Energy

Special Report

Highlights The Biden administration will not attempt a major diplomatic “reset” with Russia. The era of engagement is over. Russia faces rising domestic political risk and rising geopolitical risk at the same time. A war in the Baltics is possible but unlikely. Putin has benefited from taking calculated risks and wants to keep the US and Europe divided. The Russian economy is weighed down by structural flaws as well as tight policy. Investors focused on absolute returns should sell Russian assets. For EM-dedicated investors, our Emerging Markets Strategy recommends a neutral allocation to Russian stocks and local currency bonds and an overweight allocation to US dollar-denominated sovereign and corporate debt. Feature “We will not hesitate to raise the cost on Russia.” – US President Joseph R. Biden, State Department, February 4, 2021 The Biden presidency will differ from its predecessors in that there will not be a major attempt to engage Russia at the outset. Previous US presidents sought to reach out to their Russian counterparts to create room for maneuver. This was true of Presidents Reagan, Clinton, Bush, Obama, and Trump. Even Biden has shown a semblance of reengagement by extending an arms reduction pact. But investors should not be misled. The United States and the Democratic Party have shifted their approach to Russia since the failure of the diplomatic “reset” that occurred in 2009-11 and Washington will take a fundamentally more hawkish approach. Russia is not Biden’s top foreign policy focus – that would be Iran and China. But as with China, engagement has given way to Great Power struggle and hence there will not be a grace period before geopolitical tensions re-escalate. Tensions will keep the risk premium elevated for Russia’s currency and assets. The same is true of emerging European markets that get caught up in any US-Russia conflicts. Putin, Biden, And Grand Strategy Understanding US-Russia relations in 2021 requires a brief outline of both the permanent and temporary strategies of the United States and Russia. Russia’s grand strategy over the centuries has focused on establishing a dominant central government, controlling as large of a frontier as possible, and maintaining a high degree of technological sophistication. The nightmare of the Russian elite consists of foreign powers manipulating and weaponizing the country’s extremely diverse peoples and territories against it, reducing the world’s largest nation-state to its historical origin as a geographically indefensible and technologically backward principality. Chart 1Russia's Revival In Perspective Russia can endure long stretches of austerity in order to undermine and outlast rival states in this effort to achieve defensible borders. Russia’s strategy since the rise of President Vladimir Putin has focused on rebuilding the state and military after the collapse of the Soviet Union so as to restore internal security and re-establish political dominance in the former Soviet space (Chart 1). Partial invasions of Georgia and Ukraine and a military buildup along the border with the Baltic states show Russia’s commitment to prevent American or US-allied control of strategic buffer spaces. Expansion of the North Atlantic Treaty Organization (NATO) and the European Union poses an enduring threat to Putin’s strategy. Putin has countered through conventional and nuclear deterrence as well as the use of “hybrid warfare,” trade embargoes, cyberattacks, and disinformation. To preempt challengers within the former Soviet space Russia also maintains a “veto” over geopolitical developments outside that space, as with nuclear proliferation (Iran), civil wars (Syria, Libya), or resource production (OPEC 2.0). The evident flaw in Putin’s strategy is the decay of the economy, the long depreciation of the ruble, and the drop in quality of life and labor force growth. See the macro sections below for a full discussion of these negative trends. Compare the American strategy: America’s grand strategy is to control North America, dominate the oceans, prevent the rise of regional empires, and maintain the leading position in technology and talent. A nightmare for American policymakers would be a collapse of the federal union among the disparate regions and the rise of a secure foreign empire that could supplant the US’s naval preponderance. This is especially true if the rival empire were capable of supplanting US supremacy in technology, since then the US would not even be safe within North America. America’s strategy under the Biden administration is to mitigate internal political divisions through economic growth, maintain its global posture by refurbishing alliances, and reassert its technological primacy by encouraging immigration and trade. The status quo of strong growth and rising polarization has been beneficial for US technology but not for foreign and defense policy (Chart 2). Political polarization has prevented the US from executing a steady long-term strategy for over 30 years. As a result, Russia has partially rebuilt the Soviet sphere of influence and China is constructing a sphere of its own. A few conclusions can be drawn from the above. First, China poses a greater challenge to the US than Russia from a strategic point of view. China is capable of creating a regional empire that can one day challenge the US for technological leadership. Modern Russia must summon all its strength to carve out small pieces of its former empire – it is not a contender for supremacy in technology or in any regions other than its own. Second, however, Russia’s resurgence under Putin poses a secondary challenge to American grand strategy. Russia can undermine US strategy very effectively. The effect today is to aid the rise of China, on which Russia’s economy increasingly depends (Chart 3). Chart 2US Tech Boom Coincided With Disinflation, Polarization Chart 3Russia’s Turn To The Far East Unlike the US, Russian leadership has not changed over the past year – and Vladimir Putin’s tactics are likely to be consistent. These were underscored by the constitutional revisions approved by popular vote in September 2020. Not only will Putin be eligible to remain president till 2036 but also Russia reaffirmed its willingness to intervene militarily into neighboring regions by asserting its right to defend Russian-speaking peoples everywhere. Finally, Russia ensured there would be no giving away of territories, thus ruling out a solution on Ukraine over Crimea.1 Bottom Line: The US-Russia conflict will continue under the Biden administration, even though Biden’s primary concern will be China. Biden’s Foreign Policy Intentions It is too soon to draw conclusions about Biden’s foreign policy “doctrine” as he has not yet faced any major challenges or taken any major actions. Biden’s first two foreign policy speeches and interim national security strategy guidance establish his foreign policy intentions, which will have to be measured against his administration’s capabilities.2 His chief intentions are to revive the economy and court US allies: First, Biden asserts that every foreign action will be taken with US working families in mind, co-opting Trump’s populism and emphasizing that US international strength rests on internal unity which flows from a strong economy. This goal will largely be met as the administration is already passing a major economic stimulus and is likely to pass a second bill with long-term investments by October. The impact on Russia is mixed but the Biden administration is largely correct that a strong recovery in the US economy and reduction in political polarization will be a major asset in its dealings with Russia and other rivals. Second, Biden asserts that diplomacy will be the essence of his foreign policy. He aims to create or rebuild an alliance of democracies that spans from the UK and European Union to the East Asian democracies. The two goals of economy and diplomacy are connected because Biden envisions the democracies working together to make “historic investments” in technology, setting global standards and rules of trade, and defending against hacking and intellectual property theft. This goal will have mixed success: the EU and US will manage their own trade tensions reasonably well but they will disagree on how to handle Russia and especially