The Contrarian’s Burden

This week I published a very long letter to investors.

It’s exclusively on the oil market and the Tarpon Folio. I sent it out in four parts. You can either download each part individually here…

Part One: Eighty-four Days Without Fish (An Introduction)
Part Two: Thoughts on Risk
Part Three: Evidence of Mispricing
Part Four: The Opportunity

…or you can download the entire letter containing all four parts in a single consolidated file at this link.

If I were to compress the entire letter into a single message on Twitter, it would be this:

I refuse to let other people do our thinking for us. Also, the decline curve never sleeps.

The Short Version of The Entire Letter

The popular consensus is that the oil market is grossly oversupplied, due to Saudi Arabia’s determination to retain market share at the expense of U.S. “tight oil” producers – a relatively new breed of oil companies drilling in shale, sandstone, and carbonate rock. In this consensus view, the market will remain oversupplied until significant amounts of current production are reduced – a potentially long, painful process.

My view is different. I believe there are fundamental industry trends being ignored that, unless oil prices rise fairly soon, mean the oil market is at risk of sleepwalking into a supply shortage in 2016. In the meantime, the price of oil is unsustainably low and should self-correct fairly soon.

This collapse in oil prices has created egregious mispricings in securities across the capital structures of numerous energy companies. The common stock prices of U.S. exploration and production companies in particular appear the most untethered from conservative appraisals of true value. A number of these firms represent exploitable, once-in-a-decade opportunities for patient investors to compound capital at high rates of return with significantly less risk than extreme levels of volatility might otherwise imply.

I believe a significant and sustained rise in oil prices is inevitable much sooner than consensus. Massive cutbacks to drilling programs plus natural decline rates across the world’s oilfields may render the industry temporarily unable to increase production enough to control the pace of an increase in oil prices as demand begins to exceed supply.

Oh, and also:

Is it just me, or does the Middle East right now look like a Tom Clancy novel that ends in massive sectarian war?

Because, um, nobody has told the oil market.

The shares of the companies we now own in Tarpon have been extremely volatile. But that same volatility appears to have driven out the vast majority of institutional investors, who because of clients far less patient than you all, are doing their best to avoid the sector entirely. This has temporarily left us with a large, exploitable advantage over some of the biggest investors in the world.

I believe the odds we have on our side right now are the most favorable we have seen in any area of the stock market since late 2008. As a result, Tarpon is now entirely focused on this opportunity. I have deliberately chosen to concentrate our efforts and capital here. We are, effectively, all-in on U.S. energy companies, and this is somewhat of an unexpected and dramatic shift in our holdings.

I’m hoping the rest of this letter will help explain why.

Please email me direct with any questions. Thank you and Happy Thanksgiving!

– Cale

Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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