Dear Investor. at. The latest data from the IEA is difficult to reconcile with what

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1 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 IEA s most recent Oil Market Report (OMR) which estimates that global oil supply in Q 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 The nearby chart shows the IEA s implicit forecast of the cumulative supply excess since the end of 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

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

3 IOC EA [2.2] [Investor Letter 7-15.pdf] [Page 1 of 7] 1 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 IEA s 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 entrepôt 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

4 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 Q oil demand (and make further revisions to Q 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 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) Source: Bloomberg, Astenbeck research [2.2] [Investor Letter 7-15.pdf] [Page 2 of 7]

5 2 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 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 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

6 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 Aramco s 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] 3

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 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 month s 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

8 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 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)

9 600 CRUDE OIL PRODUCTION MILLION BPD - LHS RIG COUNT (DOES NOT INCLUDE FSU AND CHINA ASSUMES NO FURTHER DROP FROM JUNE) - RHS Source: BHI, PIRA, Astenbeck Research [2.2] [Investor Letter 7-15.pdf] [Page 4 of 7] 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 won t rise again. Even in the shale sector there are reports of numerous liquidations of service companies. Who will the E and P

10 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 hasn t happened yet. One of the problems is data availability. Here in America we still don t really know how much oil was produced six months ago. Final data

11 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 5 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. It s 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

12 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 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. Chesapeake s 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] 6 * It is also worth noting that of the current total oil surplus inventory

13 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 country s vastly expanded oil infrastructure (i.e. it is not available to satisfy demand).