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Jim Chanos: Fracking is a 'capital sinkhole for investors'

Jim Chanos REUTERS/Brendan McDermid

Influential short-seller Jim Chanos, who runs hedge fund Kynikos Associates, says the North American exploration and production sector has been a “capital sinkhole for investors.”

“One area we have been really negative on from the run up, the collapse, to the following run up, that we think is a capital sinkhole for investors is the North American exploration and production industry — frackers,” Chanos said at the Evidenced-Based Investing Conference in New York on Wednesday.

Chanos, whose been looking at the hydraulic fracking sector since going short Chesapeake (CHK) in 2011, realized it “was much an accounting story as it was a geology story.”

Specifically, Chanos found that most of the companies in the sector use what he calls “one of the great oxymoronic phrases of finance” — full-cost accounting. This means everything is capitalized and written off with the estimated life of the wells, he explained.

“What we’ve realized is over the course of oil going from $40 to $100 to $40 and nat-gas going from $4 to $12 to $2 to $6 to $3, the North American E&P space has never made a dime,” Chanos said.

“And if you allocate properly, again, the capital, and depreciate, economically, the wells over their economic life, you do not have return. And, in fact, what we would say is what they would call EBITDA minus what we would say is the real capex to keep your production constant is a negative number.”

This should terrify every commercial bank that’s lent money, he noted.

In the last 18 months, we’ve see companies cut capex “to the bone” because the capital markets were closed with oil prices hitting lows. Those companies subsequently saw their production drop. When the capital markets opened back up this year around April and May, Chanos said he expected that the companies would see their capex budgets go up next year despite oil prices still hovering around $43.

“Sure enough, it happened because it has to,” he said. “Already there’s so much capital coming back into this industry that the production numbers are starting to go back up. The problem is this is Wall Street incinerating its capital. You give an oil driller money, they are going to drill.”

Why would they do this if it’s uneconomic?

“Well, if you read the proxy statements, you’ll understand,” Chanos said. “Because if you read the proxy statements, you’ll see that a lot of the executives are compensated on production … there’s a real incentive to just keep drilling. And with capital markets open, they’re going to drill. It’s a terrible business, at least as it stands right now.”


Julia La Roche is a finance reporter at Yahoo Finance.

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