Middle East & North Africa

Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Libya's Resurgence Clobbers Benchmark Prices Libya's Resurgence Clobbers Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege G19 G19 The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq G19 G19 The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria G19 G19 Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey G19 G19 Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.

Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High U.S. Refinery Runs And Exports Remain High U.S. Refinery Runs And Exports Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 OPEC's Oil Inventory Shift Winding Down OPEC's Oil Inventory Shift Winding Down Summary of Trades Closed in 2016

Highlights Odds the leaders of the OPEC 2.0 petro-states will be forced to back up last month's "whatever it takes" declaration - perhaps deepening and extending the 1.8mm b/d production cuts agreed at the end of last year - are not yet overwhelming. All the same, they will continue to increase, if markets do not see sustained draws in visible storage. Our updated supply-demand balances indicate global crude inventories will continue to draw, and that these draws will accelerate. This will keep global storage levels on track to normalize later this year or in 1Q18. We continue to expect Brent to trade to $60/bbl by December, with WTI ~ $2/bbl under that. Energy: Overweight. Our low-risk call spread initiated last week - long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls - is down 18.9%, following continued selling. We are adding to the position with the same Dec/17 strikes in Brent at tonight's close. These are strategic positions. Base Metals: Neutral. SHFE copper inventories fell on the back of increased demand for collateral to support financing deals in China. Tightening credit conditions are beginning to bite as the government pushes deleveraging policies, according to Metal Bulletin. Precious Metals: Neutral. We remain long gold, despite the hawkish rhetoric being thrown around by Fed officials, particularly William Dudley, head of the NY Fed. Our long gold portfolio hedge is up 1.1% since it was put on May 4, 2017. Ags/Softs: Underweight. Chicago and KC winter wheat remain bid, as concerns over drought-induced damage to the crop continue to weigh on markets. Feature Chart of the WeekUpdated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Insomuch as such things can ever be "official," crude oil officially entered a bear market - down 20% or more from recent highs - with the unexpected arrival of WTI futures below the lower end of our long-time $45-to-$65/bbl trading range this week.1 The proximate causes of this turn of events are persistently sticky inventory levels - most visible in the high-frequency data from the U.S. - and growing fears increasing Libyan and U.S. shale-oil production will undermine OPEC 2.0's 1.8mm b/d production cuts. We are hard-pressed to see the case for such fears, even though the market is consistently trading in a manner that is more aligned with supply cuts being far less than advertised by OPEC 2.0, or demand slowing considerably more than any agency or data service has yet picked up on. We will never be able to confirm sovereign hedging - e.g., Mexico or Iraq hedging oil-production revenues - until after the fact. However, this cannot be dismissed out of hand. Based on our latest supply-demand analysis, OPEC 2.0 - the coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia - will have removed some 1.4mm b/d of production on average from the market between January 2017 and end-March 2018 vs. peak production in November of last year (Chart of the Week). This will be diluted somewhat by the Libyan and U.S. production gains, but this increased production will not be sufficient to counter the OPEC 2.0 cuts entirely. Global Oil Supply Contracting Sharply Chart 2OECD Storage Draws On Track OECD Storage Draws On Track OECD Storage Draws On Track Against peak production in November 2016, we see just over 1.2mm b/d of crude oil production being cut by OPEC between January and end-March-2018.2 Throw in another 200 - 300k b/d or so from the non-OPEC members of the OPEC 2.0 coalition - mostly Russia - and we get to 1.4 to 1.5mm b/d of production taken off the market in the Jan/17 - Mar/18, interval in our modeling. This will leave the highly visible OECD storage levels being targeted by OPEC 2.0 at ~ 2.70 billion barrels by the end of the year, or some time close to the start of next year (Chart 2). In our modeling, we do not agree with the implied 1.9mm b/d of production cuts that follow from the reported OPEC 2.0 compliance statistics in the press. These reports indicate OPEC 2.0 coalition members are at 106% compliance. This is remarkably high, even if reports of this compliance rely on anonymous sources speaking to reporters following the coalition's technical committee meeting in Vienna earlier this week.3 If the production discipline attested to is true, we will raise our estimate of how quickly inventories will draw this year, and lower our expected global inventory levels for the end of March 2018. As for U.S. crude production, while we do have Dec/17 production 1.1mm b/d over Dec/16, we expect America's contribution to yoy global production growth to be only ~ 340k b/d on average over the course of 2017. The U.S. gains will be driven by shale-oil production, which we expect to grow ~ 410k b/d to 5.2mm b/d this year (Chart 3). Libya's production recently surged to 900k b/d, according to press reports, but, so far this year, it is averaging just under 700k b/d (Chart 4). This is slightly higher than the level we've been modeling in our balances for this year. The 300k b/d yoy increase in Libya's production is impressive, but it does not overwhelm OPEC 2.0's cuts. Even if Libyan production were to average 1mm b/d in 2H17, its net contribution to global production this year would be ~ 840k b/d, an increase of ~ 400k b/d over 2016's levels. We also note that as production and revenue increase the likelihood of renewed violence in Libya also increases.4 Chart 3U.S. Shale-Oil##BR##Growth Could Slow U.S. Shale-Oil Growth Could Slow U.S. Shale-Oil Growth Could Slow Chart 4Libya's Recover Is Impressive,##BR##But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Between them, combined growth in U.S. and Libyan production looks like it will be a touch under 650k b/d yoy (on average). Meanwhile, OPEC 2.0's production cuts - assessed against peak output for 2016 - are on track to exceed targets set at the outset of the agreement last December. Net, on a yoy basis, we expect to register inventory draws of close to 900k b/d this year. This should lead to cumulative draws in global storage levels of at least 400mm bbls by end-March. Demand Remains Strong The EIA revised its liquids demand estimates in its most recent Short-term Energy Outlook (STEO), and now has 2015 global consumption up 300k b/d from previous estimates at 95.4mm b/d, and 2016 consumption up 180k b/d at 96.9mm b/d. Our expected growth in global demand for this year and next is in line with the EIA's average estimate of ~ 1.6mm b/d, which will put 2017 demand at 98.5mm b/d and 2018 at 100.1mm b/d, respectively. Growth this year and next is expected to be slightly higher than last year's level (Chart 5). Once again, we expect EM demand - proxied by non-OECD liquids consumption - to lead global growth this year and next. Concern over apparent slowing in U.S. refined-product demand - particularly gasoline - is, we believe, overdone. Growth this year is being compared to stellar rates last year (Chart 6), which still leaves the level of demand above 20mm b/d. Growth in gasoline demand specifically also has slowed, but, again, this is occurring in a market where the level of demand remains high, pushing toward 10mm b/d, which is a mere 2.5% below record demand set in August of last year (Chart 7). Chart 5Expect Global Demand##BR##To Remain Stout Expect Global Demand to Remain Stout Expect Global Demand to Remain Stout Chart 6The Level Of U.S. Product##BR##Demand Remains High The Level Of U.S. Product Demand Remains High The Level Of U.S. Product Demand Remains High Chart 7U.S. Gasoline Demand##BR##Also Remains Stout U.S. Gasoline Demand Also Remains Stout U.S. Gasoline Demand Also Remains Stout 2018 Getting Foggy Uncertainty surrounding the evolution of the oil market next year is growing. The EIA believes markets will tighten in 3Q17, but then get progressively looser going into 2018, apparently disregarding OPEC 2.0's efforts to date, and the high likelihood - in our view - that the coalition