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Why shale oil stocks are dropping in value

i Oct 11th No Comments by

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In the past three months ‘West Texas Intermediate’ oil has fallen from $105/barrel to $85/barrel. This has caused the stock price of shale oil companies to “tank”.

Here in Ryedale, the likelihood is that companies would be drilling for shale gas rather than oil and the prices of oil and gas are less tightly correlated than they used to be. But understanding how the shale oil market works can still help us to understand the implications for shale gas.

One reason that share prices of shale oil companies have fallen so far is that the companies now get less money for every barrel of oil they extract.

The other reason is the way shale companies are financed.

Let’s say you own a shale company and have bought the rights to drill somewhere. And let’s say your seismic survey shows the value of recoverable oil reserves is £20m.

Suppose you need £10million to finance drilling a well.

You could put up your own money, but it’s a risky business and you only have £2m spare cash.

So you go to a bank and agree that they will lend you £5m at a relatively low interest rate (because you will give them a ‘mortgage’ secured over the assets of the business).

And then you borrow the remaining £3m from the debt market, at higher interest rates, because those lenders (without the security of a mortgage) have higher risk.

So the situation is:

My own money:    £2m
Bank’s money:       £5m (at low interest, with ‘mortgage’ against the assets)
High yield debt:    £3m (at high interest rate, because higher risk)
Total:                    £10m

What then happens if the oil price falls by 20%, as it has just done?

The £20m value of the extractable reserves is now only £16m. The bank is very risk-averse and starts to get nervous. They say, “Sorry, we can now only lend you £4m.”

But the costs of drilling the well are just the same, so you have to borrow another £1m from the debt market, at a high interest rate. Which means the profit you will make goes down. Which means the return you get on your £2m is lower, so you decide you don’t want to risk so much of your own money either (because you would rather invest it somewhere you can make a safer return in, say, solar panels). So that means you need to borrow even more money from the (expensive) unsecured debt market. Which means your forecast profits are down again…

And when you go to the unsecured debt market to ask for more money, they know about your problems. They know that the value of your asset has fallen, so the risks to them have gone up, so they demand you pay an even higher interest rate to take that risk.

Which makes a bigger problem for you, because now you are making even less return on your oil field, which is supposedly worth £16m, but might turn out to be worth £15m, or £14m. And then if you have an extra £1m in interest payments, and if you get sued (or sued) (or sued), or if the local residents put up your costs by protesting and introducing delays into the system…

Any fall in the oil price (or the availability of cheaper alternative power sources) can be a double or triple-whammy for the fracking company. And the 64 million dollar question is, at what point do rising costs cross over with falling returns?

That will vary from company to company, but the people at CNBC think it’s just a few dollars below where it is now.

How long will the oil price stay low? Well, that’s hard to say. One view is that the reason the price is low is in order to put pressure on Putin. Which implies it will stay low for more than a couple of months (depending on how stable his financing is).

In the meantime, the real life fracking companies have to keep making the payments on all the loans they took out on the wells they have drilled so far.

And since the depletion rate for fracked wells is very high — 80% to 90% of all the oil can be extracted in just a couple of years — it might not be long before some of those wells, and their cashflows, start to dry up.

So the fracking companies have a choice: to take the risk to borrow new money to drill new wells, or walk away and look for easier ways to make money.

Of course the oil industry has influence with the Obama administration. So there will likely have been conversations around what level to take the oil price down to.

But other people have influence on the Obama administration as well. The fracking companies don’t have it all their own way.

Source: “Here’s why shale oil stocks are tanking“, CNBC, 10 October 2014.

(Note that here in Ryedale, companies would likely be wanting to frack for gas rather than oil. But we can still learn something from the reasons why the stock prices of shale oil companies have fallen dramatically.)

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