Open Square: the small hedge fund that rose 100% due to oil surge in 1H 2018
Ángel Martín Oro, inBestia.com
The piece was originally published in Spanish at inBestia.com (3rd of August)
If you were told that a fund had risen 100% in just 6 months, how would you think it had done so? Due to high leverage? Betting on penny stocks? Surely you would expect that it would have been, at least in part, a matter of good luck, and that in other periods with worse luck the result would have been utterly negative.
The case we are discussing today is somewhat different, and certainly interesting. We’re talking about the Open Square Fund. It is a hedge fund managed by Open Square Capital, an asset management firm founded in August 2015 and based in California, led by Nelson Wu.
The fund uses a thematic investment approach, searching for investment opportunities globally with a contrarian bias (“We believe that there’s no safety in the unanimity of opinion; and that thoughtful contrarianism can lead to extraordinary results.”, as said on their website). It consists of a concentrated portfolio of a few select assets that it maintains for the long term. In their writings they often emphasize the importance of patience for the success of their strategy.
The firm searches for “themes” in which they perceive great confidence and certainty on the part of broader market participants, and then rigorously and critically analyze the starting assumptions that the vast majority take for granted. In the event that these assumptions prove incorrect, the consensus market thesis fails which then allows the firm’s investments to outperform.
Fund performance in the first half of 2018 and since inception
The spectacular performance of this first half of the year is due to the rise in oil prices and their translation to equities in the sector. The bullish thesis that they had maintained for some time seems to be coming true, and with it their portfolio has experienced a large rerate.
This is a good example of their “thematic” approach described above. After researching the market consensus thesis of ‘lower for longer’ (that oil prices would remain low for a long time) they found serious flaws in the assumptions underlying it, and bet hard against it. Or in favor of the bullish thesis. “If just one of those assumptions proves incorrect, then the thesis breach means our investments will not only survive, but thrive.”
We see in the first table below the performance of the fund in the first half of 2018: +99.85%. But you can be sure that in previous years it was abysmal, right? Well, not really. 2017 was disappointing, but remained positive, although the benchmark (S&P 500) rose by 21%. And in 2016 they had a very good return, beating the index by about 20 points (although this is data prior to fees, unlike the rest). Since inception (August 2015), the fund has been outperforming very well, despite the challenging initial phase.
Source: Open Square Investor Letters.
Currently, according to the information provided to me by the firm, the portfolio has an exposure of 80% to the energy sector, with a gross exposure of 115% without any shorts. During the first half of the year, the fund maintained a minimal level of leverage, in the range of 110–120% of gross long exposure. “It allows us to capture some additional alpha, but still manage risk exposure. Having the ability to leverage also allows us to mechanically rotate the portfolio and enter/exit positions more easily”, said Wu.
Some of the positions that contributed most to the fund’s performance were California Resources (CRC), Whiting Petroleum (WLLL) and Gear Energy (GXE). Below you can find their 1-year charts, marking the beginning of 2018. In the last month they have dropped, accompanying lower oil prices.
(Data as of 3rd August, 2018.)
In addition to these three, Cheniere Energy (LNG) and, surprisingly, Apple (AAPL) form the top 5 positions. As the holding of the latter illustrates, Open Square is not an exclusively energy-focused fund, but one that is focused on energy today, with a flexible mandate.
In spite of the strong performance of energy equities, they think that the rally has only just begun:
Energy stocks currently comprise just 6% of the value of the S&P 500 index when the long-term average is closer to 13%, and energy equities still do not reflect today’s oil prices, let alone where they are headed. According to a recent Goldman Sachs report, E&P stocks were valued as if oil was still $60/barrel, almost 20% lower than the WTI $73/barrel now. (note: as of today it’s at $69)
This gap between the sector’s shares and the price of the commodity is expected to close as investment interest in this area returns after years of trouble. As a data point on the positioning and sentiment about the sector, they point out that since March 2012 the number of global funds dedicated to commodities has fallen from 368 to 130.
