Iraq

Highlights Lingering weakness evident in fundamental supply-demand data will fade next year, and with it the downward pressure on oil prices. Price risk is skewed to the upside: Continued monetary accommodation from systematically important central banks and fiscal stimulus will revive oil demand; OPEC 2.0 production restraint and market-imposed discipline in the US will slow the growth of oil supply. Shale-oil supply growth also is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth. Elevated geopolitical tensions cannot be ignored, particularly as economic and political discontent boils over in Iraq and Iran, where leaders could feel compelled to lash out. To the downside, global economic policy uncertainty remains elevated. It continues to keep the USD well bid. This raises consumers’ local-currency costs in the EM economies driving demand growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Weaker 2019 data showing up in demand and upward revisions to inventories pushed our 4Q19 Brent forecast down to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. We continue to expect WTI will trade $4/bbl below Brent. Feature In the multi-level game that drives the political economy of oil, domestic and international factors shaping supply-demand fundamentals are always shifting. As multiple constituencies vie for advantage, market participants will be forced to grapple with the consequences of policies now under consideration. The bullet points above provide a restricted aperture through which to view some of the issues currently in play.1 Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. Demand-side impacts of policy shifts and policy signaling remain the most prominent feature of fundamental adjustments markets will continue to grapple with, as fall-out from the Sino-US trade war; political discontent in DM and EM electorates; and ad hoc economic policy raise global economic policy uncertainty. Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. This is most visible in our global Leading Economic Indicators (LEIs), particularly in EM economies, although DM demand also looks like it could pick up (Chart of the Week). For the real economy, it is useful to remember Milton Friedman’s “long and variable lags” regarding the effects of monetary policy and how they affect oil markets.2 Chart of the WeekGlobal LEIs Point To Demand Recovery Global LEIs Point To Demand Recovery Global LEIs Point To Demand Recovery Chart 2BCA's EM Commodity-Demand Nowcast Points Toward Upturn in Oil Demand BCA's EM Commodity-Demand Nowcast Points Toward Upturn in Oil Demand BCA's EM Commodity-Demand Nowcast Points Toward Upturn in Oil Demand EM growth is hugely important to global oil-demand growth in our analysis. Our proprietary EM Commodity-Demand Nowcast continues to indicate EM economies are responding to easier global financial conditions (Chart 2).3 Global growth expectations for oil demand are diverging sharply in the lead-up to OPEC 2.0’s December 5 meeting in Vienna. At the low end, the US EIA expects 2019 growth of 760k b/d this year, a sharply lower estimate than the agency’s co-eval institutions; OPEC is closing in on the 1mm b/d growth threshold at 0.98mm b/d, followed by the IEA at 1mm b/d. We lowered our estimate of oil-demand growth this year to 1.1mm b/d, in line with weaker consumption data being reported by these big agencies. Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. We are maintaining our expectation for growth of 1.4mm b/d next year, which is close to the EIA’s estimate (Chart 3). The IEA’s estimate for 2020 stays at 1.2mm b/d, while OPEC’s is just under 1.1mm b/d. On the supply side, we expect lower US shale-oil output growth next year. Lower prices, backwardated WTI futures curves – which results in lower forward prices for producers hedging their output – and recalcitrant investors who are unwilling to commit capital to all but the most profitable shale-oil producers will take their toll (Chart 4). As a result, we expect US shale output to reach ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko). This leads to an 800k b/d increase in our US lower 48 output over this year’s levels, which is down from our earlier estimate of a 900k b/d increase. Chart 3Stronger Oil Demand, Tighter Supply Will Lift Oil Prices in 2020 Stronger Oil Demand, Tighter Supply Will Lift Oil Prices in 2020 Stronger Oil Demand, Tighter Supply Will Lift Oil Prices in 2020 Chart 4Lower Prices, Backwardated WTI Curve Lead to Lower Rig Count, Shale-Oil Output Lower Prices, Backwardated WTI Curve Lead to Lower Rig Count, Shale-Oil Output Lower Prices, Backwardated WTI Curve Lead to Lower Rig Count, Shale-Oil Output Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth, as the electorate grows increasingly restive with the practice. Industry officials in Texas and North Dakota – home to the Permian and Bakken plays – already have been sounding the alarm on this issue.4 According to Rystad Energy, flaring reached another record high in the Permian at 752 million cubic feet per day in 3Q19 amid growing oil production. Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest. We also are penciling in an extension of OPEC 2.0’s 1.2mm-barrel-per-day output cut to year-end 2020. Over-compliance likely persists, particularly from the Kingdom of Saudi Arabia (KSA). Stronger non-OPEC output from Norway and Brazil offsets this somewhat (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lingering Oil-Demand Weakness Will Fade Lingering Oil-Demand Weakness Will Fade Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest.  As our colleague Roukaya Ibrahim notes, “The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services … . This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace.”5 There is an underlying tension within the society between Iraqi forces loyal to Iran’s Shia theocracy and Iraqis seeking full autonomy for their country. “The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary,” according to BCA’s geopolitical strategists. We have consistently maintained markets are too complacent regarding these geopolitical risks, which also encompass US-Iran hostilities in the Persian Gulf. We are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. That said, our balances still reflect the lingering demand weakness discussed above, and continue to work through higher inventories. In line with revisions by the EIA to historical inventory levels and lower demand growth, we are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl (Chart 5). We continue to expect WTI will trade $4/bbl below Brent (Chart 6). Chart 5Storage Revisions Help Weaken Price Forecasts Storage Revisions Help Weaken Price Forecasts Storage Revisions Help Weaken Price Forecasts Chart 6BCA 2020 Oil Price Forecasts Fall Slightly To $67/bbl For Brent, $63/bbl For WTI BCA 2020 Oil Price Forecasts Fall Slightly To $67/bbl For Brent, $63/bbl For WTI BCA 2020 Oil Price Forecasts Fall Slightly To $67/bbl For Brent, $63/bbl For WTI Global Economic Policy Uncertainty Persists While accommodative monetary policy and stimulative fiscal policy will foster a revival in commodity demand, global economic uncertainty remains elevated.6 This risks keeping the broad trade-weighted USD index for goods (TWIBG) well bid (Chart 7). This raises consumers’ local-currency costs in the EM economies driving growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Chart 7Elevated Global Economic Uncertainty Keeps USD Well Bid, Retards Demand Lingering Oil-Demand Weakness Will Fade Lingering Oil-Demand Weakness Will Fade We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand.  However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest. As the multi-level game dominating the evolution of the political economy of the oil market becomes more complex and uncertain – particularly in re the Sino-US trade war and domestic politics in systemically important economies – monetary and fiscal policy have an additional headwind to battle in the attempt to revive aggregate commodity demand. Bottom Line: We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand. However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest, with oil prices rising ~ 10% next year. That said, if the phase-one Sino-US trade deal leads to a phase-two and –three – i.e., a durable resolution to the trade imbroglio and political discontent roiling markets, the recovery could be more significant.7     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight. Trade-related news continues to drive short-term price movements. On Tuesday, Brent prices fell 2.5% on rising pessimism about the US-China “phase one” deal. On the supply side, OPEC 2.0 countries will meet in early December to assess whether the group should extend – and possibly deepen – output cuts. Russia signaled it is unlikely to support deeper cuts, but appears to be open to extending the current quotas until year-end 2020. Our updated global oil market balances assume OPEC 2.0 will agree to extend the current production curbs. Separately, anti-government protests in Basra, Iraq, are impacting the oil sector. On Monday, protesters reportedly blocked roads leading to the major oil fields and to commodity export terminals. Base Metals: Neutral. Copper prices seem detached from their current fundamentals, moving up and down with expectations related to the US-China trade war and ongoing protests in Chile – the world’s largest copper producer. Negative sentiment has weighed on copper most of this year. Speculative short positioning reached a high of 137k contracts in August, pushing our Copper Composite Indicator into “oversold” territory. Going forward, the metal’s fundamentals will support higher prices; quarter-to-date copper prices increased 3.5%. Global visible copper inventories resumed their downward trend in 2H19 – reaching a 10-year low. We expect global growth to pick up in the coming months – led by emerging economies. Risks are skewed to the upside. Precious Metals: Neutral. Gold prices recovered to $1475/oz after trading close to our $1450/oz stop-loss last week. Slightly weaker real rates in the US and ratcheted-up trade tensions supported the yellow metal’s price this week. Over the short term, prices could be pushed lower as markets await positive developments re a Sino - US trade agreement. Ags/Softs: Underweight. Corn futures traded lower earlier in the week, but rebounded slightly Tuesday after the USDA Crop Progress reported the harvest rate for it was 76%, which was below analysts’ expectations of 77% and well below the five-year average of 92%. Wheat performed better, marking a 0.9% weekly increase in March futures on the back of a lower percentage of the crop being rated good or excellent by the USDA.  Finally, soybeans were flat throughout the week but fell almost 0.8% on Wednesday, amid reports that a phase-one trade deal between US and China may not be completed by the end of 2019.     Footnotes 1       Understanding and balancing these interests is difficult, as is forecasting outcomes. Please see Robert D. Putnam, “Diplomacy and Domestic Politics: The Logic of Two-Level Games,” International Organization, Vol. 42, No. 3 (Summer, 1988). 2      Friedman’s classic paper, “The Lag in Effect of Monetary Policy,” appeared in the Journal of Political Economy, Vol. 69, No. 5 (Oct., 1961). Our own research suggests these lags range from six to 18 months in commodity markets. 3      Our EM Commodity-Demand Nowcast uses our Global Industrial Activity (GIA) Index, and our Global Commodity Factor (GCF) and EM Import Volume (EMIV) models to characterize the current state of commodity demand. The GIA index uses trade data, FX rates, manufacturing data, and Chinese industrial activity statistics to gauge current global industrial activity, which is highly correlated with trade-related activity. The GCF uses principal component analysis to distill the primary driver of 28 different commodity prices traded globally. Lastly, the EMIV model is driven by EM import volumes, which are highly correlated with income; as income rises, oil demand – and commodity demand in general – rises. Please our report entitled Global Financial Conditions Support Higher Commodity Demand, which was published October 31, 2019, for additional discussion. It is available at ces.bcaresearch.com.  Concerns over associated natural-gas flaring into the atmosphere are rising in the shale-oil community, as political discontent with the practice grows.  Please see Gas Flaring “Running Rampant” In The Permian, published by oilprice.com, and New Initiative will Map and Measure Methane Emissions Across the Permian Basin, a press release issued by the Environmental Defense Fund outlining their initiative to install methane emissions-monitoring gear around the Permian to begin logging the massive amount of flaring in that basin.   According to the Oil & Gas Journal, “… collective volumes of flared and vented gas from (the Permian and Bakken) basins up to about 1.15 bcfd. For comparative purposes, that represents 12 billion cu m/year of wasted gas, which exceeds the yearly gas demand of nations such as Israel, Colombia, and Romania.”  Please see Permian gas flaring, venting reaches record high published by the OGJ June 4, 2019.  Please see Permian gas flaring reaches yet another high, published by Rystad Energy on its website November 5, 2019. 4      S&P Global Platts posted an interesting podcast on its website featuring an interview with Lynn Helms, director of the North Dakota Department of Mineral Resources. He said flaring in the Bakken – where production is hitting record highs – will force state regulators to throttle back on the rate of shale-production growth beginning in 2Q20, when growth could slow substantially if gas-capture technologies are not deployed.  Growth could remain subdued for 2020-21, he said.  Please see North Dakota’s record oil growth to be upended by flaring rules, posted November 18, 2019. 5      Please see Iraq's Challenge To Iran Is Underrated, published by BCA Research’s Geopolitical Strategy November 8, 2019.  It is available at gps.bcaresearch.com. 6      We measure uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related to economic policy uncertainty, which are found in newspapers and articles online from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 7      This is not our base case. Our geopolitical strategists expect a temporary ceasefire in the trade war, but doubt that a “grand compromise” leading to a new period of US-China economic engagement will emerge from the negotiations. Strategic tensions will keep rising on a secular basis between the two countries. Please see BCA’s Geopolitical Strategy weekly report entitled How Much To Buy An American President? – GeoRisk Update: October 25, 2019. It is available at gps.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Lingering Oil-Demand Weakness Will Fade Lingering Oil-Demand Weakness Will Fade Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Lingering Oil-Demand Weakness Will Fade Lingering Oil-Demand Weakness Will Fade

