The oil and gas industry is the largest sector in the world in terms of dollar value. It contributes significantly to the gross domestic product (GDP) of many nations and generates billions of dollars a year and is, therefore, a crucial element in the global economy's framework.

Investors looking to enter the oil and gas industry can quickly be overwhelmed by the complex jargon and unique metrics used throughout the sector. This introduction is designed to help anyone understand the fundamentals of companies involved in the oil and gas sector by explaining key concepts and the standards of measurement.

Key Takeaways

  • The oil & gas industry is broken down into three segments: upstream, midstream, and downstream.
  • Upstream, or exploration and production (E&P) companies, find reservoirs and drill oil and gas wells. Midstream companies are responsible for transportation from the wells to refineries and downstream companies are responsible for refining and the sale of the finished products.
  • Drilling companies contract their services to E&P companies to extract oil and gas.
  • Well-servicing companies conduct related construction and maintenance activities on well sites.

About Hydrocarbons

Hydrocarbons make up crude oil and natural gas, which are naturally occurring substances found in rock in the Earth's crust. These organic raw materials are created by the compression of the remains of plants and animals in sedimentary rocks such as sandstone, limestone, and shale.

The sedimentary rock itself is a product of deposits in ancient oceans and other bodies of water. As layers of sediment were deposited on the ocean floor, the decaying remains of plants and animals were integrated into the forming rock. The organic material eventually transforms into oil and gas after being exposed to specific temperatures and pressure ranges deep within the Earth's crust.

Oil and gas are less dense than water, so they migrate through porous sedimentary rock toward the Earth's surface. When the hydrocarbons are trapped beneath less-porous cap rock, an oil and gas reservoir is formed. These reservoirs of oil and gas represent our sources of crude oil and gas.

Hydrocarbons are brought to the surface by drilling through the cap rock and into the reservoir. Once the drill bit reaches the reservoir, a productive oil or gas well can be constructed 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, which is typically plugged and abandoned.

Upstream, Midstream, Downstream

The oil and gas industry is broken down into three main segments: upstream, midstream, and downstream.

Upstream

Upstream businesses consist of companies involved in the exploration and production of oil and gas. These are the firms that search the world for reservoirs of the raw materials and then drill to extract that material. These companies are often known as "E&P" for "exploration and production."

The upstream segment is characterized by high risks, high investment capital, extended duration as it takes time to locate and drill, as well as being technologically intensive. Virtually all cash flow and income statement line items of E&P companies are directly related to oil and gas production.

Midstream

Midstream businesses are those that are focused on transportation. They are the ones responsible for moving the extracted raw materials to refineries to process the oil and gas. Midstream companies are characterized by shipping, trucking, pipelines, and storing of the raw materials. The midstream segment is also marked by high regulation, particularly on pipeline transmission, and low capital risk. The segment is also naturally dependent on the success of upstream firms.

Downstream

Downstream businesses are the refineries. These are the companies responsible for removing impurities and converting the oil and gas to products for the general public, such as gasoline, jet fuel, heating oil, and asphalt.

E&P companies are often valued by their oil and gas reserves; these untapped resources are the key to their future earnings.

Understanding Oil Production Numbers

E&P companies measure oil production in barrels. One barrel, usually abbreviated as bbl, is equal to 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 are commonly denoted as Mbbl, and 1 million barrels are denoted as MMbbl. For example, when an E&P company reports production of seven Mbbl per day, it means 7,000 barrels of oil per day.

Gas Production Numbers Explained

Natural gas production is described in terms of cubic feet. Similar to the convention for oil, the term Mmcf means 1 million cubic feet of gas. Bcf means 1 billion cubic feet and Tcf represents 1 trillion cubic feet.

Note that natural gas futures trade on the CME Group futures exchange, but are not measured in cubic feet. Instead, the futures contract is based on 1 million British thermal units, or MMBtu, which is roughly equivalent to 970 cubic feet of gas. For this reason, investors frequently think of an Mcf of gas as being roughly equivalent to one MBtu.

E&P companies often describe their production in units of barrels of oil equivalent (BOE). To calculate BOE, companies usually convert gas production into oil equivalent production. In this calculation, one BOE has the energy equivalent of 6,040 cubic feet of gas or roughly one bbl to six 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.

E&P companies report their oil and natural gas reserves—the quantity of oil and gas they own that is still in the ground—in the same bbl and mcf terms. Reserves are often used to value E&P companies and make predictions for their revenue and earnings. However, since the value of reserves is not a GAAP figure, it might not be reflected in a company's financial statements.

Of course, new reserves are an essential source of future revenue, so E&P companies spend a lot of time and money exploring for new untapped reservoirs. If an E&P company stops exploring, it will have only a finite amount of reserves and a depleting quantity of oil and gas. Revenue will inevitably decline over time. In short, E&P companies can only maintain or grow revenue by acquiring or finding new reserves.

Drilling and Service Companies

E&P companies do not usually own their own drilling equipment or employ a drilling rig staff. Instead, they hire contract drilling companies to drill wells for them and the contract drilling companies generally charge for their services based on the amount of time they work for an E&P company. Drillers do not generate revenue that is tied directly to oil and gas production, as is the case for E&P companies.

Once a well is drilled, various activities are involved in generating and maintaining its production over time. These activities are called well servicing and can include logging, cementing, casing, perforating, fracturing, and maintenance. Oil drilling and oil servicing thus represent two different business activities within the oil and gas industry.

As is the case for drilling, many public companies are involved in well service activity. The revenue of service companies is tied to the activity level in the oil and gas industry. Rig count and utilization rates are indicators of the amount of activity happening in the United States at any given time.