Oil

A Catchup Phase For Oil Majors A Catchup Phase For Oil Majors Overweight Energy prices in 2019 have been bouncing off the recent lows touched at the end of 2018 when global markets melted down. It appears that fears over a global slowdown in energy demand have been replaced by a focus on reduced crude inventories that point to a tight market (bottom panel), aided in large part by OPEC supply cuts and reduced Iranian and Venezuelan production. Nevertheless, the S&P integrated oil & gas energy index has not kept pace with the underlying commodity as their historically tight correlation has broken down in recent years and the index has moved laterally (top panel). Still, relative forward earnings estimates in this sector, that has seen its cost base dramatically rationalized, have been gaining steam relative to the broad market (second panel). The current message from sell-side earnings revisions is that profits have fallen out of their year-end funk (third panel). Bottom Line: Stock prices in the heavyweight S&P integrated oil & gas energy subindex should catch up to the index’s earnings power, particularly if BCA’s Commodity & Energy Strategy service forecast of higher oil prices in 2019 plays out; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY.

Highlights The correlation between oil and petrocurrencies has deeply weakened in recent years. One of the reasons has been the prominence of new, important producers, notably the U.S. Oil prices should trend towards $75/bbl by year-end. This will favor the NOK, but the CAD and AUD will be held hostage to domestic slowdowns. Sell the CAD/NOK at current levels. Meanwhile, aggressive investors could begin accumulating USD/NOK shorts, given the Fed’s complete volte-face. Both the SNB and the BoE have delivered dovish messages, joining the chorus echoed by other central banks. However, the BoE remains a sideshow until the final chapter of the Brexit imbroglio unfolds. Feature Oil price dynamics have tended to have a profound impact on the trend of petrocurrencies. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payments dynamics also tend to improve during oil bull markets. Altogether, these forces combine to be powerful undercurrents for petrocurrencies. In the case of Canada and Norway, petroleum represents around 20% and 60% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher than in Norway. It is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Getting the price of oil right is usually the first step in any petrocurrency forecast. The Outlook For Oil1 Our baseline calls for Brent prices to touch $75/bbl by year-end. Oil demand tends to follow the ebbs and flows of the business cycle, with demand having slowed sharply in the fourth quarter of 2018 (Chart I-1). With over 60% of global petroleum consumed fueling the transportation sector, the slowdown in global trade brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. If, as we expect, the impact of easier global financial conditions begins to seep into the real economy, these trends should reverse in the second half of the year. BCA’s Commodity & Energy Strategy group estimates that this would translate into a 1.5% increase in oil demand this year. Chinese oil imports have already started accelerating, and should Indian consumption follow suit, this will put a floor under global demand growth (Chart I-2). Chart I-1Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Chart I-2Oil Demand Green Shoots Oil Demand Green Shoots Oil Demand Green Shoots This increase in oil demand will materialize at a time when OPEC spare capacity is only at 2%. In its most recent meeting, OPEC decided not to extend the window for production cuts beyond May, waiting to see whether the U.S. eases sanctions on either Venezuela, Iran or both. At first blush, this appeared bearish for oil prices. However, the bottom line is that global spare capacity cannot handle the loss of both Venezuelan and Iranian exports. Unplanned outages wiped off about 1.5% of supply in 2018. Lost output from both countries will nudge the oil market dangerously close to a negative supply shock (Chart I-3). Chart I-3 Bottom Line: If Venezuelan sanctions continue, we expect the U.S. will likely extend the current waivers to Iranian exports further out into the future. Meanwhile, demonstrated flexibility by OPEC makes it increasingly the fulcrum of the oil market. That said, the balance of risks for oil prices remain to the upside since a miscalculation by both sides is a possibility. The Good Old Days Historically, the above analysis would have been largely sufficient to buy most petrocurrencies, especially given the gaping wedge that has opened vis-à-vis the price of oil (Chart I-4). But the reality is that the landscape for oil production is rapidly shifting, with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members. Chart I-4Opportunity Or Regime Shift? Opportunity Or Regime Shift? Opportunity Or Regime Shift? In 2010, only about 6% of global crude output came from the U.S. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%, having largely been stable among constituents like Saudi Arabia, Iran and even Venezuela. Fast forward to today and the U.S. produces almost 15% of global crude, having grabbed market share from both developed and politically-fragile economies (Chart I-5). Chart I-5A New Oil Baron A New Oil Baron A New Oil Baron At the same time, the positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Put another way, rising oil prices benefit the U.S. industrial base much more than in the past, while the benefits for countries like Canada and Norway are slowly fading. U.S. shale output in the Big 5 basins rose by about 1.5 million barrels in 2018, close to the equivalent of total Libyan production. Meanwhile, Norwegian production has been falling for a few years.  The reality is that the landscape for oil production is rapidly shifting, with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time U.S. production was about to take off (Chart I-6). Since then, that correlation has fallen from around 0.8 to around 0.3. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the U.S. becomes a net energy exporter. Chart I-6Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble, and the Colombian and Mexican pesos. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Transportation bottlenecks for Canadian crude and falling production in Norway are also added negatives. The conclusion is that rising petrodollar reserves have historically been bullish for the currency (Chart I-7) but expect this correlation to be weaker than in the past.  Chart I-7Rising Petrodollar Reserves Will Be Bullish Rising Petrodollar Reserves Will Be Bullish Rising Petrodollar Reserves Will Be Bullish The Fed As A Catalyst The Federal Reserve recently completed the volte-face that it launched at its January FOMC meeting. The dots now forecast no rate hikes in 2019 and only one for 2020. Previously, three hikes were baked in over the forecast period. GDP growth has been downgraded slightly, and CPI forecasts have also been nudged down. Rising petrodollar reserves have historically been bullish for the currency but expect this correlation to be weaker than in the past. The reality is that U.S. growth momentum relative to the rest of the world started slowly rolling over at a time when external demand remained weak.2 Recent data confirm this trend persists: Industrial production peaked last year and continues to decelerate; the NAHB housing market index came in a nudge below expectations; and the U.S. economic surprise index is sitting close to its one-year low of -40. With bond yields having already made a downward adjustment by circa 100 basis points, the valve for financial conditions to get looser could easily be via the U.S. dollar (Chart I-8). We have been selectively playing USD shorts, mostly via the SEK and the euro, as per our March 8th report. Today, we add the Norwegian krone to the list. Chart I-8Bond Yields Down, Dollar Next? Bond Yields Down, Dollar Next? Bond Yields Down, Dollar Next? Sell CAD/NOK The Norges Bank hiked interest rates to 1% at yesterday’s meeting, which was widely expected, but the hawkish shift took the market by surprise. Governor Øystein Olsen signaled further rate increases later this year, at a time when global central banks are turning dovish. This lit a fire under the Norwegian krone. The 6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015.   The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation slightly above the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher (Chart I-9). Chart I-9The Norwegian Economy Is Faring Well The Norwegian Economy Is Faring Well The Norwegian Economy Is Faring Well Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-10). The 6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015, and our intermediate-term indicators suggest the next move is likely lower. Meanwhile, relative economic surprises are moving in favor of Norway, with export growth, retail sales and employment growth all outpacing Canadian data. The discount between Western Canadian Select crude oil and Brent has closed, but our contention is that the delay in Enbridge’s Line 3 replacement will likely push the discount back closer to $20/bbl. Chart I-10Sell USD Via CAD/NOK Sell USD Via CAD/NOK Sell USD Via CAD/NOK Over the longer term, both the Canadian and Norwegian housing markets are bubbly, but in the latter it has been concentrated in Oslo, with Bergen and Trondheim having had more muted increases. In Canada, the rise in house prices could rotate to smaller cities, as macro-prudential measures implemented in Toronto and Vancouver nudge investors away from those markets (Chart I-11).  