Middle East & North Africa

Highlights A World Organization of the Petroleum Exporting Countries (WOPEC) looks set to emerge after today’s OPEC 2.0 video conference to discuss production cuts in the wake of the COVID-19 pandemic, and the market-share war between the leaders of the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. WOPEC will not be memorialized by a Declaration of Cooperation as OPEC 2.0 was.  Oil exporters globally will cooperate on harmonizing policy to meet demand. In our latest scenario concentrating on likely supply responses, we show cuts of ~ 8mm b/d will be sufficient to clear the storage overhang caused by COVID-19-induced demand destruction of close to 4mm b/d this year. Based on this modeling, we see Brent prices averaging $36/bbl and $64/bbl this year and next, with WTI trading $2-$6/bbl lower, depending on US Gulf storage availability. This is roughly in line with our previous scenario (Chart of the Week).1 Demand destruction over 4mm b/d would require additional production cuts. Feature The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action. Chart of the WeekExpect A Sharp Oil Price Recovery Expect A Sharp Oil Price Recovery Expect A Sharp Oil Price Recovery Chart 2The Oil-Price Collapse Of 2020 The Oil-Price Collapse Of 2020 The Oil-Price Collapse Of 2020 WOPEC is bigger than OPEC 3.0 – an unofficial grouping we hypothesized at the end of March to encompass the expected future cooperation of KSA, Russia and the Texas Railroad Commission (RRC) – our shorthand for US oil-producing interests – succeeding OPEC 2.0. Today’s OPEC 2.0 video conference originally was called by KSA for Monday, but was moved to today – presumably – to give member states time to agree production cuts. The conference most likely was delayed by the acrimonious public exchange between its leaders this past weekend.2 On the heels of the OPEC 2.0 video conference comes a hastily called video conference on Friday of G20 energy ministers to discuss energy security. The G20 is led by KSA this year.3 The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action (Chart 2). KSA, Russia and their respective OPEC 2.0 allies all are fully invested in this meeting, as are producers in the US, Canada, Norway and Brazil.4 Supply Destruction Vs.Production Cuts Oil producers face a stark choice: Either cut production voluntarily to counter the global demand destruction of a pandemic, or have the market do it for them by driving prices through cash costs toward zero (i.e., $0.00/bbl), as global crude oil and product storage fills. Prices in some basins have fallen close to zero after accounting for the basis differentials to benchmark prices and transport costs (e.g., WTI-Midland), which, in the US has begun to force shut-ins (Chart 3).5 Continued weak pricing close to zero risks shutting older, high-cost landlocked production in permanently, and many states simply cannot afford to lose the critical revenue provided by oil exports. Chief among these states are the non-Gulf members of OPEC, excluding Russia, US onshore, and Canada, which we identify as “The Other Guys” (Chart 4).6 Chart 3Some Crude Grades Priced Close To $0.00/bbl Some Crude Grades Priced Close to $0.00/bbl Some Crude Grades Priced Close to $0.00/bbl Chart 4"The Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal The "Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal The "Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. The chief contribution of The Other Guys to the OPEC 2.0 coalition’s production-management scheme is their managed production decline. These states were only starting to recover from the Global Financial Crisis (GFC) beginning in 2010 when the OPEC market-share war of 2014-16 was declared. The COVID-19 price collapse, coupled with the knock-on effects of the 2020 KSA-Russia market-share war likely accelerates the rate of production decline for the Other Guys, as capital continues to avoid developing their resources. We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. Core OPEC and Russia can increase (and decrease) production, and we expect they will deliver the largest part of the OPEC 2.0 production cuts. In this week’s simulation, we project KSA will cut 2mm b/d, from their April level of from 12mm b/d; and Russia will cut 1.1mm b/d, down from 11.6mm b/d. We then project Iraq will cut 460k b/d; Kuwait 280k b/d; and the UAE 315k b/d. Outside OPEC 2.0, a lot of the production we expect will be cut is out of necessity. Canada, for example, will be forced to either shut in high-cost tar-sands production or go back to pro-rating production as it did last year, owing to a lack of storage in Alberta and pipeline takeaway capacity to move their crude south to US refiners. We expect Canada to cut 350k b/d this year, as a result. Brazil’s Petrobras already has shut in 100k b/d, and US producers have begun shutting in shale-oil production.7 US Production Cuts Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Production cuts most likely will be focused on the US, as this is the most easy-to-adjust output in the world. It also still is higher up the global cost curve, although, as we have noted earlier, this will change in the event bankruptcies pick up.8 In the US, production cuts already have begun. They are and will continue to be focused on the shales. We continue to project cuts in the US shales of ~ 1.5 mm b/d this year. However, this number could be higher: If producers respond to the collapse in prices by not sending any new rigs to the field in the next 12 months, production will fall by 2.9mm b/d from production declines alone. Just to keep production flat, the US shales will need an average of ~ 520 rigs per month (assuming no drilled-uncompleted wells are finished). The risk on our rig-count estimates are straightforward: If rig counts go much lower, we could see a large decline in shale production in the coming months (Chart 5). Chart 5US Shale Output Falls This Year And Next The Birth Of WOPEC The Birth Of WOPEC Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Including the Anadarko Basin, most of which is in Oklahoma, which also permits pro-rationing, 20% pro-rationing would push TX-OK cuts to ~ 1.33mm b/d. As we have been writing over the past month, we could see a return of pro-rationing in the states of Texas and Oklahoma. In the Great State, producers have filed a petition before the Texas RRC asking the Commission to reprise its 1928-73 production-management role.9 The Texas RRC will hold a video conference Tuesday, April 14, to consider this petition. We’re expecting this petition to be granted, and for pro-rationing to begin in the near future. On the demand side, we are staying with the scenario we presented March 30, with 2Q20 demand falling ~ 12mm b/d (y/y vs. 2Q19). In 2H20, we project demand to grow at a rate of 800k b/d by 4Q20. For all of 2020, we model average demand losses equal to 3.8mm b/d. For 2021, massive fiscal and monetary stimulus globally will lift demand 5.3mm b/d. With the supply cuts projected above and our demand view, we see balances tightening over the course of the year and moving into a physical deficit in 4Q20 (Chart 6). While near-term oversupply will force inventories to grow sharply, we expect them to draw as sharply beginning by September and continuing into next year (Chart 7). Chart 6Supply-Demand Imbalance Will Tighten Into 2021 Supply-Demand Imbalance Will Tighten Into 2021 Supply-Demand Imbalance Will Tighten Into 2021 Chart 7Inventories Will Build Sharply, Then Draw Sharply in 2021 Inventories Will Build Sharply, Then Draw Sharply in 2021 Inventories Will Build Sharply, Then Draw Sharply in 2021 Investment Implications Our projections for supply presented this week and our demand scenario presented at the end of March are evolving into our base case for oil and gas. We still do not know with certainty the OPEC 2.0 coalition will agree to production cuts today, or whether the Texas RRC will return to the business of pro-rationing. If either or both of these outcomes does not materialize, markets will take over and savagely destroy supply. This will be extremely volatile. For our part, we expect OPEC 2.0, the Other Guys outside the coalition, and the US shales to deliver something that looks like voluntary cuts. This will occur via voluntary cuts, “managed” declines, and pro-rationing and shut-ins. Unlike many of our economist colleagues who argue against such jointly coordinated policies – invoking a free-market, pure-competition paradigm that has not existed for any meaningful period in the modern history of the oil market – we believe producers are intelligently pursuing their interests by jointly coordinating the boom-bust mayhem of unfettered oil markets. Similarly, we believe consumers are better served by diversified sources of energy vs. an over-reliance on large concentrated supplies who can use their low-cost endowment to monopolize supply and set up barrier to entry to competition. Given our view, we remain constructive to the oil market, expecting a rally that will look a lot like the Chart of the Week and the balances we show in Chart 7. As a result, we are getting long 2H21 Brent vs. short 2H22 Brent futures.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight Defying the global rush to cut oil production, Mexico apparently is moving toward increasing production. Petroleos Mexicanos (PEMEX) is looking to drill 423 wells this year, according to Bloomberg. A March 26 Journal of Petroleum Technology survey suggests capex by E&P companies will fall by up to 35% this year. Base Metals: Neutral This week Japan’s Nippon Steel became the latest producer to idle blast furnaces, halting about 15% of the company’s total capacity. More generally an iron ore surplus in other parts of Asia and in Europe is expected as steel mills idle furnaces amidst lower demand for their output. However, diminished activities in mines – severely impacted by lockdowns – will offset some of the demand loss. COVID-19 induced shutdown in South Africa, Iran, India and Canada have curtailed exports from those countries until late April. Additionally, bad weather in Brazil led iron ore exports to fall on a yoy basis for the third month in a row in March. A decline of ~ 2% vs. last year’s already depressed – following the Vale dam incident – levels. China’s anticipated infrastructure stimulus will support iron ore demand, drawing down inventories and pushing up prices, but it, too, will be tempered by the pace of the recovery in its export markets. Precious Metals: Neutral A strong US dollar remains an important risk for precious metals. The dollar rose 1.6% since March 28 despite the Fed’s actions to calm the global dollar liquidity squeeze. This signals the funding crisis has not been thoroughly controlled and that swap lines will have to be extended to additional EM central banks. However, a large share of outstanding foreign exchange swaps/forwards resides in non-bank financial corporations and institutions with limited access to dollar funding via central bank swap lines. Over the short-term, our gold price recommendation remains vulnerable to deterioration, due to uncertain liquidity conditions (Chart 8). Ags/Softs:  Underweight This week we begin tracking the lumber market. Lumber consumption fell sharply as the coronavirus spread in the United States, pushing front-month futures down 44% from February highs. With housing starts already weak in February – down 1.5% month on month – and expected to be even weaker in March (Chart 9), continued lumber supply curtailments will stabilize prices in the short term and eventually push prices up once lower interest rates kick in and demand resumes. Chart 8 Global USD Squeeze Could Threaten Gold Again Global USD Squeeze Could Threaten Gold Again Chart 9 Lumber Hammered As COVID-19 Pounds Housing Starts Lumber Hammered As COVID-19 Pounds Housing Starts       1     Please see OPEC 3.0 In the Offing?, published March 30, 2020, which focused on demand destruction. 2     Please see OPEC+ meeting delayed as Saudi Arabia and Russia row over oil price collapse: sources, and G20 energy ministers to hold video conference on Friday: document published by reuters.com April 4 and April 7, 2020. 3    The G20 consists of Argentina, Australia, Brazil, Canada, China, Germany, France, India, Indonesia, Italy, Japan, Mexico, the Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, the UK, the US and the EU. 4    Please see A look at the major players in this week’s “OPEC++” meeting, a Bloomberg analysis published by worldoil.com April 7, 2020. 5    Please see Can the world agree a deal to boost oil prices? Published by Wood MacKenzie April 3, 2020.  6    The Other Guys is our moniker for all producers excluding core-OPEC, US shale, Russia and Canada. Production from this group of producers has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. 7     In its latest Short-Term Energy Forecast, the EIA estimates US crude oil production will fall 500k b/d this year and 700k b/d next year, driven by market forces. 8    For a discussion, please see How Long Will The Oil-Price Rout Last?, a Special Report we published with BCA Research’s Geopolitical Strategy March 9, 2020. It is available at ces.bcaresearch.com. 9    Please see Oil Prorationing in the Spotlight at Texas Railroad Commission, published by Baker Botts, a Texas law firm, on March 30, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 The Birth Of WOPEC The Birth Of WOPEC Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades The Birth Of WOPEC The Birth Of WOPEC

