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CHRONIC INVESTOR BLOG

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The big short against Shell came unstuck in 2016. Will it pay off this year?

By Alex Newman , 11 January 2017

At the beginning of 2015, Jim Chanos announced he had been shorting some of the largest oil companies for several years. The revelation that the hedge fund manager, who correctly predicted the demise of Enron, was betting against large energy stocks was both significant and timely. The oil price was collapsing, and shares in producers were following suit.

Part of Mr Chanos' call against the oil majors was that North American shale had set the stage for a supply glut. The prediction proved remarkably prescient, and depending on when the short was taken out, may have been a lucrative one. But Mr Chanos' main gripe with the oil majors was their historically poor performance, and what he viewed as unsustainable operating models.

Chief among that guilty pack was Royal Dutch Shell (RDSB), which between 2009 and 2015 spent $34.1bn more on dividends and buybacks than it generated in free cash flow. As Mr Chanos observed in a presentation in October 2015, this had largely been funded by borrowed money, and without expanding reserves. In fact, Shell's reserve replacement ratio was among the lowest of the oil majors.

Of Mr Chanos's major bear calls, bottlenecking in the global LNG market may prove to be the greatest concern for Shell”

Then came the acquisition of BG, which Mr Chanos said amounted to an expensive and overly-confident bet on liquefied natural gas (LNG) and Brazil, and which would leave Shell shares over-valued, based on a total enterprise value-to-cash profits (less capital expenditure) ratio.

Apparently the stockmarket did not get the memo in 2016, as Shell shares rose with the oil price recovery and shareholders bought into the turnaround story.

Before assessing how much of Mr Chanos' bear call still holds weight in 2017, a couple of points need to be highlighted. Firstly, any success the hedge fund manager may have had with timing should be tempered by the fact that short-sellers are required to cough up for the dividends of any stocks they are borrowing. Shell's resolute commitment to quarterly distributions throughout the downturn has therefore made a bet against the oil major very risky, and conversely made Shell a cornerstone of many income-focused investment portfolios.

Second, Mr Chanos' fund, Kynikos Associates, is likely to have focused on Shell's New York-listed equity (US:RDS/A), rather than UK portions of the stock. This is pertinent, because Shell's US dollar-denominated equity is still a third below its 2014 peak at around $55 a share. That's compared to a London share price which, thanks to the weakness in the pound, is less than 10 per cent off its zenith at 2,344p. Third, just 1.1 per cent of Shell's US equity is now out on loan, down from 2.5 per cent in November, before Opec's supply agreement started to push Brent crude back above $50 a barrel.

The main rejoinder to Mr Chanos has been Shell's actions since the BG deal. Third-quarter results for 2016 highlighted the company's renewed focus on net operating cash, strong production, and cost reductions which were well ahead of forecasts at the time of the BG acquisition. Brazilian offshore projects have started without a hitch, and the company is now moving ahead with its $30bn asset sale programme.

The speed of those disposals, and any further improvement in the oil price, will likely determine the direction of Shell shares in 2017. Quantifying the Brazil risk is tricky, though a weakened Brazilian real is useful for costs. Of Mr Chanos' major bear calls, bottlenecking in the global LNG market may prove to be the greatest concern for Shell. Investors should pay particular attention to the company's outlook on gas when full year results are released at the beginning of next month.

For more on Shell listen in to our free special in-depth podcast on the buy and sell cases for Shell.

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