Energy

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well Chart I-13German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Chart II-3No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

How important is the potential thawing of the Sino-U.S. trade war to oil markets?  On a scale of 1 – 10, this goes up to 11 (Chart of the Week). Brent’s and WTI’s one-day rally of ~ 5% on Tuesday, followed by a 4.5% sell-off on Wednesday, is a testimony to the importance these markets place on the evolution of the Sino-U.S. trade war, and anything that suggests a change in the status quo.1 The rally was an almost-immediate response to the announcement the U.S. would delay until December 15 the imposition of tariffs on ~ $160 billion of $300 billion of goods that become effective September 1. The tariffs were announced August 1 by President Trump. Wednesday's sell-off was triggered by weak global economic data and building U.S. crude stocks. It also was a wake-up that nothing substantive was advanced to resolve the Sino-U.S. trade war. The rally indicates pent-up demand awaits a resolution of trade uncertainties. In this report, we introduce our new proprietary Nowcast model of EM commodity demand.2 We also look at the overall macro backdrop for commodity markets, which is largely supportive, with most of the world’s central banks moving to a recession-fighting mode.3   In addition, we could get a deal between the U.S. and China following the resumption of tariff negotiations in Washington come September, which allows some resumption of trade. We have little doubt markets would welcome such an outcome. However, we remain skeptical of the deeper issues separating the two sides – e.g., IP protection, an end to forced technology transfers – will be resolved in the near future. Highlights Energy: Overweight. Saudi Aramco held its first-ever investor call this week, disclosing it earned close to $50 billion in 1H19. Earnings were down ~ 12% in the period, according to the company, partly as a result of a 4% decline in realized prices for crude oil vs. 1H18. This is a relatively small decline vs. the 7% and 12% 1H19 y/y declines in Brent and WTI, over the same period, reflecting the Kingdom’s premier position as the largest exporter of medium and heavy crudes in the world. These streams are in short supply relative to the light-sweet crude being produced in the U.S. shales. Base Metals: Neutral. Copper also got a lift from renewed trade-talk hopes, rising 2.3% on the back of the unexpected trade news from the Trump administration earlier in the week. Many of the products exempted by the Office of the U.S. Trade Representative are electronics – cell phones, laptop computers, video game consoles, and computer monitors – which will marginally support copper prices, and Christmas retail sales. Copper held on to most of its gains Wednesday. Precious Metals: Neutral. Gold and silver sold off following the U.S. trade representative’s announcement, but recovered later in the trading day, and Wednesday. Gold continues to trade above $1,500/oz, while silver trades over $17/oz. We remain long both metals as portfolio hedges against policy risk. Ags/Softs: Underweight. With the exception of corn, grains and beans mostly rallied on the trade news, with soybeans ending the day up 1.2% Tuesday. Corn traded down 6.1% Monday and a further 5.0% Tuesday, following the USDA’s WASDE report, which indicated acres planted would fall by less than analysts estimated going into the Monday morning release of the department’s supply-demand estimates, according to agriculture.com. Feature Commodity markets are noted for their ability to cover a year’s worth of price movement in a matter of days. The past two weeks in the oil markets have not disappointed, as the Chart of the Week attests. Despite the volatility introduced by exogenous policy shocks, we remain constructive on crude oil. The underlying resilience in the growth of EM economies, which drives commodity demand generally, is apparent in various gauges we’ve developed to track something close to current conditions in markets. In addition, as noted above, fiscal and monetary policy globally remains supportive of commodity demand. While growth may not match the halcyon pre-GFC days shown in the top panel of Chart 2, growth still is strong and, importantly for commodities, is coming off a higher base level.4 Broader indicators – e.g., global and country-specific LEIs – support our expectation for improved EM growth, which, ultimately is what drives commodity demand. We are compelled to note considerable uncertainty around the prospects for global growth – particularly for EM GDP growth – exists in markets and within BCA Research. Our Special Report on these divergent views elegantly presents these differences, and we highly recommend it to our readers. Fundamentally, we align with the bulls, who argue global growth can be expected to rebound this year, for reasons we cite above. The bears in BCA, which include our Emerging Market strategists, have a different view to ours, particularly on EM domestic demand. The bears expect a further deterioration in global economic activity or a delayed recovery. As a result, they expect additional downside in stocks and risk assets – including commodities – and outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar.5  EM GDP Resilience Our BCA EM Commodity-Demand Nowcast model points to an underlying recovery in oil demand, despite the continued policy-induced volatility in prices (Chart 2). This model is a weighted index of our Global Commodity Factor (GCF), Global Industrial