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JANUARY 2015 THE OIL PLUNGE. The Outlook for and Impact of Lower Oil Prices MARKET PERSPECTIVES

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JANUARY 2015

THE OIL PLUNGE

The Outlook for and Impact of Lower Oil Prices

MARKE T

PERSPECTIVES

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executive summary

RUSS KOESTERICH Managing Director,

BlackRock Chief Investment Strategist

Last fall’s precipitous drop in oil caught many by surprise, although energy prices had been weakening since last summer. The plunge was a function of three developments: weakening global demand, a surge in U.S. production and surprisingly resilient supply out of the Middle East. A stronger dollar also contributed, since by definition that affects demand for dollar- denominated commodities.

For 2015, expect oil to remain volatile, but with the potential for a two-way market should Middle Eastern production or exports falter. While lower prices will ultimately lead to some adjustment in U.S. production, current levels are unlikely to lead to an immediate cutback in U.S. shale production. However, they are likely to impact future exploration.

In terms of the implications of lower oil prices, while the collapse in oil helped produce a short-lived but still meaningful market correction, we believe lower oil prices are supportive of the global economy. Lower oil is a de facto tax cut for Western consumers and will also benefit several emerging markets, particularly those that subsidize energy prices.

We don’t believe that lower oil prices pose a fundamental threat to equities;

energy accounts for a relatively small weight in most equity indices. In addition, consumer stocks, a larger portion of most equity benchmarks, are likely to be net beneficiaries of lower oil prices.

But falling oil prices are having a more mixed impact on bonds. Lower energy prices are helping to reduce inflation and dampen inflation volatility,

particularly in the United States. However, lower energy prices are causing

some distress in several smaller high yield issuers, putting some pressure on

that segment of the market.

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Surprises are foolish things. The pleasure is not enhanced, and the inconvenience is often considerable.

—Jane Austen In any given year, investors are likely to experience more than a few shocks and surprises. Last year was no different. Against almost all expectations, long-term interest rates closed the year significantly below where they started. Perhaps an even bigger shock was the plunge in energy prices.

For most of the past several years, oil prices have remained in a relatively contained range—generally defined as between

$90 and $110 for Brent crude. But by late summer, oil prices began to succumb to a combination of a stronger dollar, slowing global growth and steadily building U.S. supply.

Between June 30 and December 31, West Texas Intermediate (WTI) and Brent fell by approximately 45%.

TRIFECTA OF PAIN

While several trends, notably the surge in U.S. oil production, were visible prior to the summer, the investment climate did undergo a significant shift in July. First, the dollar began a quick ascent, which pushed the U.S. Dollar Index up roughly 13%

within a period of just six months. Strength in the dollar was partly a function of weak growth outside the United States, which further hurt oil prices by lowering demand. Finally, and arguably most important, there was a surge in production.

FIGURE 1: CRUDE OIL PRODUCTION

Source: Thomson Reuters Datastream, EIA, BlackRock Investment Institute 08/12/14 – Data to August 14.

The full extent of increased U.S. production became evident just as production was rebounding in several Middle Eastern countries, much to everyone’s surprise.

Analysts have pinned much of the blame for lower oil prices on the surge in U.S. energy production. U.S. production rose from roughly 5.5 million barrels per day (bpd) in 2008 to more than 9 million bpd, a level last seen in the mid-1980s. The steady climb in U.S. oil production eventually produced a glut.

Investors were also taken aback by the resilience of Middle Eastern supply. Earlier in 2014, sanctions on Iran and unrest in Libya kept significant supply off the market. Libya has spent much of the past several years in what is effectively a civil war, with much of the country ruled by militias. The civil unrest caused Libyan oil production to plunge from 1.6 million bpd in the summer of 2012 to barely 200,000 by last April. However, despite still significant fighting, by the end of October several Libyan ports had been reopened and production briefly surged to more than 800,000 bpd (by year’s end production was back down below 500,000, indicating that at least one source of marginal supply may not last into 2015).

Another example of surprisingly resilient production: Iraq.

Given the intensifying fighting in Iraq, investors were not unreasonably discounting some disruption in supply. Instead, Iraqi production, which resides primarily in the Kurdish north and Shiite-controlled southern provinces, was not touched by the growing Sunni insurgency (see Figure 1).

0 3 6 9 12

0 25 50

12.7 13.1 11.2 4.2 4.2 B ARREL S PER D AY (MIL LIONS)

Iraq 3.2 Libya 0.5 Iran 3.2

U.S. 8.9 Saudi Arabia 9.7

Russia 10.1

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

PERCENT AGE

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

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Further complicating the matter: Many of these companies have hedged prices in the short term and any production cuts would likely be slow. While rig count is starting to fall—down 7% since October—overall U.S. production hit a record of more than 9.1 million bpd in December.

