Oil

Highlights Global GDP growth estimates from the OECD point to a stronger recovery in oil demand than markets are pricing in at present (Chart of the Week).  Our forecast for Brent remains at $46/bbl for 2H20 and $65/bbl on average for 2021. Global trade data – particularly EM import volumes, which are highly correlated with income (GDP) – remain supportive, as does monetary policy, particularly out of the US, EU and China.  Doubt surrounds the US Congress’s determination to extend the fiscal support that underpins many households’ and firms’ budgets, but we expect a deal. Aggregate demand uncertainty remains high.  COVID-19 infections are increasing globally.  However, death rates appear to be trending lower, which likely will keep lockdowns localized. On the supply side, the leaders of OPEC 2.0 – Saudi Arabia (KSA) and Russia – continue to insist on full adherence to agreed production levels among member states.  This carries an implicit threat the leadership may be willing to flood the market with oil to remind the laggards of the consequences of cheating, which would hit non-Gulf OPEC members particularly hard. Longer term, sharp reductions in capex point to higher prices in the mid-2020s. Feature Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared. Realized oil demand continues its V-shaped recovery, in line with rising GDP in the wake of the COVID-19 pandemic. Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared, and that growth could be stronger in 2021 than earlier anticipated, as seen in the Chart of the Week.1 The OECD is expecting global GDP growth to contract 4.5% this year vs. its June estimate of a 6% decline. The World Bank’s forecast of a 5.2% contraction in global GDP this year drives our oil-demand estimate, so the OECD’s estimate is more bullish for oil demand. Incoming data for EM import volumes suggest income is on track to recover by year-end or early 2021 in developing and emerging markets (Chart 2). EM import growth is driven by income growth; EM demand is the most important driver of global oil-demand growth. Chart of the WeekOECD Raises Global Growth Estimates Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Chart 2EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path Growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. For next year, the OECD expects global growth to expand at a 5% rate vs. the World Bank’s 4.2% rate. We are awaiting the Bank’s updated income (GDP) estimates before revising our oil demand estimates. We already show EM oil demand, proxied by non-OECD consumption, recovering to pre-COVID-19 levels by the middle of next year, while DM demand flattens at a lower level (Chart 3). A confirmation of better-than-expected growth – particularly from EM economies – would move our expectation of a full recovery in EM oil-demand into 1H21 and could push DM demand up slightly. Chart 3EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 Chart 4COVID-19 Infections Rising, But Death Rates Are Falling Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery These growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. This perforce makes any bullish demand recovery suspect. For the present, while COVID-19 infections are rising, death rates appear to be trending lower recently (Chart 4). If, as appears to be the case, a vaccine for the virus is approved later this year or in early 2021, markets likely would re-orient to discounting the time at which it is available globally to estimate a demand-recovery vector. Our estimate of the global oil-demand loss for this year is slightly larger than last month – -8.15mm b/s vs. -8.1mm b/d in August (Table 1). The US EIA and IEA also increased their estimates of 2020 global demand loss slightly this month as well, to -8.3mm b/d and -8.4mm b/d, respectively. OPEC once again is an outlier – albeit a very important source of information – in expecting a loss of -9.5mm b/d of demand this year. For 2021, we expect demand to grow 7.3mm b/d, vs. 6.5mm b/d from the EIA. OPEC expects oil-demand growth of 6.6mm b/d next year vs. last month’s forecast of 7mm b/d. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery OPEC 2.0 Production Discipline Holds Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. OPEC 2.0 continues to manage member-states’ output effectively. Compliance with the production cuts agreed by OPEC 2.0 remained strong in August – at 102%, based on OPEC’s calculations. The group’s production cut will be reduced to 5.8mm b/d starting in January 2021 from 7.7mm b/d currently (Chart 5). At its September 17 meeting, the coalition’s Joint Ministerial Monitoring Committee (JMMC) reiterated the importance of all countries complying with the agreed cuts, and recommended the so-called “compensation period” for underperforming countries failing to meet their production cuts be extended to the end of December 2020. This is meant to keep production below demand in 4Q20. For 2021, we continue to expect the group will accommodate higher demand growth by gradually increasing production beyond the currently planned January increase in quotas. This will limit the rise in prices, and will keep them below $70/bbl (Chart 6). Chart 5OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... Chart 6... And Continues To Support Prices ... And Continues To Support Prices ... And Continues To Support Prices Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. KSA and Russia are making it abundantly clear in their public remarks they intend to keep the pressure up on the rest of OPEC 2.0 to move prices higher – their budgets have been hammered by the COVID-19 pandemic, after just starting to recover from the 2014-16 market-share war launched by OPEC when the pandemic hit earlier this year.2 Even in the current relatively low-price environment, KSA imposed a value-added tax (VAT) and is paring back social spending, while Russia is signaling it will increase in taxes on oil producers and metals companies and others to raise revenues.3 In the US, we believe most of the previously shut-in wells have been brought back on line. In our modeling, we marginally reduced OPEC 2.0’s production increase in this month’s forecast due to the slight downward revisions in demand. We now expect the group to increase its production to ~ 45mm b/d by December 2021, vs our previous expectation of ~ 46mm b/d. In our lower-demand scenario, which is driven by OPEC’s 2020 and 2021 demand estimates, we estimate prices would peak at ~ $50/bbl next year when keeping OPEC 2.0’s production unchanged vs. our base case. However, without the strong upward demand pressure, we believe OPEC 2.0 will keep its 5.8mm b/d production cuts in place for most of 2021 and that KSA, and to a lesser extent Russia, will push for strict production discipline at that level. This is sufficient to move prices close to $60/bbl on average in our lower-demand scenario in 2021 (Chart 7). Securing additional production cuts – to push average prices to $65/bbl as in our base case – from other OPEC 2.0 member states, including Russia, would be a difficult task. Chart 7Lower-Demand Price Scenarios Lower-Demand Price Scenarios Lower-Demand Price Scenarios Chart 8Falling US Rig Counts … Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery In the US, we believe most of the previously shut-in wells have been brought back on line. Going forward, legacy production declines rates will push onshore production down as new production from new completed wells remains below the level required to keep production flat (Chart 8). We expect production will bottom in June 2021 at ~ 8.1mm b/d before slowly moving up in 2H21 (Chart 9). The small uptick in production will come mainly from the completion of drilled-but-uncompleted (DUC) wells in the US shales, which expand and contract with the level of drilling activity, and function as a ready source of incremental lower-cost supply (Chart 10). DUCs will provide a cheap source of new production. We expect producers will begin developing this source of supply during the first half of next year, as the only expense left to bring oil to market from them are completion costs. Chart 9… And Falling US Production ... And Falling US Production ... And Falling US Production Chart 10Expect DUCs To Be Developed In 2021 Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery   Oil’s Capex Dilemma The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The combination of OPEC 2.0’s low-cost production and high spare capacity; parsimonious capital markets and the growing appeal of ESG-driven investment decisions; and concerns over peak oil demand will continue to limit funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.4 Consequently, new oil production in non-OPEC countries risks falling below the level needed to cover legacy wells’ decline rates, which we estimate at ~ 8% for non-OPEC ex-US shale production. This will be mostly apparent in The Other Guys – our moniker for all producers excluding Gulf OPEC, US shales, Canada, and Russia – which account for ~ 40% of global oil supply. In our view, the decline rates of The Other Guys currently are being overlooked, while the prospect of so-called “peak oil demand” is receiving a disproportionate amount of attention, and could be discouraging needed investment in new E+P. Keeping production flat in The Other Guys and US onshore production will require ~ 7mm b/d of new oil production between 2022 and 2025 (Chart 11). In the US, most of the added upstream capex will be dedicated to replacing legacy production declines. The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The sluggish rebound in capex could remove another 2-4mm b/d. According to IHS Markit, for supply to meet the expected demand over the next 5 years, close to $4.5 trillion in capex and opex is needed. The capital-constrained Other Guys’ supply growth, and a similar paucity of funding in the US and Canada will barely suffice to offset the decline rates in non-OPEC producing countries. This implies OPEC 2.0’s role will increase over the coming years as its spare capacity – which allows the group to move production to market more rapidly than shale producers – and ability to grow its productive capacity at low costs will disincentivize investments in major oil projects outside of these regions. Chart 11"The Other Guys" Production Remains In Decline Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Investment Implications We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. In the near term, the recent upgrade in global GDP growth estimate from the OECD points to a stronger-than-expected recovery in oil demand, owing largely to massive fiscal and monetary support around the world. We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. As a result, we expect markets to continue to tighten (Chart 12), and for inventories to continue to draw this year and next (Chart 13). Chart 12Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Chart 13... And Storage Will Continue To Draw ... And Storage Will Continue To Draw ... And Storage Will Continue To Draw We will continue to monitor growth estimates, but for the present, we are keeping our forecast for Brent at $46/bbl for 2H20 and $65/bbl on average for 2021. WTI will trade $2 - $4/bbl below Brent over this time. Longer term, producers outside the core OPEC 2.0 states are being starved for capital. The combination of continued production discipline and a paucity of capital available for producers outside this coalition are pointing toward a lower rate of supply growth going forward.    Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight  The recent announcement by Eastern Libyan commander Khalifa Haftar that the LNA would lift its blockade on oil output for a month does not meaningfully impact our previous Libyan oil production forecast. We continue to forecast a gradual recovery in the country’s production to 600k b/d and 900k b/d by December 2020 and 2021 (Chart 14). The news signals production could resume at a slightly higher pace than in our forecasts. However, we still believe risks to an export recovery are elevated, as the underlying conflicts in the country remain unresolved. Thus, we are keeping our projections largely unchanged (see Table 1). Base Metals: Neutral  World copper markets ended 1H20 with an apparent refined copper deficit of 278k MT, after adjustments for changes in Chinese bonded stocks. according to the International Copper Study Group. World ex-China refined copper usage declined ~ 9%, led by declines of 12% in Japan, 10% in the EU and ~ 8% in Asia (Ex-China). A 31% increase in net refined copper imports lifted Chinese apparent usage 9% offsetting, which offset declines in the rest of the world (Chart 15). China accounts for ~ 50% of refined copper consumption and ~ 40% of refined copper production. Precious Metals: Neutral  The sell-off in silver took prices below our trailing stop of $26/oz, leaving us with a gain of 40.5% since inception July 2, 2020. Our views for silver and gold remain positive, as the Fed continues to signal it will look through any pick-up in inflation, which we believe will keep real rates in the US low for the foreseeable future, and lead to a weaker USD. Ags/Softs:  Underweight  Soybean and corn futures paired back their gains, falling roughly 3.5% since last week. The USDA crop progress report for the week ending September 21, 2020, indicated that the deterioration in the condition of soybean and corn crops has stalled. The sharp rise in the US dollar Index has been another headwind. Given these factors and the precarious level of current prices, we recommend staying underweight agricultural products at this juncture.    Chart 14LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND Chart 15Strong Chinese Copper Imports Strong Chinese Copper Imports Strong Chinese Copper Imports       Footnotes 1     Please see OECD Interim Economic Assessment, “Coronavirus: Living with uncertainty,” published September 16, 2020.   2     Following the JMMC meeting, Saudi Energy Minister Prince Abdulaziz bin Salman Al-Saud said OPEC 2.0 could hold an extraordinary meeting to address weaker demand, and warned traders against shorting the market.  Please see Saudi energy minister warns oil price gamblers ‘make my day’ published by aljazeera.com September 17, 2020. 3    Please see KSA VAT rate to increase to 15% from 1 July 2020 published by Deloitte Touche Tohmatsu Limited July 1, 2020.  See also Russian lawmakers give initial nod to hefty tax hike for mining, oil published by reuters.com September 22, 2020. 4    We opened our examination of the longer-term consequences of the contraction of supply growth last week in Oil's Next Bull Market, Courtesy Of COVID-19.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control

Highlights If it can maintain production discipline over the next 2-3 years, OPEC 2.0 will be the oil market’s most important determinant of price levels for years. The massive increase in OPEC 2.0 spare capacity resulting from COVID-19-induced demand destruction, along with its low-cost production, global storage and distribution will allow it to bring crude to market quicker than US shale-oil producers, and to manage an orderly drawdown in global inventories, which remains its raison d'être.  As spare capacity is drawn down over the next couple of years, Brent and WTI forward curves will backwardate in in 1H21, as spare capacity and the slope of the forward curve are inversely related (lower spare capacity leads to higher backwardation). This will keep spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge (Chart of the Week). Parsimonious capital markets will continue to deny funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.  ESG-focused investments will increasingly favor energy producers outside the oil and gas sector.  As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s. We will be updating our oil balances and 2H20 and 2021 forecasts – $46/bbl and $65/bbl for Brent in 2H20 and 2021 – next week.  Feature While the hit to oil producers’ revenues from the demand destruction caused by the COVID-19 pandemic has been severe – particularly for those states comprising OPEC 2.0, which are so heavily dependent on oil exports – it set the stage for the producer coalition to take control of global oil-price dynamics for the next couple of years. If the OPEC 2.0 coalition can maintain its production discipline, its member states could extend this control for years into the future, just as they are attempting to diversify their economies from this dependence on hydrocarbons. Once OPEC 2.0 member states manage to diversify a large part of their economies, the next optimal strategy will be to monetize their reserves and market share. Until then, it is our contention it is in these states' interest to have higher prices via gaining control of supply. The producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia today sits on some 7mm b/d of spare capacity that is a direct result of the global collapse in demand. This gives it a powerful lever to restrain the recovery of production growth in the US shales and elsewhere. Spare Capacity Turns The Tables On Shale Oil The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US Since its inception in late 2016, OPEC 2.0 has accommodated higher US shale production by reducing its output and then expanding it at a slower rate, as US production soared to meet domestic demand and, increasingly, global oil demand (Chart 2). OPEC 2.0 has been in operation since January 2017. Over that period, the coalition reduced its output growth ~ 0.37% for every 1% increase in crude and liquids output ex-OPEC 2.0. Within that adjustment, OPEC 2.0’s output falls by 0.16% for every 1% increase in US output, most of which was accounted for by the unprecedented growth of shale production.1 The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US (Chart 3). Chart of the WeekFalling OPEC 2.0 Spare Capacity Will Backwardate Brent Forward Curves Falling OPEC 2.0 Spare Capacity Will Backwardate Brent Forward Curves Falling OPEC 2.0 Spare Capacity Will Backwardate Brent Forward Curves Chart 2OPEC 2.0 Accommodated US Shales OPEC 2.0 Accommodated US Shales OPEC 2.0 Accommodated US Shales Chart 3OPEC 2.0 Would Benefit From Maintaining Spare Capacity At High Levels OPEC 2.0 Would Benefit From Maintaining Spare Capacity At High Levels OPEC 2.0 Would Benefit From Maintaining Spare Capacity At High Levels Along with its low-cost production, global storage and distribution, this spare capacity allows OPEC 2.0 member states to bring crude to market quicker than US shale-oil producers as the need for additional supply becomes apparent. This was demonstrated earlier this year by KSA when it engaged in a brief market-share war with Russia following the breakdown of negotiations to extend OPEC 2.0’s production cuts.2 The spare capacity also allows the coalition to manage an orderly drawdown in global inventories, which remains its raison d'être, by making crude available out of production on short notice. As a result, Brent and WTI forward curves will backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. By keeping forward curves backwardated, the amount of revenue – i.e., price x quantity – hedged is limited by lower forward prices vs. spot prices. This limits the volume of oil a producer can bring to market in the future. Extending OPEC 2.0’s Low-Cost Spare Capacity In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales. The advantage OPEC 2.0 realizes from holding spare capacity – KSA in particular – can be extended at low cost going forward.3 And, if OPEC 2.0 communicates its intent to maintain spare capacity at higher levels than have prevailed recently, as was indicated last week by Aramco’s CEO, who announced KSA intends to raise capacity 1mm b/d to 13mm b/d, this could, at the margin, disincentivize investment in production ex-OPEC 2.0 in the future.4 Developing spare capacity for low-cost producers like Aramco is akin to building a portfolio of deep-in-the-money options to increase output quickly at minimal expense. These options can be exercised – i.e., output can be increased in short order at low cost – before competitors can mobilize to meet the market need. What makes this strategy credible is KSA’s capacity to surge production and put oil on the water in VLCCs at astonishing speed, as noted above vis-à-vis the breakdown in negotiations earlier this year in Vienna to extend production cuts. In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales (Chart 4). This will allow them to begin rebuilding revenues sooner as demand recovers (Chart 5). Any demand increase in excess of OPEC 2.0’s flowing supply – which could be restrained to force refiners to draw storage (Chart 6) – can be met with spare capacity and storage held or controlled by coalition members. Chart 4OPEC 2.0 Supply Recovers Faster Than US Shales OPEC 2.0 Supply Recovers Faster Than US Shales OPEC 2.0 Supply Recovers Faster Than US Shales Chart 5Rate Of Demand Growth Will Exceed Supply Growth Rate Of Demand Growth Will Exceed Supply Growth Rate Of Demand Growth Will Exceed Supply Growth Chart 6Forcing Inventories Lower Forcing Inventories Lower Forcing Inventories Lower Capital-Market Parsimony Will Tighten Supply Equity investors have abandoned the oil and gas sector, as can be seen in the collapse in the percentage of the overall market accounted for by energy stocks (Chart 7). Chart 7Energy Share Of Overall Market Collapses Energy Share Of Overall Market Collapses Energy Share Of Overall Market Collapses This no doubt is fueled by underperformance vs. technology stocks and other alternatives available to investors, and to a migration toward Environmental, Social, and Corporate Governance (ESG) investing (Chart 8). Indeed, as our colleagues in BCA’s Global Asset Allocation Strategy noted, “ESG-related equities have outperformed global benchmarks over the past two years, as well as during the recent equity selloff.” In addition, “green energy” investments account for half of the $300 billion G20 governments have allocated to clean energy policies and renewable energy programs as part of the COVID-19 fiscal stimulus deployed worldwide.5 Chart 8ESG Investment Surge Oil's Next Bull Market, Courtesy Of COVID-19 Oil's Next Bull Market, Courtesy Of COVID-19 We believe this combination of a long-standing aversion to oil and gas equities and OPEC 2.0’s clear advantage in terms of its spare capacity, low-cost production and global storage and distribution networks will result in under-funding of new E+P, and will lead to a tighter market by the mid-2020s. This is particularly true for oil, which, is not confronting the competitive threat faced by natural gas vis-à-vis renewable energy. We will continue to develop these themes, and subject this thesis to fiery critique, borrowing from Kant’s methodology.6 Risks To Our View There are two major risks to the thesis developed here: OPEC 2.0 breaks down, as it came close to doing earlier this year (discussed above).  A breakdown of the coalition would lead to lower E&P investment via very low oil prices that almost surely would occur if this were to happen. This would be a far more volatile path to higher prices, which also would discourage investment. A battery-technology breakthrough that makes electric vehicles viable – i.e., unsubsidized – competitors to internal-combustion engine technology powering the vast majority of transportation. We expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Bottom Line: OPEC 2.0’s massive spare capacity resulting from COVID-19-induced demand destruction, its low-cost production and global storage and distribution network allow it to take control of crude-oil pricing dynamics over the next couple of years. These endowments also allow it to orchestrate an orderly drawdown in global inventories, which remains its raison d'être. As a result, we expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Parsimonious capital markets and a preference for ESG-focused investment will increasingly favor energy producers outside the oil and gas sector. As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight JKM and TTF natural gas prices are up 49% and 27% over the past four weeks. The price spreads for December 2020 futures contracts between the US and Europe and Asia reached $1.6/MMBtu and $1.9/MMBtu this week. This will support the ongoing recovery in US LNG exports – which was briefly halted last month by Hurricane Laura – during the coming winter season (Chart 9). Separately, Libyan oil exports could be set to rebound following statements by General Haftar – the leader of Libyan National Army (LNA) – that he was committed to lifting the current blockade on the country’s exports, according to the US Embassy in Libya. Base Metals: Neutral China’s expansionary monetary and fiscal stimulus continued in August. The country’s total social financing (TSF) climbed past market expectations of CNY 2.59 trillion to CNY 3.58 trillion (Chart 10). This will provide further support to base metals prices – chiefly copper – over the coming months. The increase in TSF reflects the strong local government bond issuance and reinforces our view that the recovery in copper prices will be policy-driven – i.e. dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in its economy with domestic supply adjusting to demand. Precious Metals: Neutral Palladium prices are up 7% since the beginning of September, supported by rebounding car sales and production in China. In August, vehicle sales grew by 12% y/y. We expect fiscal and credit stimulus in the country will allow car sales to continue growing y/y in the coming months. Ags/Softs:  Underweight Soybean prices remain strongly bid, looking to re-test 2018 highs. The latest weekly USDA crop progress report indicated continued deterioration in the number of soybean crops in good or excellent condition. Investor sentiment is fueled by China maintaining its promise to import record amounts of U.S. agricultural goods this year, as part of the Phase 1 trade deal. Last week, the U.S. Agriculture Department reported that Chinese buyers booked deals to buy 664,000 tonnes of soybeans, the largest daily total since July 22.  Chart 9LNG LNG LNG Chart 10COPPER PRICES COPPER PRICES COPPER PRICES       Footnotes 1     These estimates were generated by an ARDL model used to determine the sensitivity of OPEC 2.0 total liquids output to non-OPEC 2.0 production and consumption.  2     For a recap of this market-share war, please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020.  It is available at ces.bcaresearch.com.  Briefly, KSA put millions of barrels on the water in a matter of months after Russia launched its market-share war at the end of OPEC’s March 2020 meeting in Vienna.  This demonstrated an ability to mobilize supply and deliver it that greatly surpassed the eight-month time frame we estimate is required for shale production to reach the market after prices signal the need for additional crude. 3    Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by The King Abdullah Petroleum Studies and Research Center (KAPSARC) July 17, 2018, for a discussion of the global impact of KSA’s spare capacity. 4    Please see Aramco CEO: Saudi Arabia to raise oil production capacity to 13 million barrels per day published by Oil & Gas World Magazine September 9, 2020. 5    Please see ESG Investing: From Niche To Mainstream, published by BCA’s Global Asset Allocation Strategy August 25, 2020.  It is available at gaa.bcaresearch.com. 6    Please see O’Shea, James R. (2012), “Kant’s Critique of Pure Reason, An Introduction and Interpretation,” Acumen Publishing Limited, Durham, UK.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control

Highlights Oil-price volatility will remain subdued as markets correctly downgrade measurable risks on the supply side and upgrade financial conditions supporting demand (Chart of the Week). OPEC 2.0’s spare capacity – ~ 7mm b/d – presents the producer coalition with an opportunity to gain control of the evolution of global supply, and to restrain price volatility as global storage levels fall. Scaling production and delivery of a COVID-19 vaccine will be challenging, given limited global production and distribution capacity.1 This will slow down – but not derail – a recovery in demand. Lingering policy uncertainty will restrain a speedy return to pre-COVID-19 demand levels. Looming large are US election uncertainty and mounting geopolitical tensions. Our forecast attaches a significantly higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market is discounting in options for December 2021 delivery. Feature As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand. Oil-price volatility will remain subdued, as market participants correctly price in continued OPEC 2.0 production discipline and cohesion within the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. In addition, the coalition’s substantial spare capacity – ~ 7mm b/d, most of which is in KSA – will, as we have argued elsewhere, present OPEC 2.0 with an opportunity to influence production moreso than in pre-COVID-19 markets: It will be able to respond to higher prices quicker than US shale oil producers, as was demonstrated in 2018 when KSA took its production from less than 10mm b/d to 11.1mm b/d between June and November (Chart 2). This means OPEC 2.0 can move quickly to capture economic rents, which will slow the recovery of the shales – already limited by parsimonious capital markets – and increase OPEC 2.0’s global market share (Chart 3).2 Chart of the WeekVol Falls As Known Unknowns Are Resolved Vol Falls As Known Unknowns Are Resolved Vol Falls As Known Unknowns Are Resolved Chart 2OPEC 2.0 Quick Response Spare Capacity Advantage OPEC 2.0 Quick Response Spare Capacity Advantage OPEC 2.0 Quick Response Spare Capacity Advantage Chart 3Ensures Production Restraint Ensures Production Restraint Ensures Production Restraint As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand (Chart 4). We expect the US Federal Reserve’s monetary policy, which will now focus on reviving the labor market and on achieving a 2% average PCE index core inflation rate, to weaken the USD, which also will be supportive of oil demand.3 Demand also will be supported by expectations – and the realization – of a COVID-19 vaccine, which is expected later this year or early next year. Limited production and logistical constraints will make it difficult to scale delivery of a vaccine globally until infrastructure is built out. This will restrain – but not derail – the recovery in demand we expect (Chart 5). Lingering policy uncertainty – particularly around the upcoming US elections and mounting geopolitical tensions – remain obstacles for the recovery. Chart 4Global Financial Conditions Will Support Demand Global Financial Conditions Will Support Demand Global Financial Conditions Will Support Demand Chart 5Demand Expected To Recover Smartly Demand Expected To Recover Smartly Demand Expected To Recover Smartly Well-managed supply, coupled with steadily improving demand already apparent in the data, will allow storage to draw over the next year without raising oil-price volatility, which typically occurs when spare capacity is low (Chart 6).4 Chart 6Falling Storage Will Not Spike Vol This Time Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Oil Vol Will Stay Lower Volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market. As the Chart of the Week indicates, a surge in volatility caused by either a supply or demand shock typically is followed by a more tranquil period after markets adjust to the shock. These volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market.5 Following the resolution of the elevated risk conditions prompting the increased option trading, historical volatility, which is calculated using the annualized returns of the underlying assets, typically increases then tails off, as can be seen in the experience of 2019-20 – i.e., pre- and intra-COVID-19 markets (Chart 7). Chart 7Implied Vol Typically Leads Realized Vol Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities. Increases in oil-price volatility also are accompanied by heightened interest in news specific to oil markets or OPEC. Market participants usually expect OPEC countries will adjust output as needed following swift changes in underlying global demand – e.g., the COVID-19 demand shock – and non-OPEC supply. Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities in expectation of supply adjustments from OPEC (Chart 8). The relationship actually has strengthened since 2014, following OPEC’s market-share war and the ensuing OPEC 2.0 agreement to drain the accumulated global oil inventories. Since its formation, OPEC 2.0 has played a crucial role in balancing oil markets. This makes every meeting highly relevant for markets. Moreover, when oil prices move abruptly, internet searches for “OPEC” or “OPEC MEETING” generally move higher as investors seek guidance from the producer coalition to assess where prices will go next. High levels of speculation can affect oil price volatility. Hence, the higher the interest in oil prices from retail and institutional investors, the larger the increase in implied volatility ahead of these meetings.6 Chart 8Implied Vol Follows Google Search Activity Implied Vol Follows Google Search Activity Implied Vol Follows Google Search Activity Implied Volatility And Efficient Markets Implied volatility, like prices discovered in competitive trading markets, impounds all information available to market participants buying and selling options. As it is an estimate of the standard deviations of returns for the underlying asset against which options are traded, it can be used to estimate the probability market participants assign to the realization of a particular price outcome (Chart 9). As an be seen in Chart 9, the market is pricing more in line with the US EIA’s expectation Brent prices will average $50/bbl next year, as opposed to our estimate of $65/bbl. Based on the settlement values for prices and volatilities on Monday, the December 2021 Brent futures contract has a 15% probability of expiring above $65/bbl (Chart 10). Chart 9Markets Pricing To EIA Assumptions Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Chart 10BCA Price Forecasts Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Investment Implications Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. Our econometric modeling gives us a higher expected value for Brent prices next year than what markets currently are pricing in, based on our assessment of the distributions derived from option implied volatilities. This means the cost of gaining exposure to the upside in the Brent market next year is low, relative to our expected value, as vol drives option prices. We remain long 2H21 Brent vs. short 2H22 Brent given our expectation. We also will be looking for opportunities to get long call options or option spreads in 2H21. Bottom Line: OPEC 2.0’s spare capacity of ~ 7mm b/d (OPEC + Russia and its allies spare capacity), will allow it to gain control of global supply growth, and to manage price volatility as global storage levels fall. Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. We remain long Brent exposure next year and look for opportunities to buy calls and call spreads.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices remain in the $40/bbl to $46/bbl range in which it had been trading since mid-June. The Fed’s shift to an average inflation targeting regime makes inflation expectations an increasingly important variable to its monetary policy decisions. This implies commodities – oil in particular – will have a larger effect on interest rates due to their crucial influence on market-based inflation expectations (Chart 11). Base Metals: Neutral The LMEX and copper prices rose 5% and 6%, respectively, in August, supported by rising global manufacturing PMIs. At first glance, China’s manufacturing PMI disappointed last month as it fell to 51 from 51.1 in July. However, the underlying recovery in its industrial sector remains in place according to our China Investment strategists. The New Orders and Export Orders components of the index increased, indicating the demand-side of the economy is picking up. Metals’ prices also continued being supported by further declines in the US dollar index. The USD index ended the month of August below the upward trend line that has supported its lows since 2011.7 Precious Metals: Neutral Gold and silver prices are up 2% and 5%, respectively, since Jerome Powell’s Jackson Hole speech. According to our US and Global Bond strategists “The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past.”8 Consequently, precious metals will benefit from a lower dollar and a prolonged period of depressed interest rates. The Fed’s decision also increased gold’s attractiveness as an inflation hedge. Ags/Softs:  Underweight Soybean prices have rallied to their highest level since June 2018 (Chart 12). Crops were affected by droughty weather in the Midwest during August. The Crop Progress report listed 66% of soybeans in good or excellent condition, compared with 73% of soybeans in those categories at the beginning of the month. Strong demand from China has been supportive of prices. According to the data, for the 2019/20 marketing year, US soybean exports to China are higher than last year, but still account for only half of pre-trade war exports in volume terms. Outstanding sales to China booked for the 2020/21 marketing year are the highest since 2012/13. This is a clear indication of continued commitment to the phase one trade deal. Finally, the weak USD has been yet another tailwind for soybean prices. Chart 11Rising Oil Prices Will Revive Inflation Expectations Rising Oil Prices Will Revive Inflation Expectations Rising Oil Prices Will Revive Inflation Expectations Chart 12Soybeans Prices Rising Soybeans Prices Rising Soybeans Prices Rising     Footnotes 1     Please see The latest in the global race for a COVID-19 vaccine published by the American Enterprise Institute August 25, 2020, which notes that 29 of the 167 vaccines under development are in human trials.  Six of these candidates are in Phase III trials. 2     This outsized spare capacity also gives KSA a potent tool in enforcing production discipline within the OPEC 2.0 coalition, which was demonstrated earlier this year in the brief market-share war initiated by Russia following the breakdown in negotiations to extend the coalition’s production cuts. Please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020. It is available at ces.bcaresearch.com. 3    For an excellent discussion of the Fed’s policy change, which was announced by Chair Jerome Powell last week, please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020. It is available at gfis.bcaresearch.com. 4    For our latest view on oil fundamentals, please see The Oil Markets' Knife Edge, which we published last week. 5    Implied volatility is the estimated standard deviation of returns that solves an option pricing model. This empirical fact was explored in depth in Ogawa, Yoshiki, (1989), “Market Expectations Evident In Crude Oil Futures Options Volatility Measures Since The Opening Of The Option Trading In November 1986,” IFAC Energy Systems. Management and Economics, Tokyo, Japan, pp. 337-341. See also Feedback Loop: Spec Positioning & Oil Price Volatility, which we published May 10, 2018; and Ryan, Bob and Tancred Lidderdale (2009), “Energy Price Volatility and Forecast Uncertainty,” published by the US EIA. 6    Please see Campos, I., Cortazar, G., and Reyes, T. (2017), "Modeling and predicting oil VIX: Internet search volume versus traditional variables," Energy Economics, Elsevier, 66(C): 194-204. 7     Please see BCA Research Daily Insights A Worrying Month of August For The Dollar published August 31, 2020. 8    Please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control

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

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

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