In November 2007, the relatively unknown hedge fund manager David Einhorn raised major concerns about the accounting at Lehman Brothers. It led him to bet against the company and short the stock.
No one paid much attention… until Lehman Brothers collapsed.
Einhorn’s reputation was made, and his firm -- Greenlight Capital -- became one of the hedge funds to watch.
Now, Einhorn has found another prominent target: the frackers, U.S.-based oil exploration and production (E&P) companies.
Zeroing In
Einhorn called much of the industry “frack addicts” who were wasting money on wells that’ll never pay off.
He said some companies are currently getting a negative return on their invested capital. And that, in some cases, was true even when oil was trading at $100 per barrel!
Einhorn added, “When someone doesn’t want you to look at traditional (financial) metrics, it is a good time to look at traditional metrics.” By “someone,” he means exploration and production companies.
Einhorn dislikes how these firms report their earnings through methods like EBITDAX, which means earnings before interest, taxes, depreciation, amortization and exploration expenses. He said this measure “stands for earnings before a lot of stuff.”
In particular, Einhorn targeted five companies: Pioneer Natural Resources (NYSE:PXD), EOG Resources (NYSE:EOG), Continental Resources (NYSE:CLR), Whiting Petroleum (NYSE:WLL) and Concho Resources (NYSE:CXO).
Pioneer seems to be his No. 1 target, since he dubbed it “the motherfracker.”
“A business that burns cash and doesn’t grow isn’t worth anything,” said Einhorn about Pioneer.
Instead, Einhorn encouraged investors to focus on cash as a guide to the health of the industry.
Since 2006, the U.S. oil exploration and production industry has spent $80 billion more in capital than it made selling oil. Einhorn says companies were only kept alive by the constant inflows of capital from bankers (also known as loans) and investors alike.
David Einhorn is a well-known poker player. (He won $4.4 million at the 2012 World Series of Poker tournament.) But is he bluffing here?
On the Money, Sort Of
There is no denying the massive cash burn of these E&P companies. Many of them have debt problems, which I've noted before.
Moody’s said its LSI (Liquidity Stress Index) for these companies more than doubled in March to 9.8% from 4.4%. But keep in mind, this Index hit 26% in March 2009 when oil prices plunged due to the financial crisis.
And the group as a whole is making progress. The forecast is for these companies to be at a cash flow break-even point in 2015, thanks to cuts in capital expenditures.
For example, Pioneer says that, by the end of 2015, costs for drilling and completing a well will be 20% lower than just a year ago.
In addition, that $80 billion Einhorn mentioned didn’t just disappear. It went toward buying assets that will provide oil sometime in the future.
The Verdict on Einhorn
What is the bottom line here?
The sector is long overdue for a shakeout. Many companies’ weaknesses were masked when oil was at $100, but now, there’s nowhere to hide.
The best analogy for this situation was made by Ed Crooks of the Financial Times.
He compares it not to the Lehman debacle, but to the dot-com boom. He says the technological progress being made in shale development is real, as it was in the dot-com era. That is why drilling and completion costs for wells are falling every year.
But not all companies will survive.
Investors need to do their due diligence to separate the wheat from the chaff.
Crooks said the low-cost shale producers may turn out like Google (NASDAQ:GOOGL). But the high-cost producers may go the way of Pets.com.
And the chase continues,
Tim Maverick