Highlights Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – are experiencing mass unrest. Protesters in both states are calling for the dismantling of sectarian based political systems, economic reforms, and reduced foreign interference. The unrest in Iraq is of greater consequence due to its role as a major global oil supplier. The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary.  We remain tactically long spot crude oil on the back of the geopolitical risks to supply amid an expected revival in global demand. Feature A wave of popular uprisings has swept over Lebanon and Iraq. While the riots are to a large extent a product of long-standing economic and governance failures, the timing is consequential. The Middle East is experiencing a paradigm shift. With the US reducing its strategic commitment to the region, most recently evidenced by the withdrawal of its troops from northeast Syria, a power vacuum has emerged. This opens up the necessity for foreign actors – Russia – as well as regional powers – Saudi Arabia, Iran, and Turkey – to fill the void. The evolution of power could be unsettling given that it will likely generate greater instability in a region that is fertile ground for unrest. Iran has so far emerged a winner in this dynamic. It has expanded its influence in Iraq since the US pullout, it has played a critical role in saving the Assad regime, and it has seen Saudi initiatives fail in Syria, Yemen, Lebanon, and Qatar. It is making progress toward building its ‘land bridge’ to the Mediterranean (Map 1).1 Map 1Iran’s Aspirational ‘Land Bridge’ To The Mediterranean Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated The tensions brought about by the US withdrawal from the JCPOA further illustrate Iran’s growing regional sway. It has hardened its stance. Meanwhile the US and its allies have been vacillating. The Saudi coalition – mired in a war in Yemen and confronting domestic risks – is reluctant to engage in a full-scale confrontation.  Even though Iran has a higher pain threshold, it stands on shaky ground. Just last year it was rocked by domestic protests demanding less foreign adventurism. Lebanon and Iraq are the two countries most entrenched in Iran’s sphere of influence. Protesters in both countries are calling for greater national unity – demanding an overhaul of the political system, and arguing that the sectarian set-up has failed to meet their most basic needs. What occurs in Beirut and Baghdad will be of great consequence for Tehran. Deadlock In Iraq “Out, out, Iran! Baghdad will stay free!” - Chants by Iraqi protesters While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.2 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Chart 1AFertile Ground For Unrest In Iraq Fertile Ground For Unrest In Iraq Fertile Ground For Unrest In Iraq The protesters are also united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 1A & 1B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 1BFertile Ground For Unrest In Iraq Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Where the election results failed to translate into real change for Iraq is in the appointment of the Prime Minister. Abdul-Mahdi – a technocrat – was a compromise candidate that surfaced as a result of a five-month long political standstill between the two rival Shia blocs, each claiming to have gained a majority of seats in parliament. On one end is the Iran-backed bloc led by Hadi al-Amiri head of both the Fatah Alliance and the PMF, and Nouri al-Maliki leader of the State of Law Coalition. On the other end is al-Sadr’s Sairoon coalition, which joined forces with Ammar al-Hakim of the Wisdom Movement, and champions greater unity and less foreign interference. The result has been a weak prime minister who is perceived to be incapable of pushing back against Iraq’s ruling elites and ushering in structural reforms. Instead the Prime Minister is seen as benefiting from a corrupt system. The rift between Iraq’s rival Shia blocks is deepening. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs. Last week Abdul–Mahdi responded to calls by al-Sadr and former Prime Minister Haider al-Abadi to resign by arguing that it is up to the main political leaders to agree to put forward a vote of no confidence in the Iraqi parliament. He agreed to resign, on condition that political parties jointly approve of a replacement. For now, that appears improbable. In a move that has been interpreted as a display of Iranian interference, al-Amiri changed heart after a reported meeting with Iranian Quds Force leader Qassem Suleimani last week in Baghdad. He backed down on his agreement to support al-Sadr to bring down Abdul-Mahdi, and has instead stated Abdul-Mahdi’s resignation will only bring about more chaos. This interference on the part of Iran was likely induced by fears that a crisis-stricken Iraq would weaken its hegemony over the region. Iraq is in a state of deadlock. A vote of no confidence would require a majority of 165 in parliament and would require the support of various Sunni and Kurdish parties (Chart 2). Al-Sadr is likely calculating that a new election is in his best interest. He would be able to capitalize on the movement given that he has aligned himself with the protesters, and will gain seats in parliament. Chart 2A Shia Schism In Iraq’s Parliament Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated This would allow the nationalist bloc to gain a majority and appoint a government that is acceptable to the protesters. However, this scenario would also entail greater meddling from Iran, as it is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.3 Despite the death of over 260 Iraqis, the protesters have yet to be deterred by the violence. This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. The impasse could be resolved if the main actors – the rival Shia blocs – agree to compromise. However, that is precisely what transpired last year and resulted in Abdul-Mahdi’s appointment. It ultimately led to only a temporary resolution of the unrest: a one-year deferral. If a similar compromise is reached in the current environment, it too will result in only a temporary détente. The grievances afflicting Iraqis cannot be resolved easily or swiftly. Iraq is in for an extended period of instability. Bottom Line: Iraqi protesters and authorities are in stalemate. The rift in the Shia bloc is deepening. There does not appear to be a clear path to bridge the demands and desires of the protesters and the leadership. Any détente will be temporary. Even if under a new election the protests translate to greater seats for the nationalist bloc, it will not translate to a de-escalation of domestic tensions. It may resolve the protests, but Iran-backed groups will retaliate. Iraq is in for an extended period of instability. Deadlock In Lebanon “All of them means all of them” “No to Iran – No to Saudi” - Chants by Lebanese protesters Just as Iraqi protesters are expressing national unity in calling for an end to sectarian politics and foreign interference, Lebanon’s protests stand out for crossing religious and regional divides. They have swept across the country, and include the Shia-dominated southern region where anger is even being directed at Hezbollah. Among the protesters’ demands is the removal of all three heads of the pillars of government – the Maronite Christian President Michel Aoun, the Sunni Prime Minister Saad Hariri, and the Shia Speaker of Parliament Nabih Berri. Rather than being a source of division, the unrest is a demonstration of unity among Lebanese of all ideologies against the entire political system. Since Prime Minister Saad Hariri’s resignation on October 29, the movement rages on. Protesters are claiming that they are unwilling to back down until all their demands are met, including a complete overhaul of the sectarian power-sharing system, which has defined the country’s politics since the end of the 1975-1990 civil war.4 Chart 3Economic Deterioration In Lebanon Economic Deterioration In Lebanon Economic Deterioration In Lebanon The movement and the protesters’ complaints are not surprising. The government has failed to prevent the economy from moving toward collapse. It has long been in decline, with Lebanese feeling the pinch of corruption, economic stagnation, high unemployment, and the effects of the massive influx of Syrian refugees (Chart 3).The trigger of the uprising, a tax on WhatsApp calls amid clear signs of a domestic liquidity shortage, is a delayed response to what citizens have already known and felt for some time: a deteriorating economic situation. While the protests were caused by these economic grievances, they persist due to a crisis of confidence between the political class and the masses. Neither concessions on the part of the government in the form of a list of reforms nor the prime minister’s resignation convinced protesters to halt the movement. The uprising appears set to remain steadfast so long as the current politicians remain in power. The challenge for Lebanon’s protesters – and political elite all the same – is that while the protesters are united in their demands, they have so far been headless. The protesters have refused to present a list of acceptable replacement leaders, insisting that it is the government’s role to propose potential alternatives to the people. This has led to deadlock and will be a hurdle for the government in negotiating with demonstrators. On the other side of the conflict, the current political class, including Hezbollah leader Hassan Nasrallah, has expressed warnings about the chaos that would ensue with a government resignation. According to the Lebanese constitution, following Hariri’s resignation President Aoun is now tasked with consulting Lebanon’s fractured parliament to determine the next prime minister – a role reserved for a Sunni Muslim. However, if history is any guide, this process could take months and protesters are not that patient. Given that Hariri has sidelined himself and – unlike Parliament Speaker Nabih Berri or Foreign Minister Gebran Bassil – he is not the core target of protesters’ ire, there is a possibility that he may once again be appointed to the post of prime minister. While the outgoing government will take on a caretaker role until a new one is formed, demonstrators are standing their ground. ​​This has generated a political standoff causing Lebanese assets to bear the brunt (Chart 4). The emergence of competing rallies – in the form of support for President Michel Aoun – only complicates and possibly prolongs the situation. For now, the army is staying on the sidelines, allowing the protests to be – for the most part – a peaceful one. However, with Hezbollah also subject to the protesters’ wrath, odds of greater regional tensions have increased. Hezbollah may attempt to regain lost support by provoking Israel. The instability could also prompt Hezbollah to reassert its willingness to use force against domestic enemies, namely any new government that attempts to disarm it. In the meantime, Lebanon’s economy and financial markets will remain under pressure. The economy depends on capital inflows from citizens living abroad to finance the large twin deficit and maintain the dollar peg. Thus, the decline in sentiment will weigh on the economy (Chart 5). While the government has not implemented official capital controls, banks have independently tightened restrictions and raised transaction fees to reduce capital outflow. Chart 4Further Unrest Ahead Further Unrest Ahead Further Unrest Ahead Chart 5Weak Sentiment Weighs On Lebanon's Economy Weak Sentiment Weighs On Lebanon's Economy Weak Sentiment Weighs On Lebanon's Economy Bottom Line: Lebanese protesters and the political class are in deadlock. The prime minister’s resignation has done little to ease the tension, and demonstrators are refusing to back down until a new non-sectarian, technocratic government is formed. The domestic economy will remain frail. Earlier this week the central bank asked local lenders to boost their liquidity by raising their capital by 20% or $4 billion in 2020 in anticipation of potential downgrades. A stabilization of the political situation is a necessary precondition to boost confidence and once again shore up capital inflows. Nevertheless, with the protest movement being largely headless, the path toward compromise with the government will be challenging, raising the odds of prolonged tensions. What Of Iran’s Sphere Of Influence? “Not Gaza, Not Lebanon, I Give My Life For Iran” - Chants by Iranian protesters, January 2018 Iran has a strong incentive to preserve the established systems in both Lebanon and Iraq. The protesters’ demands risk weakening its grip on power in the region. In both movements, pro-Iranian forces have taken a stance against the protests with Hezbollah in Lebanon advising against the resignation of Prime Minister Hariri while the Iran-backed bloc in Iraq voiced concern over the chaos that will ensue with the prime minister’s resignation. Meanwhile, Tehran’s position is hardening. Iran is taking further steps away from the nuclear deal, injecting uranium gas into centrifuges at its underground Fordow nuclear complex, making the facility an active nuclear site rather than a permitted research plant. Chart 6Popular Support For Iran’s Hardening Stance Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated Chart 7US-Iran Détente Unlikely Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated This reflects the loss of public support for the JCPOA and the loss of confidence that other countries will honor their obligations toward the nuclear agreement (Chart 6). In a speech on November 3 marking the fortieth anniversary of the 1979 US Embassy takeover, Supreme Leader Ayatollah Ali Khamenei renewed his ban on negotiations with the US. His stance mirrors public opinion, which is moving toward an increasingly unfavorable view of the US (Chart 7). However, this does not mean that President Hassan Rouhani’s administration is immune to popular discontent. Rather, with Iranians living through a continued economic deterioration and assigning the most blame to domestic mismanagement and corruption, there could be cracks forming in Iran as well (Chart 8). Chart 8A Case For Unrest In Iran? Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated Bottom Line: The ongoing US withdrawal from the Middle East opens opportunities for Iran to increase its regional influence. It has been capitalizing on such opportunities by lending support to its proxies in Syria, Yemen, Iraq, and Gaza. However, the escalation of unrest in Lebanon and Iraq pose a risk to Iran’s grip on power in the region. On the one hand, if the movements there result in new governments, Iran will witness its wings clipped. This could incentivize retaliation and violence in Iraq, and provocations by Hezbollah along Lebanon’s southern border in an attempt to regain lost support. On the other hand, a prolonged standstill between protesters and the governments could result in greater Iranian influence over the long term. Other foreign powers are unwilling to wholeheartedly intervene to fill an emergent power vacuum. Investment Implications The risk of a decline in Iran’s control over its sphere of influence and the still unstable state of Iraqi domestic politics suggest that the geopolitical risk premium in oil prices should remain elevated. For now, President Trump is still enforcing sanctions and Iran’s oil exports have largely collapsed (Chart 9). The White House is continuing to add pressure by warning Chinese shipping companies – the largest remaining buyer of Iranian oil – against turning off their ships’ transponders. Chart 9The US Maintains Pressure On Iran Iraq's Challenge To Iran Is Underrated Iraq's Challenge To Iran Is Underrated News reports indicate that oil workers in Iraq’s southern region have started to join the government demonstrations. Moreover, reports on Wednesday indicate that the 30k b/d of production from the Qayarah oil field has been shut down due to road blockades in Basra that are preventing trucks from transporting crude to the Khor al-Zubair port. The geopolitical risk premium in oil prices should remain elevated. While the impact on the country’s oil production and exports have so far been minimal, a prolonged standoff between protesters and the government could result in supply outages. Today’s environment is notably different than that of the ISIS invasion of Iraq in 2014. Tensions then did not create a geopolitical risk premium in oil as they occurred amid an oil market share war, which kept supply abundant. Similarly, the September attack on Saudi Arabian oil facilities did not result in a lasting price spike as it occurred at a time of weak global demand. Moreover, Saudi Arabia possesses the technology and spare capacity that permitted it to swiftly restore output and maintain export commitments. The same cannot be said today about Iraq. A disruption there would be of greater consequence to oil markets, as illustrated by the 2008 Battle of Basra. Especially given Saudi Arabia's need to maintain high prices and amid the Aramco IPO and the tailwind created by a rebound in global growth. The fall in global economic policy uncertainty as the US and China move toward a trade ceasefire will weaken the dollar and support global demand for oil, which is overall bullish for oil prices. Moreover, US-Iran tensions remain unresolved which pose risks to production and shipping infrastructure in the region. We remain tactically long spot crude oil on the back of the geopolitical risks to supply as well as an expected revival in global demand. We are booking a 4.6% gain on our GBP-USD trade but remain long sterling versus the yen. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1    The ‘land bridge’ is an aspirational route by which Iran would create a strategic corridor to the Mediterranean, stretching through friendly territory. 2   Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 3   Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. 4   Under the current system, Lebanon’s president has to be a Maronite Christian, the parliament speaker a Shiite Muslim and the prime minister a Sunni. Cabinet and parliament seats are equally split between the two Muslims groups and Christians.

