Softs

Feature Happy Thanksgiving to all our U.S. clients. We wish you the best the holiday has to offer, as you share blessings with friends and family. In this holiday-shortened week, we are publishing a joint report with our colleagues at BCA's Energy Sector Strategy (NRG) service. We succinctly examine the pros and cons of the debate over whether OPEC will or will not agree to and uphold a *real* production cut, as it has promised, at its much-anticipated meeting on November 30. Disagreement on the likely outcome of the meeting runs high. In late September, OPEC announced an agreement in principle to cut oil production at the formal November meeting to a level of 32.5-33.0 MMb/d. This would represent a 500,000-750,000 b/d reduction from August production levels, and an 830,000-1,330,000 b/d reduction from the IEA's latest OPEC production estimate for October of 33.83 MMb/d. In addition, non-OPEC behemoth Russia has signaled a potential willingness to contribute its own production freeze or cut to the agreement in an effort to support higher oil prices. Chart 1With A 1 MMb/d Cut, ##br##Draws Would Be Greater bca.ces_wr_2016_11_24_c1 bca.ces_wr_2016_11_24_c1 There are compelling arguments to be made both supporting the likelihood of a production cut as well as for being skeptical that such an agreement will be reached and adhered to. Even within BCA, there is disagreement. This service, the Commodity & Energy Strategy (CES), which sets the BCA house view on oil prices, pegs the odds at greater than 50% that there will be a meaningful cut of 1 MMb/d+, anchored by large cut pledges from OPEC's leader, the Kingdom of Saudi Arabia (KSA), and Russia. The NRG team, dissents; they think it is more likely that no deal is reached, and if a deal is announced, it will not be adhered to. Regardless of whether there is an announced agreement to cut production or not, both CES and NRG expect KSA's production to decline by 400,000-500,000 b/d between August and December according to KSA's normal seasonal management of production levels; we would not include this expected seasonal reduction in the calculation of a *real* cut. In our analysis on Chart 1, we include a *real* cut of 1MMB/d below the normal seasonality of KSA's production, which lasts for six months. In H2 2017, we assume the cut is dissolved and the market also receives an extra 200,000 b/d of price-incentivized production from the U.S. shales. How To Bet On A Cut, The Out-Of-Consensus Call Chart 2Without A Cut,##br## Inventories Still Will Be Drawn In 2017 bca.ces_wr_2016_11_24_c2 bca.ces_wr_2016_11_24_c2 CES's view for a cut (established November 3) was significantly out-of-consensus until recent chatter from OPEC increased the perception that an agreement could be reached. Still, there remains significant doubt a freeze or cut can be accomplished. Without a cut, NRG and CES share a constructive outlook for oil markets heading towards steepening deficits during 2017 (Chart 2). Note: BCA's estimates show a tighter oil market than the EIA's estimates: Our Q3 2016 production estimates are lower than the EIA's by ~300,000 b/d due to differences in our assessments in Brazilian, Russian and Chinese production; our Q3 2016 consumption estimate is higher than the EIA due to our higher assessment of U.S. summer-time demand (the EIA has consistently underestimated U.S. demand over the past few years). A production cut coupled with a natural tightening in the market brought about by the price-induced supply destruction over the past 18 months would make 2017 inventory draws even greater, lifting oil prices higher, and providing even greater upward support to our favorite investment recommendations (Chart 1). Below we outline the investment recommendations that would benefit from an OPEC cut, spanning individual equities, ETFs, and commodity calls: Direct Commodity Investment: CES recommends two pair trades on oil contracts and call options. Long February 2017 $50/bbl Brent Calls vs. short February 2017 $55/bbl Brent Calls to play the spike in oil prices that would come from a successful OPEC cut, which was recommended November 3 and was up 50.41% as of Tuesday's close. Long August 2017 WTI contract vs. short November 2017 WTI contract to play an expected flattening of the forward curve, which also was recommended November 3 and it up 48.61% as of Tuesday's close. Oil Producers: NRG recommends overweight-rated Permian oil producers EOG, PXD, FANG and PE, which will be leaders in expanding production into an improving oil price market. Service Companies: NRG recommends overweight-rated completion-oriented services companies HAL, SLB and SLCA, which will benefit most from increased U.S. shale spending. Equity-Backed ETFs: NRG recommends overweight-rated ETFs XLE, FRAK, and OIH as vehicles that provide more diversified investment exposure to higher oil prices and oilfield service activity than individual equities. Oil-Backed ETF. Tactically buying the U.S. Oil Fund ETF (USO) would provide good direct exposure to a quick oil price surge. However, USO should not be held as a longer-term investment because the inherent cost of continually rolling contracts consistently erodes USO's value versus the equity-backed ETFs XLE and OIH. This longer-term underperformance informs NRG's underweight rating on USO. Risks To Our Views: Oil and natural gas prices that differ materially from our forecasts, possibly due to slower-than-expected global economic growth and/or greater than expected supply growth. Poor operational execution and/or changes to regulatory restrictions could negatively impact the financial and stock performance of our recommendations. A week ahead of the OPEC meeting, in the wake of recently recovering production in Libya and Nigeria, and amid campaigning by Iran and Iraq to be excluded from participation in the cuts, it is impossible to know for certain how the complicated politics of OPEC and Russia will play out. Below we outline the competing objectives and risks that will be in play. Case Against A Cut Undeniably, a cut in production, particularly a coordinated cut where several countries share the burden of restricting production, would raise oil prices and enhance 2017 oil export revenues for all OPEC producers. However, that near-term benefit for pricing and revenue has been obvious for the past two years, and yet neither KSA nor Russia has been willing to cut production, feeling the potential to lose longer-term market share outweighed the immediate revenue benefits of a cut. The hazard of a price-increasing production cut, is that the higher oil price would essentially subsidize non-OPEC competitors with higher cash flows, and would simultaneously bolster the confidence of capital markets that OPEC will support prices at a floor of $50, reducing the risk of future investments. These two effects would jointly encourage increased capital investment into establishing new production, especially by the fast-acting U.S. shale producers, whose rampant investment and production growth from 2010-2015 was, by far, the leading contributor to the 2015-2016 oversupply of oil. Encouraging a resurgence of drilling and production would certainly lead to faster production growth from the U.S. shales in 2017-2018, allowing those producers to grow market share under the umbrella of OPEC's production sacrifices that created the higher prices. OPEC has just endured a lot of economic pain through the oil price decline. The economic purpose of this pain was to starve global producers of operational cash flow and dissuade the inflow of new capital, thus choking off the reinvestment required to continue to grow oil production. By and large, this goal has been achieved, with U.S. shale producers slashing capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cutting capital expenditures by 40% over the same period. As a result, after the substantial surge in global oil production in 2014-2015 that created the current over-supply, the capital starvation caused by low oil prices will result in essentially no global production growth in either 2017 or 2018, allowing for demand growth to erode the oversupply of production during 2016, and to eat into the overstocked inventories of crude during 2017-2018. KSA has created fear and uncertainty throughout global producers and capital markets by steadfastly refusing to use its production-management powers to support a floor under oil prices. We are skeptical that KSA will ultimately agree to reverse this strategy, by now establishing a price floor. Such a reversal would undermine the profound market-share message KSA has delivered to competitors (at the cost of great financial pain), and weaken its perceived resolve to allow oil prices to be set by the market. As such, the NRG team believes KSA will not agree to cut production beyond the already-expected seasonal reduction in production, and that this position will scuttle September's tacit agreement to cut production at the official meeting next week. Such a scenario would be fairly similar to how KSA undermined the production-freeze discussions in Doha in April, by insisting other OPEC members - Iran, in particular - share in the production limitations in order to engender KSA's support; a condition that other members were unwilling to accept. The Case For A Cut The case to expect a cut agreement acknowledges that such a cut would subsidize competitors and diminish the impression of KSA's resolve and/or ability to out-last competitors through an oil price down-cycle. The case for a cut concludes that the benefits of higher 2017 oil prices simply outweigh these market share and reputational costs. The benefits that OPEC and Russia would receive are: Critical Need For Higher Revenue. If KSA and Russia each cut 2017 production by 500,000 below current expectations, and oil prices jumped $10/bbl as a result, KSA's 2017 oil export revenues would increase by close to $17.5 billion, and Russia's would increase by almost $8.25 billion. If the financial pain endured by these countries is substantially greater than NRG has estimated, this near-term revenue lift could be more critical than we appreciate, overwhelming the reputational and longer-term market-share losses resulting from the reversal of policy. Borrowing capacity for each country also would increase, as a result of higher revenues. With both states seeking to tap international debt and equity markets, this increased revenue would increase their borrowing capacity. Higher Value For Asset Sales. KSA is preparing to IPO Saudi Aramco. Bolstering the spirits of capital markets with higher oil prices would be expected to increase the proceeds received from this equity sale, increase the market value of the company, reduce debt-service costs, and improve access to debt markets, which KSA and Saudi Aramco are both likely to tap more frequently in the future as the country tries to diversify the economy away from oil. Similarly, two weeks ago, Russia signed a decree to sell a 19.5% stake in Rosneft by the end of 2016. An immediate oil price strengthening and messaging that KSA and Russia would support a pricing floor would inflate the value of this sale, given the high correlation between Brent crude oil prices and Rosneft's equity price. Production Stability Not As Strong As It Seems. Russia's production levels in 2016 have been surprisingly strong, exceeding our expectations. The collapse of the Russian Ruble has allowed for continued internal investment despite the substantial reduction to dollar-denominated oil revenues. Still, it is likely that Russian producers are pulling very hard on their fields, over-producing the optimal level in an effort to scratch out higher revenues. Such over-production is not sustainable ad infinitum, and Russia may know that its fields need a rest in 2017 anyhow, so a 4-5% production cut is ultimately not much of a sacrifice. Make Room For Libya & Nigeria. Both Libya and Nigeria are trying to overcome substantial civil obstacles to allow production to increase back towards oilfield capabilities. If these problems were solved, we estimate Libya could increase production by 400,000-600,000 b/d while Nigeria could add 200,000-300,000 b/d. If KSA, OPEC, and Russia believe these countries will be able to re-establish shut-in production, they may conclude a production cut is necessary to make room for the growth, and to keep prices from collapsing. Entrenching U.S. Shale As The Marginal Barrel: If KSA and Russia can agree to a 1 MMb/d cut, U.S. shale-oil producers would be the first to take advantage of expected higher prices, given the fast-response nature of this production. This actually would work to the advantage of KSA and Russia and other low-cost producers in and outside OPEC, by firmly entrenching U.S. shale oil as the marginal barrel for the world market. On the global cost curve, shale sits in the middle some $30 to $40/bbl above KSA and Russia, which means that, as long as the global market is pricing to shale economics at the margin, these mega-producers earn economic rents on their production. In order to retain those rents, KSA and Russia will have to find a way to keep shale on the margin - i.e., regulate their production so that prices do not rise too quickly and encourage more expensive output to come on line. For KSA and Russia, it is better to climb the shale cost curve than to encourage the next tranche of production - such as Canadian oil sands - to come on to the market too quickly, or to further incentivize electric vehicles and conservation with run-away price increases, with too-sharp a production cut. Allowing prices to trade through a $65 - $75/bbl range or higher would no doubt produce a short-term revenue jump for cash-strapped producers - particularly those OPEC members outside the GCC. But it also would make most of the U.S. shales economic to develop, and incentivize other "lumpy," expensive production that does not turn off quickly once it is developed (e.g., oil sands and deepwater). This ultimately would crash prices over the longer term, making it difficult for the industry to attract capital. This is not an ideal outcome for KSA's planned IPO of Aramco, or Russia's sale of 19.5% of Rosneft, or their investors. Global Reinvestment Needs To Be Re-Stimulated. Stimulating non-OPEC reinvestment with higher oil prices and increased price-floor confidence may actually be needed in the not-too-distant future. IOCs have barely started to show the negative production ramifications of their 40% cuts to capex; cuts which will grow deeper in 2018. We expect these production declines to show up increasingly over the next four years, and there is not much the IOCs can do to stop it, since their mega-project investments generally require 3-5 years from the time that spending decisions are made until first oil is produced. With such huge cuts to future expenditures, and enormous amounts of debt incurred by the IOCs to pay for the completion of legacy mega-projects that will need to be repaid ($130B in debt added in the past two years), OPEC could see a looming shortage of oil developing later this decade if IOC-sponsored offshore production falls into steep declines, as we think is likely. To orchestrate a softer landing, to prevent oil prices from spiking too high due to a shortage of production, to head-off an acceleration in the pursuit of alternative fuels and/or the recessionary impact of an oil price spike, KSA may actually want to accelerate the re-start of global investment. Bottom Line: There are strongly credible and well-reasoned arguments that support the expectations for a successful establishment of a production cut from OPEC and Russia, as well as to doubt that such an agreement will be achieved (and adhered to) amid the political and economic competition between OPEC members and against non-OPEC producers. A successful agreement to cut production in excess of 1 MMb/d, as CES believes is likely, would be the more out-of-consensus call, with substantially bullish implications for oil prices and for our oil-levered investment strategy and stock recommendations. Even without a production cut, the NRG service remains strongly constructive on the investment strengths of high-quality Permian oil producers and the completion-oriented service companies that will benefit from increased U.S. shale spending. If a production cut is achieved, our investment cases become even stronger, as the U.S. shale producers and service companies would be the greatest beneficiaries of an upward step-change in oil prices. Matt Conlan, Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Dairy: Moderate Upside In 2017H1 Dairy prices may have another 5%-10% upside over next three to six months, based on tightening supply in the global dairy market. China will become more important in the global dairy market. The country's dairy imports will continue heading north. Downside risks include elevated global dairy product inventory, a supply boost from major exporters, and a continuing strengthening dollar. We have been cautiously bullish on global dairy market since last October.1 Since then, the Global Dairy Trade (GDT) All-Products Price Index, which is widely used as a benchmark price for the market, has rallied over 50% in the past seven months off its November - March lows (Chart 3, panel 1). Chart 3Dairy: Tactically Bullish bca.ces_wr_2016_11_24_c3 bca.ces_wr_2016_11_24_c3 Now the question is: will the rally continue? A review of what had happened in 2015 and so far this year may be a good start of our analysis. A Terrible 2015 The GDT index tumbled to the lowest level on record in early August 2015. A sharply drop in Chinese dairy imports; the Russian import ban on dairy products; robust supply growth across major dairy producing countries; and the EU's decision to scrap its production quotas created a perfect storm for the global dairy market last year - resulting in an extremely oversupplied market, stock builds and depressed dairy prices (Chart 3, panels 2, 3 and 4). An Improving 2016 Fundamentals have improved since April, as major dairy exporting countries responded to low dairy prices, while Chinese dairy imports revived. Fonterra, the world's biggest dairy exporter, and Murray Goulburn, Australian's biggest dairy company, both announced retrospective price cuts in April to dairy farmers in New Zealand and Australia, which hit both countries' dairy industries hard. Many farmers exited the dairy business, given their production costs were well above farm-gate milk prices. As a result, dairy farmers In New Zealand have cut the national dairy cow herd size by 3.3% yoy in 2015 and then a further 1.5% in 2016, based on USDA data. In Australia, dairy farmers have sent more cows into slaughterhouse as well. According to Dairy Australia, in the past 12 months to August 2016, 109,102 head were sold, an increase of 33% on the previous year. New Zealand and Australia are the world's largest and the fourth largest dairy exporters, respectively. In June, one month before the start of the new season (July 2016 to June 2017), farm-gate milk prices set by major dairy processors in Australia were still much lower than most dairy farmers' production costs, further damaging the country's dairy production outlook for the 2016/17 season. In July, August and September, Australian milk production fell sharply for three consecutive months, with a yoy contraction of 10.3%, 9.3%, and 10.2%, respectively. In July, the European Commission funded a €150 million program to pay farmers to cut their milk production. At the same time, the region also intervened with a stock purchase program and a private-storage aid scheme to help remove excess supply from the market. The EU region is the world's second biggest exporter. Its production increase due to the removal of its quota system was one main reason for last year's price drop. The recent supportive policy has worked well - the region's milk volumes decreased in September for the third consecutive month. In the meantime, Chinese dairy imports have rebounded 9.7% yoy