Elm Ridge Capital letter for the third quarter ended September 30, 2016; titled, “I Feel Good.”

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“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” — Mark Twain

Elm Ridge Capital
Elm Ridge Capital

Elm Ridge Capital – I Feel Good

“I feel good, I knew that I would

I feel good, I knew that I would”

– James Brown, “I Got You,” 1964

I’ve had the basic gist of this letter in my head for a while now, but wasn’t going to go with it if we managed to pull out a bang up quarter. Even if it was just due to happenstance, we couldn’t have the tone reflecting the associative, inductive logic that would worry both us and our investors.

It is not that we feel good because we had a decent quarter, or that at least a few more investors are seeing things our way. No, we do read the Journal,1 one of the leading mouthpieces for all those lined up on the other side. We feel good because the data and math tell us that the energy story is almost surely going to reverse. And those everconfident and less-vigilant pontificators are going to be eating crow. (Who are we kidding? They are just going to claim they saw it coming the whole time.) Indeed, that might just serve as the spark to undermine the herding (although we might see it rekindle in the short-term, as FANG and some of the other fund favorites rebounded this past summer) and the fear of idiosyncratic risk-taking that have driven value’s underperformance over the last few years.

During the summer, we were countering logic that seemed rather straightforward. Oil prices were around $40 and falling. So therefore supply must be greater than demand. The rig count had increased. Therefore current pricing must support both more drilling and current production levels. And lastly, the world looked like a scary place. So demand appeared threatened as well.

So why were we still playing what seemed to be a losing hand? Are we just one more band of those high conviction types who shut out discordant signals? No. As we note in our deck on why value works (we’d be glad to send you that one or our slides on energy), the “stories” we take issue with are almost always more accessible, as both the press and most investors dwell on the “is’s” to the exclusion of the “should’s.” In fact, this recurring phenomenon comes in handy, supplying a rather dependable stream of counter-arguments to keep us from getting too comfortable with any particular thesis. In other words, we don’t often feel good. We do now.

Say It Loud

“You’re like a dull knife

Jack, you just ain’t cutting

You’re just talking loud

Then saying nothing”

– James Brown, “Talkin’ Loud and Saying Nothing,” 1972

To paraphrase my dad, what makes us so @#$%ing smart? Why doesn’t everyone else see what we do? It’s simple. As trends continue, those riding the consensus become more emboldened and less vigilant. They take their unsupported assertions and say them louder. The Journal is more than happy to rehash them.3 After all, they’ve been right until now, so they must be smarter than us dissenters. So as oil prices fell some 20% during the summer swoon, one of our readers forwarded me this email:

Since the Carter Burden conference in June, I gave a prediction that oil would fall. As of this date we are down 22%. Not a bad return… The culprits per my presentation were Opec Cheating, Gasoline demand peaked in July, excess gasoline inventories, US Rig Count increasing (they {E&P} have to pay the debt), and finally less demand…Although Oil is bouncing today, don’t Confuse Brains with a Bull Market (Someone has to tell the truth)[his emphasis].

We never thought that an OPEC cut was ever part of any credible higher oil case, as opposed to the more nuanced view that the group would not be able to grow production sufficiently to make up for shortfalls elsewhere. That the organization would never agree to a deal was often trotted out as a straw man in support of lower prices. Now, in light of the recent agreement (and one that might merely reflect the reality of the production constraints that we have already posited), we hear that “there is such a worldwide glut of oil; one that would need millions of barrels a day to be cut, not less than a million. This measly amount will not give you a lasting impact.”4 A day later we saw this claim:

We haven’t heard from the Russians who are going full out. The U.S. has stabilized at a production level that is 1 million barrels lower than its peak of 9.6 million — and is about to go higher because of lower production costs. So, the deal by itself is just chimerical. But, by saying it, OPEC managed to keep the price from plummeting — as it was about to. But remember, by November we will know the target can’t be hit without a big pickup in demand — and once again crude will be fighting to stay above the $40 level, where production from the U.S. keeps coming back on line because of the 43% increase in rigs in the Permian since the country’s rig-count low earlier this year.

And of course the Journal chimed in with the assertion that “most skeptics of the Organization of Petroleum Exporting Countries’ plan to limit production worry it won’t be fully implemented and prices will fall. But history [they went on to talk about 1985] suggests prices could fall even more if it is implemented.”