will maintain production discipline for the most part (Chart 8). Combined with the robust demand growth BCA and the EIA expect, we get a fairly balanced market next year (Chart of the Week). U.S. shale-oil production, once again, will dictate just how tight markets become next year. Presently, we have average 2018 U.S. shale production in the Big 4 basins - Bakken, Eagle Ford, Niobrara, and the Permian - coming in more than 1mm b/d over 2017 levels. However, the recent sell-off that took WTI into bear-market territory this week could have a profound effect on shale-drilling activity next year, if it persists. Recent econometric work we've done confirms rig counts in the Big 4 plays are highly sensitive to WTI price. A prolonged stretch below $45/bbl could reduce rig counts by as much as 40% next year, especially if private-equity-backed companies cut spending. With hedging levels down, this is not a trivial concern (Chart 9).5 If prices stay depressed for any length of time for whatever reason - an outcome we do not expect - U.S. shale drilling activity could once again plummet. Chart 8EIA Fades OPEC 2.0's Resolve,##BR##BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not Chart 9Weak Prices Could##BR##Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts In addition, low prices also increase fiscal stress levels in petro-state revenues. This is of particular concern for KSA and Russia. The former is almost wholly dependent on oil revenues to fund its budgets, and will be looking to IPO its state-owned oil company, Aramco, next year. The latter is heavily dependent on oil and gas revenues, and will be holding an election in mid-March, just ahead of the expiry of the OPEC 2.0 production-cut extensions. The benchmark Russian crude, Urals, trades ~ $1.00 to $1.25/bbl under Brent, and any prolonged excursion into the low-$40s by Brent would stress the state's revenues. This is not our base case, but it is worthwhile considering. This mutual dependence on oil prices to support their respective economies is what compels strong compliance with the OPEC 2.0 production deal. Bottom Line: Our updated balances modeling continues to support our view global oil storage will draw, with OECD inventories likely falling below five-year average levels by year-end or early next year. Self-reported compliance with OPEC 2.0's production-cutting agreement exceeds 100%, implying the coalition is tracking to a 1.9mm b/d reduction in crude-oil output at present. On the demand side, even after upward revisions to 2015 and 2016 demand figures by the U.S. EIA, liquids consumption still is expected to grow on average ~ 1.6mm b/d this year and next. Cuts in production by OPEC 2.0 this year are more than sufficient to offset increases in Libyan and U.S. production, leaving overall production below consumption globally by close to 900k b/d, which will ensure inventories draw. For next year, after storage draws have abated, we expect supply and demand to be roughly balanced. We continue to expect Brent prices to trade to $60/bbl by year-end, and, on that basis, are recommending a long Dec/17 $50/bbl Brent call vs. short a Dec/17 $55/bbl Brent call. Longer term, our central tendency for price remains $55/bbl, with a range of $45 to $65/bbl prevailing most of the time. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We are using the front-line WTI futures contract, which hit its recent high on Feb. 23 at $54.45/bbl (last price) and traded down to $43.23/bbl on June 20, registering a drop of 20.6%. First-line Brent has yet to fall more than 20% from its recent high of $57.10/bbl on Jan. 6 to $46.02/bbl on June 20 (a 19.4% drop). 2 Measuring against peak production - rather than the October levels referenced by OPEC 2.0 coalition members - is an inherently more conservative way of assessing the effect of the production cuts. 3 Please see "OPEC, non-OPEC compliance with oil cuts hits highest in May: source," published by reuters.com on June 21, 2017. 4 An uptick in Nigerian production also is cited by some observers as a cause for concern vis-à-vis slowing the normalization of global storage levels. However, as Chart 4 illustrates, that country's production remains on either side of 1.5mm b/d, more than 500k b/d below recent steady-state levels. 5 Looking at rig-count sensitivity to prices and rig productivity, we find a 1% increase (decrease) in nearby prices translates into a roughly 70bp increase (decrease) in rig counts, while a 1% increase (decrease) in lagged, deferred WTI futures prices (out to 3 years forward) translates into a 2% change in the same direction. The R2 coefficients of determination for the models we estimated average ~ 0.95. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Time For "Whatever It Takes" In Oil? Time For "Whatever It Takes" In Oil?

Highlights This week, Commodity & Energy Strategy is publishing a joint report with our colleagues at BCA's Energy Sector Strategy. Driven by the leadership of the Kingdom of Saudi Arabia (KSA) and Russia, OPEC 2.0 formalized the well-telegraphed decision to extend its production cuts for another nine months, carrying the cuts through the seasonally weak demand period of Q1 2018. The extension is will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating) setting in later this year. Energy: Overweight. We are getting long Dec/17 WTI vs. short Dec/18 WTI at tonight's close, given our expectation OPEC 2.0's extension of production cuts, and lower exports by KSA to the U.S., will cause the U.S. crude-oil benchmark to backwardate. Base Metals: Neutral. Despite "catastrophic flooding" in March, 1Q17 copper output in Peru grew almost 10% yoy to close to 564k MT, according to Metal Bulletin. This occurred despite strikes at Freeport-McMoRan's Cerro Verde mine, where production was down 20.5% yoy in March. Precious Metals: Neutral. Our strategic gold portfolio hedge is up 2.61% since it was initiated on May 4, 2017. Ags/Softs: Underweight. The USDA's Crop Progress report indicates plantings are close to five-year averages, despite harsh weather in some regions. We remain bearish. Feature Chart 1Real OPEC Cuts Of ~1.0 MMb/d##BR##For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days OPEC 2.0's drive to normalize inventories by early 2018 will be accomplished with last week's agreement to extend current production cuts through March 2018. In total, OPEC has agreed to remove over 1 MMb/d of producible OPEC oil from the market for over 400 days (Chart 1), supplemented by an additional 200,000-300,000 b/d of voluntary restrictions of non-OPEC oil through Q3 2017 at least, perhaps longer if Russia can resist the temptation to cheat after oil prices start to respond. Many of the participants in the cut, from both OPEC and non-OPEC, are not actually reducing output voluntarily, but have had quotas set for them that merely reflect the natural decline of their productive capacity, limitations that will be even more pronounced in H2 2017 than in H1 2017. With production restricted by the OPEC 2.0 cuts, global demand growth will outpace supply expansion by another wide margin in 2017, just as it did last year (Chart 2). As shown in Chart 3, steady demand expansion and the slowdown in supply growth allowed oil markets to move from oversupplied in 2015 to balanced during 2016; demand growth will increasingly outpace production growth in 2017, creating sharp inventory draws (Chart 4) that bring stocks down to normalized levels by the end of 2017 (Chart 5). Chart 2 Chart 3Production Cuts And Demand##BR##Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Chart 4Higher Global Inventory##BR##Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Chart 5OECD Inventories To Be##BR##Reduced To Normal OECD Inventories To Be Reduced To Normal OECD Inventories To Be Reduced To Normal The extension of the cut through Q1 2018 will help prevent a premature refilling of inventories during the seasonally weak first quarter next year. The return of OPEC 2.0's production to full capacity in Q2 2018 will drive total production growth above total demand growth for 2018, returning oil markets from deliberately undersupplied during 2017 to roughly balanced markets in 2018, with stable inventory levels that are below the rolling five-year average. 