Chart I-11Bubbly Housing In Norway And Canada Bubbly Housing In Norway And Canada Bubbly Housing In Norway And Canada The Canadian government has decided to provide residents with a potential line of credit in exchange for equity stakes of up to 10% in residential homes. The maximum home value that qualifies for this line of credit has been capped at C$480,000. While this does little to improve the affordability of houses in expensive cities, it almost guarantees that those in competitive markets will be bid up. This will encourage a continued buildup of household leverage. Historically, when the leverage ratio for Canada peaked vis-à-vis the U.S., it was a negative development for the Canadian dollar (Chart I-12).   Chart I-12The CAD Looks Vulnerable The CAD Looks Vulnerable The CAD Looks Vulnerable Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating short positions versus the U.S. dollar outright. Hold USD/SEK shorts established a fortnight ago, currently 3% in the money. Housekeeping We are taking profits on our short AUD/CAD position this week, with a 1.4% profit. As highlighted in our March 8th report, the Australian dollar has been severely knocked down, and is becoming more and more immune to bad news. Despite home prices falling by more than 5% year-on-year, worse than during the financial crises, the Aussie was actually up on the week. Meanwhile, Australian exports will be at the top of the list to benefit from China’s reflationary efforts.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, titled “OPEC 2.0: Oil’s Price Fulcrum,” dated March 21, 2019, available at ces.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Into A Transition Phase,” dated March 8, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data in the U.S. have shown more signs of a slowdown: February industrial production growth missed expectations, coming in at 0.1% month-on-month. Michigan consumer sentiment in March came in higher than expected at 97.8. NAHB housing market index in March came in at 62, below consensus. January factory orders slowed to 0.1% month-on-month.  Philadelphia Fed business outlook came in at 13.7, surprising to the upside. Initial jobless claims in March were 221k, also outperforming analysts’ forecast. The DXY index slumped by 0.8% post-FOMC, and is now slowly recovering on the strong data from the Philly Fed business outlook and initial jobless claims. The Fed left interest rates unchanged on Wednesday, while further signaling that no rate hike is likely through 2019. Moreover, 2019 GDP forecast was downgraded to 2%. The dovish turn by the Fed could weigh on the dollar in the coming weeks. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in the euro zone have been mostly positive: February consumer price index came in line at 1.5% year-on-year; core consumer price index also stayed at 1% year-on-year. The seasonally-adjusted trade balance in January improved to 17 billion euros. Q4 labor cost fell to 2.3%. ZEW economic sentiment survey came in at -2.5 in March, outperforming the consensus of -18.7. EUR/USD increased by 0.5% this week. The FOMC-led sharp rebound sent EUR/USD to a new week-high of 1.145 on Wednesday. We expect more positive data coming from the euro zone, which will further lift the euro. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have continued to soften: The merchandise trade balance came in at 339 billion yen in February. Total imports contracted by 6.7% year-on-year, while total exports fell by 1.2% year-on-year. Industrial production increased by 0.3% year-on-year in January. Capacity utilization in January fell by 4.7% month-on-month, missing expectations. The leading economic index in January fell to 95.9 from a previous reading of 97.2. USD/JPY slumped by 0.9% this week. Last Friday, the Bank of Japan left its key interest rate unchanged at -0.1%, as wildly expected. The 10-year government bond yield target also stayed unchanged at around 0%. Like many global central banks, the BoJ has been blindsided by the deep external slowdown that is beginning to seep into the domestic economy. Report Links: A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: Average earnings excluding bonuses in January grew in line by 3.4%. ILO unemployment rate in January fell to 3.9%. The retail price index in February stayed in line at 2.5% year-on-year. The February consumer price index increased to 1.9% year-on-year. Retail sales growth in February increased to 4% year-on-year, outperforming expectations.  GBP/USD fell by 1.1% this week, erasing the gains triggered by dollar weakness earlier on Wednesday. The BoE left its interest rate unchanged at 0.75%, and the sterling continues to show more volatility with a delayed Brexit. Report Links: A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have shown the housing market is toppling over: The housing price index in Q4 fell sharply by 5.1% year-on-year. New jobs created in February were 4,600, missing the expectations by 9,400. Moreover, 7,300 full-time employment jobs were lost, while 11,900 positions were created for part-time employment. The unemployment rate in February fell to 4.9%, while the participation rate decreased to 65.6%. AUD/USD appreciated by 0.6% this week. It pulled back a little after reaching a 0.7168 high on Wednesday following the dovish Fed decision. During a speech this week, RBA highlighted the concerns over the ability of households to service their debt. Both external and internal constraints remain headwinds for the Australian dollar. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been weak: Credit card spending growth in February slowed to 6.4% year-on-year. Q4 GDP growth came in at 2.3% year-on-year, underperforming consensus of 2.5%. The current account deficit widened to 3.7% of GDP in Q4. NZD/USD appreciated by 0.5% this week. The Q4 GDP breakdown showed that growth was mainly driven by the rise in service industries. Primary industries, however, fell by 0.8%. Agriculture was down 1.3%, mining was down 1.7%, forestry and logging fell 1.6%, and lastly, the fishing activity was down 0.9% quarter-on-quarter. The Kiwi will benefit from any dollar weakness, but is not our preferred currency. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada continue to paint a mixed picture: January manufacturing shipments increased to 1% month-on-month. Foreign portfolio investment in Canadian securities saw an increase of C$49 billion in January, while Canadian portfolio investment in foreign securities decreased by C$8.4 billion. January wholesale sales growth increased to 0.6% month on month. USD/CAD rebounded overnight after falling sharply on a dovish Fed. CAD finally ended the week flat. On Tuesday, Bill Morneau, the Finance Minister of Canada, unveiled the new federal budget for 2019. It showed several new measures aiming to assist young and senior Canadian citizens, including first-time home buyers. While these measures might appease Canadian millennial voters, they will also result in significant deficits. The deficit projection for the year 2019-2020 widened to $19.8 billion, which could crowd out private spending. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The trade balance in February came above expectations at 3,125 million CHF. Exports came in at 19,815 million CHF, while imports came in at 16,689 million CHF, respectively. USD/CHF depreciated by 1% this week. The Swiss National Bank left the benchmark sight deposit rate unchanged at -0.75%, as wildly expected. We struggle to see any upside potential for the franc, amid a dovish central bank, an expensive currency and muted inflation. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive. The trade balance in February fell to 15.8 billion NOK, from a previous reading of 28.8 billion NOK. USD/NOK fell by 1.3% this week. The Norges Bank raised rates by 25 bps to 1%, in line with expectations, while signaling further rate hikes in the second half of this year. The Norges Bank once again demonstrated to be the most hawkish among G10 members. The bank reiterated that the economy is running at a solid pace and capacity utilization is above normal levels, while inflation keeps navigating above the bank’s target. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There has been no major data release from Sweden this week. USD/SEK fell by 1.5% this week. Our short USD/SEK position is now 3% in the money since we initiated it 2 weeks ago. As we see more signs of recovery in the euro zone, we expect the exports of Sweden to pick up, which is a tailwind for the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Venezuela’s oil production likely fell ~ 500k b/d last week in the wake of nationwide power outages, reducing total output to ~ 500k b/d. However, neither OPEC 2.0 nor U.S. President Donald Trump drew much attention to it. During an industry gathering in Houston last week, an administration official conceded events in Venezuela could affect whether U.S. waivers on its Iranian oil-export sanctions are extended beyond May 4, but that was pretty much it.1 This is consistent with the thesis we laid out last month, which reflects our view OPEC 2.0 is evolving a more flexible production strategy that allows it to adjust production quickly in response to exogenous events over which it has little control; chiefly, U.S. foreign, trade and monetary policy.2 This will result in higher prices, satisfying the sometimes-conflicting goals of OPEC 2.0’s leadership – i.e., KSA’s budgetary need for prices closer to $80/bbl, and Russian producers’ need to increase revenue through higher volumes. Given this backdrop, our updated balances and price forecasts remain largely unchanged, with minor adjustments to the overall supply side and no change on the demand side. We continue to expect Brent to average $75/bbl this year. For 2020, we continue to expect Brent to average $80/bbl – higher U.S. shale output will be offset by delays in building out deepwater export facilities in the U.S. Gulf for most of the year. We expect WTI to trade $7 and $5/bbl lower in 2019 and 2020, respectively. The balance of price risk remains to the upside, as policy risk – i.e., a miscalculation on all sides – is elevated. Highlights Energy: Overweight. We are closing our 2020 long WTI vs. short Brent position at tonight’s close, given delays in the buildout of deepwater-harbor capacity in the U.S. Gulf caused by additional environmental assessments. This likely will push the spread out to $5/bbl+, vs. our target of $3.25/bbl. Base Metals: Neutral. Copper got another endorsement from Fitch Solutions, which is predicting LME prices will average $6,900 and $7,100/MT this year and next, on the back of lower inventories and improving supply-demand fundamentals. We remain long copper, which is up 2.7% since we recommended it on March 7. Precious Metals: Neutral. Our colleagues at BCA Research’s Global Investment Strategy expect the USD to weaken in 2H19, which, all else equal, will support gold and precious metals.3 Our long gold portfolio hedge is up 6.3% since inception on May 4, 2017. Agriculture: Underweight. Grain markets likely will trade sideways ahead of the USDA’s Prospective Plantings survey of farmer intentions next Friday.   Feature The sudden loss of Venezuelan output – and exports – was barely noticed in price action over the past week.  U.S. foreign and trade policy will continue to keep oil supply and demand uncertainty elevated, particularly as sanctions against Venezuela play out against the backdrop of a collapsing infrastructure. Last week’s nationwide power outage likely caused crude oil production to drop 500k b/d from ~ 1mm b/d previously.4 The sudden loss of Venezuelan output – and exports – was barely noticed in price action over the past week. Global inventories remain swollen (Chart 1), and OPEC 2.0’s spare capacity is increasing as it cuts production (Chart 2). This allows Venezuelan production losses to be covered with little or no disruption to supply or demand, and little or no increase in the level of agita in oil markets. Chart of the WeekOECD Inventories Still High, But Continue to Drain OECD Inventories Still High, But Continue to Drain OECD Inventories Still High, But Continue to Drain Chart 2 That cushion allows the U.S. to continue to prosecute its sanctions strategy against Venezuela and Iran. But it does not give the U.S. carte blanche to pursue regime change in both countries at the same time. As we noted in our New Political Economy of Oil report last month, OPEC 2.0 possibly could cover the loss of 500k b/d of Venezuelan exports and maybe up to 1.5mm b/d of Iranian exports.5 We continue to expect waivers on the Iran sanctions to be extended, although Trump administration officials remain guarded in terms of providing markets any forward guidance. However, it would tighten the heavy-sour market even more than it is now.6 And, full-on sanctions campaigns conducted simultaneously on Venezuela and Iran following the expiration of U.S. waivers on export sanctions against the latter would leave spare capacity dangerously thin, and push the risk premium in oil prices up sharply, given the volumes Iran already is supplying (Chart 3, Table 1). Chart 3 Table 1Iran Exports By Country 2018 (‘000 b/d) OPEC 2.0: Oil's Price Fulcrum OPEC 2.0: Oil's Price Fulcrum We continue to expect waivers on the Iran sanctions to be extended, although Trump administration officials remain guarded in terms of providing markets any forward guidance. The most that’s been offered came last week in Houston at an industry convention, where Brian Hook, special representative for Iran at the U.S. State Department, indicated the U.S. administration is aware of the supply-side pressure associated with its campaigns against Venezuela and Iran. However, he offered nothing definitive one way or another, so markets will continue to assign a non-zero probability that waivers will not be extended.7 Oil Supply Expectations Remain Stable For our part, we believe waivers on the U.S. Iranian export sanctions will be extended out of necessity. While more than 2mm b/d of Venezuelan and Iranian production can be offset by increased OPEC 2.0 spare capacity – now running ~ 2.1mm b/d based on U.S. EIA estimates – it is not sufficient to cover any additional losses due to unplanned outage of the sort seen in May 2016, when 1mm b/d of Canadian oil production was lost to wildfires. These are real risks, not abstractions meant to illustrate a point.8 For 2H19, our base case now assumes OPEC 2.0’s production rises by ~ 0.5mm b/d vs. 1H19 production of 44.5mm b/d. This will smooth out the loss of Venezuelan output as it falls to 500k b/d by the end of this year, vs. the 650k b/d we expected last month. We also expect Iranian production to remain close to the 3mm b/d it will average in 1H19, likely increasing as global storage levels fall and waivers are exercised (much like a call option). News reports suggest KSA continues to advocate the extension of production cuts by OPEC 2.0 to year end. However, if the coalition’s goal is to keep Brent prices close to $75/bbl this year, and closer to $80/bbl next year – the assumptions we’re working with – OPEC 2.0 likely will have to raise production by 0.5mm b/d in 2H19 and 0.72mm b/d next year. Maintaining production cuts into 2H19 risks sending prices significantly higher, in our estimation. Globally, the big driver of growth on the supply side continues to be U.S. shales, which we now expect to increase 1.2mm b/d in 2019 and 0.9mm b/d next year, a small increase of ~ 60k b/d versus our estimates last month.9 While it is true the Permian bottleneck will be cleared by the end of this year – adding some 2mm b/d of new takeaway capacity – export capacity will remain challenged by new delays to the build-out of deepwater-harbor capacity in the U.S. Gulf well into 2020, following requests of Carlyle Group and Trafigura AG to provide additional information in environmental filings to regulators before work begins.10 This will push the Permian bottleneck from the basin to the U.S. Gulf refining market. On the back of this development, we are closing our 2020 long WTI vs. short Brent recommendation at tonight’s close, given these delays likely push the deep-water expansion in the Gulf to 4Q20 or later. Oil Demand Also Remains Stable Oil demand will continue to be supported by the easing of monetary policy in DM and EM economies to offset a slowdown in global growth. In addition, we expect China’s credit cycle to bottom in 1Q19, which will be supportive of oil demand there and in EMs generally (Chart 4). We continue to expect the Sino – U.S. trade war to be resolved in 1H19, as both presidents Trump and Xi need to get a deal done to satisfy domestic audiences – i.e., U.S. elections next year and the upcoming 100th anniversary of the Chinese Communist Party in 2021, respectively. Chart 4EM Growth Will Lift In 2H19 EM Growth Will Lift In 2H19 EM Growth Will Lift In 2H19 During the second half of this year, we expect a more significant pick-up in China’s credit cycle, which will set the stage for a year-end rally in commodities generally – oil and base metals in particular. We also expect global demand to get a lift from a weaker USD beginning in 2H19 and extending to the end of 2020.11 We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, slightly more than the EIA and IEA. We expect EM to account for 53.7mm b/d of growth this year and 55mm b/d next year. Total global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. U.S. policy is keeping the supply- and demand-side uncertainty elevated, but OPEC 2.0’s hand has been strengthened by the fact that it is, more than ever, the fulcrum of the oil market. OPEC 2.0’s Balancing Strategy U.S. policy is keeping the supply- and demand-side uncertainty elevated, but OPEC 2.0’s hand has been strengthened by the fact that it is, more than ever, the fulcrum of the oil market: It can