Highlights There is a tentative decline in geopolitical risk: An orderly Brexit or no Brexit is the likely final outcome and the U.S.-China talks are coming together. The outstanding geopolitical risks still warrant caution on global equities in the near term. Internal and external instability in Saudi Arabia, any American persistence with maximum pressure sanctions on Iran, and domestic instability in Iraq pose a risk to global oil supply. Go long spot crude oil and GBP/JPY. Feature Chart 1A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk Our views on Brexit and the U.S.-China trade talks are coming together, resulting in a tentative decline in geopolitical risk (Chart 1). The British parliament still needs to ratify Boris Johnson’s exit agreement, painstakingly negotiated with the EU in a surprise summit this week. He may not have the votes. If he fails then he will have a basis to seek an extension to the Brexit deadline on October 31. But it is clear that the EU is willing to allow compromises to prevent a no-deal exit shock from exacerbating the slowdown in the European economy. An orderly Brexit is the final outcome (or no Brexit at all if an election and new referendum should say so). We are removing the $1.30 target on our long GBP/USD call in light of these developments and going long GBP/JPY. Similarly, while uncertainty lingers over U.S.-China relations, it is clear that President Trump is sensitive to the impact of the manufacturing recession and the risk of an overall recession on his reelection prospects. He is therefore pursuing a ceasefire and delaying tariffs. China is minimally reciprocating to forestall a collapse in relations. The December 15 tariff hike will be delayed and, if a ceasefire fails to improve the economic outlook, we expect Trump to engage in some tariff rollback on the pretext that talks are “making progress.” However, we do not expect a bilateral trade agreement or total tariff rollback. And other factors (like political risks in Greater China) could still derail the process. The outstanding geopolitical risks still warrant caution on global equities in the near term. These risks include a collapse in the U.S.-China talks (e.g. due to Hong Kong, Taiwan, or the tech race), and the ascent of Elizabeth Warren as the front runner in the Democratic Party’s early primary election. There is also the risk of another oil price shock emanating from the Middle East, which we discuss in this report. The Aftermath Of Abqaiq It has been a geopolitically eventful summer in the Middle East (Diagram 1). While there were plenty of warning shots, the September 14 drone and missile strikes on Saudi Aramco infrastructure was the big bang – wiping out 5.7 mm b/d of crude oil supplies overnight (Chart 2). The attacks were significant not only in terms of their impact on global oil markets, but also because they exposed the U.S.’s and Saudi Arabia’s reluctance to engage in a full-scale military confrontation with Iran. It is too early to call peak tensions in the Persian Gulf. Diagram 1Timeline: Summer Fireworks In The Persian Gulf Around The Middle East Around The Middle East Chart 2Closing Hormuz Would Be The Biggest Oil Shock Ever Around The Middle East Around The Middle East It is too early to call peak tensions in the Persian Gulf. The October 11 strike on an Iranian-owned oil tanker in the Red Sea and the reported U.S. cyber-attacks against Iranian news outlets may well mark the “limited retaliation” that we expected. Nevertheless, last month’s events uncovered vulnerabilities that suggest that even if the U.S. and its Gulf allies back off, geopolitical risk will remain elevated. Chart 3Saudis Are Profligate Defense Spenders Around The Middle East Around The Middle East The most obvious outcome of the September 14 attack is the realization of just how vulnerable Saudi Arabia is to attacks by its regional enemies. Despite being the third most profligate defense spender in the world – and the first relative to GDP (Chart 3) – Saudi Arabia was unable to protect its critical infrastructure. For that, Crown Prince Mohamed bin Salman (MBS) will surely face domestic pressure. After five years, Saudi Arabia has little to show from its war in Yemen, other than a humanitarian crisis that has hurt its international standing. Instead, the operation has been a burden on the kingdom’s finances and a nuisance to security in the southwestern provinces of Najran, Jizan and Asir, where the Iran-allied Houthis have conducted regular attacks on oil infrastructure and airports. Some domestic disquiet will be defused if the Yemen war is downgraded or resolved. Saudi Arabia recently accepted the olive branch extended by the Houthis and is reportedly in talks to deescalate. But this will not fully eliminate domestic uncertainty. After all, MBS’s other initiatives – in Syria, in Iraq, in lobbying the U.S. – are also in jeopardy. The conspiracy theory surrounding the September 29 murder of General Abdulaziz al-Faghem, King Salman’s longstanding personal bodyguard, is case in point. Rumor has it that the king was enraged upon hearing of the Houthi movement’s September 28 capture of three Saudi military brigades, and decided to revoke the Crown Prince’s title, instead appointing the youngest Sudairi brother, Prince Ahmed bin Abdulaziz, in his place.1 The ploy was allegedly uncovered, resulting in General al-Faghem’s murder.2 This is entirely speculation and we find the idea of MBS’s removal to be highly doubtful. The King’s and Crown Prince’s joint appearance during President Vladimir Putin’s visit to the kingdom earlier this week should dispel speculation about a brewing palace coup. Nevertheless, the murder itself is extremely concerning and reinforces independent reasons for concerns about internal stability. Chart 4Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability The pursuit of the Saudi reform agenda, “Vision 2030,” is premised first and foremost on the consolidation of power in the hands of MBS and his faction. The appointment of King Salman’s son, Prince Abdulaziz, as energy minister was motivated by a desire to expedite the initial public offering of state oil giant Saudi Aramco, which could begin as early as November. This was preceded by the appointment of Yasir Al-Rumayyan, head of the sovereign wealth fund and a close ally of MBS, as chairman of Aramco. Moreover, wealthy Saudis – some of whom were detained at the Ritz Carlton in November 2017 – are reportedly being strong-armed into buying stakes in the pending IPO. While weaning Saudi Arabia’s economy off of crude oil is the best course of action for long-term stability (Chart 4), the transition will threaten domestic stability. Meanwhile the conflict with Iran is far from settled. Bottom Line: The September 14 drone strikes on key Saudi oil infrastructure revealed both Saudi Arabia’s and the U.S.’s unwillingness to engage in military action against and a full confrontation with Iran. This will raise concerns regarding the kingdom’s ability to defend itself. Moreover, Saudi Arabia remains vulnerable to domestic pressure as MBS strives to maintain his consolidation of power in recent years and pursues Vision 2030. Internal or external instability in Saudi Arabia poses a risk to global oil supply. Iran’s Resistance Economy Can Handle Trump’s Maximum Pressure Chart 5Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite On the other side of the Persian Gulf, the Iranians are displaying a higher pain threshold than their enemies. The economy is suffering under the U.S.’s crippling sanctions, with exports at the lowest level since 2003 (Chart 5). The IMF expects Iran’s economy to contract by 9.5% this year, with annual inflation forecast at 35.7%. Oil exports, the lifeblood of its economy, are down 89% YoY. Nevertheless, Iran is well-versed in the game of chicken, it is methodically displaying its ability to create havoc across the region, and it has not waivered in its stance that President Trump must ease sanctions and rejoin the 2015 nuclear deal if it is to engage in bilateral talks. All the while, Iran continues to reduce its nuclear commitments. On September 5, Rouhani indicated plans to completely abandon research and development commitments under the Joint Comprehensive Plan of Action (JCPOA) and to begin working on more advanced uranium enrichment centrifuges which was capped at 3.7% under the JCPOA (Table 1). We also expect Iran to follow-through on its threat of withdrawing from the Nuclear Non-Proliferation Treaty (NPT) if Trump maintains sanctions. Table 1Iran Is Walking Away From 2015 Nuclear Deal Around The Middle East Around The Middle East The same resolve cannot be shown on the part of the United States or Saudi Arabia. Chart 6Americans Do Not Support War With Iran Around The Middle East Around The Middle East President Trump is constrained by the risk of an Iran-induced oil price shock ahead of the 2020 election. He is therefore eager to deescalate tensions with Iran. He is abandoning the field in Syria (on which more below), opting to add a symbolic 1,800 troops into Saudi Arabia for deterrent effect instead. This defensive posture is being undertaken within the context of American public opinion, which opposes war with Iran or additional military adventures in the Middle East (Chart 6). This signifies the U.S.’s strategic deleveraging from the Middle East in order to shift its focus to Asia Pacific, where America has a greater priority in managing the rise of China. At the same time, negotiations between the Saudis and Yemeni Houthis suggest a lack of Saudi appetite for all-out conflict with Iran, clearing the way for a diplomatic solution. As Rouhani stated “ending the war in Yemen will pave the ground for de-escalation in the region,” specifically between Saudi Arabia and Iran. The Saudis have amply signaled in the wake of the Abqaiq attack that they wish to avoid a direct confrontation, particularly given the Trump administration’s apparent unwillingness (under electoral constraint) to continue providing a “blank check” for MBS to conduct an aggressive foreign policy. Already the United Arab Emirates – a key player in the Saudi-led coalition against Yemen – has distanced itself from Riyadh and sought to ease tensions with Iran. It recently reduced its commitment to the Yemen war and engaged in high-level meetings with Iran. The UAE’s national security adviser, Tahnoun bin Zayed, visited Tehran on a secret mission, the latest in a series of backchannel efforts to mediate between Saudi Arabia and Iran. Other reported efforts at diplomacy include visits by Iraqi and Pakistani officials. The remaining uncertainty is whether Trump will quietly ease sanctions on Iran, and whether Iran will quit while it is ahead. If Trump maintains maximum pressure, Iran may need to stage further attacks and oil disruptions to threaten Trump’s economy and encourage sanction relief. Otherwise, Iran, smelling American and Saudi fear, could overstep its bounds and commit a provocation that requires a larger American response, thus re-escalating tensions. While Trump’s economic and electoral constraint suggests that he will ease sanctions underhandedly, Iran’s risk appetite is apparently very high: Abqaiq could have gone terribly wrong. It also has an opportunity to flex its muscles and demonstrate American inconstancy to the region. This could lead to miscalculation and a more significant oil price shock than already seen. Bottom Line: Iran has remained steadfast in its position while the United States, Saudi Arabia, and their allies appear to be capitulating. They have more to lose than gain from all-out conflict. But Iran’s decision-making is opaque and any American persistence with maximum pressure sanctions will motivate additional provocations, escalation, and oil supply disruption. Making Russia Great Again? Recent events in Turkey and Syria do not come as a surprise. We have long highlighted a deeper Turkish intervention into Syria as a regional “black swan” event. In August we warned clients that the Trump-Erdogan personal relationship would not save Turkey from impending U.S. sanctions. In September we warned that Turkish geopolitical risk premia had collapsed, as measured by our market-based GeoRisk indicator, and that this collapse was certain to reverse in a major way, sending the lira falling. As we go to press the Turks have declared a ceasefire to avoid sanctions but nothing is certain. Putin has pounced on the opportunity to capitalize on the U.S. retreat. If Turkey is the loser, who is the