David Einhorn just dropped a bomb on fracking stocks.
Einhorn is the founder Greenlight Capital. That’s the name of his hedge fund, which has $5 billion in assets.
Einhorn is viewed as one of Wall Street’s top short-sellers. He’s famous for his in-depth research into companies that have massive problems lurking beneath the surface.
Allied Capital and Lehman Brothers were two of his most-famous targets.
In both cases, Einhorn took a short position after finding aggressive accounting practices that inflated the companies’ asset values.
Lehman eventually filed for bankruptcy in 2008. Allied Capital fell more than 80%, and was eventually sold to a competitor in 2009.
On Monday, Einhorn was speaking at the Ira Sohn conference. This is an annual event where some of the top hedge fund managers share their favorite ideas.
Einhorn’s idea was to short fracking companies. He believes the entire fracking industry is in big trouble based on higher costs and lower oil prices.
Specifically, his favorite short play is Pioneer Natural Resources (PXD). This is one of the largest fracking companies in the world.
I agree with Einhorn’s thesis on fracking. The industry will see tough times as long as oil prices remain depressed.
However, I strongly disagree with Einhorn’s thesis on shorting Pioneer.
In fact, there are several other fracking companies that would be better short candidates if oil prices stay depressed longer term.
Let me explain …
The Financial Upside of Fracking
Over the past five years, I put a lot of work into learning about the fracking industry.
I visited every major shale area in America. This includes the Eagle Ford in south Texas (drove through 20 counties), the Williston Basin (Bakken) in North Dakota, and the Permian Basin in west Texas (drove through almost every county).
I jumped on rigs, talked to oil analysts, met with energy executives and visited well sites operated by the biggest fracking companies in America.
I traveled through most of these areas with a close friend who has been drilling wells in Texas for more than 40 years.
In short, I wanted to learn everything there is to know about fracking.
I was fascinated by this new technology. That’s because I saw how it could lead to big profits for many companies.
If you’re not familiar with the fracking industry …
During the past decade, American drillers learned how to crack shale rocks and extract natural gas and oil.
New drilling technologies (fracking and horizontal drilling) have enabled us to tap into oil reserves we previously could not access.
As a result, U.S. oil production increased from 5 million barrels a day in 2009 to more than 9 million barrels a day today.
Fracking helped America become the largest oil producer in the world, surpassing Saudi Arabia.
What’s Behind Einhorn’s Frack Attack?
One of the drawbacks of fracking (besides environmental concerns) is the cost.
In order for companies to extract oil through fracking, the price of oil needs to be around $60 a barrel or higher.
Over the past year, the price of oil crashed more than 50% from its highs (to under $50 a barrel).
It’s recovered some, but still trades at levels where it’s difficult for most frackers to make a profit.
As you can see from the chart, some of the biggest fracking companies have seen their stock price plummet.
This is mostly due to the collapse in oil prices.
Getting back to Einhorn …
The hedge fund manager specifically attacked Pioneer Natural Resources (PXD).
• He displayed charts highlighting the company’s large cash burn (that is, money spent by the Pioneer) since 2006.
• He also mentioned how reserves have stopped growing.
• He also made his case why Pioneer won’t be able to make money from fracking … even if oil jumped to $100 a barrel again.
Einhorn is right.
Pioneer did spent billions on capital expenditures (CapEx) to build up its reserves over the past nine years.
But Pioneer’s spending made sense.
After all, oil prices averaged more than $85 a barrel (with the exception of the 2008 credit crisis) over this nine-year period.
Pioneer was smart to drill more holes and purchase more property in prime shale areas across Texas.
Why Pioneer Should Prove Einhorn Wrong
Today, Pioneer is drastically cutting costs to account for lower oil prices. The company announced it would cut CapEx by 45% this year to $1.8 billon.
It will also focus on drilling in its most-profitable areas.
For example, Pioneer has 720,000 acres in the Permian Basin and 118,000 net acres in the Eagle Ford.
A lot of this acreage is “prime” real estate where Pioneer can drill for oil at much cheaper prices compared to its compeitors.
It’s almost like owning property on the Las Vegas Strip compared to owning property in the middle of the desert.
Pioneer also plans to save up to 20% on every new well it drills. This is due to lower services costs. (That is, the money charged by service companies like Halliburton and Schlumberger to help operate a well.)
And Pioneer is saving money using new technologies like well pad drilling.
New Well Technologies to Pay Off for Pioneer
Well pad drilling allows companies to drill more than 20 wells using one rig. Nearly 60% of wells drilled in unconventional areas in 2014 were done using well pad drilling.
