Here's why shale oil stocks are tanking

Gas prices fall under $3 a gallon in New Jersey on Oct. 6, 2014.
Oil, gas & US economy   

Why are shale plays getting hit so hard?

The short answer is, because oil is dropping. West Texas Intermediate 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!

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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