Activity (GIA) Index, and EM Import Volume (EMIV) models (Chart 3).6  Chart 2BCA EM Commodity-Demand Nowcast Suggests Oil Demand Rebounding Chart 3BCA EM Commodity-Demand Nowcast Components   Chart 4Global Growth Poised To Resume The GCF uses principal component analysis to distill the primary driver of 28 different commodity prices traded globally. The GIA index uses trade data, FX rates, manufacturing data and Chinese industrial activity statistics, which can be updated monthly. Lastly, the EMIV model is driven by EM import volumes reported with a two-month lag by the CPB in the Netherlands, which can be updated to current time using FX rates of economies highly sensitive to EM trade. Our BCA EM Commodity-Demand Nowcast is strongly correlated with y/y growth in nominal EM GDP and non-OECD oil consumption, as Chart 2 shows. This highlights the strong connection between EM GDP growth and oil demand growth. This also is critical to price formation – indeed,  our Nowcast is highly correlated with crude oil prices, which explains why EM GDP is our principal demand variable in forecasting oil prices (Chart 2, bottom panel). Other, broader indicators – e.g., global and country-specific LEIs – support our expectation for improved EM growth, which, ultimately is what drives commodity demand (Chart 4). However, these can change as local economic activity changes.7 One important thing to note, however: While China’s nominal import volumes are weaker y/y, its volume of crude oil imports (Chart 4, top panel) are growing. Partly this is the result of strong refinery margins; but there is a risk too much product will be produced, which could saturate Asian refined-product markets.8 Bullish Crude Oil Term Structure While price levels have been hammered lower by trade policy uncertainty and weekly pivots in direction, the Brent and WTI forward curves remain backwardated (Chart 5). This normally indicates market tightness – i.e., refiners are willing to pay more for prompt-delivered crude than for deferred delivery. Crude oil markets continue to be buffeted by policy shocks – particularly in regard to the Sino-U.S. trade war. Chart 5Crude Oil Forwards Remain Backwardated This is consistent with our reading of the underlying supply-demand dynamics of the crude market. It is important to note the backwardation in these forward curves weakened almost every month since the beginning of the year. This suggests demand slowed – the market is tight, but closer to balanced, and not in as large a supply deficit as it was expected earlier in the year. We expect OPEC 2.0 to continue to maintain production discipline, and for demand to turn up in 2H19.9 In addition, we continue to expect strong demand in 2H19 and in 2020 as we’ve noted above, given the supportive fiscal and monetary backdrop globally. Bottom Line: Crude oil markets continue to be buffeted by policy shocks – particularly in regard to the Sino-U.S. trade war. Despite these shocks, demand for crude is holding up, although it still is lower than what we expected previously – along with the EIA and IEA, we’ve been revising demand lower in our last three monthly Global Oil Balance assessments. Demand is now supported by monetary and fiscal policy easing globally. However, escalation in trade tensions could bring demand down again. Indeed, an escalation in Sino-U.S. trade tensions could push this to a lower equilibrium. It is important to point out our Nowcast is a coincident indicator, and that most of our series' last data points were observed in July, which is before the latest escalation in trade tensions. We could see a move down in some of our indicators next month. To be clear, we are not sounding an all-clear on the trade front, although we are seeing signs of recovery from relatively high base levels of EM GDP activity.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see USTR Announces Next Steps on Proposed 10 Percent Tariff on Imports from China, issued by the Office of the United States Trade Representative August 13, 2019. The USTR’s press release appears to be something of an olive branch, noting, “On May 17, 2019, USTR published a list of products imported from China that would be potentially subject to an additional 10 percent tariff.  This new tariff will go into effect on September 1 as announced by President Trump on August 1.”  This suggests the opening of a possible compromise ahead of trade talks set to resume next month. 2      As discussed below, our BCA EM Commodity-Demand Nowcast combines three of our proprietary models gauging EM commodity demand.  Please see Getting Long Silver, To Hedge Exogenous Shocks, published by BCA Research’s Commodity & Energy Strategy August 8, 2019.  It is available at ces.bcaresearch.com. 3    Our prior remains it is highly unlikely the PBOC or the Fed will let their economies weaken substantially without deploying additional monetary stimulus.  In addition, we believe Chinese policymakers will hold off on major stimulus in the next couple of months to get thru National Day, which will allow them to deploy further fiscal stimulus after October and next year, in the event the trade war and currency war worsens.  We also draw attention to the fact that, globally, central banks all are acting as if they’re already fighting a recession – last week, three central banks announced further easing (India, New Zealand, Thailand), following similar action by the Fed and Asian central banks (South Korea and Indonesia).  