Energy
Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey Chart 17Only The Best Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Chart of the WeekCrude Oil Prices Align With##BR##Supply-Demand Fundamentals Hedge funds are backing up the truck to get long oil in their portfolios, putting on record or near-record positions in everything from crude oil to gasoline, as global markets tighten and OPEC 2.0 leaders hint they are comfortable with prices that are higher for longer.1 When speculators significantly increase their positions in the market - on the long or the short side - market participants, policymakers and the general public typically begin to wonder whether prices are being artificially distorted by this activity. Our research into the effects of speculation in oil markets is not raising alarm bells at present. If anything, our fundamental models indicate prices are clearing the market in line with supply, demand and inventories (Chart of the Week). We remain overweight oil, and would use sell-offs to add to existing length, including energy-heavy commodity index exposure. Energy: Overweight. Oil markets remain on edge ahead of the May 12 deadline for U.S. President Trump to extend waivers on Iranian export sanctions. If waivers are extended, markets could sell off. Base Metals: Neutral. Aluminum prices fell ~ 10% earlier in the week on news the U.S. would extend the period during which American customers of Rusal had to comply with sanctions against Oleg Deripaska, the company's principal shareholder. U.S. officials also suggested they would lift the sanctions if Deripaska relinquished control over Rusal. Precious Metals: Neutral. Our tactical long position in spot silver established a week ago is down 3.1%, along with gold. A stronger USD weighed on both markets. Ags/Softs: Underweight. Chinese importers of U.S. sorghum petitioned their government to waive the 179% deposit required by Chinese customs for cargoes on the water, according to Reuters.2 The news service also reported soybean trade between the U.S. and China has ground to a halt. Feature Hedge funds are taking their oil exposure to record or near-record highs in crude oil and refined products markets. A tally of positioning by Reuters to the week ended April 20, 2018, shows specs took net oil and products positions to 1.41 billion barrels across CME Group's crude and products futures markets and those of the Intercontinental Exchange (ICE) (Chart 2).3 The reasons cited for the marked increase in speculative positioning in the oil markets have featured in our research since OPEC 2.0's formation in November 2016. These include: Restraint and erosion on the supply side. Production discipline by OPEC and non-OPEC producers has limited supply growth (Chart 3): We estimate crude oil production this year at 99.70mm b/d vs. our March estimate of 100.20mm b/d. Accelerated deterioration of Venezuelan supply has helped constrain global production growth; Chart 2Spec Open Interest Surges Chart 3OPEC 2.0 Discipline Restrains Supply Continued expansion of global demand (Chart 4). In our modeling, consumption growth for this year will be 1.70mm b/d, bringing demand to 100.30mm b/d in 2018. We expect growth for next year of 1.70mm b/d, which will take consumption to 102.00mm b/d; Together, these major fundamental drivers have combined to drain OECD commercial inventories by 395mm barrels from their peak of 3.1 billion barrels in July, 2016 (Chart 5). Chart 4Global Growth Supports Demand Chart 5OECD Inventories Will Continue Drawing As we noted last week, our price forecasts for Brent and WTI crude oil are unchanged at $74 and $70/bbl this year, and $67 and $64/bbl, respectively, next year. We expect OPEC 2.0 to provide forward guidance on its production for 2019, after member states agree on an organizational structure that institutionalizes it as a permanent production-management coalition. As we cautioned last week, this likely will cause us to revise our price forecast for 2019 upward.4 Measuring Speculative Influence In Oil Markets Oil speculators occupy a unique place in the academic literature, and the public's imagination. In the literature, academics largely see them either as bit players in the evolution of oil prices, or as traders who, by their activity, push price to levels far beyond anything justified by the fundamentals, particularly when commodity prices are rising.5 When that commodity is crude oil, and its chief refined product, gasoline - commodities with highly visible prices consumers can track continuously - everyone has an opinion. Not unsurprisingly, the media and politicians join this chorus of recrimination in rising markets, and vilify speculators as well.6 This is hardly surprising. Speculative influence over commodity prices - and the motives of speculators - has been debated for centuries.7 Chart 6Speculative Intensity (Working's T) Vs. Price In the modern era, Holbrook Working, the great Stanford ag economist, developed a speculative intensity index in 1960 to measure the effect of commodity market speculation.8 Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market.9 Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking."10 We plotted Working's T for Brent and WTI futures, and find speculative positioning has ranged between 1.10 and 1.60 (Chart 6). Speculative intensity was trending upward from 2000 - 2014, and then trended lower. Since January 2018, it has averaged 1.4. We would note this latter period encompasses the OPEC market-share war launched in November 2014, and the formation of OPEC 2.0 in November 2016. This was an especially difficult market for hedge