As drilling activity picks up, so do service costs. Those expenses get capitalized, or spread out over the life of the asset, on income statements. That’s where the problem lies, Chanos said. Many companies will simply never be able to generate enough cash to pull themselves out of the vicious cycle and deliver acceptable returns to investors.
Capitalizing expenses in other businesses can be acceptable, Chanos said, but it is a problem in the oil and gas industry because drillers have to constantly reinvest in new wells to replace cash flow from depleted ones.
“The way to think about it is that unlike other businesses, your assets literally get burned up,” he said.
Chanos also takes issues with drillers using the so-called full-cost accounting method, which allows them to capitalize costs whether or not exploration projects are successful. This is tied to reporting earnings before interest, taxes, depreciation and amortization.
EBITDA allows investors to compare profits from drillers’ operations without accounting for the other expenses, essentially giving them a view into how their assets stack up against another fracker’s wells. Reporting EBITDA is not unusual, but Chanos believes shale investors are too focused on it.
“A reliance on that EBITDA number for valuation metrics, which an awful lot of people on Wall Street still do, is going to be the road to ruin for lots of investors,” he said.
“This has attracted a lot of capital on the Street, in private equity and elsewhere, and we still think they’re being mesmerized by a metric that is going to lead to problems for returns on capital in this industry.”
