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