2018 inventory levels will still be 5-10% above the average from 2010-2014, in line with the ~7% demand growth between 2014 and 2018. Compliance Assessment: Only A Few Players Matter In OPEC 2.0 OPEC's compliance with the cuts announced in November 2016 has been quite good, with KSA anchoring the cuts by surpassing its 468,000 b/d cut commitment. In addition to KSA, OPEC is getting strong voluntary compliance from the other Middle Eastern producers (except Iraq), while producers outside the Middle East lack the ability to meaningfully exceed their quotas in any case. OPEC's Core Four Remain Solid. The core of the OPEC 2.0 agreement has delivered strong compliance with their announced cuts. Within OPEC, the core Middle East countries Kingdom of Saudi Arabia, Kuwait, Qatar, and UAE have delivered over 100% compliance of their 800,000 b/d agreed-to cuts. We expect these countries to continue to show strong solidarity with the voluntary cuts through March 2018 (Chart 6). Iraq And Iran Make Small/No Sacrifices. Iraq and Iran were not officially excluded from cuts, but they were not asked to make significant sacrifices either. We estimate Iran has little-to-no capability to materially raise production in 2017 anyhow, and KSA is leaning on Iraq to better comply with its small cuts. Chart 7 shows our projections for Iran and Iraq production levels through 2018. Chart 6KSA, Kuwait, Qatar & UAE Carrying##BR##The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts Chart 7Iran And Iraq Production##BR##Near Full Capacity Iran And Iraq Production Near Full Capacity Iran And Iraq Production Near Full Capacity Iraq surged its production above 4.6 MMb/d for two months between OPEC's September 2016 indication that a cut would be coming and the late-November formalization of the cut. Iraq's quota of 4.35 MMb/d is nominally a 210,000 b/d cut from its surged November reference level, but is essentially equal to the country's production for the first nine months of 2016, implying not much of a real cut. Despite the low level of required sacrifice, Iraq has produced about 100,000 b/d above its quota so far in 2017 at a level we estimate is near/at its capacity anyway. KSA and others in OPEC are not pleased with Iraq's overproduction and have pressured it to comply with the agreement. We forecast Iraq will continue producing at 4.45 MMb/d. Iran's quota represented an allowed increase in production, reflecting the country's continued recovery from years of economic sanctions. We project Iran will continue to slowly expand production, but since the country is almost back up to pre-sanction levels, there is little remaining easily-achievable recovery potential. South American & African OPEC Capacity Eroding On Its Own. Chart 8 clearly shows how production levels in Venezuela, Angola and Algeria started to deteriorate well before OPEC formalized its production cuts, with productive capacity eroded by lack of reinvestment rather than voluntary restrictions. The quotas for these three countries (as well as for small producers Ecuador and Gabon) are counted as ~258,000 b/d of "cuts" in OPEC's agreement, but they merely represent the declines in production that should be expected anyway. With capacity deteriorating and no ability to ramp up anyway, these OPEC nations will deliver improving "compliance" (i.e. under-producing their quotas) in H2 2017, and are happy to have the higher oil prices created by the extension of production cuts by the core producers within OPEC 2.0. Libya and Nigeria Exclusions Unlikely To Result In Big Production Gains. Both Libyan and Nigerian production levels have been constrained by above-ground interference. Libyan production has been held below 1.0 MMb/d since 2013 principally by chronic factional fighting for control of export terminals, while Nigerian production--on a steady natural decline since 2010--has been further limited by militants sabotaging pipelines in 2016-2017. While each country has ebbs and flows to the amount of oil they are able to produce, we view both countries' problems as persistent risks that will continue to keep production below full potential (Chart 9). Chart 8 Chart 9Libya And Nigeria Production Could Go Higher##BR##Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances For Nigeria, we estimate the country's crude productive capacity has eroded to about 1.8 MMb/d from 2.0 MMb/d five years ago due to aging fields and a substantial reduction in drilling (offshore drilling is down ~70% since 2013). Within another year or two, this capacity will dwindle to 1.7 MMb/d or below. On top of this natural decline, we have projected continued sabotage / militant obstruction will limit actual crude output to an average of 1.55 MMb/d for the foreseeable future. Libyan production averaged just 420,000 b/d for 2014-2016, a far cry from the 1.65 MMb/d produced prior to the 2011 Libyan Revolution that ousted strongman Muammar Gaddafi. Since Gaddafi was deposed and executed, factional strife and conflict has persisted. Each faction wants control over oil export revenues and, just as importantly, wants to deny the opposition those revenues, resulting in a chronic state of conflict that has limited production and exports. If a détente were reached, we expect Libyan oil production could quickly rise to about 1.0 MMb/d of production within six months; however, we put the odds of a sustainable détente at less than 30%. As such, we forecast Libyan crude production will continue to struggle, averaging about 600,000 b/d in 2017-2018. Non-OPEC Cuts Hang On Russia In November, ten non-OPEC countries nominally agreed to restrict production by a total of 558,000 b/d, but Russia--with 300,000 b/d of pledged cuts--is the big fish that KSA and OPEC are relying on. Mexico's (and several others') agreements are window dressing, reframing natural production declines as voluntary action to rebalance markets. Through H1 2017, Russia has delivered on about 60-70% of its cut agreement, with compliance growing in Q2 (near 100%) versus Q1 (under 50%). From the start, Russia indicated it would require some time to work through the physical technicalities of lowering production to its committed levels, implying that now that production has been lowered, Russia could deliver greater compliance over H2 2017 than it delivered in H1 2017. We are a little more skeptical, expecting some weakening in Russia's compliance by Q4, especially if the extended cuts deliver the expected results of bringing down OECD inventories and lifting prices. Russia surprised us with stronger-than-expected production during 2016. Some of the outperformance was clearly due to a lower currency and improved shale-like drilling results in Western Siberia, but it is unclear whether producers also pulled too hard on their fields to compensate for lower prices, and are using the OPEC 2.0 cut as a way to rest their fields a bit. We have estimated Russian production returning to 11.3 MMb/d by Q4 2017 (50,000 b/d higher than 2016 average production) and holding there through 2018 (Chart 10), but actual volumes could deviate from this level by as much as 100,000-200,000 b/d. Mexico, the second largest non-OPEC "cutter," is in a position similar to Angola, Algeria, and Venezuela. Mexican production has been falling for years (Chart 11), and the nation's pledge to produce 100,000 b/d less in H1 2017 than in Q4 2016 is merely a reflection of this involuntary decline. As it has happened, Mexican production has declined by only ~60,000 b/d below its official reference level, but continues to deteriorate, promising higher "compliance" with their production pledge in H2 2017. Chart 10Russia Expected##BR##To Cheat By Q4 Russia Expected To Cheat By Q4 Russia Expected To Cheat By Q4 Chart 11Mexican Production Deterioration##BR##Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Kazakhstan and Azerbaijan are not complying with any cuts, and we don't expect them to. Despite modest pledges of 55,000 b/d cuts combined, the two countries have produced ~80,000 b/d more during H1 2017 than they did in November 2016. We don't expect any voluntary contributions from these nations in the cut extension, but Azerbaijan's production is expected to wane naturally (Chart 12). While contributing only a small cut of 45,000 b/d, Oman has diligently adhered to its promised cuts, supporting its OPEC and Gulf Cooperation Council (GCC) neighbors. We expect Oman's excellent compliance will be faithfully continued through the nine-month extension (Chart 13). Chart 12Kazakhstan And Azerbaijan Not Expected##BR##To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Chart 13Oman Has Faithfully Complied##BR##With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date OPEC Extension Will Continue To Support Increased Shale Drilling Energy Sector Strategy believed OPEC's original cut announced in November 2016 was a strategic mistake for the cartel, as it would accelerate the production recovery from U.S. shales in return for "only" six months of modestly-higher OPEC revenue. As we cautioned at the time, the promise of