Oil and gas exploration and production (E&P) companies are unique from a valuation standpoint. Because of this, investors need to focus on a different subset of ratios to analyze the growth and profitability of these companies. Company revenues are important, but focus should be on netback. Oil and gas stocks are broken down into three parts:

1. Upstream

2. Midstream

3. Downstream

An oil and gas company can contain anywhere from one to all three parts. Upstream refers to E&P. The second is midstream. It includes storing, transporting and marketing of oil, natural gas liquids and natural gas. The last is downstream, which is the refining of crude and the distribution of its byproducts. These three are very different from a business and investment prospective. This article focuses on upstream and the key ratios used to analyze it.

SEE: Oil And Gas Industry Primer

Oil and gas E&P stocks have greater volatility when compared to other businesses. Oil and natural gas prices see large price swings in the face of good or bad economic news. Hedging helps to reduce a company's exposure to this risk. Finding and developing costs can also vary greatly depending on the play, and how aggressively others are working the area. Production costs are variable, as geology can differ significantly depending on the area. What separates oil and gas producers from other types of investments is depletion. Technology has increased oil production, but newer methods deplete resources at a much faster rate. Vertical wells produced oil in a more consistent fashion, where production initially increased. After a period of time that production would begin to deplete slowly. Conventional resources are now less common as most of the "easy oil" has been produced. Because of this, unconventional resources have become the main source of crude and natural gas in the United States. Horizontal drilling has high initial production rates. Depletion rates are also high, and begin immediately after production starts. Oil sands are also providing a new resource base, with extensive reserves in Canada. Both oil sands and shale provide little to no exploration risk and both types of resources are well defined.

To assess the value of an oil and gas E&P company, there are several variables of focus. Federal and state regulations can cause extrinsic problems for oil and gas. Changes in reserve pit rules are already creating additional costs. Reserve pits are where flowback is stored before the initial production phase. Fears of soil and aquifer pollution have pushed new rules. Frac water reuse is starting to be seen in some of the bigger plays. The blending of this with fresh water may become mandatory, as there are already issues with municipals being able to keep up with current water needs. Additional regulations could affect fracking, as has occurred in the Marcellus. Political risks can also affect the value of oil and gas stocks. Companies such as Marathon (NYSE:MRO) were negatively impacted by the civil war in Syria. Companies operating in the United States benefit from its stable government and politics.

SEE: Money And Politics

Next: Key Ratios For Analyzing Oil And Gas Stocks: Measuring Performance »



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