balance shortfalls out of spare capacity – boosted some by its production cuts – and it can reduce unintended inventory accumulation via its demonstrated ability to cut output rapidly. Our 2019 and 2020 Brent price forecasts remain at $75 and $80/bbl (Chart 5). Delays in building out U.S. Gulf deepwater-harbor capacity next year will keep exports constrained. This will back production up behind the pipe in the Permian Basin next year, and keep inventories fuller than they otherwise would be. And it means Brent markets will remain tighter than we previously expected in 2020, as WTI won’t be exported in the volumes needed to tighten the Brent - WTI spread as much as we previously expected. For 2019, we expect WTI to trade $7/bbl under Brent, and $5/bbl under in 2020 (vs. our earlier expectation of $3.25/bbl), on the back of these delays. This compels us to liquidate our long WTI vs. Brent recommendation in 2020 at tonight’s close. Chart 5OPEC 2.0 Output Hike Needed To Keep Market Balanced in 2H19 OPEC 2.0 Output Hike Needed To Keep Market Balanced in 2H19 OPEC 2.0 Output Hike Needed To Keep Market Balanced in 2H19 OPEC 2.0’s position as the fulcrum effectively means it can balance the market to achieve its price goals (Chart 6, Table 2). This does not drive our forecast, but it does line up with what we would expect an economically rational agent to do. Chart 6Our Ensemble Forecasts Remain Fairly Stable Our Ensemble Forecasts Remain Fairly Stable Our Ensemble Forecasts Remain Fairly Stable Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0: Oil's Price Fulcrum OPEC 2.0: Oil's Price Fulcrum We believe OPEC 2.0 is succeeding in evolving a strategy that allows it sufficient flexibility to respond to exogenous forces affecting oil prices, which are, for the most part, out of its control. Bottom Line: Policy uncertainty is elevated, but we believe OPEC 2.0 is succeeding in evolving a strategy that allows it sufficient flexibility to respond to exogenous forces affecting oil prices, which are, for the most part, out of its control – i.e., U.S. foreign, trade and monetary policy.12 As such, we believe it will adjust output to achieve price targets, which, despite the sometimes-public disagreements between KSA and Russia, are closer to our forecast levels of $75 and $80/bbl for Brent this year and next than not.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com       Footnotes 1      OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  U.S. waivers were granted by the Trump administration just before the sanctions against Iranian oil exports went into effect November 4; these waivers expire May 4, 2019. 2      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019.  It is available at ces.bcaresearch.com. 3      Please see “What’s Next For The Dollar,” published by BCA Research’s Global Investment Strategy published March 15, 2019.  It is available at gis.bcaresearch.com. 4     In its March 2019 Oil Market Report, the IEA notes, “The electricity crisis in Venezuela has paralysed most of the country for significant periods of time. Although there are signs that the situation is improving, the degradation of the power system is such that we cannot be sure if the fixes are durable. Until recently, Venezuela’s oil production had stabilised at around 1.2 mb/d. During the past week, industry operations were seriously disrupted and ongoing losses on a significant scale could present a challenge to the market.”  We await better data to assess the full extent of the production lost in Venezuela. 5      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019.  It is available at ces.bcaresearch.com. 6      Please see “Oil Price Diffs: Global Convergence,” published by BCA Research’s Commodity & Energy Strategy March 7, 2019.  It is available at ces.bcaresearch.com. 7      Please see “CERAWeek: US waivers for Iran oil imports may hinge on Venezuela sanctions impact: State official,” published by S&P Global Platts March 13, 2019. 8      We treat these waivers as quasi call options on Iranian crude oil in our analysis.  As inventories draw, importers holding waivers can be expected to exercise their option and lift more crude from Iran without running afoul of U.S. sanctions. 9      We approximate our shale production based on the big 5 basins (Anadarko, Bakken, Permian, Eagle Ford and Niobrara). 10     Please see “US Suspends Review On Trafigura Oil-Port Project” published by Hart Energy March 18, 2019.  See also “Exclusive: Environmental review could delay Carlyle deepwater oil export project up to 18 months,” published by reuters.com March 14, 2019. 11     See footnote 3 above. 12     A perfect example of this can be seen OPEC 2.0’s decision to move its ministerial meeting to June: A decision from the U.S. on whether to extend waivers on the Iranian sanctions will come May 4, right around the time OPEC 2.0 member states are deciding on export schedules.  If waivers are extended, member states can maintain production discipline or add volumes to the market as needed; if sanctions are re-imposed in full, they can increase production as needed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights Price differentials between global light-sweet crude oil benchmarks Brent and WTI will narrow over the next three years, as U.S. light-sweet crude oil exports expand and North Sea production growth remains challenged. U.S. product exports also will expand, as investments by Gulf Coast refiners allow them to take in more of the domestic light-sweet crude output. Growing volumes of WTI being exported to Europe are being priced relative to Brent. Over time, we expect the marginal light-sweet crude barrel for the global oil market – and the benchmark of refiners’ primary cost – will be directly linked to WTI – Houston pricing. Given this expectation of increased U.S. exports, we are initiating a long WTI vs. short Brent swap position at tonight’s close in 2020. The 2020 swap settled Tuesday at $6.6/bbl; we project it will average $3.25/bbl. In the heavy-sour markets, differentials – most prominently the Brent – Dubai spread – will remain tight, owing to OPEC 2.0 production cuts, lost Venezuelan and Iranian exports, due to U.S. sanctions, and ongoing difficulties getting Canadian heavy crude to refining markets. Energy: Overweight. OPEC 2.0 likely will decide to extend production cuts to year-end in June, as opposed to May, as was expected earlier.1 This will allow the Cartel to respond to whatever the U.S. decides on May 4 re extending waivers on Iranian export sanctions, and to export losses from U.S. sanctions on Venezuela’s state oil company. Base Metals/Bulks: Neutral. Chinese Premier Li Keqiang announced tax cuts amounting to almost $300 billion (~ 2 trillion RMB), as policymakers attempt to hit a GDP growth target of 6.0 to 6.5% this year. We are getting tactically long spot copper at tonight’s close, expecting this fiscal stimulus to boost prices over $3.00/lb in the next 3 – 6 months. Feature In a little more than two years from now, Exxon will add 1mm b/d of pipeline take-away capacity to the Permian Basin. The new pipe is in addition to the 2mm b/d of takeaway capacity currently being added to the basin, which is expected to be fully operational by the end of this year. Current production in the Permian is close to 4mm b/d, so the combined incremental new pipe will provide considerable room for production growth into the 2020s. Exxon’s pipeline expansion – undertaken with Plains All American and Lotus Midstream – was announced in January, just before the company proceeded with its final investment decision (FID) to expand the capacity of its Beaumont, TX, refinery by 250k b/d to 616k b/d. The new capacity is expected to come online in 2022, and will make Beaumont the largest refinery in the U.S. The refinery expansion will take in light-sweet crude from the Permian, where Exxon plans to triple production to 600k b/d by 2025.2 These announcements are not one-offs: Permian production, and shale-oil output generally, is booming. In the Permian, oil output rose just over 800k b/d last year, according to the U.S. EIA (Chart of the Week, panel 1). Overall U.S. shale output in the Big 5 basins – Anadarko, Bakken, Eagle Ford, Niobrara and Permian – rose close to 1.5mm b/d in 2018.3 Output growth in the Permian will remain super-charged on the back of the pipeline buildout, and the capex being poured into it as the Majors and large E&P companies industrialize production there, not unlike a manufacturing process. We expect the Permian to lead the development of shale-oil production, driving total crude and liquids growth in the U.S., which last year grew by 2.2mm b/d to reach 19mm b/d by December (Chart of the Week, panel 2). Chart of the WeekBrent Physical Liquidity Continues To Fall Brent Physical Liquidity Continues to Fall Brent Physical Liquidity Continues to Fall Continued investments in state-of-the-art refinery expansions in the U.S. Gulf are expected to continue as well, given the production growth we expect for the Permian, and the pipeline expansions that will take that output to the Houston refining market. Chevron, for example, is expected to close on an acquisition from Brazilian state oil company