China. Biden explicitly sets up this alliance of democracies against autocracies. He calls China the US’s “most serious competitor” but also highlights Russia: “The challenges with Russia may be different than the ones with China, but they’re just as real.”3 Table 1 shows the Biden administration’s notable comments and actions on Russia so far. What is clear is that the US will not seek an extensive new diplomatic engagement with Russia.4 The failure of the Obama administration’s “diplomatic reset” with Russia has disabused the Democratic Party of the notion that strategic patience and outreach are the right approaches to Putin’s regime. The reset and its failure are described in detail in Box 1. Table 1Biden Administration's First 100 Days: Key Statements And Actions On Russia Box 1: What Was The US-Russia Diplomatic Reset? What Comes Next? Most American presidents open their foreign policy with overtures to Russia to create space to maneuver, given that Russia is capable of undermining US aims in so many areas. The Barack Obama administration made a notable effort at this in 2009, which was dubbed the “diplomatic reset.” It was a rest because relations had collapsed over Russia’s use of natural gas pipelines as a weapon against Ukraine and especially its invasion of Georgia in 2008. Then Vice President Joe Biden led the reset. President Putin had stepped aside in accordance with constitutional term limits, putting his protégé Dmitri Medvedev in the presidential seat, which supported the reset because Medvedev had at least some desire to reform Russia’s economy. The reset lasted long enough for Washington and Moscow to agree on the need for a strategic settlement on the question of Iran – which would culminate in the 2015 nuclear deal – as well as to admit Russia to the World Trade Organization (WTO). But the aftermath of the financial crisis proved an inauspicious time for a reset. Along with the Arab Spring, popular unrest emerged in Moscow in 2011 and western influence crept into Ukraine – all of it allegedly fomented by Washington. Putin feared he would lose central control at home and frontier control abroad. He also sensed an opportunity given that commodity prices were filling state coffers while the US was focused on domestic policy, increasingly polarized, and unwilling to make the sacrifices necessary to solidify its influence in eastern Europe. Russia’s betrayal of the reset resulted in a string of losses for the US and its European allies: the Edward Snowden affair, the invasion of Ukraine, the intervention in Syria, the meddling in the 2016 US election, and most recently the SolarWinds hack. The Obama administration refrained from a strong reaction over Crimea partly to seal the Iran deal. But Russia pressed its advantage after that. It is doubtful that Russia’s influence decided the 2016 election but, regardless, the Democratic Party fell from power and then watched in dismay as the Trump administration revoked the Iran deal. Now that the Democrats are back in power they will seek to retaliate not only for the SolarWinds hack but also for the betrayal of the reset. However, retaliation will come at a time of Washington’s choosing. Bottom Line: The Biden administration’s foreign policy will emphasize alliances of democracies in opposition to autocracies like Russia and China. Biden is planning a more hawkish approach to Russia than previous recent administrations. Biden’s Foreign Policy Capabilities There are a few clear limitations on Biden’s foreign policy goals. First, his administration will largely be focused on domestic priorities. In foreign affairs there is at best the chance to salvage the Obama administration’s foreign policy legacy. Second, Biden’s dealings with China will take up most of his time and energy. China’s fourteenth five-year plan contains a state-driven technological Great Leap Forward that will frustrate any attempt by Biden to reduce tensions. Biden will not be able to devote much attention to Russia if he pursues China with the attention it deserves, i.e. to secure US interests yet avoid a war.5 Third, Biden will be limited by allied risk aversion and the need for consensus on difficult decisions. If his diplomacy with Europe is successful then China and Russia will face steeper costs for any provocative actions. If it fails then European risk aversion will prevail, the allies will remain divided, and China and Russia will faces few costs for maintaining current policies. Table 2Russia’s Pipeline Export Capacity The Nordstream Two pipeline will be a key test of European willingness to follow the US’s lead even if it means taking on greater risks: Nordstream Two is a major expansion of Russian-EU energy cooperation but contrary to America’s national interest. German Chancellor Angela Merkel still backs the project despite Russia’s poisoning and imprisonment of dissident Alexei Navalny and forceful suppression of protests. However, Merkel is a lame duck and there is some evidence that German commitment to the project is fraying.6 Biden has not tried to halt the pipeline project, but he still could. There are only 100 miles left to the pipeline. Construction resumed in January after a hiatus last year due to US sanctions. The project will take five months to complete at the rate of 0.6 miles per day. The Biden administration still has time to halt the project through sanctions. If it does, the Russians will react harshly to this significant loss of economic and strategic influence over Europe (Table 2). Biden will have a crisis on his hands in Europe. If Biden does nothing on Nordstream, then Russia will conclude that his administration is not serious and take actions that undermine the Biden administration in accordance with Putin’s established strategy. This would prompt Biden to act on his pledge to stand up to Putin’s provocations. Whereas if Biden imposes sanctions to halt Nordstream, Russia will retaliate. Elsewhere it is possible that Biden will be too confrontational with Russia for Europe’s liking. Biden plans to increase support for Ukraine, which will prompt an increase in military conflict this spring.7 The US will promote democracy across eastern Europe, including Belarus, and it is possible that Russia could overreact to this threat of turning peripheral regimes against Russia. The EU is on the front lines in the conflict with Russia and will not want the US to act aggressively – but the US is specifically seeking to “raise the cost” on Russia for its aggression.8 Bottom Line: Russia is not Biden’s priority. But his pledge both to promote democracy and retaliate against Russian provocations sets the US up for a period of higher tensions. US-Russia Engagement On Iran? Will the US not need to engage Russia to achieve various policy goals? Specifically, while highlighting competition, Biden says he will engage Russia and China on global challenges, namely the pandemic, climate change, cybersecurity, and nuclear proliferation. Nuclear proliferation is the only one of these areas where US-Russia cooperation might matter. After all, there is zero chance of cybersecurity cooperation. Whereas on nuclear issues, the US and Russia immediately extended the New START arms reduction treaty through 2026 and could also work together on Iran. Biden is determined to restore the Obama administration’s 2015 nuclear deal. Moscow does not have an interest in a nuclear-armed Iran so there is some overlap of interest. The Iranian issue will require Biden to consider whether he is willing to make major concessions to Russia: Compromise the hard line on Russia: A new Iranian administration takes office in August. Biden is likely to have to rush a return to the 2015 nuclear deal before that time if he wants a deal with Iran. Otherwise it would take years for Biden and the Europeans to reconstitute the P5+1 coalition with Russia and China and negotiate an entirely new deal. Biden would have to make major concessions to Russia and China. His stand against autocracy would be compromised from the get-go. Maintain the hard line on Russia: The alternative is for Biden to rejoin the 2015 nuclear deal with a flick of his wrist, with Iranian President Hassan Rouhani signing off by August. Biden would extract promises from the Iranians to keep talking about a broader deal in future. In this case Biden would not