winner? First, Trump, who benefits from fulfilling a campaign pledge to reduce U.S. involvement in foreign wars – a stance that will ultimately be rewarded (or at least not punished) by a war-weary public. Second, Iran and Russia, Syria’s major allies, who have invested greatly in maintaining the regime of Bashar al-Assad throughout the civil war and now face American withdrawal and heightened U.S. tensions with its allies and partners in the region as a result. Iran benefits through the ability to increase its strategic arc, the so-called “Shia Crescent,” to the Mediterranean Sea. Russia benefits through solidifying its reclaimed status as a major player in the Middle East – an indication of global multipolarity. President Vladimir Putin has pounced on the opportunity to capitalize on the U.S. retreat with official visits to both Saudi Arabia and the UAE this week. He made promises of both stronger economic ties and the ability to broker regional power. On the economic front, the Russian Direct Investment Fund (RDIF) selected Saudi Arabia as the venue for its first foreign office, signaling its interest in the region. It has already approved 25 joint projects with investment valued at more than $2.5 billion. There are also talks of RDIF-Aramco projects in the oil services sector worth over $1 billion and oil and gas conversion projects worth more than $2 billion. Moreover, RDIF signed multiple deals worth $1.4 billion with UAE partners. Chart 7Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Most importantly, the Saudis and Russians share the same objective of supporting global oil prices and have been jointly managing OPEC 2.0 supply since 2017 (Chart 7). Russia’s approach to the region focuses on enhancing its all-around strategic influence. Chart 8Erdogan Is Playing Into Turkish Concerns About Syrian Refugees Around The Middle East Around The Middle East Although Russia’s allies include Iran and Syria – Saudi Arabia’s rivals – it has presented itself as a pragmatic partner to other powers, including Turkey and even the Saudis and Gulf states. As such, the Kremlin has leverage on both sides of the regional divide, giving it the potential to serve as a power broker. However, any Saudi purchase of the Russian S-400 defense system, long under negotiation, would unsettle the United States. Turkey is threatened with American sanctions for its purchase of the same system.3 The U.S. may be willing to tolerate some increased Russian influence in the Middle East, but a defense agreement may be its red line. The Trump administration still wields the stick of economic sanctions. Growing Russian influence extends beyond the Gulf states. The U.S.’s withdrawal from northeast Syria last week and the Turkish invasion is a gift to the Russians. They are now the only major power from outside the Middle East engaged in Syria. They have embraced this position, positioning themselves as peace brokers between the Syrian regime, with whom they are allied, and Turkey, as well as the Turkish arch-enemy, the Kurds, who now lack American support and must turn to Syria and Russia for some kind of arrangement to protect themselves. Russia has therefore cemented its return as a strategic player in the region, after its initial intervention in Syria in 2015. Turkey’s incursion into Syria is an attempt by President Erdogan to confront the battle-hardened Syrian Kurds and prevent a Kurdish-controlled continuous border with Syria, and to distract from his weakened domestic position. He is striving to garner support by playing to broad Turkish concerns about Syrian refugees in Turkey (Chart 8). The intervention will seek to create a space for refugees to be placed on the Syrian side of the border. However given that there is little domestic popular support for a military intervention, he runs the risk of further alienating voters, who are already losing patience with his ruling Justice and Development Party (AKP). So far, the incursion has the official support of all Turkey’s political parties except the Kurdish Peoples’ Democratic Party (HDP). However this will change as the intervention entails western economic sanctions, a drawn-out military conflict, and limited concrete benefits other than the removal of refugees. Chart 9Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit The already vulnerable economy is likely to take a hit (Chart 9). Markets have reacted to the penalties imposed by the U.S. so far with a sigh of relief as they are not as damaging as they could have been – i.e. Turkish banks were spared.4 However, this is just the opening salvo and more sanctions are on the way – Congress is moving to impose sanctions of its own, which Trump is unlikely to veto. Moreover, the European Union is following suit and imposing sanctions of its own, including on military equipment. Volkswagen already announced it is postponing a final decision on whether to build a $1.1 billion plant in Turkey. This comes at a time of already existing sensitivities with the EU over Turkish oil and gas drilling activities in waters off Cyprus. EU foreign ministers are responding by drawing up a list of economic sanctions. These economic risks will likely hold back the central bank’s rate cutting cycle as the lira and financial assets will take a hit. Bottom Line: The U.S. pivot away from the Middle East is a boon for Moscow, which is pursuing increased cooperation in the Gulf and gaining influence in Syria. Russia is marketing itself as a strategic player and effective power broker. Erdogan’s incursion in Syria, while motivated by domestic weakness, will backfire on the Turkish economy. Maintain a cautious stance on Turkish currency and risk assets. Iraq Is The Fulcrum Iraq’s geographic position, wedged between Saudi Arabia and Iran, renders it the epicenter of the regional power struggle. In the wake of the Trump administration’s maximum pressure campaign on Iran we have frequently highlighted that a dramatic means of Iranian pushback, short of closing shipping in the Strait of Hormuz, is fomenting unrest in an already unstable Iraq. This would be a threat to U.S. strategy as well as to global oil supplies. Iraq is the epicenter of the regional power struggle. In this context, Iraq’s revered Shia cleric Muqtada al-Sadr’s visit to Iran on September 10, just four days ahead of the September Saudi Aramco attack, raises eyebrows. Sadr is the key player in Iraq today and over the past two years he had staked out a position of national independence for Iraq, eschewing overreliance on Iran. A rapprochement between Sadr and Iran is a negative domestic development for Iraq, which has recently been making strides to reduce Iran’s political and military grip. It would undermine Iraqi stability by increasing divisions over ideology, sect, economic patronage, and national security. There is speculation that Sadr’s trip was intended to discuss Prime Minister Adel Abdul Mahdi, who is perceived as weak and incapable of managing the various powers on Iraq’s political scene. The violent protests rocking Iraq since early September support this assessment. Protestors are motivated by discontent over unemployment, poor services, and government corruption, which are perceived to have mostly deteriorated since the start of Abdul Mahdi’s term (Chart 10). While Abdul Mahdi has announced some reforms in response to the popular discontent, including a cabinet reshuffle and promises of handouts for the poor, they have done little to quell the protests. The popular demands are only one of the existential threats facing the government. The second and potentially more serious risk is the security threat. Iraq has been failing at its attempts to formally integrate the Popular Mobilization Units (PMU) – Iran-backed paramilitary groups that were instrumental in ISIS’s defeat – into the national security forces. This is essential in order to prevent Iran from maintaining direct control of security forces within Iraq. A majority of the public agrees that the PMU should not play a role in politics (Chart 11), reflecting the underlying trend demanding Iraqi autonomy from Iran. Chart 10Rising Discontent In Iraq Around The Middle East Around The Middle East Chart 11Little Support For A Political Role For The PMU Around The Middle East Around The Middle East Given that the PMU is in effect an umbrella term for ~50 predominantly Shia paramilitary groups, internal divisions exist within the forces which compete for power, legitimacy, and resources. Recently, it has been purging group leaders perceived as a threat to the overall forces and the senior leadership which maintain strong links to Iran. Chart 12Iraq Is Divided Across Political Affiliation Around The Middle East Around The Middle East This internal struggle also reflects the intra-Shia struggle for power among Iraq’s main political parties. On the one side there is the conservative, pro-Khamenei bloc led by former Prime Minister Nouri al-Maliki and PMU commander Hadi al-Ameri, and on the other is the reformist, nationalist leader Muqtada al-Sadr’s joined by Ammar al-Hakim. Given that most Iraqis view their country as a divided nation across political affiliation, this is a risk to domestic stability (Chart 12). Thus even if the wider risk of regional tensions abates and reduces the threat of sabotage to oil infrastructure and transportation, the current domestic situation in Iraq remains uneasy. But given that we do not see the regional tensions abating yet – due to either American maximum pressure or Iranian hubris – this dynamic translates into an active threat to oil supplies, with 3.4 mm b/d of exports concentrated in the southern city of Basra. Bottom Line: Heightened domestic instability in Iraq poses a non-negligible threat to oil supplies. This risk is compounded by Iraq’s location as a geographic buffer between regional rivals Iran and Saudi Arabia, and Iran’s interest in fomenting unrest to pressure the U.S. into relaxing sanctions. Investment Conclusions The common thread across the Middle East is a persistent threat to global oil supply in the wake of the extraordinary Abqaiq attack. First, it cannot be stated with confidence that Iran will refrain from causing additional oil disruptions, as it is convinced that President Trump’s appetite for conflict is small (and Trump is indeed constrained by fear of an oil shock). President Rouhani has an interest in removing Trump from power, which an oil shock might achieve, and the Supreme Leader may even be willing to risk a conflict with the United States as a means of increasing support for the regime and infusing a new generation with revolutionary spirit. Iran loses in a total war, but Tehran is convinced that the U.S. does not have the will to engage in total war. Second, Russia’s interest in the region is not in generating a durable peace but in filling the vacuum left by the United States and making itself a power broker. Any instability simply increases oil prices which is positive for Russia. Third, Iraq’s instability is both domestically and internationally driven. It is nearly impossible to differentiate between the two. Iranian hubris could manifest in sabotage in Iraq. Or Iraq could destabilize under the regional pressures with minimal Iranian encouragement. Either way the world’s current below-average spare oil production capacity could be hit sooner than expected if shortages result. Go long spot crude oil. On equities, with a U.S.-China ceasefire in the works, and little chance of a no-deal Brexit, we see our cyclically positive outlook reinforced, though we maintain near-term caution due to U.S. domestic politics. In terms of equity focus, we are overweight European equities in developed markets and Southeast Asian equities in emerging markets.   Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Sudairi branch of the al-Saud family is made up of the seven sons of the late King Abdulaziz and Hussa al-Sudairi of the powerful Najd tribe. 2 Please see TRT World “Killing of Saudi King’s Personal Bodyguard Triggers Speculation,” October 2, 2019, available at https://www.trtworld.com. 3 In the wake of the attack on Saudi Aramco oil facilities, President Putin trolled the U.S. by recommending that Saudi Arabia follow the footsteps of Iran and Turkey in purchasing Russia’s S-300 or S-400 air defense systems. 4 The U.S. penalties include sanctions against current and former officials of the Turkish government, a hike in tariffs on imports of Turkish steel back up to 50 percent, and the halt in negotiations on a $100 billion trade deal.

