For whatever reason, it seems that many institutional investors analyze this sector poorly. This creates wonderful opportunities for short sellers. To recap, this sector has attractive shorts because:
- It seems that many institutional investors don’t understand how oil and gas companies inflate their reserves.
- Inflated reserves are very common among oil and gas companies.
- Institutional ownership is high enough that there are reasonable borrows on these stocks.
- Many management teams use the company as their piggy bank to pay for corporate jets, expensive meals, etc.
- Valuations are high.
- A few of these companies are pump and dumps.
Many institutional shareholders don’t perform due diligence
When oil & gas companies sell their assets to private buyers, they will open a data room so that the buyers can perform their due diligence. Institutional investors on the other hand request almost no data on the companies they own. They don’t ask for the b-factor and dmin values, decline curves, cash flow projections, etc. etc.
To value an oil/gas asset, the standard procedure within the industry is to build a discounted cash flow model. One of the most important assumptions behind these models is the projected decline curve(s) of the underlying wells. Analysts do not request this data. I can only name one company (DeeThree) that shows some of the work behind their internal asset valuations. That’s just insane. And this is only basic valuation work. Private buyers will go into more detail and look into porosity, permeability, pressure, projected water production, terms of the leases, and a whole number of other variables… hence the need for a data room.
The pump and dump industry
There is some overlap between typical oil and gas shenanigans (inflating reserves) and the pump and dump industry. Some independent oil and gas companies are also pump and dump stocks. It’s not hard to find companies that are paying for blatant stock promotion. Sometimes the 10-K will even state how much money was spent on “investor relations”.
Capitalizing on this opportunity
Here are my most important posts on shorting oil and gas:
- My approach to shorting oil and gas
- How would a sociopath fleece investors in oil and gas?
- Microcap stocks and G&A
- Spotting inflated oil and gas reserves
- Short selling update July 2014 – This post contains a table of my past short positions.
- Why would anybody want to invest in independent oil and gas?