funds and speculators generally, particularly last year, when many funds were forced to shutter their operations. Over the past three years, markets have had to adjust to a production free-for-all arising from OPEC's market-share war, which was followed by a supply shock induced by OPEC 2.0, when it agreed to remove 1.80mm b/d of oil production from the market.11 Given this backdrop, it is not surprising to see speculative intensity in oil markets falling, as our chart indicates. Specs And Prices Our research shows the evolution of oil prices is dominated by fundamentals - supply, demand, inventory and broad trade-weighted USD being the dominant fundamentals - and not by spec positioning.12 In forthcoming research, we will dig deeper into this, and also look at the evolution of price volatility in the oil markets. Our analysis using Working's T indicates speculators provide sufficient liquidity to hedgers in the Brent and WTI futures markets, suggesting they are fulfilling the role posited by the IEA in its 2012 medium-term analysis: "Speculators should not be viewed as adversarial agents. Rather, they are essential participants for the proper functioning of commodity derivatives markets by providing the necessary liquidity, thereby reducing market volatility."13 Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia, which pledged to remove 1.80mm b/d of production from the market. 2 Please see "China's sorghum importers ask government to drop tariff for cargoes en route," published by uk.reuters.com April 24, 2018, and "After sorghum spat, U.S. - China trade fears halt soybean imports," published April 25, 2018. 3 Please see "Commentary: Hedge fund oil bulls on the rampage as bears vanish," published by uk.reuters.com on April 23, 2018. 4 For our most recent assessment of supply-demand fundamentals, please see "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published by BCA Research's Commodity & Energy Strategy April 19, 2018. It is available at ces.bcaresearch.com. 5 Bookending this research are Hamilton, James D. (2009), "Causes and Consequences of the Oil Shock of 2007 - 08," published by the Brookings Institution re fundamentals dominating the evolution of oil prices, and, at the other end, Singleton, Kenneth (2011), "Investor Flows and the 2008 Boom/Bust in Oil Prices," available at SSRN. 6 Please see the International Energy Agency's "Oil: Medium-Term Market Report 2012," for a discussion on speculation beginning on p. 21. 7 See, for example, the discussion of how Thales of Miletus in modern-day Turkey monopolized the olive-press market, and how another unnamed individual in Sicily cornered the iron market, in the Politics of Aristotle, a Greek philosopher of the 4th century BCE (at 1259a in Politics). 8 Working was a pioneer in the analysis of prices and agricultural trading markets. Please see Working, Holbrook (1960), "Speculation on Hedging Markets," Stanford University Food Research Institute Studies 1: 185-220. 9 We use the specification of Working's T found in Adjemian, M. K., V. G. Bruno, M. A. Robe, and J. Wallen. "What Drives Volatility Expectations in Grain Markets?" Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management (pp. 18, 19). Working's T is calculated as with SS = Speculative Short Open Interest, SL = Speculative Long Open Interest, HL = Hedge Long Open Interest, and HS = Hedge Short Open Interest. The U.S. Commodity Futures Trading Commission (CFTC) notes, "Working's T-index is silent on the direction of speculation (long versus short). Instead, the amount of speculation is gauged relative to what is needed to balance hedging positions. Because it is directionless Working's T-index is only tested as a causal variable for market volatility." Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 10 Please see Irwin and Sanders (2010), p. 5. 11 We discuss the extremely difficult trading environment confronted by hedge funds and others over the past two years in our Special Report titled "Key Themes For Energy Markets in 2018," which was published by BCA Research's Commodity & Energy Strategy December 7, 2017. It is available at ces.bcaresearch.com. 12 Granger-causality tests on Brent and WTI prices between 2010 and now - the post-GFC era - show the level of prices leads spec position levels in these markets. 13 Please see (p. 22) of the IEA's 2012 Medium-term Market Report cited above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Solid fundamentals will keep the backwardation in the forward curves of the benchmark crude-oil streams - WTI and Brent - intact. If our long-held thesis is correct and OPEC 2.0 becomes a durable producer coalition, we believe it will maintain some level of production cuts in 2019.1 This will, in part, keep OECD commercial oil inventories close to their 2010 - 2014 levels, thus keeping oil forward curves backwardated beyond this year. Backwardation serves OPEC 2.0's interests by limiting the rate at which shale-oil production grows.2 It also drives returns from long-only commodity-index exposure, particularly the energy-heavy index exposure we favor, by maintaining an attractive roll yield for investors.3 We expect the S&P GSCI to return 10 - 20% this year. Energy: Overweight. Our recently concluded research shows commodity index exposure hedges portfolios against inflation risk. We remain long index exposure. Base Metals: Neutral. COMEX copper traded back through $3.00/lb on the back of strong official Chinese PMI data, indicating manufacturing activity continues to expand. It has since fallen back to ~ $3.00/lb, as U.S. - Sino trade-war fears grew. Precious Metals: Neutral. Gold remains range-bound, between $1,310 and $1,360/oz. Ags/Softs: Underweight. In a tit-for-tat fashion, Beijing announced on Wednesday that it would retaliate to the U.S. tariffs on $50 billion worth of Chinese imports. U.S. soybeans and beef are among the list of 106 items China plans to impose a 25% tariff on. Feature An unlikely commonality of interests unites the fates of OPEC 2.0 and long-only commodity index investors: The desire to see the crude-oil forward curves backwardated. Turns out, both interests benefit from the same configuration of the forward curves, in which prompt prices trade premium to deferred prices. Backwardation achieves a critical goal of OPEC 2.0 by making the prices most member states in the coalition receive on their crude oil sales - i.e., the spot price indexed in their term contracts - the highest point along the forward curve. A backwardated curve means the average price U.S. shale-oil producers realize over their hedging horizon - typically two years forward - is, perforce, lower than the spot price. We have shown rig counts are highly sensitive to the level and the shape of the WTI forward curve. A backwardated curve reduces the revenue that can be locked in by hedging. This reduces the number of rigs shale producers send to the field, which restrains - but does not quash - the rate at which they can grow their production (Chart of the Week). For commodity index investors - particularly those with exposure to the energy-heavy S&P GSCI index, where ~ 60% of the index is crude oil, refined products or natural gas - backwardation drives roll-yields, which are a critical component of the index's total returns. The steeper the backwardation, the higher the roll yield.4 Our balances modeling indicates oil markets will remain tight this year, given strong global growth in demand in excess of production growth, which will keep the market in a physical deficit (Chart 2). This will cause inventories to continue to draw this year (Chart 3), which will keep the crude-oil backwardation in place. This backwardation is one of the principal drivers of returns in the S&P GSCI. Chart of the WeekBackwardation Constrains##BR##Shale's Rate Of Growth Chart 2Balances Model Indicates##BR##Physical Deficit Persists This Year Chart 3Tighter Inventories Keep##BR##Backwardation In Place As for the other components of the S&P GSCI, we are neutral base and precious metals, expecting them to remain relatively well-balanced this year, and underweight ag markets, even though they appear to have bottomed, as the USDA indicated recently. As a result, we expect an energy-heavy commodity index exposure like the S&P GSCI will continue to perform for investors, driven largely by the stronger oil prices we expect this year, and the roll yields from backwardated energy futures. Any price upside from the other commodities will be a marginal contribution to returns, as energy price appreciation plus roll yields will be the primary driver of the long-index exposure. Can Crude Oil Backwardation Persist? Beyond 2018, reasonable doubts exist as to whether OPEC 2.0 can remain a durable coalition. These doubts arise from apparent differences in the long-term goals of OPEC 2.0's putative leaders, KSA and Russia. We believe that, over the short term (two years or so) KSA favors higher prices, and that the Kingdom's preferred range for Brent is $60 to $70/bbl, at least until the Saudi Aramco IPO is fully absorbed and trading in the market. Russia's apparent preference is for lower prices ($50 to $60/bbl), which will disincentivize U.S. shale producers from adding even more volume to the market and threaten its market share. How these goals are resolved within OPEC 2.0 as it negotiates its post-2018 structure will determine whether oil forward curves remain backwardated - the likely outcome if production cuts are extended into 2019 - or if OECD inventories start to rebuild and the backwardation returns to contango (i.e., deferred prices exceed prompt prices). This would happen if Russia and its allies decide they are uncomfortable with prices staying close to or above $70/bbl for too long, and therefore lift production and exports to bring them down. OPEC 2.0 Has Reconciled KSA's And Russia's Goals We believe OPEC 2.0 has reconciled KSA's desire for higher prices over the short term to allow a smooth IPO of Aramco. Both KSA and Russia share a longer-term goal of not overly incentivizing U.S. shale production, and production by others - e.g., Norway's Statoil - which also have significantly reduced their costs in order to remain competitive.5 If OPEC 2.0 is successful in achieving higher prices over the short term, it will have to offset them with lower prices further out the forward curve to reconcile KSA's and Russia's goals. This is the principal reason we believe backwardating the forward curve, and keeping it backwardated, achieves OPEC 2.0's short- and longer-term goals. After Aramco is IPO'd - something that, from time to time, seems doubtful - and the market's trading the stock, we believe KSA and Russia will want average prices to drift lower. KSA will, by that time, have lowered its fiscal break-even cost/barrel to $60 (they're at or below $70 now) and will be executing on its diversification strategy. But even with spot prices lower - we're assuming the target level would be ~ $60/bbl - the forward curve will have to remain backwardated to keep U.S. shale's growth somewhat contained. This can be done by keeping deferred contracts (2+ years out) close to $50/bbl using OPEC 2.0 production flexibility, global inventory holdings and forward guidance re production, export and inventory policies. By keeping the average price realization over the shale producers' hedging horizon in the low- to mid-$50s, OPEC 2.0 restrains rig deployment in the U.S. shales. Keeping the front of the forward curve closer to (or above) $60/bbl, means OPEC 2.0 member states get the high price on the forward curve, since their term contracts are indexed to spot prices. Once a persistent backwardation becomes a reliable feature of the forward curve, the short-term inelasticities of the global supply and demand curves - but mostly the supply curve - mean small changes by a production manager like OPEC 2.0 can readily change the price landscape and alter expectations along the forward curve covering the shale-oil producers' hedge horizon. OPEC 2.0 states already have lived through the alternative of not managing production to the best of their abilities during the 2014 - 2016 price collapse: A production free-for-all similar to what the market experienced then would again lead to massive unintended inventory accumulations globally. This would put the Brent and WTI forward curves into super-contangos, which occurred at the end of 2015 into early 2016. At that point, the market would, once again, begin pricing sub-$20/bbl oil as a global full-storage event becomes more probable. At that point, it's "game over" for OPEC 2.0 member states. The stakes remain sufficiently high for OPEC 2.0 member states to keep the coalition intact and to maintain production cuts to keep OECD inventories tight, and thus keep markets backwardated beyond 2018. Backwardation Works For Commodity Index Investors, Too We expect the S&P GSCI to continue to perform well this year - posting gains of 10 to 20% - given our expectation OPEC 2.0 will remain committed to maintaining production discipline. We've recently shown there is a close relationship between oil forward curves and oil inventories, expressed as the deviation of Days-Forward-Cover (DFC) from its 2- or 3-year average, and y/y percentage change (Chart 4).6 This analysis supports our view that - based on our expectation of a continuation of OECD commercial inventory decline - backwardation will continue throughout 2018 and early-2019. This tight relationship, allows us to include OECD commercial inventories as a proxy among our explanatory variables for the shape of the oil forward curves, when modeling and forecasting the GSCI total return. For 2018, we are modeling a continuation of the production cuts put in place at the beginning of 2017 to year end. At some point later this year, we expect the market to get forward guidance on what to expect in the way of OPEC 2.0 production levels for next year. In lieu of actual guidance, we've modelled three different scenarios for OPEC 2.0's production levels next year, leaving everything else affecting prices unchanged. This is a sensitivity analysis on OPEC 2.0's production only (Chart 5).7 Chart 4Oil Inventories, Spreads,##BR##DFC, Closely Related Chart 5BCA's 2019 Scenario Analysis##BR##For OPEC 2.0 Production Scenario 1: Our actual balances, most recently updated in our March 22, 2018, publication, with no production cuts in 2019; Scenario 2: An extension of the OPEC 2.0 production cuts to end-2019 at 100% of 2018 levels; Scenario 3: An extension of the OPEC 2.0 production cuts to end-2019 at 50% of 2018 levels. Under scenario 1, the GSCI's y/y returns slow in 2H18 and become negative in 3Q19. Returns peak in Feb/19 at 28%, and average 21% in 2018, and 9% in 2019. In scenario 2, y/y growth remains positive this year and next, peaking in Feb/19 at 30%, then falling to 13% in 2019. Average returns in 2018 are 21%, and in 2019 19%. In scenario 3, y/y growth remains positive in both years, and bottoms close to 0% but never turns negative. GSCI returns peak in Feb/19 at 29%, then fall to 3% in 2019. Average returns in 2018 are 21%, and in 2019 14%. Given the guidance already conveyed by KSA's oil minister Al-Falih, we would put a low weight on scenario 1, and attach a 50% probability to each of the 2019 simulations in scenarios 2 and 3. GSCI As An Inflation Hedge Our analysis shows the GSCI Total Return (TR) also is highly sensitive to the USD broad trade-weighted dollar (TWIB) and U.S. headline CPI inflation (Chart 6).8 This has powerful implications for the evolution of commodity-indices going forward. A decrease (increase) in the USD TWIB increases (decreases) USD-denominated commodity demand from buyers ex-U.S., thus raising prices, all else equal. An increase (decrease) in the U.S. CPI can lead to higher commodity costs, which are reflected in the GSCI, or to a positive (negative) net-inflow of cash into commodity-indices as a hedge against inflation risks. Importantly, we found the GSCI TR and U.S. CPI relationship to be bi-directional, enhancing the magnitude of the impact of a change in any of those variables. In other words, a rise in the GSCI TR causes inflation to rise which leads to a rise in the GSCI TR, and vice-versa until a new equilibrium is reached.9 Our colleagues at BCA's Global Fixed Income Strategy desk expect inflation pressures will continue to build this year. In particular, they note, "the global cyclical backdrop is boosting inflation."10 With 75% of OECD countries operating beyond full employment, capacity-utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 7, top panel). This closing of the global output gap likely will stoke inflation. Chart 6GSCI Highly Sensitive To USD, U.S. CPI Chart 7Inflation Risks Picking Up Consistent with our overweight view, we expect oil prices to move higher from current levels, as refiners come off 1Q18 maintenance turn-arounds and summer-driving-season demand picks up in the Northern Hemisphere (Chart 7, middle panel).11 Lastly, global export price inflation is showing no signs of slowing, suggesting that global headline inflation will continue moving higher (Chart 7, bottom panel). From the model shown in Chart 6, which captures ~ 82% of the variance in the y/y GSCI TR, we have high conviction that three of the four explanatory variables for the GSCI - crude spreads, DFC and U.S. CPI - will support the GSCI this year, leaving only a significant appreciation in USD TWIB as a potential risk to our view. Away from our modelling, other risks to our bullish oil case as a driver of GSCI returns remains a greater-than-expected economic deceleration in China arising from a policy error in Beijing as policymakers execute a managed slowdown, or a trade war with the U.S.12 These would affect our inflation and commodity-demand - hence commodity price - outlooks. Bottom Line: We expect persistent backwardation in the benchmark crude-oil forward curves- WTI and Brent - as OPEC 2.0 extends production cuts beyond 2018. This will achieve the goals of OPEC 2.0's leadership and underpin returns in the S&P GSCI, which we expect will post gains of 10 - 20% this year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Last month, the Kingdom of Saudi Arabia's (KSA) oil minister, Khalid Al-Falih, indicated OPEC 2.0 production cuts could be extended into 2019. Al-Falih suggested the level of the cuts could be at a reduced level. Please see "Saudi expects oil producers to extend output curbs into 2019," published by uk.reuters.com March 22, 2018. 2 OPEC 2.0 is the producer coalition led by KSA and Russia, which, at the end of 2016, agreed to remove 1.8mm b/d of production from the market. 3 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. For a primer on commodity index investing, please see "Convenience Yields, Term Structures & Volatility Across Commodity Markets," by Michael Lewis in An Investor Guide To Commodities (pp. 18 - 23), published by Deutsche Bank April 2005. 4 By way of a simplistic example, assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Please see "How we cut the break-even prices from USD 100 to USD 27 per barrel" on Statoil's website at https://www.statoil.com/en/magazine/achieving-lower-breakeven.html and "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018, where we discuss how KSA's and Russia's goals have been reconciled. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 7 This sensitivity analysis allows only for the path of OECD commercial inventories to vary while everything else is held constant. To obtain the forecasted values, we've combined the estimates of a set of different modelling techniques (i.e., a Markov switching model, threshold and break-OLS estimators). This increased the information and granularity obtained from the model and allowed us to capture time-varying characteristics in the global inventory/GSCI TR relationship. 8 We found there is two-way Granger-causality between the S&P GSCI and U.S. CPI y/y changes. This feedback loop indicates the GSCI will move with, and cause movement in, the CPI, as discussed herein. 9 This is supported statistically using Granger Causality tests in a VAR model of the GSCI TR and U.S. CPI inflation. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report titled "Nervous Complacency," published March 27, 2018. Available at gfis.bcaresearch.com. 11 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," for our latest oil price forecast. It was published March 22, 2018, and is available at ces.bcaresearch.com. 12 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," for a discussion of this risk. It was published March 29, 2018, and is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Chart 1B...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.
Overweight (High Conviction) For most of the past five years, the narrative in S&P energy stocks has been a sad one; underlying energy prices have failed to sustain a rally and stock prices have been stuck in the doldrums. This time looks different; the resilience of the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs. The surprising part of the rally in oil prices is the failure of energy stocks to catch up (top panel). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (second panel). The upshot is that margins are rapidly expanding, albeit still from a very weak base (third panel). While the most positive side of the v-shaped recovery in earnings estimates is now behind the sector (bottom panel), profit forecasts are still moving higher at near-record pace; eventually stock prices have to catch up. Stay overweight.
Highlights Our supply-demand balances indicate oil fundamentals are softening slightly. All else equal, this might prompt us to lower our average-price forecasts for Brent and WTI from $74 and $70/bbl this year by $2 to $3/bbl. However, this is oil: All else equal seldom applies. An unusual confluence of risk factors has raised the likelihood of sharp price moves - down and up - this year. These range from the threat of trade wars (bearish for demand), to renewed U.S.-led sanctions against Iran and deeper sanctions against Venezuela (bullish, as they could remove as much as 1.4mm b/d of supply). The possible extended delay of the Aramco IPO compounds the uncertainty. Brent and WTI implied volatilities - the principal gauge of price risk in trading markets - had a brief spike earlier this month, but subsequently retreated (Chart of the Week). We believe the lower volatility offers an opportunity to get long a put spread in Dec/18 Brent options, to complement an existing long call spread in these options. Energy: Overweight. We are taking profit on our long Jul/18 vs. short Dec/18 WTI calendar spread to re-position for the higher volatility. As of Tuesday's close, this spread was up 90.4% since inception November 2, 2017. Base Metals: Neutral. Metal Bulletin reported the flow of zinc into China from Spain has turned into a flood, which is depressing physical premiums and causing unintended inventory accumulation. Almost 161k MT of Spanish zinc was shipped to China last year, a 15-fold increase in annual volumes. The bulk of the increase occurring during the August-to-December period. Spain accounted for a quarter of the ~ 67k MT of zinc imported by China in January. Precious Metals: Neutral. Going into Jerome Powell's first meeting as Fed Chair, gold held recent support ~ $1,310/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. U.S. Ag Secretary Sonny Perdue warned farmers a tit-for-tat trade war could hit their markets particularly hard earlier this week, according to Reuters. Cotton could be especially hard hit (please see p. 9 for details).1 Feature Fundamentally, our global supply-demand balances indicate the global oil market will remain in a physical deficit this year, even though they do suggest a slight softening. As such, we are leaving our Brent and WTI forecasts for this year at $74 and $70/bbl (Chart 2). For next year, we also are leaving our average-price Brent and WTI expectations at $67 and $64/bbl, respectively, with the caveat that these are highly conditional on OPEC 2.0's expected forward guidance later this year.2 Chart of the WeekCrude Oil Volatility Lower,##BR##Even As Price Risks Mount Chart 2BCA's Oil Price Forecast##BR##Remains Unchanged Nonetheless, it is difficult to remain sanguine regarding the oil-price outlook. A remarkable confluence of geopolitical events has introduced higher risk to the downside and the upside for oil prices this year and next. On the downside, trade-war rhetoric continues to ramp up, as the Trump administration threatens sanctions against China for alleged theft of U.S. intellectual property, and slow-walks NAFTA negotiations with Mexico and Canada. Either or both of these could be the spark that lights a global trade war. Re the latter, U.S. Agriculture Secretary Sonny Perdue is warning U.S. farmers their markets could get caught up in a tit-for-tat trade war.3 Upside oil-price risk arises from increasingly bellicose signaling by the Trump administration re the Iran nuclear sanctions deal, and hints the U.S. could impose sanctions directly on Venezuela's oil industry, which would augment sanctions against individuals already in place. Rex Tillerson's expected replacement at the U.S. State Department, Mike Pompeo, shares President Trump's hostility to the 2015 deal that lifted trade sanctions on Iran, which allowed it to increase its production and boost exports. If the May 12 deadline for issuing waivers on the Iran sanctions passes, trade penalties again will be in force against Iran, which likely will, once again, reduce its production and exports, if U.S. allies fall in line with Washington. The odds of this are now higher with Rex Tillerson no longer at the helm at the U.S. State Department. Lastly, Saudi Crown Prince Mohammad bin Salman Al Saud, who, as Minister of Defense, is leading KSA's proxy wars against Iran throughout the Middle East, is in Washington cementing relations with President Trump. Trump has indicated his administration is abandoning his predecessor's pivot away from the Middle East and re-engaging at a deeper level with KSA. The Crown Prince also indicated he will be discussing the Iran sanctions with President Trump in meetings this week.4 Fundamentals Remain Supportive ... For Now Chart 3Supply-Demand Fundamentals##BR##Remain Supportive The slight softening detected in our supply-demand balances model is largely coming from the supply side (Chart 3). Most of this is due to surging U.S. crude and liquids production. The EIA's higher-than-expected U.S. crude oil production estimates for 4Q17 provides a higher base on which continued production gains can build this year. Our colleague Matt Conlan notes in this week's Energy Sector Strategy that, over the past three months, the EIA increased its U.S. onshore oil production estimates for 4Q17 by 310k b/d.5 Although we faded this estimate earlier this year, Matt's analysis of E&P balance sheet data for the quarter confirms this surge in production. U.S. production growth dominates global growth this year - up almost 1.3mm b/d on average y/y, led by a 1.2mm b/d y/y gain in shale-oil output. For next year, we have U.S. output up just over 1mm b/d, almost all of which is accounted for by increased shale production. Total U.S. crude production goes to 10.6mm b/d this year, and 11.9mm b/d next year. In 1Q18, the U.S. will displace KSA as the second-largest crude producer in the world. U.S. crude oil production will exceed Russia's expected crude and liquids production of 11.35mm b/d next year by 2Q19 (Table 1). Total U.S. crude and liquids production (including NGLs, biofuels, and refinery gain) goes to 17.4mm b/d this year, and 19.1mm b/d next year. Strong demand continues to absorb rising production this year and next. By our reckoning, global oil demand grows 1.7mm b/d this year, and 1.64mm b/d next year, up slightly from our earlier estimate of 1.57mm b/d. Global demand averages 100.3mm b/d this year, and just shy of 102mm b/d next year. These fundamentals continue to support our judgement that OPEC 2.0's primary goal - draining OECD inventories below their current five-year average - will be met this year (Chart 4). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 4Expect OECD Inventories To Draw A Bit Slower Expect OPEC 2.0 To Endure Next year is a different story. Not because markets fundamentally change. But because we fully expect to be substantially revising our production estimates as OPEC 2.0 evolves into a more durable, longer-lasting structure. Chart 5Backwardation Weakens Under##BR##Provisional 2019 Estimates We expect OPEC 2.0 to provide forward guidance regarding its production-management goals for 2019 and beyond, once all of the particulars in formalizing its structure are agreed later this year. As a result, we fully expect to be revising our price forecasts and OECD inventory expectations in line with more definitive OPEC 2.0 production guidance throughout this year. As things stand now, we assume volumes voluntarily removed from production - some 1.1 to 1.2mm b/d by our reckoning - will slowly be returned to the market over 1H19. By 2H19, those states within OPEC 2.0 that actually cut production - mostly KSA and Russia - are assumed to be back at pre-2017 production levels. More than likely, the coalition will maintain its production cuts at a lower level so that OECD inventories do not grow excessively and place the OPEC and non-OPEC member states of the coalition in the same dire straits that led to the formation of OPEC 2.0. This will arrest the descent in prices generated by our fundamental models toward the end of 2019 (Chart 2). In addition, the renewed OECD inventory build our model generates (Chart 4) also will be arrested. This will keep markets backwardated in 2019, as opposed to moving toward contango as production growth exceeds consumption growth, restraining the erosion in the backwardation in the forward Brent and WTI curves (Chart 5). Tail Risks Rising In Oil Markets An unusual confluence of risk factors has raised the likelihood of sharp price moves to the downside and to the upside this year. These range from the threat of growth-killing trade wars, to renewed U.S.-led sanctions against Iran and deeper sanctions directed at Venezuela's oil sector. A full-blown global trade war would be bearish for prices, as it would depress growth globally, particularly in EM economies, which are the primary drivers of oil demand. At the other end of the price distribution, reimposing sanctions on Iran and targeting Venezuela's oil industry with sanctions could remove up to 1.4mm b/d of supply from markets later this year, by some estimates.6 A former Obama administration official familiar with the Iran sanctions estimates as much as 500k b/d of exports could be lost if sanctions are reimposed. Venezuela's crude oil output has been collapsing and currently is less than 1.6mm b/d. Oil-directed sanctions from the U.S. could force the Venezuelan oil industry to collapse. Added to this volatile mix, Saudi Crown Prince Mohammad bin Salman Al Saud, also known as MBS, called on President Trump this week in Washington. MBS is leading KSA's proxy wars against Iran, and remains at the forefront of efforts to deny them political and military advantage in the Gulf and the Middle East. MBS and President Trump are on the same page in their opposition to the Iran sanctions deal, as is the presumptive U.S. Secretary of State, Mike Pompeo, who, as Reuters notes, "fiercely opposed the Iranian nuclear deal as a member of Congress."7 Lastly, reports of a possible extended delay of the Aramco IPO creates additional uncertainty re our analysis. It is entirely possible KSA thus far has failed to get indicative bids for the 5% of the firm they intend to float anywhere near its $100 billion target. A target bid would value Saudi Aramco at ~ $2 trillion. Given that we view the IPO as the principal driver of KSA's oil policy over the next two years, this raises questions as to whether the Kingdom will remain committed to higher prices over the short term - $60 to $70/bbl is the range we assume - or whether it will lower its sights to a range we believe Russia favors ($50 to $60/bbl). We continue to expect KSA to favor higher prices over the short term, as it works to reduce its fiscal breakeven oil price from ~ $70/bbl to $60/bbl. A higher price range also will help the Kingdom raise debt under more favorable terms, should it decide to wait on the IPO and finance the early stages of its diversification away from oil-export revenues. Either way, we would expect the Kingdom to favor higher prices. It also is possible a lack of bids approaching KSA's Aramco target level will make a private placement more attractive. A consortium led by China's sovereign wealth fund is believed to have shown a bid for the entire 5% placement. The quid pro quo is believed to have been KSA accepting payment for its oil in yuan. This could have profound implications for the market, as we noted in a Special Report exploring the Kingdom's anti-corruption campaign. This alternative also would tend to favor higher prices, in as much as KSA would not want its new shareholder to realize a loss shortly after its purchase of 5% of Aramco.8 Investment Implications Of Higher Tail Risk As our Chart of the Week indicates, trading markets do not appear to have priced the growing tail risks into option premiums. The market's chief gauge of oil-price risk - the implied volatilities of traded put and call options - staged a brief rally, but have since retreated.9 Volatility is the critical driver of option value. We believe the low volatility levels in the market at present offer an opportunity to add to our long Brent call spreads in Dec/18 options. Specifically, we recommend getting long a $50/bbl Dec/18 Brent put and selling a $45/bbl Dec/18 Brent put option against it. This will give investors low-cost, low-risk exposure to a sudden down move, in addition to the upside exposure our existing Dec/18 $65 vs. $70/bbl Brent call spread provides to a sudden up move resulting from the risk factors we discussed above. Of course, more adventuresome investors can choose to get long put spreads and ignore taking exposure to the upside if they believe downside risks from trade tensions will dominate the evolution of oil prices this year. On the other side of the divide, those who believe the increasing geopolitical tensions discussed above will dominate price formation going forward, can choose to get long calls or call spreads and ignore taking exposure to the downside. Separately, we will be taking profits on our long Jul/18 WTI vs. short Dec/18 WTI spread trade, to re-position for our higher-volatility expectation. This position was up 90.4% as of Tuesday's close, when we mark our recommendations to market. Bottom Line: We are keeping our forecast for 2018 and 2019 unchanged, despite the unexpectedly strong U.S. oil supply growth being reported by the EIA and in E&P quarterly earnings reports. An unlikely confluence of geopolitical risks has raised price risk to the downside and the upside. To position for this, we are recommending investors get long put and call spreads in Dec/18 Brent futures. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We discussed the implications of a trade war vis-a-vis U.S. ag markets in last week's Commodity & Energy Strategy Weekly Report. Please see "Ags Could Get Caught In U.S. Tariff Imbroglio," published by BCA Research March 15, 2018. It is available at ces.bcaresearch.com. 2 In last month's publication, we noted the Kingdom of Saudi Arabia (KSA) and Russia - the putative leaders of the producer coalition we've dubbed OPEC 2.0 - favor formalizing their agreement with a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018. It is available at ces.bcaresearch.com. 3 Please see footnote 1 references, and "U.S. agriculture secretary says exports at risk in tariff disputes," published by reuters.com March 19, 2018. 4 Please see "Trump Says of Iran Deal, 'You're Going to See What I Do,' published by bloomberg.com March 20, 2018. 5 Please see "Public Companies Confirm Large Q4 2017 Production Surge," in the March 21, 2018, issue of BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see "U.S. foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts on its online site March 15, 2018. 7 Please see "Oil nears six-week high as concern grows over Middle East," published by uk.reuters.com March 21, 2018. 8 Please see our Special Report published by BCA Research's Commodity & Energy Strategy November 16, 2017. It is available at ces.bcaresearch.com. 9 Implied volatilities, or "implieds" in trading markets, are market-cleared pricing parameters for options. They are calculated once a put (the right to sell the underlying asset upon which an option is written) or call (the right to buy the asset) price (i.e., the option premium) clears the market. Implieds are the annualized standard deviation of expected returns for whatever asset is being priced in a trading market. As such, they are often used to measure the risk that is being priced in options markets by willing buyers and sellers. When implieds are high, risk expectations are high, and the range in which prices are expected to trade widens. "The opposite holds when volatility is low." Ags/Softs Can China Retaliate With Agriculture? China's outsized population means that it is a major consumer of many agricultural products. In last week's Weekly Report, we highlighted that this has made U.S. farmers increasingly wary of the impact of a prospective trade war on the agriculture sector. We concluded that while restrictions on China's imports of U.S. soybeans would have a large impact on U.S. farmers, retaliation by China may not be feasible, given that alternative sources of supply are not readily available. Instead, cotton appears to be the more vulnerable crop, in the event of retaliation. Table 2 below formalizes this analysis. The first column shows the importance of each ag to the U.S., as measured by the percent of U.S. exports that go to China. We use this measure to derive the qualitative value displayed in the third column. The results imply that restrictions on China's imports of U.S. sorghum, soybeans, and to a lesser extent cotton, would severely harm U.S. farmers of these crops. On the other hand, wheat, corn, and rice exports to China do not make up a large proportion of U.S. exports, and thus are not especially significant to American farmers of those commodities. The second column measures China's ability to substitute away from the U.S. as a supplier. We calculate a ratio using world inventories ex-U.S. versus the volume of China's imports from the U.S. for particular crops. The larger the value in column two, the greater China's ability to substitute away from the U.S. Based on these metrics, the last column reveals that China is extremely dependent on the U.S. in terms of sorghum and soybeans, while it has greater ability to find alternative suppliers of the other commodities. Cotton accounts for 16% of U.S. exports. World inventories ex-U.S. for cotton stands at 157 times more than the volume of China's 2017 imports from the U.S. This simple analysis indicates U.S. cotton exports likely will fall victim to retaliation by China, in the event of a trade war. Table 2Cotton Could Fall Victim In Trade Dispute Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017