When oil and gas companies sell assets to each other in private transactions, they will often open a data room where the acquirer’s team of engineers can look at the data and perform their due diligence. I find it strange that supposedly sophisticated institutional investors are comfortable with oil and gas stocks without being able to perform this level of due diligence.
Maybe I’m crazy but I think that institutional investors are making huge mistakes in the oil and gas sector.
Either they’re wrong or I’m wrong. Time will tell.
I believe that there are currently very high levels of deceptive stock promotion and many opportunities for short selling. The nice thing about the current situation is that institutional investors are involved and are lending out their shares.
My approach to shorting oil and gas stocks
Unfortunately, very few oil and gas companies disclose a lot of technical information about their assets. To a large degree, these companies are black boxes. However, being precise about valuation isn’t necessarily that important. If management is very, very good at losing money then valuation isn’t that important in the long run.
I want to find the companies that have a long track record of being unprofitable. I look at the past and assume that the future will resemble the past. Sometimes these extrapolations are inappropriate. But usually they are.
Rightly or wrongly, I largely assume that management’s projections are overly optimistic. I don’t put in too much work in looking at the geology of a company’s assets and trying to value those assets. I simply assume that the assets aren’t worth that much more than the after SEC PV-10 value (or standardized measure) that is estimated for the assets.
What does a company’s historical cash flows look like?
I like to look at cash flows from operations versus the prior year’s capital expenditures. This gives a very crude (and arguably inaccurate) approximation of the cash-on-cash returns of the company’s capex. If the company is a rapidly growing shale company, its wells will usually come online within a year so this approximation will be vaguely accurate.
If the ratio is above 1:1, don’t short the stock. The company may very well be profitable. I am interested in shale companies with ratios of 0.3:1 and lower. If a company spends $1 on capex and receives 30 cents in cash flow in the first year, then the underlying wells are probably either marginal or uneconomic. In rare cases, cash flows from operations is negative (e.g. ATPG).
*For various reasons, this is not the best approximation in the world. One problem is that this shortcut is not a true indicator of the company’s cash-on-cash returns for a particular year’s set of wells. The cash flow from operations includes cash from all of the wells a company has drilled since inception, not just one particular year’s worth of wells. Including past wells inflates the ball estimate of cash-on-cash returns. Here’s the simplifying assumption: if the inflated numbers are bad, then the real number must be even worse.
Another issue is that different plays have different decline rates. My shortcut completely ignores this fact. Estimating the future decline rate would be extremely helpful in building a proper discounted cash flow model to value E&P companies. It’s just that this is incredibly difficult when E&P companies do not publish their decline curves or the technical data that supports their estimate (e.g. geology of the shale, completion technique, historic production, etc.). The decline curves included in corporate presentations are often bogus.
But at the end of the day, some management teams are so good at losing money that these details aren’t that important.
**Shales tend to decline extremely quickly so almost all of the future cash flow will occur within the first few years. The first year cash-on-cash returns give a good idea as to whether or not a well is economic. This shortcut does not work for wells that do not decline quickly.
***When I say shale well, I really mean horizontally-drilled shale wells that are completed with modern fracturing techniques. Other types of wells exist but you usually don’t encounter them when dealing with publicly-traded shale companies.
What are retained earnings (plus dividends and share repurchases) versus the amount of capital raised?
On the balance sheet, the amount of capital raised can by approximated by looking at “Additional Paid-in Capital”. I take retained earnings and divide that by “Additional Paid-in Capital”. The companies that I typically want to short are the ones that have lost 50% or more of the capital that they have raised. Usually the dividends and share repurchases (and amount allocated to common stock) don’t make a big difference, so I ignore them if they are immaterial.
However, I try to be careful about any distortions caused by GAAP accounting and distortions from aggressive/conservative accounting. Accounting varies widely from company to company. Sometimes book value is understated and at other times it is overstated.
Is the company trying to be a low-cost operator?
I look at:
- G&A as a percentage of revenues. Usually this number reflects the level of corporate waste. It might be misleadingly low if the company is reporting revenues for midstream operations, marketing, etc. It may be misleadingly high if the company is at very early stages of exploration and hasn’t yet drilled or completed its prospects (and therefore has very little revenue).
