Elm Ridge commentary for the second quarter ended June 30, 2017; titled, “Dumb And Lonely.”
“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
This was our worst half ever. This quarter and year have been all about energy, which accounted for all of our losses and then some (-12.5% and -24.5% alpha1 respectively). And while the statistical data continues to come in generally as we would have expected, there are enough inconsistencies and one-off data points to scare off investors from fighting against an overwhelming shift in sentiment – and enduring the patience necessary to mend a market that had been absorbing excess supply for the past two years. Investment banks are now tripping over each other to lower their price assumptions,2 and the sector has been the worst performer in the S&P 500 this year, trailing the index by more than 20 percentage points.
“The principal dynamics in the world’s capital markets revolve around a tug-of-war between feeling secure and making money. In the end, the feelings generally win out. A substantial amount of money can thus be made if a value investment manager is willing to spend the bulk of his or her professional life feeling depressed, isolated, and afraid, waiting for the forces of mean reversion to relieve the stress, at which point the manager will sell and use the proceeds to rebuild anxiety. Is it worth it? This question, of course, is philosophical, but the money on the table is considerable, and the question deserves serious thought.” - Lew Sanders
“Don't Give Your Money to Psychopaths, Says Science.” - E-mail Subject Line from Compliance Website
Tumbling oil and oil-linked equity prices, followed by what seems to be the last remaining bulls from both the buy and sell-side throwing in the towel, would lead anyone to question a bullish view of the oil market. And yet we are still there. Imagine that. We are once again off by our lonesome, with many of our readers and almost everyone else thinking we have lost our way, are overly stubborn and disconnected from reality. It may as well be 1999, 2002, 2006 or early 2009.3
Indeed, while we are going to spend most of this missive dwelling on our oil bet, I would hazard a guess – admittedly I can’t demonstrably support this contention – that oil’s performance has as much to do with allocators seeking bond-plus like returns in a low-rate world, as it does with the data themselves. As FMMI research notes:
In the hedge fund industry’s former years the investor base consisted of very-wealthy individuals, willing to take risk in an attempt to earn double-digit returns in a sliver of their portfolio. That’s changed … Institutions have sought refuges from market volatility… Underfunded and feeling vulnerable they believe they can ill afford to fall further behind. They’re looking for uncorrelated returns and want their portfolios… to produce bond-like volatility. For 2017 they’re targeting 7.5% returns with 6% volatility, a fairly ambitious target when the entire corporate bond market yields 3.9%. The rise of that risk-averse group, that now represents two-thirds of the asset base, has transformed the industry’s character.4
We are old school. Most professional investors and allocators cannot afford to fall behind their peers in an attempt to capitalize on what some might see as big changes ahead, as only a select few are given a long enough leash to ride it out. The much heralded shift toward quant investing is just a logical outgrowth from the enduring low interest rate bond-plus investing environment, as machines are optimized for inductive logic to uncover and capitalize on pattern behavior at what seems to be an instantaneous pace. We saw a huge opportunity, albeit with an ill-defined timeline, and filled up while we thought we still had the chance. But to this point, we got the psychology wrong and are still paying the price (and in hindsight, I’m not sure that we would have signed up to pay this price) for taking on idiosyncratic risk in order to garner what we deduce (computers can’t do that) to be some juicy rewards when the market gets too tight to ignore. Then we’ll see just how low-vol the popular funds really are.
Oil’s Well If It Ends Well
“When you're that successful, things have a momentum, and at a certain point you can't really tell whether you have created the momentum or it's creating you.” - Annie Lennox
“Doubt is not a pleasant condition, but certainty is absurd.” - Voltaire
What data are we looking at? Rather than declining, OECD inventories actually rose 50m barrels through May (the last reported monthly). The US oil rig count, up by 440 or 140% since the May 2016 trough, is back to early 2015 levels, and the prevailing story holds that producers are much more efficient and can easily balance the market at less than $50. Meanwhile, demand is supposedly weakening and it is now accepted that inventory levels won’t decline to normal levels by March 2018, when OPEC resumes production growth.
Supply / Demand
We forecast global supply and demand in great detail to inform expected changes in inventory levels and thus the direction we think oil prices are headed. Most importantly, we recognize that nearly all the data can be squishy and massaged to argue almost anything. With that said, you would expect that we have been way off on one or both given our YTD performance. Reported supply is generally the most accurate, so let’s start there.
Recent headlines suggest that a faster than expected US shale response and the return of Libya and Nigeria have muted the 2017 rebalancing. While US production has outpaced our bearish forecasts, largely due to a February bounce (winter weather evidently had a greater impact than anticipated), actual monthly data compiled by the EIA is still coming in well below its own oft-publicized initial weekly estimates (that it doesn’t bother to revise).5 And in spite of their recent ramp, Libya and Nigeria have underperformed our forecast by an equal amount, leaving our total global supply forecast largely unchanged.
Demand is a bit more difficult to measure and the IEA data, which is generally used as consensus, has historically been subject to large revisions, averaging over +1mbd per year this decade. The IEA’s initial 1Q demand growth estimate of 900kbd fueled macro concerns, but the agency still expects full-year growth of 1.3mbd. While it is entirely possible that demand is underperforming expectations, it is just too early to tell, and unlikely given the usual pattern of revisions. With that said, the purported 1Q slowdown looks temporary: as India accelerated from a flat 1Q to up 4% since March and the US grew 2% in both March and April. While oil has mostly been a supply story,