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Current Account Balance Has Improved Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Chart 5 Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. Chart 6 The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. Chart 11 With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Chart 14 Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights So What? The Trump administration’s decision to apply maximum pressure to Iran fundamentally changes the investment landscape in 2019-20. Why? The impact of the Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity. However, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. Policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Feature What are the Trump administration’s foreign policy objectives? First, to confront the U.S.’s greatest long-term competitor, China, by demanding economic reforms and greater market access. Second, to force a decision-point upon rogue regimes with significant ballistic missile programs and nuclear-weapon aspirations: North Korea and Iran. Third, to maintain credible deterrence in Russia’s periphery. Fourth, to reassert the Monroe Doctrine through regime change in Venezuela. The common thread, even with Russia, is confrontation. It is not necessary for President Trump to pursue all of these objectives at once. So his decision last November to issue waivers for eight importers of Iranian oil suggested to us that he was prioritizing – and becoming more risk averse ahead of the 2020 election. Full enforcement of the oil sanctions at that time threatened to push oil prices up at the same time as the Fed was raising rates, a pernicious combination late in the cycle (Chart 1). Thus, after walking away from the 2015 nuclear accord with Iran, it made sense for Trump to delay any confrontation with Iran until his hoped-for second term in office. He could focus on building the border wall, resolving trade tensions with China, and making peace with North Korea instead. Chart 1Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Chart 2Sanctions Will Raise Risk Sanctions Will Raise Risk Sanctions Will Raise Risk   This view has now been proved wrong. The oil waivers apparently represented only a temporary delay in the administration’s hawkish Iran policy. Now that financial conditions have eased and growth has stabilized, Trump has declared the Iranian Revolutionary Guard Corps a foreign terrorist organization and announced that he will discontinue the waivers, demanding full compliance on energy sanctions from all states by the end of May. Volatility will move higher (Chart 2). Trump is emboldened by America’s newfound energy independence (Chart 3). While the shale boom can be used to reduce U.S. strategic commitments in the Middle East, it can also encourage Washington to believe it is invulnerable to traditional Middle Eastern risks. Trump’s advisers, Secretary of State Mike Pompeo and National Security Adviser John Bolton, apparently have won the Iran policy debate on this basis. Since Trump’s reelection is far from guaranteed, it would appear his advisers view re-imposing sanctions against Iran as a rare opportunity to achieve long-term strategic objectives. They may not have the chance in 2021. Chart 3The U.S. Is Energy Independent The U.S. Is Energy Independent The U.S. Is Energy Independent Chart 4Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes All the same, the problem for Trump is that, while the U.S. will survive any chaos ensuing from an Iran confrontation, his presidency may not. Full enforcement of the sanctions could spiral out of control and, through the oil price channel, come back to hurt Trump’s economy – and hence his re-election odds (Chart 4). The implication is that Trump has either been misled about the risks of his Iran policy, or he does not care as much about his re-election odds as we believed. Either way, the result is aggressive policy, which increases the geopolitical risk premium in oil prices. We can see this in our simulations (below), which are based entirely on spare capacity and compliance by consumers to the sanctions. We did not include an Iran-retaliation scenario in this modeling. Therefore, any threat to Iraqi supplies, or talks of disrupting the Strait of Hormuz will add to our prices forecasts. U.S. Administration Sailing Close To The Wind From their public comments, it would appear the U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of production in Iran and Venezuela. For the Trump administration, this view is supported by growing U.S. shale-oil supplies, and the administration’s belief the Kingdom of Saudi Arabia (KSA) and its Gulf allies stand ready to increase production to cover any losses arising from the re-imposition of Iranian oil-export sanctions by the U.S. This belief supports the administration’s end-game, which appears to be regime change in Iran, a position long favored by Trump’s national security advisor John Bolton. Frank Fannon, U.S. Assistant Secretary of State for Energy Resources, succinctly captured the administration’s view when he declared, “We are doing this ... in a favorable market condition with full commitment from producing countries.” He further stated, “We think this is the right time.”1 We believe the Trump administration is sailing close to the wind here. The U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of oil production in Iran and Venezuela. While increasing U.S. shale output does provide something of a cushion to global oil markets, it is not a substitute for the heavy-sour crude produced by Iran and Venezuela (and others), which is favored by refiners with complex units. The loss of Iranian exports hits these refiners harder than those able to process lighter, sweeter crude of the sort exported by the U.S. (Chart 5).2 As Iranian and Venezuelan barrels are lost to the market, these heavier crudes are getting more scarce relative to the crude produced in U.S. shales – typically classified as West Texas Intermediate (WTI) crude oil. This can be seen in tighter light-versus-heavy crude oil spreads, and the wider Brent-WTI spreads, which indicate WTI is relatively more plentiful (Charts 6A & 6B). Chart 5 Chart 6AWTI Relatively More Plentiful… WTI Relatively More Plentiful... WTI Relatively More Plentiful... Chart 6B…As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce It is true U.S. production continues to grow, which is causing crude oil inventories to increase as sanctions on Iran are being re-imposed. We expect U.S. shale-oil output to grow 1.2mm b/d this year – taking it to a record 8.4mm b/d on average – and 800k b/d next year. Caution is required regarding inventories, however: U.S. refiners are in the thick of their plant maintenance – known as turn-around season – and have loaded a lot of the maintenance they would normally have done in the Fall into Spring. As a result, U.S. refiners are running at reduced rates preparing for the Northern Hemisphere’s summer driving season and the January 1, 2020, implementation of the U.N. IMO 2020 regulations, which will require shippers to use lower-sulfur fuel to power their vessels worldwide.3 OPEC 2.0 Gains Control Of Brent Forward Curve Growing U.S. production and inventories might give the Trump administration comfort the market can absorb the loss of Iran’s exports – some 1.3mm b/d at present. However, our base case holds that Iran’s exports will stabilize at ~ 600k b/d after sanctions fully kick in. In most of the scenarios we run (Table 1), the impact of Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity (Chart 7).4 Indeed, many of the low-probability scenarios we run – including the “maximum pressure” scenario, in which the Trump administration succeeds in removing all of Iran’s exports – can be accommodated by current supply and spare capacity without sending Brent prices through $100/bbl (Chart 8). OPEC 2.0 holds ~ 1.5mm b/d of what we would describe as readily available spare capacity – mostly in KSA – that can be brought to market fairly quickly, as the ramp-up last year ahead of the first round of sanctions in November amply demonstrated. Another 1.5mm b/d or so is held by the Kingdom and its GCC allies, but it would take longer to bring on line. Table 1BCA Oil Market Scenarios U.S.-Iran: This Means War? U.S.-Iran: This Means War? Chart 7OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses Chart 8Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 In reality, once refiners are up and running at max capacity in the U.S. in a few weeks, U.S. inventories will begin to draw hard. This will support what we believe to be OPEC 2.0’s goal of backwardating the Brent curve – perhaps sharply. This will allow it some breathing space to gradually add barrels to the market in 2H19 as needed, as our balances and forecasts assume. It is important to remember OPEC 2.0 was formed to drain the massive storage overhang that resulted from the 2014-16 market-share war launched by KSA. The Kingdom’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. Throughout the ramp to renewed sanctions, he has steadfastly maintained the Kingdom will provide oil as Aramco’s customers need it, following the blind-side hit KSA took from the Trump administration in November when it granted Iran’s largest customers waivers on its export sanctions. U.S. Pressure On OPEC To Raise Output Will Grow We expect the Trump administration to continue to pressure OPEC – the old cartel, not OPEC 2.0 – to boost production post-sanctions. However, it is not entirely clear that this time OPEC’s – particularly KSA’s – interests are 100% aligned with President Trump’s. KSA and other producers were shocked by the administration’s decision to grant waivers after lifting supply sharply in response to Trump’s demands. This time around, we believe OPEC – KSA in particular – will be more cautious lifting output, even as the U.S. Navy very publicly displays its ability to project and sustain force in the Mediterranean and Persian Gulf regions (Map 1). With good reason: The U.S. holds ~ 650mm barrels of oil in its Strategic Petroleum Reserve (SPR), which can be released at a rate of 1mm to 1.3mm b/d for a year or so. Realistically, it is probably more like six to nine months, since, by the time much of the oil has been released to the market the reserves that are left likely will have higher concentrations of contaminants (e.g., metals and solids that migrated to the bottom of the storage while it was sitting idle), making buyers way more leery of using it. Chart After the shock of the waivers, KSA likely will minimize its exposure to another surprise from the U.S. as sanctions take hold. The risk to OPEC – KSA in particular – is that Trump again will pull a fast one as the U.S. general election approaches. Given Trump’s demonstrated sensitivity to U.S. gasoline prices approaching elections, it is not unlikely that he would hold on to the SPR barrels until mid to late summer 2020, then release them in time to reduce prices further. If, in the run-up to U.S. elections, OPEC has steadily increased production to build precautionary inventories then it runs a non-trivial risk the crude oil price would once again crash as SPR barrels are released. The Kingdom of Saudi Arabia’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. In this iteration of Iranian export sanctions, we expect KSA to adopt a just-in-time inventory management strategy, so that it is not caught out once again over-supplying the market ahead of a U.S. surprise. U.S. Shales Will Figure Into OPEC 2.0’s Calculus Chart 9U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained The other big fundamental OPEC 2.0 will be considering is the rate at which U.S. shale oil can be exported. Export capacity still is constrained by the shortage of deep-water harbor facilities in the U.S. Gulf. This is being addressed, but it has been slowed by additional requests for environmental impact statements from the federal and state governments. If prices start moving higher because KSA and OPEC 2.0 are responding to tightening markets with caution (and slowly), we’d likely see WTI production increase – it’ll have 2mm b/d of new pipe in the Permian to fill by end-2019 – but that crude could start backing up as storage in the U.S. Gulf fills. This would again widen the Brent vs. WTI - Houston spread, which will benefit refiners in the U.S. Gulf, but will lower prices received by U.S. shale producers (again) (Chart 9). Bottom Line: Trump’s decision not to extend the Iranian oil waivers suggests that he has plenty of risk appetite ahead of the 2020 election. His Iran policy is now the biggest geopolitical risk to the late-cycle bull market. It also risks tightening the oil market considerably as the election approaches. Can Iran’s Regime Withstand The Sanctions? Iran’s economic weakness was an added inducement for the Trump administration to take an aggressive turn. The sanctions against Iran’s crude oil exports have not yet been implemented in full force, but the economy is already showing signs of distress. For one, inflation is back near 40% – levels only reached during the previous round of sanctions (Chart 10). Given that food, beverages, and transportation are among the sectors experiencing the fastest growing prices, lower income groups – which the World Bank estimates spend almost half their income on food alone – will suffer disproportionately. Economic dissatisfaction has catalyzed protests in Iran in the past, and the squeeze from the U.S. sanctions could propel further unrest. Chart 10Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Chart 11 Moreover, soaring prices are coinciding with a slowdown in activity and consumption. On the surface Iran appears relatively well protected given that its economy is not as directly correlated with oil exports as some of its peers (Chart 11). However, Iran’s oil and non-oil sectors are actually closely intertwined. This is evident from weakness in the non-oil sector during the previous round of sanctions (Chart 12). The IMF expects the economy to contract by 6% this year – faster than its 3.9% estimate for last year – leaving Iranians to face a period of deepening stagflation. Chart 12 The jump in consumer prices is a reflection of the ongoing collapse of the currency. Despite the government’s best efforts to stabilize the foreign exchange market, heightened demand for foreign currencies caused a nearly 30% depreciation in the unofficial exchange rate vis-à-vis the U.S. dollar