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Oil And Gas Industry Primer

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. One of those sectors is the oil and gas sector,

which 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. Read on as we take you through the basics. (For related

reading, see the Industry Handbook.)

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.

In order 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, there are hundreds

of public E&P companies 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.

Exploration and production 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, one thousand barrels is

commonly denoted as "mbbl" and one 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.

Production of gas is described in terms of standard cubic feet, which is a

measure of 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 1

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 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. (For related reading, see What economic indicators are especially

important to oil traders?)

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. (For related reading,

see Getting A Grip On The Cost Of 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 like Grey

Wolf Inc. or Nabors Industries Ltd. 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 of E&P companies.

Once a well is drilled, there are many activities involved with 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, there are many

public companies, like Halliburton Company and Schlumberger, that are involved

with well-service activity. Revenue of service companies is tied to the level

of activity 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 point in time.

Conclusion

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.

To learn more about investing in oil and gas, see Fueling Futures In The Energy

Market.

by Bryn Harman, CFA