Highlights The odds of an emergency meeting of OPEC 2.0 to get supply under control are growing, based on the repeated overtures from Russian officials providing the Kingdom of Saudi Arabia (KSA) an opening to resume talks on their production-management regime. We have developed a not-unreasonable scenario in which global oil consumption falls by ~ 20% y/y in April to assess the COVID-19-induced price impact. Even an aggressive 3.5mm b/d cut from OPEC 2.0 – presuming a rapprochement between KSA and Russia – and an additional 200k b/d market-induced cut by North American producers still sees Brent prices bottoming over the next two months at ~ $18/bbl. OECD inventories surge, reaching ~ 3.6 billion by June 2020, before production cuts and demand restoration start to drain them. Comments from Texas Railroad Commission (RRC) leadership indicate they could be back in the business of pro-rating production in the Lone Star state. If a new OPEC 3.0 described here can move quickly enough, Brent prices could revive to ~ $45/bbl by year end, and clear $60/bbl by 2Q21.  We are getting long Dec20 Brent and WTI at tonight’s close. Feature Refiners worldwide are reducing runs as the COVID-19 pandemic continues to cut through oil demand like a scythe through wheat.1 Refiners’ inability to sell gasoline, diesel and jet fuel, and a host of other products, is forcing crude oil to back up globally in storage facilities, pipelines and, soon, on ships (Chart 1).2  This is occurring while KSA and Russia wage a global market-share war, targeting each others’ refinery customers with lower and lower prices. Without a concerted effort by OPEC 2.0 – the coalition led by KSA and Russia – and the US shales to rein in production, the global supply of storage will be exhausted and oil prices will push well below $20/bbl to force output to shut in.  Indeed, numerous grades of crude oil worldwide already are trading below $20/bbl after factoring in their spreads vs. Brent crude oil as regional takeaway and storage infrastructure are overwhelmed (Chart 2). Chart 1Even With Production Cuts Oil Inventories Will Surge Even With Production Cuts Oil Inventories Will Surge Even With Production Cuts Oil Inventories Will Surge Chart 2Global Crude Prices Trading Below $20/bbl Global Crude Prices Trading Below $20/bbl Global Crude Prices Trading Below $20/bbl Chart 3“The Other Guys” Production Declines Will Accelerate "The Other Guys" Production Declines Will Accelerate "The Other Guys" Production Declines Will Accelerate The consequences for oil producers outside core-OPEC will be disastrous, as they were following the last market-share war led by OPEC in 2014-16.  The producer group we’ve dubbed “The Other Guys” – producers outside core-OPEC – will continue to see production falling, most likely at an accelerating rate, if the market-share war persists (Chart 3).  Even within core-OPEC – principally the GCC states – governments will be required to cut spending on public works, salaries for workers, and services.3 Sovereign wealth funds and foreign reserves will have to be drawn down to fill holes in budgets, as happened during the last market-share war of 2014-16 launched by OPEC.  The IMF last week noted the world economy is in recession, and that EM economies in particular will see growth fall sharply as a result of the COVID-19 pandemic.4 “We are in an unprecedented situation where a global health pandemic has turned into an economic and financial crisis. With a sudden stop in economic activity, global output will contract in 2020. … emerging market and developing countries, especially low-income countries, will be particularly hard hit by a combination of a health crisis, a sudden reversal of capital flows and, for some, a sharp drop in commodity prices. Many of these countries need help to strengthen their crisis response and restore jobs and growth, given foreign exchange liquidity shortages in emerging market economies and high debt burdens in many low-income countries.”  For commodity markets, this means the principal source of demand growth is being severely hobbled. The Oil Demand Hit … Estimating the demand destruction caused by COVID-19 is fraught with uncertainty.  Instead of attempting such an estimate, we simulate a sharp drop in oil demand of close to 20% y/y in April 2020, which is consistent with the lockdowns that are bringing the global economy to a standstill.  Specifically, we have 2Q20 demand falling ~ 12mm b/d (y/y vs. 2Q19).  Thereafter, demand picks up rapidly in 2H20, reaching a growth rate of 800k b/d by 4Q20.  For all of 2020, we model average demand losses equal to 3.8mm b/d.  For next year, we expect the combination of massive fiscal and monetary stimulus hitting markets globally will lift demand 5.3mm b/d. Net, we view the COVID-19 demand shock as transitory.  But it leaves a huge amount of unrefined crude oil in storage and massive amounts of unsold products in inventory. Left unaddressed, crude oil will continue to fill storage globally, as will unsold refined products.  This will leave oil producers and refiners in an untenable situation, even after demand returns to normal following the pandemic. Strategists in Riyadh, Moscow and Austin, Texas, know this. … Requires A Supply Offset KSA is forcing its competitors to endure what John Rockefeller, one of the founders of Standard Oil Co., once called a “good sweating.”5  A good sweating was a price-cutting strategy designed to drive competitors out of business and force them to sell to Rockefeller’s company.  This occurred in 2014-16 and in 1986, when KSA had to rein in fellow OPEC members that were free-riding on its production discipline. We believe KSA is well aware it cannot endure a years-long market-share war, nor does it want to.  Its primary goal in the current circumstances is to remind oil producers globally that it can, when it choses, take as much market share as it deems necessary.  After flooding global markets in April 2020 we expect the core-OPEC producers in the Gulf (Kuwait, the UAE, Iraq and, of course, KSA) to reduce production by ~ 2.5mm b/d starting in May 2020, and hold these cuts until 2021 (around the time inventories are drawn down to their 5-year average).  In 2021, we have the group increasing production by 2.5mm b/d in 1Q21. As for Russia, we have them increasing production in April 2020 – contributing to the surge in inventories globally.  However, beginning in May, we believe Russia and its non-OPEC allies will agree to remove ~ 1mm b/d , in line with the cuts we expect from core-OPEC. Russia faces political and geopolitical constraints that work against maintaining the market-share war. First, President Vladimir Putin has already been forced to shift his national strategy over the past three years to address growing concerns with domestic discontent due to the recession caused by the 2014 oil shock and the economic austerity policies his government pursued afterwards. These policies give Putin policy room to fight today’s market-share war, but they also portend another massive blow to the livelihood and wellbeing of the nation. Second, Putin is in the midst of arranging an extension of his term in office through 2036, which requires the constitutional court to approve of constitutional changes as well as a popular referendum. The referendum has been delayed due to the pandemic and need for an emergency response. While Putin is generally popular and has underhanded means of orchestrating the referendum, it would be extremely dangerous for him to compound the pandemic and global recession with an oil market-share war that makes matters even worse for the Russian people while simultaneously preparing for a plebiscite.   Third, internationally, Putin cannot ultimately defeat the Saudis or US shale in terms of market share. Therefore the domestic risks posed above are not compensated by an improvement in Russia’s international standing – neither in oil markets nor in broader strategic influence, given that an economic recession hurts Russia’s ability to maintain and modernize its military and security forces. In the US shales, we are modeling a sharp fall-off in production starting as early as May 2020.  For the rest of 2020, production will gradually decline naturally from low rig counts. In 2H20 – probably in 4Q20 – we expect the Texas Railroad Commission to once again regulate oil production in the state, provided other state regulators (e.g., in North Dakota) and producing countries, (e.g., Russia and KSA) also sign on to take on a similar role.6 In addition to the market-driven shut-ins between now and 4Q20, we expect the RRC to secure production cuts of up to 1.5mm b/d by Dec 2020. As prices pick up next year, shale production will stabilize and slowly move up. The supply-demand assumptions we make in this scenario produce a physical surplus for the better part of 2020 (Chart 4). Chart 4Supply-Demand Imbalance Leads to Physical Surplus Supply-Demand Imbalance Leads to Physical Surplus Supply-Demand Imbalance Leads to Physical Surplus Prices Could Fall Further, Then Take Off Even if we see OPEC 2.0 cut, and sharp drops in US shale output followed by renewed pro-rationing by state regulators in the US led by Texas, the fact that they’ve all increased production for April means storage will inevitably rise drastically in the coming months (Chart 5).  As inventory skyrockets in the wake of both the massive demand and supply shocks in 1Q20 and April 2020, prices will fall to $20/bbl (Chart 6). Chart 5Inventories Swell on Demand Shock, Then Drain on Supply Cuts Inventories Swell on Demand Shock, Then Drain on Supply Cuts Inventories Swell on Demand Shock, Then Drain on Supply Cuts Chart 6Brent Prices Forced Lower, Then Move Above $60/bbl Brent Prices Forced Lower, Then Move Above $60/bbl Brent Prices Forced Lower, Then Move Above $60/bbl Once the large-scale OPEC 2.0 cuts start, prices rebound rapidly. Demand also starts picking up this summer, which also will lift prices. For 2020, we expect Brent prices to average $35/bbl, while in 2021 we expect Brent to average $66/bbl. Over this period, WTI will trade $2-$4/bbl below Brent.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Please see Global oil refiners shut down as coronavirus destroys demand published by reuters.com March 26, 2020, and S&P Global Platts report Refinery margin tracker: Global refining margins take a severe hit on falling gasoline demand published March 23. 2     This appears to be happening now, as pipeline operators ask shippers to reduce the rate at which they fill the lines.  Please see Pipelines ask U.S. drillers to slow output as storage capacity dwindles published by worldoil.com March 30, 2020.  3    Prominently among the GCC states, KSA cuts public spending 5% and introduced fiscal measures meant to cushion the blow of the COVID-19 shock and to offset the low prices resulting from its market-share war with Russia.  Please see Saudi Arabia announces $32 billion in emergency funds to mitigate oil, coronavirus impact published by cnbc.com March 20, 2020. 4     Please see the Joint Statement by the Chair of International Monetary and Financial Committee and the Managing Director of the International Monetary Fund issued by International Monetary and Financial Committee Chair Lesetja Kganyago and International Monetary Fund Managing Director Kristalina Georgieva March 27, 2020. 5     Please see Daniel Yergin’s The Prize: The Epic Quest for Oil, Money & Power, published by Simon & Schuster in 1990, particularly Chapter 2 for a discussion of Rockefeller’s “good sweating,” in which competitors were driven out of business by low prices engineered by Rockefeller if they refused to sell out to Standard Oil. 6     The tone of remarks from TRR Chairman Wayne Christian has become more agreeable to having the TRR Commission return to pro-rating oil production in the Lone Star state.  His recent editorial for worldoil.com notes, “Any action taken by Texas must be done in lockstep with other oil producing states and nations, ensuring that they cut production at similar times and in similar amounts.”  Please see  Christian’s editorial, Texas RRC Chairman Wayne Christian: We must stabilize worldwide oil markets, published by worldoil.com March 25, 2020.  