A full-blown trade war between the U.S. and China would be tumultuous, but, after the dust settles, global supply chains would have to be rebuilt or augmented, as trading blocs centered on the respective antagonists regrouped and reorganized their trading relationships and supply lines. 4     Using World Bank quarterly GDP figures, we calculate Emerging and Developing markets’ GDP will be up close to 74% between 2007 and 2019, averaging $7.24 trillion in constant 2010 USD this year. 5      We urge our clients to read this Special Report, What Goes On Between Those Walls? BCA’s Diverging Views In The Open, published by BCA Research July 19, 2019. 6       The nowcasting index uses the weighted average of each component’s coefficient of determination that falls out of a regression against EM GDP growth. Our analysis indicates EM oil demand is driven by EM GDP growth.  For additional information on the separate gauges, please see Getting Long Silver, To Hedge Exogenous Shocks, Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals published by BCA Research’s Commodity & Energy Strategy August 8 and May 9, 2019.  Both are available at ces.bcaresearch.com. 7      We note Indian economic activity is slowing due to strains on the shadow-banking system in that country.  This bears watching, as India is the second largest EM economy we track in our oil-demand estimates.  Please see India's passenger vehicle sales drop at steepest pace in nearly two decades, published by in.reuters.com August 13, 2019. Auto industry representatives are pushing for government support to address the sales downturn.  S&P’s BSE index measuring the health of Indian banks is down 23% ytd.  8     Please see UPDATE 1-China's July crude oil imports rise as refiners ramp up output published by reuters.com August 8, 2019. 9      We are updating our supply-demand balances and prices forecasts for Brent and WTI next week. For our most recent forecast, please see Weak 1H19 Oil Demand Data Fuels Market Uncertainty published by BCA Research’s Commodity & Energy Strategy July 18, 2019.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Much like the rest of the global economy, oil markets await the lift in demand that fiscal and monetary stimulus have delivered in the past. As the debate among BCA Research’s strategists demonstrated, this is not a given. Uncertainty over the effectiveness of these policy responses will remain elevated as 2H19 evolves.1 For our part, we expect global stimulus – led by easing financial conditions in the U.S. and China – will reboot demand. On the supply side, we expect OPEC 2.0 production discipline and capital-constrained U.S. shale-oil production to keep output growth just below demand growth for the next year (Chart of the Week, top panel).2 Markets arguably have not been on the same page as us for the past two months or so, and appear to be pricing in supply-demand assumptions similar to those contained in the U.S. EIA’s latest Short-term Energy Outlook (STEO).3 These generate lower forecasts – $61/bbl and $57/bbl – than the $75/bbl and $70/bbl we expect for Brent and WTI next year, when we run them through our fundamental econometric model (Chart 2). Chart of the WeekOil Supply - Demand Balance Will Continue To Tighten We argue below the EIA’s assumptions are consistent with current price levels, but inconsistent with current Brent and WTI forward curves. We remain long September – December 2019 Brent vs. short September – December 2020 Brent, which is up 76% since inception February 28, 2019, and long 1Q20 vs. 1Q21 Brent, which is up 39% since inception July 18, 2019, in anticipation of steeper backwardations. We also expect the combination of global fiscal and monetary stimulus, along with the aforementioned production constraints, will lift price levels in line with our forecasts. Highlights Energy: Overweight. In line with our expectation, U.S. crude oil inventories drew 8.5mm barrels last week, posting a record seventh consecutive draw. Last week’s inventory drawdown follows a massive draw in crude oil of close to 11mm barrels the previous week. Base Metals: Neutral. Spot treatment and refining charges (TC/RC) for copper fell to $51.20/MT last week, the lowest reading since the launch of Fastmarkets MB’s Asia-Pacific index in 2013. This is consistent with tighter spot supplies – low TC/RC levels mean demand for spot refining services is weak due to low concentrate supply. Our long Dec19 $3.00/lb calls vs. short Dec19 $3.30/lb call on the COMEX was stopped out after hitting our -15% stop-loss limit. We remain bullish and will re-visit this recommendation in the near future. Precious Metals: Neutral. Gold prices remain well supported by global monetary accommodation, as seen this week following the Fed’s decision to lower its policy rate by 25bps to 2.25%. We expect another “insurance cut” later this year, and remain long gold, which is up 12% this year as central banks scramble to redress tightening financial conditions globally. Ags/Softs: Underweight. 