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Capital Management LLC 200 Pequot Avenue Southport,

CT 06890
January 4, 2016
Dear Investor,
Last year wasnt much fun for anyone investing in commodities.
Commodity indices fell to levels last seen 15 years ago and that were
initially breached over 25 years ago. An uncertain macro-economic
climate and a strengthening dollar provided strong headwinds which,
combined with moderately oversupplied markets, drove prices to
multi-decade lows.
We opined last month that it wasnt time to exit the oil market even
though there was a risk that in the short term prices could move
lower. And move lower they have. A fractious OPEC meeting, an
exceptionally warm start to the winter and the likelihood of an earlier
lifting of Iranian sanctions than originally expected all weighed on
While the last OPEC meeting did not change the fundamentals, the
rhetoric that emanated from it had a distinctly negative impact on
sentiment. OPEC producers are probably already producing close to
their maximum capacity. Last month they reiterated they would
continue to do so.
The warm start to the winter however has had a material impact on
short term supply-demand balances. Very warm weather across much
of the northern hemisphere has reduced demand for
distillate used as heating fuel by around 400,000 bpd in Q4 2015.
Distillate was already the weakest part of the refined product barrel so
this development has not been helpful.
Iran has made more rapid progress toward satisfying the conditions
necessary for sanctions to be lifted than was generally expected. This

could now occur before the end of Q1 2016 some three months
earlier than originally anticipated. No one knows exactly how much
Iran will be able to increase its exports but if it is 500,000 bpd, as the
Iranians claim, then the earlier lifting of sanctions will add on average

Source: Bloomberg
[2.2] [Investor Letter 12-15.PDF] [Page 1 of 7]

bpd of additional supply in 2016. There again, the latest reports from
official Iranian news sources say Iran will only add to supplies at a rate
that the market can absorb without unduly impacting prices.
In previous letters we have argued that to correct a short term
imbalance in the market, oil prices are being pushed to a level that is
unsustainable in the longer term. Furthermore, because the
adjustment to supply is being made through drastic cuts to capital
expenditure which cannot be quickly reversed, the stage is being set
for a supply shortfall in the future. Prices will eventually have to move
to a level that creates supply rather than destroys it. We (and most
other observers) believe that price to be well above current levels. Yet,
remarkably, the 5 year forward price for Brent crude oil has fallen
dollar for dollar with the spot price over the course of the past year.
Likewise, in the leg down seen last month, which was provoked by a

temporary deterioration in short term balances, deferred prices fell as

much as spot prices, which makes little sense to us.
While current prices are not sustainable, it is also apparent that the
supply response to low prices is taking longer than expected.
Production in places like the U.S. GOM, the North Sea and China has
been boosted from projects coming to fruition that were initiated
when oil was $100+. Production gains were registered in all three of
these regions during 2015. In Russia, oil producers have benefitted
from a depreciating ruble which has allowed them to meaningfully
step up their drilling activity and as a consequence grow production by
about 1 percent. In the U.S., producers were able to offset collapsing
rig counts down two thirds from their October 2014 peak - by
concentrating their activities in the most productive locations (the so-
called sweet spots). The brief price rally last spring also allowed some
of the weaker U.S. producers to raise fresh capital. So U.S. production,
while no longer growing and down significantly from its peak, is still at
the level of a year ago.
It wasnt only non-OPEC production that surprised to the upside in
2015: OPEC production registered an unexpected and sizeable
increase due largely to a surge in exports from Iraq as infrastructure
bottlenecks there were eliminated. Saudi Arabia also pushed its
production to record levels.
So while the demand response to lower prices was in line with
expectations demand was up by at least 1.8 million bpd in 2015
compared to a year earlier supply has come in at more than 1 million
bpd higher than forecast. This means the market will now only achieve
a balance later than originally anticipated. That said, things are clearly
moving in the right direction. At the beginning of 2015, non-OPEC oil
production was growing at over 2.5 million bpd year-over-year. By the
end of 2015, that rate had most likely fallen to zero based on current
estimates. Production from OPEC is very unlikely to show the growth it
achieved in 2015. Saudi Arabian production is close to its practical
limit. Iraq will have difficulty maintaining its current record production

levels: the cash-strapped Iraqi government has given instructions to its

IOC partners to cut back drilling as it cannot afford to see revenues
diminished by cash flows being diverted to investment.
An updated and detailed country by country analysis suggests non-
OPEC oil production should fall by around 1 million bpd in 2016. Crude
oil production in the U.S. is expected to lead the decline as rig counts
continue to fall and further gains in rig efficiency become harder to
achieve. Growth in Canadian production is expected to be offset by
continuing declines in Mexico. Overall, liquid hydrocarbon supply in
North America should fall by 500-600,000 bpd in 2016. In Latin
America, (lower) growth in Brazil is expected to be largely offset by
declines in Colombia. Europe should see production decline by a little
over 100,000 bpd as the pipeline of legacy projects there runs off and
maintenance deferred from 2015 impacts production in 2016.
Russian government officials have intimated that production there will
at best flat line in 2016. With production in Azerbaijan and Kazakhstan
expected to continue to decline, total FSU production should fall by at
least 100,000 bpd. China, which also benefitted from the startup of
legacy offshore projects in 2015, is expected to see its production drop
by 100,000 bpd in 2016. The state oil production companies are
expected to slash investment in high- cost, mature onshore oilfields
that have very high decline rates which will result in accelerating
production declines. Production is also expected to decline in India,
Malaysia and Vietnam.
As mentioned earlier, while OPEC production will rise somewhat, it is
unlikely to show the sort of growth seen this year. The biggest
element will come from Iran, with smaller increments from core- GCC
members generally offsetting declines elsewhere. This ought to leave
overall OPEC crude oil production higher by about 500,000 bpd.
With OPEC NGL and condensate production expected to grow by
200,000 bpd, total global liquids supply should decline by about
300,000 bpd.

If we assume demand growth in 2016 slows to 1.3 million bpd (from

more than 1.8 million bpd seen for last year) then the change in the
total call on inventories is 1.6 million bpd. This is about in
line with the inventory surplus implied in, for example, the EIA's
supply-demand balance for 2015. That means the market would be
balanced on average over the course of 2016.
This is encouraging but there is more to the story. Observed growth in
inventories in 2015 has been considerably less than that predicted by
the EIA and other agencies' and forecasters' balances. On average over
2015, observed inventories have built by about 600,000 bpd less than
is implied by the EIA balance.
The discrepancy between implied and observed inventories expanded
in H2 2015 widening to 1.1 million bpd. This suggests that either
demand is being underestimated, supply is being overestimated or
some combination of the two. That the current oversupply is
significantly less than that implied by most supply and demand
balances is supported by the fact that market structure i.e. the
degree of contango is not unusually elevated.
Also, part of the observed inventory build is crude oil destined for the
Chinese strategic petroleum reserve (SPR) and does not constitute a
commercial or discretionary stock build: this oil will not come back on
the market - barring some supply disruption - and for that reason
should be viewed as tantamount to consumption. Chinese SPR
purchases are expected to continue at a similar rate in 2016 to 2015
about 200,000 bpd.
This means the observed and effective oversupply in 2015 has
averaged about 800,000 bpd or about half that implied by most
forecasters' balances. If the call on inventories grows by 1.6 million
bpd in 2016, that would result in an overall decline in commercial
inventories averaging 800,000 bpd essentially reversing the
commercial build seen in 2015. Moreover, as the production declines
noted above are averages for the year, exit rate declines will be much

higher (see first box) setting the stage for implausibly high inventory
decline rates in 2017.
What are the risks to this analysis? Obviously supply could again prove
more resilient than expected. However, conditions for the oil industry
have deteriorated dramatically in the past five months. Rig counts
have resumed their decline and productivity gains appear to have
come to an end. Rising interest rates and widening credit spreads are
making it much
harder for indebted oil producers to fund their activities. Outside of
the U.S., it is unlikely that 2016 will see the sort of upside surprises
witnessed in 2015. The oil industry cannot function with $50 oil, let
alone sub $40 oil.
Another downside risk is that Libya sees some sort of accommodation
between its feuding factions and suppresses IS allowing it to increase
oil production. This could add perhaps 500,000 bpd of additional
supply. Against that, however, should be weighed the risks to supply
from other fraught countries - be they Iraq, Nigeria, Venezuela or for
that matter any of the oil exporting countries, all of which are now
wrestling with severely depressed oil revenues and the impact of this
on restive populations. The escalating sectarian faceoff between Saudi
Arabia and Iran as they jockey for regional dominance also adds a
significant tail risk to the upside. While the recent news that Saudi
Arabia (and Bahrain) has severed diplomatic relations with Iran has no
immediate impact on oil supply, it further raises tensions in the heart
of the world's largest oil exporting region.
Finally, there is the risk that a slowing global economy would also slow
the rebalancing process by reducing growth in demand for oil.
However, our assumption of 1.3 million bpd growth for 2016 is already
quite conservative other forecasters are assuming higher growth
rates. PIRA for example is currently forecasting growth at 1.9 million
bpd for 2016.
The simple fact is that the accepted oil narrative has become

uniformly negative: the glass is totally empty and lies shattered on the
floor. The consensus view is that we are in a period similar to the late
1980s and 1990s which followed the previous Saudi decision in
1985/86 to defend market share and which resulted in a long period
of depressed prices (although not as depressed -
relatively speaking - as today).
This analogy however ignores the fact that back then OPEC spare
capacity and surplus supply were together approaching 20 percent of
global consumption. Today, excess supply and spare capacity
represent perhaps as little as 1 percent of current global oil
consumption. Yet, because of a universally pessimistic outlook, cuts to
capital expenditure by the industry in 2015 and 2016 will - remarkably
- almost certainly exceed those made during that earlier era of much
greater imbalance.
Skeptics will answer that this capital expenditure is not required, and
go on to argue that the supply void created by the cancellation of high
cost oil sands, deep- water and Arctic production projects will readily
be filled by light tight oil (LTO) production in the U.S. and ultimately
elsewhere as costs continue to decline.
However, it's clear that based on various independent analyses, for
U.S. LTO production to recover to growth rates commensurate with
balancing the global
oil market it would require WTI prices to be above $75/bbl (see nearby
box). Moreover, it seems probable that many of the cost savings seen
over the past year will be temporary. Service providers are operating
at a loss which is resulting in bankruptcies and industry consolidation.
Any upturn will see a firming in service prices and therefore higher
costs for oil producers. LTO production elsewhere in the world, where
conditions are much less conducive to its development for reasons we
have discussed in detail previously, will not make a meaningful
contribution to supply for at least a decade, if ever.

But then some might retort that demand for oil is approaching
terminal decline because of the wide scale adoption of renewable
energy, electric vehicles (EVs) and the phasing out of fossil fuels. Yet
even the most optimistic forecasts see EVs capturing only 5-6 percent
of the world auto fleet by 2025 by which time the fleet will have
grown 50 percent. Demand growth for gasoline has been
extraordinarily strong during the past year with the U.S., China and
India leading the way. The latest data show gasoline demand in the
U.S. running at more than 5 percent above year ago levels (1). During
2015 apparent oil consumption in the U.S. grew at a faster rate than
GDP. If intensity of oil usage can move higher in America then why not
elsewhere in the world following a 60-70 percent decline in prices?
It remains our view that the current extreme pessimism is setting the
stage for a significant future supply shortfall and that the risk of this
rises the longer that prices stay depressed and capital expenditure in
future production is further reduced. To be sure, we have learned that
the supply response to falling prices is slower than we and most
observers expected.
However, by the same token, it follows that the supply response to
higher prices will also likely be slower than generally assumed. For a
start, oil companies and their backers will want evidence that higher
prices are going to be sustained and are not just a blip. Secondly,
producers are likely to use higher revenues to repair weakened
balance sheets, at least initially. They will also want to execute hedges
which will be difficult with depressed deferred prices as the market
inevitably swings from a contango structure to backwardation as
inventories start to be drawn down. Finally, many of the mechanisms
that delayed production decline will go into reverse when prices do
recover. Rig efficiencies will fall as companies move beyond their core
sweet spots. Service costs will rise along with demand: some 250,000
people have been laid off in the oil and oilfield service industry. In a
tight job market it will not be so easy to attract those workers back.
If for these reasons the supply response to higher prices is delayed,

then prices would need ultimately to rise to levels that destroy

demand which would require significantly higher prices. Admittedly, in
the very short term through Q1 2016 oil balances on paper look
challenging. Refinery turnarounds will ramp up as we move through
January which will result in additional builds in crude oil inventories.
On the other hand that is probably already priced into the market and
product inventories will meanwhile be falling. Gasoline inventories in
particular are already below year ago levels and with current strong
demand growth gasoline should be supportive of the overall complex.
Moreover, while the exceptionally warm start to the winter has had a
material negative impact on the demand for oil used for heating, a
recent study suggests that (were El Nio to continue) a warm snow-
free winter can add as much as 300,000 bpd of gasoline demand in the
U.S. North East. (2)
In 2015 prices rallied strongly in Q1 - precisely when the rate of crude
oil inventories builds was at its greatest. Additionally, in the U.S. crude
oil inventory builds should be much lower this turnaround season as
domestic production will be declining whereas a year ago it was still
rising. So while recognizing that short term seasonal factors are
theoretically negative we also are cognizant of the difficulty of
predicting price trajectory in the short term especially given current
extreme positioning and the potential catalysts that could trigger short
covering. We therefore continue to believe that the shorter term
headwinds are ultimately trumped by the longer term outlook for
prices which remains firmly to the upside: an industry that couldnt
function at $50 certainly can't function with prices below $40.

Best regards,

Andrew J. Hall Chairman and CEO

Based on DOE weekly data adjusted for actual exports. PIRA December
23 2015 "U.S. Gasoline Demand Stronger During Warmer, Snow-free

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views and information expressed herein are solely those of Astenbeck Capital
Management LLC (Astenbeck) as of the date of this letter and are subject to change
without notice. The contents hereof should not be construed as investment, legal or other
advice. This is not an offer or solicitation for the purchase of interests in any investment.
Any offer to invest in any fund managed by Astenbeck can only be made pursuant to the
confidential private placement memorandum for the relevant fund. Astenbeck will not
necessarily invest or continue to invest in or trade the commodities, currencies or
securities discussed in this letter. Past investment performance may not be indicative of
future results.