The oil and gas industry is loaded with abstruse terms that can overwhelm an investor new to the sector. This introduction to the industry and its key concepts and measurements can help anyone understand the fundamentals of the companies involved.

About Hydrocarbon

Crude oil and natural gas are naturally occurring substances that are found in rock in the Earth's crust. Oil and gas are organic materials that are created by the compression of the remains of plants and animals in sedimentary rock such as sandstone, limestone, and shale.

Key Takeaways

  • Exploration and production (E&P) companies find hydrocarbon reservoirs, drill oil and gas wells, and sell these raw materials to companies that refine them.
  • 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.

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 source 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 are our sources for 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. These are typically plugged and abandoned.

Exploration and Production (E&P) Companies

Exploration and production (E&P) companies find hydrocarbon reservoirs, drill oil and gas wells, extract these raw materials, and sell them to be refined by other companies into products such as gasoline.

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

This activity is often 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 related to oil and gas production.

Understanding Oil Production Numbers

E&P companies measure oil production in barrels. One 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 one million. Therefore, 1,000 barrels is commonly denoted as mbbl and one million barrels is 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

Gas production is described in terms of standard cubic feet, which is a measure of the quantity of gas at 60 degrees Fahrenheit and 14.65 pounds per square inch of pressure. Similar to the convention for oil, the term mmcf means one million cubic feet of gas. One billion cubic feet is denoted as Bcf, and one trillion cubic feet is denoted as Tcf.

Note that gas market prices are sold on the New York Mercantile Exchange futures market in quantities based on one 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). 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 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 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.

The value of reserves is not a GAAP figure and is not directly booked into a company's financial statements.

New reserves, of course, are the primary source of future revenue, so E&P companies spend a lot of time and money exploring for new petroleum reserves. If an E&P company stops exploring, it will generate revenue from a finite and depleting quantity of petroleum and revenue inevitably will decline over time.

E&P companies can only maintain or grow a revenue base 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.

Contract drilling companies generally charge for their services based on the amount of time they work for an E&P company. They 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 include well logging, cementing, casing, perforating, fracturing, and maintenance and are collectively referred to as well servicing.

As is the case for drilling, many public companies are involved with well service activity. The revenue of service companies is tied to the activity level in the oil and gas industry, sometimes measured by the rig count. That is the number of rigs working in the United States at any given time.