- Whether or not management is flying around on corporate aircraft. This may be stated in proxy statements or the related party transactions section in the 10-K. Publicly-traded companies often don’t report the use of corporate aircraft unless they have to (e.g. due to related party transactions or personal use of aircraft).
- The salaries of the board of directors and key executives. Sometimes insiders will have high pay because their pay is linked to performance and their performance was exceptional. In such cases, insider compensation may not be the greatest sign of whether or not the company is trying to keep its costs down.
Generally speaking, I want to see that the company is spending at least 10 cents on corporate overhead for every dollar of revenues. These companies are likely wasting too much money on silly stuff like private jets, entertainment, fancy headquarters, catering, etc.
Let’s look at Gulfport Energy, which I do not think is a great short. I believe it is heavily shorted because:
- Management is highly promotional (I agree with this view in my Rexx Energy post).
- The company has a huge number of related party transactions (the Bronte Capital blog has a series on this).
Let’s start with Gulfport’s cash flow (shown below). I use Google Finance to screen stocks because the website loads quickly. Sometimes Google Finance is inaccurate so it can be a good idea to look up the actual financials on EDGAR afterwards.
The ratios are above 0.3:1. In some years it was well above 1:1. Gulfport checks out fine.
Next I look at retained earnings versus capital raised (shown below). Gulfport is ok in this department. Overall, it seems that the company has largely treaded water. It is hard to tell what their track record is because the company has been continually raising money. This dilutes and/or hides the performance of past investments.
Lastly, I look at G&A as a percentage of revenue (shown below). This is a decent indicator of corporate waste.
Gulfport has had pretty low overhead except in 2013. 2013 is likely a weird year because Gulfport raised and invested a huge amount of money. It is likely paying for the G&A associated with these investments while it hasn’t seen revenues from these investments yet. This makes the 2013 number a little inflated. Overall, it looks like Gulfport has done a very good job at keeping its overhead down.
On a superficial level, Gulfport looks like a reasonably well-managed company. It is not something that I would be interested in shorting. I’d rather short the companies that are run by bad operators with an extensive track record of losing money.
Miller Energy (writeup) has very high retained earnings ($176M) relative to the capital it has raised ($98M). However, in Miller’s case, I would factor out distortions caused by aggressive accounting. In YE2010, Miller Energy recognized $461M from “Gain on acquisitions” (10-K). Without this gain, then retained earnings would be strongly negative. (The calculation would be to subtract $461M from retained earnings and then add back accumulated DD&A and tax liabilities.)
As far as deepwater E&P goes, I try to avoid those companies. Deepwater projects are high risk and have very lengthy timelines. It often takes several years to bring a deepwater project into production. There is a lag between exploration capex and cash flow from commercial production. For that reason, there is uncertainty as to management’s track record if their projects have yet to enter production. Unfortunately, a lot of deepwater E&P stocks attract my attention because they seem awful when screening based on historic cash flow.
Flaws with my approach
In general, shorting common stock is not a great idea. There is a good chance that my oil and gas shorts will all go up at the same time, causing a short squeeze.
Most shale companies have lots of exposure to natural gas, which is a beaten-down commodity trading at depressed prices. There is a good chance that natural gas rebounds.
I ignore the geology of the shale plays (as well as management’s projections) and instead extrapolate from past performance. This may not work. Perhaps some of these companies really will make money on their undeveloped plays. Maybe management isn’t lying about 40-100%+ IRRs.
I may lose money due to something that I haven’t thought of yet.
Those on the other side of my trades
Lane Sigurd / Reminiscences of a Stockblogger – Please keep in mind that Sigurd’s track record is much, much better than mine. He may still be long Magnum Hunter (he has written about Magnum Hunter in this post) while I am definitely short the stock (my MHR post). EDIT: To clarify, Sigurd has stated that he hasn’t been long Magnum Hunter since mid January as he has stated on his blog and his tweets.
Value Investors Club – VIC has writeups on ATPG, MILL, etc. I am comfortable with shorting VIC.
We’ll see who comes out ahead.
*Disclosure: I am short E&P stocks. See my March 2014 portfolio update for a (outdated) summary of my short positions.