Short seller Jim Chanos of Kynikos Associates warned that the North American energy industry could be overvalued and specifically called out Continental Resources in a best ideas presentation at a conference on Tuesday.
“In our view, people have been looking at this industry through the rose-colored glasses of Wall Street,” said Chanos at the CNBC Institutional Investor Delivering Alpha Conference at the Pierre Hotel in New York.
Noted short-seller Chanos, the founder of hedge fund Kynikos Associates, shared that as a result of this view, his firm is shorting the crude oil and natural gas producer, which is based in the Bakken Reservoir.
According to Chanos, a mismatch between production growth and capital expenditure will eventually drive down the company’s share price. Chanos said Continental Resources has had negative free cash flow, which has led to a buildup of about $6.5 billion of debt.
This, coupled with the company’s “problematic mix of gas and oil assets” as well as a corporate compensation structure that relies on production of assets rather than returns, makes Continental an attractive shorting opportunity, according to Chanos.
“I’ve got nothing against Mr. [Harold] Hamm,” Chanos said, referring to the CEO of Continental. “This is really just about more where his company is positioned. Wall Street has to struggle to get its arms around it.”
Chanos is not the first short-seller to point out problems at Continental. David Einhorn of Greenlight Capital cited it in a 2015 presentation at the Sohn Investment Conference as one of the “mother fracker” stocks he was shorting at the time. The stock fell 3.4 percent, to $34.09, during Chanos’s presentation but bounced back to $34.61 at the close, up 1.2 percent from the market open.
Beyond Continental Resources, the industry itself is rife with problems, Chanos said during his presentation.
“The problem, of course, is the rapidly depleting nature of the asset,” he said.
Chanos criticized the use of EBITDA — earnings before interest, taxes, depreciation, and amortization — as a valuation metric, saying it is particularly misleading for the fracking industry, as most of that gets eaten up by capital expenditure. “Virtually all the dollars that come out of the ground have to go right back in before you can pay your creditors,” he said.
He added that the energy production industry, particularly in North America, is prone to booms and busts.
“It is a Catch-22,” Chanos said. “The more capital it attracts, the more people are incentivized to drill.”
This then drives down asset prices.
Chanos noted Continental isn’t the only energy producer with this problem.
“I’m not singling them out as being worse than their Bakken competitors,” said Chanos. Those competitors include WPX and Hess Corp., both of which were recommended as value investments by Leon Cooperman earlier at the conference.