since the beginning of the year (Chart 13). Chart 13Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Chart 14Debt Burden Is Manageable Debt Burden Is Manageable Debt Burden Is Manageable To soften the impact of the weaker currency and the potential shortage of essential goods, authorities have introduced a three-tier exchange rate system, and banned the export of several products including grains and seeds, powdered milk, butter, and tea. Since the level of external debt remains manageable (Chart 14) the weak currency will pressure the economy through its impact on prices (highlighted above), with imported inflation eroding purchasing power. Furthermore, Iran will not benefit from any additional export competitiveness due to currency depreciation. The current account surplus is expected to deteriorate and eventually flip to a deficit amidst weak exports, and despite declining imports (Chart 15). The fact that Iran runs a non-energy trade deficit does not help. Chart 15Trade Surplus At Risk Trade Surplus At Risk Trade Surplus At Risk Chart 16Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint In terms of the fiscal purse, under normal circumstances, a weaker rial would raise government revenue from oil exports. However, given the restrictions on oil exports, the fiscal budget will not benefit from this relationship. Instead, the dominant impact will be greater government spending. Historically, expenditures tend to be countercyclical, aiming to mitigate the impact of the deteriorating economic environment on Iranian households (Chart 16). In the past, the Iranian government’s healthy fiscal balance allowed policymakers to implement social protection schemes to combat poverty and revitalize the economy. Now, however, the fiscal coffers are no longer so well-cushioned and the deficit will constrain this option. Stimulative fiscal policy in this environment would only raise inflation further. Furthermore, given that the lion’s share of Iran’s imports are capital and intermediate goods, the currency depreciation will spill over into the domestic industry and weaken demand, even for domestically produced goods. Investments have been lacking in many of the most essential services. The electricity sector is a prime example: while demand is rising, spare capacity is dwindling and causing recurring outages. Similarly, foreign direct investment will likely fall in this uncertain political environment. With the economy on the brink, Iran is not in a position to confront the United States directly. It must take total sanctions enforcement as a very grave risk and seek delaying actions and negotiations. However, this vulnerability will turn into desperation if the Trump administration proceeds with a full embargo without any “off ramp” for negotiations. Bottom Line: Full enforcement of sanctions threatens to destabilize Iran’s already vulnerable economy. Inflation is soaring, the currency is plunging, and the economy will likely be plagued by a twin deficit going forward. The implication is that Iran will eschew direct confrontation unless forced. Will Iran Retaliate In Iraq? Iran is also at risk of losing one of its great sources of leverage: Iraqi stability. Given its gloomy economic outlook, Iran is looking to expand ties with its neighbors in an attempt to soften the blow from the sanctions. Earlier this year president Hassan Rouhani and Iraqi prime minister Adel Abdul Mahdi signed several preliminary trade deals, with the ultimate aim to boost bilateral trade to $20 billion from its current ~$12 billion. However, natural gas exports to Iraq – a major traded good – are covered by the sanctions, so this target is probably unattainable. Although Iran is currently the only foreign supplier of natural gas and electricity to Iraq, the temporary halt in electricity supplies last summer coincided with violent protests in Southern Iraq.5 Growing anger over Iran’s inability to satisfy its commitments to Iraq highlights the tensions in the Iraq-Iran relationship. What’s more, the U.S. is pressuring Iraq to turn to other neighbors such as Saudi Arabia, Jordan, and Kuwait for its electricity needs.6 In March, it renewed a three-month waiver allowing Iraq to import Iranian gas. Then Saudi Arabia promised to connect Iraq to the Saudi electricity grid during a visit by its economic delegation to Baghdad on April 4.7 At that meeting, the Saudi delegation also agreed to provide Iraq with $1 billion in loans, $500 million to boost exports, and a sporting complex as a gift. Additionally, the Saudi consulate in Baghdad – which had been closed for almost 3 decades – reopened last month. Saudi Arabia and Iraq are starting to cooperate. Iraq’s new government is clearly taking a pragmatic approach to its regional relationships. This is also largely in line with growing domestic opposition to Iranian interference within Iraq. Influential Shia leaders such as Muqtada al-Sadr and Ayatollah Ali al-Sistani have been voicing concerns about Iran’s influence in Iraqi politics. As such, the new Iraqi government is attempting to walk a tight rope between placating Iran and taking advantage of new opportunities with its Arab neighbors to rebuild its economy. This trend raises the risk that Iran will strike rapidly in Iraq if it believes Trump’s maximum pressure strategy is succeeding in bringing oil exports to zero. Iraq is the logical target as Iran has great political and sectarian influence there, it is the geographic buffer with Saudi Arabia, and it is the necessary launchpad for Iran’s strategic opponents to undermine or attack the Iranian regime (Map 2). Chart Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a fullfledged conflict. Chart 17 Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. About 85% of Iraq’s crude exports flow through the southern port city of Basra (Chart 17). It is already home to recurrent protests and any disruptions there threaten around 3.5mm bbl shipping to international markets daily. Bottom Line: Iraq is caught in the strategic tug-of-war between Iran and Saudi Arabia, with the latter gaining influence at present. Sanctions could compel Iran to retaliate in Iraq, jeopardizing up to 3.5mm b/d of supply. What Comes Next? The latest data suggest that Japan is in full compliance with the U.S. sanctions against Iran as of April and that China has been front-running the sanctions and is now reducing imports, as it was at the time the waivers were first introduced. China may not go to zero, but it is apparently complying. This is important given that the Trump administration has essentially introduced a bold new demand – cut off all energy imports from Iran – at the eleventh hour of the U.S.-China trade negotiations. Our projections of spare capacity suggest that the Trump administration will believe it has room to enforce the sanctions fully (Chart 18). This is a risky approach, as a fairly standard unplanned outage anywhere else in the world could bring spare capacity much lower, but the data suggest that Trump’s team will not see it as a hard constraint. If necessary, the administration can later choose to soft-pedal enforcement on black market activity so as to calibrate the global impact. Chart 18 The Iranians, for their part, are unlikely to leap to the most aggressive forms of retaliation immediately – such as fomenting unrest in Iraq – because of their economic vulnerability. Small acts of sabotage or subversion are a way to send the U.S. a warning signal, but generally Iran will want to signal defiance while shifting the emphasis to negotiations. Hence it will primarily retaliate through diplomatic actions and calculated displays of force. A limited response enables Iran to appear innocent, divide the U.S. and EU, and thus isolate the U.S. over its belligerent policies. Previously, Trump has sought to negotiate with Iranian President Hassan Rouhani. The Iranians have so far rebuffed him, but Foreign Minister Mohammad Zarif’s initial response to the waiver announcement was to blame Trump’s advisers, instead of Trump himself, and offer an exchange of prisoners (And release of detained Americans happen to be one of the Trump administration’s key demands – see Table 2.) Negotiations could begin through back channels and an uneasy period of tensions could thus ensue without a full-blown war. Table 2Trump Administration’s 12 Demands On Iran U.S.-Iran: This Means War? U.S.-Iran: This Means War? The problem is that negotiations cannot work if Trump fully and immediately enforces the sanctions without offering Iran an “off ramp.” If the administration backs Iran into a corner it will have no option but to strike out forcefully. Negotiations also cannot work if Iran joins the U.S. in withdrawing from the 2015 deal and reactivating its nuclear program, specifically the suspected military dimensions of that program. This would force Trump to respond (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree U.S.-Iran: This Means War? U.S.-Iran: This Means War? In short, a period of “fire and fury” is about to ensue between Trump and Rouhani. It will be even more uncertain and disruptive than the summer 2017 showdown between Trump and Kim Jong Un of North Korea (Chart 19), which drove a 35 bps decline in the 10-year Treasury yield. Chart 19Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Kim Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown There is a pathway for Trump’s pressure tactics to succeed: Iran is vulnerable and the United States and its allies are in a position of relative strength in terms of global oil supply. Therefore, it is possible that Trump could fully enforce the sanctions and yet avoid any uncontrollable crisis or oil shock. However, this pathway, at a subjective 26% probability, is less likely than the combined 48% probability of the alternatives: either escalation short of war, or ultimatums leading to Middle Eastern instability and much higher odds of war. Bottom Line: The geopolitical risk of U.S.-Iran confrontation is not contained. But we do not expect Iran to overreact unless Trump plows forward with full and immediate sanctions enforcement and offers no realistic “off ramp” for negotiations. At that point Iranian retaliation will be concrete and escalation could spiral out of control. Investors should keep in mind that Iran is not North Korea. Unlike the hermit kingdom, Iran has the ability to retaliate with a number of different levers. Indeed, it has threatened to shut the Strait of Hormuz in the past, and could, at the limit, be backed into that corner. While the risk of this is extremely low, should it occur the consequences would be huge – close to 20% of the world’s daily oil supply passes through the Strait daily. Indeed, just this week Iran’s Oil Minister Bijan Zanganeh again threatened to take action against any OPEC member working against its interests. Following a meeting with the Cartel’s president, he is reported to have said, “Iran is a member of OPEC because of its interests, and if other members of OPEC seek to threaten Iran or endanger its interests, Iran will not remain silent.”8 Investment Conclusions The Trump administration’s decision to apply maximum pressure to Iran is a significant and unexpected injection of geopolitical risk that we believe fundamentally changes the investment landscape in 2019-20. While our base case is that the U.S. will enforce the oil sanctions gradually and in such a way as to avoid causing an oil shock, policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1 Please see Humeyra Pamuk and Timothy Gardner, “How Trump’s hawkish advisors won debate on Iran oil sanctions,” Reuters, May 1, 2019, available at reuters.com. 2 Heavy-sour crudes are those with low API gravity (a measure of how easily a crude flows) and higher sulfur content. Light-sweet crudes have higher API gravity and lower sulfur content. 3 Please see BCA Commodity & Energy Strategy Weekly Report, “IMO 2020: The Greening Of The Ship-Fuel Market,” February 28, 2019, available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition led by KSA and Russia, which was formed in 2016 to manage global crude oil output. Its goal is to drain the massive storage overhang caused by the market-share war launched by KSA in 2014. 5 Iran cited dissatisfaction with Iraq over the accumulation of unpaid bills as the cause of the halt in electricity exports to Iraq. This prompted Iraqi authorities – under pressure from domestic unrest – to send a delegation to Saudi Arabia in attempt to negotiate an electricity agreement. 6 Please see Edward Wong, “Trump Pushes Iraq to Stop Buying Energy From Iran,” The New York Times, February 11, 2019, available at nytimes.com. 7 Please see Geneive Abdo and Firas Maksad, “Iraq’s Place in the Saudi Arabian-Iranian Rivalry,” The National Interest, April 15, 2019, available at nationalinterest.org. 8 Please see Babk Dehghanpisheh, “Iran will respond if OPEC members threaten its interests: oil minister,” Reuters, May 2, 2019, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 4... Even Those That Produce Gridlock Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Chart 5B...Despite Volatility ...Despite Volatility ...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 9Two Hedges We Recommend Two Hedges We Recommend Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... No Geopolitical Risk Embedded... No Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling ...In Today's Pound Sterling ...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Policy Uncertainty Index Muted Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling A Liability For Sterling A Liability For Sterling Chart 15Theresa May's Tenuous Grip Theresa May's Tenuous Grip Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Fade Any Short-Term Rebound Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Out-Of-Sample Testing Of Model (I) Out-Of-Sample Testing Of Model (I) Chart 20 Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Geopolitical Calendar

