How the Oil and Gas Industry Works

 FACEBOOK
 TWITTER
 LINKEDIN

By REBECCA MCCLAY
Updated Mar 6, 2020
TABLE OF CONTENTS

 About Hydrocarbons
 Upstream, Midstream, Downstream
 Understanding Oil Production #s
 Gas Production Numbers Explained
 Drilling and Service Companies

The oil and gas industry is one of the largest sectors in the world in terms of dollar value,
generating an estimated $3.3 trillion in revenue annually.1 Oil is crucial to the global economic
framework, especially for its largest producers: the United States, Saudi Arabia, Russia, Canada
and China.2

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.3

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.3

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.4

Hydrocarbons are brought to the surface by drilling through the cap rock and into the reservoir.5
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.6 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.7 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.8

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.9

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.1 0 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.1 1 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. Public oil and gas companies are
required to disclose proven oil and gas reserve quantities as supplementary information, but not
as part of their financial statement.1 2

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.

Compete Risk Free with $100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of
Investopedia traders and trade your way to the top! Submit trades in a virtual environment before
you start risking your own money. Practice trading strategies so that when you're ready to enter
the real market, you've had the practice you need. Try our Stock Simulator today >>
ARTICLE SOURCES

Related Articles

OIL
What Percentage of the Global Economy Is the Oil and Gas Drilling Sector?

OIL
How Long Does It Take to Drill and Produce Oil?

OIL
Understanding Oil Firms And Refinery Services

OIL
How strong are the barriers to entry in the oil and gas sector?

TOP STOCKS
Top 10 Canadian Oil & Gas Companies

COMPANY PROFILES
Top 5 Companies Owned by Exxon Mobil (XOM)
Partner Links

Related Terms

Upstream
Upstream is a term for the exploration and production stages in the oil and gas industry. It is the
first stage in oil or gas production, followed by the midstream and downstream segments.
more
Finding And Development (F&D) Definition
Finding and development refers to costs incurred when a company purchases, researches and
develops properties to establish commodity reserves.
more
Barrel of Oil Equivalent (BOE)
A barrel of oil equivalent (BOE) is a term used to summarize the amount of energy that is
equivalent to the energy found in a barrel of crude oil.
more
Petroleum
Petroleum is a fluid found in the earth that can be refined into fuel and plastic. Humans rely on
petroleum for many goods and services, but it has a large and negative impact on the
environment.
more
Hydrocarbon Definition
A hydrocarbon is an organic chemical compound composed exclusively of hydrogen and carbon
atoms.
more
Trillion Cubic Feet (Tcf)
Trillion cubic feet is a measurement of natural gas used by the U.S. oil and gas industry, equal
to about one quadrillion British thermal units.
more