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US shale oil and gas investors are on a 'road to ruin,' warns renowned short-seller Jim Chanos

  • Renowned short-seller Jim Chanos is betting against a number of U.S. shale oil and gas drillers.
  • Chanos says Wall Street is overly focused on certain valuation metrics, which hide problems with the fundamental business model in the American oil patch.
  • Investors are taking for granted accounting methods that will create problems for drillers in the future, Chanos said.

Jim Chanos' Kynikos Associates is betting against a number of U.S. shale oil and gas stocks, saying Wall Street analysis of the sector is deeply flawed.

Investors are taking for granted accounting methods that mask problems with the fundamental business model in the U.S. shale patch, Chanos warned during a speech Tuesday at CNBC's and Institutional Investor's Delivering Alpha conference. Their focus on certain metrics is causing them to overlook hidden threats that will leave drillers with skimpier returns than investors are anticipating, he said.

"In our view, people have been looking at this industry through the rose-colored glasses of Wall Street. And this is the inherent problem with the North American shale business," he said.

Chanos is not the first to sound the alarm about accounting and business practices in the sector. Analysts have long warned about drillers' persistent and unfulfilled promises to generate positive cash flow, especially as oil prices remain at less than half of their 2014 peak.

"The way to think about it is that unlike other businesses, your assets literally get burned up" -Jim Chanos, Kynikos Associates founder and president

But Chanos' remarks add an influential voice to the chorus of skeptics. Chanos, who foresaw the spectacular downfall of disgraced energy titan Enron, is renowned for scrutinizing accounting methods and spotting trouble on the horizon.

He has now set his sights on the U.S. shale oil and gas industry, which uses expensive drilling methods to extract oil and gas from rock formations. Frackers typically rely much more on debt than big, integrated oil companies like Exxon Mobil.

Chanos focused on Continental Resources during his presentation, but said Kynikos is not singling out the shale oil drilling pioneer. Kynikos has taken a short position against a number of frackers in addition to Continental Resources, he said. Notably, it has not bet against those in the Permian basin in Texas and New Mexico, where producers can plumb oil at relatively low costs.

Chanos looked at about three dozen drillers and found that their capital spending would eat up almost all of their earnings, minus certain expenses, this year. That leaves them with little cash to service their debt.

"See the problem?" he asked the crowd. "It's a big one."

Drillers have reduced the amount of capital they need to produce the same amount of oil, but not enough to make many of them profitable, he said. Chanos believes that capital spending is essentially a variable that creates a vicious cycle in the oil patch.

Jim Chanos speaking at the 2017 Delivering Alpha conference in New York on Sept. 12, 2017.
David A. Grogan | CNBC
Jim Chanos speaking at the 2017 Delivering Alpha conference in New York on Sept. 12, 2017.

As drilling activity picks up, so do service costs. Those expenses get capitalized, or spread out over the life of the asset, on income statements. That's where the problem lies, Chanos said. Many companies will simply never be able to generate enough cash to pull themselves out of the vicious cycle and deliver acceptable returns to investors.

Capitalizing expenses in other businesses can be acceptable, Chanos said, but it is a problem in the oil and gas industry because drillers have to constantly reinvest in new wells to replace cash flow from depleted ones.

"The way to think about it is that unlike other businesses, your assets literally get burned up," he said.

Chanos also takes issues with drillers using the so-called full-cost accounting method, which allows them to capitalize costs whether or not exploration projects are successful. This is tied to reporting earnings before interest, taxes, depreciation and amortization.

EBITDA allows investors to compare profits from drillers' operations without accounting for the other expenses, essentially giving them a view into how their assets stack up against another fracker's wells. Reporting EBITDA is not unusual, but Chanos believes shale investors are too focused on it.

"A reliance on that EBITDA number for valuation metrics, which an awful lot of people on Wall Street still do, is going to be the road to ruin for lots of investors," he said.

"This has attracted a lot of capital on the Street, in private equity and elsewhere, and we still think they're being mesmerized by a metric that is going to lead to problems for returns on capital in this industry."