability, especially with Germany in the midst of a succession crisis and incapable of taking a lead role. Chart 11Libyan Blockade Comes Amid Demand Shock Chart 12Refugees Will Favor Western Route Across The Mediterranean Erdogan’s foreign adventurism, and aggression against the West, poses a risk for Turkish markets. We remain underweight Turkish currency and risk assets. Our Emerging Markets strategists expect foreign capital outflows from EM to weigh on Turkey’s currency, local fixed-income and sovereign credit relative to EM benchmarks. Go short the Turkish lira relative to the US dollar. Bottom Line: Historically, the Mediterranean was the world’s most important waterway. It was the “life line” of the British empire. The US succeeded the British as the guarantor of Suez and corralled both Turkey and Greece into a single alliance under the Truman Doctrine. This status quo held until the twenty-first century. Since 2000, Russia has revived, US foreign policy in the Middle East has become erratic, and the Europeans have lost clout. Turkey is seeking to carve a space for itself and challenge the settlements of the past, all the way back to the 1923 Treaty of Lausanne. Yet in the wake of the Great Recession its economy is unstable and its populist leaders are taking greater risks abroad. The result will be greater friction with Europe, or the Arab states, or both. Given Turkey’s mismanagement at home, and limited gains to be made in Syria or Libya, Turkish assets will be the first to suffer from negative surprises.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 The Eastern Mediterranean Security and Energy Partnership Act of 2019 is an American bi-partisan bill the lends full support for the East Med pipelines and greater security cooperation with Israel, Cyprus, and Greece. The US Senate also passed an amendment to the National Defense Authorization Act last June which ended the arms embargo on Cyprus. 2 Turkey has also been engaging in drilling activities in disputed waters near Cyprus – which Ankara argues it is undertaking in order to protect Turkish-Cypriot claims – motivating EU economic sanctions in the form of travel bans and asset freezes on two Turkish nationals.

Highlights Base metals appear to be pricing the impact of the Chinese 2019-nCoV coronavirus in line with the 2003 SARS outbreak. We expect an earlier peak in reported (ex-Hubei) cases than is currently discounted by markets, implying Asian economies – and base metals – will recover sooner than expected, perhaps by end-February. We estimate the marginal impact of 2019-nCoV on global oil demand implied by the recent sell-off translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20 to the full coalition, following their meetings in Vienna. This would be bullish, if Asian economies recover as quickly as we expect. Safe-haven assets – chiefly gold and the USD – rallied but do not signal an exodus from risky assets. After breaching $1,580/oz last week, gold traded lower, while the broad trade-weighted USD index rallied 1%, mildly reversing a decline begun at the end of 2019. Risky-asset markets are anticipating monetary accommodation by systemically important central banks will remain in place this year; fiscal stimulus in China and EM economies is likely. This remains supportive of commodity demand. Feature Our view differs from the markets’, which makes us relatively more bullish base metals prices. There is a tight relationship between Asian economic activity and base metals prices, which provides a window on how markets currently expect the 2019-nCoV outbreak will impact aggregate demand in Asia (Chart of the Week). Our view differs from the markets’, which makes us relatively more bullish base metals prices. Chief among the assumptions driving our view is our expectation markets will stage a recovery once the number of 2019-nCoV cases peaks outside the epicenter of the outbreak in Wuhan, a city of 11mm people in Hubei Province, which remains locked down per Chinese containment efforts.1 This is our House view, as well. Alert: The peak in cases ex-Wuhan could come sooner than expected. Our colleagues at BCA’s China Investment Strategy (CIS) note, “New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February.”2 Chart of the WeekBase Metals Prices Lead Changes in Asian Economies This will be important for base metals demand. China accounts for ~ 50% of global supply and demand for refined base metals (Chart 2). These markets are exquisitely attuned to the decisions of Chinese policymakers, so much so that they resemble a vertically integrated system: Policymakers allocate and direct credit to industries and projects – creating a demand signal – and the supply side, which includes numerous state-owned enterprises, responds. What cannot be consumed domestically is exported to neighboring economies. Chart 2China Dominates Base Metals This largely explains why base metals are so entwined with Chinese economic activity, and with Asian activity generally. Our research indicates base-metals prices lead our Asia Economic Diffusion index, reflecting the information-processing capacity of these markets vis-à-vis the evolution of the regional economies.3 This is one reason we use base-metals markets as information sources in conjunction with our proprietary models and indicators. At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode. Chart 3Markets Price Metals Hit Similar To SARS At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode (Chart 3), when the LMEX fell 9% from February to April, then fully recovered by year end (Chart 4). Also noteworthy is the fact that most commodity markets were processing this information and reflecting it in their own trajectories, as seen in the path taken by our proprietary Global Commodity Factor (Chart 4, bottom panel). Chart 4Once SARS Infection Peaked, Base Metals Recovered Quickly The market call from our CIS colleagues implies base metals – summarized by the LMEX – will begin to rally this month as the odds of a peak in 2019-nCoV cases outside Hubei increases. We expect this rally will be aided by increased fiscal stimulus in China (e.g., infrastructure and construction spending), and monetary stimulus (Chart 5), which will renew the lift in manufacturing that appeared toward the end of 2019 (Chart 6).4 Chart 5Higher China Policy Stimulus Expected Chart 6Early 2019-nCoV Peak Would Revive China's Growth Oil Marches To A Different Drummer Oil markets primarily are pricing to expectations of a deep hit to crude oil demand, driven by 2019-nCoV’s impact on China’s consumption.5 Based on our modeling, we estimate the marginal impact of 2019-nCoV on global oil demand priced into WTI and Brent prices earlier in the week translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20, following meetings in Vienna this week. These cuts would be in addition to the 1.7mm b/d cuts agreed by the coalition at its November 2019 meeting, for the January to March 2020 period. OPEC’s (the old cartel) crude oil production in January fell 640k b/d from December levels to 28.35mm b/d, as the additional cuts of 1.7mm b/d agreed in November kicked in, according to Reuters. Additionally, Gulf Cooperation Council (GCC) member states over-complied on their cuts. Output from Libya also is down by ~ 1mm b/d since last month. Importantly, the latest OPEC output levels are ~ 1.3mm b/d below average 2019 production, which Platts estimates at 29.66mm b/d – the lowest output since 2011. We will be updating our balances and price forecasts in two weeks, which will reflect these data more fully. This will allow us to include more information on the demand destruction in China, the evolution of 2019-nCoV, and OPEC 2.0 supply decisions. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves. Although China’s share of global oil demand amounts to ~ 14% – far less than its share of base metals’ supply and demand – the fact that more than 70% of its 10.2mm b/d of imports comes from OPEC 2.0 is focusing the coalition on the need to restrain supply (Chart 7).6 If, as discussed above, 2019-nCoV cases peak sooner than expected, Asia’s economies likely will recover sooner than expected, which will rally oil prices sooner than expected. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves (Chart 8). Chart 7China's Share Of Global Oil Demand Chart 8An Early Peak In 2019-nCoV Cases Would Restore Backwardation To Oil Based on this assessment, we are getting long 4Q20 WTI vs. Short 4Q21 WTI at tonight’s close, in expectation of a return to backwardation. Bottom Line: Base metals markets could rally sharply if, as we expect, 2019-nCoV cases peak sooner than expected outside the epicenter of Wuhan. This also will lift oil demand in China and Asia. Lastly, it will restore backwardation in the benchmark crude oil curves – Brent and WTI – which is why we are going long 4Q20 WTI vs. short 4Q21 WTI at tonight’s close. Commodities Round-Up Energy: Overweight Uncertainty around the potential impact of the new coronavirus in China pushed WTI prices down to $49.6/bbl as of Tuesday’s close, a 22% drop since the onset of the outbreak. Oil speculators are rapidly exiting the market; non-commercial long WTI positions fell to 564k from 626k on January 7, 2020. On the supply side, OPEC’s oil production dropped to 28.4mm b/d in January, according to Bloomberg, in line with Reuters estimate. This partly reflects the collapse in Libya’s oil production following the closure of its main export terminals by forces loyal to General Khalifa Haftar. Production there was estimated at 204k b/d – the lowest level since the uprising against Muammar Qaddafi in 2011 – vs. an average of 1.1mm b/d in 2019. Base Metals: Neutral China’s net export of steel products declined throughout 2019 amid strong production growth and range-bound inventories. This suggests steel consumption in China remained buoyant, supported by strong new property starts and infrastructure investments (Chart 9). Our commodity-demand indicators suggest most metals’ fundamentals turned constructive in late 2019. However, the coronavirus outbreak will delay the rebound in prices we expected. Over the medium term, we continue to expect prices to pick up, fueled by accommodative monetary policy, and stronger-than-expected monetary and fiscal stimulus in China to offset the negative effect of the 2019-nCoV. Precious Metals: Neutral Fears of wider contagion of the coronavirus are keeping gold above $1,550/oz despite the rise in the US dollar powered by upbeat US manufacturing data. Over the long term, periods of elevated uncertainty are associated with rising households’ precautionary demand for savings as future income becomes increasingly uncertain. This pushes up asset prices as total savings increase, and specifically safer assets, such as gold, until uncertainty abates. This high savings rate acted as a floor to gold prices in the aftermath of the global financial crisis and is currently a crucial contributor to its elevated price (Chart 10). Ags/Softs:  Underweight Abating fears of a pandemic spread of the 2019-nCoV lifted CBOT March corn futures to $3.8225/bu on Tuesday, reversing some of the damage done by disappointing export reports from the USDA and favorable crop conditions in South America supporting expectations for a large corn harvest there. Strong sales of soybeans to Egypt and favorable export inspections helped beans reverse last week's negative trend. USD strength on the back of the 2019-nCoV, particularly against the Brazilian real, remains a headwind to bean prices. Chart 9China's Steel Consumption Remained Buoyant In 2019 Chart 10Uncertainty Drives Demand For Safe Havens     Footnotes 1     It is important to note this is a highly speculative call, and that even the public-health experts are groping for understanding on the trajectory of 2019-nCoV at this point. It is possible the virus is not contained and extinguished as SARS was in 2003, but becomes a recurrent feature of the flu season globally. Please see Experts envision two scenarios if the new coronavirus isn’t contained, published by Stat February 4, 2020. Stat is a life sciences and medical news service produced by Boston Globe Media. 2     Please see Recovery, Temporarily Interrupted, published by BCA Research’s China Investment Strategy February 5, 2020. It is available at cis.bcaresearch.com. 3    Our Asia Economic Diffusion index was developed by BCA Research’s Global Investment Strategy team. The “information” we refer to here is the actual buying and selling of base metals, and contracting for services related to the economic activity accompanying a revival in manufacturing, infrastructure buildouts and construction that drives that demand. This will show up in various measures of economic activity, among them BCA’s Asia Economic Diffusion index and different gauges used by the IMF and World Bank. In other words, base metals prices lead the Asia Economic Diffusion index based on our analysis of Granger causality. This is valuable because the metals price in real time. In earlier research, we showed that, among commodity markets, base metals prices – via copper prices, the LMEX, and the IMF’s metals index – can be used to confirm the signals from our econometric indicators and models of EM and global economic activity. Please see World Bank Lowers Growth Forecast; Commodity Demand Will Pick Up, published January 16, 2020, and Godot … Trade Deal … Wait For It … Base Metals Are Primed For A Rally, published November 28, 2019, by BCA Research’s Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 4    Iron ore and steel prices also will revive on the back of this economic recovery; we will be looking into this next week. 5    Earlier this week, Bloomberg reported the initial hit to oil demand in China amounted to 3mm b/d – the largest such hit since the Global Financial Crisis. This represented ~ 20% of daily Chinese oil demand. 6    We discuss China’s position in the global oil market – and, importantly, in the global air-transportation markets – in last week’s publication, Expect OPEC 2.0 To Cut Supply In Response to Demand Shock. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights The intense focus on the weakening of global oil demand expected in the wake of another coronavirus outbreak in China – dubbed 2019-nCoV – obscures likely supply-side responses by OPEC 2.0. The producer coalition likely will rebalance markets by extending production cuts from end-March to at least the end of June when it meets in Vienna March 5-6.  OPEC 2.0 producers will be exquisitely sensitive to Asian refiner demand. They will use it as a gauge for how severe 2019-nCoV’s impact will be on EM demand, and adjust production and exports accordingly. On the demand side, it is difficult to analogue the 2019-nCoV outbreak to the 2003 SARS outbreak, given all the conflicting fundamentals at play at that time.  Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Longer-dated WTI (out to December 2023) traded below $50/bbl earlier in the week, roughly in line with shale-breakeven costs reported by the Dallas Fed earlier this month. This likely will continue to pressure capex in the US shales, keeping future supply growth constrained. Feature Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Chart of the WeekChina's Oil Demand Drives Global Growth Oil markets are rightly focused on the demand implications of the 2019-nCoV outbreak in China.1 Since 2000, China has accounted for 42% of annual oil-demand growth worldwide (Chart of the Week). China is second only to the US in oil demand, accounting for 14% of total global demand of 100.7mm b/d at the end of 2019; its oil imports averaged more than 10mm b/d last year, and are expected to remain strong as it continues to build out its refining sector. Chart 2Asian Air Travel Hit Hard By SARS Historical analogues for 2019-nCoV are difficult. The immediate analogue is the SARS coronavirus outbreak identified in China in February 2003, which lasted six months and hit Asian air travel especially hard (Chart 2). During the height of the SARS outbreak in April 2003, air-travel passenger demand in Asia plunged 45%, according to the International Air Transport Association (IATA). This pushed jet fuel prices lower in Asia and in other key markets, along with distillate prices generally (Chart 3).2 Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices China now is an extremely large share of global jet fuel consumption. Chart 4BCA Models, Base Metals Prices Suggest SARS Effect Was Short-Lived The industry now is more reliant on Chinese travelers. Since 2003, the number of annual air passengers has more than doubled, with China growing to become the world’s largest outbound travel market. In 2003, close to 7mm passengers from China traveled on international flights. By 2018, that number had grown close to 64mm people, according to China’s aviation authority.  