Highlights Rapidly changing news flows are forcing oil markets to recalibrate supply-demand fundamentals continuously. This will keep volatility at or close to recent record highs (Chart of the Week). The demand shock from COVID-19 accounts for ~ 65% of the oil price collapse, based on our modeling. USD demand is fueling record dollar strength, which could suppress commodity consumption after the COVID-19 shock dissipates. If the Fed’s epic monetary policy response sates USD demand, commodity demand will rebound strongly. Highly uncertain expectations on the supply side – fueled by the market-share war between the Kingdom of Saudi Arabia (KSA) and Russia set to begin in earnest April 1 – will keep global policy uncertainty elevated post-COVID-19. Texas regulators are debating the efficacy of re-establishing a long-dormant policy mandating the state’s Railroad Commission (RRC) pro-rate production. The chairman of the RRC and the CEO of Russia’s state oil champion Rosneft both oppose production-management schemes, arguing they allow other producers to steal market share. The Trump administration, however, sees potential in working with KSA to stabilize markets. Feature Sparse information available to markets makes it extremely difficult to estimate the impact of the COVID-19 shock to demand. Oil options’ implied volatility reached record levels following unprecedented price changes – down and up – in the underlying futures markets over the past month, as the Chart of the Week shows.1 This reflects the markets’ profound uncertainty regarding supply, demand and near-term policy outcomes that will affect these fundamentals in the short-, medium- and long-term. Sparse information available to markets makes it extremely difficult to estimate the impact of the COVID-19 shock to demand. The ever-changing evolution of supply dynamics presents its own – unprecedented – difficulties. The usual lags in information on supply and demand are compounded by the near-certain substantial revisions that will accompany these data as a better picture of the fundamentals emerges. Chart of the WeekOil Price Volatility At Record Level Oil Price Volatility At Record Level Oil Price Volatility At Record Level That said, we are attempting to develop models and an intuition for likely turning points on both sides of the fundamentals. We stress up front that these estimates are tentative, particularly on the demand side, as they use commodity prices and financial variables that are difficult to track closely even in the best of times, and are themselves continuously adjusting to highly uncertain fundamentals. COVID-19 Crushes Commodity Demand Oil prices fell 60% YTD after being struck by simultaneous demand and supply exogenous shocks (Chart 2). We capture the effect of the demand shock with a combination of multivariate regressions using various cyclical commodities, the US trade-weighted dollar, and 10-year treasury yields. Global demand for cyclical commodities – including oil – is fundamentally related to global economic activity. By extracting the common information from these commodity prices, we can estimate the proportion of the oil price decline associated with the ongoing demand shock.2 Chart 2Oil-Price Collapse Of 2020 Oil-Price Collapse Of 2020 Oil-Price Collapse Of 2020 We estimate roughly 60% of the crude oil price drop so far this year can be explained by the sharp contraction in global demand caused by the COVID-19 pandemic. To estimate the impact of the demand shock from the COVID-19 pandemic on crude oil prices, we expanded a model developed by James Hamilton in the last market-share war of 2014-16.3 Hamilton’s model uses market-cleared prices outside of oil – copper, the USD and 10-year nominal US treasurys – to estimate the extent of the global aggregate demand shock. We estimate roughly 60% of the crude oil price drop so far this year can be explained by the sharp contraction in global demand caused by the COVID-19 pandemic (Chart 3). Some specific refined-product demand (i.e., air and car travel, marine-fuel consumption) was hit harder, meaning the demand shock would be higher in those sectors. For transportation-related refined products, COVID-19-related impacts could account for as much as 70% of the decline in prices. Chart 3COVID-19 Crushes Oil Demand COVID-19 Crushes Oil Demand COVID-19 Crushes Oil Demand Chinese Demand May Be Recovering News reports suggesting a tentative recovery from the COVID-19 demand shock are emerging in China, where the virus originated late last year. Weekly data indicate inventories in bellwether commodity markets – copper and steel – should begin to fall as demand slowly recovers. While encouraging, this may not be sufficient to offset the massive losses in copper demand that likely will be posted this year as a result of the lockdown imposed in China – and globally – to contain the spread of COVID-19. China accounts for ~ 50% of global demand and ~ 40% of refined copper supply.4 Global copper inventories will be useful indicators of the state of China’s recovery, as they will be sourced early as mining and refining operations are ramped up in response to increasing demand (Chart 4). Chart 4Copper Inventories Will Track Aggregate Demand Recovery Copper Inventories Will Track Aggregate Demand Recovery Copper Inventories Will Track Aggregate Demand Recovery Chart 5China Expected To Roll Infrastructure Investment Into 2020 China Expected To Roll Infrastructure Investment Into 2020 China Expected To Roll Infrastructure Investment Into 2020 China is set to roll a large portion of its multi-year 34-trillion-yuan (~ $5 trillion) investment plan into this year, to secure economic recovery from the COVID-19 pandemic. For example, our colleagues at BCA Research’s China Investment Service expect a near 10% increase in infrastructure investments this year, which would take such investment to 198 billion yuan (Chart 5). Local governments already have ramped up their expenditures, frontloading 1.2 trillion yuan of bond issuance in the first two months of 2020, a 53% jump versus the same period last year. This includes 1 trillion yuan of special government bonds (SPBs), which is expected to rise to 3-3.5 trillion yuan by the end of 2020, up 30% from 2019 levels. Additional funding channels likely will be opened to support public spending this year. Aggressive policy easing by the Peoples Bank of China (PBOC) in recent weeks, coupled with likely additional debt issuance and infrastructure spending this year will support revived aggregate demand in China. China’s policy responses will be additive to those of the US, where more than $2.2 trillion of fiscal stimulus could be deployed following Congressional agreement on a massive fiscal package that likely will be endorsed by the White House. For its part, the Fed has gone all-in on fighting the economic, liquidity and credit shocks unleashed by the COVID-19 pandemic.5 The EU also is expected to roll out large fiscal-stimulus packages, led by Germany, which is lining up a 150-billion-euro (~ $162 billion) bond issue this year, and a 156 billion-euro supplementary budget.6 Texas Railroad Commission To The Rescue? Another possible element of a global oil-production-regulation scheme emerged in recent days from America’s Lone Star state: The Texas Railroad Commission (RRC). Based on our modeling, 30% to 40% of the decline in oil prices this year is explained by the expectation of higher supply in the coming months (Chart 6).7 It is worthwhile remembering this is anticipatory, given statements and actions from KSA and Russia regarding steps both are taking to sharply increase future production. KSA, for example, provisionally chartered transport to move close to ~ 38mm barrels of crude to refining centers, 12mm barrels of which will be pointed toward the US.8 This was part of the Kingdom’s plan to boost supplies to the market to 12.3mm b/d beginning in April, most of which will come from higher production, augmented by storage drawdowns. If we get a rapprochement between OPEC 2.0’s leaders – KSA and Russia – and the coalition’s production-management scheme is rebuilt, oil prices could outperform other cyclical commodities post-COVID-19, as a large component of supply uncertainty is removed. However, before that can happen, markets will have to absorb the surge in exports from KSA that are being priced in for April and May. Chart 6Expected Supply Increase From KSA, Russia Accounts For 30-40% Of Oil Price Collapse Expected Supply Increase from KSA, Russia Accounts for 30-40% Of Oil Price Collapse Expected Supply Increase from KSA, Russia Accounts for 30-40% Of Oil Price Collapse Another possible element of a global oil-production-regulation scheme emerged in recent days from America’s Lone Star state: The Texas Railroad Commission (RRC). Texas regulators are openly debating the efficacy of re-establishing a long-dormant policy mandating the RRC pro-rate production. The idea was floated by outgoing RRC Commissioner Ryan Sitton, who earlier this month in an op-ed proposed KSA, Russia and the US could jointly agree to 10% reductions in output to stabilize global oil markets. This would expand the management of oil production and spare capacity globally, a profound shift from earlier eras when the RRC then OPEC took on that role.9 While RRC staff are studying the idea, Sitton’s proposal has not received the endorsement of fellow commissioners, particularly Wayne Christian, the chairman of the RRC.10 Christian’s argument against the scheme is similar to that of Rosneft CEO Igor Sechin’s: Both argue such schemes allow other producers to steal market share. Russian government officials continue to signal they are open to returning to the negotiating table with KSA. The Trump administration, however, sees potential in working with KSA and to stabilize markets. Earlier this month, the administration sent a “senior Energy Department official” to Riyadh to support the State Department and the US’s energy attache.11 For its part, Russian government officials continue to signal they are open to returning to the negotiating table with KSA. The “Russian position was never about triggering an oil prices fall. This is purely our Arab partners initiative,” according to a Reuters report quoting Andrei Belousov, Russia’s first deputy prime minister, in an interview with state news agency TASS. “Even oil companies who are obviously interested to maintain their markets, did not have a stance that the deal (OPEC+) should be dissolved.” According to Reuters, Russia proposed an extension of existing production cuts of 1.7mm b/d, perhaps to the end of this year, but “(our) Arab partners took a different stance.” 12 Investment Implications The big uncertainty at present is the extent of demand destruction that will be caused by COVID-19. At this point, the diplomatic maneuvering among states on the oil-supply side is a distraction. Any substantive action will require drawn-out negotiation, particularly to reconstitute and expand OPEC 2.0 to include the Texas RRC in the management of global oil production and spare capacity. In the here and now, markets are forcing sharp reductions in oil output, particularly in the US shales – e.g., Chevron announced it will be cutting capex and exploratory spending 20% this year on Tuesday.13 This is occurring throughout the industry in the US and around the world. Reuters compiled announcements by oil producers that have indicated they will cut an average 30% reduction in capex in response to the oil-price collapse.14 We are expecting US shale output to grow ~ 650k b/d this year, and to fall by ~ 1.35mm b/d next year on the back of the price collapse this year (Chart 7).15 We do not expect a resurgent shale-producing sector in the short- to medium-term, given the capital markets’ demonstrated aversion to funding this sector until it can demonstrate long-term profitability. The big uncertainty at present is the extent of demand destruction that will be caused by COVID-19, and the effectiveness of fiscal and monetary policy in supporting national economies during the pandemic. Equally important will be policy responsiveness post-COVID-19, and how quickly economies worldwide return to normal. Chart 7US Shale Output Will Fall Sharply US Shale Output Will Fall Sharply US Shale Output Will Fall Sharply Bottom Line: We expect a re-building of OPEC 2.0, with KSA and Russia restoring their production-management scheme before global storage facilities are filled and markets push prices below cash costs to force production to shut in. The revenue gains from this course of action far exceed any benefit derived from increasing production and prolonging a market-share war.16 Any agreement to include the Texas RRC will occur after demand is bottoming and moving up – i.e., once the outlook for demand is more stable – as happened when OPEC 2.0 was formed.