Energy

Highlights When it meets in Vienna at the end of this month, OPEC 2.0 will look through the pipeline leaks in South Dakota, which are expected to take some 500k b/d of Canadian crude shipments to the U.S. off the market until repairs are done at the end of November. While this will provide an unexpected assist in draining U.S. inventories, it truly is a transitory event (no pun intended). The larger issue for prices is gauging market expectations going into the OPEC 2.0 meeting at the end of this month. We believe the market is giving high odds to the coalition extending its 1.8mm b/d production cut to cover all of 2018 at its Vienna meeting. This is without doubt the result of the synchronized messaging coming from the leaders of OPEC 2.0, the Kingdom of Saudi Arabia (KSA) and Russia. Based on our balances models, an extension of the cuts to end-June - our base case - will draw OECD stocks down below their five-year average by mid-2018 (Chart of the Week). An executed extension to end-December 2018 would produce even sharper draws. This leaves the only material risk to prices a failure to extend the cuts on Nov. 30, or a reduction in the cuts themselves. Of the two, a failure to extend the cuts is the only material downside risk we see going into the Vienna meetings. Should OPEC 2.0 fail to extend its production cuts at month-end, and cause the markets to sell, we would view it as a buying opportunity: a Mar/18 expiry runs counter to OPEC 2.0's strategy. Energy: Overweight. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 41.4%, since they were recommended in September and October. Our long Jul/18 WTI vs. short Dec/18 WTI trade initiated November 2, 2017 in expectation of steepening backwardation is up 27.7%. Base Metals: Neutral. A weaker USD is providing a tailwind for copper, which is up ~ 2% over the past week. Our U.S. Bond Strategy desk expects the Fed to remain behind the inflation curve, which will translate into lower real rates and continue to support base metals.1 Precious Metals: Neutral. Gold continues to trade on either side of $1,280/oz, hardly budging following the upheaval in KSA. U.S. financial conditions - particularly a weaker USD - are driving gold. Our long gold portfolio hedge is up 4.2% since inception May 4, 2017. Ags/Softs: Neutral. Updated projections of record-high yields from U.S. corn farmers is behind the upward revision to 2017/2018 corn ending stocks in the November WASDE. This led to a massive increase - by 7.56mm MT - in U.S. corn output, which was partially offset by an increase in expected world demand and a downward adjustment to global beginning stocks. Corn prices were down more than 3% in the week following the revisions, but have since regained 2.5%. Feature Markets appear to be pricing in an extension of OPEC 2.0's production cuts to end-2018 when the producer group meets in Vienna at the end of the month around OPEC's regularly scheduled meeting. Our updated balances suggest a sharp sell-off triggered by market disappointment in OPEC 2.0 would represent a buying opportunity, particularly in 2H18. We continue to expect Brent to average $65/bbl next year in our base case (OPEC 2.0 cuts extended to end-June), with WTI trading $2/bbl under that. An extension of OPEC 2.0's cuts to end-December could lift our 2018 Brent forecast as much as $5/bbl, although the Brent-WTI spread likely would widen to $4 to $5/bbl, if this occurs. We do not believe additional cuts are in the offing. Nor do we expect an even-more-dramatic announcement of cuts being extended beyond 2018. We are deliberately keeping our base case more conservative than the apparent market expectation of an extension to end-2018. This suggests markets will be disappointed with anything less than an extension of the OPEC 2.0 cuts to end-June. Given our balances modeling, we believe any disappointment in the market's expectation that leads to a sell-off would represent a buying opportunity, since a Mar/18 expiry – the current terminus of the OPEC 2.0 production cuts, defeats the coalition's strategy of reducing OECD inventories. Under our base case, inventories draw to their five-year average levels by mid-year 2018 (Chart of the Week). In our updated balances model, we have a 100k b/d downward revision in expected U.S. oil-shale output for 2018 tightening the supply side for next year. The U.S. EIA has repeatedly revised its historical estimated shale production lower in recent months, and late-2017 rig counts have deteriorated slightly, which have shifted our historical production curve lower as well. On the demand side, we expect growth of ~ 1.65mm b/d on average in 2017 - 18. These assumptions give an upward bias to our 2018 price forecasts for Brent and WTI crude oil (Chart 2). Chart of the WeekSupply-Demand Balances##BR##Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Chart 2Balances Are Tightening,##BR##Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Inventory Draw Could Be Sharper Chart 3Extending OPEC 2.0 Cuts To End-December##BR##Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws An extension of the OPEC 2.0 cuts to end-Dec/18 would translate to a deeper storage draw than our end-June base case expectation (Chart 3). The Keystone pipeline leaks referenced above also provide an unanticipated assist in drawing down inventories, by temporarily removing ~ 500k b/d from the market in the 2H of November. While we have modeled price-induced additions to U.S. shale-oil output next year in our base case, an extension of OPEC 2.0's cuts to end-December likely will accelerate this production increase as additional production is added in 2H18. This will tend to temper price hikes, but not arrest them, given the differential storage draws we expect of 127 mm bbls. As we have noted, an extension of the OPEC 2.0 production cuts to the end of 2018 could lift Brent and WTI prices by as much as $5/bbl. However, given the still-insufficient pipeline take-away in the U.S. shale basins, we would expect higher production would widen the Brent - WTI price spread to $4 to $5/bbl next year. Practically, if the extension of the production cuts pushes Brent to $70/bbl, we're more inclined to expect WTI prices to average ~ $65/bbl next year. EM Continues To Lead Growth In Oil Demand EM oil demand strength continues to be the dominant feature of the oil market this year, and, we expect, into next year. We are modeling a 1.13mm b/d and 1.22mm b/d increase in EM demand this year and next, respectively. This accounts for 75% and 77% percent of global growth in 2017 and 2018 (Table 1). DM demand, which we proxy with OECD oil consumption, is expected to average 47.5mm b/d over the two-year interval, an average gain of 490k b/d over the interval, vs. 1.18 mm b/d gain in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices China and India account for slightly more than one-third of the 52mm b/d of consumption we are modeling for non-OECD demand over this period, and ~50% of the non-OECD demand growth from 2016 to 2018. The indicators we use to confirm or refute the demand trends we see - EM imports and global PMIs - continue to support the global-growth theme we've noted throughout the year, particularly in the EM markets (Charts 4 and 5). Chart 4EM Trade Volumes Remain Strong,##BR##Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis Chart 5Global Manufacturing Activity##BR##Remains Robust Global Manufacturing Activity Remains Robust Global Manufacturing Activity Remains Robust Continue Watching The Fed EM oil demand and import volumes are highly dependent on Fed policy, which is of particular concern now, because the U.S. central bank is trying to carry out its rate-normalization policy (Chart 6). Still, as our colleagues on the U.S. Bond Strategy desk note, "To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve." This will be bullish for trade, since as we've shown in the past, U.S. monetary policy has a huge effect on trade.2 For the near term - into 1H18 - fundamentals will dominate the evolution of price: Supply, demand and inventories will matter more than U.S. monetary policy effects on the USD and real rates. Nonetheless, should the hawks in the Fed carry the day, we would expect a strengthening of the USD, which, all else equal, would act as a headwind to oil prices next year. For the time being, a weaker USD is reinforcing stronger prices brought about by tighter fundamentals, particularly in the Brent market (Chart 7). Chart 6Continue Watching The Fed Continue Watching The Fed Continue Watching The Fed Chart 7A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind Bottom Line: Markets are expecting OPEC 2.0 to extend its 1.8mm b/d production cut to end-2018. We are deliberately using a more conservative extension to end-June in our balances modeling, which produce 2018 Brent and WTI prices forecasts of $65/bbl and $63/bbl. An executed extension of the OPEC 2.0 cuts to end-December 2018 likely would add as much as $5/bbl to Brent prices, and perhaps $2/bbl to WTI prices, which would widen the Brent - WTI spread to $4 to $5/bbl on average next year. Fundamentals will continue to dominate the evolution of prices into 2018 - supply growth (falling), demand growth (rising), and inventories (falling) will drive prices. For the moment a weaker USD is supportive for commodities generally, particularly oil and copper. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "The Fed Will Fall Behind The Curve," published October 24, 2017, by BCA Research's U.S. Bond Strategy. It is available at usbs.bcaresearch.com. 2 Please see footnote 1 above. U.S. monetary policy effects on EM oil demand and trade volumes, and the feedback loop back to the key indicators used by the Fed, have been a recurrent theme in our research. Please see, e.g., "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Our line of research recently found support in IMF research published earlier this month; please see "Global Trade and the Dollar," published by the IMF November 13, 2017. The IMF research is available at http://www.imf.org/en/Publications/WP/Issues/2017/11/13/Global-Trade-and-the-Dollar-45336?cid=em-COM-123-36197 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. Both the steel and coal industries in China are becoming more efficient and more competitive, with low-quality output falling and high-quality supply rising. Feature Reducing capacity (also called "de-capacity") in the oversupplied commodities markets (e.g., steel, coal, cement, and aluminum) has been a key priority within China's structural supply side reforms over the past two years. The reforms were announced by President Xi Jinping in November 2015 and have focused primarily on steel and coal, and to a lesser extent on the aluminum and cement sectors. China's "de-capacity" reforms have been aiming to reduce inefficient productive capacity and low-quality output of the above mentioned commodities, as well as boost medium-to-high-quality production. The main focus of this report is to dissect China's supply side "de-capacity" reforms, and to assess their impact on steel, coal and iron ore prices. The de-capacity reforms were announced in late 2015 and, coincidentally, all major industrial commodities prices made a synchronized bottom in late 2015/early 2016 (Chart I-1). Chart I-1ASynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Chart I-1BSynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? China is the largest producer and consumer of various raw materials, ranging from steel and coal to base metals. Hence, two interesting questions arise: was it the "de-capacity" reforms or other factors that caused the various raw materials to bottom in early 2016 and rally thereafter? How will China's ongoing "de-capacity" reforms affect steel, coal, and iron ore prices going into 2018 and 2019? Progress Of "De-Capacity" Reforms Three main approaches have been used by policymakers with respect to de-capacity reforms: The government sets up capacity reduction targets and then implements concrete plans to achieve these targets. The government conducts inspections to ensure the reforms are being implemented or for environmental protection purposes. The government aims to eliminate outdated capacity by setting up electricity price rules (higher electricity prices for producers with inefficient technologies) as well as ordering banks to curtail lending to those producers. In terms