Petrobras for the 110k b/d Pasadena Refining System, also in the Houston Ship Channel. The company will feed this unit with light-sweet crude from the Permian, which it told analysts this week it expects to grow to 600k b/d by end-2020 and 900k b/d by 2023.4 At present, the U.S. Gulf Coast refining infrastructure cannot absorb all of the light-sweet crude that will be produced in the Permian and the other major basins in coming years. The export markets – particularly the Atlantic Basin, which is home to the physical Brent market – will be absorbing more and more of U.S. light-sweet production in coming years as North Sea production stagnates relative to the U.S. shales (Chart of the Week, panel 3). Output in the U.K. North Sea was at its lowest level since 1973 in 2017, following the price collapse of 2014 – 2017 instigated by the OPEC market-share war launched in 2014. UK output was flattish last year, while Norwegian production was down slightly more than 6% in 2018, bringing it to just under 1.5mm b/d. Drilling activity is picking up this year, along with M&A activity as private equity firms step in to buy properties being sold by the U.S. Majors. As can be seen in the Chart of the Week, production is expected to begin picking up at the end of this year, but base effects from the low levels of late exaggerate the gains in percentage terms. U.S. Crude Exports Set To Soar The North Sea Brent market is arguably the most important crude oil market in the world. It is the underlying physical market for the world’s benchmark crude oil – Brent Blend – against which up to two-thirds of the world’s crude oil prices are indexed.5 Production of the five constituent streams comprising the Brent index – the Brent, Forties, Oseberg, Ekofisk and Troll crudes – has been falling year on year, and one of the streams (Forties) is regularly being exported to Asian refining markets. This has prompted the main price-reporting agencies to consider adding to the constituents of the Brent index, and changing the type of pricing it records.6 At the same time, increasing volumes of WTI light-sweet crude are making their way into the Brent North Sea physical market.7 These export volumes will increase, supported by the buildout of pipeline takeaway and deep-water harbor capacity in the U.S. Gulf, which, when done, will expand the capacity of Gulf ports to accommodate very large crude carriers (VLCCs).8 On the back of these rising exports to the European market, Argus Media, one of the price-reporting agencies, this year began publishing U.S. waterborne pricing assessments as differentials to the ICE Brent futures. According to Argus, slightly over a quarter of the 2.6mm b/d of crude exports out of the U.S. last November went to Europe to compete with North Sea grades like Brent and Forties, two of the Brent index constituents. For the week ended February 22, 2019, the four-week average of crude oil exports from the U.S. was close to 3.1mm b/d, a record for average exports. According to S&P Global Platts, “There have been 48 VLCCs booked for loading out of the USGC so far in 2019 – about five times the amount booked in the first two months of 2018 and a drastic difference to the two VLCCs that were booked during the same period in 2017.”9 Most of the growth in U.S. exports is coming from the shale-oil production boom, which is swelling the volume of light-sweet barrels in the Gulf. While increasing volumes of WTI are making their way into European wet markets, it is too early to call WTI delivered to the Houston refining market (WTI – Houston) a benchmark; it’s more of a reference price for now. All the same, the necessary and sufficient conditions are falling into place for WTI – Houston to become a global benchmark: It has consistent quality; diversity of buyers (refiners and trading companies), sellers (producers and traders), and speculators to provide hedging liquidity to physical-market participants; and, in due course, will have reliable shipping facilities, including ports capable of handling VLCCs and smaller vessels. This last condition is the critical limiting factor at present.10 We expect that, by the early 2020s, the necessary and sufficient conditions will be in place to allow WTI – Houston to become a global benchmark. By that time, we project the U.S. will be exporting in excess of 10mm b/d of crude and liquids, and refined products, with crude exports alone exceeding 5mm b/d by then. Currently, the U.S. exports slightly more than 8mm b/d of crude oil and products (Chart 2). The six largest importers of U.S. crudes are found in the Atlantic and Pacific basins (Charts 3A & 3B). Chart 2U.S. Will Expand Its Lead As Largest Crude and Products Exporter U.S. Will Expand Its Lead As Largest Crude and Products Exporter U.S. Will Expand Its Lead As Largest Crude and Products Exporter Chart 3AU.S. Exports To Atlantic ... U.S. Exports To Atlantic ... U.S. Exports To Atlantic ... Chart 3B... And Pacific Growing ... And Pacific Growing ... And Pacific Growing Bottom Line: We expect the Brent vs. WTI crude oil differential to narrow next year, as U.S. light-sweet crude oil exports expand and North Sea production stagnates. On the back of this, we are opening a long WTI vs. short Brent position in 2020. We expect this differential to average $3.25/bbl next year versus current market levels of $6.6/bbl. Canadian WCS Differentials Could Relapse The Western Canadian Select (WCS) differential to WTI YTD contracted to a discount of $10.50/bbl from an average discount of $26.3/bbl in 2018, as the Alberta government’s production curtailment took effect (Chart 4).11 This is allowing Alberta’s excess inventories to start declining, which was one of the primary motivations of the government’s action. Chart 4Government-mandated Production Cuts Reverse Inventory Builds in Alberta Government-mandated Production Cuts Reverse Inventory Builds in Alberta Government-mandated Production Cuts Reverse Inventory Builds in Alberta Not all the news out of Canada is good for producers, however. An unexpected delay in Enbridge’s Line 3 replacement and expansion puts future Canadian production growth in jeopardy. This will complicate the Alberta government’s plan to stabilize the sound discount to WTI, which is necessary to maintain investors’ confidence in the sector. In our previous analysis of the Canadian oil sector, we assumed the Line 3 replacement project would be completed in the fourth quarter of this year. This is now pushed back by at least 6 months, likely into 2H20.12 The replacement was expected to restore Line 3’s original takeaway capacity of 760k b/d from 390k b/d, and was a crucial input in our Canadian oil output forecasts. The reduction of the production curtailment to ~ 95k b/d in 2H19 previously announced by the Alberta government will not be sufficient to maintain the WCS transportation discount below $15/bbl (Chart 5). Thus, the government most likely will extend part of the ~ 325k b/d mandatory cuts into 2H19. A rollback of the curtailment policy to 95k b/d ahead of the Line 3 replacement would push the differential back above the crude-by-rail range – i.e., a $15-to-$22/bbl discount over the quality discount for heavy sour crude vs. the light-sweet. Chart 5 We expect a combination of production decreases and increased crude-by-rail transport, which will have to go to record levels, could help alleviate the negative pressure on the WCS-WTI discount (Chart 6). For instance, maintaining a 225k-barrel-per-day production curtailment from April to December 2019, combined with an increase in crude-by-rail transport to ~ 460k b/d by year-end would be enough to maintain the discount in our estimated crude-by-rail range (Chart 7).13 Chart 6 Chart 7 Heavy Crude Differentials Will Remain Tight The prolongation of Canadian crude bottlenecks will contribute to keeping heavy-sour vs. light-sweet price differentials tight. Altogether, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and continued takeaway capacity constraints in Canada will keep the price differentials between light-sweet and heavy-sour crudes tight. This can be seen in the Brent – Dubai spread, which at times, favors the heavy-sour crude streams (Chart 8). Chart 8Heavy-Sour Crude Differentials Tighten As Supply Contracts Heavy-Sour Crude Differentials Tighten As Supply Contracts Heavy-Sour Crude Differentials Tighten As Supply Contracts Bottom Line: The WCS differential vs. WTI is at risk of weakening once again, following the unexpected delay in Enbridge’s Line 3 replacement and expansion. The Alberta government will have to get more deeply involved to keep unconstrained production from hammering the differential once again.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Please see “OPEC likely to defer output policy decision until June – sources,” published by uk.reuters.com, March 4, 2019. 2 Please see “Permian Majors Expand Downstream Processing,” published by Morningstar Commodities Research, February 11, 2019. 3 These data were sourced from the EIA’s Drilling Productivity Report for February 2019. 4 See fn 2 above. See also “Chevron, Exxon take turns wooing investors with shale boasts,” published by reuters.com March 5, 2019. 