an OPEC-supported price floor was foolish for them to make; instead, OPEC should have let the risk of low prices continue to restrain shale and non-Persian Gulf investment, allowing oil markets to rebalance more naturally. However, despite our unfavorable opinion of the strategic value of the original cut, since the cut has not delivered the type of OECD inventory reductions expected (seemingly due to a larger-than-expected transfer of non-OECD inventories into OECD storage), we view the extension of the cut as a necessary, and logical, next step. OPEC 2.0's November 2016 cut agreement signaled to the world that OPEC (and Russia) would abandon KSA's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers (and supporting capital markets) to pour money into vastly increased drilling programs. Now that the shale investment genie has already been let out of the bottle, extending the cuts is unlikely to have nearly the same stimulative impact on shale spending as the original paradigm-changing cut created. The shale drilling and production response has been even greater than we estimated six months ago, and surely greater than OPEC's expectations. The current horizontal (& directional) oil rig count of 657 rigs is nearly twice the 2016 average of 356 rigs, is 60% higher than the level of November 2016 (immediately before the cut announcement), and is still rising at a rate of 25-30 rigs per month (Chart 14). The momentum of these expenditures will carry U.S. production higher through YE 2017 even if oil prices were allowed to crash today. Immediately following OPEC's cut, we estimated 2017 U.S. onshore production could increase by 100,000 - 200,000 b/d over levels estimated prior to the cut, back-end weighted to H2 2017, with a greater 300,000-400,000 b/d uplift to 2018 production levels. Drilling activity has roared back so much faster than we had expected, indicative of the flooding of the industry with external capital, that we have raised our 2017 production estimate by 500,000 b/d over our December estimate, and raised our 2018 production growth estimate to 1.0 MMb/d (Chart 15). Chart 14Rig Count Recovery Dominated##BR##By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Chart 15Onshore U.S. Production##BR##Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Other Guys' Decline Requires Greater Growth From OPEC, Shales, And Russia We've written before about "the Other Guys' in the oil market, defined as all producers outside of the expanding triumvirate of 1) U.S. shales, 2) Russia, and 3) Middle East OPEC. While the growers receive the vast majority of investors' focus, the Other Guys comprise nearly half of global production and have struggled to keep production flat over the past several years (Chart 16). Chart 17 shows the largest offshore basins in the world, which should suffer accelerated declines in 2019-2020 (and likely beyond) as the cumulative effects of spending constraints during 2015-2018 (and likely beyond) result in an insufficient level of projects coming online. This outlook requires increasing growth from OPEC, Russia and/or the shales to offset the shrinkage of the Other Guys and simultaneously meet continued demand growth. Chart 16The Other Guys' Production##BR##Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat Chart 17 Risks To Rebalancing Our expectation global oil inventories will draw, and that prices will, as a result, migrate toward $60/bbl by year-end is premised on the continued observance of production discipline by OPEC 2.0. GCC OPEC - KSA, Kuwait, Qatar, and the UAE - Russia and Oman are expected to observe their pledged output reduction, but we are modeling some compliance "fatigue" all the same. Even so, this will not prevent visible OECD oil inventories from falling to their five-year average levels by year-end or early next year. Obviously, none of this can be taken for granted. We have consistently highlighted the upside and downside risks to our longer term central tendency of $55/bbl for Brent crude, with an expected trading range of $45 to $65/bbl out to 2020. Below, we reprise these concerns and our thoughts concerning OPEC 2.0's future. Major Upside Risks Chief among the upside risks remains a sudden loss of supply from a critical producer and exporter like Venezuela or Nigeria, which, respectively, we expect will account for 1.9 and 1.5 MMb/d of production over the 2017-18 period. Losing either of these exporters would sharply rally prices above $65/bbl as markets adjusted and brought new supply on line. Other states - notably Algeria and Iraq - highlight the risk of sustained production losses due to a combination of internal strife and lack of FDI due to civil unrest. Algeria already appears to have entered into a declining production phase, while Iraq - despite its enormous potential - remains dogged by persistent internal conflict. We are modeling a sustained, slow decline in Algeria's output this year and next, which takes its output from 1.1 MMb/d in 2015 down to slightly more than 1 MMb/d on average this year and next. For Iraq, where we expect a flattening of production at ~ 4.4 MMb/d this year and a slight uptick to ~ 4.45 MMb/d in 2018, continued violence arising from dispersed terrorism in that country in the wake of a defeat of ISIS as an organized force, will remain an ongoing threat to production. Longer term - i.e., beyond 2018 - we remain concerned the massive $1-trillion-plus cutbacks in capex for projects that would have come online between 2015 and 2020 brought on by the oil-price collapse in 2015-16 will force prices higher to encourage the development of new supplies. The practical implication of this is some 7 MMb/d of oil-equivalent production the market will need, as this decade winds down, will have to be supplied by U.S. shales, Gulf OPEC and Russia, as noted above. Big, long-lead-time deep-water projects requiring years to develop cannot be brought on fast enough to make up for supply that, for whatever reason, fails to materialize from these sources. In addition, as shales account for more of global oil supplies and "The Other Guys" continue to lose production to higher depletion rates, more and more shale - in the U.S. and, perhaps, Russia - and conventional Persian Gulf production will have to be brought on line simply to make up for accelerating declines. This evolution of the supply side is significantly different from what oil and capital markets have been accustomed to in previous cycles. Because of this, these markets do not have much historical experience on which to base their expectations vis-à-vis global supply adjustment and the capacity these sources of supply have for meeting increasing demand and depletion rates. Lower-Cost Production, Demand Worries On The Downside Downside risks, in our estimation, are dominated by higher production risks. Here, we believe the U.S. shales and Russia are the principal risk factors, as the oil industry in both states is, to varying degrees, privately held. Because firms in these states answer to shareholders, it must be assumed they will operate for the benefit of these interests. So, if their marginal costs are less than the market-clearing price of oil, we can expect them to increase production up to the point at which marginal cost is equal to marginal revenue. The very real possibility firms in these countries move the market-clearing price to their marginal cost level cannot be overlooked. For the U.S., this level is below $53/bbl or so for shale producers. For Russian producers, this level likely is lower, given their production costs are largely incurred in rubles, and revenues on sales into the global market are realized in USD; however, given the variability of the ruble, this cost likely is a moving target. While a sharp increase in unconventional production presently not foreseen either in the U.S. or Russian shales will remain a downside price risk, an increase in conventional output - chiefly in Libya - remains possible. As discussed above, we believe this is a low risk to prices at present; however, if an accommodation with insurgent forces in the country can be achieved, output in Libya could double from the 600k b/d of production we estimate for this year and next. We reiterate this is a low-risk probability (less than 25%), but, in the event, would prove to be significant additions to global balances over the short term requiring a response from OPEC 2.0 to keep Brent prices above $50/bbl. Also on the downside, an unexpected drop in demand remains at the top of many lists. This is a near-continual worry for markets, which can be occasioned by fears of weakening EM oil-demand growth from, e.g., a hard