As Chart 2 demonstrates, China now is an extremely large share of global jet fuel consumption. Still, oil is a global market – the avoidance of China during the SARS outbreak in 2003 would have impacted global air travel, and, as a result, global jet-fuel prices. Our proprietary EM commodity-demand models and the behavior of base metals prices, which were and remain heavily influenced by China’s economy, suggest China’s GDP growth slowed in 2003 (mainly 1H03) because of the SARS outbreak (Chart 4).  The LME’s base metals index fell 9% between February and July 2003, while copper prices fell 11%. By year-end, these markets had fully recovered. Oil-Supply Management Drives Price Evolution In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC.  During the SARS outbreak in 2003, oil-market fundamentals at the time were complicated by the sudden loss of Venezuelan output in December 2002 to a general strike, which lasted three months and removed more than 2mm b/d from the market, and the US invasion of Iraq on March 2003. Both of these supply-side shocks hit markets just as demand was being hit by SARS. This makes it difficult to extract a pure price response on the demand side to the SARS episode. In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC. These including the 9/11 terror attacks in the US in 2001; the SARS outbreak in late 2002-03; the Global Financial Crisis in 2007-08; and the euro debt crisis in 2011-12 (Chart 5).3 Chart 5Demand Shocks Abound In 21st Century Chart 6OPEC Lost Key Members' Output During SARS Outbreak   OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation. Importantly, these demand shocks were accompanied by supply shocks – Venezuela's general strike; the US invasion of Iraq continues to play havoc with global supply; the BP Macondo blowout in the Gulf of Mexico in 2010; the Arab Spring and the loss of Libyan output in 2011 – all of which complicated OPEC’s decision making (Chart 6). Much of OPEC’s adjustment then and now is made by the Kingdom of Saudi Arabia (KSA), which functions as the central bank of the global oil market increasing and decreasing production to balance markets (Chart 7). Chart 7KSA Primarily Balances Markets During Supply, Demand Shocks OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation, which would push prices lower and severely alter the forward curves for the principal crude oil pricing benchmarks, WTI and Brent (Chart 8). Chart 8OPEC 2.0’s Goal: Avoid Unintended Inventory Accumulation Navigating The 2019-nCoV Outbreak Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The relentless focus on the demand-side consequences of the 2019-nCoV outbreak is not helpful in determining how oil prices will trade going forward. Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The discussion above is meant to highlight this, by recalling OPEC’s production management during various demand shocks, not just the SARS outbreak in 2003. OPEC then, and OPEC 2.0 now, is not forced to produce oil and export regardless of the physical realities it confronts. It can adjust production and exports in response to direct demand indications from its refinery buyers and traders lifting its crude oil. Demand slowdowns, all else equal, typically will show up in falling crack-spread differentials between refined products and crude oil prices (Chart 9).4 Chart 9Crack Spreads Inform Crude Oil Production Decisions It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand. Falling crack spreads inform crude oil producers they need to throttle back on production – refiners are not able to profitably run all the crude being made available to them and crude and product are backing up in inventory.  It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand, which will determine how much production they need to cut in order to balance the market. This will be done against a backdrop of supply concerns that are not too dissimilar to those prevailing during the 2003 SARS crisis – e.g., instability in Iraq and Iran that could threaten production, and the loss of Venezuelan exports. Bottom Line: Markets still are in the process of assessing how damaging 2019-nCoV will be for industrial commodity demand – oil, bulks and base metals, in particular. As has been the case in all such demand shocks, OPEC’s supply response (and now OPEC 2.0’s) will determine how deeply and for how long prices are impacted.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices fell 8% since last Monday amid the coronavirus outbreak in China. The number of confirmed cases is rapidly expanding, reaching more than 6,000 as of Wednesday which surpasses the trajectory of SARS in the first month of the outbreak in 2003. Nonetheless, the fatality rate remains below that of SARS, estimated at less than 3% vs. ~ 10% for SARS. Separately, the WCS discount to WTI averaged -$23/bbl this month. This is in line with our view that the discount would drop below -$20/bbl in 1Q20. This level is appropriate to incentivize additional rail transportation to the US. We expect the discount will remain close to current levels and for crude-by-rail volumes to pick up this year (Chart 10). Base Metals: Neutral Base metals have been severely impacted this week by the coronavirus outbreak – copper, aluminum, zinc, and lead are down 9%, 4%, 9%, and 5%. A prolonged slowdown in China’s economic activity – the driver of the global industrial activity recovery we expect – would plunge metals’ prices. China’s base metal consumption more than doubled since 2003. Thus, the potential impact of 2019-nCoV is much larger compared to SARS and market participants are pricing in the probability of damaging scenarios to global growth. This explains the pronounced decline in metals’ prices this year vs. 2003. Precious Metals: Neutral Gold was one of the few commodities in the green since last week. The yellow metal rose 1% since last Monday, supported by renewed safe-haven demand flows. Gold and the USD have been rising simultaneously amid the virus outbreak, which is typical of uncertain periods. The spectrum of possible outcomes is wide and negatively skewed. This warrants protection through safe-haven assets. We remain strategically long gold as a portfolio hedge. Our recommendation is up 28% since inception. Ags/Softs: Underweight Corn markets focused on USDA reports of rising exports, highlighted by the sale of 124,355 MT to Mexico. CBOT March corn futures were up 6% Tuesday, reversing earlier losses Monday. Beans remain under pressure, as traders await tangible evidence that China will go ahead with purchases announced in the so-called phase-one deal negotiated between the US and China (Chart 11).  Chart 10WCS Discount Under Pressure Chart 11Markets Waiting For China Demand   Footnotes 1     The US Centers for Disease Control and Prevention’s 2019-nCoV website highlights the marked differences between China’s response to the current coronavirus outbreak vs the 2003 SARS outbreak. One notable response by the Chinese government this time around – besides the rapid lockdown on travel – has been the alacrity with which officials posted the genome for the virus to a global research database, which allowed US researchers to quickly compare it to the strain they isolated. Separately, Reuters reported Australian researchers were able to grow the virus in a lab, which could accelerate development of a vaccine.  2     Distillates comprise the so-called middle of the refined barrel, and include jet fuel, diesel fuel and heating oil (also known as gasoil). These are primarily associated with industrial markets – mining and transportation, e.g. – and are key barometers of economic activity generally.  3     The "modern" era for oil began roughly in 2000, when oil prices became a random walk. WTI prices were mean-reverting from 1986 to roughly 2000, then became a random walk. Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices," in Advances in Mathematical Finance, Birkhäuser, Boston; and Haidar, I. and C.R. Wolff, "Forecasting crude oil price (revisited)," The proceeding of the 30th USAEE Conference, Washington , D.C. USA. 9-12 October, 2011. 4     The “crack spread” is the USD/bbl difference between refined-product prices and crude-oil prices. It represents the gross margin of refiners.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Special Report

