Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Energy Complex Upended

Jim Chanos - Energy Investments After The Fall

  • High oil prices and cheap credit fuelled ramp in energy exploration and production (E&P)

    – Shale in the US

    – Large Liquefied Natural Gas (LNG) projects in Asia, Australia, and Africa

  • OPEC cracks

    – Members have competing interests

    – Politics pressuring economics

  • Tensions rise as budgets are under pressure

    – Higher breakeven costs for government promises

    – Social stability at risk

Jim Chanos - US Shale Revolution

Jim Chanos - Energy Investments After The Fall

  • Shale revolution was a game changer

    – Crude oil production in the US rose by 55% between 2009 and 2014

    – Net crude imports fell by 20% between 2009 and 2014

    – The US is the world’s largest oil and gas producer

  • Production of unconventional wells has high initial production followed by steep decline rates

    – Wells can see production declines by 70% in year 1, 50% in year 2, and 30% in year 3

    – Creates need to invest continually in order to maintain production levels

  • As global supply of oil has outgrown demand, oil price has plunged

[drizzle]A Gusher Of E&Ps

Jim Chanos - Energy Investments After The Fall

  • Shale E&P in the US is an unconsolidated sector with little control over production and pricing

    – Largely funded by low Fed rates

  • Short term management compensation plans are tied to production growth

    – Return on capital metrics are rare

    – Well participation agreements are common

  • Public valuations are tied to production growth

    – Investors relied on NAV and EV/EBITDA, both of which are heavily dependent on production growth

  • Most E&Ps need to spend 120% of cash flow to grow production with prices between $50-60/bbl

E&Ps Reduced Costs In An Unanticipated Fashion

Jim Chanos - Energy Investments After The Fall

  • High cost US oil was expected to cut production to balance the market
  • Rather than cutting production, E&Ps optimized cost per barrel and lowered 2015 costs by 30- 50%

    - Squeezed service providers

    – Retreated to core areas

    – Focused on drilling efficiency

  • US production is expected to grow 6% in 2015 despite a 59% drop in the US rig count since September 2014
  • Production expected to decline 4% in 2016 at the current strip

E&P Accounting Allows Flexibility

  • Widespread use of full-cost accounting

    – While drilling and completion is always capitalized, businesses vary in how aggressive they are in capitalizing costs

    – Drilling and completion, exploration, unsuccessful drilling/exploration efforts, gathering and transport, G&A and interest expenses can all be capitalized

    – Allows E&Ps to defer depreciation of capitalized costs associated with unproven reserves

    – Flatters EBITDA and leverage ratios

  • Due to the variation in capitalization policies across businesses, it is important to know how aggressive the policy is when evaluating cash costs and margins

    – It is equally important to watch out for changes in policy

  • GAAP reserve testing and PV-10 methodology in a deflationary price environment can lead to overstated reserves and valuations

    – Assumed selling price for all reserves is based on a trailing twelve month average (1st day of each month)

    – Cost structure used in reserve tests reflect current cost environment

E&Ps Squeezed

  • US oil and gas supply currently cannot tap global demand

    – Despite price declines, production continues

    – Federal approvals for exporting limited quantities of US oil and petroleum products are beginning

    – E&P company executives are lobbying Congress to lift the export ban on crude

  • High yield producers are challenged to fund capex in a low price oil environment

    – Equity issuance decreased to $1.8B in 3Q15 from $7.4B in 1Q15

    – Debt issuance decreased to $4.0B in 3Q15 from $12.8B in 1Q15

    – Small and medium-sized E&P company liquidity is dependent on reserve-based credit facilities and borrowing bases are expected to drop as much as 15% in October 20151

    – The weakest companies are starting to collapse under the weight of debt, as 8 bankruptcies have been announced in YTD15 vs. 3 bankruptcies between 2012 and 2014

E&Ps Do Not Generate Cash

Jim Chanos - Energy Investments After The Fall

  • Leading E&P companies show fallacy of shale economics

    – Cash flow from operations has not covered capex since 2010

    – Return of capital is funded by debt, asset sales, and equity

    – Leverage levels have increased across the industry

  • Investors focused on production growth, not returns

    – Economic returns are not as high as believed

    – Forward estimates show significant decline in returns

  • Despite significant investment, proved reserves have not grown meaningfully for most companies
  • E&Ps benefit from tax deferrals as long as drilling continues

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

[/drizzle]