landing in China, or slower-than-expected growth in India. These are the two most important states in the world in terms of oil-demand growth, accounting for more than one-third of global growth this year and next. We do not expect either to meaningfully slow; however, we continue to monitor growth in both closely.1 In addition, we continue to expect robust global oil-demand growth, averaging 1.56 MMb/d y/y growth in 2017 and 2018. This compares with 1.6 MMb/d growth last year. OPEC 2.0's Next Move Knowing the OPEC 2.0 production cuts will be extended to March 2018 does not give markets any direction for what to expect after this extension expires. Once the deal expires, we expect production to continue to increase from the U.S. shales, and for the key OPEC states to resume pre-cut production levels. Along with continued growth from Russia, this will be necessary to meet growing demand and increasing depletion rates from U.S. shales and "The Other Guys." Yet to be determined is whether OPEC 2.0 needs to remain in place after global inventories return to long-term average levels, or whether its formation and joint efforts were a one-off that markets will not require in the future. Over the short term immediately following the expiration of the production-cutting deal next year, OPEC 2.0 may have to find a way to manage its production to accommodate U.S. shales without imperiling their own revenues. This would require a strategy that keeps the front of the WTI and Brent forward curves at or below $60/bbl - KSA's fiscal breakeven price and $20/bbl above Russia's budget price - and the back of the curve backwardated, in order to exert some control over the rate at which shale rigs return to the field.2 As we've mentioned in the past, we have no doubt the principal negotiators in OPEC 2.0 continue to discuss this. Toward the end of this decade, such concerns might be moot, if growing demand and accelerating decline curves require production from all sources be stepped up. Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see the May 18, 2017, issue of BCA Research's Commodity & Energy Strategy article entitled "Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts," in which we discuss the outlook for China's and India's growth. Together, these states account for more than 570k b/d of the 1.56 MMb/d growth we expect this year and next. The article is available at ces.bcaresearch.com. 2 A backwardated forward curve is characterized by prompt prices exceeding deferred prices. Our research indicates a backwardated forward curve results in fewer rigs returning to the field than a flat or positively sloped forward curve. We explored this strategy in depth in the April 6, 2017, issue of BCA Research's Commodity & Energy Strategy, in an article entitled "The Game's Afoot In Oil, But Which One?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories

Highlights Unsurprisingly, OPEC 2.0's leadership agreed on the need to extend the coalition's 1.8mm b/d production-cutting agreement to end-March 2018. Leaders of the coalition - the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia - will recommend as much when the coalition meets next week in Vienna. Meanwhile, sequential production in U.S. shales during the first four months of the year is up just under 100k b/d, based on the EIA's latest estimates. This was led by surging Permian production. We expect shale-oil production growth to continue, and are revising our year-end 2017 light-tight-oil (LTO) production estimate for the four main shale-oil plays to 5.66mm b/d, up from our earlier assessment of 5.39mm b/d. We also are lifting our year-end 2018 estimate of shale production to 6.64mm b/d. This means December-to-December LTO production will increase ~ 1mm b/d by Dec/17 and by another ~1mm b/d by Dec/18. Energy: Overweight. As of last Thursday's close, we are long Dec/17 Brent $65/bbl calls vs. $45/bbl puts at -$1.16/bbl, and long Dec/17 vs. Dec/18 Brent at -$0.21/bbl. These positions were up 16.4% and 242.9%, respectively. Base Metals: Neutral. The physical deficit in zinc appears to be widening slightly, based on supply-demand estimates from the International Zinc Study Group. Usage totaled 2.282mm MT in Jan-Feb 2017 vs. refined production of 2.28mm MT. For 2016, usage was 13.89mm MT vs. supply of 12.67mm MT. Precious Metals: Neutral. Metal refiner Johnson Matthey expects a 790k oz. palladium deficit this year, up from a little over 160k oz. last year. Separately, the World Platinum Investment Council expects platinum supply to fall 2% this year to 7.33mm oz. Ags/Softs: Underweight. The USDA reported corn planting stood at 71% for the week ended May 14, vs. an average of 70% over the 2012 - 16 period. We remain bearish. Feature The determination of the leaders of OPEC 2.0 to clear the storage overhang could not have been made more clear, following comments earlier this week from KSA's and Russia's energy ministers the coalition's 1.8mm b/d production-cutting agreement would be extended to end-March 2018. This is three months beyond earlier speculation the deal would be extended to year-end 2017. Chart of the WeekBalances Chart Balances Chart Balances Chart Still, when dealing with a political organization of any sort - and OPEC 2.0 is nothing if not a political entity - our bias is to assume less-than-complete compliance with production cuts, and an earlier return to pre-agreement production levels than proffered by the leadership of the coalition. Hence, in our updated balances model (Chart of the Week), in addition to assuming higher U.S. production out of the shales, we have Russian production returning to a level just below 11.30mm b/d by October 2017, up roughly 150k b/d from the 11.15mm b/d we assume they'll be producing until the end of September. We also assume Iraq's production will move up to 4.45mm b/d (up 50k b/d) beginning in January, and that Iran will be steadily, yet slowly, increasing production by 5-10k b/d per month beginning this month. The only assumption we're making for staunch compliance to the OPEC 2.0 accord after our assumed extension to year-end 2017 at next week's Vienna meeting is that KSA and its GCC allies - Kuwait, Qatar, and the UAE - will continue to abide by their voluntary production cuts. This group has maintained solidarity on past production-management deals, we expect them to do so again in this round. Of course, the other members of the coalition could vote against this proposal next week, and instead decide to end the production deal in June under its original conditions. Or, they could agree to extend the deal, but only until year-end 2017. Regardless of whichever policy decisions are agreed to during next week's meeting, come November, when OPEC meets again, they might tweak/change those agreements to reflect their updated outlook at that time. Given this uncertainty, we believe the assumptions we've made are realistic, but we will be monitoring conditions closely so that we can modify our view quickly. Shale Coming On Strong Part of OPEC 2.0's desire to extend its deal likely is the improvement in the performance of shale-oil producers in the U.S. In its latest Drilling Productivity Report (DPR), the EIA noted that sequential production in the first four months of the year has risen ~ 100k b/d per month in the U.S. shales. This surge was led by higher Permian production, which accounted for ~ three-quarters of the increased output (Chart 2). Interestingly, rig-weighted production per rig dropped for the first time in April 2017, but it still is high at 732 b/d, down from 735 b/d in March. We will be watching this closely to see if it is the beginning of a trend of stagnating productivity amid a rapid expansion of industry activity. The resurgence in the shales can be seen in the year-on-year (yoy) growth in total production in the seven basins the EIA tracks, which broke back above 5.0mm b/d in February and crossed into positive yoy growth in March (Chart 3). Net, we expect 2017 global supply to average 97.65mm b/d, for an increase 610k b/d this year, and for demand to average 98.3mm b/d, for an increase of 1.5mm b/d. EM demand, which we proxy using non-OECD consumption, accounts for 1.27mm b/d of this year's global demand growth, and continues to lead overall growth in oil demand (Chart 4, panel 2). Of this, China and India account for 350k and 210k b/d, respectively, of the growth in EM demand. Chart 2Permian Basin Leads##br##U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Chart 3Year-On-Year LTO Production##br##Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Chart 4EM Growth Continues##br##To Lead Global Demand EM Growth Continues To Lead