54% of the U.S. soybean crop was rated in good or excellent condition in states accounting for 95% of bean acreage. Last year at this time, 70% of the crop was rated good or excellent, according to the USDA’s Crop Progress Report. Feature The oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. Easing financial conditions in the U.S. and China, along with higher fiscal outlays globally, are necessary and likely sufficient to reboot global oil demand, in our assessment of fundamentals.4 On the supply side, our modeling assumes OPEC 2.0’s production discipline and capital-constrained U.S. shale-oil production will be sufficient to keep output growth just below demand growth for the next year.5 Chart 2Oil Markets Pricing Weaker Fundamentals Than BCA Expects In our modeling, these supply-demand effects combine to lift prices, and to further backwardate the Brent and WTI forward curves as global storage levels fall, as the top panel of Chart 2 shows. However, as the bottom panel of Chart 2 illustrates, the oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. The EIA assumes demand growth of 1.1mm b/d this year, versus our assumption of 1.25mm b/d, and 1.4mm b/d next year, versus our 1.5mm b/d assumption. When we push the EIA’s assumptions through our fundamental supply-demand-inventory model, we get average Brent prices of $64/bbl this year and $61/bbl in 2020, versus our expectations of $70/bbl this year and $75/bbl next year for Brent.6 For WTI, the EIA’s fundamentals produce prices of $57/bbl in 2019 and $57/bbl in 2020, versus our expectation of $63/bbl and $70/bbl. Whither Storage? The EIA’s supply-demand fundamentals produce price levels closer to where the market is trading currently, when we run them through our fundamental model. However, they are not consistent with forward-curve dynamics, which presently are backwardated. Using the EIA’s supply and demand assumptions for this year and next in our econometric model produces an increase in oil inventories, which grows next year, as opposed to our expectation inventories will shrink over the course of the next year (Chart 3, bottom panel). If the EIA’s expectation for inventories was shared by market participants, Brent and WTI forward curves would be in contango, not backwardation as they are presently. In this respect, our estimates are more consistent with current forward-curve dynamics (Chart 3, top panel). Chart 3Inventories Swell Assuming EIA's Supply-Demand Fundamentals Chart 4Crude Inventories' Days-Forward-Cover This also can be seen in an analysis of days-forward-cover (DFC) dynamics, in which we compare deviations from the five-year average (trend) number of days’ worth of demand that can be covered by current inventory levels (Chart 4). Our assumptions produce deviations that align with the differentials between prompt and deferred futures contracts, which measures the backwardation and contango in Brent and WTI markets. The implied DFC ratio that falls out of running the EIA’s supply-demand assumptions in our fundamental model shows inventories in 2020 level out, even as market participants continue to price in a backwardated forward curve for Brent and WTI.7 If we are correct in our assessment of inventories, Brent volatility will increase next year as inventories and DFC fall (Chart 5).   Whither Global Trade, Manufacturing? As we’ve noted above, the next few months will provide important information to markets and policymakers alike, as both wait to see whether the concerted monetary policy efforts aimed at reviving the real economy – manufacturing, in particular – will be effective. As an aside, uncertainty regarding the effectiveness of what, in the not-too-distant past, was considered standard macroeconomic stimulus is not restricted to market participants and practitioners. Central banks, and the economics profession itself are in the midst of a fundamental rethink of its foundational assumptions and models, and will be dialed in on this entire process.8 We continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. The global manufacturing slowdown in 1H19 is confirmed in EM trade data (Chart 6). This has the potential to continue if the Sino-U.S. trade war retards capex and durable-goods spending. The IMF notes the linkage between manufacturing and global trade exists because trade includes a lot of durables, which are energy-intensive in their production and transportation.9 Again, the big unknown here is whether the fiscal and monetary stimulus in systematically important economies will be sufficient to revive manufacturing globally and commodity demand, particularly for energy. There is enough cognitive dissonance around the effectiveness of monetary policy – and the channels through which it operates – to give even a hardened monetarist pause. If, as we expect, U.S. monetary stimulus succeeds in weakening the USD, global trade and EM GDP levels can be expected to increase.10 This will be supportive of commodity demand generally, oil demand in particular. In a simulation of oil prices as a function of the broad trade-weighted USD, we found Brent prices could rally sharply on a 10% depreciation between now and end-2020 (Chart 7). Chart 6Fiscal and Monetary Stimulus Will Lift Global Trade and Manufacturing Chart 7Fed Policy Should Weaken USD, Boost Oil Demand Such a rally is unlikely to occur due to USD weakness alone, given the mitigating factors observed in recent excursions above $80 Brent. OPEC 2.0 likely would raise production as prices moved through $80/bbl, and we expect demand destruction in EM economies would quickly follow, due to the removal of fuel subsidies in many EM economies. These supply-demand responses would push prices lower after a few months. However, this exercise is worthwhile in forming an expectation around successful Fed stimulus, given the long-term equilibrium between the broad USD TWIB and oil prices since 2000. This analysis also suggests there is a role for OPEC 2.0 in increasing production, if systematically important central banks succeed in reviving global demand, and the Fed can lower the USD TWIB. Keeping production too low at that point would be self-defeating for the coalition. Successfully managing this balance would support EM GDP growth and, in so doing, lift commodity demand. Bottom Line: Oil prices are trading to lower expected levels of demand and higher supply than we currently are using in our forecasts. However, we continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. As such, we are maintaining our expectation Brent crude will average $70 and $75/bbl this year and next, with WTI trading $7 and $5/bbl lower, respectively. We also expect these forces to steepen the backwardation in Brent and WTI forward curves this year and next. Big policy issues – the Sino-U.S. trade war, U.S.