Oil & Gas Refining & Marketing

Refiners Are Headed Downstream Refiners Are Headed Downstream Underweight The drubbing in oil markets this month has not spared stocks in the S&P oil & gas refining & marketing index, which has given up all of its 2018 gains. Our downgrade to underweight on July 16 has been spot on and already returning 15.5% compared with the broad market. Crack spreads have nose-dived and should weigh heavily on earnings (second panel). Despite the collapse, the sell-side community has remained stubbornly optimistic, a position that looks untenable in the context of both a contracting crack spread and still-rising domestic gasoline inventories (inventories shown inverted, third panel). Such an imbalance can either be resolved via an inventory or earnings drawdown; we anticipate the latter. While the sector has seen a valuation correction, we would be hesitant to call the index affordable. Rather, in the context of analyst expectations that will have to return to earth, even an average valuation multiple seems too optimistic (bottom panel). Bottom Line: More pain lies ahead for refiners; we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC.

Highlights Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 Critical Reset Critical Reset FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid VIX The Comeback Kid VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Economic Impulse Yellow Flag Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Economic Growth Trouble Economic Growth Trouble Chart 5Watch Credit Quality Watch Credit Quality Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought Overvalued And Overbought Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Capex Blues Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Warning Signals... Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... ...Abound... ...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... ...Even In Intermodel... ...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets ...But There Are Offsets ...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Too Good To Be True Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion No Valuation Cushion No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... Mixed Signals... Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads ...On Crack Spreads ...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Refiners have taken it to the chin over the past six weeks, underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. Crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure (second panel). Not only is demand faltering (not shown), but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, third panel). This supply/demand backdrop will weigh on industry profitability. Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: We trimmed the S&P oil & gas refining & marketing index to underweight; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Oil And Gas Refiners Are Flaming Out Oil And Gas Refiners Are Flaming Out

Highlights Portfolio Strategy Firming crude oil prices and recovering capex budgets suggest that energy E&P stocks are in a sweet spot and primed for outperformance. Decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Recent Changes Lift the S&P oil & gas exploration & production index to overweight today. Downgrade the S&P oil & gas refining & marketing index to underweight today. Table 1 Soldiering On Soldiering On Feature Equities broke out of their recent trading range last week on the eve of earnings season despite protectionist rhetoric. While Q2/2018 EPS euphoria may serve as a catalyst to catapult the SPX to fresh all-time highs in the coming months, especially given the collapse in stock correlations (CBOE implied correlation index shown inverted, Chart 1), sell-side analysts have now revised down Q1/2019 EPS growth estimates by 300bps to 7%. We view Q1/2019 earnings as critically important, as they will give us the first clean read on trend EPS growth. By that time the one-off impact of tax reform will be filtered out of the data. At present, Q1/2019 EPS estimates are likely suffering for two reasons: delayed P&L FX translation effects from a year-to-date rise in the U.S. dollar and difficult year-over-year comparisons with a blowout Q1/2018 quarter. In recent research, we have been flagging the currency as the single biggest risk to our sanguine equity market view. In other words, a sustainable breakout in equities requires a sideways-to-lower move in the greenback (trade-weighted U.S. dollar shown inverted, Chart 2). Chart 1All-Time Highs Ahead... All-Time Highs Ahead... All-Time Highs Ahead... Chart 2...But Watch The Greenback ...But Watch The Greenback ...But Watch The Greenback Drilling beneath the surface, Charts 3 & 4 show net earnings revisions (NER) per sector as a four week average and Chart 5 summarizes the latest data points for an easier comparison. Industrials NER have taken a hit on the back of Trump's tariff rhetoric and recent implementation. Nevertheless, the tech sector shows no signs of infiltration either from a rising currency or Trump's protectionist actions. As a reminder, the IT sector garners 60% of its sales from abroad and remains the most important sector to monitor for any broad market EPS inflection points.1 Chart 3Sector... Sector... Sector... Chart 4...Net EPS Revisions ...Net EPS Revisions ...Net EPS Revisions On the economic front, a softening U.S. dollar would be synonymous with a reacceleration in global growth. We are currently in the seventh month of the economic soft patch and there are high odds that by early fall the tide will turn. The global non-manufacturing PMI is already signaling that a pick up in growth is forthcoming. Historically, the global services PMI has been an excellent leading indicator of its sibling, the global manufacturing PMI, and the current message is to expect an end to the global growth deceleration sometime in the autumn (Chart 6). Chart 5Watch Tech Stocks Soldiering On Soldiering On Chart 6Longest Uninterrupted Payrolls Expansion On Record!!! Largest Uninterrupted Payrolls Expansion On Record!!! Largest Uninterrupted Payrolls Expansion On Record!!! In the U.S., the ISM manufacturing survey reaccelerated last month despite Trump's protectionist rhetoric with both trade subcomponents of the survey - new export orders and imports - rising smartly. Even the latest employment report came in above expectations, and confirmed that the U.S. economy is firing on all cylinders and remains a key global growth engine. Importantly, non-farm payrolls have been expanding on a month-over-month basis for the longest period on record hitting 93 consecutive months as of June (Chart 7). Similarly, the yield curve has remained positively sloped for a record 134 straight months (please see Chart 2 from our April 16th Special Report titled 'Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening'). Tack on China's recent easing in monetary conditions, as evidenced by both a depreciating currency (steepest month-over-month depreciation since 1994) and falling interest rates (Chart 8), and the likelihood of additional easing measures in the pipeline, and the world's two largest economies will likely lead global growth out of its recent mini-slump. Chart 7Can Services Pull Up Manufacturing? Can Services Pull Up Manufacturing? Can Services Pull Up Manufacturing? Chart 8China Is Easing Monetary Conditions China Is Easing Monetary Conditions China Is Easing Monetary Conditions This week we are refining our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterate its high-conviction status. E&P Is Flaring Up... Exploration & production (E&P) stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 9). There are high odds that a catch up phase looms and we recommend to boost exposure to this late-cyclical energy sub-index to overweight. Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on E&P stocks along with a bottleneck-induced steep shale oil price discount to WTI. Keep in mind that as oil prices were collapsing during the global manufacturing recession of late-2015/early-2016, the U.S. E&P industry went through a clean-up phase where a plunge in free cash flow (FCF) caused a spike in bankruptcies on the back of extreme balance sheet degradation (Chart 10). Chart 9Most Vulnerable Gap Has To Be Filled Most Vulnerable Gap Has To Be Filled Most Vulnerable Gap Has To Be Filled Chart 10Balance Sheets Getting Repaired Balance Sheets Getting Repaired Balance Sheets Getting Repaired Chart 11No Longer Stressed No Longer Stressed No Longer Stressed In more detail, E&P FCF got squashed, dropping by 66% from peak to trough as net debt ballooned by 30% during the same time frame. And, in response, independent energy producers' junk bond spreads skyrocketed to over 20%, surpassing even the Great Recession peak (Chart 11). Nevertheless, the steep recovery in underlying commodity prices along with the forgiving debt and equity markets that lent a helping hand to this extremely fragmented industry, has restored some semblance of normality in the E&P space. The second panel of Chart 9 shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Not only is OPEC 2.0 supporting oil price gains, but sustained domestic inventory draws are also underpinning crude prices. BCA's Commodity & Energy Strategy service remains positive on the oil price backdrop with oil price risks skewed to the upside. The upshot is that the recovery in E&P cash flow growth will continue in the coming months (second & third panels, Chart 10). Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (middle panel, Chart 12). Rising oil prices are conducive to additional energy-related investments (bottom panel, Chart 9). Importantly, there is a sizable divergence between the oil & gas rig count and relative share prices that will likely narrow via a catch up phase in the latter (top panel, Chart 12). National data confirm the Baker Hughes weekly rig count that has been in a V-shaped recovery. Energy related investment has doubled from the depths of the manufacturing recession (bottom panel, Chart 12), and if oil prices even stand pat at current levels, additional drilling will most likely take place in the biggest shale plays (Permian, Eagle Ford, Marcellus and Bakken) where breakeven costs are roughly 30% lower. All of this suggests that U.S. producers will continue to pump oil at a brisk pace, and earnings will likely overwhelm. Sell side analysts have taken notice and relative EPS estimates are following crude oil prices higher. Similarly, S&P oil & gas E&P net EPS revisions are also in positive territory (Chart 13). Chart 12Capex Upcycle Beneficiary Capex Upcycle Beneficiary Capex Upcycle Beneficiary Chart 13Following Oil Higher Following Oil Higher Following Oil Higher Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We are boosting the S&P oil & gas E&P index to an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX. ...But Refiners Are Flaming Out While we are warming up to the S&P oil & gas E&P index, the opposite is true for the pure play S&P oil & gas refining & marketing index, and recommend to trim exposure below benchmark. Refiners have taken it to the chin over the past six weeks underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. The middle panel of Chart 14 shows that crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure. Already, margins are contracting on a six-month rate of change basis and that will continue to weigh on relative share prices (bottom panel, Chart 14). This is an ominous sign for relative profits that will likely follow crack spreads lower. The refining supply/demand backdrop is also waning. Refined products consumption has sunk recently, and the year-to-date steep momentum reversal of 13 percentage points suggests that relative profits will underwhelm (top & middle panels, Chart 15). Not only is demand faltering, but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, bottom panel, Chart 15). This supply/demand backdrop will weigh on industry profitability. Worrisomely, the sell side's analyst community is extremely optimistic with regard to 12-month forward relative EPS growth estimates (north of 20%, not shown). On a 5-year forward relative EPS basis Wall Street's exuberance is unprecedented: analysts expect refiners to double the SPX's 16% long-term EPS growth rate (Chart 16). We would lean against these great expectations. Chart 14Refiners Rally Has Cracked Refiners Rally Has Cracked Refiners Rally Has Cracked Chart 15Mind The Supply/Demand Backdrop Mind The Supply/Demand Backdrop Mind The Supply/Demand Backdrop Chart 16Too Much Optimism Too Much Optimism Too Much Optimism Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel, Chart 16). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: Trim the S&P oil & gas refining & marketing index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

In early September, we opportunistically upgraded the niche S&P oil & gas refining & marketing index to capture the earnings upside from hurricane-related capacity constraints. Such constraints have since normalized and, with some clouds on the horizon, last week we reversed our recommendation to a benchmark allocation, locking in profits of 9%. Refining margins have tightened considerably, as has the Brent-WTI crude oil spread (second panel); both signal that refiner profits will be challenged in the year to come. Analyst estimates have not yet incorporated the darker outlook, projecting lights-out earnings growth (third panel) with momentum to the upside (bottom panel). These elevated expectations introduce considerable forecast risk, offsetting the still-firm demand for refined products, underscoring our neutral recommendation. Please see our Feb 5, 2018 Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR- PSX, VLO, MPC and ANDV. The Good News Is Priced In For Refiners The Good News Is Priced In For Refiners

Highlights Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Acrophobia Acrophobia Feature Chart 1Vertigo Alert Vertigo Alert Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... No Matter The Data Set... No Matter The Data Set... Chart 3...EPS Will Shine In 2018 ...EPS Will Shine In 2018 ...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Favorable Macro Conditions... Favorable Macro Conditions... Chart 5...But Don't Get Carried Away ...But Don't Get Carried Away ...