Yesterday oil stocks caught fire and closed at three month highs.
Although I am a big oil bull, I am not sure chasing energy stocks is the best way to play it. To best understand why not, let’s go over the short side’s arguments about why energy stocks are a poor investment. And there is no better person to articulate this reasoning than famed short seller Jim Chanos. Although his timing is sometimes extremely long in duration, when Jim is on the other side of your trade, you want to think long and hard about your conviction.
This summer on the TV program Wall Street Week, Jim outlined the reasons why energy stocks were a poor investment. I have created a transcript of his comments:
Chanos: ….intergrated oil companies have one set of problems. And then the North American E&P, the so called frackers, have a completely different set of problems. But in the integrated space, the cost of replacing oil that these guys, like Chevron, Exxon, Royal Dutch Shell, is really simply that they are replacing $20 oil with $80 oil. And that’s the problem. And what were really high return on capital businesses are becoming more mundane return on capital businesses. And they are having to do things like drill in the Arctic, deal with Mr. Putin, construct these enormously expensive liquified natural gas projects. And increasingly add the risk to the portfolio, where it just used to be a much simpler drill somewhere and pull the oil out.
Q: What specific names?
I would be really leery of the very leveraged guys and any company that is running negative cash flow after capital spending, so they are not covering their dividends and their buybacks. So names like Chevron, names like British Gas/Royal Dutch and some of the big national companies – the Petrobras of the world.
Q: The Mom and Pops who own these huge integrated oil companies for the dividends. The brokers who have been piling in their retail clients into these names because they are not buying bonds, and they are buying these companies for the dividends…
Chanos: That would have been a wise strategy until a few years ago when many companies were covering their dividends with cash flow. But in many cases, they are not any more. They are borrowing to pay the dividend now. And corporate finance theory amongst other things tells us that the riskiness of the firm starts to go up dramatically on the same yield.
Chanos is also very negative on the frackers, and believes the North American oil and gas exploration companies have more pain ahead. From Market Watch:
North American oil and gas exploration and production companies are in trouble, he said, and the pain isn’t going to stop with their shareholders. Their debtholders are going to start feeling it too.
“It’s one of the few industries that senior creditors may be facing significant impairments,” he said. “The industry will continue to need capital… and money is not coming back out.”
The founder of hedge fund Kynikos Associates LP has been arguing that the business model for the industry is broken.
In September, the Journal noted that Mr. Chanos has large bets against the energy industry. Previously, he had been widely known as a China bear, but his bets against the energy industry have actually been a larger part of his portfolio.
On Tuesday, Mr. Chanos walked through the reasons why he believes the business model for “the revolutionary technology” of fracking that underpins the U.S. shale revolution will crumble. The high cost of pulling oil from the ground, he argued, means that it would take far more than a modest recovery in prices for the business to make economic sense.
“With depletion rates so high, maintenance capital costs to keep production constant are pretty much much larger than people think,” Mr. Chanos said.
Some fracking companies like Devon Energy Corp. have disclosed how much they need to spend to maintain production levels, Mr. Chanos said. That information, Mr. Chanos said, has helped him and his team of analysts model the potential costs for other fracking companies.
Additionally, Mr. Chanos said the accounting method used by most of these E&P companies obscures their actual earnings. Most E&P companies, he said, use so-called “full-cost accounting” — an accounting method designed to encourage exploration for new types of gas. Using that method, he said, many E&P companies “capitalize everything” or book the expenses over a longer period of time. He said he’s seen these companies put items including a secretary’s salary into that bucket.
Those accounting maneuvers alter the way companies report their closely watched EBITDA figures, or earnings before interest, taxes, depreciation and amortization. “Real levels of EBITDA may be lower – significantly lower,” he said. In turn, investors may be paying much higher multiples than they understand for these stocks.
I think Chanos is bang on with his analysis. I suspect many of these companies are toast. But herein lies the problem. This is by no means a new idea. This summer Greenlight Capital’s David Einhorn presented at the Sohn Investment conference and summed up his short call in the following manner (from Fortune):
In closing, Einhorn summed up his outlook by alluding to another f-word that sounds similar to “frack” but would not be appropriate to say in public. No matter what the oil price does, “the frackers are—,” Einhorn said, then pursed his lips and smiled mischievously before walking off stage.