Highlights The US election cycle is an understated risk to US equities – and the risk of a left-wing populist outperforming in the Democratic primary election is frontloaded in February. The US-Iran conflict is unresolved and remains market-relevant. Iraq is at the center of the conflict and oil supply disruption there or elsewhere in the region is a substantial risk. Even if war does not erupt, Iran has the potential to give President Trump’s foreign policy a black eye and thus could marginally impact the election dynamic. Feature Stocks have rallied mightily since our August report on Trump’s “tactical trade retreat,” but new headwinds face the market. In this report we call attention to four hurdles arising from US election uncertainty. Then we focus on the status of Iran and Iraq in the wake of this month’s hostilities, which brought the US and Iran to the brink of outright war. We maintain that the Iran risk is unresolved and will remain market-relevant in advance of the US election. Primarily due to the US Democratic primary election, we urge caution on US equities in the near term, along with our Global Investment Strategy, despite our cyclically bullish House View. Four Hurdles In The US Election Cycle The US election cycle is the chief political risk to the bull market this year – and geopolitical risks largely radiate from it. There are four immediate hurdles that financial markets are underestimating: Risks to Trump's re-election: Global investors have come around to our view since 2018 that Trump is slightly favored to win re-election (Chart 1). Bets on the related question of which party will hold the White House have flipped from Democratic to Republican (Chart 2). Everyone now recognizes that Trump will not be removed from office through impeachment. Chart 1Trump Re-election Odds Add To Risk-On Chart 2Republicans Now Favored For White House Yet, anecdotally, investors may be becoming complacent about Trump’s chances. He is not a shoo-in. Subjectively we have argued that his odds of victory are 55%. Our quantitative election model shows that Wisconsin has shifted to the Republican camp since November, but it places the odds of winning that state (and Pennsylvania) at less than 52% (Chart 3). This gives Trump 289 electoral votes, only 19 more than necessary. If both of these states tipped in the opposite direction then investors would be facing a major policy reversal in the United States. Chart 3Our US 2020 Election Model Shows Trump Win With 289 Electoral College Votes Chart 4The US Economy Is Still A Risk To Trump Trump’s low approval rating remains a liability – and in this sense impeachment is still relevant, in that it can either help or hurt his approval, or prompt him to seek distractions abroad that could deliver negative surprises. Moreover the US manufacturing sector and labor market are not out of the woods yet (Chart 4). In short, the election is still ten months away and a lot can happen between now and then. We see Trump as only slightly favored. Moreover other hurdles are more immediate than the benefits of policy continuity upon a Trump win. 2. Risks to Biden's nomination: Throughout last year we maintained that former Vice President Joe Biden was the frontrunner for the Democratic nomination, albeit with very low conviction. In particular, after Vermont Senator Bernie Sanders’s poor showing in the third debate and subsequent heart attack, we expected Massachusetts Senator Elizabeth Warren to consolidate the progressive vote and trigger a policy-induced selloff in US equities. This never occurred because Biden held firm, Sanders recovered, and Warren fell. The risk to equities from a left-wing populist Democratic nominee is frontloaded in February and March. Now, however, the risk to equities is back. The Democratic Party faces a last-ditch effort from its left or “progressive” wing and anti-establishment voters to oppose Biden. With the primary election now upon us – the Iowa Caucus is February 3 – national opinion polls show that Sanders is pushing up against Biden (Chart 5). It is less clear if Sanders is breaking through in the primary polling state-by-state, where multiple candidates remain competitive (Chart 6). But online gamblers are reasserting Biden over Sanders at just the moment when progressives are set to launch their biggest push (Chart 7). Meanwhile New York Mayor Michael Bloomberg is finally gaining some traction – and he eats away at Biden’s support from centrist voters. Everything is in flux, which warrants caution. Chart 5Biden Is The Frontrunner, But Sanders Is Challenger Chart 6Biden Not A Shoo-In For Early Democratic Primary States Biden is still favored to win the nomination, but he has not clinched it. The market faces volatility during the period when Democrats get “cold feet” about nominating another establishment candidate. Moreover the fundamental knock against Sanders – that he is not as “electable” as Biden – is debatable, judging by head-to-head polls against Trump (Chart 8). This means that a shift in momentum – for instance, if Biden lurches from disappointments in early states to underperformance in his bulwark of South Carolina – would have legs. Ultimately a “contested convention” is not impossible. This would be a negative surprise to market participants currently assuming that the world faces the relatively benign choice of two known quantities: an establishment Democrat or a continuation of Trump policies. Chart 7Betting Markets Overlooking Party 'Cold Feet' Over Biden Chart 8Electability Fears May Not Stop Sanders Rally Risks to the Republican Senate: Assuming Biden clinches the nomination, he has a 45% chance of winning the election – and in that case, his chance of bringing the Senate over to the Democrats is higher than investors realize. This is another risk that the market will awaken to later this year. Chart 9Democrats Underestimated In Senate The consensus holds that Republicans will hold the Senate, particularly with Republican senators in Maine and Iowa leading their Democratic challengers in polling. The problem is that for Democrats to unseat an incumbent president they will necessarily have generated strong turnout from key demographic groups: young people, suburbanites, women, and minorities. If that is the case, then the election will not be as tight as expected and Republicans will be less likely to hold the Senate. This would require rising unemployment or some other blow that fundamentally damages the Trump administration’s popular support in key swing states. At least until it becomes clear that the manufacturing sector is out of the woods, the Democrats should be seen as far more likely to take the Senate than the Republicans are to retake the House of Representatives – yet this goes against the consensus (Chart 9). Rising odds of a Senate victory would mean that even a “centrist” Democrat like Biden would have fewer political constraints in office – he would pose a greater threat of increasing taxes, minimum wages, and passing legislative regulation than the market currently expects. In short, Biden would be pulled to the left of the political spectrum by his party and expectations of an establishment Democrat posing a minimal threat to corporate profits would be greatly disappointed. Risks of Trump's second term: Finally, assuming the manufacturing sector rebounds and that Trump’s odds of re-election rise above 55%, market complacency becomes an even bigger concern for a long-term investor. For in his second term Trump would become virtually unshackled with regard to economic and financial constraints, since he cannot run for office again. He would still face the senate, the Supreme Court, and other constraints, but these would certainly not preclude a doubling down on trade war (or confrontations with nuclear-aspirants like Iran or North Korea). We