Here's why Jim Chanos is shorting big oil

Reuters

Famous short seller Jim Chanos is shorting oil majors Royal Dutch Shell Plc and Chevron Corp, according to Bloomberg. He is operating under the belief that the negative cash flows and dividend payments using borrowed money by both the companies is an unsustainable move in the long-term.

He also believes that a preference for electric cars and trucks can seriously dent the demand for crude oil in the near future.

Shell’s current cost of supplies earnings tanked in the latest quarter from $4.8 billion to $0.8 billion. The worrying point was the $4.6 billion in cash flow against an expenditure of $6.1 billion in Capex. $3.7 billion of dividends were distributed to the shareholders, of which the company managed to settle $1.5 billion in payouts by issuing 65.7 million A shares under the scrip dividend program.

On the other hand, Chevron also declared a below par result with a net loss of $725 million, compared to a profit of $2.6 billion in the first quarter of 2015. The cash flow situation for Chevron looks shaky. It generated $1.1 billion in operating cash flows in Q1 this year, whereas, it spent $5.6 billion in capex and $2 billion for dividends.

Both the companies are borrowing money, cutting costs and burning their cash reserves to fulfill their dividend payouts.

Bloomberg reports that the top six companies have doubled their borrowings in the last two years compared to 2014 levels.

Reuters

Due to the increased borrowings, the debt-to-capitalization ratio for Shell has increased to 26 percent from 12.4 percent at the end of first quarter 2015, whereas, for Chevron it has increased to 22 percent. Both the levels are comfortable in the short-term, and there is no immediate risk due to the prevailing low cost of borrowings.

The 75 percent rise in crude oil prices from the lows in February has boosted prices of both the companies. Investors are encouraged by the management’s commitment to maintaining dividends even during the worst oil crisis in decades. Even after the current run-up in stock prices, the dividend yields on both the companies are attractive.

The Chevron management in its latest conference call reiterated: “Sustaining and growing the dividend is still the first priority from a cash use standpoint.”

Similarly, Shell has targeted to cut spending by $3 billion, bringing total spending down to $30 billion this fiscal year, in order to continue paying dividends.

However, crude oil fundamentals don’t support higher prices, and that is a fairly significant ‘however’.

The EIA’s May STEO forecasts an average crude oil price of $41 per barrel in 2016 and an average of $51/b in 2017. Many top trading firms such as Vitol have predicted a range bound price for almost a decade.

Neither company is in any immediate danger of tanking or facing a crisis, unless the current appreciation in oil prices reverses and oil again drops to retest the lows of $27/b.

Traders who are currently holding the stock can continue to do so, keeping an eye on the crude oil prices. If for some reason crude oil were to break the lows, all bets on the oil companies should be off.

The latest STEO by EIA has raised its forecast by $6 for 2016 and $10 for 2017, compared to the previous month’s forecast, which indicates a changing trend. In case the outlook improves further, both Shell and Chevron will be in a much stronger position to continue dishing out dividends and improving their cash flow situation.

Though short-term trading opportunities exist for a small pull back when crude pulls back to under $40/b, a long-term short on both the companies is not favorable from a risk-reward perspective for the retail investor.

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