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight The COVID-19 pandemic produced one undisputed winner: the environment. Limits on movement and factory shutdowns have massively reduced air pollution in countries hit by the pandemic early on (e.g. China and Italy). We expect similar declines elsewhere in Europe. This already is reflected in the ~ 30% drop in Carbon Emission Allowances (EUA) futures this year (Chart 8). Following the GFC, worldwide CO2 emissions dropped by 2.2%, but rapidly rebounded in 2010 – surpassing pre-crisis levels. We expect a similar recovery in global emissions as record stimulus measures kick in and normal traffic resumes post-COVID-19. Therefore, we are going long December 2020 ICE EUA futures. Base Metals: Neutral The LME base metal index is down 20% YTD. Downside risks remain large as lockdowns globally continue to intensify in the wake of the COVID-19 pandemic. These drastic measures also threaten mine operations for some metals. Copper supply is reportedly reduced in Peru and Chile. Nonetheless, weak economic growth along with a strong US dollar remain the dominant factors. Base metals prices gained from a lower USD on Tuesday, signaling market participants welcomed the Fed’s actions to relieve global liquidity fears. Still, it is too early to confirm these measures will be sufficient to circumvent further deterioration in the global economy. Precious Metals: Neutral Gold, silver, platinum, and palladium rose 12%, 15%, 14%, and 16% from the start of the week, recovering part of the sharp losses from the COVID-19 shock. Metals – especially Gold – were supported by the Fed’s resolve to provide much-needed liquidity to markets. Platinum and palladium were pushed higher following South Africa’s government decision to halt metal and mining operations as part of a 21-day nationwide shutdown to prevent the spread of the virus. Silver prices remain disconnected from their main drivers – i.e. safe-haven and industrial demand – and should rise along with gold once liquidity concerns dissipate (Chart 9). Ags/Softs:  Underweight After being under pressure for the last three sessions, CBOT May Corn futures rose this week, trading above $3.50/bu, as expectations of stronger demand for ethanol were revived by increasing oil prices. Wheat and beans also put in strong showings this week, as demand starts to lift. US grain exports are holding up relatively well versus the competition – chiefly the South America powerhouses Argentina and Brazil – as COVID-19 hampers their exports. Wheat futures remain firm on the back of stronger demand as consumers stockpile during the pandemic. Chart 8 EUA Futures Will Rebound As Traffic Resumes Post Covid-19 EUA Futures Will Rebound As Traffic Resumes Post Covid-19 Chart 9 Silver Prices Should Rise As Liquidity Concerns Dissipate Silver Prices Should Rise As Liquidity Concerns Dissipate   Footnotes 1     The Chart of the Week shows prompt volatility at the end of last week, when it stood at a record 183.22%, and a sharply backwardated volatility forward curve. Implied volatility is a parameter in option-pricing models, which equates the premium paid for options with the principal factors determining its value (i.e., the underlying futures price, the option’s strike price, time to expiry, interest rates and the expected volatility, or standard deviation of expected returns on the underlying). All of the factors other than volatility can be observed in the underlying market and interest rate markets, leaving volatility to be determined using an iterative search. Please see Ryan, Bob and Tancred Lidderdale (2009), Short-Term Energy Outlook Supplement: Energy Price Volatility and Forecast Uncertainty, published by the US Energy Information Administration, for a discussion of volatility as a market-cleared parameter. 2     We estimate our model both in (1) levels given that base metals, the US dollar and oil prices are cointegrated – i.e. these variable follow a common long-term stochastic trend – and (2) log-difference. We include the US dollar and 10-year treasury yields as explanatory variables. These series are closely linked to global growth trends, weakness in global economic activity is associated with a rising dollar and falling treasury yields. We only include treasury yields in the first difference model given that it is not cointegrated with oil and metal prices in levels. 3     Please see Oil prices as an indicator of global economic conditions, posted by Prof. Hamilton on his Econbrowser blog December 14, 2014. Our model uses monthly market inputs – non-oil commodities, the trade-weighted USD, US 10-year treasurys from January 2000 to February 2020, and the last daily close for March 2020. We extend Brian Prest’s 2018 model, which is based on Hamilton but uses monthly data instead of weekly data as in Hamilton. Please see Prest, C. Brian, 2018. "Explanation for the 2014 Oil Price Decline: Supply or Demand?" Energy Economics 74, 63-75. 4    Please see China steel, copper inventories dip as demand recovers from virus and Rupture of copper demand to fuel surplus as industry hit by virus, published March 20 and March 23, 2020, by reuters.com. 5     For an in-depth discussion, please see Life At The Zero Bound published March 24, 2020, by BCA Research’s US Bond Strategy. It is available at usbs.bcaresearch.com. 6    Please see Germany expected to announce fiscal stimulus as European death toll rises published by thehill.com March 23, 2020. 7     We estimate the share of the price collapse explained by the supply shock using the residuals from our demand-only Brent price model presented in Chart 3. The difference between actual Brent prices and our demand-only estimates captures oil-specific factors unexplained by global economic growth – mainly supply dynamics. 8    Please see Saudi provisionally charters 19 supertankers, six to U.S. as global oil price war heats up published by reuters.com March 11, 2020. 9    Please see Texas regulator considers oil output cuts for the first time in decades published by worldoil.com on March 20, 2020. We discussed the historic role of the RCC during the 2014-16 OPEC-led market-share war in End Of An Era For Oil And The Middle East, a Special Report published April 9, 2014, with BCA Research’s Geopolitical Strategy. We noted, “In March of 1972, the (RRC) effectively relinquished control of Texas oil production, when it allowed wells in the state to produce at 100% of their capacity. This signaled the exhaustion of U.S. spare capacity – production no longer had to be pro-rated to maintain prices above marginal costs – and the ascendance OPEC to global prominence in the oil market.” 10   Please see Texas Railroad Commission chairman opposes OPEC-style oil production cuts published by S&P Global Platts March 20, 2020. 11    Please see U.S. to send envoy to Saudi Arabia; Texas suggests oil output cuts published by reuters.com March 20, 2020. 12    Please see Russia: Gulf nations, not us, to blame for oil prices fall -TASS published by reuters.com March 22, 2020. 13   Please see Chevron cuts spending by $4 billion, suspends share buybacks published by worldoil.com March 24, 2020. 14   Please see Factbox: Global oil, gas producers cut spending after crude price crash, published by reuters.com March 23, 2020. Refiners also are cutting runs – particularly in the US and Europe – in the wake of collapsing demand for gasoline and distillates (jet, diesel and marine fuels), as S&P Global Platts reported March 23, 2020: Refinery margin tracker: Global refining margins take a severe hit on falling gasoline demand. 15   This extends to oil-services companies as well, which are anticipating a deeper crash in their businesses than occurred in the 2014-16 market-share war. Please see Shale service leaders warn of a bigger crash this time around published by worldoil.com March 24, 2020. 16   We argued this outcome was more likely than not – given the economic and welfare stakes – in last week’s report, KSA, Russia Will Be Forced To Quit Market-Share War.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals

Feature We closed our short position in EM equities last week but still maintain our short recommendation on EM currencies. Going forward we will be looking for signs of a durable bottom in risk assets. The clash between forthcoming massive economic stimulus around the world and the unprecedented plunge in global economic activity has generated a great deal of uncertainty over the magnitude and duration of the global recession. In turn, enormous ambiguity continues to produce extreme gyrations in financial markets. The unparalleled drop in the level of business activity and uncertainty over the length of lockdowns make it impossible to determine how much stimulus is required to produce a V-shaped recovery. Notably, all these stimuli will have an effect on the real economy with a lag. In the meantime, the real economy will remain in an air pocket. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Chart 1China: Level Of Business Activity Is Still Lower Than A Year Ago China: Level Of Business Activity Is Still Lower Than A Year Ago China: Level Of Business Activity Is Still Lower Than A Year Ago Even in China, where the authorities have been stimulating and trying hard to restart the economy following lockdowns, the level of business activity remains below last year’s levels. In particular, Chart 1 illustrates that residential floor space sold in Shanghai in the past couple of weeks remains 60% lower than a year ago. This reveals how difficult it is to reboot discretionary consumer spending and business investment following a negative income shock. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Such heightened uncertainty warrants a higher risk premium. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Review Of Indicators The following market-based indicators lead us to believe that the selloff is in a late-stage, but not over. Chart 2More Downside In This Risk-On/Safe-Haven Currency Ratio More Downside In This Risk-On/Safe-Haven Currency Ratio More Downside In This Risk-On/Safe-Haven Currency Ratio Our Risk-On/Safe-Haven1 currency ratio is in free fall but has not reached the level that marked its 2011 and 2015 troughs (Chart 2). It is still well above its 2008 level.  Odds are that this indicator will drop to 2011 and 2015 levels before staging a major recovery. EM share prices, commodities and global cyclical stocks correlate closely with this ratio. A further drop in Risk-On/Safe-Haven currency ratio will be consistent with more downside in EM equities, resource prices and global cyclicals. The global stock-to-US 30-year bond ratio has crashed but is still above its 2008 trough (Chart 3). Given this global recession is worse than the one in 2008, it is reasonable to expect the ratio to drop to its 2008 level before recovering. The gold-to-US bonds ratio2 has not yet broken out of its rising channel (Chart 4). Only a decisive breakout above the upper boundary of this channel will confirm a sustainable rally in reflation plays. Chart 3Global Stock-To-Bond Ratio: More Downside Is Likely Global Stock-To-Bond Ratio: More Downside Is Likely Global Stock-To-Bond Ratio: More Downside Is Likely Chart 4The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade Meanwhile, the industrial metals-to-gold ratio has plunged below its 2008 and 2015/16 lows (Chart 5). This qualifies as a structural regime change in this indicator. Odds are that this ratio will continue to fall, heralding further weakness in global cyclicals in general and EM risk assets in particular.   The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows (Chart 6). Such a breakdown typically entails additional decline. The latter will be consistent with more weakness in global cyclicals versus defensives. Chart 5A Noteworthy Breakdown A Noteworthy Breakdown A Noteworthy Breakdown Chart 6Cyclicals Vs Defensives Cyclicals Vs Defensives Cyclicals Vs Defensives Interestingly, Chinese equity indexes have dropped less than their global and EM peers. Nevertheless, cyclical sectors within the Chinese equity universe are exhibiting very disturbing chart patterns. Chinese bank stocks appear to be in a genuine downtrend, with no immediate support (Chart 7, top panel). Property developers in the onshore A-share market have hit key resistance levels and appear to be vulnerable to the downside (Chart 7, middle panel). Finally, Chinese investable small-cap stocks have broken down, and their path of least resistance is down (Chart 7, bottom panel). Overall, the relative resilience of Chinese share prices has been due to tech and “new economy” stocks. The rest of Chinese equities have been quite week in absolute terms. Finally, the net aggregate long position in US equity futures by asset managers and leveraged funds as of March 17 was still above its 2011 and 2016 lows (Chart 8).  It is reasonable to expect that the ultimate capitulation in US stocks will be consistent with a lower reading of this indicator. Chart 7Weak Internals Of Chinese Equity Markets Weak Internals Of Chinese Equity Markets Weak Internals Of Chinese Equity Markets Chart 8No Capitulation Among Investors In US Equity Futures No Capitulation Among Investors In US Equity Futures No Capitulation Among Investors In US Equity Futures     Bottom Line: The recent rebound in EM risk assets is unlikely to be sustainable. Several important indicators are not confirming a durable rally in reflation plays. Investment Strategy Even though EM equities have become cheap and very oversold as we discussed last week, odds are that the bear market in EM risk assets and currencies is not yet over. It might be too late to sell EM stocks, but also too risky to buy them aggressively. Chart 9EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction Provided the selloff in EM fixed-income markets commenced only a couple of weeks ago, it will likely persist as investors facing losses are forced to further trim their positions (Chart I-9). We continue to recommend staying put on EM fixed-income markets. As EM US dollar and local currency bond yields rise, EM share prices will struggle. Finally, EM currencies remain vulnerable against the greenback. We are maintaining our short in a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Reshuffling EM Equity Country Allocation We are making the following changes within a dedicated EM equity portfolio: Upgrading Peru from neutral to overweight, and Colombia from underweight to neutral. Both bourses have underperformed substantially and warrant a one-notch upgrade. Peru will - on the margin - benefit from relative resilience in gold and silver prices. The collapse in Colombia’s relative equity performance is advanced. While we are not bullish on oil prices, we are protecting our gains on the underweight Colombian stocks allocation by moving it to neutral. Reiterating our underweight allocations in both Indonesian and Philippine equities. Both bourses are breaking down relative to the EM benchmark (Chart I-10). More downside is in the cards. Readers can click here to access our latest fundamental analysis on financial markets in Indonesia and the Philippines.  