Open Square Capital’s Bullish Thesis on Oil
At the beginning of the year they presented and updated their bullish thesis, which they published under the title ‘The impending oil shortage’ (1 and 2). They predicted that we were “on the cusp of the next oil super cycle”. But this view was not shared by the majority. They ended their presentation with the following graph, which showed the expectations of investment banks on the price of oil during 2018. The consensus saw the price in the narrow range between $50–60 in the case of WTI oil. It can be said that the rising oil prices view was in the minority…. And it was right. Today it is above $67, which is clearly above the range of estimates.
In their latest quarterly letter to investors, they review the current state of the oil market and its prospects. Despite the price rise and the upward revision of estimates, the idea that prices will continue to rise to as high as $100 a barrel is contrary to consensus. Open Square Capital predicts that the shortage of supply will continue, eventually leading to an “energy crisis” with multiple repercussions on the economy and markets.
Eventually as inventories draw further, prices will readjust. The entire curve will lift higher when the market understands and then believes that the oil shortage will be more acute and longer lasting than what the consensus believes today.
The measures that could be taken to mitigate this supply shortage are of very limited impact, as illustrated in the figure below.
The solutions should have been taken long ago. Today, given the underinvestment that the sector has suffered for years, it is already too late according to Open Square: even if producers wanted to, it is not possible to significantly increase global oil production in the short term. Recent OPEC+ (including Russia) announcements will not be enough. Saudi Arabia or Russia can do their bit by increasing production, but countries like Venezuela (which they think it’s close to a “failed state”), Libya (where there is high uncertainty) or Iran (with the problem of sanctions and structural problems due to lack of investment) are offsetting this. And the U.S. shale oil sector cannot do much more, partly due to saturation problems that exist in the oil pipeline infrastructure, which restricts production in the short term.
In short,”Oil supplies are insufficient to meet today’s level of demand. Even if producers were to immediately deploy capital, there would still be a multi-year lag between the spend and when oil actually enters the market.” All of this translates into the current fall in inventories (see the chart below), which the firm predicts will accelerate from now on, causing oil prices to rise sharply above $100, and consequently, a considerable rerate of the fund’s portfolio.
Now, what about demand? The central pillar of Open Square Capital’s thesis rests on supply, but it is also necessary to analyse the demand side, which Open Square’s Wu said “is much more difficult to triangulate than supply”. In his opinion, “demand will continue to grow this year at more than the IEA’s 1.4M bpd forecast, and also into 2019 if the economy maintains its trajectory. We tend to look at a dashboard of leading economic indicators to take the temperature of the global economy and still see robust China / India growth.”
In this positive global scenario, they believe that the turbulences generated by trade war tensions will not further increase because it is of no interest to either party. But even in a case of economic slowdown affecting oil demand, they still see a scenario in which supply would be difficult to meet demand, especially in the near future.
In the last part of their most recent quarterly letter they reflect on the progress made so far. They point to the initial difficulties, when the price of oil plummeted and the fund started on the wrong footing, testing the conviction of their contrarian ideas.
I didn’t want to close this article without including two quotes from two investment legends appeared on Open Square’s letter. Both are excellent and can be very useful for investors who are going through a difficult time challenging the market consensus.
“Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom” — David Swensen (Yale University endowment manager)
“To be a successful investor, you have to have a philosophy and process you believe in and can stick to, even under pressure. Since no approach will allow you to profit from all types of opportunities or in all environments, you have to be willing to not participate in everything that goes up, only the things that fit your approach. To be a disciplined investor, you have to be able to stand by and watch as other people make money in things you passed on” — Howard Marks (Oaktree Capital)
Note: This article has been prepared both from publicly available information and from the information that Nelson Wu has provided to me in the exchange we have had. I thank him for his availability, kindness and time dedicated]