need to give the Russians or Chinese any new concessions. Chart 4China Enforces Iran Sanctions The Biden administration will be keen to make sure that Russia does not exploit the US eagerness for a deal with Iran as it did with the original deal in 2014-15. Iran has an individual interest in restoring the deal, which is to gain sanction relief and avoid air strikes. The Europeans have helped Iran keep the deal alive. China is at least officially enforcing sanctions (Chart 4). Russia is also urging a return to the deal and would be isolated if it tried to sabotage the deal. This could happen but it would escalate the conflict between the US and Russia. Otherwise, if a deal is agreed, the US will continue putting pressure on Russia in other areas. Bottom Line: The Biden administration is likely to seal an Iranian nuclear deal without any major concessions to Russia. Tail Risk – A War In The Baltics? It is well established that the Putin regime will use belligerent foreign adventures to distract from domestic woes. Just look at poor opinion polling tends to precede major foreign invasions (Chart 5). With the eruption of social unrest in the wake of COVID-19 and the imprisonment of opposition leader Alexei Navalny, it is entirely possible that Russia will activate this tool again. The implication is a new crisis in Ukraine, a larger Russian military presence in Belarus, or further escalation of hybrid warfare or cyberwar in other areas. What about an invasion of the Baltic states of Latvia, Lithuania, and Estonia? Unlike other hotspots in Russia's periphery this is a perennial "black swan" risk that would equate with a geopolitical earthquake in Europe. A Baltic war is conceivable based on Russia’s geographic proximity, military superiority, and military buildup on the border and in the Kaliningrad exclave. The combined military spending of NATO dwarfs that of Russia but NATO is extremely vulnerable in this far eastern flank (Chart 6). However, Europe would cutoff Russia’s economy and join the US in countermeasures while Russia would be left to occupy hostile countries.9 Chart 5Putin Lashes Out When Popularity Falls The Baltic states are members of NATO and thus an attack on one is theoretically an attack on all. President Trump ultimately endorsed Article V of the NATO treaty on collective self-defense and President Biden has enthusiastically reaffirmed it. The guarantee is meaningless without greater military support to enforce it, so NATO could try to reinforce its forward presence there. This could provoke Russia to retaliate, likely with measures short of full-scale war. Chart 6Russia Would Be Desperate To Invade Baltics Since the wars in Iraq and Afghanistan, US rivals have observed that the American public lacks the willingness to fight small wars. It responded weakly to Russia’s invasion of Crimea and China’s encroachments in the South China Sea and Hong Kong. However, foreign rivals do not know whether the unpredictable US leadership and public are willing to fight a major war. Hence Russia and China are likely to continue to focus on incremental gains and calculated risks rather than frontal challenges. Based on the Biden administration’s moderate political capital (very narrow electoral and legislative control), the US will continue to be divided and distracted. Russia, China, and other powers will test the administration and make an assessment before they attempt any major foreign adventures. The testing period is imminent, however, and thus holds out negative surprises for investors. It is also possible that Biden could make the first move – particularly on Russia, where retaliation for the 2020 SolarWinds hack should be expected. Bottom Line: A full-scale war in the Baltics is possible but unlikely as the Russians have succeeded through calculated risks whereas they face drastic limitations in a major war against the NATO alliance. Growth Weighed Down By Tight Policy We now turn to Russia’s domestic economic conditions. Here, Russia also faces major challenges. Authorities are determined to keep a tight lid on both monetary and fiscal policies. In particular, high domestic borrowing costs and negative fiscal thrust will weigh down domestic demand over the next six-to-12 months. There are three reasons authorities will maintain tight monetary and fiscal policies: First, concerns about high inflation are deeply entrenched among consumers, enterprises, and policymakers. Russian consumers and businesses tend to have higher-than-realized inflation expectations. This is due to the history of high inflation as well as stagflation in Russia. A recent consumer poll reveals that rising prices are the number one concern among households (Table 3). Remarkably, the poll was conducted in August amid the height of the pandemic and high unemployment. This suggests that households do not associate growth slumps with lower inflation but rather fear inflation even amid a major recession (i.e., worry about stagflation). Table 3Fear Of Inflation Prevalent Amongst Consumers’ Expectations Second, Central Bank of Russia Governor Elvira Nabiullina is one of the most hawkish central bankers in the world. Her early tenure was characterized by the 2014-15 currency crisis and a major inflation spike. To combat structural inflation and bring down persisting high inflation expectations, the central bank has adopted a very hawkish policy stance since 2014. There is no sign that the central bank is about to change its hawkish policy. Specifically, monetary authorities have been syphoning liquidity from the banking system. With relatively tight banking system liquidity and high borrowing costs, private credit growth will fail to accelerate from current levels. Third, the government still projects an austere budget for 2021. The fiscal thrust will be -1.7% of GDP this year (Chart 7). While a moderate spending increase is likely, it will not be sufficient to boost materially domestic demand. There are no signs yet that the fiscal rule10 will be further relaxed, potentially releasing more funds for the government to spend this year. The fiscal rule has become an important gauge of the country’s ability to weather swings in energy prices. In addition to the points listed above, policymakers’ inflation worries stem from the economy’s structural drawbacks: Despite substantial nominal currency depreciation in recent years, Russia runs a current account deficit excluding energy. When a country runs a chronic current account deficit, including periods of major domestic demand recessions and currency devaluations, it is a symptom of a lack of productivity gains. Real incomes grew at a quick pace from the mid-1990s, largely driven by the resource boom in the 2000s. Yet rising real incomes were not complemented by expanding domestic manufacturing capacity to produce consumer and industrial goods. As such, imports of consumer goods and services rose alongside real incomes. Russia has been underinvesting. Gross fixed capital formation excluding resources industries and residential construction has never surpassed 10% of GDP in either nominal or real terms (Chart 8). Chart 7Russia: Fiscal Policy Will Remain Austere In 2021 Chart 8Russia: Underinvestment Within Domestic Sectors Geopolitical tensions with the West have discouraged FDI inflows and hindered Russian companies’ ability to raise capital externally. This has inhibited capital spending and ”know-how” transfer and, hence, bodes ill for productivity gains. Russian domestic industries are highly concentrated and, in some cases, oligopolistic in nature. This allows incumbents to raise prices. The number of registered private enterprises has fallen below early 2000s levels (Chart 9). Despite chronic currency depreciation, Russian resource companies have failed to grab a large share of their respective export markets. For instance, Russia’s oil market share of total global oil production has been flat for over a decade and the nation has been losing market share in the global natural gas industry. A shrinking labor force due to poor demographics and meager immigration complements Russia’s sluggish productivity growth and caps its potential GDP growth (Chart 10). Chart 9Russia: Increasing Industry Concentration Some positive signs are appearing in the form of import substitution. Since the Ukraine conflict in 2014 and the