5 This estimate comes from ICE Brent Crude Oil, published by The Intercontinental Exchange (ICE), which runs the Brent futures market. 6 Please see “Viewpoint: North Sea benchmark changes looming” which was published by Argus Media on December 27, 2018. 7 Please see “US waterborne crude trade shifts toward Brent basis” published by Argus Media on February 15, 2019. 8 See, e.g., Carlyle Group’s recently announced involvement in such a venture. Carlyle expects its deep-water buildout to be done in late 2020. 9 Please see “In the LOOP: Record US crude exports boost VLCC tanker demand, rates,” published by S&P Global Platts on March 5, 2019. 10 Please see Liz Bossley’s article “There Can (Not) Be Only One,” beginning on p. 15 of the May 2018 issue of the Oxford Energy Forum – Oil Benchmarks – Issue 113, for a discussion of different oil-price benchmarks. 11 We discuss Canada’s take-away dilemma in our November 29, 2018, publication entitled “The Third Man At OPEC 2.0’s Meeting.” It is available at ces.bcaresearch.com. 12 Please see “Enbridge’s Line 3 pipeline replacement likely won’t be in service until second half of 2020,” published by The Globe and Mail on March 3, 2019. 13 The government intends to increase the production ceiling by 100k b/d by April 2019, this makes the mandatory cuts at 225k b/d from 325k b/d in January 2019. https://www.alberta.ca/protecting-value-resources.asp Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Trades Closed in Oil Price Diffs: Global Convergence Oil Price Diffs: Global Convergence

Political economy – i.e., the interplay between critical nation states’ policies and markets – often trumps straightforward supply-demand analysis in oil. This is because policy decisions affect production and consumption, along with global trade. These decisions, in turn, determine constraints states – central and tangential – confront in pursuit of their interests. Presently, U.S. policies toward Venezuela and Iran dominate oil supply considerations, while Sino – U.S. trade tensions and their effect on EM consumption dominate the demand side. In this month’s balances assessment, we revised some of our supply-side assumptions to include the high probability U.S. waivers on Iranian export sanctions will have to be extended until Venezuela stabilizes. OPEC 2.0 appears to be flexible -- positioning for either an extension of waivers, or sanctions. This keeps our baseline oil-supply assumptions fairly steady this year as the coalition adjusts to changes in Venezuela’s output. Adjustments could be volatile, however. On the demand side, we continue to expect growth of 1.49mm b/d this year and 1.57mm b/d in 2020. Steadier production and unchanged demand assumptions lower our price forecasts slightly to $75/bbl and $80/bbl this year and next for Brent, with WTI trading $7.0/bbl and $3.25/bbl below those levels, respectively (Chart of the Week). Chart of the WeekExpect OPEC 2.0 To Smooth Venezuelan Production Losses In 2019 Expect OPEC 2.0 To Smooth Venezuelan Production Losses In 2019 Expect OPEC 2.0 To Smooth Venezuelan Production Losses In 2019 Highlights Energy: Overweight. Nigeria’s elections, scheduled for this past weekend, were unexpectedly postponed until Saturday. Political leaders urged Nigerians to “refrain from civil disorder and remain peaceful, patriotic and united to ensure that no force or conspiracy derail our democratic development.”1 Nigeria produces ~ 1.7mm b/d of oil. Base Metals/Bulks: Neutral. Estimated LMEX, CME, SHFE and bonded Chinese warehouse copper inventories are down 29.8% y/y, which will continue to be supportive of prices. Precious Metals: Neutral. Palladium is trading ~ $111/oz over gold, as concerns over supply deficits persist. The last time this occurred was on November, 2002. Ags/Softs: Underweight. Chinese buyers are believed to have cancelled as much as 1.25mm bushels of soybean purchases last week, according to feedandgrain.com. Feature The analytical framework informing global political economy provides a useful augmentation to our standard supply-demand analysis, particularly now, when U.S. policy continues to play a pivotal role in the evolution of oil fundamentals. In particular, we believe the near-term evolution of oil prices hinges on how events in Venezuela play out, following the imposition of U.S. trade and financial sanctions directed against the state-owned PDVSA oil company and the Maduro regime. The evolution of the U.S.’s PDVSA sanctions will directly determine whether waivers on Iranian export sanctions granted by the Trump administration in November are extended when they expire in May.2 These tightly linked evolutions, in turn, will drive OPEC 2.0 production policy, and whether its production-cutting agreement is extended beyond its June 2019 termination. As we discussed recently, we see OPEC 2.0 building its flexibility to adjust quickly to either an extension of the waivers on Iranian sanctions, or to accommodate the termination of these sanctions at the end of May. Given the state of the market, which we discuss below, we believe waivers on Iranian export sanctions almost surely will be extended when they expire in May. Global Oil Markets Are Tightening Our supply assumptions are driven by our assessment that global spare capacity of just over 2.5mm b/d could accommodate the loss of Venezuelan oil exports with little difficulty (in a matter of months), aside from a further tightening at the margin in the heavy-sour crude oil market (Chart of the Week and Table 1). In fact, the loss of up to 1mm b/d or more of Iranian exports – versus the ~ 800k b/d we now expect if waivers are extended until December – could also be accommodated by OPEC 2.0’s spare capacity, given the rebuilding of this potential output on the back of OPEC production cuts, which have the effect of increasing spare capacity (Chart 2).3 Table 1BCA Global Oil Supply – Demand Balances (MMb/d) (Base Case Balances) The New Political Economy Of Oil The New Political Economy Of Oil Chart 2 However, should this combination of events be realized, an unplanned outage similar to the one that removed ~ 1mm b/d of Canadian production due to wildfires in the summer of 2016, with Venezuela production falling toward 650k b/d and Iranian exports even partially constrained, could move the oil market perilously close to the limits of global spare capacity, which now stands just over 2.5mm b/d, based on the EIA’s reckoning. This would increase the risk of dramatically higher prices, simply because the flex in the system would approach zero. Iranian Waivers Hinge On Venezuela The manner in which U.S. sanctions against PDVSA and the Maduro regime evolve – in particular, whether regime change is affected – will determine whether waivers on the oil-export sanctions the U.S. re-imposed on Iran last November are extended beyond their end-May terminal point. In turn, this will affect OPEC 2.0’s production policies, particularly after its production-cutting agreement expires in June. In our current model of OPEC 2.0 production, we now expect its 2019 production to continue to decline in 1H19, to drain the overhang resulting from the ramp-up member states undertook in preparation for U.S. sanctions against Iran. This policy was substantially reversed with the last-minute granting of waivers to eight importing countries by the Trump administration prior to sanctions kicking in in November. This led to a sharp sell-off in crude oil prices in 4Q18, as market participants re-calibrated the supply side of global balances. In 2H19, our base case assumes OPEC 2.0’s production rises by ~ 900mm b/d (December vs. July 2019 level), to smooth out the loss of Venezuelan output as it falls to 650k b/d by the end of this year from just under 1.1mm b/d now. The goal of this policy is to quickly drain global inventories to levels comfortably below the five-year average (in 1H19), and then to keep Brent prices in the $75/bbl to $80/bbl range over 2H19 – end-2020 (Chart 3). We expect core OPEC 2.0 countries, led by KSA, core GCC states and Russia production to rise by more than 500k b/d in 2H19 (vs. 1H19 levels), to maintain inventories at desired levels and prices in the $75/bbl to $80/bbl range. Chart 3Core OPEC And Non-OPEC Output Will Rise To Offset Venezuelan Losses Core OPEC And Non-OPEC Output Will Rise To Offset Venezuelan Losses Core OPEC And Non-OPEC Output Will Rise To Offset Venezuelan Losses To this end, we assume core OPEC 2.0’s production rises in 2020 to 33.52mm b/d from 32.98mm b/d in 2019, led by a ~ 200k b/d increase from KSA – which takes its output to ~ 10.4mm b/d from ~ 10.2mm b/d in 2019. We expect Russian production to rise to 11.7mm b/d from ~ 11.5mm b/d in 2019. Additional output hikes come from core OPEC and other non-OPEC producers (Chart 4, Table 1). Chart 4OPEC 2.0's Goal: Quickly Reduce Inventories In 1H19 OPEC 2.0's Goal: Quickly Reduce Inventories In 1H19 OPEC 2.0's Goal: Quickly Reduce Inventories In 1H19 We do not try to forecast how the sanctions against PDVSA and the Maduro government play out – i.e., whether the incumbent government survives, or whether a peaceful or violent regime change occurs. If Venezuela were to descend into civil war, or were to experience a violent revolution, the