Jim Chanos – Energy Investments After The Fall: Opportunity Or Slippery Slope? [SLIDES]

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Energy Complex Upended

  • 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

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

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