resulting Western sanctions, the government has enacted various laws and decrees to incentivize domestic production, and with it providing substitutions for imported goods. Their impact is noticeable in certain sectors. Chart 10Russia: Poor Potential Growth Outlook In particular, the country has invested heavily in the food industry, as food imports are 16% of overall imports. Agricultural sector output has been rising while imports of key food categories have declined. Recent decrees on industrial goods will likely boost domestic production of some goods and processed resources. Around 40% of Russian imports are concentrated in machinery, industrial equipment, transportation parts, and vehicles. Hence, raising competitiveness in production of industrial goods is essential for Russia to reduce reliance on imports. In short, fewer imports of goods for domestic consumption will make inflation less sensitive to fluctuations in the exchange rate. The current trend is mildly positive, but its pace remains slow. Bottom Line: Russia needs to raise its productivity and labor force growth and, hence, potential GDP growth to deliver reasonable high-income growth without raising inflation. The Cyclical OutLook: Worry About Growth, Not Inflation Cyclically, high domestic borrowing costs and lackluster fiscal spending will weigh down domestic growth and cap inflation for the next 12 months. Russia’s real borrowing costs are among the highest in the EM space. High borrowing costs are causing notable financial stress amongst corporate and household debtors. Commercial banks’ NPLs and provisions are high and rising (Chart 11). Unwilling to take on more credit risk, banks have shunned traditional lending and have instead expanded their assets into financial securities. This trend will likely persist and corporate and consumer credit will fail to boost investment and consumption. The recent pickup in inflation was primarily due to rising food prices and the previous currency depreciation pass-through. Chart 12 illustrates the recent currency appreciation heralds a rollover in core inflation. Chart 11Russia: High Borrowing Costs Are Leading To Higher Credit Stress Chart 12Russia: Inflation Will Rollover Due To Stable RUB In fact, a broad range of inflation indicators suggest that core inflation remains within the central bank target (Chart 13). These measures of inflation are less correlated with the ruble movements. Chart 13Russia: Inflation Is At Central Bank Target Of 4% Chart 14Russia: Tame Recovery In Domestic Activity High-frequency data suggest that consumer spending and business activity remain tame (Chart 14). Bottom Line: The latest uptick in Russia’s core CPI is likely transitory. Cyclical conditions for a material rise in inflation and hence monetary tightening are not in place. Investment Takeaways Chart 15Russia Underperforms Amid Commodity Bull Run Russia’s sluggish economy and austere policy backdrop suggest that the fires of domestic political unrest will continue to burn. While political instability may force the Kremlin to ease fiscal policy, the easing so far envisioned is slight. The implication is that Russia faces rising domestic political risk simultaneously with the rise in international, geopolitical risk stemming from the Biden administration’s efforts to promote democracy in Russia’s periphery and push back against its regional and global attempts to undermine the US-led global order. So far the totality of Russia’s risks have outweighed the benefits of the global economic recovery as Russian assets are trailing the rally in commodity prices (Chart 15). The ruble is above the lows reached at the height of the Ukraine crisis, whether compared to the GBP or the EUR, suggesting further downside when US-Russia tensions spike (Chart 16). The currency is neither cheap nor expensive at present (Chart 17). Chart 16Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Chart 17Russia: The Ruble Is Fairly Valued   Chart 18Geopolitical Risk Will Revive Despite Apparent Top Our Geopolitical Risk Indicator for Russia is forming a bottom, implying that global investors believe the worst has passed. This is a mistake and we expect the indicator to change course and price in new risk. The result will weigh on Russian equities, which are fairly well correlated with this indicator (Chart 18). Overall, we recommend investors who care about absolute returns to sell Russian assets. For dedicated EM equity as well as EM local currency bond portfolios, BCA's Emerging Markets Strategy recommends a neutral stance on Russia (Chart 19). Rising bond yields in the US will continue weighing especially on high-flying growth stocks. The low market-cap weight of technology/growth stocks in the Russian bourse makes the latter less vulnerable to rising global bond yields. Concerning local rates, we see value in 10-year swap rates, as tight monetary and fiscal policies will keep a lid on inflation. With the central bank unlikely to hike rates anytime soon, a steep yield curve offers good value in the long end of the curve for fixed income investors. Finally, orthodox macro policies will benefit fixed-income investors on the margin. In regard to EM credit (USD bonds) portfolio, the Emerging Markets Strategy team recommends overweighting Russia (Chart 20). The government has little local currency debt and minimal US dollar debt. Not surprisingly, Russia has been a low-beta credit market and it will outperform its EM peers in a broad sell off. Chart 19Russia: Move To Neutral Local Currency Bond Allocation Lastly, the Emerging Markets Strategy is moving Ukrainian local currency government bonds to underweight and closing the 5-year local currency bond position. Risks of military confrontation on the Ukraine front have escalated. Chart 20Russia: Remain Overweight On USD Credit     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Andrija Vesic Associate Editor Emerging Markets Strategy AndrijaV@bcaresearch.com   Footnotes 1 See Pavlo Limkin et al, “Putin’s new constitution spells out modern Russia’s imperial ambitions,” Atlantic Council, September 10, 2020, atlanticcouncil.org. 2 See White House, “Remarks by President Biden on America’s Place in the World,” February 4, 2021, and “Remarks by President Biden at the 2021 Virtual Munich Security Conference,” February 19, 2021, whitehouse.org. 3 See “Remarks … at the … Munich Security Conference” in footnote 2 above. 4 We first outlined this US-Russia disengagement in our last joint special report on Russia, “US-Russia: No Reverse Kissinger (Yet),” July 3, 2020, bcaresearch.com. 5 See Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Jamestown Foundation, February 1, 2021, Jamestown.org. 6 Biden’s “Interim National Security Strategic Guidance,” White House, March 3, 2021, whitehouse.org, reinforces this point by focusing most of its attention on China and largely neglecting Russia. 7 See “Kremlin concerned about rising tensions in Donbass,” Tass, March 4, 2021, tass.com. 8 One way in which this could transpire would be a carbon border tax. The EU says imposing a tariff on carbon-intensive imports will proceed unilaterally if there is not a UN agreement in November because it is a “matter of survival” for its industry as it raises green regulation. The Biden administration also promised in its campaign to levy a “carbon adjustment fee.” Russia, which is exposed as a fossil fuel exporter that does not have a carbon pricing scheme, says such a fee would go against WTO rules. See Kate Abnett, “EU sees carbon border levy as ‘matter of survival’ for industry,” Reuters, January 18, 2021, reuters.com; Sam Morgan, “Moscow cries foul over EU’s planned carbon border tax,” Euractiv, July 27, 2020, euractiv.com. 9 See Heinrich Brauss and Dr. András Rácz, “Russia’s Strategic Interests and Actions in the Baltic Region,” German Council on Foreign Relations, DGAP Report, January 7, 2021, dgap.org; Christopher S. Chivvis et al, “NATO’s Northeastern Flank: Emerging Opportunities for Engagement,” Rand Corporation, 2017. 10 The rule stipulates that a portion of oil and gas revenues that the government can spend is determined by a fixed oil price benchmark. Currently, the benchmark oil price stands at $42 per barrel. The fiscal rule also encompasses constraints on the National Welfare Fund withdrawals in oil prices below $42 per barrel.