outcome would be unpredictable and the rebuilding of that economy – regardless of who emerges to take control of the state – would require years. Likewise, if President Maduro and the military leaders supporting him were to quietly decamp, it still would require years to rebuild that country’s oil industry and economy.4 We view the odds of a confrontation between the U.S. and Venezuela’s benefactors/creditors as extremely low. We believe the U.S. would revive the Roosevelt Corollary to the Monroe Doctrine, and that Russia and China most likely would concede Venezuela is within the U.S.’s sphere of influence, as neither intend to project the force and maintain the supply lines such a confrontation would require.5 Because the resolution of the political uncertainty in Venezuela is unsure and the outcome unknowable – particularly when unplanned outages represent such a non-trivial risk to global supply at the margin – we strongly believe waivers granted on U.S. sanctions against Iranian oil exports will be extended at least by 90 to 180 days when they expire at the end of May. As we discuss above, global spare capacity is insufficient to cover the loss of Venezuelan and Iranian output, and still have the flexibility required to meet a large unplanned outage over the course of this year or next. For this reason, Iranian sanctions will not be immediately re-imposed following the termination of U.S. waivers on exports from that state; importers most likely will be increasing their liftings of Iranian crude, in line with the extension of the waivers we expect over the course of 2H19 (Chart 5). Chart 5 Oil Demand Continues To Hold Up We continue to expect global oil demand to grow by 1.49mm b/d this year and 1.57mm b/d in 2020, led as always by strong EM demand growth, with China and India at the forefront (Table 1). DM demand growth is expected to slow this year, but put in a respectable performance, as well. EM commodity demand growth generally has been trending down at a slow and constant pace since the beginning of 2018, as we discussed last week when we presented our new Global Industrial Activity (GIA) index. The index indicates demand is not as stellar as it was during the synchronized global upturn of 2017, but that it also is not as bad as sentiment and expectations would indicate.6 Pulling It All Together On balance, we expect the combination of stronger OPEC 2.0 output, plus an 800k b/d increase in U.S. shale-oil production, which lifts total U.S. crude-oil output from 12.42mm b/d to 13.49mm b/d next year, is enough to keep Brent prices close to $80/bbl next year, vs. the $75/bbl we expect this year (Chart 6). We revised our expectation for WTI slightly, and now expect it to trade ~ $7.0/bbl under Brent this year and at a $3.75/bbl discount next year. Chart 6Balanced Oil Market Expected This Year and Next ... Balanced Oil Market Expected This Year and Next ... Balanced Oil Market Expected This Year and Next ... The OPEC 2.0 production discipline and lower U.S. shale-oil output, coupled with strong – not stellar – demand growth combine to allow OECD commercial oil inventories (crude and products) to resume drawing and to fall comfortably below OPEC 2.0’s 2010 – 2014 five-year average target (Chart 7). This will be supportive of the Brent backwardation trade we recommended on January 3, 2019 which now is up 265.5%, as of Tuesday’s close. Chart 7... And Oil Inventories Resume Falling ... And Oil Inventories Resume Falling ... And Oil Inventories Resume Falling Bottom Line: We revised our supply estimates, and now expect OPEC 2.0 to cover lost Venezuelan output arising from the imposition of U.S. sanctions on PDVSA and the continued deterioration of that state’s oil industry. Because global spare capacity cannot handle the loss of Venezuelan and Iranian oil exports at the same time and still cover a large unplanned outage, we expect the waivers on U.S. sanctions of Iranian oil exports to be extended for up to 180 days following their termination at the end of May. We expect Brent crude oil prices to average $75/bbl this year and $80/bbl next year as oil markets balance. We expect WTI to trade ~ $7.0/bbl below Brent this year, and $3.25/bbl under in 2020.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Please see “Nigeria Election 2019: Appeal For Calm After Shock Delay,” published February 16, 2019, by bbc.com. 2 OPEC 2.0 is the name we coined for the producer coalition of OPEC states, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC states led by Russia, which recently agreed to cut production by ~ 1.2mm b/d to drain commercial oil inventories and re-balance markets globally. OPEC 2.0’s market monitoring committee meets in April to assess the production-cutting deal it reached in November, which is set to expire in June. The full coalition meets in May to set policy going forward. This is just ahead of the expiration of U.S. waivers on Iranian oil exports. For a discussion of OPEC 2.0’s production optionality, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy January 24, 2019.  It is available at ces.bcaresearch.com. 3 We are watching the evolution of the partial closure of the offshore Safaniya field in KSA about two weeks ago closely. With 1mm b/d capacity, this is the world’s largest offshore producing field; no updates have been provided by KSA this week. 4 Please see “What Next For Venezuela,” by Anne Kreuger published by project-syndicate.org on February 15, 2019 for a discussion. 5 We note here that Gazprombank, the Russian bank, froze PDVSA’s accounts over the weekend to avoid running afoul of U.S. sanctions against the company. Please see “Russia’s Gazprombank decided to freeze PDVSA accounts – source,” published by reuters.com February 17, 2019. See also “What Comes Next For Venezuela’s Oil Industry,” published by the Center for Strategic and International Studies February 12, 2019, which details how U.S. sanctions amount to the equivalent of a full-on embargo by forcing payment for Venezuelan oil to be deposited in accounts that cannot be accessed by the government or PDVSA. 6 We discuss our global demand outlook in last week’s Commodity & Energy Strategy Weekly Report, in an article entitled “Oil, Copper Demand Worries Are Overdone.” It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed in Image

Highlights Investors like to hear non-consensus views, … : Part of our role is to help clients think about all of the potential outcomes, including ones that may not be as improbable as commonly believed. … but it seems that our Fed/rates call is starting to strike them as a little too non-consensus: Clients are having a hard time seeing the potential for inflation after ten years of errant predictions that it’s just around the corner. From our perspective, the probability of higher-rate outcomes is considerably higher than the probability of lower-rate outcomes, … : An investor with a low-duration bias has a whole lot more ways to win than an investor with a high-duration bias. … so we’re staying the course: We continue to recommend underweighting Treasuries and maintaining below-benchmark duration exposure, which aligns with our constructive take on markets and the economy. It’s too early to get defensive if a recession is at least a year away. Feature BCA clients like to hear contrarian calls, and there is little that’s more deflating from a strategist’s perspective than to be told in a meeting that his/her views are the same as everyone else’s. Except for the handful of strategists who make their living from provocative views that have almost no chance of coming to fruition, however, the calls have to be plausible. For many investors, our inflation concerns seem to be straining the bounds of plausibility. Even if BCA has only lately begun to beat the inflation drums, investors have had enough of warnings about inflation and interest-rate spikes that have repeatedly failed to come to pass. Regular readers are familiar with our contention that the sizable injection of fiscal stimulus into an economy already operating at capacity is a sure-fire recipe for inflation. They are also familiar with our view that an extremely tight labor market will necessarily give rise to robust wage gains. We have repeatedly argued that the Fed will respond to the combination of inflation pressures by hiking the fed funds rate above its equilibrium level, bringing the curtain down on the expansion and the equity bull market. With a Special Report examining the links between wage gains, consumer price inflation, and the Fed’s reaction function on the way, we’re instead devoting this week’s report to several other reasons why an investor would want to maintain below-benchmark duration in a fixed-income portfolio. Oil Prices Will Rise There is a good reason for devising core price indexes that smooth out the volatility inherent in food and energy prices. Core indexes provide a better read on the underlying inflation trend, and are a better predictor of moves in headline inflation than the headline indexes themselves. Inflation-linked Treasuries (TIPS) are tied to headline CPI, however, leaving the long-run inflation break-evens at the mercy of swings in oil prices (Chart 1). As we have