Oil & Gas Refining & Marketing

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 SPX 3,000? SPX 3,000? Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model SPX 3,000? SPX 3,000? Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Joined At The Hip Joined At The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity SPX 3,000? SPX 3,000? Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map SPX 3,000? SPX 3,000? Chart 4Negative Correlation Is Re-Established Negative Correlation Is Re-Established Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Crude Oil... Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Improving Supply Dynamics Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Unloved And Fairly Valued Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag EPS Model Waves Green Flag EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over Refining Profit Contraction Is Over Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Three Positives... Three Positives... Chart 12...But Do Not Get Carried Away ...But Do Not Get Carried Away ...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Time To Move To the Sidelines Time To Move To the Sidelines Chart 14Conflicting Signals Conflicting Signals Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective An Historical Perspective An Historical Perspective Chart 16Positive Offsets Positive Offsets Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Feature Chart 1Why Is Equity Vol So Low? bca.uses_wr_2016_12_12_c1 bca.uses_wr_2016_12_12_c1 The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 324-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 4A Blow-Off Top? A Blow-Off Top? A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade bca.uses_wr_2016_12_12_c5 bca.uses_wr_2016_12_12_c5 Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields bca.uses_wr_2016_12_12_c6 bca.uses_wr_2016_12_12_c6 Chart 7No Sales Growth bca.uses_wr_2016_12_12_c7 bca.uses_wr_2016_12_12_c7 True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets bca.uses_wr_2016_12_12_c8 bca.uses_wr_2016_12_12_c8 Chart 9Sell Software... bca.uses_wr_2016_12_12_c9 bca.uses_wr_2016_12_12_c9 The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode bca.uses_wr_2016_12_12_c10 bca.uses_wr_2016_12_12_c10 Chart 11Not Worth A Premium bca.uses_wr_2016_12_12_c11 bca.uses_wr_2016_12_12_c11 Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... bca.uses_wr_2016_12_12_c12 bca.uses_wr_2016_12_12_c12 Chart 13... May Be Pressured bca.uses_wr_2016_12_12_c13 bca.uses_wr_2016_12_12_c13 Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices bca.uses_wr_2016_12_12_c14 bca.uses_wr_2016_12_12_c14 The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... bca.uses_wr_2016_12_12_c15 bca.uses_wr_2016_12_12_c15 Chart 16... Erode Excess Oil Supply bca.uses_wr_2016_12_12_c16 bca.uses_wr_2016_12_12_c16 This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally bca.uses_wr_2016_12_12_c17 bca.uses_wr_2016_12_12_c17 Chart 18Sell Refiners bca.uses_wr_2016_12_12_c18 bca.uses_wr_2016_12_12_c18 Chart 19Global Capacity Growth bca.uses_wr_2016_12_12_c19 bca.uses_wr_2016_12_12_c19 Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Whether OPEC's announcement of its intention to curtail production actually feeds through into meaningfully lower output next year remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expect the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. On the downside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent. That is a strain on refining margins. Our model warns that there is little profit upside ahead. Instead, our preference is to maintain outsized exposure to the oil field services group. Increased E&P confidence that underlying commodity prices could drift toward the top end of their trading should boost drilling activity. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the former. We are underweight refiners, overweight oil field services, and neutral on the broad sector. bca.uses_in_2016_12_01_002_c1 bca.uses_in_2016_12_01_002_c1

Highlights The inexorable shift of refining eastward would be accelerated if the Kingdom of Saudi Arabia (KSA) and Russia fail to curb crude oil production as we expect. Prolonging the crude oil market-share war - particularly between opposing camps led by KSA and Iran within OPEC, and Russia's campaign outside the Cartel - will advantage Asian refiners in the short term. Over the longer term, the expansion of oil refining in Asia and the Middle East likely will accelerate, as these warring camps invest directly in refining capacity in Asia and expand their domestic and regional refining and trading capacity. The risk Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and export markets are used to dispose of product surpluses. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Energy: Overweight. We continue to expect a production cut by KSA and Russia to be announced at the OPEC meeting this month. Base Metals: Neutral. LME aluminum prices still have upside as the market will likely remain supply deficit in the short term. We look to buy aluminum on weakness. Precious Metals: Neutral. We remain on the sidelines ahead of the Fed's December meeting. Ags/Softs: Underweight. We still look to go long wheat versus soybeans. We also look to go long corn versus sugar. Feature We continue to expect an announcement from KSA and Russia of a net 1mm b/d production cut at this month's OPEC meeting in Vienna, after accounting for the 400k b/d or so of seasonal production declines in KSA. A failure to follow through on a cut will prolong the global market-share war among OPEC and Russian oil producers seeking long-term customers in Asian refining markets, particularly in China. China's so-called teapots, which refine 60k to 70k b/d, only started importing crude oil for their own accounts late last year. These refiners represent about one-third of China's 14.3 mm b/d refining capacity as of 2015. It's been a slow ramp - some of these teapots only got started on importing their own crude this year - but they're definitely on a growth trajectory and should catch up with KSA and India in the near future. Some of them already are using hedge markets and setting up their own trading operations, according to media reports. Also, we're expecting to see increased investment in refining in China by KSA and others in the very near future, which will bring state of the art technology to the sector. In and of itself, a failure of KSA and Russia to agree a production cut would be bullish for the growth potential of Asian refiners, as Middle Eastern and Russian crude oil supplies continue to be aggressively marketed to them, allowing them to build capacity and grow their share of global exports (Chart of the Week). Chart of the Week (A)Asia/Middle East Refining Inputs Continue to ##br##Grow As OPEC Market-Share War Drags On bca.ces_wr_2016_11_10_c1a bca.ces_wr_2016_11_10_c1a Chart of the Week (B)Asia/Middle East Refiners' Market Share Of ##br##Gasoline Exports Is Growing bca.ces_wr_2016_11_10_c1b bca.ces_wr_2016_11_10_c1b Chart of the Week (C)...As Are ##br##Diesel/Gasoil Exports bca.ces_wr_2016_11_10_c1c bca.ces_wr_2016_11_10_c1c Our expectation for crude production cuts by KSA and Russia, perhaps with sundry cuts from their allies in the market-share war, would accelerate the draws in crude and product inventories globally. Absent a cut, inventories will continue to draw slowly, based on an assessment of data provided by the Joint Oil Data Initiative (JODI), a transnational oil-data service (Chart 2). The current cycle of supply destruction is being prolonged by high global inventory levels. High inventories keep prices under pressure, which, as we have often noted, raise the odds of civil unrest in cash-strapped states. The odds of unplanned production outages and loss of exports thus remains elevated. A price spike in such a scenario cannot be ruled out. Chart 2Inventories Will Continue To Fall Slowly ##br##If KSA-Russia Don't Cut Crude Output bca.ces_wr_2016_11_10_c2 bca.ces_wr_2016_11_10_c2 Chart 3Asia/Middle East Diesel Output##br## Growth Will Continue bca.ces_wr_2016_11_10_c3 bca.ces_wr_2016_11_10_c3 Global Refining and Storage Markets Continue Transformation Longer term, we see an inexorable shift in refining eastward, as local refiners expand their capacity in China and India, and financially stronger crude and product exporters expand their refining and trading operations by investing in existing or new Asian refining capacity - e.g., KSA in China and South Korea, and Russia's Rosneft in India alongside a major trading company. This will keep high-valued-added exports growing in Asia (Chart 3 and Chart 4), and will take market share from traditional processing centers - e.g., northwest Europe, and Singapore's processing refineries (Chart 5). Chart 4Along With ##br##Gasoline Output bca.ces_wr_2016_11_10_c4 bca.ces_wr_2016_11_10_c4 Chart 5Asia/Middle East Refiners ##br##Displace Traditional Processors bca.ces_wr_2016_11_10_c5 bca.ces_wr_2016_11_10_c5 With or without a production cut by KSA and Russia, the incidence of crude-oil supply destruction will continue to fall on the poorer OPEC producers outside the Gulf Cooperation Council (GCC), which lack the wherewithal to invest in higher crude-oil output domestically, or in refining and trading capacity domestically or abroad. These cash-strapped states also will be unable to make direct investments in refining assets in end-use markets, depriving them of assured outlets for crude production enjoyed by exporters like KSA with substantial refining investments domestically and worldwide.1 This means that, unlike KSA, where refined-product sales and trading will constitute a greater share of revenues over the medium term (out to 10 years), these cash-strapped producers will continue to depend on crude oil sales alone. Chart 6U.S. Product Exports Hold Up Well bca.ces_wr_2016_11_10_c6 bca.ces_wr_2016_11_10_c6 Given its technological edge and nearby crude supplies - Canadian heavy shipped south via pipeline, conventional and light-tight oil (LTO) from shale fields, and increasing volumes of Mexican crude following the sale of deep-water acreage next month - we do not expect U.S. refiners to lose export-market share in the high-value-added light-product markets (diesel and gasoline/aviation fuels) (Chart 6). Indeed, on a 5-year seasonal basis, U.S. refined-product exports actually are increasing, as nearby refiners - e.g., Mexico - continue to find it difficult to maintain operations. Even as Asia and the Middle East refining and trading markets develop, we continue to expect a deepening of crude and product flows among North and South American producers and refiners.2 China Policy Put Could Spur Refining Output In our earlier research, we noted the implicit put provided to Chinese refiners, after the National Development and Reform Commission mandated products be sold at a minimum crude oil reference price of $40/bbl. This was done to encourage conservation and to support domestic refiners and producers.3 So, if crude oil prices go below $40/bbl for Chinese refiners, this regulation incentivizes them to refine as much as possible, then store or export output surplus to domestic needs. Unless the government steps in to tax away the refining windfall resulting from this put whenever the reference crude price falls below $40/bbl, this policy will, at the margin, pressure global refined-product prices, and keep refining margin growth potential limited as Chinese capacity increases. This pattern was seen in Chinese agricultural markets, where crop price supports resulted in a massive accumulation of corn in storage, as farmers bought cheap corn on the international market and sold it into the government storage market. The crop price supports are being unwound, but it does illustrate the Ironclad Law of Regulation - markets always find a way to game regulations to their advantage. Refining Margins Will Remain Under Pressure Chart 7Refining Margins Will Remain Under Pressure bca.ces_wr_2016_11_10_c7 bca.ces_wr_2016_11_10_c7 The rapid expansion of refining capacity in Asia and the Middle East - driven by increased domestic and foreign investment in refining and trading capacity - suggests to us refined-product markets could be in for an extended period of oversupply, which will limit refiner margins going forward. OPEC's market-share war, and the massive supplies produced by U.S. shale-oil producers made it abundantly clear that crude oil is a super-abundant resource, particularly with shale-oil production ready to come on line as soon as prices move above $50/bbl. The buildout in refining capacity by KSA and other OPEC members, along with plans to expand Asian and Middle East refining capacity and, critically, to supply that capacity with aggressively priced crude charging stock, will keep refining margins under pressure going into 2017 (Chart 7). The risk of super-saturating Asian markets in the near future with unsold refined products as crude supplies and production are ramped up in the near future, therefore, poses a risk for refiners generally, since, at the right prices, crude and product can be moved anywhere on the globe. This poses a particular risk for KSA as it readies the IPO of is state-owned oil company Aramco. KSA is simultaneously attempting to grow its own refining capacity worldwide - from a current level of ~ 6mm b/d to as much as 10mm b/d - and retain and secure long-term customers for its crude. In effect, as a refiner it will be competing with the very customers to which it provides crude oil. This doubly compounds the difficulty of IPOing Aramco, as well, since investors will want to be assured the refining side of the enterprise is not being disadvantaged by the crude-oil supply side of the enterprise. However, for KSA as a sovereign state, this expansion of revenues earned from a massive refining presence worldwide is clearly a boon. KSA could, at the end of the day, refine, export and trade product volumes that equal or surpass its current crude export volumes, as it continues to invest and build out its global refining presence. This will further distance it from its OPEC brethren and other crude oil producers worldwide, making it less a crude exporter and more a global vertically integrated portfolio manager. Bottom Line: We see an inexorable shift of refining eastward, with or without a production cut by KSA and Russia. Failure to agree and implement a production cut would prolong the crude oil market-share and provide a tailwind to Asian refiners in the short term. With or without a production cut, we see the expansion of oil refining in Asia and the Middle East continuing apace, as direct investment flows to refining and trading. The risk that Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and exports from Asian and Middle East refineries grow. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Aluminum: Buy On Weakness Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices.4 Supply shortages will likely persist in the ex-China world over next three to six months. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Profitable Chinese smelters will continue boosting their aluminum production, which will eventually spill over into the global market. We recommend buying Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss at $1,500/MT. Aluminum prices have gone up considerably this year (Chart 8, panel 1). Global aluminum producers cut their production sharply while global consumption only contracted slightly, reversing a deep supply-surplus market in 2015 to a significant supply-deficit market in 2016 (Chart 8, panel 2). Moreover, aluminum inventories in both LME and SHFE markets also have fallen to multi-year lows (Chart 8, panel 3). However, aluminum prices went nearly vertical in China with a 48% rally since late last November, while LME prices have been only up 21% during the same period of time (Chart 8, panel 1). Why have prices in China gone up much more than the global LME prices? Will the rallies in aluminum prices in both LME and SHFE markets continue? The answer is mainly in China. China: The Most Important Factor In The Global Aluminum Market As the world's largest aluminum producer and consumer, China accounts more than 50% of global aluminum production and consumption (Chart 9, panel 1). The country has also been the major contributor to the growth of both global supply and demand for at least the past 10 years (Chart 9, panels 2 and 3). Chart 8Aluminum: Still More ##br##Upside Ahead? bca.ces_wr_2016_11_10_c8 bca.ces_wr_2016_11_10_c8 Chart 9China: The Most Important Factor ##br##In Aluminum Market China: The Most Important Factor In Aluminum Market China: The Most Important Factor In Aluminum Market China And The Price Collapse In 2015 In November 2015, while LME aluminum prices plunged to their lowest levels since February 2009, aluminum prices in China (SHEF) collapsed to their lowest levels since at least 1994. There were four main factors driving for the price drop. Chinese aluminum output increased more than 3 million metric tons (Mn MT), which accounted 87% of global supply growth, and resulted in excessive global supply. At the same time, global aluminum demand growth experienced a sharp slowdown -- yoy growth was 6% in 2015, versus 16.1% in 2014. This was mainly led by China, where, last year, aluminum demand growth slowed from 27.5% in 2014 to 10.9% in 2015. Inventories at SHFE were boosted by about 68% in 2015, while inventories at LME remained elevated. With China producing much more than it consumed, the country started to encourage exports of semi-manufactured aluminum products last year to reduce the domestic supply surplus (Chart 9, panel 4). In April 2015, the country removed the export tariff on several major aluminum semi-manufactured products. In November 2015, the country implemented a policy of giving a 13-15% value-added tax rebate to exporters of semi-manufactured products. As a result, last year net Chinese unwrought aluminum exports increased 16.7% yoy, which have weighed on global LME aluminum prices. China And The Price Rally In 2016 Chart 10Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Similarly, China was the major driving factor behind this year's rally as well. Global supply was cut massively for the last two months of 2015 and the first eight months of 2016, as extremely low aluminum prices resulted in huge losses for most global aluminum producers. According to the World Bureau of Metal Statistics (WBMS), for the first eight months of this year, China accounted for 55% of the global aluminum supply cuts, as the country suspended its high-cost producing capacity and started industry-wide coordinated production cutbacks in last December (Chart 10, panel 1). Extremely low inventory levels also spurred the price rally. Inventories at SHFE warehouses fell 76.5% from mid-March to late-September (Chart 10, panel 2). In addition, the social inventory at major cities (Wuxi, Shanghai, Hangzhou, Gongyi and Foshan) also fell to record lows. Surging coal prices and rising alumina prices have also pushed up domestic aluminum production costs (Chart 10, panel 3). In addition, China implemented its newly promulgated Road Traffic Management Regulations regarding overloaded and oversized trucks, and unsafe vehicles on September 21. It was common before these regulations were implemented for drivers to overload shipments of commodities in order to increase profits. This raised road transportation costs for commodities like steel, coal, aluminum, aluminum products and other metals. It also created a bottleneck for timely transporting of coal to aluminum smelters, which own self-generated power plants, and transporting primary aluminum from major producing provinces Xinjiang, Inner Mongolia and Ningxia to some inner-land provinces like Henan for further manufacturing. As China cut its aluminum production this year, the country's exports of semi-manufactured aluminum products also fell 1.9% yoy for the first nine months of this year. As for Chinese aluminum demand, the data are confusing: The WBMS data showed a contraction for the first eight months of 2016, but the domestic industry association reported a decent increase in Chinese aluminum demand so far this year. Based on domestic auto output and construction activity data, we are inclined to believe Chinese aluminum demand rose moderately on the back of this year's fiscal stimulus. Other Factors For The Price Rally In 2016 There are two factors besides China for this year's aluminum rally. U.S. aluminum output fell nearly 50% yoy this year as Alcoa and Century Aluminum massively cut capacity late last year in response to lower prices (Chart 10, panel 4). For the ex-China world, while its supply fell 1.2%, consumption actually grew 0.4% for the first eight months of this year. This increased the supply deficit for the world excluding China, which is positive for LME aluminum prices (Chart 10, panel 5). So, What's Next? Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices. Chart 11Aluminum: Buy On Weakness bca.ces_wr_2016_11_10_c11 bca.ces_wr_2016_11_10_c11 Most of the aforementioned positive factors are still in place. Even though China has enough capacity to oversupply both its domestic market and global markets again, the key factor will be how fast China boosts its aluminum output. With new added capacity and idled capacity returned to service, China's operating capacity for aluminum has been rising every month so far this year. According to the data provided by Sublime China Information Group, as of the end of October, China's aluminum operating capacity was 35.1 MMt/y (million metric tons per year), a rise of 0.575 MMt/y from the previous month, and an increase of 2.034 mtpy from the end of 2015. Based on our calculations, so far, total aluminum output from January to September is still much lower than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Therefore, as domestic supply becomes more ample, China's domestic prices - including SHFE aluminum prices - should have limited upside. At the same time, the downside also should be limited by low inventory and rebounding demand. We expect more upside for LME aluminum prices as the supply shortage will likely persist in the ex-China world over next three to six months. Currently, Chinese aluminum prices are about 20% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of the world. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is profitable. With new low-cost capacity and more idled capacity coming back line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term such as nine months to one year, should eventually spill over into the global market. Risks China has imposed stricter environmental regulations on the domestic metal smelting and refining process since 2014 to control domestic pollution. The government currently is sending environmental inspection teams to major aluminum producing provinces to check how well the smelters and refiners comply with state environment rules. Some unqualified factories may be ordered to close. If this occurs, domestic SHFE aluminum prices may go up further in the near term. On the other side, if unprofitable aluminum producers in China also increase their output quickly, in order to creating jobs and revenue for local governments, prices at both SHFE and LME may face a big drop. We will monitor these risks closely. Investment Strategy We probably will see increasing Chinese aluminum production in 2016Q4, which may induce price corrections in both LME and SHFE prices. We prefer to buy LME aluminum on weakness. We recommend buying the Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT) (Chart 11). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss level at $1,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report for an extended discussion of increasing Asian and Middle Eastern refining capacity "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 2 We will be exploring inter-American crude and product flows - and the potential for expanding this trade - in future research. 3 Please see Commodity & Energy Strategy Weekly Report p. 6 of the earlier-referenced "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 4 LME denotes London Metals Exchange and SHFE denotes Shanghai Futures Exchange. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy bca.ces_wr_2016_10_20_c1 bca.ces_wr_2016_10_20_c1 Chart 2Core PCE ##br##Ticking Up bca.ces_wr_2016_10_20_c2 bca.ces_wr_2016_10_20_c2 Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend bca.ces_wr_2016_10_20_c3 bca.ces_wr_2016_10_20_c3 Chart 4EM Leading Indicators ##br##Point to Growth Upturn bca.ces_wr_2016_10_20_c4 bca.ces_wr_2016_10_20_c4 The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... bca.ces_wr_2016_10_20_c5 bca.ces_wr_2016_10_20_c5 Chart 6...As Will##br## Base Metals Demand bca.ces_wr_2016_10_20_c6 bca.ces_wr_2016_10_20_c6 As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish bca.ces_wr_2016_10_20_c7 bca.ces_wr_2016_10_20_c7 Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors bca.ces_wr_2016_10_20_c8 bca.ces_wr_2016_10_20_c8 Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy bca.ces_wr_2016_10_20_c10 bca.ces_wr_2016_10_20_c10 Chart 11Go Long Wheat Versus Soybeans With Stops bca.ces_wr_2016_10_20_c11 bca.ces_wr_2016_10_20_c11 Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

A bearish outlook for refiners is becoming a more mainstream thesis, but there likely is one more meaningful relative performance downleg before it will be time to book profits. Refined product consumption has been solid for much of the past year. As a result, refiners have operated at full tilt in order to produce enough gasoline to meet demand. However, overproduction has occurred, compounded by accelerating refinery production outside the U.S. Increased import competition is a serious threat. Saudi Arabia, China and India have all ramped up refined product output this year on the back of cheaper OPEC oil supplies; consequently, exports are flooding the global market, depressing relative demand for U.S. oil product exports, which are falling steadily. Consequently, U.S. refiners will need to both cut refinery production and selling prices in order to rebalance the market. That is a toxic combination for any low margin, high volume cyclical industry. Against a structural backdrop of rising global refining capacity, rich valuations need to be reset. Stay underweight The ticker symbols for the stocks in this index are: BLBG: S5OILR-MPC, PSX, TSO, VLO. Refiners Have Cracked Refiners Have Cracked

A two-speed economy requires selective portfolio construction, favoring consumer-oriented and mainly non-cyclical industries. Put communications equipment on the high-conviction overweight list, and stay clear of refiners.

Clearing the refined-product overhang in the global storage markets is not as straightforward as it used to be: The Kingdom of Saudi Arabia (KSA), China, and India all are making concerted efforts to boost refining capacity, which is leaving them with surplus product that ends up being sold in export markets.

Refiners will reduce run rates over the next month or so to clear unintended inventory accumulation, but it's not like they've never had to deal with this situation.

We view the "sweet spot" for market-balancing oil prices to be within a range of $50-$65/ barrel: Oil prices will be below/in the lower half of this range during 2016H2 and will average in the upper half of this range in 2017, perhaps exceeding the range in 2018. Without OPEC serving as an attentive "human regulator" of production, bouts of oversupply and undersupply will have to be managed through the drill bit (not the output valve), leading to increased price volatility beyond our "sweet spot" range. In this environment, quick-reacting U.S. shale producers and service companies are best positioned to benefit early in the up-cycle.