Special Report

Highlights OPEC 2.0’s production-management strategy and physical supply deficits in base metals will keep growth in demand above that of supply into 2022 (Chart of the Week). Over the next decade, markets will have to reconcile sustaining oil and gas supplies during the low-carbon transition and incentivizing investment in metals used in renewable energy grids. Electric vehicle sales will rise, particularly in China, which has built a commanding position in global EV supply chains. This supports China’s goal of reducing dependence on imported oil, but increases supply-chain concentration risk ex-China. Investors will expect sustainable returns from energy and metals producers and lower CO2 emissions. Otherwise, capital markets will remain parsimonious and investment will be delayed. This will increase price volatility. The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. Differing supply-demand drivers in oil and metals will result in separate, asynchronous bull markets for each, not a global commodity super-cycle. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided the sector can attract funding. Feature Happy families are all alike; every unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina   Every commodity market is different in its own way. Over the short term – to the end of 2022 – oil and base metals will appear to be in the early stages of a commodity super-cycle. But, upon closer examination, it is apparent the fundamental drivers for each are, and will remain, different. These markets are entering asynchronous bull markets driven by different fundamentals. The key driver of these cycles is the demand side: Oil demand will rise slightly or remain flat to declining over the next decade, while base metals demand will be rising as a function of actual spending on renewables and EVs. This means the supply side in oil and metals will have entirely different demand expectations to plan for when allocating capex going forward. Chart of the WeekDemand Will Recover Faster Than Supply Chart 2OPEC 2.0 Production Management Keeps Level Of Demand Above Supply Oil markets will be in physical deficits this year and next by design over the next couple of years, with the level of supply maintained below that of demand. This is the result of a deliberate strategy by OPEC 2.0, the producer coalition formed in late 2016 following the disastrous market-share war launched by the old OPEC cartel in 2014 (Chart 2).1 Metals markets – particularly copper and aluminum, which are critical for the transition to renewable generation – likely will be in physical deficits this year and next as well, with the level of demand above that of supply. Copper demand was exceptionally strong in the wake of a construction boom in China last year, which drew inventories from around the world (Chart 3).2 Aluminum demand in China also moved higher last year and likely will continue this year (Chart 4). We expect the global recovery this year ex-China to pick up the slack resulting from a slowdown in China in 2H21, which will keep these markets tight. Chart 3Copper Will Be In Physical Deficit... Chart 4...As Will Aluminum As the decade progresses, oil and base metals fundamentals will continue to diverge, becoming increasingly different it their own ways. Asynchronous Bull Markets: Oil First Oil demand’s rate of growth will slow as the decade progresses, but we believe OPEC 2.0’s production management strategy will continue to keep supply at a level that supports a Brent crude oil price range that accommodates both Saudi and Russian goals. Saudi Arabia’s preferred price range for Brent crude oil is, we believe, in a range of $70-$75/bbl, which allows the Kingdom to fund its diversification away from oil exports as the dominant source of GDP growth. Russia's goal is to keep price incentives for US shale producers at a minimum. Its ideal price range is between $50-$55/bbl. Neither the Kingdom of Saudi Arabia (KSA) nor Russia benefits from launching another internecine price war. Both states have endured repeated policy-induced shocks – e.g., the imposition of sanctions on Iranian crude oil exports in 2018, which was followed by waivers to Iran’s eight largest importers just before this export ban went into effect, then removed the waivers – and the pandemic demand shock this past year. Neither do they benefit from pushing Brent prices too far above $75/bbl over the next couple of years, given the fragile state of the global economy. Besides putting a dent in demand, it also would incentivize US shale production, which can ramp quickly, or encourage EV sales. This could even encourage a push to find alternatives in a market where supply chains for battery materials – chiefly cobalt and graphite – and copper are dominated by China. OPEC 2.0’s preferred range likely will be widened out to $65-$80/bbl for Brent by 2025. Given the trajectory we expect for global demand – global demand returns to pre-COVID-19 levels in 2023 – OPEC 2.0 should be able to continue with its strategy until 2024-25, making use of its spare capacity and low-cost production (Chart 5). Our demand estimates are driven by GDP estimates from the World Bank and the IMF, and we assume, at least until 2025, OPEC 2.0 will maintain its level of supply just below the level required to completely offset demand, to keep inventories from registering another round of unintended growth. This will, per the OPEC 2.0 strategy we believe is in place, keep the forward Brent curve – and by extension the WTI and other benchmark forward curves – in backwardation, which will limit the level at which producers outside the coalition can hedge forward revenues. We do not believe OPEC 2.0 wants to aggressively invest in increasing crude-oil production capacity, given the diversification goals of its core producers – i.e., those states capable of actually maintaining current production levels and increasing them if needs be.3 Chart 5OPEC 2.0 Will Match Production To Consumption Beyond 2025 and out to 2030, the supply side of the oil market becomes more cloudy. We believe core-OPEC 2.0 will be able to source capital without significant constraint, unlike the US shale producers at present. However, core-OPEC 2.0 alone cannot keep the market balanced out of its production alone, nor does it wish to launch 20- to 30-year projects when it becomes more uncertain by the year how much oil and gas is going to be needed by the market once renewables kick into high gear. OPEC 2.0 will need the US shales to increase production, along with Canada, Brazil and the North Sea, once it has exhausted its spare capacity and low-cost production that is readily available. At that point, availability of capital becomes critical, particularly following the capex reductions in the wake of the OPEC market-share war from 2014-16, the Trump waivers, and the short-lived market-share war launched by Russia in March 2020, following the breakdown of OPEC 2.0 negotiations last year to extend production cuts. The International Energy Forum (IEF), a transnational study group headquartered in Riyadh comprised of representatives from energy producer and consumer states, released a report in December showing global oil and gas capex fell 34% y/y in 2020 (Chart 6), and likely will fall another 20% in 2021 to ~ $200 billion (Chart 7). By 2030, the IEF estimates an additional $225 billion will be required in capex -- in addition to its previous estimate of close to $300 billion by then -- “to stave off a crisis.” If capital remains scarce, oil-price volatility will increase as supply growth contracts and prices move higher. At that point, prices will not be moving sharply higher per OPEC 2.0's production-management strategy. Chart 6Oil + Gas Capex Collapses In COVID-19’s Wake Chart 7Global Oil + Gas Capex Will Require A Sharp Boost By 2030 Base Metals’ Decade Spending on renewable energy last year was ~ $700 billion, according to the IEA.4 This could go to $3.4 trillion by 2030, of which $2.7 trillion could be spent on solar and wind power.5 The growth in solar and wind will require sharply higher volumes of tradeable metals important to investors, i.e., aluminum, copper, and nickel (Charts 8 & ​​​​​​9). Chart 8Solar Investment Will Soar… Chart 9…Along With Investment In Wind Energy Aluminum and copper will account for ~ 85% and 11% of solar inputs respectively; iron will account for close to 85% of wind inputs (mostly the