A very fundamental aspect of equity investing is understanding the companies and sectors in which you invest. In the equity universe, there are a number of sectors, and equity investors require some specialized knowledge to make educated investment decisions. The oil and gas sector is teeming with complicated terminology that can overwhelm investors new to the space. With a basic understanding of this terminology and the oil and gas business in general, investors can better understand the fundamentals of oil and gas stocks.

Hydrocarbon Basics
Crude oil and natural gas are naturally occurring substances present in rock amidst the earth's crust. The origin of oil and gas is organic material - the remains of plants and animals - compressed in sedimentary rock such as sandstone, limestone and shale. Sedimentary rock is a product of sediment deposits in ancient oceans and other bodies of water. As layers of sediment were deposited on the ocean floor, decaying remains of plants and animals were integrated into the forming rock. This organic material eventually transformed into oil and gas after being exposed to a specific temperature and pressure range deep within the earth's crust.

Because oil and gas are less dense than water, which occurs in huge quantities in the earth's subsurface, oil and gas migrate through relatively porous sedimentary source rock toward the earth's surface. When the hydrocarbons are trapped beneath relatively less-porous cap rock, an oil and gas reservoir is formed. These reservoirs, which are simply layers of rock containing relatively large quantities of oil and gas, are our source for crude oil and gas.

To bring the hydrocarbons to the surface, a well must be drilled through the cap rock and into the reservoir. Drilling rigs work in a similar fashion as a hand drill; a drill bit is attached to a series of drill pipes, and the whole thing is rotated to make a well in the rock. Once the drill bit reaches the reservoir, a productive oil or gas well can be completed and the hydrocarbons can be pumped to the surface. When the drilling activity does not find commercially viable quantities of hydrocarbons, the well is classified as a "dry hole." Dry holes are typically plugged and abandoned.

Production and Reserves
Exploration and production (E&P) companies focus on finding hydrocarbon reservoirs, drilling oil and gas wells, and producing and selling these materials to be later refined into products such as gasoline. This activity is usually referred to as upstream oil and gas activity. Today, hundreds of public E&P companies are listed on U.S. stock exchanges. Virtually all cash flow and income statement line items of E&P companies are directly attached to oil and gas production, Therefore, investors should develop an understanding of basic production terminology when assessing E&P stocks.

E&P companies measure oil production in terms of barrels. A barrel, usually abbreviated as "bbl," is 42 U.S. gallons. Companies often describe production in terms of bbl per day or bbl per quarter. A common methodology in the oil patch is to use a prefix of "m" to indicate 1,000 and a prefix of "mm" to indicate 1 million. Therefore, 1,000 barrels is commonly denoted as "mbbl" and 1 million barrels is denoted as "mmbbl." For example, when an E&P company reports production of 7 mbbl per day, it is referring to 7,000 barrels of oil per day.

Gas production is described in terms of standard cubic feet, which is a measure of gas quantity at 60 degrees Fahrenheit and 14.65 pounds per square inch of pressure. Similar to the convention for oil, the term "mmcf" means 1 million cubic feet of gas. One billion cubic feet is denoted as "Bcf," and 1 trillion cubic feet is denoted as "Tcf." Note that gas market prices are sold on the New York Mercantile Exchange futures market in terms of million British thermal units, or "mmbtu," which is roughly equivalent to 970 cubic feet of gas. Investors frequently think of an mcf of gas as being equivalent to one mmbtu.

E&P companies often describe their production in units of barrels of oil equivalent (BOE). In calculating BOE, companies usually convert gas production into oil equivalent production using an energy-equivalent basis. In this basis, one BOE has the energy equivalent of 6,040 cubic feet of gas - or roughly one bbl to 6 mcf. Oil quantity can be converted into gas quantity in a similar fashion, and gas producers often refer to production in terms of gas equivalency using the term "mcfe." Note that the energy conversion basis often is not reflected in the respective market prices of oil and gas.