Maintaining our overweight positions in Korean and Thai equities. Underperformance in both bourses relative to the EM benchmark is at a late stage. We expect the relative performance of these markets versus the overall EM equity index to find a support close to current levels (Chart I-11). Chart 10Continue Underweighting Indonesian And Philippines Equities Continue Underweighting Indonesian And Philippines Equities Continue Underweighting Indonesian And Philippines Equities Chart 11Overweight Korean And Thai Stocks Within The EM Universe Overweight Korean And Thai Stocks Within The EM Universe Overweight Korean And Thai Stocks Within The EM Universe Downgrading UAE from overweight to underweight. We have been bearish on oil prices, but the speed of the collapse in crude prices has wreaked havoc on Gulf equity markets. Similarly, the speed of decline in oil prices has caused considerable tremors in Mexican and Russian financial markets. Our overweight position in Russian equities is now back to its breakeven level, but the one in Mexican stocks is deep under water. We are reiterating our overweight in both bourses but have much lower conviction on Mexican stocks versus Russian ones. We will publish an updated analysis on Mexico in the near term. Finally, we have been and remain neutral on the following equity markets relative to the EM benchmark: China, Taiwan, India, Malaysia, Brazil and Chile. We have been negative on Brazil but have not formally downgraded it to underweight. Among our underweights are also Turkey, South Africa and Hong Kong domestic stocks. The complete list of our equity recommendations is available on page 8. Our fixed-income and currencies recommendations are available on page 9 (all of our recommendations are always enclosed at the end of our Weekly Reports and are available on our Website as well).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Average of CAD, AUD, NZD, BRL, IDR, RUB, CLP, MXN & ZAR total return indices relative to the average of CHF & JPY total returns. 2   It is calculated by dividing gold prices by total return on 10-year US government bonds. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights As the global economy moves toward shut-down, the Kingdom of Saudi Arabia (KSA) and Russia will be forced to end their market-share war and focus on shoring up their economies and tending to their populations’ welfare. Governments worldwide are rolling out fiscal- and monetary-policy responses to the COVID-19 pandemic. They also are imposing seldom-seen freedom-of-movement and -gathering restrictions on their populations to contain the spread of the virus. A surge in bankruptcies among US shale-oil companies is expected as demand and supply shocks push Brent and WTI below producers’ breakeven prices. In our base case, benchmark prices are pushed toward $20/bbl this year, which will keep volatility elevated. Prices recover in 4Q20 and 2021, as the pandemic recedes, and economies respond to fiscal and monetary stimulus. We have reduced our oil-price forecasts in the wake of the deterioration in fundamentals, expecting Brent to average $36/bbl in 2020, and $55/bbl in 2021. WTI will trade ~ $3-$4/bbl lower. COVID-19 is transitory. Therefore price risk is to the upside in 2021, given the global stimulus being deployed. Feature Brent and WTI prices are down 61.4% and 66.6% since the start of the year (Chart of the Week), taking front-month futures to their lowest levels since 2002. Oil markets are in a fundamental disequilibrium – the expected global supply curve is moving further to the right with each passing day, as the KSA and Russia market-share rhetoric escalates. Global demand curves are moving further to the left on an hourly basis, as governments worldwide impose freedom-of-movement restrictions and lock-downs to contain the spread of COVID-19 seen only during times of war and natural devastation.  These effects combine to swell inventories globally, as rising supply fails to be absorbed by demand. The collapse in crude oil prices since the beginning of this year is lifting volatility to levels not seen since the Gulf War of 1990-91. Chart of the WeekBenchmark Crude Prices Collapse Toward Cash Costs Benchmark Crude Prices Collapse Toward Cash Costs Benchmark Crude Prices Collapse Toward Cash Costs Chart 2Oil-Price Volatility Surges To Wartime Levels Oil-Price Volatility Surges To Wartime Levels Oil-Price Volatility Surges To Wartime Levels Prices, as can be expected under such circumstances, are plunging toward cash costs – i.e., the level at which only operating costs are covered – which are below $20/bbl. The collapse in crude oil prices since the beginning of this year is lifting volatility to levels not seen since the Gulf War of 1990-91 launched by the US and its allies following Iraq’s invasion of Kuwait (Chart 2). As inventories rise, the supply of storage globally falls, and prices are forced below cash costs to drive surplus crude oil production from the market. The rapid evolution from backwardation (prompt prices exceed deferred prices) to steep contango (prompt prices at a discount) in the benchmark crudes is how markets signal the supply of storage is falling (Chart 3). Chart 3Markets' Violent Move From Backwardation To Contango Markets' Violent Move From Backwardation To Contango Markets' Violent Move From Backwardation To Contango Chart 4Storage Constraints Drive Price Volatility KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War This strain on global inventory capacity will keep volatility elevated: As physical constraints on storage intensify, only price can adjust to clear the market, which results in massive price moves as markets respond in real time to supply-demand imbalance (Chart 4). Shales Lead US Output Lower At this point, massive increases in supply are not required to keep benchmark oil prices below $30/bbl. Markets are seeing and anticipating a sharp contraction in demand in the near term, with storage building as consumers “shelter in place” around the world. Production is set to increase in April, in the midst of a global exogenous shock to demand. As these fundamentals are worked into prices volatility will remain high. In our updated forecasts, our base case assumes KSA and its allies, and Russia raise production by 1.3mm b/d in 2Q20 and 3Q20.  KSA's and Russia's output increase to ~ 11mm b/d and 11.7mm b/d, respectively. We expect the reality of low prices and a slowing world economy to force these states back to the negotiating table in 2H20, with production cuts being realized in 4Q20 and 2021 (see below). With less capital made available to shale drillers, production growth in the shales literally is forced to slow. While KSA’s and Russia’s budgets almost surely will bear enormous strain in such an environment, we believe it is the US shales that take the hardest hit over the short run, if KSA and Russia maintain their avowed production intensions. The growth in US shale output – Russia’s presumed target – is expected to slow sharply this year under current circumstances, increasing at a rate of just 650k b/d over 2019’s level. Next year, we expect shale production in the US to fall ~ 1.3mm b/d to 7.7mm b/d. Part of this is driven by the on-going reluctance of capital markets to fund shale drillers and hydrocarbon-based energy companies generally, which can be seen in the blowout in high-yield bond spreads dominated by shale issuers (Chart 5). With less capital made available to shale drillers, production growth in the shales literally is forced to slow. Chart 5Low Price Force US Shale Cutbacks Low Price Force US Shale Cutbacks Low Price Force US Shale Cutbacks With funding limited and domestic oil prices well below breakevens – and cash costs – more shale-oil producers will be pushed into bankruptcy or into sharp slowdowns in drilling activity (Charts 6A and 6B). These constraints will force total US output to contract by 1.3mm b/d next year, based on our modeling. This will take US lower 48 output this year and next to 10.5mm b/d and 9.2mm b/d, respectively (Chart 7). Chart 6ALow Prices Force US Shale Cutbacks KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War Chart 6BLow Price Force US Shale Cutbacks KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War Capital markets will not tolerate unprofitable production. When the dust settles next year, US shale-oil output is expected to take the biggest supply hit globally, based on our current assumptions and modeling results. Worthwhile remembering, however, shale-oil production is highly likely to emerge a leaner more efficient sector, as they did in the OPEC-led market-share war of 2014-16.1 Also worthwhile remembering, for shale operators, is capital markets will not tolerate unprofitable production. So, net, a stronger, more disciplined shale-oil producer cohort emerges from the wreckage of the COVID-19 demand shock coupled with the KSA-Russia market-share war of 2020. Chart 7US Shale Contraction Leads US Output Lower In 2021 US Shale Contraction Leads US Output Lower in 2021 US Shale Contraction Leads US Output Lower in 2021 Demand Uncertainty Is Huge We are modeling a shock that reduces global demand – a highly unusual occurrence – by 150k b/d this year versus 2019 levels (Table 1). Most of this shock occurs in 1H20, where a large EM contraction originating in China set the pace. We expect China’s demand to begin recovering in 2Q20. The demand contraction moves into OECD states in 2Q20, which are expected to follow a similar trajectory in demand shedding seen elsewhere (Chart 8). In 2H20, we expect global demand to begin recovering, and, barring another outbreak of COVID-19 (or another novel coronavirus) next winter, for global demand growth to re-accelerate to ~ 1.7mm b/d in 2021. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War The uncertainty around our demand modeling is large. Expectations from the large data providers are all over the map: The EIA expects demand to grow 360k b/d this year, while the IEA and OPEC expect -90k and 60k b/d. In addition, some banks and forecasters make a case for demand falling by 1mm b/d or more in 2020, a scenario we do not expect. Sorting through the evolution of demand this year – i.e., tracking the recovery from China and EM through to DM – will be difficult, particularly as Western states go into lock-down mode and the global economy remains moribund. This makes our forecasts for supply-demand balances and prices highly tentative, and subject to revision. Chart 8Demand Shock + Market-Share War = Imbalance Demand Shock + Market-Share War = Imbalance Demand Shock + Market-Share War = Imbalance Market-Share War: What Is It Good For? As we argue above, the US shale-oil producers will, for a variety of reasons, be forced by capital and trading markets to retrench, and to cut production sharply. They lost favor with markets prior to the breakdown of OPEC 2.0, and this will not change. At this point, it is unlikely KSA and Russia can alter this evolution by increasing or decreasing production – investors already have shown they have little interest in funding their further growth and development. The KSA-Russia market-share war reinforces investors’ predispositions, and decidedly accelerates this retrenchment by the shale producers. As the global economy moves toward shut-down, KSA and Russia will be forced to turn their attention to shoring up their economies and tending to their populations’ welfare. The strain of a global shut-down will absorb governments’ resources worldwide, and self-inflicted wounds – which, at this point, a market-share war amounts to – will only make domestic conditions worse in KSA, Russia and their respective allies. The income elasticity of supply for these producers is such that small adjustments – positive or negative – on the supply side have profound effects on oil producers’ revenues (Table 2). Both KSA and Russia are aware of this. Russia burns through its $150 billion national wealth fund in ~ three years in a market-share war, while KSA burns through ~ 10% of its foreign reserves, when export prices fall $30/bbl and Russia's exports rise 200k b/d and KSA's rise 2mm b/d.2 In a world where demand destruction is accelerating revenue losses, and storage limitations threaten to collapse oil prices below cash costs, production management – even if that means extending the 1Q20 cuts of 1.7mm b/d for the balance of 2020 – is necessary to avoid larger, longer-term economic damage (Chart 9). Table 2Market-Share War Vs. Revenue KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War Chart 9Global Inventories Could Surge Global Inventories Could Surge Global Inventories Could Surge We believe the leadership in both of these states have sufficient reason to return to the negotiating table to figure out a way to re-start their production-management accord, if only to preserve funds to cover imports while global demand recovers. It may take a month or two of unchecked production to make this point clear, however, so volatility can be expected to remain elevated. These fundamental and political assessments compel us to reduce our oil-price forecasts in the wake of the deterioration in fundamentals, expecting Brent to average ~ $36/bbl in 2020, and $55/bbl in 2021. WTI will trade ~ $3-$4/bbl lower. Price risk is to the upside in 2021, given the global fiscal and monetary stimulus being deployed. Bottom Line: The confluence of a true global demand shock and a market-share war on the supply side has pushed benchmark crude oil prices close to cash costs for many producers. The damage to states highly dependent on oil revenues is just now becoming apparent. We expect KSA and Russia to return to the negotiating table, to hammer out a production-management accord that allows them to control as much of the economic damage to their economies as is possible. Capital markets already are imposing a harsh discipline on US shales – Russia’s presumptive target in the market-share war. The consequences of the COVID-19 vis-a-vis demand destruction are of far greater moment for KSA and Russia than their market-share war. They need to shore up their economies and get in the best possible position to benefit from a global economic rebound, not destroy themselves seeking a Pyrrhic victory that devastates both of them.