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James Chanos – Energy Investments After The Fall

Energy Investments After The Fall: Opportunity Or Slippery Slope? – James Chanos

James Chanos, founder and President of Kynikos Associates, a hedge fund specializing in short selling presented at the Grant’s Fall 2015 Conference about his thoughts on energy macro, US E&P, major integrated oil & gas companies, LNG, residential solar, Shell, Cheniere, and SolarCity.

  • High oil prices and cheap credit fueled ramp in E&P; as global supply outgrew demand, oil price has plunged
  • Shale revolution was a game changer (oil production rose 55% between 2009 and 2014); unconventional wells have high initial production followed by steep decline rates (need for continued capital spend to maintain production)
  • Short term management compensation plans are tied to production growth (return on capital metrics are rare); public valuations are tied to production growth; most E&P’s need to spend 120% of cash flow to grow production with prices between $50-60/bbl
  • While production cuts in the US was expected, E&P’s optimized cost per barrel and lowered 2015 costs by 30-50%; US production expected to grow 6% in 2015 despite a 59% drop in US rig count since September 2014
  • E&P Accounting: widespread use of full-cost accounting allows for aggressive capitalized costs and deferral of depreciation, which flatters EBITDA and leverage ratios; GAAP reserve testing and PV-10 methodology in a deflationary price environment can lead to overstated reserves and valuations
  • E&P cash flows: leading E&P companies show fallacy of shale economics (CFO 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; E&P’s benefit from tax deferrals as long as drilling continues
  • Traditional signs of balance sheet stress paint a dire picture (current and quick ratios are routinely below 1.0x); high yield energy market is stretched and issuers are becoming constrained by covenants; energy bulls cite revolver capacity and distant financing maturities as reason to ignore depleted balance sheets
  • Return to growth cannot happen without cheap equity and debt; high yield producers are challenged to fund capex in a low price oil environment
  • Major integrated companies have negative cash flow after distribution (growing debt funding the gap); reserve replacement ratio at its lowest level since 2007
  • Global LNG supply/demand balance now unfavorable for producers; Korea/Japan benchmark below $7/mmbtu, down 55% in the last year; buyers are asking for lower prices on long-term “fixed price” contracts; Petronet broke contract with Qatar and Qatar is no longer opposed to making changes to existing contracts;
  • Shell: pays 50% premium to acquire BG, a restructuring story focused on LNG and Brazil; an expensive solution to aid struggling legacy upstream portfolio; pro-forma LNG capacity of 70Mtpa by 2020 which is 17% of estimated global trade; major LNG projects will depend on strong Asian demand; production growth dependent on Brazil (estimates 20% of total production will be Brazil, up from less than 10% currently); $30B in asset sales between 2016 and 2018 to offset incremental debt
  • Cheniere’s Dream vs. Reality:

(DREAM) Annual EBITDA of $4.1B from 9 trains
(DREAM) Capacity from Sabine Pass and Corpus Christi of 40Mtpa
(DREAM) No commodity pricing risk gives Cheniere a unique position in the LNG market
(DREAM) Activist involvement will manage cost base more efficiently
(DREAM) Cost to build facilities is at a fraction of Australian projects
(REALITY) Annual EBITDA of $1.7B from 7 trains generated by contracted volumes
(REALITY) 87% of commissioned capacity on “take or pay” which represent less than half of Cheniere’s DREAM EBITDA
(REALITY) 13% of uncontracted capacity will struggle to breakeven regardless of destination
(REALITY) Liquefaction terminals have an average utilization rate of 88%
(REALITY) Most of the LNG trains have not been completed and still need funding
(REALITY) Class B shares of Cheniere Energy Partners increase by 3.5% compounded each year

  • Residential solar market is uneconomical: government largess, not economics, drive residential rooftop systems; SolarCity and other finance systems to households lacking sufficient income and upfront capital to take advantage of arbitrage
  • SolarCity: perceived as a solar company with the Elon Musk Effect; does not scale as smaller competitors claim similar installation costs; competition is increasing and lease rates are declining faster than costs; solar leases become a liability when selling a home; recent changes undermine business model (net metering under pressure in many states with Hawaii as the first to eliminate the program; 30% ITC expires in 2016; CA electricity rate reform lowers savings for homeowners); returns on invested capital based on lease revenues below 8%; claims >30% margins on its leasing business but requires outside capital to build new systems; uses 6% discount rate to calculate the NPV of 20-year residential leases (assumes that 90% of customers will renew the contract for another 10 years)

 

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