have argued that Trump will not instigate a trade war with Europe, at least until the economy has clearly rebounded, and most likely not until his second term. But we fully expect chapter two of the trade war to begin in 2021 – and this could mean China, Europe, or even a two-front war. Re-election could go to Trump’s head and prompt him to overreach on the global stage. Hence we expect the relief rally on Trump’s re-election to be short-lived and would be looking to sell the news. But the S&P 500 faces more immediate hurdles anyway, and that is why we urge caution in the very near term. Iran is still a major geopolitical risk this year. Bottom Line: None of these hurdles are insurmountable, but the US election cycle is now an understated risk to the equity bull market. We agree with our Global Investment Strategy that it is prudent to shift to a neutral position tactically on US equities, especially for the February and March period when uncertainty rises over the Democratic Party primary. This does not change our view that the underlying global economy is improving, largely on China’s rebound, and that the cyclical outlook is positive. Don’t Bet On Regime Collapse In Iran (Yet) The January 8 Iranian attack on US bases in Iraq was intended to serve as a breather for Iranian leaders. It was meant to put on pause the rapid escalation in US-Iran tensions – allowing Iranian leaders to recover from the assassination of top military commander Qassem Suleimani – all the while appeasing the public through a public show of revenge. As fate would have it, however, the Iranian regime was granted no such respite. Days later, domestic unrest descended on the Islamic Republic as protesters returned to the streets across the country, criticizing the regime’s downing of a civilian airliner and re-stating their long-running complaints against the regime. Civil strife is not uncommon in Iran (Table 1). Economic inefficiencies, corruption, and discriminatory policies which serve to reward regime loyalists while suppressing the private sector are only some of the grievances faced by Iranians.1 Table 1Civil Strife Ongoing Problem In Iran Today’s strife is relevant, however, because it is fueled by US-imposed “maximum pressure” sanctions that have created an even bleaker economic reality. Iranian exports were down 37% in 2019 following an 18% decline the previous year. Oil exports fell to 129 thousand barrels per day in December 2019, down from an average 2.1 million barrels per day in 2017 (Chart 10). Households are facing the brunt, experiencing a 17% unemployment rate and a whopping 36% inflation rate (Chart 11). Chart 10US 'Maximum Pressure' Sanctions On Iranian Oil Exports Chart 11Iranian Households Bear Brunt Of Economic Shock The 2020-21 budget, released in December and described as a weapon of “resistance against US sanctions,” intends to plug the deficit using state bonds and state property sales (Chart 12). However Iran’s fiscal condition is shaky. The International Monetary Fund estimates a fiscal breakeven oil price of $194.6 per barrel for Iran, more than 3 times higher than current oil prices. Chart 12Iran’s Fiscal Condition Is Shaky Chart 13Iran Avoiding Devaluation Under Trump Chart 14Iranians Also Blame Their Government For Malaise The solution of former President Mahmoud Ahmadinejad, the populist hawk who led the government during the US’s previous round of sanctions, was to devalue the official exchange rate. The weaker rial raised local currency revenues for each barrel of exported oil and encouraged import substitution in other industries. However devaluation came at a steep political cost and sparked riots and protests. So far President Hassan Rouhani has eschewed this strategy, instead maintaining a stable official exchange rate, used as the reference for subsidized basic goods and medicine (Chart 13). Nevertheless, the unofficial market rate has weakened 68% since the beginning of 2018. It is no surprise then that Iranians all over the country are taking to the streets. The latest bout of unrest is significant in size, geographic reach, and in that protesters are calling on Grand Ayatollah Ali Khamenei to step down as supreme leader. Despite US sanctions, Iranian protesters are partially blaming Khamenei and the government for the country’s malaise (Chart 14). Even prior to the US withdrawal from the 2015 nuclear deal, Joint Comprehensive Plan of Action (JCPA), Iranians were angry about economic mismanagement. Nevertheless, according to our checklist for an Iranian revolution, the regime is not yet at risk of collapse (Table 2). Although the street movement is picking up pace, it is not organized or unified. There is no alternative being offered against the all-powerful supreme leader, and the political elite are mostly united in preserving the current system. Table 2Iran Regime Stability Checklist The regime has two main options going forward: seek immediate economic relief through negotiations with the United States, or hunker down and wait to see whether President Trump is reelected and able to sustain his campaign of maximum pressure, and go from there. We fully expect the latter. Domestic dissent can still be suppressed for the time being. The parliamentary – or Majlis – elections scheduled for February 21 could in theory offer Iranians an opportunity to voice their discontent through the ballot box. However this democratic exercise conceals the known political reality that the supreme leader holds supreme authority, even in the selection of parliament or the president (Diagram 1). Thus the election result will not drive major policy change. Diagram 1Supreme Leader Controls Iran A case in point was the regime’s 2016 strategy in the parliamentary election. At that time, the conservative-dominated Guardian Council, responsible for screening potential candidates, rejected well-known reformist applicants (Chart 15). As a result, the reformists who were able to win seats were either lesser-known figures or unaligned with liberals in the reformist movement. Thus while the reformist presence in parliament nominally surged, these lawmakers were ineffective, reneging on campaign promises or collaborating with the conservative faction. The 2016 election serves as a blueprint for what to expect in the upcoming elections in February. The Guardian Council ruled that out of around 15,000 candidates, only 60 (relatively unknown) reformist candidates were qualified to run for the election.2 The elections will not change anything, but this means the grievances of the population will fester in the coming years, especially if the US does not change policies. This is where the medium-term risk to regime stability – namely through elite divisions – becomes apparent. The impending leadership succession is a major source of uncertainty. Supreme Leader Khamenei is the main barrier to political change. At 80 years old and reportedly suffering from poor health, a change in leadership is imminent. However, no one has been officially endorsed as his successor. This is an immense source of uncertainty in the coming years. There are several possibilities for the succession.3 A successor is appointed by the Assembly of Experts. Because we exclude Rouhani as a candidate for supreme leader, the potential candidates for Iran’s top position listed below ascribe to Khamanei’s hardline ideology: Hojjat ol-Eslam Ebrahim Raisi, head of judiciary and of the Imam Reza shrine since March 2019. Raisi is reportedly Khamenei’s favorite for succession. He is a hardliner who lost the May 2017 presidential election to Rouhani.4 Ayatollah Sadeq Larijani, the conservative former head of the judiciary and current chairman of the Expediency Discernment Council, which is responsible for resolving disputes among government branches. Larijani is also a member of the Guardian Council.5 Ayatollah Ahmad Khatemi, hardline Tehran Friday prayer leader and senior member of the Assembly of Experts. The Iranian Revolutionary Guard Corps (IRGC) – a military force with immense influence in the regime – may choose to rule itself. We assign a low likelihood of this occurring. The IRGC is more likely to ensure that Khamenei’s successor is someone who supports its hardline ideology and vision for Iran. Some moderate