What is safe to say is that constant improvements in technology and extraction techniques suggest that prices need to remain at these levels, or potentially even lower, for a considerable period of time to remove existing production.

For bulls, the best that can be said is that future supply growth will decelerate as exploration and production (E&P) companies cut back exploration on marginal properties.

Another consideration is whether OPEC can find the discipline to enforce production cutbacks, something it was unable to do during the November meeting. The problem is that, given growing U.S. energy independence, most producers are unwilling to cede market share. Another complication is that many oil producers have become dependent on higher oil prices to balance their budgets. In some cases, budget constraints mean they are not only unwilling to accept lower revenue, they may be unable.

All of this suggests several themes for 2015. Oil prices are likely to remain volatile, but with the potential for a two-way market should Middle Eastern production or exports falter.

Second, prices remain vulnerable to further disappointments in global growth. Finally, while lower prices will ultimately lead to some adjustment in U.S. production, current prices are unlikely to result in an immediate cutback in U.S.

production, although they will impact future exploration.

Bottom line: Oil prices are likely to stabilize and rise over the long term, but this will not be immediate. Nor is the rise likely to take prices back to the upper end of the previous range.

The final nail in the coffin for oil prices was the decline in demand, a function of another disappointing year for the global economy. While the United States has managed, for now, to decouple from most of the rest of the world, the second half of 2014 was marked by slower growth in most other countries (see Figure 2). European growth decelerated from already lethargic levels while Japan—following last April’s ill-timed hike in the consumption tax—slipped into a technical recession. In emerging markets, the continued deceleration in the Chinese economy along with stagnation in other large emerging markets, notably Brazil, contributed to the slowdown. As a result of this worsening picture, the Energy Information Administration (EIA) cut its 2014 estimate of world energy demand by 200,000 bpd and its 2015 forecast by 300,000, to 93.5 million bpd.

HOW LOW CAN YOU GO?

Looking ahead, the outlook for 2015 is likely to rest on a few questions: Can the Middle East maintain its current production profile? Will OPEC pull together and cut production? How much will U.S. shale producers cut back given the 45% drop in prices?

On the latter question, estimates vary wildly. The “breakeven”

rates for various wells are highly idiosyncratic and vary depending on whether a particular property represents current or future production. For example, the IEA estimates breakeven rates at $80, while Wood Mackenzie suggests $70 to

$75, both numbers well above current levels. However, other estimates are much lower, meaning that many shale producers can remain profitable at current prices. ConocoPhillips has suggested a rate of $50 and says that 80% of the U.S.

shale sector is profitable at $40 to $80 a barrel for WTI.

Source: Thomson Reuters Datastream, OECDBlackRock Investment Institute 02/01/15

FIGURE 2: OECD LEADING INDICATORS

-6 -8 -4 -2 0 4 2 8 6 10

YEAR-O VER- YEAR CHANGE (%)

Spain (Sep 14) U.K. (Sep 14) Japan (Sep 14)

France (Jun 14) Germany (Sep 14)

U.S. (Sep 14)

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Thomson Reuters Datastream, OECD, BlackRock Investment Institute 01/15/15.

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EQUITIES AND OIL

Last fall’s plunge in oil prices culminated in a brief but not insignificant pullback in equity markets. Lower oil prices are generally procyclical, but the drop in energy prices scared many investors as it implied that global growth was weaker than expected. At the lows, global stocks—measured by the All Country World Index (ACWI)—were down roughly 7%.

While increased volatility in energy prices may produce another bout of volatility in financial markets, we believe that for the most part lower oil is a positive for developed countries and many emerging markets. Given that oil consumers have a greater propensity to spend than oil producers, lower energy prices have generally been procyclical. According to the International Monetary Fund, a 10% drop in oil prices translates into a 0.2% increase in global GDP. With oil prices down nearly 50% from their summer highs, this should represent a significant tailwind for global growth in 2015.

Faster growth should also be generally positive for stocks.

Our view is that the positive impact on consumer stocks from falling oil prices more than offsets the negative effect on energy-related companies. In addition, energy stocks appear to already reflect the deep drop in oil prices.

To underscore this point, it is useful to start by noting that energy stocks comprise a relatively small portion of major global indices. Energy companies are roughly 8% of the ACWI.

Energy stocks in U.S. large cap indices, as well as those in Europe and emerging markets, make up a similar amount of their respective benchmarks (see Figure 3). For other markets, notably U.S. small caps and Japanese equities, the portion is even lower. Even in frontier markets, often viewed as a play on energy given the heavy weighting of Middle Eastern and African companies, the weight to energy is only 13%.

Obviously, there are several resource-dependent economies for which the energy exposure is much greater. Among developed markets, Canada stands out, with energy companies comprising more than 20% of most equity benchmarks. In emerging markets, the countries to focus on are Brazil, Venezuela and Russia, where energy accounts for nearly 50% of the MSCI Russia Capped Index.

But outside of these outliers, oil exposure is modest and generally dwarfed by consumer-related sectors. In the United States, energy represents roughly 8.5% of the S&P 500—

down from more than 16% in June 2008. By comparison, consumer discretionary and consumer staples companies, both beneficiaries of lower energy prices, make up more than 20% of the index.

FIGURE 3: ENERGY SECTOR AS % MAJOR INDICES

Source: Bloomberg, iShares.com 12/23/14.

0 2 4 8 6 12 10 14%

ACWI U.S. Large Cap

(S&P 500) U.S. Small Cap

(Russell 2000) Europe

(Europe 350 Index) Japan (MSCI

Japan Index) Emerging Markets

(MSCI EM) Frontier Markets

(MSCI FM)

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CHEAP OR CHEAP FOR A REASON

Not only are energy companies a relatively small portion of most markets, but many companies in this sector appear to have already discounted much of the drop in crude. At both the global level and in the United States, energy valuations relative to the broader market are at their lowest level in more than a decade (see Figures 4 and 5).

Based on price-to-book ratio, U.S. energy companies are trading at a 35% discount to the broader market. Historically, the discount in the United States has been around 15%.

Globally, energy companies trade at a similar discount, despite the fact that this sector has generally traded at par versus the broader market. Not only are valuations low on an absolute basis, but they also appear to be discounting a further drop in oil prices as well as even lower profitability.

Not surprisingly, energy valuations tend to track oil prices.

Historically, the level of crude has explained roughly 30% of the variation in the sector’s relative valuation (see Figure 6).

Assuming an oil price of roughly $60 a barrel, based on the historical pattern, the energy sector should be trading at around a 13% discount to the broader market, rather than today’s much steeper discount of 35%. Discounts at today’s level have historically been associated with much lower oil prices, such as was the case back in the mid- to late 1990s when crude was trading in the teens and low 20s. Investors are either expecting a much bigger decline in crude prices or other factors are needed to explain today’s historically low relative valuations.

Outside of oil prices, industry level profitability is also helpful in explaining variations in valuation. In the past, the ROE of FIGURE 4: U.S. ENERGY SECTOR RELATIVE

VALUATION

1995 to Present

FIGURE 6: U.S. ENERGY SECTOR VALUATIONS VS. OIL PRICES

1995 to Present Source: Bloomberg 12/23/14.

Source Bloomberg 12/23/14.

Source: Bloomberg 12/23/14.

0.6 0.8 1 1.2 1.4

U .S . ENERG Y SE CT OR P /B VS . S&P 500

1/1/95 7/1/97 1/1/00 7/1/02 1/1/05 7/1/07 1/1/10 7/1/12

0.6 0.8 1 1.2 1.4

GL OB AL ENERG Y SE CT OR P/B VS . MSCI W ORLD

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

FIGURE 5: GLOBAL ENERGY SECTOR RELATIVE VALUATION

2004 to Present

0.5 0.7 0.9 1.1 1.3 1.5

S&P 500 ENERG Y SE CT OR RELA TIVE P /B

WTI CRUDE ($)

0 25 50 75 100 125 150

TODAY

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the energy sector has accounted for about one-third of the variation in relative value. As was the case with oil prices, the drop in profitability also does not fully explain the plunge in relative valuations.

To be sure, the sector’s profitability has declined with the price of crude. Currently, the ROE of the U.S. energy sector has contracted to approximately 13.5%, from nearly 17%

in mid-2012. While the current level is below the historical average—16.6% since 1995—low valuations more than compensate for the fall in profitability. Based on the historical relationship between ROE and the relative valuation of the sector, you would expect energy stocks to be trading at roughly a 20% discount to the market, not 35% (see Figure 7).

While the energy sector as a whole looks cheap and potentially underpriced, we would still advocate a selective approach rather than a broad overweight. With the bottom in oil difficult to call, investors should emphasize long-term value while still remaining hedged to a further drop in energy prices. This suggests a focus on the larger, global integrated companies, which are particularly cheap. The five top weights in a global index—Exxon Mobil, Chevron, Royal Dutch Shell, Total and BP—have an average price-to-book of 1.37 and an average indicated dividend yield of 4.8%. The industry should also benefit from its downstream operations, which will cushion cash flow even if oil prices fall further. This resiliency is evident in the empirical relationship between the

integrated oil companies and energy prices. Compared to the rest of the sector, they have a much lower correlation with oil (see Figure 8).

Source: Bloomberg 12/23/14.

Source: Bloomberg, BlackRock 12/8/14.

FIGURE 7: U.S. ENERGY SECTOR ROE VS. P/B

1995 to Present

FIGURE 8: PRICE RETURN SENSITIVITY TO OIL PX

Drilling Equipment

& Service Integrated Oil

Exploration

&

Production Refining &

Marketing Storage &

Transport

Coal &

Consumable

Fuel Energy

Composite 3-Year Beta

to WTI 0.63 0.59 0.27 0.50 0.28 0.28 0.33 0.38

3-Year Beta

to Brent 0.92 0.78 0.33 0.64 0.64 0.32 0.46 0.49

0.5 0.7 0.9 1.1 1.3 1.5

S&P 500 ENERG Y SE CT OR RELA TIVE P /B

S&P 500 ENERGY SECTOR ROE

-5 0 5 10 15 20 25 30 35

TODAY

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BIG WINNERS: CONSUMERS AND SELECT EMERGING MARKETS

While energy stocks may have corrected too far relative to the drop in crude and profitability, there is little doubt that lower energy prices will put the sector under near-term pressure. In contrast, lower oil and the corresponding drop in gasoline prices are a clear boon for developed market consumers (see Figure 9). This is particularly true in the United States given low gasoline taxes; any drop in crude has a more dramatic impact on retail gasoline prices than in Europe, where taxes make up a larger portion of the overall price.

The effect of lower gasoline prices can be particularly significant for middle-class families. A recent Wall Street Journal article cited a study by ClearView Energy Partners and IHS Global Insight that estimated savings of $380 for the average American consumer and $750 for the average American household.

Not only do lower prices improve household cash flow, but they also tend to be associated with better sentiment. U.S.

consumers have a very intimate awareness of gasoline prices, often basing their views on inflation

disproportionately on food and energy prices (see Figure 10).

Partly as a result of this behavioral bias, lower gasoline prices tend to boost sentiment, and along with it consumption, particularly for lower and middle-income households.

According to Bank of America Merrill Lynch, in 2012 households earning less than $50,000 spent 21% of their after-tax income on energy, versus 9% for those earning more than $50,000. This is important as lower income households have a higher propensity to spend. For investors looking to capitalize on the likely increase in consumption, retailers catering to middle-income consumers are likely to be the biggest beneficiaries of any marginal increase in spending.

EMERGING MARKETS: IT DEPENDS

Other potential beneficiaries of lower oil prices include big net importers of oil. Many of these countries tend to be in Asia, including China, India, Japan and South Korea. China provides a useful illustration of the magnitude of the benefit.

Based on 2013 figures, for every $1 drop in the price of oil, China saves roughly $2.1 billion.

India is another large beneficiary. India imports roughly 85%

of its oil, so lower prices will dramatically improve the terms of trade as well as the current account deficit.

FIGURE 9: U.S. GASOLINE PUMP PRICE

2006 to Present

Source: Thomson Reuters Datastream, EIA 01/12/14.

1.0 2.0 1.5 2.5 3.5 3.0 4.5 4.0

US $/GAL LON

2006 2007 2008 2009 2010 2011 2012 2013 2014

U.S. Retail Gasoline Regular

-60 -40 -20 0 20 40 60 80

2000 2002 2004 2006 2008 2010 2012 2014

-15.1

PERCENT

Year-on-Year Change

Source: Bloomberg 12/31/14.

FIGURE 10: OIL PRICES AND INFLATION EXPECTATIONS

2000 to Present

0 50 100 150

0 2 4 6

WTI CRUDE ($) U . MICHIGAN 1 -YEAR INF AL TION EXPE CT ATIONS (%)

3/00 9/01 3/03 9/04 3/06 9/07 3/09 9/10 3/12 9/13

1-Year Inflation Expectations (%)

WTI Crude ($)

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Moreover, given the heavy weight to energy in the typical Indian’s consumption basket, lower energy prices will help in the central bank’s efforts to bring down India’s chronically high inflation rate. Lower oil prices will also help India’s, as well as Indonesia’s, fiscal position. Historically, both countries were heavy subsidizers of fuel. The drop in oil is providing a perfect opportunity to reduce these subsidies, thus freeing up government funds for more productive uses.

However, there are also several emerging market countries likely to suffer. Emerging market producers—notably Venezuela, Russia and several of the Gulf nations—are coming under intense pressure, which is only likely to grow the longer oil prices remain at these depressed levels. For many of these countries, government budgets are dependent on oil prices at or close to $80/barrel.

Russia is in an even more precarious position. Not only is the country feeling the brunt of Western sanctions, but its most recent budget assumes oil prices of $104/barrel for 2014 and

$100/barrel for 2015-2017. As more than half of Russia’s revenue comes from oil and gas, prices at these levels will likely require a serious fiscal contraction and could lead to an even worse erosion in the country’s current account position.

JP Morgan estimates that at $60/barrel, Russia’s current account deficit would be 2.6% of GDP, a major decline from its existing surplus.

BONDS, A MIXED BAG

Theoretically, lower oil prices should be supportive of bond markets; low oil prices will dampen already low inflationary pressure. That said, much of the angst in December was over bond prices, specifically the potential for another Russian default.

In late December, a growing number of investors began to worry about a repeat of the crisis in 1998, when Russia defaulted on its debt. While Russia’s reserve stockpile, now down to approximately $360 billion, according to Bloomberg, will mitigate the risk in the near term, a prolonged period of low oil prices will put real pressure on the government, corporations and the banking sector.

Closer to home, in recent years energy companies, particularly U.S. exploration and production firms, have been some of the most prodigious issuers of high yield bonds (see Figure 11).

Depending on the index, energy issuers now account for roughly 15% to 18% of U.S. high yield benchmarks.

We are likely to see some pain in this space, although again the effect may not be immediate. Many E&P companies have already hedged production at higher prices. In addition, most companies have the latitude to cut capital spending by 50%

or more without impacting near-term production levels. This will give the issuers some time. This suggests that for 2015, defaults should be limited. That said, the longer prices remain at such low levels, the more companies will need to find alternative sources of funding. If the market is unwilling to provide these sources, default rates will rise post-2015.

* As of November.

Source: CreditSights, The Wall Street Journal.

FIGURE 11: GUSHER

High-Yield Debt By Energy Subsector

0 50 150

100

$200

BIL LION

Refining and marketing Other Oil-field services

Exploration and production

2010 2011 2012 2013 2014*

Midstream/MLPs

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CONCLUSION

Oil is like a wild animal. Whoever captures it has it.

—J. Paul Getty Oil markets are starting 2015 in a very different position than a year ago. Anemic growth in Europe and Japan coupled with decelerating growth in China and other emerging markets suggests that a rebound in prices is unlikely. But it is also not clear that oil prices continue to head straight down. The current level of oil prices is unlikely to remove existing production, but at this level future production is likely to be curtailed. Finally, it is not clear that given the ongoing security issues in Libya, Iran and South Sudan that the Middle East will be able to maintain existing production levels.

So while we assume some mean reversion in oil prices, slower global growth and still rising U.S. production suggest that, absent a much bigger supply shock from the Middle East, they are, at best, likely to revert back to the lower end of their previous range. This has several implications for equities: a need to be selective in the energy sector; a tailwind for U.S.

and other developed market consumers; and a windfall for several large oil importers, notably India.

On the fixed income side, rising U.S. production and structurally lower energy prices should not only dampen inflation but also the volatility of inflation. This represents yet another factor likely to keep long-term yields lower than their historical range. However, while lower inflation is a positive for bonds, U.S. high yield will remain under some pressure as investors assess the fallout to E&P issuers.

Like a stronger dollar and lower rates, cheaper oil represents

yet another shift in the investment climate. While there are

some exceptions, for the majority of assets, it is a positive one.

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For more information visit www.blackrock.com or call 1-800-474-2737

Unless otherwise indicated, all sources of data are Bloomberg.

This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2015 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This paper may contain “forward-looking”

information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

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Tel: 020 7743 3000. For your protection, telephone calls are usually recorded.

BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

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In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Hong Kong, this document is issued by BlackRock Asset Management North Asia Limited 貝萊德資產管理北亞有限公司 and has not been reviewed by the Securities and Futures Commission of Hong Kong. Not approved for distribution in Taiwan or Japan. In Canada, this material is intended for permitted clients only. In Latin America this piece is intended for use with Institutional and Professional Investors only. This material is solely for educational purposes and does not constitute investment advice, or an offer or a solicitation to sell or a solicitation of an offer to buy any shares of any funds (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which such an offer, solicitation, purchase or sale would be unlawful under the securities laws of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico, Peru or any other securities regulator in any Latin American country, and thus, might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein.

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These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

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