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Capex Theme Beneficiary Capex Theme Beneficiary Chart 7Catch Up Phase Looming Catch Up Phase Looming Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Levered To Global Growth And Rising Inflation Levered To Global Growth And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Favorable Supply/Demand Backdrop Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green EPS Model Flashing Green EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Buy Oil Majors Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex Prime Beneficiary Of Rising Capex Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Encouraging Oil Market Dynamics Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Cheap With A 150bps Dividend Carry Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Return To Normalcy... Return To Normalcy... Chart 16...But Cracks Are Forming ...But Cracks Are Forming ...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Watch Out Down Below Watch Out Down Below Chart 18Consumption Is A Positive Offset Consumption Is A Positive Offset Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A1 Chart A1 Chart A2 Chart A2 Chart A2 Chart A3 Chart A3 Chart A3 Chart A4 Chart A4 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Portfolio Strategy Rising oil prices, a weakened U.S. dollar, ongoing global oil producer discipline and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Wide crack spreads, sticky price hikes and sustained inventory drawdowns are a harbinger of more gains in the S&P refiners sub-index. Recent Changes There are no changes to our portfolio this week. Table 1 Invincible Invincible Feature Equities plowed higher last week, as earnings growth continues to surprise to the upside and synchronized global growth alongside fiscal easing remain the key macro themes. Over 81% of the companies have now reported earnings, with EPS growth pushing the Q3 blended figure to 8.0% on the back of 5.2% revenue growth. Last quarter's margin expansion is in line with the S&P 500's historical operating leverage of 40%.1 In the context of synchronized global growth macro backdrop, we have been adding deep cyclical exposure to our portfolio at the expense of defensives over the past few months, participating in the SPX's march higher. A simple manufacturing versus services indicator, comparing ISM manufacturing with ISM non-manufacturing, suggests that not only are there more gains ahead for the broad market, but cyclicals will also continue to outpace defensives (Chart 1). When the most cyclical part of the U.S. economy is flexing its muscle, typically a capex upcycle sustains the self-reinforcing earning upsurge. In mid-October2 we posited that such an investment boom will be the dominant macro theme next year. While this theme continues to fly under the radar, our confidence of a durable and broad-based capital spending cycle notched higher following the recent Q3 real GDP print. Table 2 shows the evolution of real GDP, real capex growth and real capex contribution to real GDP growth over the last year. CEOs are voting with their feet and making the longer-term oriented investment decisions as animal spirits are lifting, despite a very slow moving Washington, D.C. Chart 1Most Cyclical Part Of##br## U.S. Economy Is Flexing Its Muscle Most Cyclical Part Of U.S. Economy Is Flexing Its Muscle Most Cyclical Part Of U.S. Economy Is Flexing Its Muscle Table 2Evolution Of GDP ##br##And Capex Growth Invincible Invincible Chart 2 depicts these data on a longer time horizon. There are high odds that capital outlays will remain upbeat if BCA's view of a tax bill passage materializes3 in the next 6 months with some of the money making its way toward investment, sustaining the virtuous cycle. Were the GOP's tax plan to pass and allow businesses "to immediately write off the full cost of new equipment", then almost certainly CEOs will embark on a capex binge. Importantly, similarly to the synchronized global growth macro backdrop, there is a synchronous capex upcycle brewing. The top panel of Chart 3 shows our equal-weighted real gross fixed capital formation composite of 23 DM and EM countries using national accounts alongside our diffusion index. Our Global Capex Composite has stabilized, but more importantly the diffusion index (percentage of countries with an improving year-over-year capex) is showcasing a coordinated global capex recovery. Chart 2Capex... Capex… Capex… Chart 3...Is Growing Globally …Is Growing Globally …Is Growing Globally True, DM capex is more advanced than EM capex, but the V-shaped recovery in corporate profitability nearly guarantees a pickup in capital outlays in the coming quarters (middle and bottom panel, Chart 3). Another way we show this simultaneous global capex upcycle is the color coded map in Table 3, with green denoting an expansion in year-over-year real capex, and red a contraction. Green is taking over the table (please click here if you would like to receive this table with more details from our client services department). Table 3Synchronized Global Capex Growth Invincible Invincible Encouragingly, this is not only a national accounts reported capex phenomenon, but is also borne out by stock market reported data. Using Datastream-compiled stock market reported data, Charts 4, 5, & 6 show capital expenditures growth around the globe covering a number of DM and EM. Similar to our mid-October analysis, we advance operating earnings by one year, and investment should follow profit growth higher in the coming quarters underpinning the virtuous cycle. Chart 4Virtuous... Virtuous… Virtuous… Chart 5...Global Capex... …Global Capex… …Global Capex… Chart 6...Upcycle …Upcycle …Upcycle The implication of this synchronous capex growth backdrop is that high operating leverage deep cyclicals will dominate defensives next year and we reiterate our recent preference of cyclical versus defensive sectors. This week we update a deep cyclical sector we continue to overweight, and highlight one niche subcomponent. A Burst Of Energy? We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. While this was a timely upgrade, we still believe there is more room for additional relative gains in the coming months. All the reasons we cited during our summer upgrade call4 have started to move in our favor, signaling more upside ahead. Namely, the U.S. dollar remains down significantly for the year (Chart 7) and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (Chart 8). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. Chart 7Weakened U.S. Dollar Is Bullish Energy Weakened U.S. Dollar Is Bullish Energy Weakened U.S. Dollar Is Bullish Energy Chart 8Catch Up Phase Catch Up Phase Catch Up Phase On the supply front, both the overall U.S. oil & gas and horizontal only rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. As global oil inventories get whittled down and OPEC stays disciplined oil prices will remain well bid. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher. The implication is that the relative share price advance is still in the early innings (Chart 9). Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. On a price to book, prices to sales and price to cash flow basis energy is trading at a 40%, 30% and 5% discount, respectively, to the broad market. The recent carnage in EPS skews the results with the energy sector trading at a 47% forward P/E premium to the overall market (Chart 10). Our Technical Indicator has also tentatively troughed. Historically once the one standard deviation below the historical mean level gives way, a sling shot recovery ensues (Chart 10). Finally, the budding recovery in energy earnings remains intact and our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline (Chart 11). Chart 9Oil Inventory Drawdown = Buy Energy Stocks Oil Inventory Drawdown = Buy Energy Stocks Oil Inventory Drawdown = Buy Energy Stocks Chart 10Compelling Valuation Backdrop Compelling Valuation Backdrop Compelling Valuation Backdrop Chart 11EPS Model Is Still Flashing Green EPS Model Is Still Flashing Green EPS Model Is Still Flashing Green Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintain an above benchmark allocation in the S&P energy index. Bottom Line: We reiterate our early-July S&P energy sector upgrade to overweight. Refiners Are Heating Up In the summer we lifted the S&P oil & gas refining & marking index to neutral from underweight locking in impressive gains and that tilted our overall S&P energy sector exposure to above benchmark.5 Subsequently in early-September we further augmented exposure in this pure play energy downstream index to overweight.6 Since then, relative performance is up over 8%. Is it time to book profits? The short answer is not yet. While these relative gains are impressive in such a short time span, we are staying patient before monetizing them, as leading indicators of refiners' profits continue to flash green. Our thesis in September was that the Hurricane Harvey catastrophe presented a trading opportunity from the long side for the S&P refining index. Not only did production get substantially curtailed, but also, as a result, inventories gave way. The longer the disruption, the sweeter the profit spot for the refining industry, as only higher industry selling prices could bring the market back to equilibrium. Indeed, the Brent/WTI crude oil spread, a great proxy for refining margins, recently vaulted to $8/bbl, the highest since early-2015 (Chart 12). Refining margins and gasoline prices also jumped to multi-year highs. While the industry has recovered since the hurricane devastation and brought production back online, selling price inflation is proving sticky, which is a boon for industry margins and thus profits. Already, this earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (Chart 13). Looking closer at the inventory backdrop, the refined product drawdown is ongoing. From the early 2017 peak, gasoline and distillate fuel supplies have collapsed by roughly 100mn bbl (inventories shown inverted, top panel, Chart 13). In particular, gasoline stocks are now contracting at 5% per annum (inventories shown inverted, middle panel, Chart 13). Historically, industry inventory accumulation has been weighing on relative share prices and vice versa. Evidently, the market has yet to reach an equilibrium, which is a boon for refining profits and relative share prices. Finally, following the collapse in refined product net exports as refiners focused on primarily fulfilling domestic demand, net exports have jumped back to all-time highs near 3mn bbl/day. This represents an over 6mn bbl/day swing in net exports over the past decade (bottom panel, Chart 14). A weak U.S. currency coupled with the higher prices oil products fetch abroad should continue to underpin exports and represent another sizable avenue for industry profits. Chart 12Too Early To##br## Lock In Profits Too Early To Lock In Profits Too Early To Lock In Profits Chart 13Decreasing Refined Product ##br##Stocks Are A Boon For Refiners Decreasing Refined Product Stocks Are A Boon For Refiners Decreasing Refined Product Stocks Are A Boon For Refiners Chart 14Export Relief ##br##Valve Reopened Export Relief Valve Reopened Export Relief Valve Reopened Netting it out, it is still too soon to take profits on the S&P oil & gas refining & marketing index. Refined product inventories continue to fall, crack spreads are wide and industry price hikes are sticky. This is a fertile profit margin and EPS backdrop, underscoring that the path of least resistance is higher for relative share price, at least until an equilibrium is reached. Bottom Line: Stay overweight the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," dated April 17, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 5 Ibid. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Still Goldilocks," dated September 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Overweight We lifted refiners to overweight in mid-September as the pricing environment looked set to improve dramatically, driven by Hurricane Harvey-related refinery shutdowns and the resulting inventory drawdowns, boosted by an accelerating Brent/WTI spread. This view has largely played out as expected; inventories have declined steeply (second panel), the Brent/WTI spread has remained relatively wide (third panel), margins have been grinding higher and the refiners index has been outperforming (first panel). This earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (fourth panel). This should presage stock price strength on the back of strong earnings and a valuation re-rating; stay overweight the refiners index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Refiners Rally Not Cracking Yet Refiners Rally Not Cracking Yet

Overweight In early July, we lifted refiners to neutral but refrained from turning outright bullish for three reasons: all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Hurricane Harvey has significantly changed this calculus; severe refinery shutdowns are likely to represent a major, albeit temporary, setback. This production curtailment will result in sizable petroleum products inventory drawdowns and a significantly positive pricing backdrop. Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (second panel). Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works. Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (bottom panel). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. Bottom Line: A playable rally in refiners is in the offing on the back of a budding profit recovery. Boost the S&P oil & gas refining & marketing index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Buy Refiners For A Trade Buy Refiners For A Trade

Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Still Goldilocks Still Goldilocks Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Manufacturing Flexing Its Muscle Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue CapEx To The Rescue CapEx To The Rescue Chart 4Dollar... Dollar… Dollar… Chart 5...And EPS Model Waving Green Flag …And EPS Model Waving Green Flag …And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Hurricane Related Blues… Hurricane Related Blues… Chart 7... Are A Boon For Crack Spreads … Are A Boon For Crack Spreads … Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Brisk Demand Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Shining Shining Chart 10Increase In Partisanship Is Bullish Gold Increase In Partisanship Is Bullish Gold Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Safe Haven Demand Comeback Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Not All The Glitters Is Gold Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Watch The Fed’s Balance Sheet Watch The Fed’s Balance Sheet Chart 14EPS Model Is Outright Bearish EPS Model Is Outright Bearish EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.