What it means
Many oil and gas deposits sit in tight rock that does not let fluids flow easily. Operators drill down and then sideways through the rock layer, and then pump in fluid at high pressure to create small fractures.
Sand carried in the fluid holds the cracks open so that oil and gas can flow into the well. From a business viewpoint, fracking wells behave differently from conventional wells.
They need a large amount of money at the start for drilling and completing the well, they produce strongly in the first months and then decline sharply. Because a field's output falls quickly, producers must keep drilling new wells just to hold production steady, which makes capital spending a continuing necessity.
The quick start and rapid decline give the industry a short investment cycle. A well can be drilled and producing within months, so producers can raise or cut activity as prices move.
This responsiveness is one reason why shale producers have often been seen as marginal suppliers that influence the global oil price. The key financial measure is the break-even price, which is the oil or gas price at which a well earns an acceptable return.
It depends on well cost, the volume it will produce, royalties paid to landowners, operating costs and taxes. Producers with low break-even prices survive downturns, while those with high costs and heavy debt may struggle.
Fracking is also controversial because of environmental and regulatory concerns, including water use, emissions and local effects such as earthquakes. Rules vary widely by country and region, and changes in regulation can raise costs or restrict activity.
Investors and lenders therefore treat regulatory and reputational risk as an important part of their analysis.
In practice
Real-world examples.
Example
A shale producer plans to drill 40 wells next year at $8,000,000 each, a total capital budget of $320,000,000. The chief financial officer compares this with expected cash flow from existing wells, and finds a funding gap of $60,000,000. She arranges a credit facility to cover it.
Example
A bank lends to a small fracking operator and sets the loan size against the value of its proven reserves. When oil prices fall, the reserves are worth less and the bank reduces the borrowing limit. The operator has to sell assets to repay part of the debt.
Example
A manufacturer of steel pipes and sand sees a rise in orders as drilling activity increases. Its sales director tracks the count of active drilling rigs and the oil price, because demand follows both. She plans her production schedule accordingly.
Formula
Calculation
Simple payback period = Well cost / Annual net cash flow from the well
Annual net cash flow = Barrels x Price - Royalties - Operating costs
Suppose a well costs $8,000,000 to drill and complete and produces 150,000 barrels in its first year. At $70 per barrel, revenue is 150,000 x 70 = $10,500,000. Royalties of 20% take 10,500,000 x 0.20 = $2,100,000, and operating costs of $20 per barrel take 150,000 x 20 = $3,000,000.
Net cash flow is 10,500,000 - 2,100,000 - 3,000,000 = $5,400,000. The payback is 8,000,000 / 5,400,000 = about 1.5 years if output stayed flat, and longer in practice because production declines quickly.Case study
Seen in the real world.
Prairie Wind Energy is a fictional shale producer with a plan to drill 20 wells at a cost of $8,000,000 each. The finance director, Raj, built a model that showed each well breaking even at an oil price of about $45 per barrel, based on the company's costs and royalty terms.
When prices fell to $40, he compared two choices. Continuing to drill would add 20 x 8,000,000 = $160,000,000 of spending, with each well failing to earn its cost of capital, while pausing would conserve cash but leave the company's rigs idle at a cost of $12,000,000.
In this illustrative case the board paused the programme, kept the cash and waited for prices to recover. Raj explained that, because shale wells can be started again within months, the option to wait was worth more than the idle rig cost.
Watch out
Common mistakes.
- Assuming a well keeps producing at its first-year rate, when output typically falls steeply in the early years.
- Quoting a single break-even price for the whole industry, when costs differ between regions and companies.
- Ignoring the capital needed to keep drilling, which makes free cash flow much lower than reported operating profit.
Questions
People also ask.
What is hydraulic fracturing?
It is the process of injecting fluid at high pressure into underground rock to create cracks that release oil and gas.
Why does fracking matter to oil prices?
Shale wells can be started and stopped relatively quickly, so supply responds faster to price changes than from large conventional projects.
What are the main financial risks?
They include price falls that push wells below break-even, heavy debt, rapid production declines and changes in environmental regulation.
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