E&P companies report their oil and gas reserves - the quantity of oil and gas they own that is still in reservoirs in the ground - in the same bbl and mcf terms as above. Reserves are often used to value E&P companies and make predictions for their revenue and earnings. Note that reserves' values are not GAAP figures and they are not directly booked into a company's financial statements.

Because new reserves are the primary source of future revenue, E&P companies spend a lot of time and effort in finding new petroleum reserves. If an E&P company stops exploring, it will generate revenue from a finite and depleting quantity of petroleum and, therefore, revenue will naturally decline over time. As a result, E&P companies can only maintain or grow a revenue base by acquiring or finding new reserves.

Drilling and Service
E&P companies do not usually own their own drilling equipment or employ drilling rig staff. Instead, they hire contract drilling companies to drill wells for them. Contract drilling companies generally make a living based on the amount of time they work for the E&P companies. Drilling companies do not generate revenue in a way that is tied directly to oil and gas production as is the case for E&P companies.

Once a well is drilled, many activities are involved in generating and maintaining its production over time. These activities, such as well logging, cementing, casing, perforating, fracturing and maintenance are collectively referred to as well servicing. As is the case for drilling, many public companies are involved with well-service activity. Revenue of service companies is tied to the activity level in the oil and gas industry, sometimes measured by the "rig count" or the number of rigs working in the United States at any given time.

Investing in energy stocks can be complicated business. As is the case for most company analysis, a good starting point is to understand how the businesses derive revenue. For E&P companies, investors should strive to understand production and the production potential tied to current and planned exploration activity. For drilling and service companies, investors should develop a feel for the energy cycle, the drilling and service companies' competitive landscape and the omnipresent impact of oil and gas price changes over time.

Related Articles
  1. Economics

    The Biggest Oil Producers in the Middle East

    Discover which countries produce the most oil in the Middle East, a region long known for its influence on international petroleum markets.
  2. Stock Analysis

    Who Are Exxon’s Main Competitors?

    Learn about some of the main competitors to Exxon Mobil in the energy sector, and find out how their businesses are different from that of Exxon.
  3. Active Trading Fundamentals

    The Biggest Private Equity Firms in Los Angeles

    Learn why Los Angeles is a thriving market for private equity, and identify the five largest private equity firms operating in the city.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares US Oil&Gas Explor&Prodtn

    Learn about the iShares U.S. Oil & Gas Exploration & Production ETF, which provides an efficient way to invest in the exploration and production sector.
  5. Stock Analysis

    Gazprom and Shell: The Right Partnership?

    Learn about Shell and Gazprom, what industry they operate in and if they're competitors. Understand if their recent partnership is worth it for Shell.
  6. Active Trading

    Uncovering Oil And Gas Futures

    Find out how to stay on top of data reports that could cause volatility in oil and gas markets.
  7. Mutual Funds & ETFs

    Investing In Oil And Gas UITs

    Unit investment trusts provide direct exposure to the energy sector, fueling better returns.
  8. Fundamental Analysis

    5 Biggest Risks Faced By Oil And Gas Companies

    Before investing in gas and oil stocks, consider such factors as political and geological risks.
  9. Investing

    5 Common Trading Multiples Used In Oil And Gas Valuation

    Before you decide to invest in oil and gas, you should understand these multiples.
  10. Fundamental Analysis

    Accounting For Differences In Oil And Gas Accounting

    How a company accounts for its expenses affects how its net income and cash flow numbers are reported.
  1. What are average operating expenses for the oil and gas sector?

    The oil and gas sector plays an important role in the economy by drilling, extracting, and processing oil and gas. Because ... Read Full Answer >>
  2. How does the risk of investing in the oil and gas sector compare to the broader market?

    The oil and gas sector has unique risks, since it is exposed to fluctuations in the prices of oil and natural gas as opposed ... Read Full Answer >>
  3. What are the main reasons an investor should consider an allocation to the oil and ...

    An investor should consider some asset allocation to the oil and gas sector due to the stability of the sector as an investment, ... Read Full Answer >>
  4. How does analyzing an oil and gas's financial statements differ from companies in ...

    Oil and Gas Price Volatility Financial statements for companies in the oil and gas sector are different from those of companies ... Read Full Answer >>
  5. What methods can an oil and gas producer use to transport oil?

    Depending on the quantity, oil and gas producers can transport oil by land or by sea. For steady supplies on a long-term ... Read Full Answer >>
  6. Why do investors consider the rig utilization rates when investing in oil and gas?

    A rig utilization rate measures a company’s rigs that are operating in proportion to the company's total available rigs. ... Read Full Answer >>
  7. What impact will the growing popularity of electric cars have on the oil sector?

    The growing popularity of electric cars is not expected to have a serious impact on the oil and gas industry, at least for ... Read Full Answer >>
  8. What are some of the major companies in the chemicals sector?

    As of 2014, BASF, a German company, was the largest in the chemicals sector based on annual sales. Next was the Chinese company ... Read Full Answer >>
  9. What product categories make up the chemicals sector?

    The chemicals sector is one of the largest industry sectors in the world, covering five major subsectors that impact manufacturing, ... Read Full Answer >>
  10. How does the law of supply and demand affect the oil industry?

    The law of supply and demand primarily affects the oil industry by determining the price of oil. The price, and expectations ... Read Full Answer >>
  11. What percentage of the global economy is comprised of the oil & gas drilling sector?

    According to market research by IBISWorld, a leading business intelligence firm, the total revenues for the oil and gas drilling ... Read Full Answer >>
  12. What are risks associated with investing in the oil & gas drilling sector?

    As the demand for oil and gas remains strong in the global economy, more investors are intrigued by the investment opportunities ... Read Full Answer >>
  13. Besides oil companies, what businesses are hurt by cheap oil prices?

    When oil prices begin to fall, oil companies are the most palpable victim; however, the negative impact of cheap oil and ... Read Full Answer >>
  14. Where and when is fracking advantageous?

    Economically speaking, hydraulic fracturing, or "fracking," is advantageous whenever new oil supply can be brought to market ... Read Full Answer >>
  15. What regulations are in place that affect fracking?

    Regulations on hydraulic fracturing in the United States vary from state to state. On the federal level, fracking is primarily ... Read Full Answer >>
  16. When does it makes sense for a company to pursue vertical integration?

    Vertical integration makes sense as a strategy, as it allows a company to reduce costs across various parts of production, ... Read Full Answer >>
  17. What are the main benchmarks that track the oil & gas drilling sector?

    Oil and gas exploration and production is crucially important to modern nations. Exploration and production companies search ... Read Full Answer >>
  18. What is the average return on equity for a company in the oil & gas drilling sector?

    The energy sector, and specifically those companies engaging in upstream activities of oil and gas drilling, provides investors ... Read Full Answer >>
  19. What is the average price-to-book ratio in the oil & gas drilling sector?

    Oil and gas drilling companies under the purview of energy sector stocks can provide attractive value investing opportunities ... Read Full Answer >>
  20. What is the average price-to-earnings ratio in the oil & gas drilling sector?

    The energy sector provides unique opportunities for individuals interested in value investing, especially with companies ... Read Full Answer >>
  21. What is the average profit margin for a company in the oil & gas drilling sector?

    Investors looking for portfolio diversification through sector-specific funds can find multiple opportunities within the ... Read Full Answer >>
  22. What developed countries have the greatest exposure to oil & gas drilling?

    Precise information on the distribution of oil and gas drilling does not exist, mostly due to uncertainty about the size ... Read Full Answer >>
  23. What are the effects of fracking on the environment?

    The oil and gas industry has been expanding consistently for decades due, in part, to the advances in technology in the processes ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  5. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
Trading Center