How do Small Players Deduce Beliefs about Uncertainty? A Look at Texas Shale Oil Investments

Abstract

Derivative markets enable firms to eliminate unwanted risk and, thereby, focus on their core competence. We ask whether small firms respond to changes in complex risk structures, using the emerging Texas shale oil industry. Unlike their conventional drilling counterparts, shale oil producers are small, with short production lead times and most revenue earned in two to three years. This exposes them to recent unprecedented volatility in product prices, production costs, and-in the Permian, pipeline transportation basis risk. We develop a real option model of their decision process, within which we measure firm responsiveness to volatility. To estimate revenue expectations, we use forward-looking time-varying beliefs deduced from futures and futures option prices. For costs, we use expectations about the evolution of production technology and forward-contracted transport capacity. Our results show that investment in new wells responds optimally not only to time-varying market price, but also to a second source of uncertainty: transportation basis. This demonstrates that even small firms are able to coordinate their production activity to integrate two sources of risk, impacting their investment returns. Lastly, we estimate the impact of the Nixon-era crude export ban, which became binding in August 2013, and caused US domestic crude price to fall below the world price, distorting US shale oil production revenue by $10.7B.