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

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