clerics are advocating a change in structure, whereby the position of supreme leader is abolished. This school of thought argues that political leaders should be selected based on popular election rather than appointment.6 We do not assign high odds to this scenario. Until the Assembly of Experts selects the successor, a three-member council made up of the Iranian president, the head of judiciary, and a theologian of the Guardian Council, will assume the functions of supreme leader. Such a “triumvirate” could last longer than expected, or could even be formally decided as an alternative to a new supreme leader. In the context of such extreme uncertainty for the regime’s leadership in the coming decade, it is highly unlikely that the current political leaders will engage in negotiations with President Trump until they are sure of his staying power (Chart 16). First, the Iranians will continue to refuse talks prior to the US election. They will seek to undermine the Trump administration, yet without crossing red lines on the nuclear program (one year till nuclear breakout) or militant activities (killing American citizens). Chart 15Iran’s Guardians Vet Election Candidates Second, if Trump wins, then the shift to negotiations may or may not come, but the subsequent diplomatic process will be prolonged. Trump will have to gain the full cooperation of Europe, Russia, and China – and any new US-Iran deal is an open question and will involve tensions flaring up more than once. Chart 16Iranians Opposed To Talks With Trump Third, even if the Democrats win, the regime will play “hard to get” and will not immediately return to status quo ante Trump, although eventually there could be a restoration of the 2015 Joint Comprehensive Plan of Action or something like it. This process could also involve saber-rattling despite the Democrats’ more dovish disposition toward Iran. Bottom Line: The US maximum pressure campaign is not aimed at regime change in Iran, but if it brings any political change it will be a shift in a more hawkish direction as the regime faces immense internal and external pressures and an uncertain succession in the coming years. Iran’s leaders will continue to suppress unrest and can probably succeed in the near term. The confrontation with the US discredits any political actors who advocate negotiations. The path toward reform and improved relations with the West is closed until after the US election at minimum. Since Iran will seek to undermine both President Trump and the US presence in the Middle East in the meantime, US-Iran tensions remain a market-relevant source of risk in 2020. Iraq Still Poses An Oil Supply Risk Chart 17Iraqis Suffering From Poor Governance Iraq is ground zero for the US-Iran showdown, since the two powers have eschewed direct military confrontation. Iraqis have also been suffering the consequences of an ill-functioning political system (Chart 17). Corruption has prevented the trickle down of oil revenues, resulting in endemic poverty and inequality (Chart 18). Yet unlike its neighbor, Iraq is not ruled by a supreme leader who controls a powerful armed forces to which anger can be directed. Instead, protesters have been blaming the deep seated influence of the Iranian regime, which often results in what Iraqis’ argue to be a prioritization of foreign – i.e. Iranian – objectives over national ones. The demonstrations were successful in forcing the resignation of Prime Minister Adel Abdul Mahdi and the passing of a new electoral law. However Iraq remains in a state of chaos as Iraqis have vowed to remain on the street until all their conditions are met, including the appointment of an acceptable prime minister and early elections. Chart 18Poverty, Inequality, Corruption Plague Iraq This batch of reforms has been challenging for politicians to execute. For one, there is a lack of clarity as to which political group holds the majority of seats in Iraq’s Council of Representatives. Both the Iran-backed al-Binaa bloc as well as the al-Islah coalition led by Muqtada al-Sadr claim this position (Chart 19). A list of candidates for the temporary position of prime minister until early elections are held, proposed by Binaa in December, was rejected by President Barham Salih on grounds that it did not include anyone who would possess the support of the demonstrators. Chart 19Iraqi Parliamentary Control Up For Grabs Iraqi protesters have consistently reiterated their desire for a sovereign state, free from both American and Iranian interference. However, this nationalistic call has been disrupted and overshadowed by the US-Iran conflict. Importantly, the protest movement has now lost its most influential backer within the Iraqi political system: Sadr of the Islah bloc. This year’s Iran tensions and the parliamentary resolution to eject US troops from Iraq have unified the warring Shia political blocs. Sadr has called on the Mahdi army – a notoriously anti-American force also known as the Peace Brigades – to re-assemble. On January 13, in what can only be interpreted as a rapprochement among the main Shia political factions, Sadr met with paramilitary leaders making up the Popular Mobilization Forces in the Iranian city of Qom. They discussed the creation of a “united resistance” and the need jointly to expel foreign troops. Sadr also called for a “million-man march” against US troops in Iraq.7 Sadr’s pivot to Iran has not gone down well in Iraq’s streets, where protesters are accusing him of putting aside national goals for his own personal aspirations. While the protest movement will keep going, it is now largely headless and competing with the unified priorities of the Shia parties. This state of affairs weakens the odds of a sovereign Iraq that curbs Iranian regional influence. The political class is more likely to turn a blind eye to the repression of protesters, which is likely to increase as the system notches up its crackdown on dissent. A return to the status quo ante in Iraq is also now more likely. A new government may be elected. It may include more technocratic politicians in a nod to the protestors, but the pro-Iranian faction has fortified its position as kingmaker. Meanwhile, Sadr has decided that reform should be postponed for a later day. Iraqis who have been camping out on the streets for nearly four months, risking their lives, are unlikely to be easily put down. Instead their frustrations will manifest in more aggressive forms, such as through violence and the sabotage of infrastructure. Saudi Arabia may or may not seek to interfere in Iraq to maintain the pressure on Iranian interests. If it does so, it risks escalating the situation and provoking retaliation from Iran. Iraqi efforts to force a US troop withdrawal will clash with US interests. President Trump wants to reduce commitments but does not want to risk anything remotely resembling a Saigon-style evacuation during an election year. As such, some form of sanctions against Iraq is possible. The US administration may pass up imposing sanctions on oil sales and instead target USD flows to Iraq’s central bank. Blocking or reducing access to Iraqi accounts at the Federal Reserve Bank in New York – to which all revenues from Iraqi oil sales are directed – would debilitate the economy and amplify the risk to stability and hence oil flows. Washington’s decision whether to renew waivers allowing Iraq to import Iranian gas – set to expire mid-February – will signal whether the events earlier this year changed the US’s calculus. Iraq is extremely dependent on Iranian gas to generate power. A decision not to extend the waivers would cause greater friction between the Iraqi street and the ruling elite.8 Bottom Line: Baghdad is getting dragged deeper into chaos. Alignment with Iran, and delays in government formation and economic reform, will aggravate tensions between the street and the political class. Dissent may take on more violent forms going forward. Middle Eastern oil supply will remain vulnerable to instability and sabotage in Iraq and the broader Persian Gulf. Investment Conclusions In the very near term we expect US equities to encounter headwinds due to the over extension of the rally and immediate risks from the US election cycle. We also see global risk appetite suffering due to US uncertainty, as well as to fears about the new coronavirus. These may reach a crescendo in the wake of Chinese New Year travel season. However, China’s stimulative policy trajectory will ultimately be reinforced due to the economic threat from the outbreak. And China’s economy is showing signs of rebounding. This reinforces our constructive view on the global business cycle overall, on commodities, and on select emerging markets that produce oil or are undertaking structural reforms. The US-Iran conflict is ongoing and we expect it to continue injecting a risk premium into oil markets. The two sides are effectively playing Russian roulette.