- Iran tensions in the Persian Gulf, uncertainty around how the crisis in Venezuela is resolved – still dog markets, as do persistent doubts re the effectiveness of monetary policy.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see What Goes On Between Those Walls? BCA’s Diverging Views In The Open, a Special Report published by BCA Research July 19, 2019. It is available at bca.bcaresearch.com. 2      OPEC 2.0 is the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was founded in 2016 to reduce global oil inventory levels bloated by a market-share war launched by the original OPEC cartel in 2014. Backwardation is a term of art in commodity markets, which describes a forward curve in which prompt prices exceed deferred prices. The opposite of backwardation is contango. 3      The U.S. Energy Information Administration’s Short-term Energy Outlook is published monthly. 4      Please see Weak 1H19 Oil Demand Data Fuels Market Uncertainty, published July 18, 2019, for our latest forecast. 5      NB: Our forecast for U.S. shale-oil production includes the drawdown of excess drilled-but-uncompleted (DUC) wells, especially in the Permian as pipeline constraints are removed this year. Recent reports have suggested DUC excess inventory is over-estimated in EIA data we use in our models, and that more wells than actually are reported by the EIA are required to produce the volumes reported for the Permian Basin. Please see Analytics Firm: Permian Fracturing Work Underreported by 21% in 2018 published by the Journal of Petroleum Engineering July 24, 2019. 6      The EIA’s forecast calls for Brent to average $67/bbl in 2H19 and for all of 2020, and for WTI to trade $5/bbl and $4/bbl under Brent in 2H19 and 2020, respectively. For 2H19, we expect Brent to trade at $74/bbl; we expect WTI to trade $7/bbl below Brent in 2H19 and $5/bbl lower in 2020. 7      We assume OPEC 2.0 will need to increase production in 2H20, to keep inventories from falling so low that Brent prices risk breaching $80 - $85/bbl, which we view as the no-go zone the producer coalition is most sensitive to. 8      Please see Rebuilding macroeconomic theory Volume 34, Issue 1-2 of the Spring-Summer 2018 issue of the Oxford Economic Policy Review for an excellent treatment of this effort. The Fed also is examining how it conducts monetary policy, in an effort led by Vice Chair Richard Clarida. The initial research goals were laid out in November 2018, when the Fed announced it would be conducting a comprehensive review of its monetary policy strategy, tools, and communication practices. In June of this year, the Fed followed through with a two-day symposium to discuss many of the topics we routinely address in our publications. Prof. Maurice Obstfeld of Berkeley’s Global Dimensions of U.S. Monetary Policy was an insightful paper re how U.S. monetary policy affects global growth; Prof. Kristin Forbes of MIT’s discussion also was excellent, and highlighted the role of commodity markets in this framework. 9      Please see Still Sluggish Global Growth in the IMF’s World Economic Outlook Update, published July 23, 2019. The Fund lowered its global growth forecast slightly, and cautioned, "GDP releases so far this year, together with generally softening inflation, point to weaker-than-anticipated global activity. Investment and demand for consumer durables have been subdued across advanced and emerging market economies as firms and households continue to hold back on long-term spending. Accordingly, global trade, which is intensive in machinery and consumer durables, remains sluggish. The projected growth pickup in 2020 is precarious, presuming stabilization in currently stressed emerging market and developing economies and progress toward resolving trade policy differences." 10     These variables are intimately connected. Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah published by BCA Research’s Global Investment Strategy June 28, 2019, for our House view on global growth, interest rates and the expected evolution of the USD. It is available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades  

The long global gold miners/short S&P oil & gas exploration & production pair trade hit our recently augmented trailing stop intraday yesterday, and we obeyed this stop and locked in gains of 12% since its July 15th inception. As a reminder, we have been increasingly using risk management techniques to protect our portfolio from the late cycle market turbulence.  Our view on the pair trade, first articulated in mid-July, has not changed and we remain cautious on the U.S. and global growth prospects. As such, more gains are expected in the long global gold miners/short U.S. oil producers pair trade, but not before a much needed breather. We will be looking to re-initiate this market-neutral trade once overbought conditions have been worked off and a better entry point emerges.  Bottom Line: Lock in the gains of 12% in the long global gold miners/short S&P oil & gas exploration & production pair trade via the long GDX:US/short XOP:US exchange traded funds and move to the sidelines for now, but stay tuned. 