That compares to just 5% of wells in 2006. (That’s the starting date Einhorn is using for his CapEx and oil reserves analysis for Pioneer.)
Plus, new technologies allow frackers to drill wells in a shorter period of time.
For example, in 2011 it used to take more than three weeks for the average fracking company to drill a well.
Today, that time frame is down to just a little more than one week.
Fracking companies are now able to save millions of dollars because they do not have to pay employees for two extra weeks of work.
This drastically increases productivity, as workers are able to move on to new projects at a much faster pace.
Want to Short Pioneer? Read This First
Before you decide to follow Einhorn’s suggestion to short Pioneer, here’s what you need to know …
Einhorn’s short thesis is based on Pioneer’s “historical” CapEx (spending) over the past nine years.
That’s like valuing Hewlett-Packard (HPQ) today based on what it cost the company to make a computer nine years ago.
In other words, over the past few years Pioneer has saved millions using new technologies to frack wells.
Plus, the company is significantly cutting back on CapEx to account for lower oil prices.
Pioneer has one of the strongest balance sheets of any fracking company. The company has …
• About $1 billion in cash on hand.
• Another $1 billion coming its way from one of its asset sales in the Eagle Ford.
• A $1.5 billion line of credit.
Many oil companies use the futures market to lock in prices at a fixed cost. This is called “hedging.”
On top of all the other good things going for the company, it has hedged roughly 90% of its oil production for this year at over $70 a barrel.
Pioneer also has about 70% of its production hedged through 2016.
That makes Pioneer one of the most-hedged fracking companies in America.
In other words, if oil prices stay at these levels or fall further over the next two years …
Why would anyone want to short Pioneer, which will have the best margins (due to its hedges) of any fracking company?
2 Better Shorts in the Fracking Space
Einhorn would do much better shorting Continental Resources (CRL).
This large fracking company is not hedged at all.
Plus, its property is mostly located in the Bakken in North Dakota — where the cost to drill is higher compared to shale areas in Texas.
He would also do better shorting Laredo Petroleum (LPI). This fracking company has prime real estate in the Permian Basin in Texas.
But Laredo is one of the most leveraged companies in the industry.
Even if Einhorn is Right About Pioneer …
One final note …
Pioneer has one of the best shale acreage packages in the world. Goldman Sachs (GS) estimates this acreage has a resource life of more than 80 years.
Let’s say Einhorn is right and shares fall another 15% to 20% from here. Pioneer would have a market-cap of roughly $20 billion.
This would make Pioneer a huge takeover target.
Most of the major oil companies have enough cash to buy Pioneer (including its debt). And they usually invest in projects based on a 10-year-plus outlook.
Consider that most of the major oil companies missed out on the shale oil boom.
They would love to get prime acreage — which has an 80-year-plus resource life — at a huge discount.
Plus major oil companies need to replace their reserves.
If you were a major oil company, how would you spend $20 billion to find oil?
You could drill off the coast of Brazil or Australia. However, deepwater drilling is super-expensive and dangerous.
You could also drill for oil in unstable countries in the Middle East or Africa. Yet, political instability could lead to higher taxes, which could negatively impact returns on investment.
The safer bet is to buy Pioneer. The company has one of the best shale land packages in the world. This land is located in the most mine-friendly country in the world.
Plus, most of Pioneer’s acreage has already been mapped out. (Seismic data and past drilling makes it easier for Pioneer to find oil.)
That’s why the company discovers oil on just about every well it drills.
Bottom Line: Don’t Get Caught Short in Pioneer
A takeover of Pioneer would result in a huge one-day loss for short-sellers.
This is what happened to Green Mountain Coffee, another company Einhorn shorted in 2013.
Beverage giant Coca-Cola (KO) invested more than $1 billion (10% stake) in Green Mountain in early 2014.
The stock popped 30% in one day — resulting in a huge loss for short-sellers.
This is a serious risk investors should think about before shorting Pioneer.
Coke was having trouble growing sales. And the move to invest in Green Mountain seemed desperate, something that even the best analysts in the world didn’t see coming.
The same goes for major oil companies today.
They are having trouble increasing reserves. Yet, they have a ton of cash to spend.
It’s just a matter of time before they start acquiring oil companies that are trading at huge discounts compared to just a few months ago.
One of those acquisitions could be Pioneer.
Einhorn is one of the best short-sellers on Wall Street. He has a great track record and I’m a huge fan of his research.
However, his thesis on shorting Pioneer Natural Resources is flawed.
It’s more of a bet on lower oil prices — which will impact the rest of the fracking industry much more than Pioneer.