Global Demand EM Growth Continues To Lead Global Demand China, India Lead EM Oil Consumption Non-OECD countries represent more than 50% of global oil consumption. Indeed, within the ~1.6mm b/d global oil demand growth we expect for 2017 and again in 2018, slightly more than 87% of it comes from EM economies. Table 1 below shows the average yoy growth by year for different regions - DM and EM - and countries from 2011 to 2018. Over this period, almost all of the world's oil-demand growth comes from non-OECD countries. From 2011-2018, the average p.a. demand growth for non-OECD countries is 2.79%, while for OECD countries it is only 0.12%. Table 1EM Leads Oil-Demand Growth Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Looking more closely at the composition of the EM economies, we see that, on average, between 2010 and 2018 Chinese oil consumption accounts for 24% of non-OECD demand, while the Indian oil consumption represents 8.3%, for a combined total of 32.37% of non-OECD average consumption. These two countries alone contributed on average to around 50% of the world oil consumption growth from 2010 to 2018. China has been the fastest-growing oil market in the world since the early 2000s. However, since 2015, when it emerged as an important growth market on the world stage, India's consumption has been increasing at a faster pace than China's. One of the reasons for this likely is the desire of the Chinese government to resume its pivot to a more service-oriented economy, which is less commodity-intensive than the export-oriented economy dominated by heavy industry. India, meanwhile, is looking to increase its manufacturing output, lifting it from the low-teens to 25% of GDP by 2022 under Prime Minister Narendra Modi's "Make in India" campaign. This change in the composition of global oil-demand growth is reducing demand for residual fuel oil and distillates. Indeed, IEA data continues to show a steady decline in yoy consumption for these two types of fuel in China, with residual fuel oil consumption down 26.5% yoy in 2016, and gasoil and diesel (distillates) consumption down close to 3% yoy. By contrast, gasoline consumption, is up more than 8% yoy along with jet fuel and kerosene. LPG demand (propane and butane, along with other light ends) and ethane demand (a petrochemical feedstock) is surging, up 24% in 2016, according to the IEA. In relative terms, China will remain the main driver of global oil consumption. At ~ 12.5mm b/d, China's oil demand is close to three times as high than India's. However, India likely will surpass China in terms of its contribution to global oil demand growth in coming years. A combination of structural and policy-driven factors points toward a possible sustainable growth path for Indian oil consumption for the coming years (oil consumption per capita is increasing, as is vehicle usage, particularly motorcycles (Chart 5); and, the government's desire to increase the share of the manufacturing to 25% of GDP by 2022 will boost oil demand growth as well). Chart 5India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring Recent studies assessing the "take-off" of an economy look at its per capita oil consumption in transportation, in particular, given that this sector accounts for more than half of the world's oil consumption (63% according to IEA Energy Statistics 2014). The theory boils down to the following: As income grows, a larger share of the population becomes vehicle owners. This is referred to as the "motorization" of an economy. In India, the transportation sector represents around 40% of total oil consumption.1 According to Sen and Sen (2016), the level of vehicle-ownership per capita is still low in India compared to other economies that have experienced similar take-offs. The government's targeted increase in manufacturing as a share of GDP to 25% under the "Make In India" program (from a current level of ~ 15%) would, according to the Sen and Sen (2016) formulation, lead to an increase in oil consumption. The "Make in India" campaign was launched in 2014 by Prime Minister Narendra Modi and aims to transform the country's manufacturing sector into a powerhouse for growth and employment. Other key objectives of this campaign include a target of 12-14% annual growth in the manufacturing sector, and the creation of 100 million new jobs by 2020 in the sector.2 In 2017Q1, India's liquid fuels consumption declined by 3% yoy. This decline was, for the most part, caused by the government's "demonetization" program, which was designed to streamline the economy and reduce rampant black-market transactions. The government chose to invalidate the 500- and the 1,000-rupee banknotes, the most-used currency denominations in the economy (around 86% of the total value of currency in circulation). This represented a huge shock to the average citizen, since it limited the purchasing power of a large part of the consumer economy for an extended period of time and impacted India's overall economic activity. Recent data show Indian oil and liquids consumption up 3% in April (yoy), and its money supply is almost back to its pre-demonetization levels, according to the EIA. This suggests economic activity and liquid-fuel consumption will get back to their previous levels. Bottom Line: We believe OPEC 2.0's deal will be extended at next week's Vienna meeting to March 2018. However, after September, we are expecting compliance to fall off meaningfully, leaving KSA and its allies as the only producers adhering to their voluntary cuts past year-end 2017. Even so, we expect the storage overhang to be worked off - mostly this year - but also into next. Even though U.S. shale production is surprising on the upside, the commitment of a majority of OPEC 2.0 to production cutbacks at least through September of this year will force the storage overhang to draw down by year end. KSA and its core allies will maintain production discipline to March 2018, which will keep storage from refilling too quickly during the seasonally weak consumption period in the first quarter next year. We continue to expect oil forward curves to backwardate by December 2017, and remain long Dec/17 Brent vs. short Dec/18 Brent. In addition, we remain long Dec/17 Brent $65/bbl calls vs. short Dec/17 Brent $45/bbl puts, expecting prices to rally toward $60/bbl by the time Brent delivers in December. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Sen, Amrita; Anupama Sen (2016), "India's Oil Demand: On the Verge of 'Take-Off'?". Oxford Institute for Energy Studies. 2 Some of the recent policies to enhance the manufacturing growth include: Government subsidies of up to 25% for specific manufacturing sub-sectors; area-based incentives to increase the manufacturing development in key regions; allowances for companies that invest a predetermined amount in new plant and machinery; deductions for additional wages paid to new regular employees; deductions for R&D expenditures; and other incentives aimed at promoting the manufacturing sector and improving the India's ease of doing business to attract foreign direct investments. Please see http://www.makeinindia.com/article/-/v/direct-foreign-investment-towards-india-s-growth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts

Highlight Once-ebullient oil markets are overwrought. Fears that an economic slowdown in China will spill over into EM - the engine of global commodity demand growth - along with a very weak 1Q17 U.S. GDP performance, will keep oil markets focused on downside risks to prices. On the supply side, high-frequency inventory data from the U.S. suggests visible OECD stocks remain high, seemingly impervious to OPEC 2.0's best efforts to drain them. Steadily rising U.S. shale output also weighs on prices. Markets appear to be looking right through the choreographed comments on production cuts from leaders of OPEC 2.0, which suggest these cuts will definitely be extended to year-end 2017, and possibly into 2018. We doubt the demand picture is anywhere close to a fundamental downshift, expecting, instead, continued robust demand. We also expect the extension of OPEC 2.0's production cutbacks to year-end 2017 to significantly drain storage, even as shale output continues to grow. If anything, recent market action has presented an opportunity re-establish length, and to position for backwardation toward year-end. Energy: Overweight. The stop-loss on our Dec/17 Brent $45/bbl puts vs. $65/bbl calls was elected May 4/17, leaving us with a loss of $1.54/bbl (-327.7%). We are reinstating the position as of tonight's close, anticipating Brent will reach $60/bbl by year-end. We also stopped out of our