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Chinese refiner Sinochem International Oil (Singapore) turned down an offer of crude-oil cargoes for May-June deliver from Russian oil company Rosneft PJSC, which is under US sanctions, according to Bloomberg. Sinochem refuses cargoes from Iran, Syria, Venezuela, and Kurdistan, which also are under sanction or are commercially aligned with sanctioned entities. Base Metals: Neutral The downward trend in base metal prices remains,  as the spread of the coronavirus intensifies outside of China, and governments worldwide impose freedom-of-movement restrictions on their populations to contain further spread. Persistent US dollar strength – supported by inflows to safe assets amid the elevated global economic uncertainty – pressures EM economies’ base metal demand. As a result, the LME index is down 18% YTD, reaching its 2016 lows. We were stopped out of our long LMEX recommendation on March 17, 2020 for a 12% loss. Precious Metals: Neutral Gold and silver are caught up in a global selloff of assets that have performed well over the past year as safe havens, as market participants raise cash for liquidity reasons or margin calls. We are waiting for an opportunity to go long gold again after being stopped out earlier in the sell-off. Silver will recover with industrial-commodity demand, which we expect to occur in 4Q20, when the COVID-19 threat recedes, and consumers worldwide are responding to the globally fiscal and monetary stimulus being rolled out now. We are staying on the sidelines for now, as volatility is extremely high for metals (Chart 10). Ags/Softs:  Underweight CBOT May Corn futures were down 3% Tuesday, reaching 18-month lows, driving mostly by high USD levels, which make US exports less competitive. Supplies from South America, where a large harvest is ongoing in Argentina and Brazil, are taking market share. Furthermore, according to a report from the University of Illinois, lower gasoline consumption resulting from the COVID-19 pandemic will reduce the amount of corn needed for ethanol production; demand could fall 120mm to 170mm bushels. Soybeans and wheat futures ended the day slightly higher on the back of bargain buying, after falling to multi-month lows on Monday. USD strength remains a headwind on ags, encouraging production ex-US at the margin and contributing to stifling demand for US exports (Chart 11). Chart 10Gold Is Experiencing Extremely High Volatility Gold Is Experiencing Extremely High Volatility Gold Is Experiencing Extremely High Volatility Chart 11USD Strength Remains A Headwind On AGS USD Strength Remains A Headwind On AGS USD Strength Remains A Headwind On AGS   Footnotes 1     Please see How Long Will The Oil-Price Rout Last?, a Special Report we published March 9, 2020, which discussed US bankruptcy law and the re-cycling of assets. 2     Please see Russia's Supply Shock To Oil Markets and Russia Regrets Market-Share War?, which we published March 6 and March 12, 2020, for additional discussion. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades KSA, Russia Will Be Forced To Quit Market-Share War KSA, Russia Will Be Forced To Quit Market-Share War

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support EM Share Prices Are At Their Long-Term Support EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Global Trade Growth Was Positive In September 2008... Global Trade Growth Was Positive In September 2008... Chart I-3B…But Was Negative In December 2019 ...But Was Negative In December 2019 ...But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now China Business Cycle Was Much Stronger In Q4 2008 Than Now China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession US Growth At Trough Of 2008 Recession US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 US Small Caps: Overlay Of 2008 And 2020 US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise EM Stocks Fall When EM Corporate Bond Yields Rise EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking Chinese And Emerging Asian Corporate Bond Yields Are Spiking Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM Equities Drop When EM Local Bond Yields Rise EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices EM Currencies Move In Tandem With Commodities Prices EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio More Downside In Risk-On/ Safe-Haven Currency Ratio More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output The Largest Oil Producers Are Ramping Up Output The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices Structural Breakdown In Oil Prices Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights While not exactly conciliatory, Russian officials are signaling they will re-consider the declaration of a market-share war with the Kingdom of Saudi Arabia (KSA). KSA upped its shock-and-awe rhetoric promising to lift maximum sustainable capacity to 13mm b/d, which has kept prices under pressure (Chart of the Week) and will resonate into 3Q20, even if a market-share war is averted. Failure to stop a market-share war will fill global oil storage, and Brent prices again will trade with a $20 handle by year-end. Demand forecasts by the IEA and prominent banks are tilting toward the first contraction in global oil demand since the Global Financial Crisis (GFC). Central banks and governments are rolling out fiscal and monetary stimulus to counter the expected hit to global aggregate demand in the wake of COVID-19. Given the extraordinary uncertainty surrounding global oil supply and demand, our balances and prices forecasts are highly tentative. We are reducing our 2020 Brent forecasts to $40/bbl for 2Q-3Q20, and $50/bbl for 4Q20. For 2021, we are expecting Brent to average $60/bbl. WTI trades $3-$4/bbl below Brent in our estimates. Feature Russian officials appear to be seeking a resumption of talks with OPEC. Since the declaration of a market-share war following the breakdown of OPEC 2.0 negotiations to agree a production cut to balance global oil markets, Russian officials appear to be seeking a resumption of talks with OPEC.1 Putting such a meeting together before the expiration of OPEC 2.0’s 1.7mm b/d production-cutting deal at the end of this month will be a herculean lift for the coalition, but it can be done. All the same, it may require a quarter or so of re-opened floodgates from KSA and its GCC allies to focus everyone’s attention on the consequences of market-share wars. To that end, the Kingdom announced it will lift production above 12mm b/d, and supply markets out of strategically placed storage around the world. It was joined by the UAE with a pledge to raise output to 4mm b/d. Chart of the WeekMessy OPEC 2.0 Breakdown Crashes Benchmark Crude Prices Messy OPEC 2.0 Breakdown Crashes Benchmark Crude Prices Messy OPEC 2.0 Breakdown Crashes Benchmark Crude Prices Assessing Uncertain Fundamentals While the dramatis personae on the supply side maneuver for advantage, markets still are trying to form expectations on the level of demand destruction in EM and DM wrought by COVID-19. Given the elevated uncertainty around this issue, modeling our ensemble forecast has become more complicated. On the demand side, we are modeling three scenarios for 2020: Global demand growth falls 200k b/d y/y, flat growth, and growth of 600k b/d. Our previous expectations had growth increasing 1mm b/d in 2020 and 1.7mm b/d in 2021. We maintain the rate of growth for next year – 1.7mm b/d – but note it is coming off a lower 2020 base for consumption. On the supply side, it’s a bit more complicated. We have three scenarios: In Scenario 1, we model the OPEC 2.0 breakdown, i.e., OPEC 2.0 gradually increases production by 2.5mm b/d between Apr20 and Dec20. Compared to our previous estimates it also removes the 600k b/d we previously expected would be added to the cuts in 2Q20, which produces a supply increase of 2.5mm b/d + expectation of 600k b/d vs. our previous balances. In Scenario 2, we run our previous balances expectation, which cuts production by a total of 2.3mm b/d in 2Q20, 1.7mm b/d in 2H20, and 1.2mm b/d in 2021.2 Scenario 3 models the additional cuts as recommended by OPEC last in week in Vienna of 1.5mm b/d on top of the 1.7mm b/d already agreed on for 1Q20. These cuts are realized gradually, moving to 2.3mmm b/d in 2Q20 and 3.2mm b/d in 2H20. For 2021, our supply assumptions revert to the OPEC 2.0 production cuts of 1.2mm b/d that prevailed last year. The price expectations generated by these scenarios can be seen in Table 1 and in Charts 2A, 2B, and  2C, which show our supply-side scenarios with the three demand-side scenarios above. We show our balances estimates given these different scenarios in Charts 3A, 3B, and 3C, and our inventory estimates in Charts 4A,  4B, and  4C. Table 1Unstable Brent Price Forecasts Russia Regrets Market-Share War? Russia Regrets Market-Share War? It may require a quarter or so of re-opened floodgates from KSA and its GCC allies to focus everyone’s attention on the consequences of market-share wars. Chart 2AOil Price Scenarios Driver: OPEC vs. Russia Price War Oil Price Scenarios Driver: OPEC vs. Russia Price War Oil Price Scenarios Driver: OPEC vs. Russia Price War Chart 2BOil Price Scenarios Driver: Pre-OPEC 2.0 Breakdown Oil Price Scenarios Driver: Pre-OPEC 2.0 Breakdown Oil Price Scenarios Driver: Pre-OPEC 2.0 Breakdown Chart 2COil Price Scenarios Driver: Proposed OPEC Cuts Oil Price Scenarios Driver: Proposed OPEC Cuts Oil Price Scenarios Driver: Proposed OPEC Cuts Chart 3AOil Balances Scenarios Driver: OPEC vs. Russia Price War Oil Balances Scenarios Driver: OPEC vs. Russia Price War Oil Balances Scenarios Driver: OPEC vs. Russia Price War Chart 3BOil Balances Scenarios Driver: Pre-OPEC 2.0 Breakdown Oil Balances Scenarios Driver: Pre-OPEC 2.0 Breakdown Oil Balances Scenarios Driver: Pre-OPEC 2.0 Breakdown Chart 3COil Balances Scenarios Driver: Proposed OPEC Cuts Oil Balances Scenarios Driver: Proposed OPEC Cuts Oil Balances Scenarios Driver: Proposed OPEC Cuts Chart 4AOECD Inventory Scenarios Driver: OPEC vs. Russia Price War OECD Inventory Scenarios Driver: OPEC vs. Russia Price War OECD Inventory Scenarios Driver: OPEC vs. Russia Price War Chart 4BOECD Inventory Scenarios Driver: Pre-OPEC 2.0 Breakdown OECD Inventory Scenarios Driver: Pre-OPEC 2.0 Breakdown OECD Inventory Scenarios Driver: Pre-OPEC 2.0 Breakdown Chart 4COECD Inventory Scenarios Driver: Proposed OPEC Cuts OECD Inventory Scenarios Driver: Proposed OPEC Cuts OECD Inventory Scenarios Driver: Proposed OPEC Cuts Given all of the moving parts in our forecast this month, we will only be publishing a summary of these estimates (Table 1). We will publish our global balances table next week after we have had time to process the EIA’s and OPEC’s historical demand estimates. Given the dynamics of supply-demand and storage adjustments these different scenarios produce, we use them to roughly estimate forecasts for 2Q and 3Q20, 4Q20 and 2021. We are reducing our 2020 Brent forecasts to $40/bbl for 2Q-3Q20, and $50/bbl for 4Q20. For 2021, we are expecting Brent to average $60/bbl. WTI trades $3-$4/bbl below Brent in our estimates. The implicit assumption here is COVID-19 is contained by 3Q20 and is in the market’s rear-view mirror by 4Q20. Obviously, such an assumption is fraught with uncertainty. Russia May Be Re-Thinking Strategy I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest. Winston Churchill, BBC Broadcast, October 1, 1939.3 Russia appears to be sending up trial balloons to indicate to OPEC it would not be averse to renewing the OPEC 2.0 dialogue. It is worthwhile noting Russian officials immediately responded to KSA’s first mention of sharply higher output – going to 12.3mm bd from 9.7mm b/d – with their own assertion they will lift current output of ~ 11.4mm b/d by 200k – 300k b/d, and ultimately take that to +500k b/d. Of course, as Churchill’s observation makes plain, it is difficult to interpret Russia’s overtures in this regard, particularly in light of the growing popular dissatisfaction with President Vladimir Putin’s regime within Russia itself. At the outset, it seems to us that the cause of the breakdown in OPEC 2.0 was the collapse in demand from China following the COVID-19 outbreak in Wuhan Province, and Putin’s attempt to secure a longer stay in power.4 The former focused Russia’s oil oligarchs on shoring up market share, and focused Putin on maintaining the support of these important oligarchs. The basis for Russo-Saudi cooperation under the OPEC 2.0 umbrella was rising oil demand, and the simple fact that both sides had exhausted their ability to sustain low prices brought on by the 2014-16 oil-price collapse ushered in by OPEC’s previous market-share war amid the global manufacturing downturn. The slowdown in global demand due to China’s slow-down and the Sino-US trade war in 2019 weakened Russian commitment to OPEC 2.0 by end of year. Putin faced domestic popular discontent and grumbling among the oligarchs (e.g. Igor Sechin, the head of Rosneft), just as he was preparing to extend his term in power. The possibility of a drastic loss of Russian influence over global oil markets – and hence of its own economic independence – emerged at a time when Putin still has the ability to maneuver ahead of the 2021 Duma election and 2024 presidential election which are essential to his maintenance of power. Going into 2020, Russia also had gained monetary and fiscal ammunition over preceding three years that would allow them to challenge KSA within OPEC 2.0, while KSA’s reserves stagnated (Chart 5). The Wuhan Coronavirus pushed things over the edge by hitting Chinese oil demand directly in the gut. Putin gave into the oil sector’s demands for prioritizing market share. As is apparent, this is the critical issue for him and the oligarchs running Russia’s oil and gas companies. Chart 5Foreign Exchange Reserves Foreign Exchange Reserves Foreign Exchange Reserves Russia’s US Focus The fact that US President Donald Trump and Iran are harmed by the oil price collapse is secondary. The Russians may have known that the US and Iran would suffer collateral damage, but their primary objective was not to unseat Trump and definitely not to increase the chances of regime collapse in Iran. It is not unthinkable that President Putin would attempt to upset the US election yet again. Regardless of the relationship between Putin and Trump, Russia benefits from promoting US polarization in general. And the Democrats will impose stricter regulations on US resource industries (including shale). All the same, Russia will suffer from Democrats taking power and strengthening NATO and the trans-Atlantic alliance. A knock on shale is a short-term benefit to Russia, but the loss of Trump as a president who increases geopolitical “multipolarity,” which is good for Russia, would be a long-term loss. President Putin would not have triggered the conflict with Saudi over such a mixed combination. The breakdown of OPEC 2.0 happened after Super Tuesday, so it was clear Biden was leading the US Democratic Party’s bid for the Oval Office come November. Biden is hawkish on Russia and is more likely than Trump to get the Europeans to reduce their energy dependence on Russia. Also, it is possible Trump will benefit from lower oil prices anyway, since it will reduce prices at the pump by November and also help China recover – thus allowing it to boost global demand and follow through on Phase 1 of the Sino-US trade deal. As noted above, market share is primary. The US election, if it is relevant at all, is subsidiary. The Trump administration is furious because the turmoil threatens to upset the US election. As for Iran, Russia does at least consider its position, but is driven by its own needs and, as usual, threw Iran under the bus when necessary. Russia will continue to support the Iranian regime in other ways. And if the consequence of the market-share war is government change in the US, then Iran has its reward. Clearly President Putin was willing to throw President Trump under the bus, as well. It was not surprising to see US officials singling out Russia when discussing the oil-price collapse last week and earlier this week, when US Treasury Secretary Steve Mnuchin and Russia’s foreign minister, Anatoly Antonov, met in Washington. This blame game is consistent with what we think we know: Russia wavered on the deal presented by OPEC. Saudi Arabia was not the instigator.5 Saudi Arabia massively reacted to retaliate against Russia’s declared price war, but it was Russia that refused to agree to more cuts.6 The Trump administration is furious because the turmoil threatens to upset the US election. From Trump’s perspective, oil and gasoline prices weren’t too high, but, now that they are lower, the risk of higher unemployment in key electoral states – even Texas – is elevated. Trump wanted more oil production but not oil market chaos.  Trump wanted more oil production but not oil market chaos. This short-term thinking is likely to drive US policy in advance of the election, although from a long-term point of view the US has little reason to regret Russia’s actions as Russia is ultimately shooting itself in the foot. From an international point of view, the breakdown shows that Russia and KSA are fundamentally competitive, not cooperative, and the fanfare over improving relations was dependent on stronger oil demand, not vice versa. Russia’s strategy for decades – in the Middle East and elsewhere – has been to take calculated risks, not to undertake reckless adventures that expose its military and economic weaknesses relative to the United States and Europe. This strategic logic applies to the market-share war as well as to Russia’s various conflicts with the West. The oil price collapse is bad for Russia’s economy and internal stability and hence the door to talks is still open. The immediate risk to both KSA and Russia is a forward oil curve that stays lower for longer, regardless of what the Russian Finance Ministry says. A reconciliation between KSA and Russia to restore the production-management deal would limit the negative fallout. The immediate risk to both KSA and Russia is a forward oil curve that stays lower for longer, regardless of what the Russian Finance Ministry says.7 Bottom Line: The COVID-19 pandemic and the breakdown of OPEC 2.0 last week in Vienna dramatically heightened uncertainty and volatility in oil markets. Although it appears Russian officials are trying to walk back the market-share war declared at the end of last week, events already in train could keep oil prices lower for longer. We lowered our oil-price forecasts for 2020 to reflect the demand destruction and a possible supply surge this year. The underlying assumption of our modeling on the demand side is the COVID-19 pandemic will be contained and the global economy will be back in working order by 4Q20. On the supply side, nothing is certain, but we are leaning to a re-formation of OPEC 2.0, which ultimately restores the production-management regime that prevailed until last week. Both of these assumptions are highly unstable. We lowered our 2020 Brent forecasts to $40/bbl for 2Q-3Q20, and to $50/bbl for 4Q20. For 2021, we are expecting Brent to average $60/bbl. WTI trades $3-$4/bbl below Brent in our estimates. These forecasts will be constantly reviewed as new information becomes available. Commodities Round-Up Energy: Overweight Total stocks of crude oil and products in the US drew another 7.6mm barrels in the week ended March 6, 2020, led by distillates, the EIA reported. Crude and product inventories finished the week at close to 1.3 billion barrels (ex SPR barrels). Total product demand – what the EIA called “Product Supplied” – was up close to 600k b/d, led by distillates (e.g., heating oil, diesel, jet and marine gasoil). Commercial crude oil inventories rose by 7.7mm barrels (Chart 6). Base Metals: Neutral After falling almost to the daily downside limit early on Monday, Singapore ferrous futures staged a recovery on Tuesday when iron ore jumped 33%, as declining inventories of the steelmaking material sparked supply concerns among investors. SteelHome Consultancy reported this week Chinese port-side iron ore stocks dropped to 126.25mm MT, down 3.4% for the year. In addition, China’s General Administration of Customs reported iron ore imports rose 1.5% in the January and February relative to the same period a year ago. The decreasing number of new COVID-19 cases in China should help iron ore and steel going forward as construction and infrastructure projects resume. Precious Metals: Neutral Gold prices are up 9% YTD, supported by accommodative monetary policy globally in the wake of the rapid spread of COVID-19 cases outside of China. Fixed income markets are pricing in 80bps cuts in the Fed funds rate over the next 12 months. Additionally, negative-yielding debt globally – which is highly correlated with gold prices – increased 26% since January 2020. Continued elevated uncertainty stemming from the spread of the coronavirus keeps demand for safe assets buoyant. We estimate the risk premium in gold prices related to this persistent uncertainty is ~$140/oz (Chart 7). Nonetheless, positioning and technical signal it is overbought and vulnerable to a short-term pullback. Ags/Softs:  Underweight In its World Agricultural Supply and Demand Estimates (WASDE), the USDA lowered its season-average price expectations for the current crop year for corn to $3.80/bu, down 5 cents, and for soybeans to $8.70/bu, a decrease of 5 cents. The USDA kept its expectation for wheat at $4.55/bu. The Department estimates global soybean production will increase 2.4mm MT, with most of this stemming from increases in Argentina and Brazil. CONAB, Brazil’s USDA equivalent, confirmed this projected increase, saying the country’s soybean output is poised to rise 8% to a record 124.2 Mn Tons this year. May soybean futures were up slightly, as were corn and wheat on Tuesday. Chart 6 US Crude Inventories Are Rising US Crude Inventories Are Rising Chart 7 Russia Regrets Market-Share War? Russia Regrets Market-Share War?   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1     Please see Russia keeps door open for OPEC amid threats to raise output, published by worldoil.com; Russian ministry, oil firms to meet after OPEC talks collapse -sources, published by reuters.com March 10, 2020, and Russia says it can deal with pain of a Saudi oil price war published by ft.com March 9, 2020. 2     For non-OPEC 2.0 countries, we also included downward adjustments to Libya and US shale production vs. our previous balances 3    Please see “The Russian Enigma,” published by The Churchill Society. See also Kitchen, Martin (1987), “Winston Churchill and the Soviet Union during the Second World War,” The Historical Journal, Vol. 30, No. 2), pp. 415-436. 4    We also would observe Russian producers never fully abided by the output cuts voluntarily in every instance. Often, compliance was due to (1) seasonal maintenance; (2) extreme temperatures in the winter, and (3) the pipeline contamination incident. Thus, producers were probably close to full capacity most of the time OPEC 2.0's production cuts were in place. This implies that for a minor voluntary production cut, Russia enjoyed prices close to $70/bbl, vs. mid $30s currently. This begs the question why they would provoke a market-share war when they would have been better off continuing to flaut their quotas instead of collapsing prices. 5    Please see Mnuchin wants ‘orderly’ oil markets in talk with Russian ambassador published by worldoil.com March 9, 2020. 6    One could argue that while the Saudis reacted quickly and threatened a massive response, they may have been less fearful of a breakdown given the recognition that it could seriously damage Iran’s economy. 7     The Financial Times noted Russia’s confidence that its National Wealth Fund of ~ $150 billion, equivalent to ~ 9% of GDP, which officials believe allows it “to remain competitive at any predicted price range and keep its market share” – i.e., the state will draw down the fund to cover any difference between low oil prices and domestic oil company’s breakeven prices. Energy Minister Alexander Novak said Russia would “pay special attention to providing the domestic market with a stable supply of oil products and protecting the sector’s investment potential.” Please see Russia says it candDeal with the pain of a Saudi price war, published by ft.com March 9, 2020.  

Highlights Oil prices fell 30% when markets opened Monday morning, following a split between OPEC 2.0’s putative leaders – the Kingdom of Saudi Arabia (KSA) and Russia – over production cuts to balance global oil markets (Chart 1). If KSA and Russia are able to repair the break in what OPEC Secretary General Mohammad Barkindo once called their “Catholic Marriage” the sudden collapse in prices could serve a useful purpose in reminding producers, consumers and investors of the need for full-time management of production and inventories, and restore prices to the $60/bbl neighborhood in 2H20.1 If not, markets could be in for a drawn-out market-share war lasting the better part of this year, with damaging consequences for all involved, with Brent prices remaining closer to $30/bbl (Chart 2). Feature Much as we rely on modeling to guide our expectations, this is purely political at the moment. How Long Will The Oil Price Rout Last? That’s the question that repeatedly is being asked by clients following the breakdown in Vienna last week, and news over the weekend that KSA would engage a market-share war opened by Russian Energy Minister Alexander Novak prior to departing Vienna. Novak gave every impression of renewing a market-share war after Russia rejected the plan put forth by OPEC to remove an additional 1.5mm b/d of production from the market, to combat the demand destruction expected in the wake of COVID-19. The only answer we have to the question: No one knows with certainty. Chart 1Oil Sell-Off Accelerates, As Market-Share War Looms Oil Sell-Off Accelerates, As Market-Share War Looms Oil Sell-Off Accelerates, As Market-Share War Looms Chart 2A Market-Share War Will Keep Oil Prices Depressed A Market-Share War Will Keep Oil Prices Depressed A Market-Share War Will Keep Oil Prices Depressed Neither of the principal actors responsible for the 30% rout in oil prices on Monday morning when markets opened for trading – KSA and Russia – are providing guidance at present. Prices since recovered slightly and were down ~ 20% Monday afternoon. Much as we rely on modeling to guide our expectations, this is purely political at the moment. There are two large personalities involved – Saudi Crown Prince Mohammad bin Salman bin Abdulaziz Al Saud and Russian President Vladimir Putin – who have staked out opposing positions on the level of production cuts needed to balance markets in the short term, as the COVID-19 outbreak spreads beyond China leaving highly uncertain demand losses in its wake.2 If a meeting of OPEC 2.0’s leadership can be arranged before the end of March, a hope expressed by Iran's Oil Minister Bijan Namdar Zanganeh in a Bloomberg interview over the weekend,3 the stage could be set for a rapprochement between KSA and Russia allowing them to repair the rupture in the OPEC 2.0 leadership. Should that occur, the rally in prices could be dramatic – maybe not as dramatic as today's price collapse when markets awoke to the opening rounds of a full-on market-share war between OPEC and Russia. But, over the course of the next few weeks, prices for 2H20 Brent and WTI would begin recovering and moving back toward $60/bbl as markets price in lower inventories on the back of a return to production discipline by OPEC 2.0. If we do not see such a meeting next week, markets will be forced to price in a prolonged price-war that could extend into the end of this year, which will not be easy to arrest. If, as seems to be the case, the Russians' goal is to directly attack shale-oil production in the US with a market-share/price war, the effort most likely will fail. True, there will be an increase in bankruptcies among the shale producers and their services companies. This will set up another round of industry consolidation – i.e., more M&A in the US shales – with the large integrated multinational oil companies that now dominate these provinces adding to their holdings. It is worthwhile remembering that US bankruptcy law recycles assets; it does not retire them permanently. In addition, the acquirers of bankrupt firms’ assets get them at a sharp discount, which greatly helps their cost basis. So, shale assets will change hands, stronger balance sheets will take control of these assets, and a leaner, more efficient group of E+Ps will emerge from the wreckage. What’s Being Priced? It is in neither KSA’s nor Russia’s interest to engage in a prolonged market-share war that keeps Brent prices closer to $30/bbl than to $70/bbl. We estimate oil markets now have to price in the return of ~ 2.8mm b/d of OPEC 2.0 production at the end of this month – i.e., a 10% increase of GCC output, led by KSA’s production getting up to 11mm b/d by year-end; ~ 600k b/d of cuts we were assuming would be approved in last week’s Vienna meetings; and ~ 260k b/d from Russia (Chart 3). This could be understated, as KSA claims 12.5mm b/d of capacity (including its spare capacity). Unchecked supply growth would force inventories to build this year (Chart 4).  In fact, absent a return to production-management by OPEC 2.0, oil markets will extrapolate the higher production and low demand into an expectation for steadily rising inventories, that will – once it becomes apparent the supply of storage globally will be exhausted – force prices toward $20/bbl. Weaker-than-expected demand growth would accelerate this process. Chart 3Higher Production Will Overwhelm Demand In Market-Share War Higher Production Will Overwhelm Demand In Market-Share War Higher Production Will Overwhelm Demand In Market-Share War Chart 4Market-Share War Could Exhaust Storage Forcing Production Out of The Market Market-Share War Could Exhaust Storage Forcing Production Out of The Market Market-Share War Could Exhaust Storage Forcing Production Out of The Market It is in neither KSA’s nor Russia’s interest to engage in a prolonged market-share war that keeps Brent prices closer to $30/bbl than to $70/bbl. The apparent unwillingness of Putin and the Russian oligarchs running the country’s oil companies to make relatively small additional production cuts – vis-à-vis what KSA already has delivered – to support prices has not been well explained by Russian producers. The revenue benefits from small production cuts almost surely exceed the additional revenue that would accrue from a 200-300k b/d increase in  output and keeping prices in the $30-$40/bbl range, a level that is below Russian producers' cost of production onshore and offshore, according to the Moscow Times.  KSA's costs are ~ $17/bbl on the other hand.4 Russia’s economy was wobbly going into the Vienna meetings, which makes sorting this out even more complicated. One thing that can be said for certain is that over the past six months Vladimir Putin has entered into another consolidation phase in attempting to quell public unrest, improve the government’s image, and tighten up control over the country, while preparing for another extension of his time as Russia’s supreme leader. A Battle For Primacy? At one level, it would appear the Russians were pushing back against an apparent demand by OPEC (the old cartel led by KSA) to fall in line. Russia’s rejection of the OPEC proposal could be read as an assertion of their position to show they were, at the very least, KSA’s equal in the coalition. A stronger read of the rejection, given the Russian Energy Minister’s comments following the breakdown in Vienna at the end of last week – "... neither we nor any OPEC or non-OPEC country is required to make (oil) output cuts” – would be Russia was attempting to assert itself as the leader of OPEC 2.0. Giving Russia what amounted to a take-it-or-leave-it ultimatum on production cuts was a high-stakes gamble on KSA’s part. On KSA’s side, it is likely the Saudis grew irritated with the Russian failure to get on board to address a global oil-demand emergency that was spreading beyond China, when they were discussing extending and deepening production cuts in the lead-up to last week’s meetings. Giving Russia what amounted to a take-it-or-leave-it ultimatum on production cuts was a high-stakes gamble on KSA’s part, to say the least. However, as OPEC’s historic kingpin, KSA may have believed its role was to lead the coalition.  Russia’s in a better position now relative to KSA in the short term vis-à-vis foreign reserves ($446 billion), budget surplus (~ $8 billion), and its lower fiscal breakeven price for oil ($50/bbl) vs KSA’s ($84/bbl), as we discussed in our Friday alert (Chart 5). However, with Russian per-capita GDP at ~ half that of KSA’s, it is highly likely – if this market-share war is prolonged – its citizens are going to be hit with the consequences of the oil-price collapse in short order: FX markets are selling ruble heavily today, and, in short order this will feed through into higher consumer prices and inflation. Indeed, we estimate a 1 percentage-point (pp) depreciation in the ruble vs. the USD y/y leads to a 0.14pp increase in Russian inflation (Chart 6). Chart 5Foreign Exchange Reserves Foreign Exchange Reserves Foreign Exchange Reserves Chart 6Russian Ruble Sell-Off Presages Inflation Russian Ruble Sell-Off Presages Inflation Russian Ruble Sell-Off Presages Inflation The Saudi riyal is pegged to the USD, and does not move as much as the ruble. However, KSA’s citizens also will be buffeted once again by a collapse in oil prices, as they were during the 2014-16 market-share war when government revenues came under severe stress. Things To Watch The OPEC 2.0 joint market-monitoring committee could meet again next week in Vienna, but that is not a given. If they do meet, the agenda likely will be dominated by trying to find a face-saving way for both sides to resume production management. Arguably, the presumptive target of the Russian strategy – US shale producers – will be severely damaged by this week’s price collapse, and both could argue the short-term tactic of threatening a price war was a success. The Saudis could also go for a quick solution, if their primary objectives are to sort things out with Russia, stabilize the global economy, and keep President Trump in office, rather than to push down prices in an adventurous attempt to escalate Iran’s internal crisis. We believe Russia badly miscalculated, and was too early in making a play for dominance in OPEC 2.0, if that was its intent. If, on the other hand, these large personalities cannot agree, the price collapse begun today will continue until global oil storage – crude and products – is filled, forcing prices through cash costs of all but the most efficient producers in the world. This level is below $20/bbl. These lower prices could redound to the benefit of China, as fiscal and monetary stimulus provided by policymakers there in the wake of COVID-19 to get the economy back on track for 6% p.a. growth gets super-charged by low oil prices. Bottom Line: We believe Russia badly miscalculated, and was too early in making a play for dominance in OPEC 2.0, if that was its intent. Russian GDP has twice the sensitivity to Brent prices that KSA does, which means such a tactic takes a toll on it as well as the shale producers (Chart 7). Capital markets had the US shale producers on the ropes, so it is difficult to argue there was a need to accelerate the process and shock the world. We again note a full-blown market-share war will set up another round of industry consolidation in the US shales, but, over the medium to longer term, the shale assets of bankrupt companies will only be re-cycled to more efficient operators, as we saw following the last market-share war. This will contribute to a stronger shale sector in the US in the medium term. Chart 7Russian GDP More Sensitive to Brent Prices Russian GDP More Sensitive to Brent Prices Russian GDP More Sensitive to Brent Prices The only other consolation for Russia is a higher likelihood of regime change in the US (more political polarization in the US benefits Russia), and yet the Trump administration has been the most pro-Russian administration in years so this is not at all a clear objective. We will be watching very closely for a meeting of OPEC 2.0’s joint committee next week. If we get it and a face-saving resolution is agreed by KSA and Russia we would expect stronger demand growth in 2H20 to absorb whatever unintended inventory accumulation a still-born price war causes. If not, we will expect a price war into the end of the year, after which the economies of oil producers globally will have been sufficiently battered to naturally force production lower and investment in future production to contract sharply. At that point, oil and oil equities will be an attractive investments for the medium and long term.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1     Please see Russia and Saudi Arabia Hold 'Catholic Marriage' with Poem and Badges, Form Enormous Oil Cartel published by Newsweek July 3, 2019. 2     We will be updating our demand estimates in Thursday’s publication, after we get fresh historical data from the principal providers (EIA, IEA, OPEC). 3     Please see Iran's Oil Minister Wants OPEC+ Output Cut, Hopes for Russia Meeting Soon published by Bloomberg, March 8 2020. 4     Please see Russian Oil Production Among Most Expensive in World published November 12, 2019 by The Moscow Times.  

Highlights Crude oil prices fell ~ 10% Friday after Russia refused to support additional production cuts agreed by OPEC in Vienna (Chart 1). As we go to press, Brent is trading close to $45/bbl and WTI is trading ~ $41/bbl. OPEC producers could implement the go-to strategy they’ve employed in the wake of past demand shocks and cut production on their own, in order to balance the market. That said, there are indications the Saudis will not shoulder the market-balancing role alone. Russian producers have consistently demanded relief from production restraints since 2017, when OPEC 2.0 took over balancing the market. With shale-oil producers on the back foot owing to parsimonious capital markets, Russia could finally be able to deliver the coup de grâce it has been waiting for. This supply shock hits the market as COVID-19 threatens demand globally. Whatever Russia’s intent – be it removing the near-certainty of a production cut, which it always agreed to in the past, or crippling US shale production – two-way risk has returned to these Vienna meetings. Feature Oil markets once again are faced with a possible price collapse – not unlike the swan dive seen when OPEC’s market-share war took Brent from more than $110/bbl in mid-2014 to $26/bbl by early 2016. The proximate aim of that market-share war – led by the Kingdom of Saudi Arabia (KSA) – was to significantly reduce the revenue Iran would receive when it returned to export markets, following its agreement with the US to end its nuclear program in 2015. Tanking oil prices was the most expedient way of accomplishing this. Secondarily, shale-oil producers also may have been targeted, although such a goal was never clearly articulated by KSA’s leadership. Chart 1Russia's Supply Shock Craters Brent, WTI Prices Russia's Supply Shock Craters Brent, WTI Prices Russia's Supply Shock Craters Brent, WTI Prices OPEC’s market-share war did thin the US oil-shale herd, but it did not destroy the industry. If anything, it forced shale-oil producers to focus on their best drilling prospects with their best rigs and crews. This produced a leaner more productive technology-driven cohort of drillers, which posted record production levels on a regular basis. Indeed, by the end of 2019, US production topped 12.9mm b/d – 8.2mm b/d of which was accounted for by shale-oil output – making the US the largest oil and gas producer in the world. The market-share war also brought KSA and Russia together in November 2016 as the putative leaders of OPEC 2.0. The sole mission of this unlikely coalition was to clear the global inventory overhang left in the wake of the market-share war by managing OPEC and non-OPEC production. Russia’s Coup de Grâce Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers.   Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers. Ahead of OPEC 2.0 meetings in Vienna, Russian oligarchs could be counted on to demand higher output levels, and President Vladimir Putin could be counted on to deliver something close to agreed production cuts in time to assuage markets. This semi-annual ritual came to resemble a tightly choreographed set-piece, which may have inured market participants to the oligarchs’ resolve to ultimately increase production levels. Russia certainly was well-prepared when it delivered Friday’s supply shock. Time will tell, but Friday’s breakdown in Vienna could be the coup de grâce Russia’s oligarchs have been waiting to deliver to US shale producers since the formation of OPEC 2.0. Or it could be a well-timed reminder that nothing in oil markets is certain – particularly Russian compliance with production-restraint agreements. The once-certain 11th-hour agreement to adhere to whatever production-cutting agreements OPEC 2.0 came up with is now gone. And with it, the high-probability bet that, regardless of the tensions leading up to the Vienna meetings, a production-management agreement would be delivered, and shale-oil producers would live to fight another day. Chart 2Russia, KSA Foreign Exchange Reserves Russia, KSA Foreign Exchange Reserves Russia, KSA Foreign Exchange Reserves Whatever the case, Russia certainly was well-prepared when it delivered Friday’s supply shock. It has steadily built its foreign-exchange reserves since the price collapse begun in 2014, which now stand at $446 billion, up 45% from their nadir of 2015 (Chart 2). KSA’s foreign-exchange reserves, on the other hand, fell sharply in the wake of the 2014 – 2016 market-share war and have languished at lower levels since. Chart 3Russia, KSA Per-Capita Income Russia's Supply Shock To Oil Markets Russia's Supply Shock To Oil Markets Still, the Kingdom is not without stout resources. It’s gross national income per capita is ~ 2x that of Russia’s (Chart 3), and its days-forward import cover expressed in terms of days of foreign reserves is similarly stout (Chart 4). Chart 4Russia, KSA Import Cover Russia's Supply Shock To Oil Markets Russia's Supply Shock To Oil Markets The economies of both KSA and Russia are exquisitely linked to Brent oil prices (Chart 5). So tempting another market-share or price war is a strategy that could not be sustained by either country for an extended period of time. Chart 5Russia, KSA GDP vs Brent Prices Russia, KSA GDP vs Brent Prices Russia, KSA GDP vs Brent Prices Chart 6Russia, KSA GDP Highly Sensitive To Brent Prices Russia, KSA GDP Highly Sensitive To Brent Prices Russia, KSA GDP Highly Sensitive To Brent Prices The End Of OPEC 2.0? Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Oil markets will gnaw on Friday’s breakdown in Vienna, sorting out the signals that were missed in Russian messaging, and figuring out what happens next. Neither Russia nor KSA have the resources to wage an indefinite war of attrition with US shale producers. Both are highly dependent on oil revenues to sustain their economies (Chart 6). Of the two, Russia’s economy is more sensitive to Brent oil prices than KSA’s, as it markets more of its output in trading markets. Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Russia’s $50/bbl fiscal breakeven price vs. KSA’s $84/bbl price might give Russia more staying power in the short run, but with per-capita income at roughly half that of Saudi citizens, it will not want to revisit the dire days of 2014-16 when its economy last suffered through an oil-price collapse.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com  

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