Last Thursday we were stopped out from our tactical S&P semi equipment underweight position as it hit our -7% stop loss (bottom panel). We are obeying the stop loss and are returning this index to a neutral weighting as better than expected profits from both ASML and TSMC lifted all chip-related equities. In marked contrast, our long global gold miners/short S&P oil & gas exploration & production trade initiated just last week has gone parabolic, spiking to 17% (top panel). While our thesis has not changed in this high beta tactical pair trade, from a risk management perspective, we are moving our stop loss from -10% to +12% in order to protect profits. Bottom Line: Stick with the counter-cyclical long global gold miners/short S&P oil & gas exploration & production trade via the long GDX:US/short XOP:US exchange traded funds. For additional details on the rationale behind this trade, please refer to last Monday’s Weekly Report.  

Oil price volatility will remain elevated, as markets transition from a pronounced demand slowdown in 1H19, which is apparent in actual consumption data, to stronger growth. We expect global fiscal and monetary accommodation will arrest and reverse this slowdown in 2H19, and spur oil demand growth in 2020. Consistent with BCA’s Geopolitical Strategy, we are not expecting a resolution to the Sino – U.S. trade war that boosts demand; however, we could see a limited deal by 2H20 that partially addresses tariff barriers and boosts trade in the short run.1 In line with the EIA’s and IEA’s weaker 1H19 oil-consumption assessments, we now expect global demand to grow 1.25mm b/d this year, and 1.50mm b/d next year. These expectations are down 100k b/d and 50k b/d, respectively, from our June estimates. Chart of the WeekOPEC 2.0’s Storage Strategy Continues To Drive Production Supply – demand factors combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. On the supply side, we continue to expect OPEC 2.0’s production strategy to be driven by its primary goal – reducing global oil inventories – which means it will maintain production discipline this year and possibly into 1Q20 (Chart of the Week). We also expect capital discipline in the U.S. to restrain shale-oil production. Lastly, news flows around U.S. – Iran tensions continue to oscillate between hopeful resolution and a hardening of positions, which fuels price volatility. At the end of the day, we expect any increase in Iranian exports resulting from an easing of U.S.-GCC-Iran tensions to be accommodated by OPEC 2.0, as it was prior to the re-imposition of U.S. export sanctions.2 These supply – demand factors combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. We continue to expect WTI to trade $7/bbl below Brent this year, and $5/bbl lower next year (Chart 2). Chart 2Demand Slowdown In 1H19 Pushes Brent Forecast Lower Highlights Energy: Overweight. Given our expectation for tighter markets, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close, expecting steeper backwardation in the benchmark forward curve as global inventories draw in 2H19. Base Metals: Neutral. At $52.50/MT, Fastmarkets MB’s spot copper TC/RC Asia – Pacific index remains depressed, suggesting smelters will have to continue to discount their services due to tight physical supplies. Expecting tighter markets, we are getting long Dec19 $3.00/lb COMEX call spreads, vs. short Dec19 $3.30/lb COMEX calls at tonight’s close. Precious Metals: Neutral. Gold prices are largely being driven by U.S. real interest rates and the broad trade weighted USD, which we will explore in detail next week in a Special Report written with our colleagues in BCA’s Foreign Exchange Strategy. Given our expectation for Fed accommodation this year, we remain long gold. Ags/Softs: Underweight. The USDA lifted expected ending stocks for corn in its latest WASDE released last week. The department expects supply growth to outstrip use, which will raise stocks 335mm bushels to 2.0 billion. Feature Last week, we had the good fortune to visit U.S. clients in “The Great State,” otherwise known as Texas. It was a fortuitous swing through the Promised Land, because we had the opportunity to gain insight on a wide range of topics impacting commodity markets, particularly oil and gold, which are responding to many of the same factors driving markets for risky assets generally. Demand for industrial commodities in particular should pick up this year and next. More than a few of our discussions centered on global aggregate demand for real and financial assets. Prior to the Osaka G20 meeting last month, it looked like the odds of a global recession were increasing. Markets were contending with tightening financial conditions in the wake of the Fed’s December 2018 rate hike, the fourth such hike last year; escalating Sino - U.S. trade tensions, which were depressing capex and demand for industrial commodities; and slowing growth generally ex U.S. (Chart 3). Positioning as if the Fed was too late in reversing the policies that led to tighter financial conditions in 2H18 and earlier this year, and in a manner consistent with a deepening of the Sino - U.S. trade war was not unreasonable. That said, a client at one of the Lone Star state's larger investment managers observed that the powerful rallies in markets for risky assets following Fed accommodative signaling beginning earlier this year strongly suggest the markets’ verdict — at least