Dec/17 Brent long vs. Dec/18 Brent short on May 4/17, with a $0.50/bbl loss (-263.2%). We will re-establish this position as well basis tonight's close. Base Metals: Neutral. LME and COMEX stock builds are keeping copper under pressure, offsetting possible renewed labor unrest. This is keeping us neutral. Precious Metals: Neutral. We were made long spot gold at $1230.25/oz basis last Thursday's close as a hedge against inflation risk, and a possible equities correction. Ags/Softs: Underweight. USDA data indicate a favorable start to the grain planting season. We remain bearish. Feature Softer Chinese PMIs spooked commodity markets, coming as they did on the heels of a very visible and much-reported weakening of base metals and iron ore prices emanating from Chinese markets (Chart of the Week).1 Financial markets fear weaker Chinese growth could presage weaker EM growth, which is the engine of commodity growth generally.2 With U.S. GDP coming in weak as well - registering a paltry growth of 0.7% in 1Q17 - markets started re-calibrating oil demand estimates for this year in light of still-high inventory levels. Adding to the market's agita, visible oil inventories in the OECD remain stubbornly high, thwarting OPEC 2.0's best efforts to drain them via their closely followed production cuts. By Wednesday of this week, this potent combination shaved some 9.6% off 1Q17 average prices, taking international benchmarks Brent and WTI below $50/bbl. Dubai prices have largely been spared similar carnage, as Gulf OPEC states continue to reduce supplies of heavier sour crude availabilities (Chart 2). Chart of the WeekChina PMIs Weaken As Monetary##BR##Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly Chart 2Oil Prices##BR##In Retreat Oil Prices In Retreat Oil Prices In Retreat OPEC 2.0 Responds To Weaker Prices OPEC 2.0 - our moniker for the producer group comprised of OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia - was not oblivious to these concerns. Indeed, earlier this week KSA Oil Minister Khalid al-Falih said the group would "do whatever it takes" to drain stocks and normalize global inventories (Chart 3). The OPEC 2.0 leadership is well aware that failure to do so would again expose these petro-states to the risk of a price collapse, as, absent production discipline, oil inventories once again would fill. This would force prices through producers' cash costs until enough production was knocked off-line to drain the storage overhang.3 Comments by leaders of OPEC 2.0 regarding the extension of its 1.8mm b/d production cuts this year and into next year are consistent with a strategy we laid out earlier, part of which includes the use of forward guidance to convince markets the supply side will tighten in the future.4 The other critical part of the strategy is for OPEC 2.0 to keep the front of the Brent curve at or below $60/bbl, using their own production, spare capacity and storage, and guiding to higher supply in the future, which would keep markets backwardated in 2018 once visible storage returns to five-year average levels. A persistent and deep backwardation - on the order of 10% p.a. - would, based on our modelling, slow the return of rigs to U.S. shale fields. In addition, the combination of a front-end forward curve capped at $60/bbl and persistent backwardation would keep depletion rates elevated, as cash-strapped producers - e.g., non-Gulf OPEC producers with high fiscal breakeven oil prices - are forced to forego maintenance capex. Taken together, this would give OPEC 2.0 a stronger hand in guiding prices - provided the coalition can hold together and maintain production discipline. We continue to expect an extension of the 1.8mm b/d OPEC 2.0 cuts will backwardate markets once inventories normalize later this year, even with strong growth from U.S. shales.5 Indeed, we expect this combination of fundamentals will clear the storage overhang by end-2017, and produce draws of more than 1mm b/d on average from April - December (Chart 4). Chart 3OPEC 2.0 Leaders KSA,##BR##Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" Chart 4Steady Demand,##BR##Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Wobbly Oil Demand Is Transitory The 1Q17 demand-side scares emanating from China and the U.S. are transitory. Chart 5Fiscal And Infrastructure Spending##BR##Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Following their return from the mainland, our colleagues on BCA's China Investment Strategy desk note that monetary conditions still are fairly stimulative, and are unlikely to cause the economy to roll over.6 Most of the deterioration in economic growth results from a slowing in the depreciation of China's trade-weighted RMB, following a years-long appreciation from 2012 to 2015, which did dampen growth. In addition, while fiscal stimulus was reduced at the end of 2016, the government "quickly reversed course" as direct spending and investment in infrastructure picked up substantially (Chart 5). Our China Investment Strategy colleagues note China's fiscal spending is pro-cyclical - it increases as the economy improves and tax revenues increase. The government shows no sign of wanting to wind this down: "China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant." The impact of Chinese demand on global oil demand is increasing, based on econometric work we've recently completed. From 2000 to end-April 2017, a 1% increase in Chinese oil demand has translated into a 0.64% ncrease in Brent prompt prices. During this period, the impact of non-OECD demand ex China was more than two times that of China's - a 1% increase there could be expected to lead to a 1.3% increase in Brent prices. China's impact on Brent prices in the post-GFC world more than doubled, while the impact of non-OECD demand ex-China increased marginally. Since the Global Financial Crisis, a 1% increase in China's oil consumption has produced a 1.4% increase in Brent prices, while a similar increase in EM ex-China has translated into a 1.8% increase in Brent prices.7 Turning to the U.S., we believe, along with the Fed, the weak patch in GDP in 1Q17 is transitory. Following the report on the quarter's weak 0.7% GDP growth, the U.S. Bureau of Labor Statistics surprised markets with a reading of 4.4% unemployment (U3 measure), and an equally impressive U6 measure of 8.6%, which takes it almost to pre-GFC levels. We expect robust U.S. labor-market conditions will keep demand for refined products in the U.S. robust, which will support oil prices there going forward. Globally, the U.S. EIA expects oil consumption will grow 1.6mm b/d this year - unchanged from last year. This is above our 1.4mm b/d estimate for the year. If the EIA's demand estimate is accurate, we can expect a sharper draw (+200k b/d) in global inventories than the average 860k b/d we currently are projecting, all else equal (Chart 4). This would lead to a sharper and earlier backwardation in prices that we currently expect. We will be re-estimating our balances model next week. Investment Implications We continue to expect the global storage overhang to clear by year-end, given the extension of OPEC 2.0's production cuts to at least year-end 2017. Wobbly demand is a transitory phenomenon, and we expect a recovery in the balance of the year. Given our expectation, we are re-establishing our long year-end Brent exposure, and are going short a $45/bbl Dec/17 Brent put vs. long a $65/bbl Dec/17 Brent call at tonight's close. We had a -$1.00/bbl stop-loss on this position, which was elected May 4/17 and resulted in a 1.54/bbl loss (-327.7%). We stopped out of our long Brent front-to-back position - long Dec/17 Brent vs. short Dec/18 Brent - in anticipation of backwardation. We also will be looking to re-establishing this position at tonight's closing levels, and for a good entry point to re-establish the same position in WTI. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Iron-ore (62% Fe) prices are down 33.5% after peaking this year at close to $91/MT in March. The LMEX base metals index is down 7.7% from its 2017 peak in February. Regular readers of Commodity & Energy Strategy will recall we've been bearish iron ore and steel for months, and have remained neutral base metals. Please see "China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals," and "Copper's Price Supports Are Fading," in the January 19, and March 23, 2017, issues of Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 2 In the May 5, 2017, issue of BCA Research's Foreign Exchange Strategy, our colleague Mathieu Savary notes, "The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing." Please see "The Achilles Heel of Commodity Currencies" in the May 5 FES, available at fes.bcaresearch.com. 3 Please see "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," published by BCA Research's Commodity & Energy Strategy April 20, 2017, for a further discussion of the logic behind these cuts. 4 This aligns with a strategy we laid out last month, which uses forward guidance to convince markets to anticipate tighter supply further out the curve. By leading markets to anticipate lower crude oil availabilities in the future - while storage is drawing - OPEC 2.0 is setting the stage for forward curves to remain backwardated. Please see "The Game's Afoot In Oil, But Which One?" published April 6, 2017, in BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 5 "Backwardation" refers to a futures forward-price curve in which contracts for prompt delivery are higher than prices for deferred delivery. This indicates merchants and refiners are willing to pay more for a commodity delivered close in time versus in the future. It is the opposite of a "contango" curve, in which deferred prices exceed prompt prices. 6 Please see "Has China's Cyclical Recovery Peaked?" in BCA Research's China Investment Strategy Weekly Report published May 5, 2017. It is available at cis.bcaresearch.com. 7 These coefficients are all significant at less than 0.01. R2 coefficients of determination for these cointegrating regressions, which include the USD broad trade-weighted index (TWIB) all exceed 0.90, indicating that the USD TWIB and Brent prices share a common long-term trend, and that FX effects remain important in assessing oil prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong

Highlights Despite Saudi-Iranian tensions, the OPEC 2.0 production-cut deal will survive; Petro-state balance sheets remain under pressure; OPEC 2.0 agreement will backwardate the forward curve, and slow the pace of shale recovery; Aramco IPO will motivate Saudi Arabia to over-deliver on the cuts; In expectation of backwardation, investors should go long Dec/17 Brent vs. short Dec/18 Brent, while also going long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts. Feature Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 The Interests At Stake By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady ... And Imports From KSA Steady ... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.2 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Before we get into the intricacies of energy geopolitics, a brief recap is in order.3 Chart 3Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.4 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.5 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.6 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.7 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.8 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting \ Chart 5KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.9 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex ##br##Reserves Depleting Russia: Forex Reserves Depleting Russia: Forex Reserves Depleting Chart 7Backwardation ##br##Under Way Backwardation Under Way Backwardation Under Way Chart 8Unlimited Resources ##br##Undermine Democracy OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, the main national security risk for energy-producing regimes is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.10 Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Chart 9Oil Prices Too Low For National Budgets OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Chart 10Support For Putin Holding Up Support For Putin Holding Up Support For Putin Holding Up Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."11 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Saudis Cut Production More Than Russkies ... Saudis Cut Production More Than Russkies ... Chart 12... Or The 'Shia Bloc' ... Or The 'Shia Bloc' ... Or The 'Shia Bloc' To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:12 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13Shia Bloc Gaining On KSA Shia Bloc Gaining On KSA Shia Bloc Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.13 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.14 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 3 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 4 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 8 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 9 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 10 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 11 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 12 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 13 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, available at reuters.com. 14 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com.

Highlights Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 Energy: Overweight. We are long the Dec/17 Brent $65/bbl calls vs. short the Dec/17 Brent $45/bbl puts at a net premium of -$0.47/bbl. This new recommendation was down 46.8%, which we initiated last week following our assessment of OPEC 2.0's strategy to reduce global oil inventories. We remain long the Dec/17 Brent vs. short Dec/18 Brent, which is up 94.7%. Our long GSCI position is down 4.5%; we have a 10% stop on this position. Base Metals: Neutral. Copper registered a 51k metric ton physical surplus in January, according to estimates from the International Copper Study Group. Precious Metals: Neutral. Gold retreated going into French elections over the weekend, indicating investors were not as fearful as some pundits. Our long volatility position is down 43.8%. Ags/Softs: Underweight: Reuters reported the Brazilian government will provide up to 500 million reals (~$159mm) to market this year's corn crop. An expected record harvest and weak export volumes prompted the action.2 Feature By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady ... And Imports From KSA Steady ... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.3 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Chart 3Saudi Profligacy Has Continued In 2017 Saudi Profligacy Has Continued In 2017 Saudi Profligacy Has Continued In 2017 Before we get into the intricacies of energy geopolitics, a brief recap is in order.4 Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.5 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.6 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.7 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.8 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.9 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting Chart 5KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.10 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex Reserves Depleting Russia: Forex Reserves Depleting Russia: Forex Reserves Depleting Chart 7Backwardation Under Way Backwardation Under Way Backwardation Under Way What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, energy-producing states face a primary security risk that is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.11 Chart 8Unlimited Resources Undermine Democracy OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Chart 9Oil Prices Too Low For National Budgets OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Chart 10Support For Putin Holding Up Support For Putin Holding Up Support For Putin Holding Up Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."12 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Saudis Cut Production More Than Russians ... Saudis Cut Production More Than Russians ... Chart 12... Or The "Shia Bloc" ... Or The "Shia Bloc" ... Or The "Shia Bloc" To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:13 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13"Shia Bloc" Gaining On KSA "Shia Bloc" Gaining On KSA "Shia Bloc" Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.14 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.15 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 Please see "Brazil readies $159 million in corn subsidies amid record crop," Reuters, April 19, 2017, available at Reuters.com. 3 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 4 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 5 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 9 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 10 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 11 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 12 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 13 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 14 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, availableat reuters.com. 15 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets