Energy

Special Report

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Chart 7The Mother Of All V-ShapesBiden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years   Chart 10Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Chart 12No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Chart 15Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.  

Highlights The leading providers of fundamental oil data differ sharply in their estimates of demand destruction caused by the COVID-19 pandemic. This will keep uncertainty over the trajectory of prices elevated this year. Our forecast of demand destruction and those of the US EIA and the IEA are clustered around 8mm b/d for 2020, while OPEC’s most recent estimate exceeds 9mm b/d. The rebound in actual demand, which is apparent in the data, a weakening USD and strengthening of global trade in the wake of global fiscal and monetary stimulus support our expectation of lower demand destruction. As mentioned last month, we believe the odds of a COVID-19 vaccine are high by year-end or early 2021 (Chart of the Week). Against this, bloated floating storage levels – and their attendant port congestion – threaten to slow crude-oil demand growth in Asia into 4Q20, particularly if China follows through on putting 19 very large crude carriers (VLCCs) filled with oil from the US on the water over the coming months. We continue to see the balance of risk favoring the upside for prices. We are raising our 2H20 Brent forecast $2/bbl to $46/bbl, and keeping our 2021 expectation at $65/bbl. WTI will trade ~ $3/bbl below those levels.   Feature OPEC continues to see a higher level of demand destruction in the wake of the COVID-19 pandemic than BCA, the US Energy Information Administration (EIA) and the Paris-based International Energy Agency (IEA). OPEC continues to see a higher level of demand destruction in the wake of the COVID-19 pandemic than BCA, the US Energy Information Administration (EIA) and the Paris-based International Energy Agency (IEA). The cartel’s economists are estimating global oil-demand destruction would be ~ 9mm b/d year-on-year (y/y) in 2020. In their August projections, the EIA’s and IEA’s expectations for demand destruction are closer to ours at ~ 8mm b/d for this year. In the past, we focused more on OPEC’s output estimates for members of the cartel, particularly for its leader and top producer, the Kingdom of Saudi Arabia (KSA). In this month’s report, and in subsequent reports, we are incorporating OPEC’s demand estimates as a direct input to our price-forecasting models. For 2020, we are giving it an equal weight to the apparent consensus we share with the EIA and IEA. Chart of the WeekActual Oil Demand Continues Strong Recovery The immediate effect of this will be to temper the effect of the stronger demand growth expectations we share with the EIA and IEA in this year’s price forecast, which will put us at $46/bbl on average for 2H20.1 The improvement in actual demand is apparent in our base case model up to July, as seen in the Chart of the Week. Much of this recovery is the result of the massive fiscal and monetary stimulus deployed globally by governments and central banks, which will continue to support the demand this year and next.2 This stimulus also is visible in global trade data – particularly in EM imports, which we follow closely, given their high sensitivity to changes in income (GDP). Our modeling indicates this recovery will continue to year-end (Chart 2). Chart 2EM Imports Recovery Likely Continues Weaker USD Will Support Oil-Demand Recovery Speculators have crowded into the short-dollar trade, which augurs for a near-term correction in the USD DXY futures. We expect the USD to continue to weaken on the back of the Fed’s aggressive monetary accommodation, in line with our Global Investment and FX strategists.3 This will support the continued rally in crude oil prices we expect for the balance of this year and next. There are a number of short-term risks to our bearish USD view, however. These are mainly due to the marginal improvement of the US economy vis-à-vis Europe, which is evident in the manufacturing and services PMIs (Chart 3). Improving mobility data, which is coincident with the decline in its number of COVID-19 cases vs Europe, also is supportive of the USD (Chart 4). In the trading markets, speculators have crowded into the short-dollar trade, which augurs for a near-term correction in the USD DXY futures. Close to 60% of the DXY index is accounted for by the Euro (Chart 5). Lastly, while global economic policy uncertainty has fallen from its recent peak, taking the USD lower with it, it still is elevated and continues to represent a risk to the USD bear market (Chart 6). Chart 3USD Bear Market Could Stall All else equal, a weakening USD will continue to support Brent prices, and with that the rest of the global oil complex. As long as EM growth continues to improve, these short-term USD effects discussed above will affect the DXY more than the broad trade-weighted index (TWIB) for the USD, which has a Euro weight of 18% and is a more representative gauge of USD strength vis-à-vis trade. Chart 4DXY Could Rally Briefly As US Recovers Chart 5Specs Have Crowded Into The Short USD Trade Chart 6A Weaker USD Will Boost Oil Prices OPEC 2.0 Discipline, Capital Markets Will Restrain Supply While we expect some of this US production to come back on line as prices improve, overall output in the shales likely will continue to fall until 2H21. OPEC 2.0 production discipline largely is responsible for the 6.1mm b/d y/y decline in global oil production we estimate. The producer coalition’s putative leaders – KSA and Russia – continue to lead by example, having removed 460k b/d and 900k b/d y/y, respectively, from the market (Chart 7, top panel). We expect this to continue into next year (Table 1). Outside OPEC 2.0, US oil production is estimated to have fallen ~ 2mm b/d from its peak of 12.9mm b/d in 4Q19, in line with our expectation. This is largely the result of significantly reduced shale-oil output (Chart 7, bottom panel). While we expect some of this US production to come back on line as prices improve, overall output in the shales likely will continue to fall until 2H21. Chart 7OPEC 2.0, US Shales Output Will Remain Constrained Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect the combination of sustained demand growth and constrained supply to tighten balances globally, producing a physical deficit this year and next (Chart 8). As before, we expect this physical deficit to translate into lower inventories in the OECD, as refiners are forced to draw down stocks to meet demand (Chart 9). Chart 8Supply-Demand Balances Continue To Tighten Chart 9Expect OECD Inventories To Draw Asia’s Floating Storage Set To Increase Additional imports of US crude by China threaten to increase floating storage levels in Asia, which likely will reduce Chinese demand for light-sweet barrels sourced ex-US, and reverse the tightening in Brent and WTI forward curves. The inventory draw in the US – the largest component of OECD crude inventories – could accelerate if China follows through on its planned increase in imports of US crude oil, consistent with reports oil companies there recently chartered 19 VLCCs.4 This apparently was done to comply with the Phase 1 trade deal China and the US negotiated earlier this year. While these imports of US crude into China will lower US inventories – most of the tankers are shipping from the US Gulf – they could add to the swollen floating storage levels currently clogging Chinese harbors, and reduce demand for additional crude until these stocks are absorbed either by refinery demand or strategic reserves (Chart 10). In this context, we also are watching the evolution of forward curves, particularly for Brent, as this surge in Chinese imports could back out other light-sweet crudes similar to those produced in the US – and similar to Brent, for that matter – leaving them distressed on the water looking for a home. There already is early evidence the Brent forward curve’s flattening and expected return to backwardation has stalled (Chart 11). Given this pause in the tightening of the forward curve over the next year, we are closing our 4Q20 backwardation trades at tonight’s close. Chart 10China’s US Crude Imports Will Swell Asia’s Floating Storage Chart 11Brent Forward Curves Weaken Over the Next 12 Months Bottom Line: Global crude oil markets continue to tighten, as demand recovers, and supply discipline remains intact. However, additional imports of US crude by China threaten to increase floating storage levels in Asia, which likely will reduce Chinese demand for light-sweet barrels sourced ex-US, and reverse the tightening in Brent and WTI forward curves. This is prompting us to exit our 4Q20 backwardation trades at tonight’s close. The balance of price risks continues to favor the upside, in our estimation. We are raising our 2H20 Brent forecast slightly by $2/bbl to $46/bbl, and keeping our 2021 expectation at $65/bbl. WTI will trade ~ $3/bbl below those levels (Chart 12). Chart 12BCA Oil Price Trajectory Unchanged   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight US natgas prices were up this week as Hurricane Marco and Laura approached the Gulf of Mexico (GoM). Oil and gas producers evacuated part of their offshore facilities and shut 61% of their natural gas production from the region. Cheniere reported it suspended operation at its Sabine Pass LNG export terminal located in the GoM. Still, abundant oil and gas storage in the US limits the price increase. Separately, the latest estimate of US LNG cargo cancellations for October delivery – down to only 10 cancelled vessels – confirms natgas price spreads relative to Asia have reached levels sufficient to incentivize additional exports of US gas, supporting Henry Hub prices (Chart 13). Base Metals: Neutral Copper theft is rising in Chile and Africa, boosting LME copper prices and pushing treatment and refining charges lower. In Chile, “About 40 incidents were reported in the first half of this year, up from six in 2014,” according to mining-journal.com. Falling spot supplies in the wake of COVID-19 mining restrictions likely explain the thefts and increases in the cash-to-three-month copper spread on the LME to $17.25/MT earlier this week. Precious Metals: Neutral We closed our long gold recommendation for a 20% profit after reaching our $1,950/oz stop loss on August 11. We remain positive on gold strategically based on our view the dollar will continue depreciating and the Fed will keep rates low even as inflation and inflation expectations move up. As we go to press, markets await Jerome Powell’s speech at the annual Jackson Hole summit, where he is expected to discuss the Fed’s strategic review of its monetary policy strategy. This could push inflation breakevens slightly higher, and real yields lower. We are recommending a buy order at $1,875/oz as spec positioning remains stretch (Chart 14). Ags/Softs:  Underweight The USDA reported 69% of the US soybean crop was rated in good to excellent condition this week, up sharply from last year’s level of 55%. However, this was down from last week’s level of 72%, which was supportive of prices. Separately, the Sino-US Phase 1 trade deal is back in the news this week, with reports the two countries agreed to resume shipments of soybeans on a record scale – in the range of 40mm tons for 2020, which would be 10% above record purchases by China set in 2016, according to bloomberg.com. China had turned to Brazil earlier in the year as the trade deal became mired in tit-for-tat tariff spats. Chart 13Natgas Prices Supported By Hurricane Laura Chart 14Gold Vs. USD Spec Positioning Stretched   Footnotes 1     We also reduced the pass-through of the supply-demand difference into the oil price forecast in this month’s report, based on recent research we’ve completed, which also tempers the impact of the stronger growth expectations we share with the EIA and IEA. 2     Please see Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks published June 18, 2020, for additional discussion of global fiscal and monetary stimulus vis-à-vis oil markets. 3    Please see The Dollar And The Budget Deficit: From Theory To Practice, a Special Report published by BCA Research’s Global Investment Strategy and Foreign Exchange Strategy on August 14, 2020.  It is available at gis.bcaresearch.com. 4    In July and August, China imported ~ 17mm barrels of US crude, according to S&P Global Platts.  Please see Crude moves higher amid China's US import boost ahead of key OPEC meet published by Platts August 17, 2020.  China reportedly charted 19 VLCCs to import ~ 37mm barrels of US crude beginning in August, according to worldoil.com.  Please see China charters 19 tankers for record U.S. crude oil shipment published August 21, 2020.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights ‘Value’ sector profits are in terminal decline. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain. Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources. Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. As such, structurally overweighting the value-heavy European market versus the growth-heavy US market is a ‘widow maker’ trade. The caveat is that a vicious snapback out of growth into value is possible when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. This would create a burst of outperformance from Europe, but any such snapback would be a brief interruption to the mega downtrend. Fractal trade: Long RUB/CZK. Feature Chart of the WeekValue' Has Underperformed For 12 Years... But The Mega Downtrend Isn't Over I have just returned from a summer holiday, on which I took a clean break from the financial markets. A clean break that is highly recommended for anybody who looks at the markets day in, day out. Nevertheless, I made two market-relevant observations. First, that having to wear a face mask on an aeroplane was an unpleasant experience. Tolerable for a short-haul flight lasting a couple of hours, but something that would be unbearable for the duration of a long-haul flight. Second, that even the most popular bars and restaurants in the most popular places were operating at half capacity. They were fully booked, yet the requirements of physical distancing at the bar, and between tables, meant that their operating capacity and revenues had collapsed. Worse, the owners feared a further hit in the winter when eating and drinking in their outdoors spaces became impossible. The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others. These first-hand experiences simply confirm the message in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs.1 The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others – like flying, or drinking and eating out. Hence, if governments remove the financial incentives for employers to retain workers while the pandemic is still rampant, expect structural unemployment to rise sharply. In which case, expect bond yields to remain ultra-low, and where possible, go even lower. And expect ‘growth’ sectors to continue outperforming ‘value’ sectors. Explaining Recent Market Action Returning to the financial markets after a break, several things stood out. Apple has become America’s first $2 trillion company, while HSBC’s share price is within a whisker of its 2008 crisis low. This vignette encapsulates that growth sectors – broadly defined as tech and healthcare – have been roaring ahead, while value sectors – broadly defined as banks, oil and gas, and basic resources – have been struggling. Hence, the growth-heavy S&P500 has reached a new all-time high, while the value-heavy FTSE100 and other European indexes are still deeply in the red for 2020 and have recently drifted lower (Chart I-2). The combined effect is that the strong recovery in global stocks has taken a breather. Chart I-2US Market At All-Time High, But European Markets Still Deeply In The Red In turn, the breather in the stock market explains the recent support to the dollar. Significantly, the 2020 evolution of the dollar is a perfect mirror-image of the stock market. Nothing more, nothing less. If the stock market gives back some of its gains, expect the countertrend strengthening in the dollar to continue (Chart I-3). Chart I-3The Dollar Is A Mirror-Image Of The Stock Market Yet the best performing major asset-class in 2020 is not growth equities, nor is it gold. Instead, it is the US 30-year T-bond, which has returned a spectacular 32 percent (Chart I-4). Chart I-4The Best Performing Major Asset-Class Is The 30-Year T-Bond Suddenly, everything becomes crystal clear. If the ultra-long bond has surged, then other ultra-long duration investments must also surge. Within equities, this means that growth sectors, whose profits are skewed to the very distant future, must receive a huge boost to their valuations. Whereas value sectors whose profits are not growing will receive a smaller (or no) valuation boost. In fact, the value sectors have a much bigger structural problem. Not only are their profits not growing. Their profits are in terminal decline. Since 2008, Overweighting Value Has Been A ‘Widow Maker’ In the 34 years through 1975-2008, value trebled relative to growth.2 Albeit, with the occasional vicious countertrend move, such as the dot com bubble. But through 2009-2020, the tables turned. For the past 12 years, value has structurally underperformed growth and given back around half of its 1975-2008 outperformance (Chart of the Week). This means that for the past 12 years ‘proxy’ value versus growth positions have also structurally underperformed. The best example of such a proxy position is overweighting the value-heavy European market or Emerging Markets versus the growth-heavy US market. Since 2008, underweighting the US market has been a ‘widow maker’ trade. A widow maker trade is when you are on the wrong side of a megatrend. A widow maker trade is when you are on the wrong side of a megatrend. It is a widow maker because it can kill your career, or your finances, or both. The big danger is that a widow maker trade can last for decades. As the uptrend in value versus growth lasted more than three decades, there is no reason to suppose that the downtrend cannot also last a very long time. What drove value’s outperformance for 34 years, and what is driving its underperformance for the past 12 years? The simple answer is the structural trend in profits. Until 2008, the profits of banks, oil and gas, and basic resources kept up with, or even beat, the profits of technology and healthcare. This, combined with the higher yield on these value sectors, resulted in the multi-decade 200 percent outperformance of value versus growth. But since 2008, while the profits of technology and healthcare have continued their strong uptrends, the profits of banks, oil and gas, and basic resources have entered major structural downtrends. It is our high conviction view that these declines are terminal, and the reasons are nothing to do with the pandemic (Chart I-5). Chart I-5Value Sector Profits Are In A Major Structural Downtrend Sector Profit Outlooks In One Sentence Each When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Essentially, the sector has entered a terminal decline. As strong believers in brevity, we can summarise the reason for the terminal declines in one sentence per sector, as follows: When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain (Chart I-6). Chart I-6Bank Profits In Terminal Decline Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources (Chart I-7). Chart I-7Oil And Gas Profits In Terminal Decline Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources (Chart I-8). Chart I-8Basic Resources Profits In Terminal Decline Conversely: Technology profits can grow, because we now rely more on information, ideas, and advice, and over half of the world’s population is still not connected to the internet (Chart I-9). Chart I-9Technology Profits Continue To Grow Healthcare profits can grow, because as economies (and people) mature, they spend a much greater proportion of their income on healthcare to improve the quality and quantity of life (Chart I-10). Chart I-10Healthcare Profits Continue To Grow Nevertheless, a vicious snapback out of growth into value is possible. Indeed, it is to be expected when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. But any such snapback, even if vicious, will be a brief countertrend rally in a terminal decline. This is because the megatrends driving down value sector profits were already in place long before the pandemic hit. The pandemic just gave the megatrends an extra nudge. This is our high conviction view. Fractal Trading System* This week’s recommended trade is long RUB/CZK, with the profit target and symmetrical stop-loss set at 5 percent. In other trades, the explosive rallies in precious metals reached exhaustion as anticipated by their fragile fractal structures. This has taken our short gold versus lead position into profit. However, short silver was stopped out before its rally eventually ended. The rolling 1 year win ratio now stands at 60 percent. Chart I-11RUB/CZK When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs", dated July 30, 2020 available at eis.bcaresearch.com. 2 In total return terms. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights We expect limited upside to gas prices from current levels as the comeback of US Liquefied Natural Gas (LNG) exports will add to an already oversupplied market. In the short term, prices will remain below full-cycle costs. This will limit investment in LNG and the infrastructure required to get it to market in future. European storage will peak below maximum capacity. Gas forwards are pricing a rapid drawdown over the winter. Whether this occurs depends critically on winter demand in the northern hemisphere and a continued recovery in world economic activity. In the US, declining production in the prolific natural-gas shales and rising LNG exports will help balance its domestic gas markets: Rig counts in the Appalachian basin are at multiyear lows, which is weighing on output. Collapsing oil production in major shale-oil basins is dramatically reducing associated gas output, which represents more than 16% of total gas production. Still, a second wave of COVID-19 that results in another round of widespread lockdowns could send natgas prices back below $2/MMBtu as storage fills. Over the next few months, the balance of risk in natgas markets – especially in the US – remains to the downside, though highly uncertain. We are staying on the sidelines for now.  Over the medium term, global demand for LNG will catch up with supply by 2024, supported by additional coal-to-gas switching and slower supply growth. Feature The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. Global natural gas markets have been severely hit by the COVID-19 pandemic. Natgas prices in Asia, Europe, and the US were amongst the worst performing commodities during the crisis (Chart 1). This reflects weak fundamentals – i.e. a significant global supply surplus – which gas markets faced even before the exogenous shock. The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. This development renders shipments of US gas overseas uneconomical. The cancellation of US cargoes is acting as the primary balancing factor and will allow inventories to stay below full capacity – assuming global economic activity continues to accelerate in 2H20. Henry Hub prices surged by 34% since the beginning of the month on the back of higher gas demand – from warmer-than-normal weather and rebounding global economic activity – depressed US LNG exports, and prolonged maintenance at Australia’s Gorgon plant. Chart 1Global Gas Benchmarks Collapsed In 1H20 Chart 2Relative Prices Will Favor Additional US LNG Exports As storage-related fears abate, LNG economics is turning favorable for cargoes to be delivered in 4Q20 and 1Q21. This will allow exports of US gas to Europe and Asia to resume as regional demand rises. This improvement is already apparent in relative futures curves (Chart 2). Still, we expect only limited price gains from current levels, especially in the US. The resurgence in US LNG exports will add to the global supply surplus and cap the upside. Relative prices will remain below LNG offtakers' (exporters) full-cycle costs, limiting additional investments in LNG projects over the medium term. We expect demand to catch up to supply by 2024. Gas Fundamentals Worsened In 2019 Global gas demand increased by 2% y/y in 2019, led by growth in the US and China as coal-to-gas switching intensified amid the low-price environment (Chart 3). However, this rate of growth is a marked slowdown relative to the average 3.5% y/y growth from 2016-2018. It was also slower than the strong global supply growth – up 3.4% y/y – and LNG export growth – up 12.7% y/y. Chart 3US, China Supported Gas Demand Growth In 2019 The US was the largest contributor to both new gas and LNG supply, accounting for 65% of the world’s incremental gas production (Chart 4). The liquefaction capacity addition from the first wave of investments – i.e. projects that received a final investment decision (FID) before 2017 – is now mostly operational. Chart 4US Dominated Natgas Supply And LNG Growth In 2019 US LNG capacity stands at ~10 Bcf/d and serves as a needed pressure valve to its oversupplied domestic market – a consequence of rapid shale production growth – forcing the excess gas to Europe and Asia. However, the economic slowdown in Asia in 2H19 meant the region could no longer adequately absorb these new volumes. As a result, global gas markets moved to a supply-surplus. Relative gas price spreads began trending downward and moved in favor of exports to Europe over Asia.1 Europe plays a growing role as a market of last resort for global natural gas – particularly US LNG – due to its well-developed storage infrastructure, regasification units, and pipeline networks. Around 80% of LNG exports from newly added terminals were absorbed by European markets, and most of that went into storage. Around 40% of the global natural gas supply increase last year ended up in storage, according to the IEA (Chart 5). Moreover, milder-than-expected weather last year exacerbated these trends and forced global prices to converge closer to Henry Hub. Chart 5European Storage Absorbed ~ 40% Of Global Gas Supply Growth By the end of 2019, gas storage in Europe was drastically higher than its 5-year average for that period (Chart 6). Chart 6Elevated US And Europe Gas Storage European Storage Will Stay Below Capacity-Testing Levels Cargo cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Global gas markets confronted the COVID-19 pandemic from a fragile starting point. The shock reinforced the imbalances that began in 2019 and completely erased US LNG’s competitiveness in European and Asian markets. As demand fell in response to lockdowns – down 2.8% in the US and 7% in Europe y/y in Jan-May by IEA’s reckoning – storage in Europe was projected to reach full capacity by end-August.2 Consequently, in June, natural gas prices plunged to a more than two-decade low to incentivize supply and demand adjustments. Around 100 LNG cargoes from the US were cancelled for delivery in June and July, based on EIA estimates (Chart 7). US LNG supply is now the main balancing factor in global gas markets: It is a high-cost source of supply when delivered to Europe or Asia and is contracted under more flexible agreements facilitating cargo cancellations. Over the short term, the number of vessels cancelled each month is an important indicator of storage availability in Europe. The decision to cancel a cargo is complex but mainly depends on whether the spreads between US Henry Hub (HH) and Dutch Title Transfer Facility (TTF) or Japan Korea Marker (JKM) prices cover the exporter's variable costs. Based on a Cheniere-type contract,3 this implies the spread must be higher than 115% of Henry Hub prices plus shipping and regasification costs (Chart 2). Chart 7US LNG Vessel Cancellations Balance Global Gas Markets The spread failed to cover variable costs for most of 2020 and even moved to a premium – i.e. HH above TTF – in July. Moreover, because most contracts have a 40-day to 70-day notice period for cancellation, the supply of US LNG only reacted to the rapid drop in demand with a lag, aggravating the supply surplus and flooding European inventories. The resulting supply adjustments, combined with stronger-than-expected demand in Europe, have slowed the storage injections rates in August and pushed prices higher.4 Cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Forward curve behavior suggests market participants expect US LNG shut-ins, combined with robust demand recovery in Asia and Europe, to move price spreads above variable costs by November this year (Chart 8). This is mostly a consequence of rising Asian LNG prices. We expect this will incentivize added exports of US LNG over the coming months which will move Henry Hub prices slightly higher over the winter. Chart 8Relative Price Spreads Cover LNG Variable Costs, But Not Total Costs In fact, some cargoes are reportedly already selling their gas in forward Asian markets and taking longer routes or reducing their travel speed to remain at sea for longer and profit from these higher deferred prices.5 Still, the increase in US prices will be limited given that relative prices need to remain wide enough to cover LNG variable costs. While global prices will move up gradually over the winter, we believe their upside is bounded by the supply surplus, especially as US exports normalize. At current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu. On the demand side, low prices will favor additional coal-to-gas switching as economies recover in 2H20 (Chart 9). Current forward TTF prices are signaling deep drawdowns in European storage this winter as demand in the region increases (Chart 10). Chart 9Cheap Gas Favors Coal-To-Gas Switching Chart 10TTF Forwards Signaling Strong Inventory Draws This Winter In Chart 11, we simulated the remaining of the filling season based on previous monthly seasonal injection rates for Europe. This suggests storage remains at risk of being maxed out by October. However, we believe – in agreement with current forward curves – that the pickup in demand from recovering economic activity, coal-to-gas switching, and lower US exports will further diminish injection rates in Aug-Sep-Oct relative to historical rates (Chart 12). This will allow inventory to reach its seasonal peak slightly below capacity-testing levels. Chart 11Euopean Storage Remains A Significant Downside Risk Chart 12Low US LNG Exports, Warmer Weather Drastically Reduced Injections In July Moreover, flows from Europe to Ukraine should continue freeing up capacity in core EU storage facilities (Chart 13).6 Chart 13Filling Ukrainian Storage Acts As A Safety Valve Chart 14Lower US Gas Supply Slows Inventory Builds In the US, the multi-year-low active gas rigs in the Appalachian basin are starting to weigh on production. Moreover, collapsing oil production in major shale-oil basins is bringing associated gas – which is now more than 16% of total gas production – down rapidly (Chart 14). This contributes to the slowdown in domestic storage injection and to the recent Henry Hub price gains. Still, at current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu (Chart 15). Consequently, we believe short-term downside risks from lockdowns are too elevated to try to profit from the limited price increase expected this winter. Chart 15Renewed Lockdowns In Europe Would Push Storage to Capacity   Rising US-Russia Competition Keeps Prices Lower For Longer Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs. In 2019, a record volume of liquefaction capacity reached FID globally (Chart 16). By 2025, global LNG capacity is expected to reach ~73Bcf/d, a ~ 15Bcf/d increase from current levels. Despite the COVID-19 shock, most projects under construction in the US remain on track to be completed as previously scheduled in 2020.7 Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs – i.e. below variable costs plus a fixed contracted liquefaction capacity fee estimated at ~$3/MMBtu. Chart 16Record FID Risks Keeping Markets Oversupplied Mounting competition – especially from Russia – in both Europe and Asia will hold down prices over the coming years. In Europe, the completion of the Nord Stream 2 pipeline would add 5.3Bcf/d of cheap Russian gas supply and could keep prices ~ $1/MMBtu lower than otherwise.8 These new volumes would be absorbed by higher European consumption – fueled by low prices – and lower US LNG exports – from weak relative prices. Geopolitics is a major factor driving Russian behavior and hence oversupply: The US and Russia will vie with each other for market share in Europe. As gas markets further liberalize globally, Europe will be increasingly essential for US LNG as its destination of last resort in times of low demand elsewhere. If Russia floods this market with gas, it reduces Europe’s ability to absorb US gas, which will lead to lower Henry Hub prices. It will shut in US supply in times of low demand, making investments there riskier. While US administrations of either party almost always attempt to engage Russia at the beginning of a four-year term, the US foreign policy establishment no longer believes that engagement with Russia is beneficial (Chart 17). This is apparent under the Russia-friendly Trump administration but will be especially relevant if the Democratic Party wins the White House in November. Democrats blame Russia for undermining and ultimately reversing the Obama administration’s policies by betraying the US-Russia diplomatic “reset” and interfering in the 2016 election. Chart 17Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Hence the US will continue to impose sanctions on Russia and probably on a range of companies involved in Nord Stream 2 and Turkstream. If both pipelines are completed, then Washington will ask Europe to compensate for its Russia dealings in other ways. Meanwhile Russia will use a combination of commercial and strategic measures to woo Germany and the Europeans so that they do not commit to preferential bilateral deals with the United States. Because the US and Russia are engaged in a great power struggle – rather than healthy trade competition – they will attempt to achieve their aims through means other than price and volume. Punitive measures will create volatility by occasionally removing supplies but probably cannot change the backdrop of oversupply. The gist is that US-Russia relations will remain antagonistic and Europe will benefit from the oversupply except during times of surprise sanctions and strategic blows. In China, we expect imports of US LNG to increase. However, rising Russian LNG and pipeline supplies, increasing domestic gas output, and a persistent global oversupply of gas will limit the incentives for Chinese buyers to sign long-term agreements with US exporters at a price above full-cycle costs – i.e. ~ $7/MMBtu.9 The ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. This has large implications for the US gas market, as LNG capacity represents ~ 11% of its domestic supply – based on 1H20 production levels. Low demand growth for its gas in Europe or Asia will keep Henry Hub prices low to limit supply growth from shale gas and limit investment in additional liquefaction capacity. Here too geopolitics will undermine Henry Hub prices: China is strengthening economic ties with its strategic partner, Russia, and the ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. A Biden administration would approach China differently from the Trump administration but it would still have to face fundamental trade tensions due to China’s mercantilism and the US attempt to contain China’s technological rise. China is crucial for global LNG demand growth, but trade tensions will reignite even under Biden and spill over into China’s demand for US commodities. China has substitutes for American LNG. If trade tensions affect China’s imports of US LNG then they will lead to lower Henry Hub prices and possibly to vessel cancellations, especially if European storage once again proves unable to absorb these exports during the injection season. The Biden administration will not ultimately be China-friendly, looking beyond any diplomatic “reset” in its first year, and thus the risk of China diversifying away from US LNG is real. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. There are currently more than 6Bcf/d of approved, not yet FID, projects in the US. We do not expect much of this capacity to move forward until LNG economics turn favorable and buyers’ willingness to sign long-term contracts comes back. Large projects expected to start closer to 2025 – e.g. Shell’s LNG Canada and Total’s Mozambique LNG – could be delayed to the second half of the decade. On the demand side, persistent low prices will reinforce two ongoing trends. First, this will favor additional coal-to-gas switching in most regions, helping demand to catch up to supply by 2024 and eventually forcing European and Asian prices significantly higher in anticipation of tighter fundamentals. Second, low spot LNG prices in Asia and the availability of flexible supply will accelerate the shift to a merchant/trading market.10 The movement toward shorter and non-indexed-oil contracts continued in 2019, with spot and short term contracts reaching 34% of total LNG flows in 2019, up 32% vs. 2018 (Chart 18). The COVID-19 shock augmented the incentive to switch to non-oil-indexed contracts given the steep discount it created in LNG spot market prices versus oil-indexed contracts. Based on our Brent price forecasts, we expect this divergence to persist in 2021 (Chart 19). Chart 18Shorter, Gas-On-Gas Contracts Will Increase In Asia Chart 19Spot Prices Will Decouple From Oil-Indexed Again In 2021 The convergence in regional prices that began in 2019 is disrupting the standard LNG model based on significant regional price spreads. Low and uniform prices reduce the arbitrage of moving gas overseas. Companies will need to start using sophisticated financial instruments and will increasingly resort to spot and futures markets, like in oil markets.11 Crucially, our expectation that demand will catch up to supply assumes government policies aimed at reducing carbon emissions continue being implemented in major consuming countries. Future gas consumption is a function of economic – i.e. price incentives – and policy variables. A reversal in China’s environmental policies could drastically slow gas demand growth and remains a risk to our view. At present China’s policy setting aims for growth recovery at all costs, but the driver of Xi Jinping’s green policy is the middle class demand for healthier air and environment (Chart 20). Hence the slog to diversify away from coal will resume over the medium and long run. Bottom Line: The large collapse in prices will remain bearish for US LNG over the short term as global gas markets remain firmly oversupplied and storage levels hew dangerously close to maximum capacity. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. Relative prices will be capped close to variable costs. These unfavorable conditions for additional investments in LNG projects could create a supply deficit later in the decade. Chart 20China"s Green Policy Is Driven By Its Growing Middle Class   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com         Footnotes 1     These destination adjustments in response to price incentives are possible because of the flexibility in US long-term LNG agreements. These contracts, for the most part, have no predetermined destination clause. 2     For instance see "NWE gas storage sites could be 'almost' full by end-August: Platts Analytics" published by S&P Global Platts on May 21, 2020. 3    There exists two main types of LNG contracts in the US: (1) Tolling agreements in which the LNG exporter needs to secure the feedgas, transport the gas to the liquefaction facility, and ship it to the buyer. In this model, the LNG operator charges a fixed fee – usually in the range of $2.25 to $3.5/MMBtu, paid regardless of whether they use their contracted LNG space to liquefy the gas. The ownership of the gas remains in the hand of the offtaker. (2) Chienere-type agreements – or a hybrid merchant-tolling structure – in which the LNG operator secures the feedgas and transports it to its liquefaction facilities. It takes ownership of the gas until it is liquefied and sold to the exporter responsible for shipping the gas to the final buyer – the pricing scheme is usually ~115% of Henry Hub gas prices + a fixed liquefaction fee. In the US, the Cove Point, Freeport, Cameron, and Elba terminals mostly use the tolling model, while all of Cheniere’s installations – i.e. Sabine Pass and Corpus Christi – are operating under Cheniere-type models. In our analysis we use the Cheniere-type as it is slightly more flexible and seems more vulnerable to cargo cancellations – subject to a penalty, or fixed fee, to ensure a reliable cash flow to Cheniere. Moreover, it is difficult to estimate how much of the shipping cost are truly variable, some offtakers have long-term shipping contracts to diminish total variable costs. Please see “Steady as She Goes, Part 5 - How Global Prices Drive U.S. LNG Cargo Destinations,” published by RBN Energy on August 1, 2020 for a detailed discussion of LNG exporters’ costs. 4    Maintenance delays at Australia’s Gorgon LNG plant also contributed to the price increase, especially in Asia. Please see "Chevron says expects to restart Train 2 of Gorgon LNG plant in early September" published by reuters.com on July 28, 2020 for more details. 5    Please see "Buyers of U.S. LNG cancel September cargoes but pace slows, sources say," published by reuters.com on July 21, 2020. 6    Since May this year, the Ukrainian storage and gas pipeline managing company UkrTransGaz started offering discounts on transportation fees and other arrangements to incentivize European traders to storage gas at their facilities. Natgas stored by non-resident in customs warehouses with UkrTransGaz are more than four times higher than last year. Please see “European gas storage: backhaul helps open the Ukrainian safety valve,” published by Oxford Institute For Energy Studies in May 2020. 7     A few projects reported lockdown-related delays of up to 4 months. 8    Please see "Nord Stream 2 and the battle for gas market share in Europe" published by Wood Mackenzie on July 24, 2020. 9    Please see “No Upside: The U.S. LNG Buildout Faces Price Resistance From China,” published by The Institute for Energy Economics and Financial Analysis (IEEFA), July 2020. 10   We highlighted in our October 4, 2018 report titled "US Set To Disrupt Global LNG Market" that the large LNG supply expansion in the US would incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. 11    Please see “Covid-19 And The Energy Transition,” published by Oxford Institute For Energy Studies in July 2020. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Special Report

Highlights The Beirut blast calls attention to instability in the Shia Crescent. A turbulent push for political change will now ensue in Lebanon. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Lebanon is a red herring, but Iraq is a Black Swan. It is at risk of social unrest contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. It is adopting a strategy of measured sabotage and deterrence against US interests in Iraq. The double whammy of low oil prices and pandemic is weighing on Saudi Arabia’s finances. Nevertheless it is prioritizing a cooperative relationship with Iraq. Iran could stage a major attack or President Trump’s poor election prospects could force him to “wag the dog.” Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Stay long Brent crude oil and gold. Feature The August 4 explosion at the Port of Beirut was devastating. It killed more than 220, wounded over 6000, left 300,000 homeless, and damaged buildings as far away as 9km from the site of the explosion. The blast added insult to injury to the country’s already troubled finances. Estimates for the cost of repair range anywhere between $5 billion and $15 billion. Global investors can largely write off the incident as an idiosyncratic shock. Even though emigration is likely to pick up, Lebanon’s population is only a third of Syria’s prior to its civil war. Assuming that a third of Lebanese become displaced abroad – a generous assumption more suitable to Syrian-style civil war than Lebanon’s situation – about 2 million Lebanese will be displaced, half of which will make their way to Europe or elsewhere outside the Middle East. As long as an antagonistic Turkey upholds its agreement with the EU, a mass exodus from Lebanon does not risk an unmanageable migrant crisis for Europe (Chart 1). Political tensions will rise and potentially lead to a populist backlash, given Europe’s battered economy. But Lebanon alone is not enough. The risk is broader Middle Eastern instability, which is a credible risk. Chart 1Middle Eastern Instability Could Fuel European Populism Thus Lebanon in itself is a red herring, but it is a bellwether for further unrest in the Middle East in countries that are not red herrings (Map 1). Map 1Lebanon Is A Red Herring; Iraq And Saudi Arabia Are Relevant A major conflict in Iraq is an underrated risk to global oil supply. The catastrophe calls attention to instability the Shia Crescent – a region in a tug of war between rival sectarian and geopolitical interests. Whereas the 2008 crisis led to the largely Sunni Arab states in the so-called Arab Spring, the 2020 crisis is piling pressure onto already unstable Shia states and regions: Iran, Iraq, Lebanon, Syria, and possibly eastern Saudi Arabia. Of particular significance is the fate of Iraq. Popular grievances are eerily similar to Lebanon’s. Baghdad is on shaky ground, yet the ramp up in US-Iran tensions going into the November US elections makes the threat of instability in Iraq more acute. As OPEC’s second ranked oil producer, a major conflict in Iraq poses an underrated risk to global oil supply. Supply losses are a tailwind to oil prices when market conditions are tight. However OPEC 2.0’s 8.3mm b/d of voluntary cuts means massive spare capacity is available globally to offset potential losses in Iraq, reducing the potential upside to oil prices. Nevertheless, this risk becomes more relevant as markets tighten on the back of a demand-side recovery, i.e. as balance is restored to the oil market and as excess spare capacity is eliminated. With oil markets likely rebalancing in 3Q20, unrest in Iraq poses an upside risk to our Commodity & Energy Strategy service’s expectation that 2H20 Brent prices will average $44/bbl and 2021 prices will average $65/bbl (Chart 2). Even though gold has already rallied 30% since mid-March, geopolitical risks including US-Iran tensions suggest any near-term selloff is a buying opportunity (Chart 3). The bullish gold narrative – geopolitical risks, falling dollar, and low real interest rates for the foreseeable future – remain intact even as the downturn gives way to a cyclical recovery. We continue to recommend gold on a strategic time horizon. Chart 2Oil Price Rally Remains Intact Chart 3Gold Is Due For A Breather Lebanon’s economic collapse highlights risks to other regional economies tied to the oil dependent Arab economies of the Persian Gulf. As the latter grapple with record low oil prices, production cuts, and the pandemic-induced recession, second-order effects will reverberate throughout the region, hitting economies such as Egypt and Jordan whose economic as well as political structures are intimately intertwined with Gulf Cooperation Council finances and policies. Lebanon’s Collapse Was Inevitable Lebanon was already going through an economic and financial meltdown before the explosion (Chart 4). Aside from the humanitarian loss, the economic impact is also profound. The country – highly dependent on imports of basic goods and suffering from food insecurity – must now contend with the loss of its main port and most of its grain reserves, destroyed in the explosion. As the dust settles, grief is morphing into anger on the streets. Regardless of whether the blast was due to happenstance or malice, the immediate cause was 2,750 tons of ammonium nitrate in storage for six years. The government was warned about the risks of the explosive chemicals at least four times this year – with the latest being on the day of the blast. Chart 4Beirut Port Explosion Accelerated Lebanon’s Collapse Mass protests are already taking place, calling on the government to be held accountable for criminal negligence. A controversial petition to return Lebanon to French mandate has gained more than 60,000 signatures. Prime Minister Hassan Diab’s seven-month-old cabinet has resigned. (It was put in place last year amid an earlier bout of unrest.) Official incompetence and neglect are in fact the best-case explanations for the explosion. Many questions remain unanswered. For instance, what triggered the fire? Israel swiftly denied any connection and offered humanitarian aid, while Hezbollah’s leader Hassan Nasrallah claimed to know more about the Port of Haifa than about Beirut Port. Early parliamentary elections and the cabinet’s resignation will not appease the protesters. Photos of Nasrallah, President Aoun, Speaker of Parliament Nabih Berri, and former Prime Minister Saad Hariri were among those hung by protesters in gallows in Martyrs’ Square over the weekend. Berri and Gebran Bassil are known to be the source of the cabinet’s decision-making power.1 They have veto over all decisions, large and small. During the mass protests in October 2019, Nasrallah stated that Hezbollah has two red lines:     Aoun must finish his term, which expires in 2022;     No early elections will be held, i.e. the speaker of the house will not be changed. While early elections have now been promised, these red lines highlight that corruption runs deep in Lebanon and opposition groups face an uphill battle against the establishment. A turbulent push for political change will now ensue. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Another Israeli confrontation with Hezbollah is not the base case but it could occur. Bottom Line: Lebanon is a failed state. As with the Arab Spring, the question is whether popular anger will prove contagious and spread to more market-relevant neighboring countries. The rally in the Israeli shekel in trade weighted terms since mid-March has already started to fizzle and may be tested further as turmoil in Lebanon raises the risk of confrontation. Contagion? In order for a geopolitical event in the Middle East to warrant investors’ attention, it must affect at least two of the following factors : (1) global oil supply, (2) geography of existential significance to a regional power, or (3) sectarian conflict which could lead to contagion. In this context, Lebanon is a red herring, but Iraq is not – therefore investors should watch to see if anything causes destabilization in Iraq. A decline in Iranian funds will weaken Tehran’s sphere of influence. Like Lebanon, Iraq is dominated by a highly corrupt sectarian system that has been plundering the wealth; people are suffering from rising rates of unemployment; and the regime is in the crosshairs of competing foreign agendas (Chart 5). Chart 5Iraqis And Lebanese Suffer Similar Grievances Iraq is in Iran’s sights because it aspires to establish a land bridge to the Mediterranean through a friendly “Shia Crescent” (Map 2). Iran’s modus operandi is to establish a presence in its neighbors’ domestic politics through Iran-backed factions. Map 2Iraq Essential To Iran’s Aspirational ‘Land Bridge’ To The Mediterranean Given the current state of Iran’s economy, it is not far-fetched to envision a significant drop in the funding of its foreign proxies (Chart 6). Historically these funds have followed the ebbs and flows of oil prices. For instance, in 2009, when faced with declining oil prices and US sanctions Iran’s funds to Hezbollah were estimated to have fallen by 40%. This happened again in 2014-16 and is not too different from today. Thus Iraq is at risk of contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. Syrian fighters have reported paychecks being slashed, Iranian projects in Syria have stalled, and Hezbollah employees report to have missed paychecks and lost other benefits. Tehran’s finances are essential for Hezbollah’s survival.2 Iran’s proxies in Iraq are facing a similar fate.3 Chart 6Iran Suffering Under "Maximum Pressure" Bottom Line: Iraq faces an uptick in social unrest due to the poor living conditions and possible contagion from Lebanon. Meanwhile, Iran-backed groups there face a decline in funds from Tehran, which will send them searching for replacement funds. If Lebanon falters the world can usually ignore it but if Iraq falters the world will have to take notice. Saudi Arabia Prioritizes Revenue Over Growth Beirut’s foreign policy stances in recent years have been seen as appeasing Iran at the expense of Gulf Arab states.4 This trend coincides with a decline in Gulf Cooperation Council financing to Lebanon. Now the collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget, which still depends on the energy sector for most of its revenues despite efforts to diversify. State revenues were down 49% year-on-year in Q2 pulling the budget deficit down to $29 billion (Chart 7). Riyadh is reassessing its priorities. Opting for revenue at the expense of growth, Riyadh has tightened the screws on its citizens. The government has had to pare back some of the benefits Saudis have long been accustomed to. The value-added-tax rate tripled from 5% to 15%, and a bonus cost-of-living allowance of $266 for public sector employees ended. The kingdom also announced plans to reduce spending on major projects by $26 billion – including some of those associated with Crown Prince Mohammed bin Salman’s reform agenda, Vision 2030. Chart 7Saudi Arabia Under Pressure From Double Whammy Severe economic turmoil poses a risk to the Saudi social contract in which citizens pledge allegiance to the ruling class in exchange for financial and social guarantees. The risk now is that the fiscal challenges dent Saudi citizens’ pocketbooks and thus impact social and political stability. However, oil prices are recovering to levels consistent with the kingdom’s fiscal breakeven oil price next year. The global economic recovery will begin to support the kingdom’s economy in the second half of this year (Chart 8). This will ease pressure on the budget and hence households. Moreover the slowdown is likely to hit foreign workers hardest and thus hasten the Saudization process. Foreign workers are the lowest hanging fruit and will be the first to find themselves jobless. In that sense the crisis is expediting some of Riyadh’s long-term reform targets. That said, there is still some risk of internal instability or even a palace coup. Tehran could incite sectarian tensions in the kingdom’s Eastern Province where an estimated 30-50% of the population is believed to be Shia. This is relevant given that nearly all Saudi oil production is located there. Chart 8KSA Benefits From EM GDP Growth ... Regarding the possibility of a palace coup, Crown Prince Mohammed bin Salman has spent this year cracking down on potential dissidents. Former Crown Prince Mohammed bin Nayef and King Salman’s only surviving full-brother Prince Ahmed bin Abdulaziz – both influential and well-liked – were among those detained in March. The kingdom’s contradictory policies – reform through repression – may eventually culminate in an overt political crisis. Though such a crisis may not occur until the time of royal succession. These economic and political challenges may force Saudi Arabia to adopt an inward stance. Its foreign interventions to date have been costly and come with little benefit – judging by the war in Yemen. It is also possible that Saudi Arabia, which is already the third largest defense spender globally, will try to strengthen its position vis-à-vis Iran. Crown Prince Mohammed bin Salman has already stated that the kingdom will pursue a nuclear program if Iran develops a nuclear bomb. This is relevant in today’s context with Iran no longer complying with restrictions to its nuclear program (Table 1). Saudi Arabia, like Iran, claims its nuclear program is for peaceful purposes – in order to generate nuclear power as part of efforts to diversify its economy.5 Table 1Iran No Longer Complying With 2015 Nuclear Deal Still, low oil prices tend to discourage petro states from engaging in conflict (Chart 9). Arab petro states may show restraint, at least until oil markets recover. Chart 9Low Oil Prices Discourage Petro States From Engaging In Conflict Overall weakness in oil-producing economies will hurt various countries that rely on remittances (Chart 10). The downturn will also hurt countries dependent on remittances from petro states in the region such as Egypt and Jordan. Bottom Line: The collapse in oil prices is forcing Saudi Arabia to reconsider its priorities and is expediting some long-term reforms. For now, it is adopting a pro-revenue rather than a pro-growth stance. This is likely to result in a focus inward for the kingdom. The implication is that countries that are leveraged to the petro-economies of the Gulf for remittances, bilateral aid, and capital flows will take a hit. These include Lebanon, Egypt, and Jordan. Chart 10Egypt And Jordan Also Vulnerable To Petro State Weakness Iraq Is The Prize Not unlike Lebanon, Iraq’s political class has been suffering a legitimacy crisis since protests erupted there last October resulting in the resignation of then-Prime Minister Adel Abdul Mahdi. However unlike Lebanon, Iraq is a significant geography for global investors. It is a major OPEC producer – second only to Saudi Arabia – accounting for 16% of the cartel’s production last year. The Iraqi oil minister’s first foreign trip was to the Saudi capital. This is not surprising. Iraq not only seeks Saudi leniency in OPEC 2.0 cuts, but also needs financial assistance to develop a natural gas field that will allow it to reduce dependence on Iran. Saudi Arabia also hopes to reduce Iraq’s dependence on Iranian natural gas and coax it into its sphere of influence. When it comes to crude oil, the additional 1mm b/d of voluntary cuts in June announced unilaterally by Saudi Arabia beyond its agreed OPEC 2.0 commitments are also a sign of Saudi willingness to accommodate Iraq and its non-compliance  (Chart 11).6 Saudi Arabia does not want to see Iraq’s newly elected government failing on the back of budgetary strain. In fact, al-Kadhimi is an opportunity for the Saudis. Formerly the director the National Intelligence Service with warm ties to the US, he is a champion of Iraqi sovereignty. Even though Iraq is being forced to compensate for past overproduction of oil in August and September, it was cajoled by the promise of a $500 million “bridging” loan from Saudi Arabia, to be repaid when oil markets recover. While financial assistance shows the kingdom’s commitment to Iraq, more significantly it reflects Riyadh’s desperation to revive oil markets and bring prices closer to its fiscal breakeven oil price amid the still uncertain demand outlook. Chart 11Saudi Arabia Willing To Accommodate Iraq Neither Saudi Arabia’s nor al-Kadhimi’s efforts are guaranteed to succeed in pulling Iraq out of Iran’s sphere. The prime minister received a rude awakening upon his arrest of 14 Kata’ib Hezbollah fighters in June on grounds of a plan to launch a rocket attack on US interest in Baghdad. They were swiftly released, and the case against them dropped. It is hard to curb Iranian influence. For its part, Iran stood behind al-Kadhimi’s nomination despite him being perceived as pro-Western. Tehran needed to avoid an anti-Iranian backlash on the streets of Baghdad if it had stood against him. Instead, Iran’s calculus was that it is in its best interest to swallow the pill and work with the new government at a time when Iraqi anger was targeted against US involvement rather than at Iranian interference. Prior to the US assassination of Qassem al-Suleimani and Abu Mahdi al-Muhandis on Iraqi soil, Iraqis were rebelling against Iran’s influence. That being said, Iran will maintain pressure on Iraq through continued attacks on US interests there (Table A1 in Appendix). This is also reflected in the July assassination of top Iraqi security expert Hisham al-Hashimi, who had previously advised the government on how to curb Iranian control. Iran was looking to make it to the US election in November without an escalation in tensions, hoping the US elections will result in a more dovish Democratic Party leadership averse to conflict with Iran. However, recent cyber-attacks on key Iranian infrastructure raise the likelihood that tensions will escalate ahead of the elections. The US is also threatening to maintain maximum sanctions even if the United Nations Security Council disagrees. As always, Iraq will find itself in the crossfire of any deterioration in relations. Bottom Line: Maintaining a cooperative relationship with Iraq aligns with both of Saudi Arabia’s interests there: limiting Iranian interference and supporting global oil markets through supply-side discipline. Iran will maintain pressure on Iraq’s new government through continued attacks on US interests. However, these attacks are supposed to fall short of killing US citizens and giving President Trump a reason to launch air strikes that could give him a patriotic boost in opinion polls. Nevertheless, tensions in the Gulf could escalate if Iran stages a major attack or if President Trump’s poor election prospects force him to “wag the dog.” In that case Iraqi oil supply would be disrupted. Investment Implications The Shia Crescent remains at heightened risk of instability on the back of Iran’s economic deterioration. Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Given that the Saudi loan will ensure Iraq’s commitment to compensatory production cuts in August and September, supply-side risks are a tailwind to oil prices in H2. The elevated risk of an escalation in US-Iran tensions also favors holding gold. President Trump’s polling has bottomed, yet he remains the underdog in the election – we maintain his odds of winning reelection are 35%. This raises the risk that he adopts a “war president” posture. Iran could become a target as the financial price of confronting Iran is negligible for Trump, whereas a major China confrontation could sink the stock market. The collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget. It has adopted a revenue over growth posture. While this could be a risk to domestic stability, our base case is that it accelerates the kingdom’s long-term reforms. The oil market rout and economic downturn will hurt other countries in the region that are leveraged to Arab petro states – chiefly Egypt and Jordan. Investors should monitor risks to state stability in the coming years. Lebanon’s crisis will incentivize emigration, but given the relatively small size of its population, the major risk to Europe comes from any broader state failures and Middle Eastern instability rather than from Lebanon’s failure alone. If the Democratic Party wins the US election, as expected, then the US-Iran strategic détente will resume and Iran will get a lifeline. But the immediate transition will still be rocky given the Israeli and Saudi desire to exploit Iran’s extreme vulnerability and build leverage with Washington. The COVID-19 crisis heralds another round of Middle Eastern crisis, much as the 2008 crisis led to the Arab Spring. Stay strategically long Brent crude oil and gold. Also, in the wake of yesterday’s 15% pullback in silver, go strategically long silver (XAGUSD), which will continue benefiting from the same structural trends favoring gold but also outperform gold as the global economy recovers, given its greater industrial utility.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com       Appendix Table A1Iran Adopting Deterrence Strategy In Iraq   Footnotes 1     Berri is of the Hezbollah-allied Amal Movement and has been parliamentary speaker since 1992, while Bassil is President Aoun’s son-in-law and president of the Free Patriotic Movement, which has the most seats in parliament. 2     Hezbollah gains legitimacy at home through its charity work that plugs the gap in services normally provided for by the government. 3    According to a commander of an Iran-backed paramilitary group in Iraq, Iran slashed its monthly funding to the top four militias by nearly half this year. Please see “Coronavirus and sanctions hit Iran’s support of proxies in Iraq,” Reuters, July 2, 2020. 4    Hezbollah has gained control over the foreign policy and Lebanon has recently taken stances that are seen as bowing to Iranian pressure. Lebanon did not attend a March 22, 2018 extraordinary Arab League meeting discussing violations committed by Iran. Prior to that, Beirut did not condemn Iranian attacks on a Saudi diplomatic mission in Tehran. 5    However an undisclosed facility for processing uranium ore in the northeast of the kingdom has recently appeared. 6    This is not unlike the US’s decision to extend sanction waivers by four months, allowing Baghdad to import Iranian energy in order to ensure that the new government of Prime Minister Mustafa al-Kadhimi can stand on its own and is not overly dependent on Iran.

Highlights The implementation of an oil-price hedging strategy by Russia’s government – consisting of put buying a la Mexico’s strategy for putting a floor under government revenues – would force us to re-consider our bullish view. On the one hand, systematically hedging forward revenues when deferred prices met the government’s budget threshold – currently $42.40/bbl for Urals crude oil – would tangibly increase Russia’s impact on forward price discovery.  This could become one of the tools available to OPEC 2.0 that allow it to influence the shape of the forward curve, perhaps supporting a backwardation benefiting member states.  On the other, hedging government revenues could free Russia and its oil companies from supporting the OPEC 2.0 framework, thus returning the swing-producer responsibilities for balancing the market to OPEC. Significant obstacles stand in the way of implementing a hedging program by the Russian government.  Hedging even volumes in futures could overwhelm the supply of liquidity in these markets, particularly in the deferred contracts: Average daily Brent volumes are ~ 700mm b/d for the entire market.1 Feature OPEC 2.0’s mostly successful production management scheme is a key factor driving our bullish view of oil. The coalition led by KSA and Russia is keeping output constrained while global demand recovers from the COVID-19 pandemic. This will tighten global supply-demand balances and reduce inventories (Chart of the Week). This dynamic drives our expectation that prices will remain around current levels for 2H20 – at ~ $44/bbl for Brent – and, based on our modeling, push prices to $65/bbl on average next year. At the end of the day, OPEC 2.0 is a quasi-cartel operating under a Declaration of Cooperation signed by the original cartel and non-OPEC producers led by Russia in late 2016 and renewed and expanded periodically since then. Without this cooperation, it is highly doubtful oil prices would have recovered from the demand-destruction visited upon the market by the COVID-19 pandemic as quickly as they have. Chart of the WeekOPEC 2.0 Production Discipline Underpins Our Bullish Oil View Nor is it likely the inventory overhang dogging markets since the end of the 2014-16 market-share war launched by KSA, then compounded by waivers on Iranian oil-export sanctions in November 2018 by the US, could have been addressed as effectively as they were prior to the pandemic’s arrival. In all likelihood, a punishing continuation of low prices would have been required to destroy enough production globally – in OPEC and ex-OPEC – into 2017 for prices to finally recover. OPEC 2.0’s Days Numbered? We have long argued the OPEC 2.0 framework benefitted Russia and KSA more than unrestrained production, which, left unchecked, would keep prices closer to $30/bbl than $70/bbl. The leadership of Russia’s oil sector has been a reluctant participant in the coalition’s production-management scheme. This was apparent in every meeting of OPEC 2.0 up to an including it March 2020 meeting in Vienna, where an extension of the coalition’s production cut advanced by KSA was nixed by Russia. A brief market-share war followed just as the COVID-19 pandemic started advancing beyond China’s borders, resulting in lockdowns and unprecedented demand destruction. OPEC 2.0 was then reconstituted, and the production cuts it agreed have restored balance to the market. However, this balance is tentative. On the demand side, a second wave of the pandemic is spreading, and with it the risk widespread lockdowns again are mandated. This would lead to another round of demand destruction if the scale of the lockdowns approached that of the first wave seen in 1H20. This is not our base case, but it is a risk we have been highlighting repeatedly in our reports. We find KSA’s GDP increases ~ 1% when EM oil consumption goes up by one percent, while Russia’s GPD increases by ~ 0.5%. On the supply side, we have long argued the OPEC 2.0 framework benefitted Russia and KSA more than unrestrained production, which, left unchecked, would keep prices closer to $30/bbl than $70/bbl.2 In the current arrangement, KSA and Russia are able to grow their GDPs as they see fit, with KSA apparently targeting EM sales, which will grow as those economies grow, and Russia apparently pursuing a strategy that centers on making its barrels available to trading markets and EM buyers (Charts 2A and 2B).3 Chart 2AKSA Benefits From EM GDP Growth ... Chart 2B... As Does Russia This arrangement can endure as long as the OPEC 2.0 members' revenues – particularly those of its leadership – are at risk from uncontrolled production – e.g., another market-share war. A New Game? If, however, one or both of OPEC 2.0's leaders is able to hedge its revenue, the game changes. If it is Russia, as President Putin has suggested, and the government is able to hedge the ~ 40% or so of the federal budget covered by oil and gas revenues, the game changes profoundly (Chart 3). The only motive for Russia to participate in the OPEC 2.0 framework is to keep prices from collapsing below the level assumed for budgeting purposes. This is $42.40/bbl for Urals, the benchmark Russian crude traded in global markets (Chart 4). At present, OPEC 2.0 production discipline is contributing to holding prices just above this level, as member states calibrate their output consistent with the recovery in global demand. Chart 3Russia's Budget Relies Heavily On Oil & Gas Revenues Chart 4OPEC 2.0 Cuts Contribute To Stronger Urals Crude Price Of course, if Russia were able to hedge the oil and gas revenues funding its budget, this production discipline would not be needed in the short term – it could produce at will knowing there is a floor under revenue. Crude-oil futures and options markets cannot handle the volume Russia likely would require to fully hedge the oil and gas revenues funding its budget. That’s a big IF, however. The demand destruction caused by the COVID-19 pandemic in the first five months of this year was responsible for the loss of up to 25% of Russia’s oil, gas and coal exports, which translated into a 50% loss of export revenues and a 25% decline in budget as prices and volumes fell, according to the Carnegie Moscow Center.4 Russia’s GDP is expected to fall by 6% this year, according to the World Bank, in the wake of the pandemic.5 Crude-oil futures and options markets cannot handle the volume Russia likely would require to fully hedge the oil and gas revenues funding its budget. Brent futures and options open interest on the Intercontinental Exchange (ICE) total 3.34 billion barrels on July 21, 2020 (Chart 5). This is spread across the whole term structure. Worthwhile considering that just 1mm b/d of production hedged for 1 year = 365mm bbls = ~ 11% of total Brent open interest. Such a large concentration of open interest accounted for by one entity – even if it is a bona fide government – would, perforce, raise regulators concerns over market manipulation.6 Chart 5Russia's Hedging Volumes Likely Would Swamp Futures Markets Broadening OPEC 2.0’s Tool Kit The successful implementation of a hedging strategy by Russia would force us to re-consider our bullish oil view. Even though we view the likelihood Russia’s government will adopt a full revenue hedging program to be low, we think the argument that it – and KSA – could hedge discrete exposures over time makes sense. These markets exist to process information via trading activities. If there are discrete exposures Russia hedges that keep Brent forward curves backwardated, for example, this would affect the hedging economics of US shale producers protecting their revenues one to three years into the future (Chart 6). Hedging in future while keeping production in the prompt-delivery months in line with OPEC 2.0 quotas would support a backwardation. Prices in the deferred part of the curve would be lower than at the front, which would produce less revenue for hedgers, while higher prices in the front of the curve would redound to OPEC 2.0 member states’ benefit, whose term contracts and spot sales typically reference spot prices. Chart 6Discrete Hedging Could Support Backwardation This would tangibly increase Russia’s impact on forward price discovery. Indeed, hedging could become one of the tools available to OPEC 2.0 that allow it to influence the economics of oil production by US shale producers, among others. Bottom Line: The successful implementation of a hedging strategy by Russia would force us to re-consider our bullish oil view – there would be little or no need for the Russian government to demand its producers adhere to an OPEC 2.0 production quota if the government is able to hedge its revenue. (Whether those producers choose to hedge is another matter entirely.) We do not give a high probability to the Russian government adopting a Mexico-style hedging program to put a floor under its budget revenues. We cannot dismiss the possibility that discrete exposures could be hedged to support a backwardated forward curve structure going forward, however.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices have been remarkably steady at ~ $43/bbl in July, balancing expectations of a sustained global economic recovery and the risk of a second wave of lockdowns. Rising COVID-19 cases in the US pose a risk to oil demand as the US still represents ~ 20% of global demand. Brent futures spreads – 1ST vs. 12th – moved from -$1.38/bbl to -$3.29/bbl, suggesting the pace of drawdowns in inventories slowed in recent weeks. Nonetheless, we continue to expect a persistent supply deficit in 2H20 and 2021, pushing prices above $60/bbl next year.7 Base Metals: Neutral Base metals are mostly flat since last week after moving up 23% since March. A continuation of recent trends is largely dependent on China’s economic outlook as it represents ~ 50% of global BM demand. The IMF expects China’s GDP to reach its pre-crisis level somewhere this quarter and to resume trend growth afterward (Chart 7). Monetary policy needs to remain accommodative for such a recovery to occur. Historically, policymakers in China have favored easy monetary policy for at least three quarters following a crisis. This implies the accommodative stance should be maintained until year-end, supporting metals’ prices.8 Precious Metals: Neutral We are putting a stop-loss of $1,850/oz on our long gold recommendation at tonight’s close (Chart 8). We remain constructive on the gold market, but believe the market is out over its skis presently, as investors have realized central banks globally likely will not move to raise rates this year, or perhaps even next year. The Fed, in particular, has been consistently signaling its intent to remain accommodative in its effort to reflate the US economy.9 Ags/Softs:  Underweight The USDA this week reported 72% of the corn crop was in good to excellent condition for the week ended July 26 in the 19 states accounting for 91% of the crop last year. For beans, 72% of the crop was reported in good to excellent condition, up sharply from last year’s level of 54% in the 18 states accounting for 96% of the crop. Chart 7 Chart 8   Footnotes 1     Russia came close to setting up an oil-hedging program in 2009, following the collapse of oil prices during the Global Financial Crisis (GFC). Please see Russia considers oil price hedges modeled on Mexico’s system published by worldoil.com July 22, 2020. 2     See, e.g., How Long Will The Oil-Price Rout Last?, which we published March 9, 2020. It is available at ces.bcaresearch.com. 3    In previous research, we found KSA real GDP (in 2010 constant USD published by the World Bank) benefits more than Russia when EM GDP growth expands, while Russia benefits more from increases in Brent prices. For this report we updated that analysis and looked only at EM oil consumption, while including lagged USD and Brent crude oil prices as common regressors. We find KSA’s GDP increases ~ 1% when EM oil consumption goes up by one percent, while Russia’s GPD increases by ~ 0.5%. Please see our earlier research report entitled Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions, which we published on April 11, 2019, when KSA and Russia again were contesting the necessity of production cuts. 4    Please see The Oil Price Crash: Will the Kremlin’s Policies Change?, by Tatiana Mitrova, which was published by the Carnegie Moscow Center July 8, 2020. Russia presently exports ~ 5mm b/d of oil, which is down from earlier levels of ~ 5.5mm b/d due to the OPEC 2.0 cuts it is observing. We do not have the disposition of revenue sources funding Russia’s budget (primarily oil and gas), and therefore cannot calculate the precise hedging volume Russia’s government would need to cover to provide a floor for all of its fiscal obligations. 5    Please see Recession and Growth under the Shadow of a Pandemic published by the Bank July 6, 2020. 6    Russia’s central bank came out against the hedging proposal, citing the lack of liquidity available for large-scale programs. Please see Russia central bank opposes using wealth fund to hedge oil revenues, governor says published by uk.reuters.com July 24, 2020. 7     Please see Balance Of Oil-Price Risk Remains To The Upside, which we published last week. It is available at ces.bcaresearch.com. 8    Please see Chinese Stocks: Stay Invested published by BCA Research’s China Investment Strategy July 22, 2020. It is available at cis.bcaresearch.com. 9    Please see What A Weaker US Dollar Means For Global Bond Investors published by BCA Research’s Global Fixed Income Strategy July 28, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades