To Frack or Not to Frack: Option Value Analysis on the U.S. Natural Gas Market

Advances in horizontal drilling, 3-D seismic imaging, and hydraulic fracturing made it highly profitable for firms to produce large quantities of shale gas, making the natural gas boom possible. The number of firms entering the natural gas market from 2000 to present increased tenfold. There are three main testable explanations behind this jump in firm entry: reduced production costs from higher levels of recoverable reserves, lower risk of entry from less natural gas reserve uncertainty, and reduced sunk costs of entry lowering the risk of entry. We develop a real options model exploring the market entry decision of a firm when natural gas prices and reserves are uncertain to examine which of these three explanations impacts the market entry decision the most. The model shows that expected reductions in average costs of production and sunk costs of entry push the firm to optimally enter the natural gas market from 2000 to 2008 when firms were flooding the market. Surprisingly, expectations of lower natural gas reserve uncertainty do not have an influence on the entry decisions made by firms.

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Paper #9628

 Record created 2017-04-01, last modified 2018-01-23

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