of timelines, the Chinese supply side "de-capacity" reforms so far have been rolled out in three phases: Phase I: Initiation and preparation phase (2015 Q4 - 2016 H1): The first phase involved policy makers drawing related policies and capacity reduction targets in the steel and coal industries. Local governments and related SOEs began implementing the so-called "de-capacity" reforms. During this period, only 30% of the 2016 capacity reduction targets for both steel and coal markets were achieved. Phase II: The accelerating implementation phase (2016 H2): The second phase included a ramp-up of "de-capacity" reforms, with over 70% of 2016 steel and coal capacity reduction targets being implemented. Meanwhile, steel production disruptions increased due to more stringent environmental rules, more frequent inspections, and government-ordered closures of low-quality steel (called "Ditiaogang" in Chinese) production in Jiangsu and Shandong provinces. Phase III: The reform-deepening phase (2017): The third phase, implemented in the first half of this year, was a clamping down on overcapacity to eliminate all illegal sub-standard steel (Ditiaogang) production and capacity by the end of June 2017. To date, the Chinese authorities have succeeded in their "de-capacity" reforms in steel and coal: both the steel and coal industries in China have become more efficient, more competitive, and have much less obsolete excess capacity: The government's plan was to reduce capacity by 100-150 million metric tons in steel and 1 billion metric tons in coal within "three to five years." This equated to a 9-13% and 18% reduction of existing 2015 Chinese capacity in steel and coal, respectively. In addition, this is equivalent to 7-9% for steel and 10% for coal of 2015's global output (Table I-1). As of August 2017, within less than two years since the beginning of the supply side reforms, 77% of the steel "de-capacity" target (or 10% of 2015 capacity) and 52% of the coal "de-capacity" target (or 7% of 2015 capacity) have been achieved (Table I-1). Table I-1Chinese Supply-Side Reform - Capacity Reduction Target And Actual Achievement China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed With declining capacity and rising production, the capacity utilization rates (CUR) of the steel and coal industries have increased meaningfully. The National Bureau of Statistics (NBS) reported that as of the third quarter of 2017, the CUR for the steel industry has risen to 76.7% (the highest since 2013, and an increase of 4.4 percentage points from a year ago). As for the coal sector, the CUR reached 69% (the highest since 2015, and an increase of 10.6 percentage points from a year ago). With outdated and illegal production capacity exiting the marketplace, the number of companies and the number of employees have declined significantly in both the steel and coal industries (Chart I-2 and Chart I-3). Since the start of the "de-capacity" reforms, the central government has allocated 100 billion yuan (0.1% of GDP and 3.6% of central government spending) to a special fund for the relocation of employees in the coal and steel industries. Chart I-2Consolidation In Chinese Steel ##br##And Coal Sectors: Fewer Companies... Consolidation In Chinese Steel And Coal Sectors: Fewer Companies... Consolidation In Chinese Steel And Coal Sectors: Fewer Companies... Chart I-3...And Fewer Employees ...And Fewer Employees ...And Fewer Employees Higher prices for steel and coal have greatly boosted producers' profitability. From January 2016 to September 2017, the number of loss-making enterprises as a share of all enterprises has dropped from 25% to 17% in the steel industry and from 34% to 21% in the coal sector. Improving financial conditions have enhanced steel and coal companies' ability to invest in industrial upgrades (i.e., more investment in advanced technologies and new equipment). Bottom Line: Chinese "de-capacity" reforms have been successfully implemented, which has improved economic efficiency in the steel and coal industries by reducing high-cost and low-quality supply, and by increasing lower-cost and high-quality output. Understanding The Cycle In this section, we try to connect the dots between the progress of China's supply side reforms, and steel and coal prices. Chart I-4A and Chart I-4B show the fascinating dynamics among policy actions, production and prices. Chart I-4APolicy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector Chart I-4BPolicy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector Here are our major findings: (A) Except for coal, Chinese "de-capacity" reforms were not the major trigger for the price bottom in major industrial commodities in early 2016. As the period from November 2015 to June 2016 was only the initiation stage of the reforms, not much steel capacity reduction - only 1.2% of total existing 2015 capacity - occurred in the first half year of 2016. Moreover, most of the reduced capacity was outdated capacity and probably had been offline for years. Therefore, the policy driven capacity cut in the first half of 2016 was unlikely the reason for the rally in steel prices. The reasons behind the bottom in raw materials prices in general and steel in particular during the first half of 2016 were the following: 1. Production cuts in both 2015 and the first half of 2016 was market-driven. In other words, it was not government reforms but natural market forces (the dramatic drop in raw materials prices in 2015) that caused company closures and declines in various raw materials output in both 2015 and the first half of 2016 (Chart I-4A). The price recovery in the first half of 2016 was not sufficient to make most producers profitable. 2. Remarkably, the authorities injected considerable amounts of credit and fiscal stimulus in late 2015 and early 2016. As a result, demand recovery was another major trigger for the synchronized bottom in early 2016. The rise in the aggregate credit and fiscal spending impulse led to a revival in property construction, automobile production and infrastructure investment in the first half of 2016 (Chart I-5). 3. Financial/speculative demand for commodities was also a driving force behind the early 2016 price recovery. Chart I-6 illustrates that Mainland trading volumes in various commodities futures surged in the first half of 2016, and specifically in coal in the third quarter of 2016, coinciding with their respective price spikes. Chart I-5Strong Demand Recovery In 2016 Strong Demand Recovery In 2016 Strong Demand Recovery In 2016 Chart I-6Speculative Buying In Early 2016 Speculative Buying In Early 2016 Speculative Buying In Early 2016 All of these factors contributed to the synchronized price bottom in early 2016 and the consequent price rally in the first half of 2016, in which Chinese "de-capacity" reforms only played a minor role, especially in the steel market. (B) Chinese "de-capacity" reforms were the determining factor for the coal price spike in 2016 and steel price appreciation in 2017. Coal in 2016: "De-capacity" reforms were behind the surge in coal and coke prices throughout 2016. In February 2016, the National Development and Reform Commission (NDRC) stipulated that domestic coal mines could operate no more than 276 working days in one year, down from 330 working days in the past. This was equivalent to the immediate removal of 16% of existing operating capacity off the market. Before this decision, Chinese coal production had already declined 2.5% in 2014 and 3.3% in 2015 (Chart I-4B on page 6). On top of this decision, the government enforced a 250 million metric ton capacity cut target in the coal industry in 2016. Furthermore, actual coal capacity reduction in 2016 was 116% of that year's target (Table I-1). The end result was a 10% decline in Chinese coal production during the period of January and September of 2016 from the same period of 2015, triggering an exponential rise in both thermal coal and coking coal prices (Chart I-1 on page 2). Coking coal is mainly used for coke production, and coke is employed as a fuel in smelting iron ore in a blast furnace to produce steel. Therefore, a shortage of coking coal combined with a revival in steel production made coke the best-performing commodity last year, with its price skyrocketing by 300%. Chart I-7Diverging Prices In 2017 DIVERGING PRICES IN 2017 DIVERGING PRICES IN 2017 Towards the end of last year, the authorities realized that "de-capacity" in the coal market was too aggressive, and began loosening up coal production restrictions in September 2016. Last November the NDRC further eased policy by allowing companies to operate 330 days a year again (Chart I-4B on page 6). In response to these adjustments, thermal coal, coking coal and coke prices all peaked in December 2016/early 2017 (Chart I-1 on page 2). This reveals how Chinese supply side reforms can be a determining factor for global commodities prices. Steel prices in 2017: Steel prices have exhibited a steady rally throughout 2017, even though prices for coal, coke and iron ore all declined. There has been considerable price divergence this year between steel, on one hand, and coal, coke and iron ore, on the other. Prices for thermal coal, coking coal, coke and iron ore all peaked in late 2016/early 2017, while prices for steel continued to rise and reached a six-year high in September, expanding profit margins for steel producers (Chart I-7). The resilience of steel prices this year was because the Mainland had dismantled all "Ditiaogang" capacity by the end of June 2017, resulting in an accelerated drop in steel products production (Chart I-4A on page 6). "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. "Ditiaogang" is often converted into products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Both falling steel products production and surging scrap steel exports entail that the "Ditiaogang" capacity elimination policy has been very effective (Chart I-8). Chart I-8The Removal Of 'Ditiaogang' Has ##br##Been Successfully Implemented The Removal Of 'Ditiaogang' Has Been Successfully Implemented The Removal Of 'Ditiaogang' Has Been Successfully Implemented As reported by the government, about 120 million metric tons per year of "Ditiaogang" capacity has been eliminated, more than double this year's steel "de-capacity" target of 50 million metric tons. A considerable portion of the 120 million metric ton "Ditiaogang" capacity was still in operation early this year when "Ditiaogang" producers enjoyed higher profit margins than large steel producers. This rapid change created a sudden squeeze on steel products supply, which consequently boosted their prices. Bottom Line: China's "de-capacity" reforms have played a major role in driving the rallies in steel prices in 2017 and in the coal markets in 2016. In short, China's supply-side reforms have been effective in shaping prices and boosting efficiency in Mainland industries by eliminating weak/inefficient producers or forcing their industrial upgrade. However, the government efforts at times have also produced large price swings, as in the case of both coal and coke. The Outlook For 2018 And 2019 Given past success and the nation's leadership adherence to reforms, China will firmly proceed with its "de-capacity" reform strategy over the next two years. However, steel and coal prices are likely to decline going forward. The most aggressive phase of "de-capacity" reforms is now behind us. The pace of capacity reduction for both steel and coal will decrease over the next two years as more than half of the 2016-2020 target has already been achieved for both sectors. Both steel and coal producers currently enjoy near-decade high profit margins, and their profits have swelled (Chart I-9A and Chart I-9B). Not surprisingly, steel and coal producers have already sped up their investment in advanced technologies to augment their capacity - by introducing ecologically friendly equipment that can produce medium- to high-end quality products. Chart I-9AStrong Profits For Steel And Coal Producers Rising Profit Margins For Steel And Coal Producers Rising Profit Margins For Steel And Coal Producers Chart I-9BRising Profit Margins For Steel And Coal Producers Strong Profits For Steel And Coal Producers Strong Profits For Steel And Coal Producers Importantly, the capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity to replace obsolete capacity at a ratio of 1:1-1.25 (the range depends on region). In short, having eliminated the inefficient/outdated capacity, producers are now allowed to add as much capacity as they had before, but using efficient technologies. This will weigh on steel and coal prices as output gains and production costs will likely be lower with new technologies. In addition, Chinese steel producers are accelerating the expansion of advanced electric furnace (EF) capacity. At 6%, current Chinese EF steel output as a share of total steel production is much lower than the same ratio for the major world steel producers and the world average (Chart I-10). The Chinese government's target is to raise the share of EF crude steel production as a share of total production to 15% by 2020. It usually takes at least 1-2 years to build a new EF plant. Hence, newly installed EF capacity will likely come into operation in 2018-'19. On the whole, this points to lower prices for crude steel and steel products. The EF steel-making process only requires scrap steel and electricity to produce crude steel. It does not need either iron ore or coke. This is negative for iron ore and coke prices. With the abundance of used cars and used home appliances in China, the domestic availability of scrap steel has significantly improved over the past few decades. In addition, electricity prices for industrial use have declined by about 5% since March 2015. Therefore, easing resource constraints (availability of scrap steel) and lower electricity costs will facilitate EF steel capacity expansion in China. Some words about the policy-driven steel production cut during the winter season. More than two dozen cities in northern China drew up detailed action plans during September and October to fight the notorious winter smog. China has set a target to reduce the level of Particulate Matter (PM) 2.5 pollution by at least 15% in cities around the Beijing-Tianjin-Hebei region between October 2017 and March 2018. The new rules will require seasonal suspensions or production cuts of steel, aluminum and cement (with the most focus on steel) during the winter heating season from November 15 to March 15. Therefore, over the next four months, downside in steel and coal prices may be limited due to support from these output cuts. This also entails less short-term demand for coke and iron ore, prices for these commodities may remain under downward pressure. Nonetheless, Chinese crude steel output is set to continue rising over the next two years, which in turn will eventually reverse the recent decline in steel products production and assure expansion in steel products production in 2018-'19 (Chart I-11). Chart I-10Chinese Electric Furnace Crude ##br##Steel Production Will Go Up China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed Chart I-11Steel Products Output Will Soon Catch Up Steel Products Output Will Soon Catch Up Steel Products Output Will Soon Catch Up For coal, production will accelerate in 2018. The NDRC expects coal production capacity to rise by a net 200 million metric tons this year as increases at more "advanced" mines exceed shutdowns of outmoded facilities. This will be a 50 million metric ton gain over this year's 150 million metric ton obsolete capacity reduction target. In addition, China's coal utilization rate as of the third quarter of 2017 was still below 70%, implying substantial additional capacity remains, potentially boosting coal output, so long as the government does not alter the 330 working-day rule. Importantly, on the demand side, China is aiming to reduce coal usage for electricity generation while promoting renewable energy like hydro, nuclear, wind and solar. This constitutes a structural headwind to coal prices. This is especially significant, given than China accounts for half of global coal consumption. The supply side reforms of the past two years (shutting down inferior capacity) along with the adoption of new, more efficient technologies, has already strengthened the competitiveness of Chinese steel and coal producers. This entails that China will soon resume net exports of steel products, and that its net imports of coal will drop (Chart I-12). This is bad news for international steel and coal producers, who in the past two years have benefited from higher steel and coal prices on the back of a revival in Chinese demand, and curtailed supply. Last but not least, our broad money impulse as well as the aggregate credit and fiscal spending impulse shows that economic growth in general and demand for industrial metals in particular are set to decelerate considerably in the next nine to 12 months or so (Chart I-13). Chart I-12China May Increase Its Net Steel Exports ##br##And Decrease Its Net Coal Imports China May Increase Its Net Steel Exports And Decrease Its Net Coal Imports China May Increase Its Net Steel Exports And Decrease Its Net Coal Imports Chart I-13Demand Is Set To Decelerate bca.ems_sr_2017_11_22_s1_c13 bca.ems_sr_2017_11_22_s1_c13 Chinese steel and coal markets will determine the direction of coke and iron ore prices, both of which will likely be headed lower as well. Coke: Rising coking coal output as a result of coal production ramping up will increase coke supply sizably. As an increasing share of steel output will come from non-coke-reliant EF capacity, coke demand growth will be constrained. Iron ore: Recovering domestic iron ore production could cap China's imports of iron ore (Chart I-14). First, a marginal rise in profit margins for Chinese iron ore domestic producers and a declining number of loss-generating companies heralds modest upside for iron ore output in China (Chart I-15). Chart I-14Chinese Iron Ore Output Will Rise Chinese Iron Ore Output Will Rise Chinese Iron Ore Output Will Rise Chart I-15Chinese Iron Ore Producers: ##br##Marginal Rise In Profit Margins Chinese Iron Ore Producers: Marginal Rise In Profit Margins Chinese Iron Ore Producers: Marginal Rise In Profit Margins Second, more vertical integration - a rising number of Chinese steel producers that have bought iron ore mines - will result in higher domestic iron ore output. Steel companies' current fat profit margins could prompt them to boost iron ore output from the mines that they have integrated into their production chain. Although profits from iron ore production specifically are likely to be limited. This will be the case especially if the government encourages them to do so. Last year, Chinese iron ore imports accounted for 87% of national total consumption - an all-time high. The authorities dislike such great dependence on resource imports, and the government will likely introduce policies such as reducing taxes for domestic iron ore producers or other efforts to boost domestic production. Bottom Line: China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. Ellen JingYuan He, Editor/Strategist EllenJ@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Time To Worry? Time To Worry? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings Time To Worry? Time To Worry? The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.

Highlights The Arabic title of this Special Report is "Against Wasta." Wasta roughly translates as reciprocity in formal and informal dealings. It "indicates that there is a middleman or 'connection' between somebody who wants a job, a license or government service and somebody who is in a position to provide it."1 While it has been helpful, it also has led to profound corruption. Feature The political sandstorm ripping through the Kingdom of Saudi Arabia (KSA) - visible in the lifting of the ban on women driving cars earlier this year, and, most recently in the consolidation of military and political power by Crown Prince Mohammed bin Salman (often referred to as "MBS") over the past few weeks - must be seen as prelude to implementing Vision 2030, which will feature an ongoing battle against wasta in KSA. If successful, this could transform a feudal desert kingdom into a modern nation-state.2 When the storm passes, MBS will hold the military and political reins of power in the Kingdom. This will allow the Sudairi branch of the Saud family, led by MBS's father, King Salman, to execute on its Vision 2030 agenda to wean itself from an almost-complete dependence on oil-export revenues. To do so, the Kingdom's leadership must successfully navigate OPEC 2.0's production-cutting deal in the short term, and the IPO of Saudi Aramco in the long term.3 KSA's Leadership Is On A Mission Chart of the WeekMarkets Take KSA News In Stride Markets Take KSA News In Stride Markets Take KSA News In Stride It's fairly obvious KSA's leadership and Russian President Vladimir Putin are on the same page re extending OPEC 2.0's 1.8mm b/d production-cutting deal to end-2018, given the public statements of MBS and Putin supporting such a measure. While markets have been responsive to this messaging, Russian Energy Minister Alexander Novak is restraining a full-throttled embrace of this expectation, saying a decision to extend the deal might not come at OPEC's November 30 meeting, given the amount of data to be analyzed.4 Markets appear to be taking the recent news - particularly the headlines out of KSA - in stride, as the major safe-haven assets have been remarkably well-behaved (Chart of the Week). In our base case, we continue to expect the OPEC 2.0 deal to be extended to end-June, which will lift Brent and WTI prices to $65 and $63/bbl next year. If we do get an extension of the OPEC 2.0 deal to end-December - and the odds of this appear very high - our 2018 Brent and WTI average-price forecasts could increase by as much as $5/bbl.5 KSA, Russia Have A Transactional Relationship, Not An Alliance The public alignment of the views of the Saudi and Russian leaderships are important over the short term. However, this does not necessarily mean both states have achieved a general alignment of views on everything of common concern to them. The OPEC 2.0 coalition led by KSA and Russia - the two largest oil exporters in the world - is a transactional relationship, not an alliance. The coalition members negotiated a deal to remove 1.8mm b/d of oil from the market in order to drain global inventories, particularly in the OECD. This deal was negotiated under duress - Brent prices threatened to fall through the $20/bbl level at the beginning of 2016 in the wake of the market-share war declared by OPEC at the end of 2014.6 Such an outcome would have imperiled the very survival of the member states (Chart 2). The success of OPEC 2.0 has taken many by surprise: The overwhelming market consensus in the lead-up to the deal getting done was the coalition would never come about, and, if it did, it would never be able to maintain the discipline necessary to follow through on its goal to return OECD inventories to their five-year average. BCA was outside this consensus from the get-go.7 And we continue to expect OPEC 2.0's production discipline to be maintained into next year, with KSA and Russia leading by example (Chart 3). Chart 2Oil-Price Collapse Clobbered Reserves Oil-Price Collapse Clobbered Reserves Oil-Price Collapse Clobbered Reserves Chart 3OPEC 2.0 Production Discipline Holds OPEC 2.0 Production Discipline Holds OPEC 2.0 Production Discipline Holds As important as the management of OPEC 2.0 is to KSA, Russia and the oil markets, the Kingdom's leadership has a laser focus on its chief long-term goal: the Saudi Aramco IPO. In light of its Vision 2030 agenda, the most important decision the Kingdom's leadership will make will be whether to IPO Aramco on a Western bourse - e.g., the NY Stock Exchange - or whether the initial offering of KSA's crown jewel is placed directly with China's sovereign wealth fund (SWF) and two of that country's largest oil companies. KSA controls this evolution. Decisions made by its leaders will resound in the oil markets for years, if not decades, to come. KSA's Anti-Corruption Campaign And The Aramco Offering The recent arrest of Saudi royals and consolidation of power by the Sudairi branch of the Saud royal family - led by King Salman and his son, MBS - appear to be part and parcel of an anti-corruption campaign laid out in the Vision 2030 document last year. This campaign, like the formation of OPEC 2.0, is being undertaken to support the IPO of Saudi Aramco next year. Proceeds from the IPO will support KSA's diversification away from being almost wholly dependent on oil exports.8 King Salman, MBS and their closest advisors have concluded they must reform the system of wasta if the Kingdom is to offer anything resembling a prosperous future full of opportunity to its restive population, most of which - more than 50% - are members of MBS's 30-something demographic cohort (Chart 4). Chart 4KSA's Under-30 Cohort Needs Jobs KSA's Under-30 Cohort Needs Jobs KSA's Under-30 Cohort Needs Jobs The wasta system in the Middle East - like the "old-boy" networks in the West - can be positive, in that it can "lower transaction costs and reduce the problem of asymmetric information if, for example, the use of such connections can place disadvantaged groups or individuals into the workforce who might otherwise not have the same opportunity as others," according to Prof. Ramady. However, such a system can, and has, become corrosive to the evolution of society, and can stunt the evolution toward an innovative, dynamic society and economy. Prof. Ramady notes, "Fighting negative wasta is important for the countries that seek to truly implement a more equal opportunity and entrepreneurial knowledge-based economic base." This discontent with the status quo post-Arab Spring was apparent in 2016, when BCA's Geopolitical Strategy noted KSA was in the early stages of such reforms.9 From everything King Salman and MBS have said and done to date, this appears to be the agenda that is being enacted. The lifting of the ban on women driving in KSA to take effect next year; hosting investors and entrepreneurs in Riyadh in September - the so-called Davos in the Desert presentations; even the recent mass arrests and consolidation of power are part and parcel of this reform.10 Early indications of this agenda could be seen in April 2015, when KSA lowered the value of projects requiring approval by the Council of Ministers to SR100 million from SR300 million ($27 million from $80 million). The collapse in oil prices from more than $100/bbl in 2014 likely drove this decision, but, as Prof. Ramady notes, "the intention of the Saudi government was clear: that even 'small' projects (by Saudi standards) could now be scrutinised to avoid 'hidden costs' and corruption." Following the April 2015 reforms, King Salman told the Kingdom's Anti-Corruption Committee "that his government would have zero tolerance for corruption in the country and that he and other members of the royal family are not above the law and that any citizen can file a lawsuit against the king, crown prince or other members of the royal family. These were some of the strongest statements to be made by a Saudi monarch on the issue of combating corruption and nepotism." (Emphasis added.)11 The Aramco IPO The way KSA monetizes its crown jewel will have a profound effect on the evolution of the country's institutions and the oil markets. MBS's implementation of the anti-corruption campaign laid out by his father, King Salman, suggests an IPO on a western bourse is in the offing. Such a listing would impose regulatory and transparency requirements on Aramco that are fully consistent with the royal family's words and deeds since King Salman took power in January 2015. Monetizing 5% of what could potentially be the largest oil-producing and -refining enterprise in the world - the only asset capable of funding the transformation of an entire country of 32mm people - on a bourse that requires even a minimal level of transparency for investors means the government of KSA could demand similar transparency from every other firm and individual in the Kingdom. It gives the government license, so to speak, to develop and enforce the rule of law, consistent with King Salman's remarks to the Anti-Corruption Committee. This will resonate with the younger KSA elites, many of whom are tech-savvy, educated in the West and in MBS's 30-something cohort. This would be a huge gamble on the future and the Kingdom's ability to transform itself into an open monarchy. Success would transform a feudal kingdom into a modern nation-state with an enfranchised population that can advance based on entrepreneurial innovation and merit. The rule of law and transparency in business and governmental dealings would replace wasta, privilege and corruption. It also could expose the royal family to a palace coup, as Marko Papic, BCA's Chief Geopolitical strategist, notes in his most recent report "The Middle East: Separating The Signal From The Noise," which we cite above. The stakes couldn't be higher. Listing on a Western bourse also would position Saudi Aramco squarely in the market and central to it, executing on its plan to become the dominant global oil refiner, and funding the Kingdom's diversification away from near-total dependence on oil exports. Lastly, it would allow KSA to retain its geopolitical optionality - playing competing global interests off each other when negotiating alliances and commercial deals. Implications Of An Aramco Private Placement If the Aramco shares are privately placed with China's SWF and the country's two largest oil companies, the pressure to reform likely would be lessened, as the Chinese government typically does not make reform demands on governments of resource-rich countries in which it is investing.12 Assuming China's SWF and/or the oil companies participating in its bidding consortium received a seat(s) on the Aramco board, China certainly would gain greater assurance over its crude oil and refined product supplies going forward. This is a critical concern with domestic production falling and demand for crude oil increasing (Chart 5). And it would give China an eventual interest in using military power to protect its investments in KSA, thus advancing and supporting its long-term evolution as a superpower.13 It also would, in all likelihood, expand the membership of the club trading oil in yuan, which now includes Russia and Iran, to KSA and its GCC allies and Iraq by 2020, if not sooner. This would represent ~ 39mm b/d of production (Chart 6), and 23mm b/d of exports. BP estimates just over 42mm b/d of crude oil are traded globally, meaning this petro-yuan producing coalition would account for 55% of total exports.14 Chart 5China Needs To Offset Declining Production China Needs To Offset Declining Production China Needs To Offset Declining Production Chart 6A Petro-yuan Would Be Formidable A Petro-yuan Would Be Formidable A Petro-yuan Would Be Formidable At some 9mm b/d, China accounts for ~ 21% of global crude oil imports. The combination of OPEC 2.0's crude production and exports with China's import volumes could make the OPEC 2.0 + 1 - the "+1" being China - the most potent force in the oil trading markets, if such a coalition can find a way to balance the competing interests of the world's largest exporters (KSA and Russia) with those of the world's largest importer (China). It also would put the petro-yuan bloc firmly in China's geopolitical orbit, allowing it to expand its sphere of influence deeply into the Persian Gulf, and the global oil market. Bottom Line: The recent turmoil in KSA must be seen as the opening moves in the transformation of a feudal desert kingdom into a modern nation-state. The evolution of the transformation is critically dependent on decisions made by KSA's leadership. How this breaks will profoundly affect the global oil markets and the Kingdom itself particularly in regard to how oil is priced - USD vs. yuan - and the effect new trading blocs have on market structure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Ramady, Mohamed A., ed. (2016), "The Political Economy of Wasta: Use and Abuse of Social Capital Networking," Springer International Publishing Switzerland. Ramady is a professor of Finance and Economics at King Fahd in Dhahran, Saudi Arabia. The introduction of the book starts by quoting the proverb: To accept a benefit is to sell one's freedom. 2 Please see "The Middle East: Separating The Signal From The Noise," published November 15, 2017, in BCA Research's Geopolitical Strategy, for a full analysis of these issues. 3 OPEC 2.0 is our moniker for the OPEC and non-OPEC coalition of oil producers led by KSA and Russia, which agreed to remove 1.8mm b/d of oil production from the market at the end of last year. 4 Please see "Russia's Novak: Oil cut pact extension decision not necessarily at Nov meeting," published November 2, 2017, by reuters.com. Elevating the level of uncertainty as to when the OPEC 2.0 pact will be unwound is exactly the sort of forward guidance OPEC 2.0 leaders would need to convey to markets in order to backwardate the forward oil-price curve - i.e., keep longer-dated prices below prompt prices. A backwardated forward curve means U.S. shale producers realize lower prices on longer-dated hedges, which restrains the number of rigs they can deploy in the field. On Wednesday, Reuters also reported as spokesman for Rosneft, Russia's largest oil company, foresees difficulty in the wind-down of OPEC 2.0's production cuts - and the return to unrestrained production. Mikhail Leontyev said, "Speaking about the company's concerns, first of all it was about how to prepare for suspending measures to restrict production. This is a serious question. Sooner or later, of course, these measures will be lifted," Leontyev said. "Now or later, that's a separate question. It's a serious challenge, for which one needs to prepare." Roseneft is responsible for 40% of Russia's oil output; it is 50% owned by the Russian government. Please see "Russia's Rosneft says managing exit from OPEC+ deal is a serious challenge," published by reuters.com on November 15, 2017. 5 Please see "Oil Forecast Lifted As Markets Tighten," published by BCA Research's Commodity & Energy Strategy, October 19, 2017. It is available at ces.bcaresearch.com. Worth noting is the fact that should OPEC 2.0 not extend the expiry of the production-cutting deal markets likely would sell off quickly. This is because the leadership of the coalition - MBS and President Putin - have publicly embraced such a move; not doing so would be a disappointment to markets. Our modelling in the article cited here indicates the cuts have to be extended at least to end-June 2018, if the OPEC 2.0 goal of reducing OECD commercial oil inventories to their 5-year average levels is to be achieved. Also worth noting, if we do see the OPEC 2.0 cuts extended to end-2018, we likely will be widening our implied Brent vs. WTI spread to $4/bbl, given the transportation bottlenecks that are likely to emerge in the event of a further lift in U.S. prices: Pipeline infrastructure in the most productive shales, particularly the Permian Basin, cannot get oil to export facilities as quickly as it is produced. Please see "Transportation constraints and export costs widen the Brent-WTI price spread," published in the U.S. EIA's This Week in Petroleum series November 8, 2017. 6 We discuss this at length in our 2017 outlook. Please see "2017 Commodity Outlook: Energy," published by BCA Research's Commodity & Energy Strategy December 8, 2016. See also our "2016 Commodity Outlook: Neutral Across the Board," published December 17, 2016, for a detailed discussion of pricing dynamics as this time. Both are available at ces.bcaresearch.com. 7 Please see the 2017 Outlook referenced above in footnote 6. 8 KSA officials believe the company is worth $2 trillion, based on their expectation a 5% IPO of the company would generate $100 billion. 9 Please see "Saudi Arabia's Choice: Modernity Or Bust," the May 2016 issue of BCA Research's Geopolitical Strategy. It is available at gps.bacresearch.com. 10 Please see "Saudi Arabia plans to build futuristic city for innovators," published October 24, 2017, by phys.org. 11 Please see footnote 1, p. ix. 12 Please see "Exclusive - China offers to buy 5 percent of Saudi Aramco directly: sources," published by reuters.com October 16, 2017. 13 We examined this in depth in our report entitled "OPEC 2.0: Fear and Loathing in Oil Markets," published by BCA Research's Commodity & Energy Strategy on April 27, 2017. It is available at ces.bcaresearch.com. 14 Please see https://www.bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy/oil/oil-trade-movements.html. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades ضد الواسطة ضد الواسطة Commodity Prices and Plays Reference Table ضد الواسطة ضد الواسطة Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Middle Eastern geopolitics will add upside risk to our bullish oil view, but not cause a drastic supply shock; Saudi Arabia is at last converting from a feudal monarchy to a modern nation-state; The greatest risk is domestic upheaval, motivating Saudi internal reforms and power consolidation; Abroad, the Saudis are constrained by military weakness, relatively low oil prices, and U.S. foreign policy; Geopolitical risk premia are seeping back into oil prices, but OPEC 2.0 and the Saudi-Iranian détente are still intact. Feature Geopolitical and political turbulence in Saudi Arabia kicked into high gear in November, with Crown Prince Mohammad bin Salman apparently turning the Riyadh Ritz-Carlton into a luxury prison for members of the royal family.1 At the same time, rumors are swirling that the bizarre resignation of Lebanese Prime Minister Saad Hariri, allegedly orchestrated by Saudi Arabia, is a potential casus belli. In this scenario, Lebanon would become a proxy war for a confrontation between Sunni Gulf monarchies led by Saudi Arabia (aided by Israel) and their Shia rivals, led by Iran and its proxy Hezbollah. To our clients around the world we say, "please take a deep breath." In this report, we intend to separate the signal from the noise. The Middle East has been a theater of paradigm shifts since at least 2011.2 Not all of them are investment relevant. In this report, we conclude that: Changes under way in the Middle East are the product of impersonal, structural forces that have been in place since the U.S. pulled out of Iraq in 2011; Saudi Arabia is engaged in belated, European-style nation-building, a volatile process that will raise tensions in the country and the region; Saudi Arabia remains constrained by a lack of resources and military capabilities, and unclear alliance structures. Iran, meanwhile, benefits from the status quo. As such, no major war with Iran is likely in the short term, although proxy wars could intensify. In the short term, we agree that the moves by Saudi leadership will increase tensions domestically and in the region. However, over the long term, the evolution of Saudi Arabia from the world's last feudal monarchy into a modern nation-state should improve the predictability of Middle East politics. Regardless of our view, one thing is clear: Saudi Arabia has an incentive to keep oil prices at the current $64 per barrel, or higher, as domestic and regional instability looms. As such, we believe that risks to oil prices are to the upside, but a global growth-constraining geopolitical shock to oil supply is unlikely. The Paradigm Shift: Multipolarity "Tikrit is a prime example of what we are worried about ... Iran is taking over [Iraq]."3 -- Prince Saud al-Faisal, Saudi Foreign Minister, to U.S. Secretary of State John Kerry, March 5, 2015 Pundits, journalists, investors, and Middle East experts all make the same mistake when analyzing the region: they assume it exists on "Planet Middle East." It does not. The Middle East is part of a global system and its internal mechanic is not sui generis. Its actors are bit players in a much bigger game, which involves nuclear powers like the U.S., China, and Russia. Yes, the whims and designs of Middle East leaders do matter, but only within the global constraints that they are subject to. The greatest such constraint has been the objective and observable withdrawal of the U.S. from the Middle East, emblematized by a dramatic reduction of U.S. troops in the region (Chart 1). The U.S. went from stationing 250,000 troops in 2007 to mere 36,000 in 2017. The withdrawal was not merely a manifestation of President Barack Obama's dovish foreign policy. Rather, it was motivated by U.S. grand strategy, specifically the need to "pivot to Asia" and challenge China's rising geopolitical prowess head on (Chart 2). Chart 1U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging Chart 2China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. As we expected, President Donald Trump has not materially increased the U.S. presence in the region since taking office.4 His efforts to eradicate the Islamic State have largely built on those of his predecessor. While he has rhetorically changed policy towards Iran, and taken steps to imperil the nuclear deal by decertifying it, he has not abrogated the deal. The U.S. president can withdraw from the nuclear deal without congressional approval, yet President Trump has merely passed the buck to Congress, which has until the end of the year to decide whether to re-impose sanctions. For Saudi Arabia, U.S. rhetoric and half measures do not change the fact that Iraq is now devoid of American troops and largely in the Iranian sphere of influence. Following the 1991 Gulf War, Saudi Arabia enjoyed the best of both worlds for two decades: a Sunni-dominated but weakened Iraq serving the role of an impregnable buffer between itself and the much more militarily capable Iran. Since Iraq's paradigm shift in the wake of American invasion, the buffer has not only vanished but has been replaced by a Shia-dominated, Iranian-influenced Iraqi state (albeit still relatively weak). Unsurprisingly, Saudi military spending as a share of GDP nearly doubled from the 2011 U.S. withdrawal to 2015, and in absolute terms has risen from $48.5 billion in 2011 to $63.7 billion in 2016, revealing a deep concern in Riyadh that its northern border has become nearly indefensible (Chart 3). Chart 3Saudis React To U.S. Withdrawal The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Meanwhile, Baghdad's heavy-handed political and military tactics produced an immediate reaction from the Sunni population.5 Militant Sunni insurgent groups, with material support from unofficial (and probably official) channels in Saudi Arabia and wider Gulf monarchies, began to fight back. Violence escalated and soon melded with the emerging civil war in Syria, which by early 2013 had taken on a sectarian cast as well. This led to the emergence of the Islamic State, which grew out of the earlier Sunni insurgence against the U.S. in the Al Anbar governorate. The military success of the Islamic State in 2014 against the inexperienced and demoralized Iraqi Army forced Baghdad to lean even more heavily on domestic Shia militias, and Iran, for survival. Islamic State militants reached the outskirts of Baghdad in September 2014 and were only beaten back by a combination of hardline Shia militias and Iranian advisers and irregular troops. From the Saudi perspective, this direct intervention by the Iranian military in Iraq was the final straw. Most jarring to the Saudis was the fact that the Americans acquiesced to the Iranian presence in Iraq and even collaborated with Iran. In fact, the overt presence of Iranian military personnel in Syria and Iraq drew no rebuke from the U.S. Some American officials even seemed to praise the Iranian contribution to the global effort against the Islamic State. Meanwhile, the nuclear negotiations continued undisturbed, right down to their successful conclusion in July 2015. Bottom Line: Global multipolarity and the rise of China has forced America's hand, and the dramatic withdrawal of military assets from the Middle East is the direct consequence. Saudi Arabia has suffered a dramatic reversal of geopolitical fortunes, with its crucial geographic buffer, Iraq, now dominated by its strategic rival, Iran. Saudi Arabia "Goes It Alone," And Fails Miserably "Saudi Arabia will go it alone."6 -- Mohammed bin Nawwaf Bin Abdulaziz Al Saud, Saudi ambassador to the U.K., December 17, 2013 To counter growing Iranian influence across the region and its strategic isolation, Saudi Arabia relied on five general strategies, all of which have failed: Map 1Saudi Arabia's Shia-Populated Eastern Province Is A Crucial Piece Of Real Estate The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Asymmetric warfare: Saudi Arabia has explicitly and implicitly supported radical-Islamist Sunni militant groups around the region. Some of these groups were either directly linked to, or vestiges of, al-Qaeda. The Islamic State, which received implicit support from Saudi Arabia in its early days of fighting president Bashar al-Assad in Syria, eventually turned against Saudi Arabia itself. Its agents claimed multiple mosque attacks in the Shia-populated Eastern Provinces (Map 1), attacks intended to incite sectarian violence in this key oil-producing Saudi area. Saudi officials also became alarmed at a large number of Saudi youth who went to fight with Islamic State fighters across the region, some of whom are now back in the country (Chart 4). "Sunni NATO": Talk of a broad, Sunni alliance against Iran has not materialized. Despite the Saudis' best efforts, the main Sunni military powers - Egypt and Pakistan - have remained aloof of its regional efforts to isolate Iran. The best example is the paltry contribution of its Sunni peers to the ongoing war in Yemen, where anti-government Houthi rebels are nominally allied with Iran. Pakistan contemplated sending a brigade of 3,000 troops to the Saudi-Yemen border earlier this year, but has refused to join the fight directly. Egypt sent under 1,000 troops early in the war, but none since. Talk of a 40,000 Egyptian deployment to the Yemen conflict earlier this year has not materialized. If Pakistan and Egypt are unwilling to help Saudi Arabia against the Houthis, why would they be interested in directly confronting a formidable military power like Iran? Direct warfare: When supporting militants and spending money on allies did not work, Saudi Arabia decided to try its hand at direct warfare. In February 2015, it began airstrikes against the Houthi rebels in Yemen. The war, which costs Saudi Arabia over $70 billion a year, has gone badly for Saudi Arabia.7 Despite two years of intensive involvement by Saudi Arabia and its GCC allies, the capital Sanaa remains in Houthi hands. As far as we are aware, there has been no real Saudi ground troop commitment to the conflict. K-street: Despite its best efforts, and the vast resources spent on lobbyists in Washington, Saudi Arabia could not prevent the U.S. détente with Iran. What the Saudis failed to appreciate was multipolarity, i.e. how the U.S. pivot to Asia would affect Washington's policy toward the Middle East.8 Oil prices: At the fateful November 2014 OPEC meeting, Saudi Arabia refused to cut oil production in the face of falling prices, instead increasing production (Chart 5). Since late 2016, however, Saudi Arabia has reversed this aggressive bid for market share and orchestrated oil production cuts with Russia and OPEC states. Chart 4The Islamic State Movement Threatens Saudi Arabia The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 5Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Each and every one of the above strategies has failed. The last one is the most spectacular: Saudi Arabia was forced to backtrack from its oil production surge and negotiate with long-time geopolitical rival Russia, which was courting the Saudis to relieve its budget pressures from low oil prices. Saudi Arabia not only accepted the need to work with Russia, but also acquiesced to Russia's geopolitical demands for détente in the ongoing Syrian Civil War. The latter will force Saudi Arabia at least tacitly to accept the continued leadership of President al-Assad in Syria. Furthermore, Saudi intervention in Yemen has gone nowhere. Pundits who claim that the Saudis are on the verge of a major military engagement in ______ (insert Middle East country), should carefully study the effectiveness of the Saudi military in Yemen. After over two years of Saudi bombardment, the Houthis are further entrenched in the country. Meanwhile, Saudi Arabia's Sunni allies have not committed many ground troops to the effort, save for Sudan, which is impoverished and has no choice but to curry favor with its largest foreign donor. Bottom Line: The past six years have taught the Saudi leadership a series of hard lessons. Saudi Arabia cannot "go at it alone." On the contrary, the rise of the Islamic State - a messianic political entity claiming religious superiority to the Saudi kingdom - has alarmed the Saudi leadership and awoken it to a truly existential risk: domestic upheaval. Nation-Building, Saudi Style "What happened in the last 30 years is not Saudi Arabia. What happened in the region in the last 30 years is not the Middle East. After the Iranian revolution in 1979, people wanted to copy this model in different countries, one of them is Saudi Arabia. We didn't know how to deal with it. And the problem spread all over the world. Now is the time to get rid of it."9 -- Saudi Crown Prince Mohammed bin Salman, October 24, 2017 European nation-states developed over the course of five hundred years, from roughly the end of the Hundred Years' War between England and France to the unification of Italy and Germany in the mid-nineteenth century. Fundamentally, these efforts were about centralizing state power under a single authority by evolving the governance system away from feudal monarchy toward a constitutional, bureaucratic, and national system. The defining feature of feudalism was the separation of feudal society into three "estates": the clergy, the nobility, and the peasantry. The first two estates - the clergy and the nobility - had considerable rights and privileges. The king, who was above all three estates, nonetheless had to curry favor with both in order to raise taxes and wage wars. The state was weak and often susceptible to foreign influence via interference in all three estates. Saudi Arabia is one of the world's last feudal monarchies and it does not have five hundred years to evolve. Still, the best model for what is going on inside Saudi Arabia today is the European nation-building of the past. In brief, recent Saudi policies - from foreign policy assertiveness to domestic reforms - are intended to centralize power and evolve Saudi Arabia into a modern nation-state. Three parallel efforts, modeled on European history from the last millennia, are under way: Curbing the "first estate": Saudi Arabia has begun to curb the power of the religious establishment. In April 2016, it severely curbed the powers of the hai'a - the country's religious police. They no longer have the power to arrest. Instead, they have to report violations of Islamic law to the secular police; and they are only allowed to work during office hours.10 The state has even arrested a prominent cleric who opposed the change in hai'a powers, and has dismissed many other conservative clerics since King Salman came to power. Curbing the "second estate": The detention of members of the Saudi royal family at the Ritz Carlton is part of an ongoing effort to curb the powers of the "landed aristocracy" and bring it under the control of the ruling Sudairi branch of the royal family.11 This is not just palace intrigue, but a necessary step in harnessing the financial resources of the state, which are currently dispersed amongst roughly 2,000 members of the "second estate." Rallying the "third estate": Nationalism was used by European leaders of the nineteenth century to rally the plebs behind the state-building efforts of the time. Similarly, King Salman and his son, Crown Prince Mohammad bin Salman, are building a Saudi national identity. To do so, they are appealing to the youth, which makes up 57% of the country's population (Chart 6), as well as emphasizing the existential threat that Iran poses to the kingdom. Chart 6Still A Young Country Still A Young Country Still A Young Country We do not see these efforts as merely the reckless agenda of an impulsive thirty year-old, as Crown Prince Mohammad bin Salman is often derisively portrayed by his opponents. We see genuine strategy in every policy that has been initiated by Saudi leadership since King Salman took over in January 2015. Several efforts are particularly notable. Vision 2030: A Major Salvo Against The "First Estate" As we indicated in May 2016, we consider the Saudi "Vision 2030" reform blueprint to be a serious document.12 While its plan to address Saudi economic constraints is overly ambitious and vague, there are nonetheless several prominent themes that reveal the preferences of Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. As if on cue, the Saudi leadership announced that it would soon end its policy of forbidding women to drive. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. We were right to emphasize these three themes back in May 2016 as it is now obvious that King Salman and his son Mohammad bin Salman are following the prescriptions of their Vision 2030. What explains their reformist zeal? Over half of the Saudi population of almost 30 million is below 35 years of age. The youth population is facing difficulty entering the labor force, with unemployment above 30% (Chart 7). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart 8). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,13 and Twitter has the highest level of penetration in Saudi Arabia of any other country in the region.14 Chart 7A Potential National Security Risk A Potential National Security Risk A Potential National Security Risk Chart 8Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others The idea that the royal family can take on the religious establishment on behalf of the youth seems far-fetched. Skeptics point out that the conservative Sunni Wahhabi religious movement lies at the foundation of the Saudi state. However, commentators who take this mid-eighteenth-century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, but Westerners may even overstate the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.15 Although Saudi Arabia has not appeared in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart 9). In addition, Saudis identify with values of self-expression over values of survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart 9Saudi Arabia: More Modern Than You Think The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise The Weekend At The Ritz: The "Second Estate" Is Put On Notice The ongoing effort to curb the power of the Saudi "second estate" is not just about court intrigue and political maneuvering. Without harnessing the economic resources of the wider Saudi aristocracy, the state would succumb to debilitating capital outflows. If the Saudi "second estate" decided to "vote" against King Salman and his son with their "deposits" - and flee the country - the all-important currency peg would collapse. Despite a pickup in oil prices, Saudi Arabia's currency reserves are falling rapidly and could soon dip below the total amount of local-currency broad money (Chart 10). Beneath that point, confidence among locals and foreigners in the currency peg could shatter, leading to massive capital flight, which was clearly a very serious problem as of end-2016 (Chart 11). Chart 10KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting Chart 11KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist The peg of the Saudi riyal to the U.S. dollar is not just an economic tool. It is a crucial social stability anchor for an economy that imports nearly all of its basic necessities. De-pegging would lead to a massive increase in import costs and thus a potential political and social crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years. However, this is only the case if capital outflows do not pick up and oil prices continue to stabilize. The Russia-OPEC deal is in place to ensure the latter. The "weekend at the Ritz" is meant to ensure the former. But doesn't the crackdown against the wealth of 2,000 royal family members represent appropriation of private property? Not in the minds of King Salman and his reformist son. In fact, if the financial wealth of the royal family is used to fill the coffers of the Saudi sovereign wealth fund, there is no reason why members of the Saudi "second estate" cannot benefit from its future investment returns and essentially "clip coupons" for a living. In fact, prior to the anti-corruption crackdown against the "second estate," Saudi officials hosted a completely different event at the Ritz Carlton: a gathering of top international investors for a conference called "Davos in the Desert." Judging by the conversations we had with a number of participants at that event, the point was not to encourage investments in Saudi Arabia. Rather, it was to secure the services of top international managers as Saudi Arabia ramps up the investment activities of its Public Investment Fund (PIF). Investors should therefore consider the first weekend at the Ritz as the launch of a new international investment vehicle by Saudi officials and the second weekend at the Ritz as its capitalization by the wider "second estate." We expect that fighting corruption will remain a major domestic policy thrust going forward. A recent academic study, for example, takes on the difficult job of eradicating wasta - the concept that each favor or privilege in Saudi society flows through middlemen or connections.16 The volume has been edited by Mohamed A. Ramady, professor of Finance and Economics at King Fahd University in Dhahran, Saudi Arabia, and is undoubtedly supported by the royal family. Moreover, King Salman and his son have the example of Chinese President Xi Jinping's impressive power consolidation via anti-corruption campaign right in front of them and are unlikely to have embarked on this course with the expectation that it would be a short process. Iran As An Existential Threat: Harnessing The "Third Estate" Real reform is always and everywhere difficult, otherwise the desired end-state would already be the form. For the Saudi leadership, attacking both the first and second estate presents considerable risks. It is appropriate, therefore, to believe that a palace coup may be attempted against King Salman and his son.17 International tensions with Iran are a particularly useful strategy to distract the opposition and paint all domestic dissent as treasonous. This is not to say that Saudi Arabia does not face considerable strategic challenges from Iran. As mentioned, Iranian influence in Iraq is particularly threatening to Saudi Arabia as it gives Tehran influence over a key strategic buffer that also produces 4.4 million barrels of crude per day. Furthermore, Iran supported the 2011 uprising in Shia-majority Bahrain against the Saudi-allied al-Khalifa monarchy; it at least nominally supports the Houthi rebels in Yemen; it has directly intervened in Syria on behalf of President al-Assad; and it continues to support Hezbollah in Lebanon. It is safe to say that, since 2011, Iran has been ascendant in the Middle East and has surrounded Saudi Arabia with strategic threats on all points of the compass. But to what extent is the Saudi rhetoric on Lebanon, Bahrain, Yemen, and Qatar a real threat to the stability in the Middle East? We turn to this question in our next section. Bottom Line: Saudi Arabia's domestic intrigue is far more logical than pundits and the media make it out to be. King Salman and his son, Crown Prince Mohammad bin Salman, are trying to build a modern nation state from what is today the world's last feudal monarchy. To do so, they have to enlist the support of the third estate - the country's large youth population - and curb the powers of its first and second estates - the religious establishment and the landed aristocracy. The process will be filled with risks and volatility, but is ultimately necessary for the long-term stability of the kingdom. Regional Risk Of War Is Overstated "[I am] positive there will be no implications coming out of this dramatic situation at all."18 -- Secretary of Defense James Mattis, asked about the Qatar crisis and the fight against ISIS, June 5, 2017 As this report goes to publication Saudi Arabia has accused Iranian-allied Hezbollah of forcing Lebanese Prime Minister Saad Hariri to run for his life. Hariri resigned while visiting Saudi Arabia. Although he claims that he is not being held against his will by Saudi authorities, his resignation is highly suspect. Saudi officials have also called a failed missile attack on Riyadh's airport, allegedly launched by Houthi rebels in Yemen, as a possible "act of war" by Iran. Meanwhile, Bahrain's Saudi-allied government has accused Iran of destroying an oil pipeline via terrorist action. The region's rumor mill - one of the most productive in the world - is in overdrive. What are the chances of increased proxy warfare between Saudi Arabia and Iran? We think that there is a good chance that Saudi Arabia will step up its military activity in the ancillary parts of the Middle East. In particular, we could see renewed Saudi military campaigns in Yemen and Bahrain. In isolation, these campaigns would add a temporary risk premium to oil prices. But given that Iran has no intention to become directly involved in either, we would expect Saudi moves to be largely for show. Over the long term, we do not see a direct confrontation between Iran and Saudi Arabia for three reasons. First, Saudi military capabilities are paltry and the kingdom has failed to secure the support of the wider Sunni world for its "Sunni NATO." We have already mentioned Saudi military failures in Yemen. Anyone who thinks that Saudi Arabia is ready to directly confront Iran must answer two questions. First, how does the Saudi military confront a formidable foe like Iran when it cannot dislodge Houthis from Yemen? Second, if Saudi Arabia is itching for a real conflict with Iran, why is it not saber-rattling in Iraq, a far more strategic piece of real estate for Saudi Arabia than any of the other countries where it accuses Iran of meddling? Chart 12Correlation Between Oil Prices And Military Disputes The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Second, oil prices remain a constraint to war. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 12). Political science research shows that the relationship is not spurious. Chart 13 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.19 While oil prices have recovered from their doldrums from two years ago, they are also a far cry from their pre-2014 highs. In fact, by our calculation, oil prices are still below the Saudi budget break-even price of oil, despite its best efforts to implement austerity (Chart 14). Chart 13More Oil Revenue = More Aggression The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 14Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Third, Saudi Arabia has failed to secure a clear security commitment from the U.S. While the Trump administration is far more open to supporting Saudi Arabia than the Obama administration, it still criticized the Saudi decision to ostracize Qatar. Secretary of Defense James Mattis made a visit to Qatar in September to offer American support. In a shocking reversal to over half-a-century of geopolitics, King Salman went to Moscow this October to deepen geopolitical relations with Russia.20 The visit included several business deals in the realm of energy and a significant promise by Saudi Arabia to purchase Russian arms in the future, including the powerful S-400 SAM system. Saudi Arabia is the world's third-largest arms importer and uses purchases as a tool of diplomacy, but has never purchased weapons from Russia in a significant way in the past. While many pundits have pointed to the Saudi-Russian détente as a sign of strength, we see it as a sign of weakness. It illustrates that Saudi Arabia is diversifying its security portfolio away from the U.S. It is doing so because it has to, not because it wants to. As U.S. petroleum imports continue to decline due to domestic shale production, Saudi Arabia is compelled to find new allies (Chart 15). The plan to hold an initial public offering for Aramco, and to target sovereign Chinese entities as major bidders for Aramco assets, fits this pattern as well. Chart 15Saudi Arabia Has To Diversify Its Security ##br##Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline However, diversifying the geopolitical security portfolio to include Russia and China will not mean that Saudi Arabia will have a blank check to wage direct war against Iran. Both Russia and China have considerable diplomatic and economic interests in Iran and are as likely to restrain as to enable Saudi ambition. Finally, talk of a Saudi-Israeli alliance against Hezbollah in Lebanon is as far-fetched as a direct Saudi-Iranian confrontation. Israel won the 2006 war against Hezbollah, but at a high cost of 157 soldiers killed and 860 wounded.21 The Israeli public grew tired of the one month campaign, showing political limits to offensive war. Furthermore, twelve years later, Hezbollah is even more deeply entrenched in Lebanon. Unless Saudi Arabia is willing to provide ground troops for the effort (see Yemen discussion above), it is unclear why Israel would want to enter the morass of Lebanese ground combat on behalf of Riyadh. Bottom Line: Constraints to Saudi offensive military action remain considerable: paltry military capability, fiscal constraints imposed by low oil prices, and a lack of clear support from the U.S. While rhetorical attacks on Iran serve the strategic goal of nation-building, we do not expect a major war between oil-producing states that would significantly raise oil prices over the medium term. The rhetoric and posturing will increase volatility and temporarily push up prices from time to time. Investment Implications Of Saudi Nation-Building First, on the question of OPEC 2.0, our baseline case is for the 1.8 million barrel-per-day production cuts to be extended through June 2018, drawing OECD inventories down toward their five-year average and creating the conditions for Brent and WTI prices to average $65 per barrel and $63 per barrel respectively next year.22 Moreover, both Crown Prince Mohammad bin Salman and Russian President Vladimir Putin have endorsed extensions through end-2018. These comments add bullish upside risk to prices, though they also alter perceptions and thus raise the short-term downside risk if no extension is agreed this month (which we think is the least likely scenario). Second, as to broader geopolitical risks in the Middle East, we believe they are rising yet again in the short and medium term, after the relative calm of 2017.23 We could see Saudi officials decide to ramp up military operations in Yemen or revive them in neighboring Bahrain. However, we do not see much of a chance of serious conflict in Lebanon or Qatar. The former would require an Israeli military intervention, which is unlikely given the outcome of the 2006 war. The latter would require American acquiescence, which is unlikely given the vital U.S. strategic presence in the country's Al Udeid military base. Nonetheless, even temporary military operations in any of these locales could add a geopolitical risk premium to oil markets. For example, the 2006 Lebanon-Israel War, which had no impact on oil production, generated a significant jump in oil prices (Chart 16). Chart 16Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Over the long term, how should investors make sense of the complicated Middle East geopolitical theater? Our rule of thumb is always to seek out the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. For a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications, we would need to see it have an impact on at least two of the following three factors: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni versus Shia. When we consider the security dilemma between Iran and Saudi Arabia, Iraq and the Eastern Province in Saudi Arabia are two regions critical to global oil supply. Tellingly, neither has played a role in the recent spate of tensions between the two countries. Saudi Arabia has been very careful not to increase tensions with Iran in Iraq. In fact, the Saudi leadership has reached out to Iraqi Prime Minister Haider al-Abadi, who was received by King Salman in October in the presence of U.S. Secretary of State Rex Tillerson. How should investors price domestic political intrigue in Saudi Arabia? In the long term, any failure of King Salman and his son to reform the country would be negative for internal stability, with risks to oil production if social unrest were to increase. In the short and medium term, however, even a palace coup would likely have no lasting impact on oil prices as it would be highly unlikely that an alternative leadership would imperil the kingdom's oil exports. On the contrary, a coup against King Salman could lead to lower oil prices if the new leadership in Riyadh decided to renege on their oil production cuts with Russia. The bottom line is that the geopolitical risk premium is likely to rise. The evolution of Saudi Arabia away from a feudal monarchy requires the suppression of the kingdom's first and second estates, a dangerous business that will likely be smoothed by nationalism and saber-rattling. Risks to oil prices, therefore, are to the upside. However, given the considerable constraints on Saudi Arabia's military and foreign policy capabilities, we do not foresee global growth-constraining oil supply risks in the Middle East. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The latest news from Riyadh is that the nearby Courtyard by Marriott Hotel may have been enlisted by the Saudi authorities for the crackdown, in addition to the Ritz Carlton. If true, we can only imagine the horrors that the prisoners are subject to! 2 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, and BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 3 Please see "Iran 'taking over' Iraq, Saudis warn, blaming U.S. refusal to send troops against ISIS," The National Post, dated March 5, 2015, available at nationalpost.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 5 Iran's influence in Iraq grew almost immediately following the American military withdrawal. Iraq's Shia Prime Minister, Nouri al-Maliki, wasted no time revealing his allegiance to Iran or his sectarian preferences. Baghdad issued an arrest warrant for the Sunni Vice President Tariq al-Hashimi literally the day after the last American troops withdrew from the country, signaling to the Sunni establishment that compromise was not a priority. Persecution of the wider Sunni population soon followed, with counter-insurgency operations in Sunni populated Al Anbar and Nineveh governorates. 6 Please see Mohammed bin Nawwaf bin Abdulaziz al Saud, "Saudi Arabia Will Go It Alone," New York Times, dated December 17, 2013, available at nytimes.com. 7 Please see Bruce Riedel, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 8 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 9 Please see Martin Chulov, "I will return Saudi Arabia to moderate Islam, says crown prince," The Guardian, dated October 24, 2017, available at www.theguardian.com. 10 Something tells us that most violations of Islamic law are likely to be committed after hours! 11 The Sudairi branch of the Saud dynasty refers to the issue of Saudi Arabia's founder Abdulaziz Ibn Saud with Hassa bint Ahmed Al Sudairi, one of Ibn Saud's wives and a member of the powerful Al Sudairis clan. The union produced seven sons, the largest faction out of the 45 sons that Ibn Saud fathered. As the largest grouping, the sons - often referred to as the "Sudairi Seven" - were able to consolidate power and unite against the other brothers. In addition to the current King Salman, the other member of the Sudairi faction who became a king was Fahd, ruling from 1982 to 2005. 12 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 2016, available at gps.bcaresearch.com. 13 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is highly unlikely to be used for religious education. It is highly likely to be used by teenagers for ... well, use your imagination. 14 Please see "Social Media In Saudi Arabia - Statistics And Trends," TFE Times, dated January 12, 2017, available at tfetimes.com; "Saudi social media users ranked 7th in the world," Arab News, November 14, 2015, available at arabnews.com. 15 The World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge: Cambridge UP, 2005). For more information, please see http://worldvaluessurvey.org. 16 Please see Mohamed A. Ramady, ed., The Political Economy Of Wasta: Use and Abuse of Social Capital Networking (New York: Springer, 2016). 17 It would not be the first such coup in Saudi history. King Saud was deposed in 1962 by his brother, King Faisal. 18 Please see Nahal Toosi and Madeline Conway, "Tillerson: Dispute Between Gulf States And Qatar Won't Affect Counterterrorism," dated June 5, 2017, available at www.politico.com. 19 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 20 Please see BCA Energy Sector Strategy and Geopolitical Strategy Special Report, "King Salman Goes To Moscow, Bolsters OPEC 2.0," dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see "Mideast War, By The Numbers," Associated Press, August 17, 2006, available at www.washingtonpost.com. 22 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," dated October 19, 2017, available at ces.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com.

We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. We cited a soft U.S. dollar, firming demand, constrained supply growth and still-compelling valuations as reasons to go overweight; these have started to move in our favor, signaling more upside ahead. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (second panel). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, the rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher (third panel). Valuations have ticked up recently but on a price to book and price to sales basis, energy stocks still sport compelling multiples (bottom panel). Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Please see yesterday's Weekly Report for more details. A Burst Of Energy? A Burst Of Energy? Content

Highlights Portfolio Strategy Rising oil prices, a weakened U.S. dollar, ongoing global oil producer discipline and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Wide crack spreads, sticky price hikes and sustained inventory drawdowns are a harbinger of more gains in the S&P refiners sub-index. Recent Changes There are no changes to our portfolio this week. Table 1 Invincible Invincible Feature Equities plowed higher last week, as earnings growth continues to surprise to the upside and synchronized global growth alongside fiscal easing remain the key macro themes. Over 81% of the companies have now reported earnings, with EPS growth pushing the Q3 blended figure to 8.0% on the back of 5.2% revenue growth. Last quarter's margin expansion is in line with the S&P 500's historical operating leverage of 40%.1 In the context of synchronized global growth macro backdrop, we have been adding deep cyclical exposure to our portfolio at the expense of defensives over the past few months, participating in the SPX's march higher. A simple manufacturing versus services indicator, comparing ISM manufacturing with ISM non-manufacturing, suggests that not only are there more gains ahead for the broad market, but cyclicals will also continue to outpace defensives (Chart 1). When the most cyclical part of the U.S. economy is flexing its muscle, typically a capex upcycle sustains the self-reinforcing earning upsurge. In mid-October2 we posited that such an investment boom will be the dominant macro theme next year. While this theme continues to fly under the radar, our confidence of a durable and broad-based capital spending cycle notched higher following the recent Q3 real GDP print. Table 2 shows the evolution of real GDP, real capex growth and real capex contribution to real GDP growth over the last year. CEOs are voting with their feet and making the longer-term oriented investment decisions as animal spirits are lifting, despite a very slow moving Washington, D.C. Chart 1Most Cyclical Part Of##br## U.S. Economy Is Flexing Its Muscle Most Cyclical Part Of U.S. Economy Is Flexing Its Muscle Most Cyclical Part Of U.S. Economy Is Flexing Its Muscle Table 2Evolution Of GDP ##br##And Capex Growth Invincible Invincible Chart 2 depicts these data on a longer time horizon. There are high odds that capital outlays will remain upbeat if BCA's view of a tax bill passage materializes3 in the next 6 months with some of the money making its way toward investment, sustaining the virtuous cycle. Were the GOP's tax plan to pass and allow businesses "to immediately write off the full cost of new equipment", then almost certainly CEOs will embark on a capex binge. Importantly, similarly to the synchronized global growth macro backdrop, there is a synchronous capex upcycle brewing. The top panel of Chart 3 shows our equal-weighted real gross fixed capital formation composite of 23 DM and EM countries using national accounts alongside our diffusion index. Our Global Capex Composite has stabilized, but more importantly the diffusion index (percentage of countries with an improving year-over-year capex) is showcasing a coordinated global capex recovery. Chart 2Capex... Capex… Capex… Chart 3...Is Growing Globally …Is Growing Globally …Is Growing Globally True, DM capex is more advanced than EM capex, but the V-shaped recovery in corporate profitability nearly guarantees a pickup in capital outlays in the coming quarters (middle and bottom panel, Chart 3). Another way we show this simultaneous global capex upcycle is the color coded map in Table 3, with green denoting an expansion in year-over-year real capex, and red a contraction. Green is taking over the table (please click here if you would like to receive this table with more details from our client services department). Table 3Synchronized Global Capex Growth Invincible Invincible Encouragingly, this is not only a national accounts reported capex phenomenon, but is also borne out by stock market reported data. Using Datastream-compiled stock market reported data, Charts 4, 5, & 6 show capital expenditures growth around the globe covering a number of DM and EM. Similar to our mid-October analysis, we advance operating earnings by one year, and investment should follow profit growth higher in the coming quarters underpinning the virtuous cycle. Chart 4Virtuous... Virtuous… Virtuous… Chart 5...Global Capex... …Global Capex… …Global Capex… Chart 6...Upcycle …Upcycle …Upcycle The implication of this synchronous capex growth backdrop is that high operating leverage deep cyclicals will dominate defensives next year and we reiterate our recent preference of cyclical versus defensive sectors. This week we update a deep cyclical sector we continue to overweight, and highlight one niche subcomponent. A Burst Of Energy? We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. While this was a timely upgrade, we still believe there is more room for additional relative gains in the coming months. All the reasons we cited during our summer upgrade call4 have started to move in our favor, signaling more upside ahead. Namely, the U.S. dollar remains down significantly for the year (Chart 7) and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (Chart 8). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. Chart 7Weakened U.S. Dollar Is Bullish Energy Weakened U.S. Dollar Is Bullish Energy Weakened U.S. Dollar Is Bullish Energy Chart 8Catch Up Phase Catch Up Phase Catch Up Phase On the supply front, both the overall U.S. oil & gas and horizontal only rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. As global oil inventories get whittled down and OPEC stays disciplined oil prices will remain well bid. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher. The implication is that the relative share price advance is still in the early innings (Chart 9). Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. On a price to book, prices to sales and price to cash flow basis energy is trading at a 40%, 30% and 5% discount, respectively, to the broad market. The recent carnage in EPS skews the results with the energy sector trading at a 47% forward P/E premium to the overall market (Chart 10). Our Technical Indicator has also tentatively troughed. Historically once the one standard deviation below the historical mean level gives way, a sling shot recovery ensues (Chart 10). Finally, the budding recovery in energy earnings remains intact and our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline (Chart 11). Chart 9Oil Inventory Drawdown = Buy Energy Stocks Oil Inventory Drawdown = Buy Energy Stocks Oil Inventory Drawdown = Buy Energy Stocks Chart 10Compelling Valuation Backdrop Compelling Valuation Backdrop Compelling Valuation Backdrop Chart 11EPS Model Is Still Flashing Green EPS Model Is Still Flashing Green EPS Model Is Still Flashing Green Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintain an above benchmark allocation in the S&P energy index. Bottom Line: We reiterate our early-July S&P energy sector upgrade to overweight. Refiners Are Heating Up In the summer we lifted the S&P oil & gas refining & marking index to neutral from underweight locking in impressive gains and that tilted our overall S&P energy sector exposure to above benchmark.5 Subsequently in early-September we further augmented exposure in this pure play energy downstream index to overweight.6 Since then, relative performance is up over 8%. Is it time to book profits? The short answer is not yet. While these relative gains are impressive in such a short time span, we are staying patient before monetizing them, as leading indicators of refiners' profits continue to flash green. Our thesis in September was that the Hurricane Harvey catastrophe presented a trading opportunity from the long side for the S&P refining index. Not only did production get substantially curtailed, but also, as a result, inventories gave way. The longer the disruption, the sweeter the profit spot for the refining industry, as only higher industry selling prices could bring the market back to equilibrium. Indeed, the Brent/WTI crude oil spread, a great proxy for refining margins, recently vaulted to $8/bbl, the highest since early-2015 (Chart 12). Refining margins and gasoline prices also jumped to multi-year highs. While the industry has recovered since the hurricane devastation and brought production back online, selling price inflation is proving sticky, which is a boon for industry margins and thus profits. Already, this earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (Chart 13). Looking closer at the inventory backdrop, the refined product drawdown is ongoing. From the early 2017 peak, gasoline and distillate fuel supplies have collapsed by roughly 100mn bbl (inventories shown inverted, top panel, Chart 13). In particular, gasoline stocks are now contracting at 5% per annum (inventories shown inverted, middle panel, Chart 13). Historically, industry inventory accumulation has been weighing on relative share prices and vice versa. Evidently, the market has yet to reach an equilibrium, which is a boon for refining profits and relative share prices. Finally, following the collapse in refined product net exports as refiners focused on primarily fulfilling domestic demand, net exports have jumped back to all-time highs near 3mn bbl/day. This represents an over 6mn bbl/day swing in net exports over the past decade (bottom panel, Chart 14). A weak U.S. currency coupled with the higher prices oil products fetch abroad should continue to underpin exports and represent another sizable avenue for industry profits. Chart 12Too Early To##br## Lock In Profits Too Early To Lock In Profits Too Early To Lock In Profits Chart 13Decreasing Refined Product ##br##Stocks Are A Boon For Refiners Decreasing Refined Product Stocks Are A Boon For Refiners Decreasing Refined Product Stocks Are A Boon For Refiners Chart 14Export Relief ##br##Valve Reopened Export Relief Valve Reopened Export Relief Valve Reopened Netting it out, it is still too soon to take profits on the S&P oil & gas refining & marketing index. Refined product inventories continue to fall, crack spreads are wide and industry price hikes are sticky. This is a fertile profit margin and EPS backdrop, underscoring that the path of least resistance is higher for relative share price, at least until an equilibrium is reached. Bottom Line: Stay overweight the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," dated April 17, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 5 Ibid. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Still Goldilocks," dated September 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Overweight We lifted refiners to overweight in mid-September as the pricing environment looked set to improve dramatically, driven by Hurricane Harvey-related refinery shutdowns and the resulting inventory drawdowns, boosted by an accelerating Brent/WTI spread. This view has largely played out as expected; inventories have declined steeply (second panel), the Brent/WTI spread has remained relatively wide (third panel), margins have been grinding higher and the refiners index has been outperforming (first panel). This earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (fourth panel). This should presage stock price strength on the back of strong earnings and a valuation re-rating; stay overweight the refiners index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Refiners Rally Not Cracking Yet Refiners Rally Not Cracking Yet

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Exceptionally Strong Sentiment… Exceptionally Strong Sentiment… Chart 2...Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Industrial Conglomerates: Rebooting Industrial Conglomerates: Rebooting Chart 4U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index GE Still Dominates The Index GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Energy Services Is A Bright Spot Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Valuations Are Not Compelling Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com