Andrew Hall‘s letter to Astenbeck Capital investors for the second quarter ended June 30, 2015.

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.

Andrew Hall – Astenbeck Capital: Renewed fears of Grexit

While renewed fears of Greece exiting the Euro zone and the sell-off 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 IEA’s most recent Oil Market Report (OMR) which estimates that global oil supply in (12 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 IEA’s 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.

[drizzle]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 has actually been happening in the oil market however. If there had been a 3.3 million bpd surplus in OZ 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 02. 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 IEA’s supply/demand balance for OZ. 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 entrepot facilities. It is hard to believe that over 140 million barrels of oil could go unobserved.

Andrew Hall – Astenbeck Capital: Explanation of the missing barrels

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 C11 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.

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.

Andrew Hall – Astenbeck Capital: Falling crude oil inventories

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 let’s 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

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