Highlights Iraq remains vital for the security of the Middle East and global oil supply; Sectarian tensions in Iraq have peaked, but risk of Shia-on-Shia violence is rising, which could imperil the all-important export facilities in Basra; With the Islamic State defeated, Iran's military support is no longer needed; This opens a window of opportunity for Saudi Arabia and its Gulf Cooperation Council (GCC) allies to make diplomatic inroads in the country; Stability and security are positive for investments in Iraq's energy sector, but official targets are overly ambitious. BCA's Commodity & Energy Strategy expects oil prices to push higher ahead of the likely loss of 2 million bbl/day of exports on the back of U.S.-imposed sanctions against Iran and the all-but-certain collapse of Venezuela's economy. Feature "Divisiveness is not good for the people ... the policy of exclusion and the policy of marginalization must end in Iraq ... All Iraqis should live under one roof and for one goal." Muqtada Al Sadr, April 2012 "Competition between parties and election candidates must center on economic, educational, and social service programs that can be realistically implemented; to be avoided are narcissism [and] inflammatory sectarian and nationalist rhetoric" Ayatollah Al Sistani, May 4, 2018 "Say no to sectarianism, no to corruption, no to division of shares, no to terrorism and no to occupation" Muqtada Al Sadr's call for a peaceful million man "Day of Rage," September 2018 Moqtada Al Sadr's Sairuun party's unlikely victory in Iraq's May elections came as a surprise. The former leader of the Mahdi Army - a militia that terrorized U.S. forces - has reinvented himself into a champion of reform and a counterweight against foreign influence in the country, particularly Iranian. His political success is due to his ability to recognize that Iraq is at a crossroads. Attitudes and priorities are shifting on several levels: Iraq is turning away from sectarian politics after a decade and a half of internal strife. The security threat from the Islamic State has been eliminated, with nationalism replacing sectarianism. Iran-Saudi tensions are ramping up again at the same time that the U.S. is putting pressure on Iran by reimposing a global oil embargo. Iraq, a buffer state between Iran and Saudi Arabia, will become a battlefield between the two regional powers, but the battlefield may be shifting from the military theatre to the economic one. These junctures provide both opportunities to transition the country to a new stage, as well as challenges in cleansing the system of its old demons. The composition of Iraq's new government matters. It will ultimately determine whether these impulses will pave the way for a stronger, more unified country, or whether Iraq will remain consumed with internal battles. Unity is required for Baghdad to boost its oil output in the way it hopes. The Iraqi economy's relationship with oil markets is two-sided. Not only is its income dependent on oil, but global oil markets are also reliant on Iraqi supplies at a time when global spare capacity is razor-thin. Given that Iraq is currently the fifth-largest crude oil producer in the world - the second-largest within OPEC - and accounts for 5% of global crude oil supply, Iraq's production ambitions are important for global oil markets (Chart 1). Chart 1Iraqi Upstream Production Matters Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply As such, when Baghdad announced its ambitions to raise capacity to 6.5 million bbl/day by 2022, the energy markets were paying attention. If this capacity increase translates to a rise in actual production, additional Iraqi oil by the end of the four-year period would roughly equal 2 million bbl/day. This is equivalent to BCA's Commodity and Energy Strategy's expectation of a loss of exports from the two main risks to energy markets today: the Iranian oil embargo and the internal strife in Venezuela (Chart 2).1 (Of course, the Iraqi production would not come in time to prevent the run-up in prices that we expect as a result of the latter two risks, given that they are immediate risks whereas Iraq will take four years to ramp up.) Chart 2Losses From Venezuela and Iran Will Push Prices Higher Losses From Venezuela and Iran Will Push Prices Higher Losses From Venezuela and Iran Will Push Prices Higher The doubling of Iraq's production over the past decade occurred despite constant sabotage of its oilfields, pumping stations, and pipelines by insurgents. It would seem that the restoration of security offers an optimistic outlook for Iraq's production plan, especially given Iraq's naturally competitive conditions (Table 1). But there is no certainty in Baghdad's ability to reach these targets. Iraqi output is now operating near full capacity (Chart 3). The past decade and a half have wreaked havoc on its infrastructure and discouraged investments needed to develop its fertile oilfields. Table 1Operating Costs Are Competitive Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Chart 3Not Much Idle Capacity Not Much Idle Capacity Not Much Idle Capacity In this report, we assess whether political conditions will support stability in Iraq. The alternative scenario, one where Iraq becomes a physical battlefield between Iran and Saudi Arabia, would not only snuff out any hope of an oil export boom, but could also become yet another risk to global oil supply. Political Will Is Not Enough To Boost Oil Output An expansion of oil production capacity would bring much needed revenue to aid in Iraq's rebuilding efforts. Iraq's economy is highly dependent on the energy sector, even relative to other major oil-producing Middle Eastern peers (Chart 4). The rebound in oil prices over the past couple of years has therefore helped support Iraq's budget, with a surplus expected this year for the first time since 2012 (Chart 5). Extra revenue has, in turn, helped grease the wheels of stability and reconciliation in the country. Chart 4Addicted to Petrodollars Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Chart 5Higher Prices Will Help Flip the Deficit Higher Prices Will Help Flip the Deficit Higher Prices Will Help Flip the Deficit However, political will is not a sufficient condition. Rather, the success of the plan to expand capacity is contingent on Baghdad overcoming several key constraints: While the threat from Islamic State has for the most part subsided, security and the potential for sabotage remain risks to Iraq's current oil infrastructure. Ongoing disputes over the status of Kurds in northern Iraq - risks that contains almost 20% of proven reserves - raise the potential for conflict. Additionally, oil infrastructure may become vulnerable to sabotage from Iran, or Iranian-backed militants, if there is a souring of relationships (see more on that below). Discontent among Iraqis in the southern oil-rich region also raises the probability of disruptions. Over the weekend, protesters upset with corruption and poor services gathered near the Nahr Bin Omar oilfield. Clashes between Basna protesters and security forces have already led to six deaths over the past three days. Iraq's current network of pipelines, pumping stations, and storage facilities - many of which are damaged beyond repair - are not capable of handling greater volumes. An expansion of the export capacity is required for Iraq to be able to benefit from future increases in production. Such an expansion will require FDI, which in turn will require stability and a political climate conducive to large-scale, long-term investments. There are currently two main functioning oil export hubs - the northern network of pipelines, and the southern shipping route (Map 1). Map 1Iraq's Oil Infrastructure On Shaky Ground Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply In northern Iraq, the Iraq-Ceyhan pipeline is connected to Kurdish lines at the city of Fishkabur and carries northern oil to the Turkish port (Table 2). Table 2Defunct Pipelines Leave Room For Improvement Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Northern exports account for ~15% of Iraq's total crude exports (Chart 6). While the Fishkabur-Ceyhan pipeline has a nameplate capacity of 1.5 million bbl/day, usable capacity is reportedly significantly lower, constraining Iraq's northern exports. Chart 6Southern Crude Accounts For Bulk Of Iraqi Exports Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Although the Kurdistan Regional Government (KRG) has its own network of pipelines transporting crude from fields in the Khurmala Dome and Tawke fields to Ceyhan via Fishkabur, the main infrastructure on the Baghdad-controlled side - the Kirkuk-Fishkabur pipeline - has been targeted by insurgents and has slowly been losing capacity. Its pre-2003 0.9 million bbl/day capacity was reduced to 0.25 million bbl/ day in 2013. Finally, it was closed down in March 2014 rendering it inoperable. Exports from Kirkuk have been on hold following Iraq's takeover of the oilfield in October 2017, as the Iraqi government does not have the infrastructure to bypass Kurdish pipelines. As a result, exports through Ceyhan have collapsed to almost half their pre-October levels.2 The closure of the Kirkuk pipeline undercuts Iraq's ambitions to increase Kirkuk's oil production to 1 million bbl/day. This has been partially mitigated by an agreement for Iraq to truck 0.03-0.06 million bbl/day of Kirkuk oil to Iran in exchange for oil in the south. Ultimately, the vulnerability of northern exports highlights the need for more reliable transportation channels. As such, the Iraqi government announced plans late last year to build a new pipeline from Baiji to Fishkabur, replacing the defunct Kirkuk pipeline in transporting oil to Ceyhan. Furthermore, the idea of using KRG pipelines to export Kirkuk's oil was floated during meetings between current Prime Minister Haider al-Abadi and former President of the Kurdish Regional Government (KRG) Masoud Barzani, and thus could be a possibility going forward. A positive outcome would require a thaw in Iraqi-Kurdish relations and ultimately hinges on the outcome of government formation in Baghdad. Thus, the northern infrastructure - which currently has a nameplate export capacity of 1.5 million bbl/day - underlines the vulnerability of Iraq's exports, not only to sabotage, but also to internal strife. Export capacity from southern Iraq, which accounts for 85% of oil exports, will also require expansion. Pipelines between the oilfields, storage facilities, and export terminals on the Persian Gulf are also susceptible to damage. However, authorities have been expanding export capacity there. The authorities currently operate five single point moorings, bringing total export capacity from the Persian Gulf to 4.6 million bbl/day. The Iraqi Pipeline to Saudi Arabia (IPSA), which could support export capacity from the south, runs through the Arabian Peninsula to the Red Sea. However, it has not been operating since the first Gulf War, and the Saudis have converted their section of the pipeline to transport natural gas. Talks of a revival of this line have recently surfaced. An improvement in Saudi-Iraqi relations would certainly be a positive sign for southern export capacity, providing another outlet for any potential supply increase. Currently there are no operating export pipelines going westward.3 The Kirkuk-Baniyas pipelines were damaged in 2003, and while Iraq and Syria agreed to replace these pipelines with two new ones in 2010, no progress has been made yet. Given instability in Syria, this is unlikely to happen anytime soon. However, there is a plan in place to create a new line between Basra and Aqaba in Jordan with an export capacity of 1 million bbl/day. This would allow Iraq to transport just under a quarter of its total exports via the Red Sea, rather than the Persian Gulf. In terms of internal transportation, the Iraq Strategic Pipeline is a pair of bi-directional lines that run vertically between the country's most important oil-producing regions. However, it has been damaged and currently operates only northward, from Basra to Karbala. Since there are no operational pipelines to the north under Iraqi control, it is currently of limited use. In other words, the oil is stuck in Iraq. Increases in water injection facilities are also required to maintain pressures in the reservoir and boost oil production. Natural gas, which Iraq currently flares, could technically be used as an alternative to water injection. Iraq is working towards reducing gas flaring and hopes to use the captured gas for electricity. The Common Seawater Supply Project (CSSP) aims to treat and transport 5-7.5 million bbl/day of seawater from the Persian Gulf to oil production facilities. 1.5 bbl of water injected are required to produce 1 bbl of oil in the major southern oilfields. However, since the termination of talks with Exxon Mobil Corp on the construction of the facility in June (after two years of negotiations!) there has been no progress on this project. It will likely be awarded to another company, but the lack of clarity regarding CSSP's completion date adds uncertainty to Iraq's expansion plans. Electricity shortages also put expansion plans in peril. Iraq needs significant upgrades to its electricity grid. Given that the oil and gas industry is the top industrial customer of electricity, a stable connection is required to boost output. The World Bank reports that in 2011, an average of 40 outages occurred each month, affecting 77% of firms in Iraq. Bottom Line: Export capacity of Iraq's northern pipeline to Ceyhan currently stands at 1.5 million bbl/day, while its southern ports allow for 4.6 million bbl/day to be shipped through the Persian Gulf. These figures are generous. Usable capacity is reportedly much lower. Iraq has plans to increase its western export capacity to 1 million bbl/day through a new pipeline to Aqaba. Nevertheless, this infrastructure is vulnerable to sabotage by residual insurgents, as well as to Iraq-Kurdish and Iraq-Iran disputes. Iraq's Shifting Interests... Policymakers in Baghdad face the challenge of ensuring sufficient water and electricity not only for the country's oilfields but also for the population. Electricity shortages triggered the recent protests in Basra. Demonstrators have been calling for improved access to these essentials, along with job opportunities and a crackdown on corruption. Furthermore, there is increased evidence that Iraqis have become disillusioned with the political elite and are losing confidence in the political "establishment," such as it is (Chart 7). Transparency International rates Iraq as "highly corrupt" and ranked it 169 out of the 180 countries in its 2017 Corruption Perceptions Index. It stands out even among its highly corrupt Middle Eastern peers (Chart 8). Chart 7Iraqis Lack Confidence In Their Leaders Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Chart 8Corruption Is Rampant Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraqis fear that even as their country exploits its oil, they will remain destitute. Although the southern region contains three-quarters of Iraq's oil reserves (Table 3), it has the highest poverty rate (Chart 9). Table 3Southern Oilfields Are Iraq's Crown Jewel... Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Chart 9...Yet Poverty Is Widespread There Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Anti-establishment sentiment is rising, as reflected in the most recent parliamentary elections in May 2018. Voter turnout was reported at 44%, down from 60% in the previous two elections. The success of Moqtada Al Sadr's Sairuun coalition in winning the majority of seats highlights this shift in allegiance (Box 1). While Iraq's demographic makeup remains heterogeneous, voters are no longer instinctively looking for sectarian parties to represent them. Rather, they want policymakers to resolve basic needs like electricity, water, and corruption. Protesters in Basra are therefore not chanting sectarian slogans, but rather demanding basic services and jobs (Chart 10). Box 1 Ma'a Salama Sectarianism? In surprising results from the May parliamentary elections, the Sairuun coalition - an unlikely combination of communists, leftists, and centrist groups, led by firebrand Shia cleric Moqtada Al Sadr - attained the largest number of votes (Table 4). Nevertheless, it was not able to garner enough seats to secure an outright majority necessary to form the government on its own. Instead, alliances are now being forged as parties scramble to establish the largest coalition group. Of the 329 seats in Iraq's Council of Representatives, just over half are represented by the main Shia parties. The challenge for them this time around is that the five main Shia blocs, which were previously united, have split into two opposing camps. Table 4Politicians Are Picking Up On Shifting Trends Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply The Sadr-backed Sairuun coalition, along with (1) Prime Minister Abadi's Nasr al Iraq, (2) the conservative Hikma bloc, and (3) the Ayad Allawi, centrist Wataniyya bloc have already announced a preliminary agreement to form a coalition as well as a commitment to take an anti-sectarian approach. Several smaller Sunni, Christian, Turkmen, and Yazidi parties have pledged that they would support the non-sectarian, nationalist, bloc of parties. This brings their seats to 187. At the other end are the pro-Iranian Fateh and Dawlet al Qanun blocs, which recently announced that they had formed the largest bloc. The two main Kurdish parties are not included in either alliance. Together they hold 43 seats, giving them the power to be the tie-breakers. They have drafted a list of demands and stated their willingness to join whichever bloc is able to guarantee their fulfillment. Given Maliki's previously divisive rule, we assign a greater probability to the scenario in which they join the core coalition headed by Sadr, as several Sunnis have already done so. The danger of a nationalist, cross-sectarian movement is that it would signal the rebirth of an independent Iraq, which is not necessarily in the interest of its two powerful neighbors, Saudi Arabia and Iran. Iran, in particular, would feel its dominant position weaken and might want to instigate sectarian conflict in order to arrest the nationalist, Sadr-led movement. This would definitely matter to global investors as a Shia-on-Shia conflict in Iraq would geographically take place around Basra, the main shipment route for 85% of the country's oil exports. Chart 10Iraqis Want Better Services Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Prime Minister al-Abadi has also become more responsive to people's needs. He recently sacked the electricity minister and promised to fund electricity and water projects. Furthermore, amid demands for employment opportunities in the oil sector and accusations of corruption, the Iraqi cabinet recently announced a regulation requiring that at least 50% of foreign oil company employees be Iraqi citizens. Given that the voice of discontent in Iraq is getting louder, we expect the government to uphold these promises. Pacifying protesters will increase stability, reduce risks of violence and disruptions, and build support for the government. Nevertheless, many voters still see the prime minister as part of the corrupt political elite. Bottom Line: Iraqis are demanding their basic rights, and this is taking the form of increased pro¬tests, especially in the south where key oilfields are located. The schism among the main Shia parties along the nationalist/Iran axis suggests that Iraq has evolved beyond the purely sectarian political system. This is a positive in the long term as it means that the country can focus on material issues that matter to Iraqis. However, in the short term, the Iran-aligned Shia groups could spur violence, especially if they realize that the sectarian model of politics is waning. ...And Shifting Allegiance? Apart from the shift in focus toward issues-based politics, the election also highlights a pivot in allegiance away from Iran. Sadr's Sairuun bloc is critical of Iranian interference, and while it was initially open to joining forces with Amiri's Iran-backed Fateh coalition, it ultimately allied with the more secular Shia parties. Iran's recent role in Iraq has been mainly through military aid. It proved vital in driving the Islamic State militants out of Iraq - training, equipping, and funding Iraqi militias who fought against the terrorist group. Iran-backed militias united in 2014 to form the Popular Mobilization Forces (PMF) and eventually defeated Islamic State. The PMF, estimated to be between 100,000-150,000 strong, was officially recognized as part of the Iraqi army earlier this year. However, the loyalty of the Shia militias to Baghdad remains unclear. Furthermore, when Washington expressed reluctance in arming Iraq with U.S. military equipment to fight terrorist groups in early 2014, Iran stepped up and signed a deal to sell arms and ammunition worth $195 million (Table 5). Iran also sent its own troops to support in fights against insurgencies - dispatching 2,000 troops to Central Iraq in June 2014. This military collaboration culminated in the signing of a July 23, 2017 agreement between Iran and Iraq for military cooperation in the fight against terrorism and extremism. Table 5Iran's Military Support Was Needed In The Past... Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Yet with the curbing of Islamic State, Iraq is preparing to begin a new chapter - rebuilding its war-torn cities. In doing so, its needs will shift from military support to financial support, potentially shifting its allegiance from Iran to Saudi Arabia. Furthermore, Iran's current economic situation - especially with the anticipated impact of U.S. sanctions - will leave fewer funds available for it to direct towards Iraq. The electricity crisis earlier this summer symbolizes the shifting dynamic. Iran, which has been supplying southern Iraq with electricity, announced it would no longer provide Iraq with power, citing its dissatisfaction with the accumulation of unpaid bills. Iran itself is experiencing electricity shortages and is no longer willing or able to sacrifice for Iraq, which it fears is drifting outside its sphere of control. Iran eventually took back this move and restarted its electricity exports. However, this occurred only after the Iraqi government sent a delegation to Saudi Arabia to negotiate an agreement to supply electricity to southern Iraq. The Saudis also offered to build a solar power plant to provide electricity to Iraq at a quarter of the Iranian price. Baghdad therefore used the crisis to signal to Tehran that it has other options, including a closer economic relationship with Iran's chief rival, Saudi Arabia. This emerging rift was also apparent during the International Conference for Iraq's Reconstruction, hosted in Kuwait, where Iraq hoped to secure $88 billion worth of funds. There, Iraq obtained $30 billion in pledges toward rebuilding its economy (Chart 11). While Iraq's Arab neighbors jointly pledged over $10 billion, Iran - despite being present at the conference - failed to guarantee any funds. Later it offered Iraq a $3 billion credit line. Chart 11...But Now Iraq Needs Monetary Support Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iran is not only limited by the dire state of its economy. Protests in Iran earlier this year partly focused on Tehran's foreign policy expenses, i.e. its support of various loyal regimes around the region. This "loyalty" costs money that Iranians believe could be better spent on their domestic needs. As such, Iranian policymakers will be wary of committing more funding to Iraq, as it could be seen as wasteful by restless voters at home. What's more, Iraq's Arab GCC neighbors have both the willingness and the ability to ally with Iraq and, in turn, to curb Iran's influence in the region. Bottom Line: Stronger ties with its Arab neighbors - and the accompanying funds - are what Iraq needs right now. Iraq requires another $58 billion towards its reconstruction efforts. Its southern neighbors can help it get there. Whether this will transpire hinges on Iran's ability to infiltrate Iraq's political elite. Given that Iraqi people have become disillusioned with many of these leaders, Iran will likely face a bigger challenge this time around. Investment Implications: Short-Term Pain For Long-Term Gain Since 2011, BCA's Geopolitical Strategy has stressed the emerging Saudi-Iranian proxy war as the main regional dynamic.4 With the U.S. "deleveraging" out of the Middle East, the field is open for regional power dynamics. The result is a "security dilemma," in which Saudi and Iranian attempts to improve their defenses appear offensive to the other side, resulting in a vicious cycle of distrust. The Trump administration has deepened the tensions by ending the Obama administration détente with Iran. Lower oil revenue will limit Iran's ability to influence the Middle East through its proxies, including in Iraq. Iran may decide that Iraq is lost. At that point, it may conclude that if it cannot own Iraq, it must break it. Recently, Reuters reported that Iran has moved short-range ballistic missiles into Iraq in order to threaten Saudi Arabia and Israel, in case it needs to retaliate against a U.S. attack against its nuclear facilities.5 While the report was strongly denied by Iran, it suggests that Tehran could be trying to sow discord in Iraq, or even that its operatives are working with impunity in Iraq. Iran's pain is ultimately Saudi Arabia's gain. An Iranian economy battered by the imposition of sanctions will give way to increased Saudi influence in Iraq. The oil-rich GCC countries certainly have the coffers to incentivize such a switch. In offering to fill the funding gaps of its less fortunate neighbors, Saudi Arabia has already won the allegiance of other strategic regional partners such as Egypt, Pakistan, and Sudan. In 2016, amid economic turmoil in Egypt, Saudi Arabia signed agreements worth over $40 billion to support Egypt (Table 6). This does not include financing from other GCC allies. The UAE and Kuwait also support Egypt's economy in a significant fashion. Table 6Saudi Arabia Is No Stranger To Purchasing Allies Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply Similar financial backing in Iraq would go a long way towards filling the $58 billion funding gap for its reconstruction. The quid pro quo would be the backing of Saudi Arabia's regional political agenda, which includes curbing Iranian influence. Not only would such investment accelerate the eventual increase in Iraqi oil production. It would also curb Iran's ability to retaliate through the region, both by removing an important ally and by cutting off Syria and Lebanese Hezbollah geographically from Tehran. Domestic Iraqi politics are therefore critical for global investors. If Iraq forms a nationalist, non-sectarian government over the next several months, it will degrade Iran's ability to influence the country. At that point, Iran may either lash out against the new Baghdad government and try to create domestic strife through its proxies - the battle-hardened Shia militias - or it may be pressed into negotiations with the U.S., lest it lose more allies in the region. If Iran choses to lash out against Iraq, we suspect that it will do so through attacks and sabotage against Iraqi infrastructure. This could present an additional tailwind to oil prices over the next several months. Any additional risk premium on the cost of a barrel of oil would be a boon for Iran as it deals with a loss of exports due to sanctions. Such a campaign of sabotage, however, would ensure that Baghdad firmly moves outside the Iranian sphere in the long term, which could open up the potential for Saudi Arabia and its GCC allies to invest in the country. In the short term, therefore, there is further risk to global oil supply as the shifting political dynamics in Iraq will put the country squarely in the middle of the ongoing Saudi-Iranian proxy war, right where it has always been. In the long term, we believe that Iranian influence in Iraq has peaked and will wane going forward. This opens up the opportunity for Baghdad to rely on Saudi Arabia and GCC countries for funding. This could be a boon for global oil supply over the next decade. Of course, much will hinge on whether Saudi Arabia is willing to finance the development of Iraqi oil fields. Oil produced in those fields would compete directly for market access with Saudi's own production. If Saudi Arabia decides to look out for its own, short-term, economic interests, then Iraq may be limited in terms of funding its development, or even be thrust back into Iran's orbit. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Special Report, "Re Oil Demand: Fed Policy Trumps Tariffs," August 30, 2018, available at ces.bcaresearch.com. 2 Prior to the takeover, Kirkuk oil was being transported to Fishkabur via KRG pipelines, which the Iraqi government can no longer access. 3 The Kirkuk-Haifa line has been defunct since 1948. 4 Please see BCA Emerging Markets Strategy and Commodity & Energy Strategy Special Report, "Riyadh's Oil Gambit," dated October 11, 2011, available at ces.bcaresearch.com. 5 Please see John Irish and Ahmed Rasheed, "Exclusive: Iran moves missiles to Iraq in warning to enemies," Reuters, dated August 31, 2018, available at reuters.com.