for the first nine months of this year, a significant improvement from last year's 44.4% contraction over the same period. China is the world biggest dairy importer, accounting for 51% of global fluid milk imports, and 40% of dry, whole-milk powder imports (Chart 4, panel 1). Chart 4China Needs More Dairy Imports bca.ces_wr_2016_11_24_c4 bca.ces_wr_2016_11_24_c4 In comparison, the number of Chinese cow herds only accounts for 6% of global total cows for milk production, which is clearly far from meeting its domestic demand (Chart 4, panel 2). Early this year the country loosened up the "one-child" policy, and now allows "two-kids" in a family, starting this year. This will increase the country's baby formula's demand. The country's dairy product intake per capita is still far below Asian peers like Japan and Korea. Growing family wealth and increasing demand for healthy dairy food will continue boosting the dairy consumption in China. Due to the limited pasture land in the country for raising cows, we expect China's dairy imports will continue heading north. What about the price outlook in the remainder of 2016 and 2017? Most of the positive factors aforementioned are still in place. In the near term, we do not see significant supply increase. Despite the 61% price rally in the GDT price index over the past seven months, most of the price increase still has not passed to farm-gate milk prices in major producing countries (except New Zealand). Hence, for the remainder of 2016 and 2017H1, we expect prices will be prone to the upside. Pullbacks are always possible. But overall we still expect another 5% to 10% upside over next three to six months for the GDT price index. Beyond 2017H1, the price outlook is less clear. If prices either go sideways or up, milk production in major producing countries should eventually recover. For now, we hold a neutral view for dairy prices in 2017H2. Downside Risks Chart 5Downside Risks bca.ces_wr_2016_11_24_c5 bca.ces_wr_2016_11_24_c5 First, global dairy stockpiles are much higher than previous years (Chart 5, panel 1). According to the European Commission, at the end of September, around 428 thousand metric tons (kt) of skimmed-milk powder (SMP) was in public intervention stocks, while another 73 kt SMP was in private storage. In addition, there also is about 90 kt butter and 19 kt cheese stored privately. As the EU still is aiming to cut milk production to boost dairy prices, we believe the odds of an unexpected release from storage in a fast and massive manner is low. The release will likely be gradual. Second, much of New Zealand's milk production is dependent on weather conditions, which have improved from mid-August. Moreover, Fonterra increased its farm-gate milk price to $6 per kgMS (kilogram milk solid) from $5.25 per kgMS last week, which was the third increase over the past four months. Since August, farm-gate milk price in New Zealand has already been up 41% and well above the country's production cost. A combination of both factors may boost the country's milk production more than the market expected. In this case, prices could decline in 2017H1. Third, if the U.S. dollar continues strengthening versus the RMB and other major exporters' currencies, this will tend to discourage purchases from China and encourage sales from New Zealand, the EU and Australia, which will be negative to dairy prices (Chart 5, panel 2). We will monitor these risks closely. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 please see Commodity & Energy Strategy Weekly Report for softs section "Oil Markets Pricing In $20/Bbl Downside," dated October 1, 2015, available at ces.bcaresearch.com Investment Views And Themes Recommendations Tactical Trades Commodity Prices And Plays Reference Table Closed Trades

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

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

The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.

India's agricultural output per capita has not increased at all. Thus, food and headline inflation will remain structurally high, which will negatively impact savings and investment dynamics in the years ahead. With respect to cyclical growth, household spending is very strong, but investment expenditures are stagnant. Fixed-income traders should bet on yield curve steepening in India. A section <i>Brazil's Business Cycle Illustrated</i> highlights the cyclical profile of this economy.

Fed policy - and, importantly, policy expectations' effect on the broad trade-weighted USD (TWI) - will dominate price evolution over the short term, as markets puzzle out if and when a rate hike is coming this year.

If the Fed convinces markets it is on track to lift rates this year and a couple of times next year, we expect a 10% appreciation of the USD over the next 12 months. This would be extremely bearish for commodities.

A Fed rate hike by December could erode the slowly evolving fundamentals favoring base metals.

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.