Saudi Arabia

Highlights By now, the Kingdom of Saudi Arabia (KSA) and Russia have figured out that if each cuts 500k b/d of production, the revenue enhancement for both will be well worth the foregone volumes. Even without additional cuts from other OPEC and non-OPEC producers - most of whom already have seen output drop as a result of OPEC's market-share war - KSA and Russia benefit. A 1mm b/d cut would accelerate the draw in oil inventories next year, allowing U.S. shale-oil producers to quickly move to replace shut-in output. Importantly, shale producers' marginal costs will then begin to set market prices. Longer term, KSA and Russia would have to manage their production in a way that keeps shale on the margin. Whether they can continue to cooperate over the long term remains to be seen. Energy: Overweight. We are recommending investors go long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of a production cut from KSA and Russia. Base Metals: Neutral. We remain neutral base metals, despite the better-than-expected PMIs for China reported earlier this week. Precious Metals: Neutral. We are moving our gold buy-stop to $1,250/oz from $1,210/oz, expecting higher core PCE inflation. Ags/Softs: Underweight. We are recommending a strategic long position in Jul/17 corn versus a short in July/17 sugar. Feature The options market gives a 43% probability to Brent prices exceeding $50/bbl by the end of this year (Chart of the Week). We think these odds are too low, given our expectation KSA and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30, 2016 in Vienna. Chart of the WeekOptions Probability Brent Exceeds $50/bbl By Year-End Is Less Than 50% Raising The Odds Of A KSA-Russia Oil-Production Cut Raising The Odds Of A KSA-Russia Oil-Production Cut A production cut totaling 1mm b/d - plus whatever additional volumes are contributed by GCC OPEC members - will, in all likelihood, send Brent prices back above $50/bbl by year end. This is a fairly high-conviction call for us: We are putting the odds prices will exceed $50/bbl by year-end closer to 80%. As such, we are opening a Brent call spread, getting long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of this production cut from KSA and Russia.1 There are two simple facts driving our assessment: KSA and Russia are desperate for cash - they're both trying to source FDI, and will continue to need external financing for years. They can't wait for supply destruction to remove excess production from the market, given all they want to accomplish in the next two years. The vast majority of income for these states is derived from hydrocarbon sales - 70% by one estimate for Russia, and 90% for KSA - and both have seen painful contractions in their economies during the oil-price collapse, which forced them to cut social spending, raise fees, issue bonds and sell sovereign equity assets.2 With the exception of KSA, Russia, Iraq and Iran, most of the rest of the producers in the world have seen crude oil output fall precipitously - particularly poorer non-Gulf OPEC states (Chart 2), and market-driven economies like the U.S. (Chart 3). Thus, KSA's insistence that others bear the pain of cutting production has already been realized. Iran and Iraq, which together are producing ~ 8mm b/d, maintain they should be exempt from any production freeze or cut, given their economies are in the early stages of recovering from economic sanctions related to a nuclear program and years of war, respectively. Chart 2GCC OPEC Production Surges, ##br##Non-Gulf OPEC Production Collapses bca.ces_wr_2016_11_03_c2 bca.ces_wr_2016_11_03_c2 Chart 3Russia' Gains Lift Non-OPEC Production;##br## U.S. Declines Continue bca.ces_wr_2016_11_03_c3 bca.ces_wr_2016_11_03_c3 Why Would KSA And Russia Act Now? Neither trusts the other, which is why neither cut production unilaterally to accelerate storage drawdowns. Any unilateral cut would have ceded market share to the arch rival. Both states have gone to great efforts to show they can increase production even in a down market, just to make the point that they would not give away hard-won market share (Chart 4). Chart 4KSA and Russia Devoted##br## Significant Resources to Lift Production bca.ces_wr_2016_11_03_c4 bca.ces_wr_2016_11_03_c4 These states are at polar-opposite ends of the geopolitical spectrum - KSA is supporting Iran's enemies in proxy wars throughout the Middle East, while Russia is supporting Iran and its allies. In the oil markets, they are both going after the same customers in Asia and Europe. Each state had to convince the other it could endure the pain of lower prices, which brought both to the table at Algiers, and allowed their continued dialogue since then to flourish. Globally, the market rebalancing already is mostly - if not completely - done. Excess production has been removed from the market, and very shortly we will see inventory drawdowns accelerate. But, if KSA and Russia leave this process to the market, we may be looking at 2017H2 before stocks start to draw hard. By cutting production now, KSA and Russia accelerate the stock draw and hasten the day when shale is setting the marginal price in the market. While shale now is comfortably in the middle of the global cost curve, it still sits above KSA's and Russia's cost curve, which means the marginal revenue to both will be higher than if their marginal costs are driving global pricing. Both states have a lot they want to do next year and in 2018: Russia is looking to sell 19.5% of Rosneft; KSA is looking to issue more debt and IPO Aramco. Both must convince FDI that the money that's invested in their industries will not be wasted because production has not been reined in. And, they both must keep restive populations under control. Cutting production by 1mm b/d or more would push prices back above $50/bbl, perhaps higher, resulting in incremental income of some $50mm to $75mm per day for KSA and Russia. Viewed another way, the incremental revenue generated annually by higher prices brought on by lower production would service multiples of KSA's first-ever $17.5 billion global debt issue brought to market last month. Both KSA and Russia will be able to lever their production more - literally support more debt issuance - by curtailing production now. KSA will need that leverage to pull off the diversification it is attempting under its Vision 2030 initiative. Russia would be able to do more with higher revenues, as well. Balances Point To Supply Deficit Next Year The meetings - "sideline" and otherwise - in Algiers, Istanbul and Vienna over the past month or so at various producer-consumer conclaves were attended mostly by producers that already have endured painful revenue cutbacks brought on by the OPEC market-share war declared in November 2014. Even those producers that did not endure massive production cuts - e.g., Canada, where oil-sands investments sanctioned prior to the price collapse continue to come on line despite low prices - will see far lower E&P investment activity going forward, given the current price environment. Chart 5Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Global oil supply growth will be relatively flat this year and next (Chart 5). This will create a physical deficit in supply-demand balances, even with our weaker consumption-growth expectation: We've lowered our growth estimate to 1.30mm b/d this year, and expect 1.34mm b/d growth next year. We revised demand growth lower based on actual data from the U.S. EIA and weaker projections for global growth.3 Among the major producers, only Iran, Iraq, KSA, and Russia increased output yoy. North America considered as a whole is down despite Canada's gains, and will stay down till 2017H2, based on our balances assessments. South America is essentially flat this year and next. The North Sea's up slightly this year, down more than 5% yoy in 2017, while the Middle East ex-OPEC is flat. Lastly, we expect China's production to be down close to 7% this year, and almost 4% next year. Managing The KSA-Russia Production Cut If KSA and Russia can cut 1mm b/d of production, they'd have to actively manage global balances so that the U.S. shale barrel meets the bulk of demand increases, while conventional reserves fill in decline-curve losses. Iran and Iraq together will be up 1mm b/d this year, but only 350k b/d next year. Both states are going to have a tough time attracting FDI to accelerate production gains, although ex-North America, these states probably have a higher likelihood of attracting investment than Non-Gulf OPEC, which is in terrible shape, and will have a hard time funding projects. Recently recovered Libyan and Nigerian output likely is the best they will be able to do until additional FDI arrives.4 At low price levels, even KSA can't realize the full value of the assets it is attempting to sell and the debt it will be servicing (lower prices mean lower rating from rating agencies). This is a worry for KSA, as it looks to IPO 5% of Aramco and issue more debt.5 Without higher prices, they will need to continue to slash spending, cut defense budgets, salaries and bonuses, and begin to levy taxes and fees. Below $50/bbl Brent, Russia faces similar constraints, and cannot expect to realize the full value of the 19.5% share of Rosneft it hopes to sell into the public market. Net, if KSA and Russia can get prices up above $50/bbl by cutting 1mm from their combined production and increase their gross revenues doing so, it's a major win for them. Such a cut would bring forward the global inventory drawdown we presently see picking up steam in 2017H2 without any reductions in production. In addition, because International Oil Companies (IOCs) are limited in terms of capex they can deploy to invest in National Oil Company (NOC) projects, conventional oil reserves will not be developed in the near term due to funding constraints. That, and higher capex being devoted to the U.S. shales, will keep a lid on production growth ex-U.S. Given how we see investment in production playing out over the medium term - i.e., 3 - 5 years - it will fall to the U.S. shales and Iran-Iraq production to find the barrels to meet demand increases and to replace production lost to natural declines. Given that we expect non-Gulf OPEC yoy production in 2017 to be down close to 1.3mm b/d (or -13%), and that we expect Brazil to be flat next year, cutting 1mm b/d from KSA and Russia's near-record levels of production is a bet both states will find worth taking, in order to lift and stabilize prices over the medium term. GCC OPEC production is expected to be up ~ 1% next year, or ~ 150kb/d, so these states have some scope for reducing output, as well. Price Implications If KSA and Russia Cut If we do indeed see KSA and Russia reduce output 1mm b/d as we expect, we expect storage draws will likely accelerate next year, which will flatten WTI and Brent forward curves, and send both into backwardation (Chart 6). We also would expect prices to move toward $55/bbl in the front of the WTI and Brent forward curves, once the storage draws start backwardating these curves. This would be a boon to KSA's and Russia's gross revenues, generating ~ $75mm a day of incremental revenue post-production cuts. Chart 6Expect Backwardation With ##br##A KSA-Russia Production Cut bca.ces_wr_2016_11_03_c6 bca.ces_wr_2016_11_03_c6 Given this expected dynamic, we recommend going long a February 2017 Brent call spread: Buy the $50 Brent call and sell the $55/bbl Brent call. We also recommend getting long WTI front-to-back spreads expecting a backwardation by mid-year or thereabouts: Specifically, we recommend getting long August 2017 WTI futures vs. short November 2017 WTI futures. This scenario also will be bullish for our Energy Sector Strategy's preferred fracking Equipment services companies, HAL and SLCA. ...And if They Fail to Cut Production? If KSA and Russia fail to cut production, and instead freeze it or raise output following the November OPEC meeting, the market will quickly look through their inaction and continue to price to the actual supply destruction we've been observing for the better part of this year. In such a scenario, prices will push into the lower part of our expected $40 to $65/bbl price range for a longer period of time, which not only will prolong the financial stress of OPEC and non-OPEC producers, but will keep the probability of a significant loss of exports from poorer OPEC states elevated. Either way, global inventories will be significantly reduced by the end of 2017, either because of a production cut by KSA and Russia, or because of continued supply destruction brought about by lower prices. Bottom Line: We expect KSA and Russia to announce a 1mm b/d production cut at the upcoming OPEC meeting at the end of this month. This will rally crude oil prices above $50/bbl, and accelerate the drawdown in global storage levels, which will backwardate Brent and WTI forward curves. We recommend getting long Feb17 $50/bbl Brent calls vs. short $55/bbl Brent calls, and getting long Jul17 WTI vs. short Nov17 WTI futures in anticipation of these cuts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Sugar: Downgrade To Strategically Bearish, Look To Go Long Corn Vs. Sugar We downgrade our strategic sugar view from neutral to bearish, as we expect a much smaller supply deficit next year. We also downgrade our tactical sugar view from bullish to neutral, as prices have already surged over 120% since last August. We expect corn to outperform sugar in 2017. Brazil will likely increase its imports of cheaper U.S. corn-based ethanol. We look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. Sugar prices have rallied more than 120% since last August on large supply deficits and an extremely low global stock-to-use ratio (Chart 7). Falling acreage and unfavorable weather have reduced sugarcane supplies from major producing countries Brazil, India, China and Thailand. Chart 7Sugar Tactically Neutral, Strategically Bearish bca.ces_wr_2016_11_03_c7 bca.ces_wr_2016_11_03_c7 Tactically, We Revise Our Sugar View From Bullish To Neutral. Sugar prices are likely to stay high over next three to six months on tight supplies. The global sugar stock-to-use ratio is at its lowest level since 2010 (Chart 7, panel 3). Inventories in India and China fell to a six-year low while inventories in the European Union (EU) were depleted to all-time lows. These three regions together accounted for 36.7% of global sugar consumption last year. However, we believe prices will have limited upside over next three to six months. Despite tight inventories, India and China likely will not increase imports. India currently has a 40% tax on sugar imports, and the government also imposed a 20% duty on its sugar exports in June to boost domestic supply. China started an investigation into the country's soaring sugar imports in late September. The probe will last six months, with an option to extend the deadline. In the meantime, other sugar importers likely will reduce or delay their sugar purchases because of currently high prices. Lastly, speculative buying is running out of steam, as traders already are deeply long sugar - net speculative positions as a percentage of total open interest is sitting at record-high levels (Chart 7, panel 4). Strategically, We Downgrade Our Sugar View From Neutral To Bearish. Assuming normal weather conditions across major producing countries next year, we believe the global sugar market will have a much smaller supply deficit over a one-year time horizon. Although sugar prices in USD terms reached their highest level since July 2012, prices in other currencies actually rose to all-time highs (Chart 8). Record high sugar prices in these countries will encourage planting and investment, which will consequently result in higher sugar production, especially in Brazil, India and Thailand. This year, due to adverse weather during April-September, the USDA has revised down its sugarcane output estimates for Brazil and Thailand by 3.2% and 7.1%, respectively. Assuming a return of normal weather next year, we expect sugarcane output in these two countries to recover. Farmers in China and India have cut their sown acreage for sugarcane this year on extremely low prices late last year and early this year. With prices up significantly in the latter half of this year, we expect sugar output in these two countries to rebound on acreage recovery as well. In addition, Brazilian sugar mills have clearly preferred producing sugar over ethanol so far this year on surging global sugar prices. According to the Brazilian Sugarcane Industry Association (UNICA), for the accumulated production until October 1, 2016, 46.31% of sugarcane was used to produce sugar, a considerable increase from 41.72% for the same period of last year. We expect this trend to continue in 2017, adding more sugar supply to the global market. Moreover, as the market becomes more balanced next year, speculators will likely unwind their huge long positions, which may accelerate a price drop sometime next year (Chart 7, panel 4). Where China Stands In The Global Sugar Market? China is the world's biggest sugar importer, the third-largest consumer and the fifth-biggest producer, accounting for 14.2% of global imports, 10.3% of global consumption and 4.9% of global production, respectively (Chart 9, panel 1). Chart 8Sugar Supply Will Increase In 2017 bca.ces_wr_2016_11_03_c8 bca.ces_wr_2016_11_03_c8 Chart 9Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Sugar production costs are much higher in China than in Brazil and Thailand, due to higher wages and low rates of mechanization. Falling sugar prices in 2011-2015 further reduced the profitability of Chinese sugar producers. As a result, the sugarcane-sown area in China has dropped 24% in three years, resulting in a huge supply deficit (Chart 9, panel 2). Because domestic prices are much higher than global prices, the country has boosted its imports rapidly in recent years (Chart 9, panel 3). We believe, in the near term, the recently announced investigation into surging sugar imports will slow the inflow of sugar into the country, which will be negative for global sugar prices. In the longer term, the sugarcane-sown area in China will recover on elevated sugar prices, indicating the country's production is set to rebound, which likely will reduce its sugar imports. This is in line with our strategic bearish view. Chart 10Corn Is Likely To Outperform Sugar In 2017 bca.ces_wr_2016_11_03_c10 bca.ces_wr_2016_11_03_c10 Risks To Our Sugar View In the near term, sugar prices could rally further on negative weather news or if the USDA revises down its estimates of global sugar production and inventories. Prices also could go down sharply if speculators unwind their huge long positions before the year end. We will re-evaluate our sugar view if one of these risks materializes. In the long term, if adverse weather occurs and damages the Brazilian sugarcane yield outlook for next season, which, in general starts harvesting next April, we may upgrade our bearish view to bullish. How To Profit From The Sugar Market? In the softs market, we continue to prefer relative-value trades to outright positions. With regards to sugar, we look to go long corn vs. short sugar, as we expect corn to outperform sugar in 2017. Both sugar and corn are used in ethanol production. Ethanol is also a globally tradable commodity. While sugar prices rose to four-year highs, corn prices fell to seven-year lows, resulting in a significant increase in Brazilian sugar-based ethanol production costs and a considerable drop in U.S. corn-based ethanol production costs. We believe the current high sugar/corn price ratio is unlikely to sustain itself, as Brazil will likely increase its imports of cheaper U.S. corn-based ethanol (Chart 10, panels 1, 2 and 3). In addition, global ethanol importers will also prefer buying U.S. corn-based ethanol over Brazilian sugar-based ethanol. Eventually, this should bring down the sugar/corn price ratio to its normal range. Therefore, we look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94) (Chart 10, panel 4). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. In addition to the risks related to the fundamentals, this pair trade also faces the risk of a steep contango in the corn futures curve, and a steep backwardation in the sugar futures curve. The July/17 corn prices are 6.2% higher than the nearest futures prices and July/17 sugar prices are 5.2% lower than the nearest sugar futures prices. Long Wheat/Short Soybeans Relative Trade On another note, our long Mar/17 wheat/short Mar/17 soybeans relative trade was stopped out at a 5% loss on October 26. We still expect wheat to outperform soybeans over next three to six months. We will re-initiate this relative trade if the ratio drops to 0.41 (current: 0.426) (Chart 10, bottom panel). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 The Feb17 options expire 22 December 2016, three weeks after the OPEC meeting. 2 Please see Commodity & Energy Strategy Weekly Report "Ignore The KSA - Russia Production Pact, Focus Instead On The Need For Cash," dated September 8, 2016, available at ces.bcaresearch.com. 3 The IMF expects slightly slower global GDP growth this year (3.1%), and a slight pick-up next year (3.4%). Please see "Subdued Demand, Symptoms and Remedies," in the October 2016 IMF World Economic Outlook. 4 Please see "OPEC Special-Case Nations Add 450,000 Barrels in Threat to Deal," by Angelina Rascouet and Grant Smith, published by Bloomberg news service November 2, 2016. 5 Please see Commodity & Energy Strategy Weekly Report "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.

We put the odds of an oil-production freeze agreement between OPEC and Russian officials next week in Algiers at slightly better than a coin toss.

Forget about the production-cooperation pact agreed between Russia and KSA over the weekend at the G20 meeting in China. With or without it, rebalancing of the oil market will force global inventories to draw beginning in 2016Q4 and continue into next year, setting the stage for a gradual rise in prices - slightly above our central tendency for WTI of $50/bbl - to encourage more rigs to return to the U.S. shales.

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.

While the Fed's recent forward guidance leading markets to increase the odds of a policy-rate hike earlier than previously expected will restrain the recovery in crude oil prices, fundamentals will dominate price formation now that markets have rebalanced.

For the foreseeable future, Saudi Arabia will remain a price-taker, and not a price-maker in the oil markets; While the economy will face a growth recession, the kingdom has sufficient resources to weather the pain; Policymakers are dead serious about transitioning away from an oil-addicted economy, but will struggle to execute structural reforms; The ultra-conservative religious establishment is at risk of losing political power; Low oil revenues and a move to sideline conservatives will have profound geopolitical implications for the region. Writing in 2011, BCA's Geopolitical Strategy made three conclusions about Saudi Arabia:25 Saudi Arabia finds itself engulfed in a geopolitical morass. Bahrain and Yemen remain volatile to its east and south, respectively, and crisis in the Levant is never too far off. Iran is Saudi Arabia's main challenger in the region. With the U.S. withdrawing from Iraq and a relatively Tehran-friendly government in place in Baghdad, Iran feels emboldened and resurgent. Oil prices will be Riyadh's main weapon against Tehran. The forecast was three years too early on the Saudi decision to allow oil prices to fall (which is another way of saying it was wrong!). However, the geopolitical trends that have forced Saudi Arabia to take its foreign and economic policy into its own hands are now self-evident. The kingdom's decision to defend its oil market share rather than the price of oil has effectively ended OPEC as a price-setting cartel.26 There are three key geopolitical questions that investors need to answer about Saudi Arabia going forward: Will Saudi Arabia reverse its decision on oil production? Can Saudi Arabia evolve beyond an oil economy over the next decade? Will Saudi Arabia look to export its domestic risks by confronting Iran militarily? We do not see Saudi Arabia changing its decision on oil production, regardless of how low prices go. In fact, the strategy is already working by putting pressure on high-cost producers, both private (U.S.) and state-owned (Iraq, Nigeria, Venezuela, etc.). We doubt that the just-announced "Vision 2030" will lead to the country's successful transition away from oil; nonetheless, we think the document holds important information for investors. Finally, we believe that Saudi Arabia's foreign preferences will be constrained by a decade of low oil revenues. What does the future hold for Saudi Arabia? Tell us the oil price forecast for 2025 and we will give you an answer! In other words, this report eschews the media discussion of whether Saudi Arabia will "survive" the next decade. Ceteris paribus, it does. Rather, we try to answer a much more cogent and topical question: whether the country will be a source of global instability or stability. Surprisingly, we think it will be a factor of global stability, even as (or perhaps because) instability grows domestically. Will Saudis Cut Oil Production? BCA's Geopolitical Strategy has had a high-conviction view throughout 2015-2016 that Saudi Arabia would not participate in a deal that would cut its current oil production.27 There are three main reasons behind this: Geopolitical Rivalry With Iran: Saudi Arabia's only leverage over Iran is its wealth. Iran is more populous, its population is better educated, its economy less reliant on oil exports, its citizens far more resilient to economic pain, its military far more experienced in combat, and its geography practically impenetrable. In addition, Iran's Shia allies in Lebanon, Syria, Iraq, Yemen, and Bahrain surround Saudi Arabia and are geopolitically ascendant everywhere except in Bahrain. By contrast, Saudi Arabia's Sunni allies have either turned against the kingdom (the radical Sunni militants in Iraq), or are weak (Syrian anti-Assad rebels), or non-committal to Saudi foreign policy (Egypt and Pakistan). While Saudi Arabia's oil production strategy curtails Tehran's revenue, it also forces Iran to worry about domestic stability while limiting in the foreign direct investment (FDI) that Iran needs to boost its production. Shia Production Bloc: In the long term, Iran and Iraq are projected to catch up to Saudi production (Chart II-1). The only reason why their combined production does not already match Saudi Arabia's is geopolitical: Iran has been a pariah state since 1979 and Iraq since at least 1990. With the right mix of foreign technology and direct investment, both could catch up to Saudi output eventually. This is terrible news for the Saudis given that all three compete for the same market share among Asian refiners. As such, Saudi Arabia has no incentive to make room for its Shia rivals in the global energy marketplace. The Market Will Eventually Rebalance: Assuming stable demand growth over the rest of the year, our Commodity & Energy Strategy team expects oil markets to be in physical balance by 2016Q3 (Chart II-2), mainly due to loss of supply from the U.S. light tight oil (LTO) producers. It will then take around 18 months for U.S. producers to make up the lost production.28 In addition, we expect that geopolitical risk will rise in unstable countries with high budget breakeven oil prices, such as Algeria, Iraq, Nigeria, and Venezuela.5 The Saudis understand this and have no problem waiting for the physical market to rebalance, either through a "natural" process of high-cost production being shut-in, or an "unnatural" process of geopolitical risk taking production off line. At that point, the Saudi fiscal position will be much better due to a combination of budget cuts and higher oil prices. Chart II-1'Shia Bloc' Catching Up To Saudi Arabia bca.gps_mp_2016_05_11_s2_c1 bca.gps_mp_2016_05_11_s2_c1 Chart II-2House View Is Physical Balance By Q3 2016 bca.gps_mp_2016_05_11_s2_c2 bca.gps_mp_2016_05_11_s2_c2 We therefore expect Saudi Arabia to continue with its current strategy of maximizing production. What about the recent Saudi threat to increase production in order to force other producers to agree to a production cut or freeze? BCA's Energy Sector Strategy does not believe that Saudi Arabia can meaningfully increase production beyond current levels. Saudi Arabia has brought online 3.25 million b/d of new projects over the past decade, with another 550,000 b/d of expansions projected to come online over the next two years. However, its production has not increased much above the 9.6 million b/d it produced in 2005. Chart II-3Saudi Production: ##br##Already Running At Max The Socialism Put The Socialism Put If one assumes that Saudi fields have no decline rates at all, then the country's productive capacity today is above 13 million b/d, allowing the kingdom to ramp up production significantly. On the other hand, if Saudi Arabia has decline rates of 3% a year, which is a reasonable assumption, today's productive capacity is around its actual production (Chart II-3). We believe its real capacity is closer to the latter. Finally, the recent cabinet reshuffle that has claimed 20-year Minister of Petroleum and Mineral Resources Ali Al-Naimi suggests that the current oil policy will remain in place. Al-Naimi's authority and leadership were necessary in a world where Saudi statements moved oil prices. But in a new paradigm where physical supply and demand determine the price, a much more lower-profile minister will do. Bottom Line: Saudi Arabia is no longer a price-maker but a price-taker. This will significantly reduce Saudi oil revenues over the near term, and force the kingdom to seek alternative revenue-generating avenues, such as refining. We believe that the proposed IPO of state-owned oil producer Aramco is partly an acknowledgment of the new reality as well as an attempt to bring in FDI that would allow Saudi Arabia to become a major refiner in the Asia-Pacific basin.29 Can Saudi Arabia Evolve Beyond An Oil Economy? Given that OPEC is dead and that Saudi Arabia is now an oil price-taker, will the kingdom face a fiscal crisis that will break its back over the next three years? And what of the longer-term forecast for the country? The Short Term: Pain, But No Collapse Saudi Arabia's planned fiscal restraint is going to be too little to stave off a massive fiscal deficit for this year. Even assuming oil prices average an optimistic $45 per barrel this year, calculations by the BCA's Frontier Market Strategy suggest the following (Table II-1):30 Table II-1Saudi Arabia's Projected Debt Levels And Foreign Reserves The Socialism Put The Socialism Put The country will face a higher fiscal deficit of over 20% of GDP this year versus 16% in 2015. This is after assuming the government will reduce expenditures by an additional 5% this year following last year's 12% cut. We expect fiscal cuts to continue throughout the rest of the decade, particularly in defense spending, which currently accounts for a quarter of the budget. Furthermore, assuming that half the deficit will be financed by issuing new debt (and the other half by drawing down government deposits in the central bank), total government debt could rise to $150 billion by the end of 2017 from less than $40 billion now. Foreign reserves will plunge by over $140 billion in 2016. By the end of 2017 and 2018, reserves could fall to $350 billion and $250 billion, respectively, assuming oil prices average $50 and $55 in those years. These are dire figures, but they suggest that Saudi Arabia has sufficient bandwidth to withstand the current oil price environment. Forecasts of Saudi doom assume that its budget expenditure remains static (particularly on the military) and that its budget breakeven oil price remains static at around $100 a barrel. In our scenario analysis, we assume a worst-case scenario in terms of government spending, with a modest cut of 5% in 2016, followed by an increase in both 2017 and 2018. The more likely outcome is that the government will be forced to cut spending by double-digits, as it proved capable of doing in 2015, every year. The Long Term: Clouded Picture Threats to oil revenue from technology (electric vehicles) and new low-cost producers (U.S. LTO producers) are bringing into question the long-term viability of the Saudi economy. The Saudi leadership has responded to these threats by announcing "Vision 2030," a plan to develop the economy beyond oil.31 Restructuring the economy is a fearsome task. It is far from clear that economic bottlenecks can be resolved: Productivity growth in Saudi Arabia is extremely low, with an average growth rate of only 0.3% over the past 25 years. The level of productivity has actually fallen since the 2008 global credit crisis (Chart II-4). One reason behind this is insufficient capital expenditure in productive capacities. Even during the era of high oil prices, when the country's savings rate surged, capital spending remained rather low. Odds are that capital expenditure will remain muted in the foreseeable future (Chart II-5). The current reform agenda does not envision de-pegging the currency. But a pegged currency has forced the country to import U.S. interest rates (see Box II-1). As a result, real rates on bank deposits have remained negative for several years now, encouraging excessive consumption. Negative real rates have also brought on a migration out of banks' time and savings deposits. The share of the latter as a portion of total deposits has been shrinking since 2009, when real rates on bank deposits turned negative (Chart II-6). Short-term liabilities are not ideal to finance long-term capital assets. Chart II-4Saudi Productivity ##br## Gains Averaged Only 0.3% ##br##Per Annum Over The Past 25 Years bca.gps_mp_2016_05_11_s2_c4 bca.gps_mp_2016_05_11_s2_c4 Chart II-5Shrinking Domestic ##br##Savings Will Rein In##br## Capital Expenditures Too bca.gps_mp_2016_05_11_s2_c5 bca.gps_mp_2016_05_11_s2_c5 Chart II-6Negative Real Rates ##br##Caused Harmful Distortions ##br##In The Economy bca.gps_mp_2016_05_11_s2_c6 bca.gps_mp_2016_05_11_s2_c6 Box II-1 Will The Currency Peg Stay? Box Chart II-1Oil Prices And U.S. Interest ##br## Rates Moved Together Until 2008 bca.gps_mp_2016_05_11_s2_c21 bca.gps_mp_2016_05_11_s2_c21 By many academic accounts, the Saudi riyal and U.S. dollar should never have been pegged in the first place. The reason is that the structure and dynamics of the Saudi economy are very different from those of the U.S. economy. Their business cycles are different and their economies react differently to the same exogenous shocks, such as a surge or plunge in crude oil prices. In other words, the two countries do not constitute an optimal currency area, so it does not make sense for Saudi Arabia to be importing U.S. monetary policies via a fixed exchange rate. The reason the fixed exchange-rate system has managed to survive so long (since 1986) is that oil prices have historically been correlated with U.S. interest rates (Box Chart II-1). Higher oil prices used to represent a positive shock for the Saudi economy, which was counterbalanced by rising interest rates in the U.S., and therefore, in Saudi Arabia. This is no longer the case. Following the global credit crisis, oil prices surged to beyond $100 a barrel, yet interest rates remained low. Now oil prices have plunged, while the U.S. is gearing up to raise interest rates. Hence, keeping the riyal pegged to the U.S. dollar has become sub-optimal, and is now preventing adjustments in the real economy through financial variables such as interest rates and the exchange rate. If this continues, pressure points will build up and eventually policymakers will have no choice but to either de-peg the currency from the U.S. dollar or endure deep economic pain. That said, the authorities maintain a firm commitment to the peg given that Saudi Arabia imports almost all of its non-energy consumption. De-pegging would lead to a massive increase in import costs and thus a potential political crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years, which means that the peg will likely remain in place for the time being. Incidentally, forward markets are discounting only a 1% riyal depreciation over the next 12 months, and 2% over the next 24 months. By the end of next year, if oil prices remain at current levels, assuming SAMA has run down a significant amount of its foreign reserves, the possibility of de-pegging and devaluing the riyal will be much greater. A lack of productivity brews a lack of competitiveness. Net exports of goods and services have steadily declined over the past two decades (Chart II-7). Despite a rather young population (the median age in Saudi Arabia is 27 years), the country has failed to reap demographic dividends. The labor force participation rate among Saudi nationals remain low, and among women is extremely low. Most Saudi nationals are employed in cushy government jobs rather than the private sector. Expatriate workers dominate the country's labor force, and their share is rising (Chart II-8). Expat remittance outflows have surged in recent years, to $40 billion per annum (Chart II-8, bottom panel). This is now a significant contributor to the country's current account deficit. Chart II-7Saudi Economy ##br##Lacks Competitiveness bca.gps_mp_2016_05_11_s2_c7 bca.gps_mp_2016_05_11_s2_c7 Chart II-8Expat Workers Dominate Labor Force, ##br##And Their Remittance Outflows Are Booming bca.gps_mp_2016_05_11_s2_c8 bca.gps_mp_2016_05_11_s2_c8 Vision 2030: A Revealing Document Calling Vision 2030 a "plan" to address the above structural constraints would be too generous. It is a wish list of reforms that, if any were to get off the ground, would take a long time to take effect. However, several prominent themes in the Vision 2030 document reveal the preferences of the current Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion in educational reforms. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. Taken together, these items suggest that Saudi leadership, led by the young Deputy Crown Prince Mohammad Bin Salman Al Saud, is looking to steer the country towards modernity and away from the dominant conservative interpretation of Islam. Even if the reforms are likely to move at a snail's pace, investors should recognize that Saudi policymakers see the youth population, and its rising angst, as their main national security risk. Rather than cracking down against the youth, Saudi leaders are throwing in their lot with them, at the expense of the religious establishment. This is a smart strategy, given that over 50% of the Saudi population of almost 30 million is below 35 years of age (Chart II-9). The youth population is facing difficulty entering the labor force, with unemployment near 30% (Chart II-10). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart II-11). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,32 and Twitter has the highest level of penetration in Saudi Arabia out of any other country in the region.33 Chart II-9Still A Young Country bca.gps_mp_2016_05_11_s2_c9 bca.gps_mp_2016_05_11_s2_c9 Chart II-10A Potential National Security Risk bca.gps_mp_2016_05_11_s2_c10 bca.gps_mp_2016_05_11_s2_c10 Chart II-11Saudi Youth Is As Internet Savvy As Others bca.gps_mp_2016_05_11_s2_c11 bca.gps_mp_2016_05_11_s2_c11 The decision to steer domestic policy away from religious conservatives may also be motivated by security. In 2009, al Qaeda attempted to assassinate the then-head of the country's intelligence service, now Crown Prince and first Deputy Prime Minister Mohammed bin Nayef. This was a wake-up call for the kingdom in terms of the threat that radical Sunni terrorists pose. In 2015 and 2016, Islamic State militants targeted the country's Shia minority in the Eastern Province in an attempt to stir sectarian violence in the oil-rich province. So far, the efforts have backfired against the Islamic State, with support for the group in Saudi Arabia well below the regional average (Chart II-12). Chart II-12Saudi Arabia Is Worried About The Islamic State The Socialism Put The Socialism Put If our interpretation of Vision 2030 - and other recently-announced reforms34 - is correct, it is a very dramatic development given Saudi policy over the past half-century.35 Saudi support for a fundamentalist interpretation of Islam emerged in 1970s as the country's coffers became flush with cash. Ultra-conservative Sunni Islam became Saudi Arabia's bulwark against Egypt's secular Arab nationalism and Soviet-supported left-wing groups like the Palestinian Liberation Organization. Later, following the 1979 Islamic Revolution in Iran, Saudi support for conservative Islam also took on the Sunni sectarian hue it retains today. Since the Arab Spring revolts of 2011, however, these hyper-conservative Islamic movements have now become a threat to Saudi Arabia. First, the Muslim Brotherhood's co-optation of democracy as compatible with conservative Islam is a threat to non-democratic monarchies like Saudi Arabia. Second, the Islamic State has evolved from a group that may have received material support from within Saudi Arabia into an independent entity that threatens Saudi Arabia itself. To counter these forces, Saudi leaders are using geopolitical tensions with Iran, the war in Yemen, and the collapse in oil prices as opportunities. Judging by the behavior of Saudi policymakers, it would appear that they are (somewhat ironically) pursuing a strategy of Sunni Arab nationalism. In many ways, Saudi Arabia is de-emphasizing religion and re-emphasizing the nation-state. That is the main conclusion one should draw from Vision 2030. Sceptics would be right to point out that the links between the al-Saud royal family and the ultra-conservative Sunni Wahhabi religious movement lie at the foundation of the Saudi state.36 However, commentators who take the mid-eighteenth century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, Westerners may even be overstating the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.37 Although Saudi Arabia has not figured in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart II-13). In addition, Saudis identify with values of self-expression rather than survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart II-13Saudi Arabia: More Modern Than You Think The Socialism Put The Socialism Put High youth population, rising self-expression values, and widespread adoption of social media are ingredients of a potent brew for social unrest. It is naïve to think that such protest would take on radical Islamic characteristics in Saudi Arabia when they did not do so in Tunisia or Egypt amidst the Arab Spring, or in Iran during its "Green Revolution" in 2009. And in a negative economic context, student activism may not be isolated - it may merge with currents of discontent in other segments of society. Investors should not expect Saudi Arabia to change overnight, or even at all. However, Vision 2030 suggests that policymakers have moved to nip any youth rebellion in the bud by slowly easing the conservative establishment's hold on society. Religious conservatives may retaliate with protests or even militancy - and the attempt at controlled modernization could produce a flood of popular demands - so the execution of this strategy is risky. However, there is no evidence that the country's intelligence and security services are incapable of dealing with such episodes. In fact, Saudi policymakers may be hoping that a confrontation with religious conservatives devolves into violence so that they can de-legitimize and neutralize them. Bottom Line: Saudi leadership appears to have taken the side of modernity and youth over that of religious conservatism. In the long run, this bodes well for Saudi evolution away from the oil economy, even if it will not do much immediately to resolve structural problems. However, the process will be very long and halting. In the short and medium term, we expect resistance from conservative forces. This could have major implications globally, with Saudi Arabia evolving from a supporter of ultra-conservative Islamic militant groups to a supporter of stability around the Middle East and South Asia. Will Saudi Arabia Export Instability? Chart II-14Saudi Arabia: Lock And Load The Socialism Put The Socialism Put Saudi-Iranian tensions have been the fulcrum of the region since 2011. However, they appear to have peaked.38 Why? The simple answer is that a sustained geopolitical conflict requires resources and Saudi military expenditure is basically unsustainable: the country has overtaken Russia in third place in terms of absolute military expenditure (Chart II-14). The Saudi leadership is not signalling any drawdown in tensions with Iran. In fact, the two countries broke off diplomatic relations earlier this year. The deputy crown prince even explicitly promised that low oil prices would not change Saudi foreign policy, with on-budget military spending expected to rise by 24% in 2016. These are all bluffs. Just as the rhetoric surrounding oil production is bullish, so is the sabre-rattling with Iran. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart II-15). Political science research shows that the relationship is not spurious. Chart II-16 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes.39 Chart II-15Correlation Between Oil Prices And Military Disputes The Socialism Put The Socialism Put Chart II-16More Oil Revenue Equals More Aggression The Socialism Put The Socialism Put The air war against the Iran-allied Houthi rebels in Yemen alone costs up to $6 billion a month, or over $70 billion a year.40 Any direct Saudi intervention in Iraq or Syria would cost a lot more given the complexity of the battlefield and sophistication of the opposing forces. Thus, we are unsurprised by the April ceasefire in Yemen. Saudi officials have recently proclaimed victory there, but we fail to understand what they have accomplished, aside from gaining some valuable fighting experience. As we wrote in March 2015, the Yemen intervention provided an opportunity for Saudi Arabia to test its military capabilities and the willingness of its Sunni allies - other Gulf Cooperation Council countries, Egypt, Jordan, and Pakistan - to commit to joint military operations.41 The Saudi military proved competent, but the air force alone has not dislodged Houthi rebels from their strongholds. Meanwhile, only the UAE responded to the Saudi call for support with any vigor. As such, Saudis will likely conclude from Yemen that military operations are prohibitively expensive. Their thinking could change, of course, as the regional dynamic evolves. However, we doubt that Iran will look to confront Saudi interests with much vigor. Tehran is desperately looking to re-establish itself in the global economy, wants FDI flows to return, and is largely satisfied with the position that its allies in Syria and Iraq find themselves in. Bottom Line: Saudi Arabia is likely going to focus inward and eschew direct military entanglements in the region. The Yemen experiment has largely failed and has taught the Saudis a valuable lesson: you can't rely on allies to fight your land wars. Investment Implications In the short term, Saudi Arabia will have to focus on budget consolidation and domestic reform. These efforts will lead to a growth recession and political instability. Shrinking bank deposits will hamper private-sector credit growth, which at 88%, is already high (Chart II-17). As a result, banks face rising liquidity pressures and are selling their holdings of central bank bills and withdrawing their deposits to meet liquidity needs (Chart II-18). As Saudi Arabia is unlikely to cut oil production, prices will likely stay soft in the foreseeable future. Hence, the financing needs of government and quasi-government entities will stay high. This will crowd out the private sector from bank financing - a negative sign for the stock market. This is particularly negative for Saudi stocks given that they are not cheap relative to their counterparts in emerging and frontier markets (Chart II-19). Chart II-17Private-Sector Credit ##br##Is Set To Decelerate bca.gps_mp_2016_05_11_s2_c17 bca.gps_mp_2016_05_11_s2_c17 Chart II-18Surging Public-Financing Needs ##br##Are Straining Bank Liquidity bca.gps_mp_2016_05_11_s2_c18 bca.gps_mp_2016_05_11_s2_c18 Chart II-19Saudi Stocks##br## Are Not Cheap Saudi Stocks Are Not Cheap Saudi Stocks Are Not Cheap Sovereign spreads are likely to widen, given the country's mammoth fiscal borrowing needs for as long as oil prices stay low. Credit default swaps (CDS) have spiked three-fold in the past year, and may rise again (Chart II-20). Investors should consider going long 5-year CDS. Chart II-20...And Sovereign Spreads Will Rise ...And Sovereign Spreads Will Rise ...And Sovereign Spreads Will Rise At the same time, Saudi Arabia's domestic focus will reduce geopolitical tensions in the region. First, the fiscal crisis will constrain foreign adventures and force the kingdom to negotiate with Iran on sharing regional influence. Our earlier fears of a Saudi intervention in Iraq and Syria - always a low-probability risk - have receded given the economic constraints and the lessons of the Yemen intervention. Second, a move to curb the power of religious conservatives inside Saudi Arabia will likely be complemented with more discerning support for extremists outside of the country. It is no secret that Saudi Arabia has provided the funding for religious extremist groups and educational institutions around the world over the past half-century. This strategy will change as Saudi Arabia struggles to evolve beyond oil, a process that necessitates radical change in domestic factors. This particular trend has three main investment implications: Long Iran / Short Saudi Arabia: Both Saudi Arabia and Iran find themselves focused on a similar challenge: an angst-filled youth population. The youth do not see religious institutions as a source of inspiration but rather as tools of social or generational oppression. Iran is far more advanced in the process of domestic reform.42 It has begun to moderate both its foreign and domestic policy, while its economy has already undertaken the shock-therapy of developing non-oil sources of revenue. Saudi Arabia has only begun to contemplate reforms and we suspect that religious conservatives will push against them with vigor. Alternative Energy: The IMF forecasts that in the absence of energy reforms that curb consumption growth, Saudi Arabia will consume all of its refined product by 2022 and all of its oil production by 2042.43 The easiest way for Saudi Arabia to boost government revenues and cut its expenditure is to develop alternative sources of energy. Nuclear and solar power will allow Saudi Arabia to cut its energy subsidies and set aside more oil production for export. While Vision 2030 promises to develop alternative energy, we suspect that the initial investment opportunity will be in global companies. Defense Stocks: Vision 2030 intends to "on-shore" much of the kingdom's military expenditure over the next several decades, starting with maintenance and basic weapons manufacturing, and later developing a domestic aerospace industry. This should be relatively bullish for foreign defense contractors given that Saudis will need time to develop a native defense industry. In the long term, defense spending is unsustainable and will contract significantly. We suspect that the phase of purchasing major defense systems - such as fighter jets - is over. While this is undoubtedly bearish for global defense stocks, Saudi demand will erode only gradually and will be more than compensated by increasing geopolitical tensions in East Asia.44 We therefore continue to recommend that investors stay long defense stocks. Perhaps the most important investment implication of the oil price collapse is that it has created a massive constraint on all actors in the Middle East. Vast oil revenues have allowed Iran, Iraq, Saudi Arabia, and others to play an outsized role in global affairs, either by pursuing aggressive foreign policies, supporting various proxies, or propping up otherwise unstable regimes. In Saudi Arabia's case, oil revenue has allowed the country to delay dealing with the aspirations of its vast youth population. It was easy to expand public-sector jobs while the oil was flowing. Overflowing coffers also allowed Saudi policymakers to support extremism abroad and fight proxy wars against Iran across the region. As Saudi Arabia and Iran focus on domestic reforms, one consequence may be the waning investment-relevance of the Middle East globally. We suspect that this has already happened, given the collapse of oil prices despite a raft of conflicts in the region over the past two years. This geopolitical shift will ultimately support our view that markets continue to ignore geopolitical tensions in East Asia at their own risk. 25 Please see BCA Geopolitical Strategy Special Report, "Riyadh's Oil Gambit," dated October 11, 2011, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Monthly Report, "Annus Horribilis - Energy: Tug Of War Between Tailwinds And Headwinds," dated January 20, 2016, available at gps.bcaresearch.com. 28 Please see BCA Special Report, "More Bullish Than Consensus On Oil Recovery," dated March 29. 2016, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Frontier Markets Strategy Special Report, "Saudi Arabia: The Pain Will Linger," dated May 9, 2016, available at fms.bcaresearch.com. 32 Please see "Full text of Saudi Arabia's Vision 2030," available at alArabiya.net 33 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is useful for teenagers for, well, obvious reasons. 34 Please see Arab News, "Saudi social media users ranked 7th in world," dated November 14, 2015, available at arabnews.com 35 For example, the country's religious police - the hai'a - have been curbed. They no longer have the power to arrest - instead, they have to report violations of Islamic law to the police and are only allowed to work during office hours. Something tells us that most violations of Islamic law are likely to be committed after hours. 36 Please see Matthiesen, Toby, "The domestic sources of Saudi foreign policy: Islamists and the state in the wake of the Arab Uprisings," Rethinking Political Islam Series, Brookings Institute, available at brookings.edu. 37 Al Shihabi, Ali (2015). The Saudi Kingdom Between The Jihadi Hammer And The Iranian Anvil. London: The Choir Press. 38 World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge UP, 2005). For more information, please see http://www.worldvaluessurvey.org/index_html. 39 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back - Middle East: Saudi-Iranian Tensions Have Peaked," dated February 10, 2016, available at gps.bcaresearch.com. 40 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 41 Please see Riedel, Bruce, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 42 Please see BCA Geopolitical Strategy Client Note, "Does Yemen Matter?," March 26, 2015, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 44 Please see International Monetary Fund, "Saudi Arabia Selected Issues," October 2015, IMF Country Report 15/286, available at imf.org. 45 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com.

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.