Open Square Capital letter to partners for the fourth quarter ended December 31, 2016.

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2016 Hedge Fund Letters

Oil Prices Could Be Headed To $100: Andy Hall

Dear Limited Partners,

2016 . . . what a year. Just after we sent out our holiday letter, the fund’s performance climbed higher in December and we ended on a positive note:

Open Square Capital

In our previous letter, we described the performance as “average.” We said this because while many things went right for us this year, a few things went wrong. Let’s talk about our missteps first because recognizing them should help prevent future ones.

Lessons Learned, Tuition Paid

We completely misinterpreted some warning signs in our Allergan and Bellatrix investments, having failed to accurately account for the weaknesses of the management teams. Both were errors of commission. We rationalized that the value of the underlying assets could overcome what we considered questionable decisions. Management teams though can destroy asset values much more quickly than it can build them, and investors’ confidence can suddenly evaporate. We experienced both; perhaps the former was really illusory and the latter ephemeral, but we should have taken pause, and next time we will.

Our second foot fault was to underestimate how far commodity prices could fall. Our thesis has been that oil prices were too low to be sustainable, and eventually prices would rise again. After oil prices fell from +$100/barrel to sub-$50/barrel in 2015, the market saw no reason why $28/barrel wasn’t an unreasonable price in 2016, and downward it went.

As a result, our investments in oil producers suffered greatly in Q1. We subsequently repositioned the portfolio to focus on companies that had a greater chance of surviving if oil continued to languish; companies that gave us a longer timeline. Fortunately, both oil and our investments lifted off from the lows, and at the trough we had increased our oil investments by 25%. So while we were wrong about the extent of the decline, we remained resilient and even increased our invested capital. Thus, two good lessons for us, the volatility in commodity prices can be much greater than even our most conservative estimates, but having confidence in our analysis gave us conviction to buy more during the difficult times. Overall good lessons, we just wish the tuition sometimes wasn’t so steep.

2017 and Beyond

Someone asked us how we think the stock market will perform in 2017 and our response was “we don’t know.” We didn’t say it to be curt, but we’re reminded of this quote.

“The greatest enemy of knowledge is not ignorance. It is the illusion of knowledge.” — Stephen Hawking

While we certainly have a viewpoint about where we think the market may go (and certainly our investments), we’re on guard against thinking we know for certain. After having a positive year, this is where investors can become vulnerable. Just as our thesis is beginning to work, we have to keep learning to stave off ignorance because if we don’t, the Dunning-Kruger Effect may just get us!

Named after two Cornell University scientists, David Dunning and Justin Kruger, this cognitive bias is often played out on Jimmy Kimmel’s segment “Lie Witness News”, when the show interviews people on the streets and asks them satirical questions like whether Bill Clinton gets enough credit for ending the Korean War, or if the 2014 Godzilla movie was insensitive to the survivors of the 1954 giant lizard attack on Tokyo that killed 100,000 people. To that question, one person answered “Yes, cuz it’s a travesty; it portrays death and loss,” . . . yikes.

The Dunning-Kruger Effect is a paradox. It’s the notion that if you’re incompetent, your incompetence masks your ability to recognize the incompetence. It explains why many incompetent people think they are not just doing fine, but great.

What’s important is to understand that “we don’t know” is liberating. That simple phrase frees us to know that it’s okay not to know. It means that perhaps it’s time we do some research and find out. What it doesn’t mean, however, is that we’re allowed to be cognitively “lazy”, that we don’t need to do the hard work that comes from researching and challenging our positions because choosing that option means we’re choosing to be willfully ignorant. Like Winnie the Pooh, we need to think things over, and think things under.

So although we’ve had some successes for 2016, we’re guarding against hubris, Dunning, and/or Kruger because psychologically even small “wins” can blind us with overconfidence. If anything, we know we don’t know, and we know for certain 2017 will bring many challenges, challenges that hopefully translate to opportunities and successes.

Even so, we’ll stay humble to the unknowns . . . lest we end up like Toby, who bit off more than he could chew that fateful day in Tokyo.

Our Three Themes

Let’s update you on our three themes again: oil, natural gas and undervalued companies.

1. Oil

As we described in our Q3 letter, the OPEC members came together in Algiers to announce an oil production cut. While the oil market responded positively, oil prices again declined over skepticism that OPEC could successfully allocate the cuts among its members.

On November 29, at a meeting in Vienna, Austria, OPEC members agreed to share a production cut of 1.2M barrels per day (bpd) for six months, beginning in January 2017. This was a historic agreement, as OPEC members seldom set-aside competing political and economic self-interest to collectively limit production. Non-OPEC countries (Russia, Mexico, etc.) also agreed to cut 558K bpd. Accordingly total production cuts pledged equaled 1.76M bpd.

The cuts have just begun, but the market is discounting the cuts because some producers will almost certainly cheat. It’s hard to wrangle cats, and much harder when the cats are named Iran, Iraq, Venezuela, Nigeria, Russia, etc. We believe some cheating is inevitable, but contrary to the market, we don’t believe the cheating will prevent oil inventories from drawing down. Given that supply and demand is already in balance at year-end, even a 60% compliance rate means that oil inventories will be whittled away at a rate of 1M bpd, effectively eliminating excess inventory by H2 2017. The cut simply accelerates the inventory decline, but overall that decline is inevitable.

We also think that compliance may turn out to be higher than most anticipate. We recently wrote:

“For us, it’s important to remember a key idea in the prelude leading up to the OPEC agreement and its aftermath, and that is this: [s]elf- interest will broker the deal, and self-interest will enforce it.” – The Oil Deal – Pay Attention Because the Game Just Started (12/2016)

Incentives matter, and Saudi Arabia, the largest producer for OPEC (accounting for 30% of OPEC’s 35M bpd output) will materially drive whether the production cut succeeds. As Saudi Arabia transitions its economy away from oil dependency, it plans to sell a portion of its national oil company (Saudi Aramco) in 2018. We described the rationale in our Q2 2016 letter by saying

“Vision 2030 is a strategy shift, and represents an attempt by the government to tackle its dependence on oil revenues and tack away from a future where its main product is no longer desired. With King

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