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The IRGC and bonyads – para-governmental organizations that provide funding for groups supporting the Islamic Republic – have access to subsidies, favorable contracts, and cheap loans. Together they run a considerable part of the economy. 2 Questions Loom In Iran As Reformist Factions Lose Hope In Elections," dated January 23, 2020, available at en.radiofarda.com. 3 In an interview with Fars news agency in June 2019, Ayatollah Mohsen Araki, a prominent member of the Assembly of Experts, mentioned that a committee of three members from the Assembly of Experts were working on a list of prospective supreme leaders, which they will present to the full AE when necessary. Please see "Is Iran’s Next Supreme Leader Already Chosen?," dated June 18, 2019, available at en.radiofarda.com. 4 Please see "Ebrahim Raisi: The Cleric Who Could End Iranian Hopes For Change," dated January 5, 2019, available at aljazeera.com. 5 Please see “A Right-Wing Loyalist, Sadeq Larijani, Gains More Power in Iran,” dated January 8, 2019, available at atlanticcouncil.org. 6 Mohsen Kadivar, an unorthodox cleric who was forced to flee Iran due to his political views, and is now an instructor at Duke University is a critic of the system of Velayet-e Faqih, or clerical rule. He claims that since the death of Khomeini, a majority of Iran’s religious scholars hold a “secretive belief” that supreme clerical rule should be abolished as it only leads to despotism. 7 In response to Sadr’s call for a “million man march”, Ayatollah al-Sistani repeated his warning against “those who seek to exploit the protests that call for reforms to achieve certain goals that will hurt the primary interests of the Iraqi people and are not in line with their true values.” 8 The last time Iran reduced electricity exports to Iraq resulted in mass protests in Iraq in July 2018. Thus if the sanction waivers are not renewed the cutoff of gas risks a greater clash between the Iraqi street and government, especially during the hot summer months.

Highlights The Wuhan coronavirus outbreak in China is now being priced into commodity markets, with comparisons to the 2003 SARS outbreak serving as an early benchmark.1 If it follows the SARS trajectory its impact likely will be limited, although oil demand could fall at the margin as global travel falls. The IMF expects growth in EM economies, the engine for commodity demand, to come in at 4.4% and 4.6% this year and next, respectively, down two-tenths of a percent from its previous forecast, but still up from 2019’s 3.7% rate. The Fund’s risk assessment tilts slightly to the upside, nonetheless, in the wake of global monetary and fiscal stimulus. We introduce our 2021 oil balances and price forecasts this week. We expect Brent crude oil to average $70/bbl next year, and for WTI to average $4/bbl below that. We are maintaining our $67/bbl Brent and $63/bbl WTI 2020 forecasts (Chart of the Week). Chart of the WeekCrude Oil Price Forecasts For 2020, 2021 Feature In its latest World Economic Outlook – Tentative Stabilization, Sluggish Recovery? – the IMF flags key risks to EM growth, which will continue to feed the economic policy uncertainty that dogs commodity demand.2 The Fund’s “downward revision primarily reflects negative surprises to economic activity in a few emerging market economies, notably India, which led to a reassessment of growth prospects over the next two years. In a few cases, this reassessment also reflects the impact of increased social unrest.” That said, the Fund sees the balance of risk slightly tilted to the upside versus its earlier assessment in October, in the wake of global monetary and fiscal stimulus. This is in line with our view that the effects of monetary stimulus – deployed over the better part of last year and still expected to remain accommodative this year – will boost growth this year. Our view remains tempered by risks we’ve been highlighting that keep political and economic policy uncertainty elevated – e.g., trade tensions, civil unrest, and the still-underappreciated risks to oil markets arising from US-Iran tensions and social unrest in Iraq, which remains high (Chart 2). The loss of 800k b/d from Libya is significant, but the world does not lack spare light-sweet crude oil production capacity – the US shales, in particular, abound in this type of crude oil. Chart 2Policy Uncertainty Will Trend Lower, But Continues To Dog Commodities Oil Fundamentals Improving As is typically the case, we expect global oil-demand growth this year will be led by EM economies. Crude oil fundamentals continue to favor higher prices: Production management and capital discipline will constrain the rate of growth of oil supplies, and, as discussed above, demand will benefit from policy stimulus globally (Chart 3). Oil demand growth will recover this year, following a lower-than-normal rate of just 830k b/d last year, based on the US EIA’s most recent estimates of historical consumption. We continue to expect demand to grow 1.4mm b/d this year.  For 2021, we expect growth of just under 1.5mm b/d, reaching 103.65mm b/d globally. For its part, the EIA’s estimating growth of 1.34mm and 1.37mm b/d for 2020 and 2021, respectively. As is typically the case, we expect global oil-demand growth this year will be led by EM economies, proxied by non-OECD oil consumption, of 1.26mm b/d. For next year, we expect EM demand growth to come in at 1.34mm b/d, or just over 90% of global oil consumption growth in 2021. On the supply side, we continue to expect OPEC 2.0 output to increase slightly in 2Q20 and return to levels consistent with its previous agreement to cut 1.2mm b/d of production. Our modeling also assumes this level of production remains flat for the rest of 2020. Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices Next year, we assume the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to increase production by 350k b/d in 1H21. In addition, we gradually remove 300k b/d of KSA’s overcompliance of 400k b/d next year, which moves its crude oil output in 2021 to 9.94mm b/d vs 9.76mm b/d this year. For Russia, we anticipate an increase in its condensate production, which it lobbied for last year. This will put our estimate of Russia’s crude and condensate production at 11.4mm b/d in 2020 and 11.64mm b/d in 2021.3 Most of the production cuts realized by OPEC 2.0 – ~ 2mm b/d – come at the expense of Venezuela and Iran, both of which are under sanctions limiting their production imposed by the US. We are holding Venezuela’s production at ~ 700k b/d in 2021, and will be monitoring this closely for any indication it is significantly changing. For Iran, we are keeping its production at 2.10mm b/d this year and next, assuming US sanctions remain in place. Oil production in both countries could be impacted by the outcome of US elections in November, and right now this is a near-impossible call to make. US Shales: No Longer A Growth Story? We continue to see slower production growth in the US than the EIA, particularly in the shales, as we expect capital markets to continue to discipline shale producers by only funding those firms that are able to return capital to shareholders or to deliver steady and increasing dividends. In our modeling, total US onshore production this year and next is expected to rise 800k b/d, and 310k b/d for 2021. We also continue to expect drilled-but-uncompleted (DUC) wells to continue to make significant contributions to overall shale-oil production in the US. Indeed, we expect DUCs to continue to offset part of the decline implied