Shale Acreage = Out of the Money Options [Gaille Energy Blog Issue 25]
- Posted by scottgaille
- On May 9, 2016
- 0 Comments
“Out of the money (OTM) is a call option with a strike price that is higher than the market price of the underlying asset. . . . An out of the money option has no intrinsic value, but only possesses extrinsic or time value.” – Investopedia
As buyers evaluate shale packages in bankruptcies and foreclosures, they struggle to value undrilled acreage. “The big shale fields cover hundreds of thousands, even millions of acres. But the quality of the geology is not homogenous across the landscape. There are sweet spots in these fields, which the companies, naturally, drill first . . . Trouble is, as these sweet spots are developed the companies have to move down the continuum of sweetness, and profitability. That costs more” (Forbes).
The image above captures this using a continuum of colors to reflect the Eagle Ford’s break-even points (BTU Analytics). Companies with yellow or red acreage effectively own OTM options. Wells are not going to be drilled there because returns would be negative. Even in light green areas (where returns are marginally positive), IRRs may not be high enough to offset inherent drilling risks.
Prior to the collapse of oil prices, most of this acreage was green. Shale companies’ drilling locations (or options) were “in the money.” Sweet spots generated IRRs in excess of 100% (at $80+ oil). When prices fell, the green turned red, and prospective sites were rendered nearly worthless. This is why shale companies lost more of their market capitalizations than supermajors, which had valuations more closely tied to conventional production.
The point at which a drilling location becomes economic – effectively, its option exercise price – is one component of valuing undrilled acreage. Another is the duration of the option. The longer an operator has for markets to rebound, the more valuable its option. Shale acreage is subject to the conditions of leases negotiated with mineral rights owners. These leases (usually) can be indefinitely held if the operator drills at least one well and then maintains its production. This is referred to as “held by production” (or HBP). Just one well could, for example, HBP ten future drilling locations.
In contrast, leases without productive wells are on a clock, typically expiring within three to five years. If production is not established during that period, the lease terminates. Consider a package of non-HBP acreage with a breakeven of $70 oil and an average expiration of one year. The acreage will have few, if any, buyers because it’s unlikely that the market will recover soon enough.
Some leases also have extension clauses pursuant to which the operator can add a year or two of term. Leases expiring in 2016 or 2017 were entered into prior to the oil crash, and their extension rates are likely to reflect outdated pricing. These will need to be renegotiated.
All of this sets the stage for a “mothballing” strategy. The term “mothballing” has its origins in the 19th century, when warships still had wooden hulls. After a war, nations sought to preserve their fleets by hanging mothballs inside them to deter insect damage. Asset packages with drilling locations on HBP acreage are good candidates for mothballing. Adjacent non-HBP acreage also can be part of the plan. Targeted renewals (or new leases) can be sought, with the longest term possible. Then, the operator just needs to wait for oil prices to rise again. Just as drilling locations were rendered nearly worthless, they can become exponentially valuable again – if the options have a low enough cost and a long enough duration.
About the Gaille Energy Blog. The Gaille Energy Blog discusses issues in the field of energy law, with weekly posts at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).