for the moment — is the Fed acted in time to arrest the risk of a global recession this year. Chart 3Global Growth Slowdown Likely Drove Policy Responses Chart 4BCA's GIA Index Signaling Industrial Commodity Rebound Added to this is the fact that the U.S. central bank is being supported by other systematically important central banks (specifically the PBOC, BOJ, and ECB), and that fiscal stimulus is being deployed globally. Against this backdrop, it is difficult to remain bearish re global aggregate demand going forward, which is to say demand for industrial commodities in particular should pick up this year and next. Indeed, this is starting to show up in our Global Industrial Activity (GIA) Index, which is heavily weighted toward EM industrial commodity demand (Chart 4).3 Oil Demand Will Roar Back In 2H19 Our updated 2019 demand estimates align with the EIA’s and IEA’s depressed 1H19 oil-consumption assessments: We now expect global consumption to grow 1.25mm b/d this year, down 100k b/d vs. our previous estimate. Next year, however, we expect demand to be up 1.50mm b/d in the wake of global stimulus, which is only 50k b/d below our June estimate.4 The IEA’s assessment of 1H19 demand weakness is particularly striking. In its latest forecast, the agency noted that in 2Q19, they show a global surplus of 500k b/d (i.e., supply exceeded demand), where previously they expected a 500k b/d deficit. This million-barrel swing – if it is confirmed when data are later revised with more accurate reporting – suggests the global economy did come close to entering recession earlier this year. We are not as bearish as the IEA, but we do incorporate the severity of the trend they highlight in our forecast. We expect 1H19 global demand grew 520k b/d y/y. In 2H19, like the IEA, we expect demand to come roaring back. We expect consumption to grow at a rate of slightly over 2mm b/d, whereas the IEA’s expecting a 1.8mm b/d rate (Table 1). We believe this momentum will be maintained into 1H20, with growth expected to come in at just over 1.8mm b/d, followed by a more subdued 1.35mm b/d growth rate in 2H20.5 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) It is important to note here that monetary stimulus hits the economy after “long and variable lags,” in the phrasing of Nobel laureate Milton Freidman. Therefore, we will be closely monitoring our demand estimates for signs the coordinated stimulus being deployed by central banks globally actually is translating into higher industrial commodity demand.6 It also is worthwhile pointing out there is a non-trivial risk – i.e., greater than Russian-roulette odds of 1:6 – the Sino – U.S. trade war metastasizes into a global trade war as positions on both sides harden. This could usher in a new Cold War, and see global supply chains broken and reconstituted within trading blocks. The transition to such a realignment of global trade no doubt would be volatile, but, at the end of the day likely would support commodity demand as supply chains are re-built. OPEC 2.0 Remains Sensitive To EM Demand On the supply side, we continue to expect OPEC 2.0’s production strategy to be driven by its primary goal – i.e., reducing global oil inventories. This means the coalition will continue to exercise production restraint: We expect OPEC 2.0 to reduce output by 540k b/d this year per this strategy. In addition to its inventory goals, we believe OPEC 2.0 also does not want to see Brent price go through $85/bbl. This is because many EM states removed fuel subsidies following the oil-price collapse of 2014 – 2016, and the demand-destruction effects of higher prices would be realized in fairly short order above $85/bbl.7 We view this as a binding constraint – prices above the $80 - $85/bbl range will destroy EM demand, which makes them counterproductive for OPEC 2.0. As a result, next year, we expect the producer coalition to gradually raise output by 800k b/d over the January – August 2020 period, to restrain prices below $80/bbl (Chart 5). It is worthwhile mentioning, since it came up repeatedly in conversations during our Texas swing, we do not share the view OPEC 2.0’s production restraint allows U.S. shale producers to increase production and steal market share from OPEC 2.0. This restraint does play a pivotal role in our balances estimates, and is part of the equation propelling prices higher in our modeling. It is a necessary condition for U.S. shale output to grow, but it is not sufficient. U.S. shale oil is filling a market need for light-sweet crude and condensate, and is attracting investment to meet this need. It does compete with light-sweet OPEC production ex Persian Gulf, but investment in these provinces has proven to be difficult to sustain and commit to over the long haul for a variety of reasons, many of which spring from the lack of rule of law, corruption, and hostile operating environments. Shale oil production, in addition to presenting an opportunity to tap into an abundant resource, allows E&Ps to operate in a low-risk political and geological environment, where contracts are enforced by a disinterested judiciary. In terms of its importance, these factors cannot be overestimated. More importantly, the medium and heavier crudes produced and marketed by KSA and Russia are not in direct competition with U.S. shale oil, which means OPEC 2.0’s leadership is not directly fighting for market share with this