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Dear

Investor
Last month was brutal for most commodities and anyone investing in
them. Except for the very nearby contracts oil prices fell to new lows
for the year. Precious metals prices made multi year lows while the
Bloomberg commodity index touched a thirteen year low.
While renewed fears of Greece exiting the Euro zone and the selloff in
the Chinese equities markets provided ample macro worries there
were other reasons provoking the declines. For metals the prospect of
the Fed imminently raising interest rates provides a strong headwind.
For oil the successful conclusion of the P5 + 1 negotiations with Iran
over its nuclear program weighed very heavily. Even more
importantly, the perception of a large and persistent crude oil glut is
now endemic and has triggered a massive shift in sentiment one that
we frankly did not anticipate. One reason for that is that we see
fundamentals continuing to improve and believe there is something of
a disconnect between perception and reality.
That perception is colored by the IEAs most recent Oil Market Report
(OMR) which estimates that global oil supply in Q2 2015 exceeded
demand by a staggering 3.3 million bpd. For 2015 the IEA is effectively
predicting a surplus of supply over demand averaging more than 2
million bpd that continues through 2015 and 2016. The nearby chart
shows the IEAs implicit forecast of the cumulative supply excess since
the end of 2014. Its supply and demand balance is much more
negative than the others we look
at.
However, the IEA forecast is the one used by most oil analysts on Wall
Street as the basis for their own forecasts. For that reason the
consensus view is now extremely bearish.
The latest data from the IEA is difficult to reconcile with what
2000
1800

1600
1400
1200
1000
800
600
400
200
0

FORECAST CUMULATIVE TOTAL OIL SUPPLY SURPLUS SINCE 4Q 2013 ('000 BBL)

PIRA IEA

IOC EA
[2.2] [Investor Letter 7-15.pdf] [Page 1 of 7]

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has actually been happening in the oil market however. If there had
been a 3.3 million bpd surplus in Q2 the contango would have
exploded as oil would need to price itself to make it economic to carry
in ever scarcer and therefore costlier storage. That did not happen. In
fact the contrary was the case contango narrowed for Brent and WTI
and the Dubai market moved from contango into backwardation by
the end of Q2. This is not suggestive of a growing crude oil surplus.
Even more striking is the absence of an increase in observable
inventories anywhere close to that suggested by the IEAs
supply/demand balance for Q2. Preliminary estimates show that OECD
onshore inventories of oil built by a little over 700 thousand bpd last
quarter. Inventories (government plus commercial) in China are
estimated to have risen by about 400 thousand bpd. Oil in floating
storage rose by about 600 thousand bpd. That all adds up to about 1.7
million bpd leaving 1.6 million bpd of oil unaccounted for. Where
could it be? Oil in floating storage is monitored ship by ship in real
time and data are available for most commercial entrept facilities. It
is hard to believe that over 140 million barrels of oil could go
unobserved.
The more likely explanation for these missing barrels is that the
current surplus is not nearly as big as the IEA is estimating. In the July
OMR the IEA was still showing a balancing item for unaccounted oil of
1.4 million bpd for Q4 of 2014 and 900 thousand bpd for the first
quarter of this year (they have yet to analyze the Q2 balance).
Historically, large balancing items are revised away by changes to
initial estimates of demand. Since 2009, on average the IEA has
revised its initial estimate of actual quarterly demand upwards by over
500 thousand bpd over the ensuing two to three years. On four

occasions the cumulative revision to estimated not forecast demand


has been 1 million bpd or more.
It would hardly be surprising therefore if the IEA were to revise higher
its initial estimate of Q2 2015 oil demand (and make further revisions
to Q1 2015 and Q4 2014). This would of course reduce the apparent
ongoing surplus. High frequency data certainly supports the notion of
above trend demand growth this year following the dramatic drop in
prices in the latter part of 2014. Year to date demand in the U.S. is up
over 600 thousand bpd or 3.4 percent. The latest four week average is
up 1 million bpd or 5.7 percent. Lower prices together with more
people working translates into more demand for oil. Europe will see
growth in demand for oil in 2015 for the first time in years. Demand
growth in China during H1 was higher year over year by almost 500
thousand bpd, or nearly 5 percent. Demand was particularly
strong in June which should assuage concerns regarding the impact of
the recent swoon of the stock market there.
ATLANTIC BASIN CRUDE OIL INVENTORIES (MILLION BBL)
650
600
550
500
450
400

Source: Bloomberg, Astenbeck research


[2.2] [Investor Letter 7-15.pdf] [Page 2 of 7]

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Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15
May-15 Jun-15 Jul-15

It is not only on the demand side of the equation that we can question
the scale of the apparent oil surplus predicted by the IEA. Compared
to other credible forecasts, the IEA supply forecast for 2015 for NGLs
produced by OPEC is higher by about 500 thousand bpd. OPEC NGL
production is a notoriously difficult number to gauge accurately.
Moreover it should be largely irrelevant to a discussion of crude oil
prices as NGLs cannot be processed in oil refineries.
Crude oil inventories have already started to fall. Unsold West African
oil that was floating on tankers until June has now been sold to
refiners. Crude oil inventories in the Atlantic Basin the epicenter of
the global oil excess - have fallen 55 million barrels from their peak at
the end of April. Based on the balances we look at, crude oil
inventories should on average fall over the rest of the year albeit
with a hiatus during the fall turnaround season in October.*
But these green shoots have been trampled down by concern that Iran
will now add to the glut of oil and that it will take much longer for the
market to balance. These fears have been compounded by reports
that Iraq and Saudi Arabia are setting new production records.
There is no question that the core OPEC producers in the Middle East
are producing oil at historically high rates. But lets examine this more
closely.
First Iran: virtually all serious analyses suggest that sanctions on oil
exports will not be lifted until sometime in 2016. Moreover these
analyses indicate that Iran will not be able to increase its production
by much more than 500 thousand bpd without substantial investment
and the involvement of the international oil companies. That will not
happen quickly. Also, the risk that the oil Iran currently has in floating
storage will flood the market is being overstated. In all there are about

30 million barrels but the majority of this is highly corrosive


condensate produced in association with natural gas from the South
Pars field. This condensate was not covered by the current sanctions
regime. The reason this oil is in floating storage is because Iran has
been unable to sell it since its principal customer Dragon Aromatics
in China - suffered a plant failure in April. Moreover construction of a
new refinery in Iran designed specifically to run this condensate has
been delayed just as additional production from a new stage of South
Pars came on stream.
As to Iraq, it is true that its production has reached record levels in
recent months. But given the fall in capex there and the dramatic drop
in rig counts in Iraq down 45 percent since last summer - it is difficult
to see how further growth in production can be sustained. Rather,
there is a significant downside risk to Iraqi production given the
persistent threat from ISIS and disaffection among the population over
chronic electricity shortages. Renewed antagonism between Baghdad
and the KRG threatens exports from the north as does sabotage of the
Kirkuk-Ceyhan pipeline.
As regards Saudi Arabia, while it has increased production, its oil
exports have actually dropped. According to the most recent data for
May, combined crude oil and net oil product exports from Saudi
Arabia fell 700 thousand bpd from the level seen in April. The ramp up
in crude oil production in recent months has been primarily to meet
increased domestic demand for crude oil burned to generate
electricity during the peak demand months for air conditioning. Saudi
Aramcos latest pricing schedules are also not suggestive of an overly
aggressive marketing stance and reports from Saudi Arabia suggest
production will be throttled back at the end of the summer as the
cooling season passes its peak.
[2.2] [Investor Letter 7-15.pdf] [Page 3 of 7]

As a result of these high production rates particularly that of Saudi


Arabia - spare capacity within OPEC is now at very low levels not
much more than 1 percent of global oil consumption. Any supply
hiatus today would therefore result in a rapid draw down in
inventories with predictable consequences for prices. Nonetheless the
current market environment has been compared by many analysts to
that of 1986, the last time that Saudi Arabia shifted its policy from
seeking price stability to production. But back then global spare
capacity was of the order of a staggering 20 to 30 percent or ten times
what it is today. Nonetheless, the futures curve today is predicting a
much slower recovery in prices than actually occurred in 1986.
With Saudi Arabia having abdicated its role as the swing producer, oil
prices should be determined by the cost of the marginal producer. In
the short term that is the U.S. shale oil producer, as the lead time
between deciding to invest and bringing on production is much
shorter for them than it is for other producers. Accordingly the market
has fallen to what it believes is the average cost of shale oil production
which itself has fallen as companies squeeze service suppliers. It was
notable that last months collapse in prices was led primarily by heavy
selling of deferred futures contracts. The assumption is that prices will
be capped for the foreseeable future by the cost of producing shale oil
in America.
However, there is simply not enough shale oil that can be produced at
$60 a barrel let alone $50 a barrel to meet the global growth in
demand at those prices and offset production decline in the rest of the
world. This means that in the longer term U.S. shale oil is not the
marginal source of production.
There are a bit less than 50 million bpd of oil being produced outside
of the core Middle East OPEC countries and North America.
Production from these countries was already falling or stagnating in
recent years even though rig counts there had been rising.
Since last summer rig counts have fallen by 20 percent in the countries

within this group for which data are available. This will inevitably
result in an acceleration in the rate of production decline of this oil.
We estimate that because of the fall in rigs, production from these
producers will on current trends fall by about 3 million bpd by 2020.
Global oil demand over this period should rise by at least 7 million bpd
and probably more at current price levels. This means at least 10
million bpd of new supplies will be needed. Iraq and Iran can possibly
add 3 million bpd provided there is
no further deterioration in the political climate in the region. Perhaps
the other Middle East OPEC producers can add another million bpd.
But that leaves a shortfall of at least 6 million bpd and it cannot
CRUDE OIL PRODUCTION EXCLUDING NORTH AMERICA AND MIDDLE EAST OPEC (MILLION BPD)
49 900

48
47
46
45
850
800
750
700
650

600
CRUDE OIL PRODUCTION MILLION BPD - LHS
RIG COUNT (DOES NOT INCLUDE FSU AND CHINA - 2015 ASSUMES NO FURTHER DROP FROM JUNE) - RHS
44 550
500
43
450
42 400
Source: BHI, PIRA, Astenbeck Research
[2.2] [Investor Letter 7-15.pdf] [Page 4 of 7]

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2014
2012
2010
2008
2006
2004
2002
2000

be filled by growth in North American shale oil production which


accounts for just 6 percent of world supplies - and certainly not with
prices at current levels.
For the market to balance in the longer term will therefore require
prices to rise to a level needed to support investment in more
expensive sources of production than U.S. shale. We believe that level
to be at least $80. Even in 2014, when prices were above $100,
projects were being cancelled as uneconomic. While service costs
have fallen it is not at all obvious that this reflects a permanent shift.
Oil service companies have cut fat, muscle and bone in this downturn.
When demand for oil field services returns it is hard to believe costs
wont rise again. Even in the shale sector there are reports of
numerous liquidations of service companies. Who will the E and P

companies turn to when they want to bring back rigs in quantity? The
longer prices stay depressed and the more that non-shale projects are
postponed or cancelled the greater the risk that the world finds itself
short of supply and prices have to rise to a level to once again ration
demand. Long term projects cannot be cranked up overnight. A
recently published report by analysts Wood Mackenzie estimated that
$200 billion worth of oil and gas projects have now been shelved
globally. That is up from $135 billion in May and this during a period
when deferred futures prices were 20 percent higher than they are
now.
We have said previously that price cures price because of its effect on
supply and demand. The demand side of the equation has certainly
performed with year over year demand growth running at close to 2
million bpd so far this year. However, as yet, there is little evidence of
a slowdown in supply above all in the U.S. - despite the massive fall
in rig counts.
Because of this there is much debate about the resiliency of U.S.
production in the face of lower prices. The fact that rig counts stopped
falling and even rose modestly in July has been cited as evidence that
the industry can survive and even prosper in a low price environment.
We think that the results being announced by the exploration and
production companies for Q2 are hardly reflective of an industry that
is flourishing. Prices in Q3 look like they will be much lower than they
were in Q2. Meanwhile hedges set at much higher levels are rolling
off. High grading, squeezing suppliers and exploiting efficiencies can
help but they are strategies for survival that can only be taken so far
and are not a recipe for sustained growth.
However, with the current sour mood in the oil market, it will take
hard evidence that supply is rolling over for prices to stage a recovery
and, as noted above, it hasnt happened yet.
One of the problems is data availability. Here in America we still dont
really know how much oil was produced six months ago. Final data

for May was released at the end of July but will be subject to revision
for months (if not years) to come. The much vaunted weekly
production data published by the EIA is simply a projection based on
the most recent monthly data now May - which itself is likely to
change over time. Data
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connoisseurs prefer to look at the adjusted or implied weekly
production for guidance this is the sum of the (projected) production
and the balancing item that the EIA calculates to equate their
projection of production with observed changes in inventories,
refinery runs and net crude oil imports. Although it has recently been
very volatile, adjusted production does appear to be rolling over.
Pessimism in the oil market is currently at extreme levels as reflected
by speculative positioning. The ratio of longs to shorts is at a
historically low level. Producers cannot hedge profitably at current
prices so they will not be selling. Indeed they should be persistent
buyers as they buy back existing hedges as production is sold.
Furthermore, if we are right about crude oil inventories falling through
the balance of the year, inventory hedges will also have to be bought
back. But for a sustained recovery the market will need to see
evidence that low prices really are impacting supply and that physical
oil balances are beginning to improve. We believe that is coming.
There could be other catalysts obviously any sort of supply
disruption would bring in buyers. Its also not beyond the realm of
reason that core OPEC could revisit their current policy. Saudi Arabia
and Kuwait both recently announced bond issues to cover expenditure
deficits and the UAE is eliminating fuel subsidies as it tries to staunch
the burn of its foreign currency reserves reportedly down by almost
half since the start of the year. The hint of an OPEC policy change in
August of 1986 was sufficient to cause prices to rally 50 percent in 24
hours.
The recent fall in oil prices was preceded by a fall in oil equity prices

which have now made new lows for this cycle. Valuations for the oil
majors relative to the broader market are at 35 year lows. Prices for
the equities of the E and P companies have fallen 30 percent on
average from the recent high in May. The market has abandoned its
expectation of a V- shaped recovery to $70+ WTI and reflects an
expectation of lower prices for longer in line with the futures strip
which is below $60 all the way to 2018. It is certainly the case that
companies are hurting at current prices especially those with weaker
balance sheets, less good acreage or low levels of hedges in place.
Chesapeakes suspension of its dividend speaks to the stress being
experienced across the sector. There has already been a flurry of
recently announced bankruptcies among smaller producers and more
will likely follow. It is hard to reconcile the distress in the sector with
predictions that shale production can be maintained and even grown
at current prices.
Turning now to metals these have been hit by the growing expectation
of a rate rise by the Fed in September. Gold has broken through key
support levels and dragged the PGMs with it. However, there has been
no change in the supply and demand fundamentals which remain in
prolonged deficit. Current prices are deep into the cost curve for the
South African producers with much production uneconomic. Short
positioning in PGMs is at an extreme which raises the potential for a
sharp recovery in prices.
Best regards
Andrew J. Hall Chairman and CEO

[2.2] [Investor Letter 7-15.pdf] [Page 6 of 7]

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* It is also worth noting that of the current total oil surplus inventory

to historic norms of about 250 million barrels, some 80 million barrels


are NGLs in the U.S. and hard-to-sell Iranian condensate on tankers in
the Persian Gulf. The rest is primarily crude oil, much of it in the U.S.
(because that is where the cheapest and most flexible storage facilities
are). Of this probably 40 million barrels is required to service the
countrys vastly expanded oil infrastructure (i.e. it is not available to
satisfy demand).

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