Reed Hoffman, founder of LinkedIn, recently said that the first truth of entrepreneurship and investing is that the very big ideas are contrarian because being a contrarian is why other competitors haven't already done the same thing, which leaves the space for the creation of something. For entrepreneurs, that something is a company that can dominate its space and for investors its higher returns. This hero's journey isn't without risk as the pitfalls are plentiful, and sometimes the room to fail can seem large and lonely.

If this were a prom, not only has no one showed up, but we've also been stood up as the investment community abandoned the energy sector and energy stocks in droves these past two quarters. Energy has turned out to be the worst investments among the entire S&P this year, as the initial year-end celebration of oil cuts and inventory drawdowns gave way to the difficulty of actually seeing it come to fruition. We've seen the shares of our oil companies falter dramatically, and many famous oil investors have become apoplectic, abandoning their oil thesis and declaring that oil inventories will rebalance too slowly and that "lower for longer" is the new reality. Sentiment as they say turned negative:

As oil prices tumbled past 20% from the highs reached in Q1 to the lows reached in Q2, their sentiment became our reality, and yet . . . we're still bullish on oil.

We continue to test and retest our thesis because while we could be wrong, we just don't think we are at this stage. We frankly utterly failed to predict the sentiment shift, but the vagaries of emotions aren't where we've historically excelled at. Our advantage, if there ever was one, was in examining the fundamental data. So when you read that we're still "bullish" our conviction isn't borne of consistency bias or fear of reputation risk, it stems from the data.

For now, reality is that investors have effectively decided oil is worthless, but as capital retreats and stocks and bond prices fall, the bearish prophecies inevitably create a "new" reality (the opposite of "fake" news if there ever was one), one where the industry begins to contract, produce less and draw down inventories.

This is the nature of economics in the short term and the long; what's proven unprofitable will be starved of capital until supply and demand resets and profitability restored. It's an immutable law, and one of the few certainties in the capital markets. In the meantime when excessive inventories predominate, fundamentals and sentiment can dislocate. Prices first decline because that's what they do when there's too much of a commodity, but as the market tentatively begins rebalancing, the perception of if/when/how the market will/will not rebalance plays a much larger role. This perception change means prices can overshoot in either direction, and in times of plenty, it's usually down. Once fundamentalists abandon the sector, the energy market is increasingly left to traders and computer trading advisors (i.e., quant funds), which further exacerbates the momentum change.

Much of the recent fall is simply due to market sentiment, which turned from healthy skepticism to outright cynicism. Cynicism over OPEC/non-OPEC's production cuts, cynicism that the oil market can rebalance in the face of overwhelming growth in US shale production, and a creeping fatalism that oil will forever stay below $50/barrel because shale technological breakthrough means "this time it's different."

Our thesis has and continues to be that it's not. The logical frameworks are fairly simple. We're wagering that three historical rules that applied three years ago still apply today:

So unless economics reversed itself in the last few years, it will act as gravity to restrain and eventually constrain oil supplies and the downward spiral of prices we've seen the first half of this year will reverse.

Contrary to what you see in the price action, oil fundamentals are not that bad. There, we said it. Someone had to say it and we did -- italicized, no less.

"Opinion is the medium between knowledge and ignorance." - Plato

Fundamentally, how the oil picture looks depends on how you interpret the data. Coming out of Q1 we updated our oil thesis and explained that the recent swoon in oil prices was caused by three factors that increased inventory and negatively affected sentiment:

These factors in Q1 rolled into Q2, masking the underlying demand and affecting the perception of rebalancing. For their part, OPEC and Non-OPEC also failed to inspire confidence. On May 25th, both groups decided to renew their 1.7M barrel per day (bpd) cut ("Vienna Agreement") for another 9 month (to now expire in March 2018) and rein in exports. Normally, you'd expect an extended production cut to lift prices, but the participants bungled the announcement. In an attempt to bolster the market a few weeks before the meeting, Russia and Saudi Arabia, the two key players for the agreement announced that they'd extend the cut by nine months, oil prices quickly rallied. This unfortunately heightened market expectations. It began expecting even better news such as a deeper or broader cut, but none materialized. Oil prices then fell after the meeting as the market was left with "only" a nine-month cut. In a nutshell it was a public relations disaster for OPEC and non-OPEC.

A week later, the calendar turned to June and sentiment deteriorated further. US oil data in early June showed light inventory draws, and the market began surmising that demand may have fallen off. A respite in domestic violence in Nigeria and Libya allowed both to increase productions, which negated close to 30% of the cuts in the Vienna Agreement. Faced with the additional prospect of increasing US production, investors lost faith and the sky promptly fell.

In our view though, all of the above, all of the shifting inventories, overproduction and subsequent "channel stuffing," OPEC and Non-OPEC's meeting and the market's bipolar sentiment is simply volatility caused by the ongoing rebalancing. If inventories continue to decline, then prices will rise. Everything else is noise. In the next series of articles, we'll look at what's happened, what's currently happening, and reasons we think the trend will continue to be favorable for oil bulls. In the meantime, keep the faith, being contrarian can be often dark at times, but we'll let the data and our rational mind lead the way.

As always, we welcome your comments. If you would like to read more of our articles, please be sure to hit the "Follow" button above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Oil Today: When Emotionalism Trumps Rationalism - Seeking Alpha