towers), with copper making up more than 4%; nickel will account for almost 60% of inputs into new geothermal renewable generation, according to the World Bank.6 The other big slug of base metals demand comes from EVs. A battery-powered EV can contain more than 180 pounds of copper vs up to 50 pounds for conventional autos. By 2030, the demand from EVs alone would amount to close to 4mm tons of copper per year, if demand for these vehicles grows in line with the IEA’s aspirational goals (44mm units/yr). Even if that growth is delayed, this still is a significant share of total demand in a market that consumes ~ 26mm tons/yr. Nickel demand also will surge if EV demand grows in line with IEA projections. By 2040, nickel-intensive battery technology could lift demand by close to 300%, to 2.6mm tons, according to Roskill Information Services. By 2050, nickel demand could increase by as much as 3.7mm tons (Chart 10).7 Chart 10Nickel Demand Could Rise Parabolically Bull Markets, But Not A Super-Cycle … Yet It is true oil and base metals markets are tight, and likely will get tighter over the next couple of years. As the global economy recovers from the COVID-19 pandemic, demand for these commodities will rise, and supply will be constrained. However, it is important to note the supply-side constraints are idiosyncratic – different in their own ways: Oil supply will remain tight as a consequence of OPEC 2.0’s production-management strategy. Base metals – particularly copper and aluminum – will be tight owing to actual supply constraints in the face of strong demand. Over the course of the next decade, we will see asynchronous bull markets for each, not a global commodity super-cycle. Oil will behave like a commodity in its sunset phase, regardless of whether that is true: Firms in the industry are turning toward renewables and away from oil (e.g., Shell and BP). Base metals, because of their criticality to renewables and EVs, will behave like a commodities in their early-growth phase. The evolution of base metals demand as renewables and EV demand increases is difficult to estimate without solid metrics re spending, output goals and timelines. Of course, higher metals output will require higher capex to meet increasing demand for renewable energy and EVs. Just how much output will have to rise is completely unclear: Governments have yet to fully specify their goals or the budgets that will be supporting renewables demand. Whether EV demand meets the IEA’s aspirational goals is anyone’s guess, particularly as the concentration risk in the EV battery supply chain remains acute. The Biden administration appears poised to direct significant investment to reducing US exposure to battery supply chains’ concentration risks – e.g., ~ 80% of EV batteries supply chains are controlled by China – and other exposures.8 Oil output will require higher capex to maintain production to the point where it can meet declining demand. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided they attract funding. Bottom Line: The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. We remain bullish and retain our exposure to oil and base metals. While our recommendations are meant to be strategic, managing these exposures will require tactical agility.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1    Please see Oil Markets Steady, Despite Weather; Brent Forecast Back At $65/bbl For 2021, published 18 February 2021, for additional discussion of OPEC 2.0’s production-management strategy. It is available at ces.bcaresearch.com. 2    Please see Copper Surge Welcomes Metal Ox Year, which we published 11 February 2021. 3    These core producers, in our estimation, are KSA, Russia, Kazakhstan, Kuwait and the UAE. Others like Nigeria, Iraq and Libya are capable of increasing production, but their output is volatile. The other member states either are managing to a flat or declining profile. 4    Please see World Energy Investment 2020 (p. 8), published by the IEA in 27 May 2020. 5    Please see $3.40 Trillion to be Invested Globally in Renewable Energy by 2030, Finds Frost & Sullivan. 6    Please see our 26 November 2020 report entitled Renewables, China's FYP Underpin Metals Demand for further discussion. 7    Please see Nickel's Decade-Long Rally Is Underway, which we published last week. It is available at ces.bcaresearch.com. 8    Please see Nickel, cobalt price: 10 charts show China’s grip on battery supply chain to last decades published by mining.com 26 February 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights The multiple paid for oil sector profits is collapsing because the market fears that the profits slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility, but an existential fear for fossil-fuelled road transportation in the post-pandemic world. Stay structurally underweight oil and gas. Within the cyclical and value segments of the equity market, overweight metals and miners versus oil and gas. Structurally underweight the stock markets of Norway and the UK which are oil and gas heavy. Structurally overweight the stock markets of Germany, Switzerland, and Denmark which have zero exposure to oil and gas or basic resources. Fractal trade: tin’s near-vertical rally is at high risk of correction. Feature Chart of the WeekOil Production Has Gone Nowhere The Brent crude oil price recently hit $65, not far below its pre-pandemic level of $69. Yet in the stock market, oil and gas equities remain the dogs, languishing 32 percent below their pre-pandemic price level. Relative to the market, the oil and gas sector has underperformed by 42 percent, and the underperformance has been almost a straight line down. Moreover, since last June when the crude oil price has risen by 50 percent, oil and gas equity prices have gone nowhere. This massive divergence of a surging crude oil price from slumping oil and gas equities raises the obvious question, what can explain this dichotomy? (Chart I-2 and Chart I-3) Chart I-2Oil And Gas Equities Have Slumped In Absolute Terms... Chart I-3...And In Relative ##br##Terms One apparent puzzle is that the oil sector’s profits have underperformed their established relationship with the crude oil price. In fact, there is no puzzle. The oil sector’s profits might appear to track the oil price, but the reality is that profits track the value of oil production, meaning the product of oil production and the oil price. Clearly though, if output is flat, then profits will appear to track the oil price.  But as it took a massive cut in oil output to support the oil price, the value of oil production and therefore, the oil sector’s profits, have significantly underperformed the oil price. Put another way, if you need to cut output to boost the commodity price it might help the commodity price, but it doesn’t much help the equity sector’s profits! (Chart I-4 and Chart I-5). Chart I-4Oil And Gas Profits Appear To Track The Oil Price Chart I-5In Reality, Oil And Gas Profits Track The Value Of Oil Output Will Fossil-Fuelled Road Transportation Be Driven To Extinction? We can now explain the 42 percent underperformance of oil equities, and perhaps more importantly, forecast what will happen next. When the pandemic took hold, and economic mobility ground to a halt, the oil sector’s 12-month forward profits slumped. Bear in mind that aviation accounts for 8 percent of oil consumption but, more crucially, road transportation accounts for half of all oil consumption. However, as the pandemic’s impact was expected to be short-lived, the multiple paid for those depressed 12-month forward profits rose. This partly compensated for the profit slump, but still left oil equity prices much lower. The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. When profits started to recover – albeit, as just discussed, by much less than the oil price rise – it should have boosted oil equity prices. The problem was that the multiple paid for those profits fell by much more than the recovery in profits, with the result that oil equities continued to underperform. Begging the question, why is the multiple paid for oil sector profits collapsing? (Chart I-6) Chart I-6Why Is The Multiple Paid For Oil Sector Profits Collapsing? The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility. The fear has become existential. Governments’ plans for pandemic stimulus and recovery have put green energy at front and centre stage. Thereby the recovery has fast-tracked the ultimate nemesis of the oil industry – the extinction of fossil-fuelled road transportation. Are the fears for oil consumption justified? Yes. Aviation is not likely to reach its pre-pandemic level of oil consumption for many years, and long-haul aviation may never get there. But the much bigger threat is fossil-fuelled road transportation. From October 2021, London will extend its Ultra Low Emission Zone (ULEZ) to an 8 mile radius from the city centre.1 The effect will be to banish from London all diesel-fuelled vehicles made before 2015 as well as some older petrol-fuelled vehicles. We expect other major cities to follow London’s example. In most cases, this initiative will happen regardless of the success (or not) of electric vehicles (EVs). Combined with other green initiatives around the world, policymakers’ unashamed aim is to drive fossil-fuelled road transportation to extinction. To repeat, road transportation accounts for half of all oil consumption. The upshot is that the structural downtrend in oil consumption will persist unless the shift away from fossil-fuelled road transportation hits a brick wall, or at least a bottleneck. We do not see such a brick wall or a bottleneck in the foreseeable future. We conclude that though the sector may offer occasional countertrend tactical buying opportunities, long-term equity investors should underweight oil and gas. Structurally Prefer Metals And Miners To Oil And Gas The preceding analysis of the oil sector can be extended to other commodity equities, like the metals and miners. To reiterate, it is the total value of commodity output – the product of commodity production and the commodity price – that drives the profits of commodity equities. On this basis, the long-term prospects for the metals and miners appear somewhat brighter than for oil and gas equities (Chart I-7). Chart I-7Commodity Sector Profits Track The Value Of Commodity Output Looking at the production of copper, it has increased by around 25 percent over the past decade, albeit this is just in line with world real GDP. By comparison, the production of oil has gone nowhere (Chart of the Week). It is the total value of commodity output that drives the profits of commodity equities. Turning to price, relative to the 2011 high the copper price is around 15 percent lower, whereas the oil price is 50 percent lower (Chart I-8). Chart I-8The Copper Price Has Outperformed The Oil Price Hence, on the all-important value of output, copper has moved in a sideways channel over the past decade while oil has been in an unmistakeable structural downtrend, with lower highs and lower lows (Chart I-9). Chart I-9The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil This relative trend is likely to continue as the shift from fossil-fuelled road transportation to EVs will weigh on oil demand, while supporting copper (and other metal) demand. We do not recommend an outright overweight in metals and miners given that their profits are just moving in a sideways channel. However, within the cyclical and value segments of the equity market, a good structural position is to overweight metals and miners versus oil and gas. When Oil And Gas Underperforms, So Does Norway’s OBX And The UK’s FTSE 100 Regional and country equity market performances is driven by the dominant sectors within each stock market. In relative terms, it is also driven by the sectors that are missing. If the oil and gas sector is a structural underperformer, then oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too. If the oil and gas sector is a structural underperformer, it inevitably means that oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too (Chart I-10 and Chart I-11). Chart I-10When Oil And Gas Underperforms, Norway's OBX Underperforms... Chart I-11...And The UK's FTSE 100 ##br##Underperforms The corollary is that stock markets which are under-exposed to the structurally underperforming sector will be at a relative advantage. This supports our structural overweighting to the stock markets of Germany, Switzerland, and Denmark, which all have zero exposure to oil and gas and basic resources. Fractal Trading System* Tin’s near-vertical rally is at high risk of correction based on fragility on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to short tin versus lead, setting a profit target and symmetrical stop-loss at 13 percent. In other trades, the underweights to China and Korea surged, but short AUD/JPY and short copper/gold reached their stop-losses. The rolling 12-month win ratio stands at 57 percent. Chart I-12Tin Vs. Lead When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1   ULEZ will be the zone inside London’s North Circular and South Circular Roads. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Chart 7China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Chart 11Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning HawkishIran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Chart 17Nuclear Bomb Key To Regime Survival The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.

Highlights Transitory dislocations – i.e., supply and demand disruptions in the wake of the Polar Vortex engulfing the US midcontinent – are wreaking havoc on spot oil markets; however, they will not profoundly alter longer-term fundamentals (Chart of the Week). Gasoline prices in the US are up 10 cents/gal this month, as are diesel prices, indicating the impact on production and consumption is affecting the former slightly more at the margin.  In the hard-hit Midwest and US Gulf regions, price gains are slightly less, according to the US EIA. Oil production in the vanguard Permian Basin likely will fall 7-8mm barrels this month. Refineries and pipelines experiencing power outages and severe cold are reducing operations, which will dampen exports. The weather-induced rally pushed Brent above $63/bbl this week, our average price forecast for this year in January. This month, we are lifting our 2021 average price forecast back to $65/bbl and lowering our 2022 forecast slightly to $70/bbl. The balance of price risks remains to the upside. Nonetheless, we remain cautious given ongoing COVID-19 risks – particularly around variants; a strong USD; and the resumption of Saudi-Russian tensions that likely will arise within OPEC 2.0 with prices above $60/bbl. Feature Despite headline-grabbing reports of the Polar Vortex engulfing the US Midwest and Gulf regions, supply-demand fundamentals are unlikely to experience a prolonged dislocation in its wake.  Oil output likely will be hit hard in the short term, particularly in the Permian Basin, where producers, by and large, are unaccustomed to the deep-freeze conditions their colleagues to the north take for granted.  We expect some 7-8mm barrels of production will be lost in the Permian this month, but that it will be returned next month, which will restore US output to its previous trajectory (Chart 2). Chart of the WeekOil Forecasts Steady, Despite Polar Vortex Chart 2Lost US Oil Ouput Will Return In March Operations at refineries and pipelines are ramping down as a precaution, which will force product inventories to draw as temperatures return to normal.1 This will reduce exports until refining assets and pipelines are brought back up to speed as refiners prepare for the summer driving season.  With vaccine distribution in the US picking up steam, we expect product demand to rise, and, given the lost oil and refining output from the current weather-induced disruptions, we expect refining margins in 2Q21 and 3Q21 to be stout. Global Oil Markets Remain Steady Our global oil balances are largely unchanged versus last month, save for a few marginal adjustments, leaving our price forecasts largely unchanged. The weather-induced push to prices that lifted Brent to our $63/bbl forecast from last month ahead of schedule – mostly as lost US production opened short-term sales opportunities for Brent-related crudes – will recede, producing a shallow correction as markets return to normal.  Thereafter, in 2Q21, we expect global supply-demand fundamentals to resume the pre-winter evolution we have been modeling for months.  WTI prices, which were pushed above $60/bbl this week, also will recede in the short term as weather returns to normal. On the demand side, we continue to expect a stout recovery in DM and EM markets, with consumption gaining 6.6mm b/d this year and 2.8mm b/d in 2022 on the back of massive fiscal and monetary stimulus globally (Chart 3).  