If there is something I have learned over the years, it is that hedge funds travel in packs. Too often they are all doing the same “supposedly” brilliant trade. My guess is many of these hedge funds are short frackers and other oil names out the wazoo. I worry the recent rally is more a function of short covering than improving fundamentals.
Although I believe the demand side of the oil equation is set to rise as China progresses to a more consumer driven economy, the really bullish side of the story is the potential collapse on the supply side. This reduction in supply will be the direct result of the pain the energy companies are experiencing. It therefore seems illogical to buy the companies whose misfortunes are causing the increase in price of the commodity they produce.
Last month Ecstrat’s oil strategist Emad Mostaque appeared on Bloomberg TV and made the case oil was headed to $130 by 2017. His whole argument was based on the idea capital to the energy sector has collapsed, and this will eventually cause oil to rebound. He stated that there has been “$300, $400, $500 billion in spending cuts.” Furthermore, according to Emad, “Iraq is falling apart, Kurdistan is a mess and Iran needs $30 billion a year of capex to develop their oil production. It’s not going to happen.” Not only that, “shale oil is like Wile E. Coyote running off a cliff” and he finishes with the warning that shale oil productivity has not kept up with drilling – “look at the productivity numbers – drilling rigs do not produce oil.” This last point is an interesting one. In the emotion of the collapse in the price of oil, this debate has been shoved to the side. But for the longest time there has been considerable disagreement about the front loaded nature of shale oil. It could be shale oil is not nearly as profitable as the industry believes.
I think we can all agree on one thing – the oil industry is in big trouble. Capital flowed in at a fierce rate, and created way too much supply. This over supply has resulted in a collapse of the price of oil, and the ensuing pain is having its forecasted effect of reducing that supply.
As prices plummeted, in the short run, the perverse nature of markets is that supply actually increased as the oil producers desperately tried to pump more to offset the lower price. However, this feedback loop sent prices even lower. Eventually supply dried up as oil companies went bankrupt, stopped spending on new drilling and hunkered down.
This is where we are now. We have set the stage for little new supply in the coming years. And this is why oil prices are set to rally.
I know stock prices discount the future, but the good times are still a long way off for oil companies. They have way too much debt. The price of the commodity they produce is still severely depressed. We are still a long way away from any good times.
As the price of their equity rallies, oil companies will issue stock into the demand. They simply cannot afford not to. Their balance sheets are a mess. From Fortune:
The mountain of debt advanced to drillers in recent years is estimated to be in the neighborhood of $500 billion — some $300 billion in leveraged loans and another $200 billion in high yield debt. That’s about 16% of the U.S. high yield debt market, quadruple its share a decade ago. That’s a lot, even when weighed against the roughly $1.6 trillion in annual investment required to provide the people of the world with energy.
As analyst Ed Westlake at Credit Suisse summed up the trouble in a recent note: “in four years of $100/bbl oil, the global oil and gas industry has taken on a quarter of a trillion dollars in debt, has delivered zero production growth outside of North America and is facing a $1 trillion+ reduction in global revenues.”
Although the energy stocks are rallying, the price of this debt has fallen and doesn’t look like it can get up. Here is the chart of the iBoxx USD Liquid High Yield Oil & Gas Index:
This is complete carnage. Having a bond index fall 30% in a year is about as bad as it gets. These bond investors have been completely destroyed.
Yet over the past three years, an investor in the XLE index ETF has broken even, while a iBoxx investor finds himself underwater by 27%.
Smart investors like Oaktree’s Howard Marks and Omega Advisor’s Leon Cooperman are buying oil & gas debt. From Fortune:
Already, distressed debt investors like Oaktree Capital’s billionaire Chairman Howard Marks are swooping down to start picking at the still warm carcasses. As Marks said in a letter to investors this week: “This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt.” He’s reportedly raising billions to build funds to buy the debt of solid but overleveraged operators.
I think this trade makes so much more sense than chasing oil & gas equities. Although I am bullish on oil, I think there is a lot more pain ahead for the industry. Buying the debt with a big yield seems like such a better risk reward than trying to see through the next up cycle with the equities. I suspect the rallies are going to be more a function of short covering than any real solid change in business. They will be sold into by the energy companies desperate for liquidity.
I would also rather own crude oil futures outright, but that’s a story for another day. In the mean time, if you are bullish on energy stocks, at least think about buying some high yielding debt instead of being 100% in the equites.
Thanks for reading,