output. However, there are constraints to shale-oil production, coming mostly from capital markets. We are modeling slower U.S. onshore production growth this year and next, arising from capital constraints on shale-oil producers. Our recent Special Report on the financial performance of E&P companies and the Majors highlighted the importance they attach to prioritizing investors’ interests, which is clearly visible in the financial metrics of these companies.8 Chart 5OPEC 2.0 Will Raise Supply In 2020 To Keep Brent Prices Below /bbl Chart 6Capital Discipline Will Reduce U.S. Onshore Output In 2020 Consistent with our investor-driven framework for modeling U.S. output, we reduced our expectation for U.S. onshore supply growth by 160k b/d for next year (Chart 6). As a result, we now expect U.S. onshore production to grow by 1.2mm b/d to ~ 10.0mm b/d this year and by 900k b/d to ~ 10.8mm b/d next year – mostly from shales. We expect U.S. offshore production to increase 170k b/d this year and 130k b/d next year, to 1.9mm b/d in 2019 and 2.0mm b/d in 2020. Expect Tighter Balances, Steeper Backwardation The fundamental supply – demand expectations above combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. We continue to expect WTI to trade $7/bbl below Brent this year, and $5/bbl lower next year (Chart 7). As can be seen in the Chart of the Week, our balances estimates indicate inventory draws will resume this year, which will lead to a steeper backwardation in benchmark crude streams (Chart 8). Given this expectation, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close, expecting steeper backwardation in the benchmark forward curve as global inventories draw in 2H19. Bottom Line: Oil price volatility will remain elevated, as markets transition from the profound demand slowdown reported for 1H19 to a higher-growth footing (Chart 9). We expect Brent crude to average $70 and $75/bbl this year and next, with WTI trading $7 and $5/bbl lower, respectively. On the back of our expectation balances will tighten, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close. Chart 7Balances Will Tighten In 2H19, Following 1H19 Weakness Chart 8Backwardations Will Steepen, As Inventories Draw Chart 9Volatility Will Remain Elevated We are not sounding an all-clear on aggregate demand in the wake of the fiscal and monetary stimulus being deployed globally. The odds the Sino – U.S. trade war expands to encompass global markets are not trivial (we make them greater than 1:6 in our estimation), and this could keep demand and demand expectations uncertain for an indefinite period. Evidence of this will be visible in the options markets, which will price to higher implied volatilities for a longer period of time.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see The Polybius Solution published by BCA Research’s Geopolitical Strategy July 5, 2019. It is available at gps.bcaresearch.com. 2      OPEC 2.0 is the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was founded in 2016 to manage oil production, so as to reduce global inventory levels, which were bloated by a market-share war launched by the original OPEC cartel in 2014. In the political-economy framework driving our analysis, OPEC 2.0 treats U.S. and Chinese policy as exogenous factors, and maintains sufficient flexibility to respond to whatever these states do. We develop our paradigm for this in The New Political Economy Of Oil, published by BCA Research’s Commodity & Energy Strategy February 21, 2019. It is available at ces.bcaresearch.com. 3      Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4      The EIA has lowered its growth estimates for oil consumption six consecutive times this year, with the publication of this month’s forecast. This is the third time we’ve lowered our forecast. 5      Global oil demand is extremely difficult to estimate. It is an estimate subject to large revisions, as we discussed last year: From 2010 to 2016, “On average, the EIA has increased net demand (increases in estimated demand in excess of the increase in estimated supply) by about 470,000 b/d, with the lowest retroactive increase of net demand being 260,000 b/d (2012).” Copies of this research are available upon request. 6      Please see The Lag in Effect of Monetary Policy, by Milton Friedman (1961). Journal of Political Economy, University of Chicago Press, vol. 69, pages 447-466. 7      Please see With the Benefit of Hindsight: The Impact of the 2014-16 Oil Price Collapse, published January 13, 2018, by the World Bank for a discussion of subsidy removal by EM states. 8      Please see Shale-Oil E&Ps Turning A Corner?, published June 13, and U.S. Shales, GOM Production Reinforce Our Robust Production Forecasts, published July 11, 2019. These are available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

One way to benefit from the global growth soft-patch is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. Since our Monday inception three days ago, this pair trade is already up 9%. The relative moves in the underlying commodities that serve as pricing power proxies are the key drivers of this share price ratio (top panel). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Meanwhile, global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel). Bottom Line: We initiated a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Please refer to this Monday’s Weekly Report for additional details.