We expect supply to continue reflecting the production management of OPEC 2.0 (Chart 4), which has been remarkably successful in keeping the level of supply below demand (Chart 5), which is driving the drawdown in global inventory levels (Chart 6).  OPEC 2.0’s strategy likely will be maintained into 2022, however, as we discuss below, this is not a given (Table 1). Chart 3Stout EM, DM Demand Expected Chart 4OPEC 2.0 Production Will Respond Quickly To Demand Changes Chart 5OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 6...Allowing Inventories To Draw Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) US Real Rates Keep USD Bid US nominal rates are increasing while inflation has yet to show up in the data, which means implied real rates are rising.  This has been supporting the USD and keeping it well bid in the new year (Chart 7). We continue to expect a weaker USD – given the massive fiscal stimulus and support measures deployed globally, particularly in the US. The Fed continues to signal it will continue to accommodate as much debt as the government takes on to support America’s recovery from COVID-19 and reduce unemployment. Global Economic Policy Uncertainty continues to fall as pandemic uncertainty falls.  This will bring the USD down with it, as demand for safe havens diminishes along with lower uncertainty.2 However, markets still remain highly sensitive to any news suggesting the struggle to contain the COVID-19 pandemic is tipping in favor of the virus. Chart 7US Real Rates Keep USD Well Bid OPEC 2.0 Tensions Will Follow Prices OPEC 2.0 has been remarkably consistent in its adherence to a policy of calibrating production to demand, so much so that even as demand was collapsing during the worst of the COVID-19 pandemic global inventories fell.  This is the result of a deliberate effort by OPEC 2.0 to keep the level of supply below demand.  In so doing, markets tightened, prices rose, and forward curves backwardated as inventories drew down, as we have been expecting for months (Chart 8). Going forward, as prices continue to strengthen – we expect Brent to average $65/bbl and $70/bbl this year and next – the cohesion of the OPEC 2.0 coalition again will be tested by differing domestic policy goals in the Kingdom of Saudi Arabia (KSA) and Russia. Chart 8Forward Curves Backwardate In Line With OPEC 2.0 Policy Our maintained hypothesis in assessing oil-market supply-demand fundamentals is KSA and Russia are trying to strike a balance between their disparate goals: KSA needs higher prices to support its diversification efforts away from oil exports as the principal driver of its economy, and Russia desires lower prices so as to discourage another surge in US shale-oil output.  In our estimation, for the near term – i.e., the next 2-3 years – KSA prefers Brent prices in a range of $70-$75/bbl, while Russia prefers prices in a range of $50-$55/bbl.3 In the best of all possible worlds, maintaining OPEC 2.0 cohesion likely represents a compromise that keeps Brent prices somewhere between $60-$70/bbl, perhaps a touch lower.  Our modeling assumption is $65/bbl is a policy variable KSA and Russia can accept, and can agree to manage their production around that level.  Brief excursions below and above the $65/bbl level are acceptable to both sides, but neither expects an excursion favoring their desired price level to endure indefinitely.  Nor, we believe, do they expect the other side to countenance supporting their target at the expense of their domestic goals. At present, with Brent prices gravitating toward that ideal midpoint (at least in our estimation) of $65/bbl, markets will begin looking for signs the OPEC 2.0 alliance once again will start to fray, as it did in March 2020, when KSA and Russia could not agree on the level of production cuts at the start of the COVID-19 pandemic. At that time, Russia effectively declared a market-share war, which was readily engaged by KSA. Our prior – every month when we re-estimate supply-demand balances, and price forecasts – is both sides are sufficiently sensitive now to the damage they can inflict on the other, which, of course, also damages their economic interests. To borrow a well-turned phrase from the Bard, “Things should start to get interesting right about now.”4   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Words fail to describe the price surges seen in US natural gas markets, which, on at least one pipeline system squarely situated along the cold front engulfing the midcontinent, surged to $500/MMBtu in spot trading going into this past weekend.  The Polar Vortex powering through the midcontinent brought sub-zero temperatures and snow as far south as Galveston, TX.5 In futures trading, March-delivery futures in Henry Hub, LA, traded above $3.20/MMBtu earlier this week and settled above $3.10/MMBtu as we went to press (Chart 9).  Base Metals: Bullish At ~ $3.85/lb, copper prices are trading at levels not seen since the beginning of 2012 on the CME’s COMEX exchange.  Falling on-exchange inventories globally are contributing to bullish sentiment, as we discussed last week.6  Key markets – e.g., iron ore, which is holding ~ $160/MT, and nickel at ~ $18,800/MT – remain well bid during the Lunar New Year in China, when liquidity typically falls (Chart 10).  We are getting tactically long spot London nickel at tonight’s close, with a price target of $29,000/MT by July.  Precious Metals: Bullish Silver is holding up better than gold, which moved sharply lower as US real rates rose on the back of higher 10-year bond yields, which went from 1.2% on Friday to 1.3% on Tuesday, a one-year high.  We remain long gold, and are getting tactically long silver at tonight’s close.  We expect COMEX silver to reach $30/oz by July, as supply tightens, and demand increases on the back of a recovery in DM and EM economies. Ags/Softs: Neutral Wheat moved higher this week in the wake of the Polar Vortex sweeping through the US midcontinent, which raised fears of a winter crop kill-off as temperatures dropped well below zero (F) in key crop regions.  Corn prices also moved higher, reversing WASDE-induced selling last week. Chart 9Prices Surge In US Natgas Markets Chart 10Nickel Remains Well-Bid During The Lunar New Year   Footnotes 1     Please see U.S. oil wells, refineries shut as winter storm hits energy sector, posted by reuters.com for a summary of refinery and pipeline outages in oil and gas markets in the US midcontinent and Gulf regions.   2     Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published 28 January 2021, for additional discussion on the interplay of these factors. 3    In our estimation, Russia’s budget is geared toward a Urals price of $42/bbl, while KSA’s likely assumes a price closer to $65/bbl.  Please see Saudi Arabia's 'realistic' 2020 budget assumes lower oil price than 2019: economists published by S&P Global Platts 19 Dec 2019, and “Falling oil prices threaten to derail Putin’s spending promises,” published by ft.com 2 March 2020. 4    This is a line from a song titled Mississippi, which is found on Bob Dylan’s “Love And Theft” album.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Overweight Last April following the massacre in oil prices and the consequent slam in the S&P oil & gas exploration & production (O&G E&P) group, we created the USES Crash Indicator to try to forecast a likely recovery path in this index; today we update our analysis. After a hiccup in late-2020, the relative share price ratio is back on track and will likely continue its ascent, especially given crude oil supply/demand dynamics. Odds are high that oil prices will remain upward-sloping as the EIA forecasts demand outpacing supply growth over the course of 2021 and 2022 (not shown). Oil oversupply has been a major drag on oil prices to the point that E&P companies had to put artificial breaks on production. Should these breaks remain in place at the same time as the global economy reopens as we continue to expect, oil prices have further to run. The implication is that rising crude oil prices will pave the way for sustained gains in the S&P O&G E&P relative share price ratio. Bottom Line: Stay overweight the S&P O&G E&P index. The ticker symbols for the stocks in the index are: BLBG: S5OILP – COP, EOG, HES, COG, MRO, APA, PXD, DVN, FANG. Chart 1How It Started... Chart 2...How It Is Going