Let me see if I got this right. Oil prices are going to fall because OPEC won’t cut. But if they do cut, prices will still fall. And the evidence for that assertion: 30 years ago, in the wake of an embargo, and after prices soared twelvefold in the previous six years (5x on an inflation adjusted basis), world oil demand fell 6% over that time (OECD demand was down 15%, while non-OECD demand continued to grow). The resulting imbalance was only compounded by the fact that non-OPEC production grew from a 54% share to more than 2.5x OPEC’s size during that same period.7 Does this lesson really apply to one where world demand is still growing at a 1.5% rate and where OPEC’s peak-to-trough (2014) market share declined by less than two points?

If we’re talking about the ‘70s and ‘80s, most of you know that some personal recollections are in order: starting with eight of us driving everywhere alone in our 5-mpg Mustangs, Impalas, Cutlasses and Trans Ams; to having to sneak into a gas station at 2am to get our tanks filled during odd-even rationing; to finally piling those same eight into a Mazda GLC some 5 years later. In fact, after conservation had seemed to finally run its course, my first research task at Sanford Bernstein back in 1988-1989 (when I was just a couple of years away from trading in that GLC for a Jeep Cherokee), was to figure out just when the world would need new offshore production facilities. True (that), the above might be better stated as the Journal’s assertions are no more relevant than my anecdotes. But if we look at the more relevant history, the biggest drop in OECD demand since I dumped that GLC was the 8.5% decline from 2005-09 after prices more than doubled, with total world consumption edging down just 1.5% during those last two years (after creeping up during the first two).

Still, my favorite claim was this incoming e-mail. “A solid rule of thumb is ‘every 5% rise in spot erodes demand by 1.5%.’ Consequently OPEC cutting by 700k bpd would be over ridden by the ~1.4m bpd loss in demand. Basically an OPEC cut leaves market 700k bpd oversupplied.” There are two interesting equations here. The first (i.e. 5 gets you 1.5) completely ignores the readily available math in the paragraph above (100 got you 1.5, where some might argue that the declines were compounded by the Great Recession). It might also imply that the more than 50% price plunge starting in November 2014 would have boosted demand by some 15%, instead of the 1-2% that actually ensued. But the second (700k cut produces 1.4m demand drop) is absolutely ludicrous, implying that any curtailments in supply will drive down demand by twice that amount. In other words, previous oil spikes didn’t really happen. While I may already have devoted too much space to this one example of loose-lipped ignorance, I might suggest that we replace the “th” in his rule.

But let’s dissect the case with a little more precision. First, oil prices are dropping, so supply must exceed demand. That must be true at the moment. But supply at any one point includes that which can be sold out of inventory and we will admit that inventories have built over the past few years. Today, the world has four more days of supply than the 2010-14 average of 43-44 days, during a period when oil often sold for more than $100 and OPEC maintained much more spare capacity. Indeed, this inventory issue is why we are not making a more definitive call on timing. Next, the US oil rig count has increased (from 300 at the trough to 425 of late, compared to 1600 two years ago – and yes we recognize that some of them are more efficient). Also true. But this was also bound to happen as we recovered from the dislocations spurred by rigs moving from high-cost and financially levered players to areas and operators better able to utilize them in a low price environment.

Now we get to the big (unsupported) assertion: current pricing must support current production levels. That we would argue is flat out wrong. At this point, current production is almost entirely driven by decisions made in a higher priced environment. We now have growth coming from Canadian Oil Sands, offshore Brazil and Gulf of Mexico projects that were all sanctioned 5-10 years ago. Meanwhile, less than 25% of current U.S. shale output, which continues to edge down, is coming from wells completed within the last year, when the rig count had been cut in half (again). Due to natural decline rates and demand growth, we need to replace approximately 5-7% of global supply each year to keep the market in balance. Yet since the start of 2015, newly sanctioned projects (the best indicator of future production) have only totaled 1% of supply, implying that in just two years, low oil prices have destroyed enough supply that will leave the world more than 10% short.9 One might think that US shale can easily fill the gap. Yet our calculations (which have been on target to this point) would suggest that at the current rig count, US crude production will be down another 500-600kbd 12 months from now. In fact, if those saying it loud ever read the various reports forecasting increasing production, they might actually see that in almost all cases, those making the estimates are assuming that prices will indeed rise to create that result.

And with world demand slowing…oops let’s take that one. An IEA report arguing that demand growth had slowed (note that this is not the same as declined) drew headlines this summer, just after India returned to a normal monsoon season and China had curtailed industrial production in an attempt to reduce pollution in advance of the G20 summit. Of course, just one day later, we saw India’s August consumption come in at up 11% y/y, a 300kbd swing from July.

Today, just as I was putting this letter to bed, the US DOE reported one more “surprising” inventory draw. (In fact, since the beginning of August these draws have come in 33 million barrels better than consensus.10) And yet rather than reading about these boring statistics, I saw “’Wall of Supply to Block Oil Rally at $55” displayed across my Bloomberg. In fact, our read of the inventory and production data suggests that we may already have crossed that point where we are sustainably producing less than current demand. And given the capex cutbacks to this point, there is little that can be done – even if prices spike – to keep that spread from widening over the next year.

Saying it Loud has not confined itself to the energy debate. As trends have endured, the investment world in general gives short shrift to analysis. Every day we wonder whether a research piece, newspaper article or management claim was lifted right from today’s political headlines. So we get this defense of a medical waste collector whose core business is now threatened by the trend of hospitals buying up local medical practices: The ongoing hospital group consolidation across the US has created “blend customers” –small quantity customers that are somewhat hospital-affiliated…. Management does not expect a material margin impact as consolidation moves more volumes from large quantity to small quantity customers, which are much more profitable.”

In other words, hospitals are going to direct business to a local practice that would have to pay higher rates for collection than what their new owners already have under contract. I get it.11 Of course, just a couple of months later, when the company publicly conceded that its core business was indeed under pressure, the offending firm noted that “pricing issues in the core medical waste business resulting from consolidation of doctors’ practices into larger hospitals whereby contracts are re-negotiated or RFPs put out were not well telegraphed.”

In an article arguing against higher interest rates, Barron’s challenged my understanding of the gozintas.12 WHY ARE THE HAWKS SO HAWKISH? For starters, their concerns aren’t unreasonable. The U.S. unemployment rate has fallen to 4.9%, a level that has, in the past, suggested the country has reached full employment. And concerns that ultra-low interest rates could lead to asset bubbles—a topic that was brought up at Fed chief Janet Yellen’s press conference when she was asked about commercial real-estate prices—are real…

It is, however, important to separate those fears from reality, [the Chief Economist at a wealth management firm ] says. If the U.S. economy were at full employment, wages would be going up. Instead, they have recently started to decelerate. [my emphasis]

No fact or logic checkers here. Decelerate = going up, albeit more slowly.

Saying it Loud is not just confined to the press and the analysts who feed it. We can’t help but relate this one from a CEO who sent his shareholders a letter stating that the six ships his company was buying “will be financed from internal resources i.e. we do not plan to issue stock to finance these acquisitions.” Of course, just four weeks later they announced an equity offering, spurring this dialogue:

ER: I’m surprised that you are issuing equity 26 days after explicitly saying you would not need to. IR: We said we wouldn’t need to issue equity for previously ordered ships; this is for potential future acquisitions. ER: So, you are planning to buy more ships? IR: We may be. You see, no other shipping companies have any money to buy ships.

Then again, this company had already learned how gullible the market truly is. During a February interview on CNBC, the CEO was asked “Is the dividend at risk in any way – cutting it in some form or fashion?” His response, “well I haven’t cut it for 74 quarters,” sent the stock up nearly 25% in the 30 minutes around the interview. Oh, by the way, the dividend was cut some 40% this past summer.

Elm Ridge Capital – Where We Are – Portfolio Statistics

Elm Ridge Elm Ridge Capital
Elm Ridge Capital

“Can I speak that intelligently to their free cash flow? No. But can I speak to their dividend yield and the fact that they are buying back stock? Yes.” – CNBC Contributor

Our financial exposure led the way during the quarter, as the 15% or so we deployed in our banks (BAC, BPOP and C) insurance (AIG) and student loan servicer (NAVI) more than regained what they lost during the Brexit rout (these five accounted for about 2.5% of outperformance during the quarter, bringing them back to about even on the year). While low interest rate levels (hard to see them declining too much further) remain a general overhang, we expect the three banks and insurance companies (trading at about 80% of tangible book) to retire 7% of their shares outstanding over the next year, while providing a 2% dividend yield without levering up. So, while we wait for a potential re-rating, the book value per share continues to grow in excess of earnings, as they repurchase shares below book. (And we’d be remiss if we didn’t distinguish these kinds of buybacks from all those done at much higher valuations and financed with additional leverage.)

Meanwhile, the 15% we have in the two monolines chipped in a percent of outperformance as well (same for the year). For most of the quarter, investors were awaiting the PROMESA control board that was put in place at the end of August. As it gets to work, the next two quarters should show more tangible progress. The deal for PREPA (which is 1/3 of MBI’s Puerto Rican exposure) is on track to be completed early this winter. And once there’s more clarity on resolving some of the credits, both AGO and MBI will request (and likely receive) approval for dividends to the holding companies, which would allow for accelerating stock repurchases. With the stocks trading at a fraction of book value, these buybacks are highly accretive.

While benchmark oil prices closed the quarter about flat with the previous one, our energy longs still managed a 5% gain and added another 1% of outperformance (bringing the yearly total to nearly 11%). We remind you that our target prices here still average more than a triple from this point.

While our shorts cost us slightly less than 2%, they did add about a point of alpha as they trailed the market. As is the case with our longs, our short research tends to focus on those areas where supply responses (excesses) overwhelm the more accessible demand stories one often sees trumpeted in research and the media. We think of these in four general buckets. We have excess supply: 1) of cyclically-induced capacity; 2) stemming from new entrants into a formerly attractive secularly-growing business; 3) of an asset class; and 4) in response to a heretofore successful investment strategy. In the present environment, you could think of 3) as creating new “safety” stocks and those with high-dividend yields (a number of which are unsupported by cash flow and are financed with asset sales and equity issues instead). And 4) has produced all of the roll-ups, platform companies and excess leverage designed to reward activist financial engineers.

While our bucket sizes held relatively still in the 25%, 20%, 15% and 20% range, we were still busy here, adding six and exiting eight names in a wide range of industries, with almost all of the moves coming because we found better replacements. The last two buckets led the way, contributing about 1.5% each of outperformance, offsetting the 2% hit from the second category (where in a few instances the reversal of the long-term trend was interrupted by slightly better-than-expected performance in the short-term).

Turning to the statistics that we typically report, low near-term energy expectations are still producing the rare condition where the Street P/E’s of our longs exceed those of our shorts. Yet we can again repeat that our estimates paint a very different picture. Meanwhile, the short-to-long ratio for the Elm Ridge P/NEPS (our primary internal measurement of the overall potential return in the portfolio) has continued to remain at levels only surpassed by a few readings in the past year and a few months during 2008-09, echoing the gap shown in the Price/Book chart (below left). History has shown that when value rebounds, the turn is swift, with a multi-year tail of steady gains (below right). To repeat what we said three months ago, for those investors prepared to step outside the comfort of the herd, the potential rewards of our contrarian strategy are the best they’ve been since Elm Ridge has been around.

Elm Ridge

In the meantime, most value managers continue to drift away from what we deem to be true value. The trend is most evident by our own valuation measures (next page left), but also reveals itself using objective P/B measures (next page right). Other value managers have drifted to such an extent that we could now be called “deep” value despite us not having changed our process over our 17 year history. When they return to being true value managers, we will again be just plain value.

Elm Ridge

Elm Ridge Capital – Payback

“The brother get ready! That’s a fact!

Get ready you Mother, for the big payback”

– James Brown, “The Payback,” 1973

“Speak Softly and Carry a Big Stick”

– Teddy Roosevelt

Back in the late 90s, I used to keep a folder labelled “Payback” where I would keep notes, assertions etc. that I wanted to respond to (talking trash was a required subject where I grew up) when they were shown to be ludicrous. Of course, by the time the pontificators threw in the towel – no let me correct that, they never throw in the towel, the ref had to stop the fight – we’d just be echoing the prevailing narrative. (Our June 2002 letter was less than a page excluding the tables.)

But that’s our lot in life. The reason we are able to capitalize on such huge (sticking to the political theme) and to us, rather obvious, opportunities is precisely because the early success and resulting din from the other side drowns out all attempts to question prevailing wisdom. We may say the crowd has it all wrong when no one wants to believe us, but we’re already too unpopular to go with the I-told-you-so when the tide turns. The pack will be too busy searching for scapegoats to compete against our efforts to look for the new winners. And so we get both Mo’ and value on our side.

It shouldn’t be too long before I can turn down the invective and echo Teddy Roosevelt. It will waste a lot less paper.