Lower Oil Prices Killing Fracking

[planosteve]

Why are shale plays getting hit so hard?

The short answer is, because oil is dropping. West Texas Intermediate (New York Mercantile Exchange: @CL.1) has gone from $105 to $85 in three months.

But a large part of the problem has to do with the way shale drilling is financed.

Let's say you own a shale company and you want to finance drilling a well in, say, the Bakken. You need $10 million (I am just using $10 million as an example). You have a demonstrated reserve value from the well of, say, $20 million.

Here's how you might finance the $10 million deal. First, get a line of credit from a bank based on the value of the reserves. In turn, the lender becomes a secured creditor. Let's say that based on a value of $20 million, a secured lender is willing to put up $5 million.

You can fund another $2 million from your own cash flow. Now you have $7 million.

For the remaining $3 million, you go to the high-yield debt market, which of course is an unsecured creditor.

Here's what the deal looks like:
•Secured creditor: $5 million
•Cash flow: $2 million
•Unsecured creditor: $3 million (high yield)
•Total: $10 million

This is simplified, but you get the point.

Now, let's look at what happens when oil starts to drop fast, which is exactly our scenario.

That secured creditor with the line of credit? He's getting nervous, because now instead of reserves worth $20 million for your project, those reserves are now worth only, say, $16 million.

That's a problem. The line of credit you will be able to get will drop because as the price of oil drops banks don't want to lend as much

So, instead of $5 million, your secured creditor will only lend $4 million, and at a higher rate. Now you need $6 million more.

Another problem: because the price of oil is down, you can't contribute as much from your cash flow, so instead of $2 million that you contribute, you can only contribute $1 million.

That's $5 million total. You still need another $5 million, and now you have to go to the high-yield market.

Except the high-yield market is aware of your problems, and they want a higher interest rate too.

So here's what this new deal looks like:
•Secured creditor: $4 million
•Cash flow: $1 million
•Unsecured creditor: $5 million
•Total: $10 million

This is a problem, because you are: 1) making less money from selling oil, and 2) shelling out a lot more money in interest to your creditors.

As oil drops, you now run an increased risk of cash flow problems, and there is default risk in the debt.

So you are making less money, and your one cheap source of financing (the line of credit) is shrinking, forcing you to go to high yield.

You are in a debt spiral.

Get it? So, at what point does all this start to get problematic? That's not easy to answer, because every company is different. There are different yields from different wells, and some have more gas than oil.

But there's no doubt that things get a bit difficult for some producers when oil is in the low $80's, which is where it is heading now.

And rather than differentiate between companies...which is what analysts are paid to do...there is a lot of indiscriminate selling. Oil vs. gas, doesn't matter. Sell and ask questions later.

Here's another point: the depletion rate is very high in these wells. You are literally squeezing oil from a rock. It can be on the order of 80 to 90 percent depletion over a couple years. So you have to constantly keep drilling new wells to meet the production quota.

And there really isn't a lot of options. They have to drill, or they don't have cash flow. And they still have to make the interest payments!

http://finance.yahoo.com/news/heres-why-shale-oil-stocks-200009552.html

[Bob Of Burleson]

We got a letter today from a Fort Worth lawyer who wants us as royalty owners to join a class-action lawsuit against Chesapeake.

Fat chance. Even if the lawyer wins the case, we'd only get a couple of bucks for our sub-acre property.

[planosteve]

I've been saying for two years now that fracking was a ponzie scheme. It can only be economical at high oil prices and cheap interest. When oil goes down or interest rates rise or both, fracking becomes a big looser.

[John in Plano]

Domestic oil production has been increasing for about 4 years,


Wonder why those stupid oil companies aren't listening to plano and his goldbugs

[planosteve]

Domestic oil production has been increasing for about 4 years,


Wonder why those stupid oil companies aren't listening to plano and his goldbugs

I thought the article explained why the economics doesn't work pretty well. Did you not understand it? Or if you think it is wrong, why?

[John in Plano]

I enjoy reading fiction as much as I do reading non-fiction and in the case of the article I place it in the fiction category. Its based on 2 guesses which makes this an op/ed piece and I got no desire to debate it.

With some time a reporter could run numbers on companies that are producing oil from shale and then we'd have something to discuss.

[planosteve]

I enjoy reading fiction as much as I do reading non-fiction and in the case of the article I place it in the fiction category. Its based on 2 guesses which makes this an op/ed piece and I got no desire to debate it.

With some time a reporter could run numbers on companies that are producing oil from shale and then we'd have something to discuss.

What are the two guesses?
Actually, I just listened to Ed Wallace arguing basically the same point about the financing.

[John in Plano]

I enjoy reading fiction as much as I do reading non-fiction and in the case of the article I place it in the fiction category. Its based on 2 guesses which makes this an op/ed piece and I got no desire to debate it.

With some time a reporter could run numbers on companies that are producing oil from shale and then we'd have something to discuss.

What are the two guesses?
Actually, I just listened to Ed Wallace arguing basically the same point about the financing.

The cost and the value are.........examples........10 million borrowed and a 20 million value. Cost could be 1/2 that and reserves could be multiples higher, but that wouldn't fit the objctive of the writer and I not surprised you skipped that part.