by lower rig counts, as they require less capex than drilling and completing new wells. We add ~ 500k b/d of production from DUCs completion over 2020 and 2021. Future production will depend heavily on the Majors and on productivity and lateral length. Our US crude and condensate production estimates for 2020 and 2021 reflect these constraints, and the slowing rate of growth being imposed by capital markets. For 2020, we expect total US crude and condensate production of 13.16mm b/d, of which 9.20mm b/d will come from the main shale basins led by the Permian.4 Tighter Fundamentals, Steeper Backwardations Our fundamental supply-demand balances are tighter than those assumed by the US EIA and the Paris-based IEA (Table 1). We expect US crude and liquids production to grow 1.6mm b/d this year, and only 500k b/d next year. We see global production growing 1.15mm b/d and 1.39mm b/d in 2020 and 2021, respectively. With demand growing 1.4mm b/d and close to 1.5mm b/d in 2020 and 2021, respectively, against this supply backdrop, our balances point to a deficit this year vs. the surplus expected by the IEA  (Table 2 and Chart 4). Table 1Fundamentals Comparison Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4BCA Research's Balances Estimates Point To Falling Inventories Chart 5Tighter Storage, Steeper Backwardation For this reason, we continue to anticipate a steepening in the Brent and WTI forward curves – i.e., more backwardation – which will support our long 2H20 Brent vs. short 2H21 Brent curve trade (Chart 5). As a result of the steeper backwardation, we expect higher volatility, and will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls (Chart 6). Bottom Line: We continue to expect crude oil markets to tighten, given persistent production restraint by OPEC 2.0, capital-market-imposed restraint on US shale-oil producers, and revived global demand growth in 2020 and 2021. The IMF’s assessment re the balance of risk being tilted to the upside, in the wake of global monetary stimulus, is broadly consistent with our maintained view. While we expect global policy uncertainty to fall following the so-called phase-one US-China trade deal and a definitive Brexit vote in the UK, geopolitical tension remains high, particularly in the Persian Gulf. Chart 6Steeper Backwardation To Higher Implied Volatility We will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. As a result, we are keeping our 2020 Brent forecast at $67/bbl, and are expecting 2021 Brent to trade at $70/bbl; WTI is expected to trade $4/bbl below Brent this year and next, on average. At tonight’s close, we will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices traded sideways ~ $64/bbl since last Tuesday, dismissing the US and China phase-one agreement and disruptions to Libyan production and exports which could total as much as 800k b/d.  Over the weekend, concerns re the Wuhan coronavirus outbreak in China started being priced into commodities, particularly oil.  Separately, the US Treasury Department renewed Chevron’s waiver to operate in Venezuela for another three months.  The company is scheduled to export 1mm barrels of oil produced by PDVSA via a joint-venture, partially dodging US sanctions on Venezuelan oil.5  We expect the country’s output to stabilize close to its current level of 710 kb/d this year. Base Metals: Neutral On Tuesday Beijing reported more than 400 people had been infected with the Wuhan coronavirus, confirming person-to-person transmission of the virus. Concerns that a wider spread over the lunar New Year holidays starting this weekend will impact economic growth in the world’s top metal consumer brought copper prices down 1.8% on Tuesday.  Zinc reached two-month highs this week amidst concerns of low LME warehouses stocks, now close to their 20-year lows at 50,900 MT (Chart 7).  Supply concerns stemming from low iron ore stocked in China’s ports, along with good Chinese macro data, lifted iron-ore prices. Precious Metals: Neutral The US dollar is a key missing piece needed to propel gold prices higher from current levels. The 2.4% decline in the trade-weighted dollar index supported gold’s 5% increase since October 1, 2019 (Chart 8).  We expect the dollar to continue depreciating in 2020, as global growth rebounds and the Fed remains accommodative, keeping gold prices well bid.  Most precious metals have followed gold’s lead this year; palladium and platinum are up 17.63% and 3.15%, respectively. Chart 7 Chart 8 Ags/Softs:  Underweight CBOT Corn and soybeans futures traded lower on Tuesday as markets awaited evidence of China purchasing additional U.S. agricultural goods, fulfilling its commitment to buy $32 billion of agricultural goods over two years per the phase-one deal negotiated between China and the US earlier this month.  Corn traded lower, as US grain elevators have yet to confirm any Chinese buying.  Soybeans, further weakened by expectations of a massive harvest in rival exporter Brazil.  Wheat was the only ag posting gains early in the week on the back of strong Black Sea export demand.     Footnotes 1     Please see CDC SARS Response Timeline, published by the US Centers for Disease Control and Prevention.  The SARS outbreak was identified in February 2003 and lasted six months.  The CDC noted: “Globally, WHO received reports of SARS from 29 countries and regions; 8,096 persons with probable SARS resulting in 774 deaths. In the United States, eight SARS infections were documented by laboratory testing and an additional 19 probable SARS infections were reported.”  According to Chinese officials, there were 440 confirmed cases of the new coronavirus as of Wednesday; nine people were reported to have died thus far.  The World Health Organization met Wednesday to assess the Wuhan coronavirus outbreak.  The 2003 coronavirus outbreak was minor compared to the typical influenza outbreak: by way of comparison, every year there are an estimated one billion cases of influenza, resulting in 290,000 to 650,000 deaths, according to the International Federation of Pharmaceutical Manufacturers & Associations in Switzerland. 2               Economic policy uncertainty is a recurrent theme in our research.  It has been driving safe-haven demand for the USD and gold for months, as we recently discussed in Iran Responds To US Strike; Oil Markets Remain Taut.  It is available at ces.bcaresearch.com. 3     We use World Bank growth estimates to drive our EM demand forecasts.  Earlier this month, the Bank forecast EM GDP growth of 4.1% for 2020 and 4.3% for next year.  This will outpace last year’s growth rate of 3.5%. 4     US production growth, particularly in the Permian and Bakken basins, could be constrained by environmental restrictions, if state regulators crack down on the massive flaring occurring in both states.  Please see Lingering Oil-Demand Weakness Will Fade, published November 21, 2019, where we discuss this risk in more depth. 5     Please see Exclusive: PDVSA's partners act as traders of Venezuelan oil amid sanctions - documents, published by reuters.com January 13, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Overweight US refiners enjoyed a solid run for the better part of 2019, but over the past three months have retraced roughly a third of those relative gains. Nevertheless, we remain overweight the S&P oil & gas refining & marketing (O&G R&M) index for three reasons. First, US gasoline inventories are on the cusp of contracting anew. Whittled down inventories have historically underpinned US refiners’ margins (gasoline inventories shown inverted, second panel). Second, historically rising crack spreads have been synonymous with expanding relative forward earnings growth. Thus, an inventory-led boost to refining margins should continue to underpin relative profit growth (third panel). Finally, the dollar is a key driver behind the entire commodity complex as well as commodity exposed equities. Since the 2015 manufacturing recession, US refiners have been tightly inversely correlated with the greenback and the current message is that the sell-off in the S&P O&G R&M index is near exhaustion (US dollar shown inverted, bottom line). Bottom Line: We remain overweight the S&P O&G R&M index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.