previously written, our commodity strategists view the October-November swoon as a one-off event disconnected from market fundamentals that will quickly be unwound1 (Chart 2). Chart 1As Oil Goes, So Go Inflation Expectations, ... As Oil Goes, So Go Inflation Expectations, ... As Oil Goes, So Go Inflation Expectations, ... Chart 2... And Oil Prices Are Poised To Rise ... And Oil Prices Are Poised To Rise ... And Oil Prices Are Poised To Rise One need not fear that a rise in oil prices, while giving a fillip to headline inflation, would slow the economy and thereby offset inflation’s upward pressure on rates. Now that the U.S. is the world’s largest oil producer, its economy and financial markets are no longer negatively correlated with oil prices (Chart 3). It is still true that falling oil prices amount to a tax cut for American businesses and households, but they now also amount to fewer high-paying jobs in the oil patch, reduced earnings in an important domestic industry, and tighter monetary conditions as fracking bond spreads widen. Chart 3No Longer A Contrary Indicator No Longer A Contrary Indicator No Longer A Contrary Indicator Bottom Line: Higher oil prices will push headline inflation and inflation expectations higher, while also boosting the economy at the margin. The combination promotes higher bond yields, all else equal. The Economy’s Improved. Yields Haven’t Budged. Though we attributed the bulk of the fourth-quarter selloff to misplaced fears that the Fed was pulling the rug out from under the expansion, the economy was finding it harder and harder to produce positive surprises. By late January, however, the expectations bar had been reset low enough that new releases began surpassing it, day in and day out (until the end of last week). So far, though, the 10-year Treasury yield has stubbornly failed to reflect the improvement (Chart 4). Chart 4Surprises Turned Around, But Yields Didn't Surprises Turned Around, But Yields Didn't Surprises Turned Around, But Yields Didn't Financial conditions tightened sharply upon the sudden widening in corporate bond spreads and the sudden drop in equity prices. We viewed the seize-up as equivalent to at least a quarter-point increase in the fed funds rate and thereby found pausing to be a perfectly logical course of action for the Fed. The swiftness of the subsequent bounce in risk assets – the S&P 500 has retraced more than two-thirds of its losses and high-yield bonds have retraced close to 60% of their spread widening – has gone a long way toward undoing last quarter’s tightening. With the recovery in financial conditions, all three components of our Fed monitor now point to a need for tighter monetary conditions (Chart 5). Chart 5The Fed Can Pause, But It Can't Stop The Fed Can Pause, But It Can't Stop The Fed Can Pause, But It Can't Stop Adaptive Expectations’ Sluggish Response Investors’ inflation outlooks adhere closely to an adaptive expectations framework in which future predictions are largely a function of inflation’s recent path (Chart 6). This is not unreasonable; one could do a lot worse than pick the Patriots to reach the Super Bowl or only South American and European (ex-England) teams to win the World Cup. Adaptive expectations can fall prey to the recency bias, however, in which individuals overemphasize the most recent data points to the exclusion of older, potentially more representative data when forming their future views. From a recency-bias perspective, adaptive expectations can trap investors like the mythical frog contentedly lingering in a pot of water that’s only slowly brought to a boil. Chart 6Inflation Forecasts Take Their Cue From The Past ... Inflation Forecasts Take Their Cue From The Past ... Inflation Forecasts Take Their Cue From The Past ... We are skeptical of the notion that there will be no more inflation because there’s been no inflation since the crisis. The trend may be your friend, but not once the output gap has closed and the unemployment gap is persistently negative. Using the 10-year CPI forecast from the Philly Fed’s Survey of Professional Forecasters as an inflation-expectations proxy, one could argue that the lion’s share of the outsized gains in the pre-crisis phase of the bond bull market resulted from excessively generous inflation compensation (Chart 7, bottom panel). Chart 7... Which Is Great For Investors When Inflation Trends Lower ... Which Is Great For Investors When Inflation Trends Lower ... Which Is Great For Investors When Inflation Trends Lower The excessive compensation was a by-product of adaptive expectations. After the experience of the mid-seventies and early eighties (Chart 8), investors and issuers both assumed inflation would be higher than it turned out to be. Today’s bond-market participants, conditioned by ten years of soggy post-crisis readings, could well assume that inflation will be lower than it ultimately turns out to be. That may leave long-maturity bondholders with insufficient compensation, just like their early-fifties forebears. Chart 8Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Reversal Of Globalization The apex of globalization has been a key theme of our Geopolitical Strategy service since its launch. We cannot go as far as they sometimes do, arguing that globalization did more to bring inflation to heel than Paul Volcker, but it surely has been an important factor in limiting wage gains for low- and semi-skilled workers (Chart 9), and has helped to stymie retail price increases. The imposition of new tariffs have exacerbated globalization’s reversal, but it had already begun before the 2016 presidential election. The Reagan-Thatcher-Koizumi policies that were ascendant after the fall of the Berlin Wall, boosting global growth while tamping down inflation, have been in retreat in the developed world ever since the crisis. Chart 9China Syndrome China Syndrome China Syndrome Decomposing Core CPI When assessing inflation’s future direction, our U.S. Bond Strategy colleagues decompose the core CPI series into its primary components: Shelter (42% of the index); Goods (25%); Services, excluding shelter and medical care (25%); and Medical Care (8%). They then look at the drivers for each of the largest three components for an advance read on their future direction. Home price appreciation and the rental vacancy rate power their shelter costs model. With home price appreciation decelerating but still positive, and the rental vacancy rate hovering around its all-time lows, the model projects that shelter costs will remain well above 3% (Chart 10, top panel). Chart 10Core Inflation Isn't About To Melt Core Inflation Isn't About To Melt Core Inflation Isn't About To Melt Core goods inflation lags non-oil import prices by about a year and a half. The path of import prices suggests that core goods inflation will have a tailwind for much of the rest of the year before facing a headwind next year that will push it back to its current levels (Chart 10, second panel). Wage growth is the best predictor of core services inflation, ex-shelter and medical care (Chart 10, third panel). We expect continued upward pressure on services inflation, as labor-market slack continues to be absorbed, keeping wage growth accelerating. The Golden Rule Of Bond Investing Simplicity is a virtue in investment recommendations, models, and rationales, and our U.S. Bond Strategy colleagues’ golden rule of bond investing is elegantly simple.2 If Fed rate hikes exceed market expectations over a given time horizon, overweight duration positions will underperform over that horizon, and if Fed hikes fail to meet market expectations, overweight duration positions will outperform. Now that the money market has entirely priced out any rate-hike prospects over the next two years (Chart 11), overweight duration positions face a challenging backdrop. How will the fed funds rate surprise to the downside from here? Chart 11The Money Market Is Calling For A Rate Cut The Money Market Is Calling For A Rate Cut The Money Market Is Calling For A Rate Cut It can’t unless the Fed carries out more than one 25-basis-point cut in the next year or so. Given the underlying strength of the economy, gathering inflation pressures, and the swift unwinding of much of the tightening in financial conditions, rate cuts are a stretch. Against the current backdrop, the golden rule is a stern warning away from the longer-maturity reaches of the Treasury curve. Investment Implications We continue to stay the course with our fixed-income recommendations. If the Fed’s pause will extend the expansion for a few more months, it will extend the shelf life of our underweight Treasuries and overweight spread product recommendations, as well. As outlined above, we see many more potential catalysts for higher interest rates than we do for lower rates. We reiterate our recommendation that investors maintain below-benchmark duration across fixed-income segments. The expansion, and the bull markets in risk assets, will eventually end, but it’s too soon to position portfolios for it.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Does Oil’s Slide Mean?,” published November 26, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.