Demystifying the Oil and Gas Sector

As with most of the industries and sectors that stock investors may seek to invest in, the oil and gas sector is often intimidating because of the massive amount of jargon that is involved.  Another layer of complexity is added by the global nature of the oil market and the political nature of international relations in historically volatile regions. It is important to realize that oil and gas are commodities.  Supply and demand economics rules commodity prices. When there is a surplus of oil or gas, prices tend to go down. When demand is high, and supply is too low to meet it, then prices climb sharply. These fluctuations in commodity prices have an enormous impact on the bottom line of companies in this sector.  

Oil and gas are sometimes referred to as hydrocarbons because of their shared chemistry.  They are commonly referred to as “fossil fuels” because of the way they originated. The basic idea is that ancient plant and animal life were covered over by sediment, and this sediment later formed into rock.  Add a few million years, and presto: you get natural gas and crude oil. The first thing this tells us is that oil deposits are hard to find because they are in the ground, buried under hundreds or thousands of feet of rock.  In the case of offshore deposits, you can’t even get to the rocks without going through hundreds of feet of water. The sector that is most closely associated with finding the oil and gas in the first place is usually called exploration.   This exploration and production end of things are dangerous; if the geologists get it wrong and the hole is dry, then many millions of dollars have been wasted.  Many of these companies take the raw commodities out of the ground and turn them into the useful products, such as gasoline, that people want to buy; this is most often referred to as refining.  Some companies get involved in the retail and distribution end of oil and gas as well, and these companies are usually classified in the “Integrated Oil and Gas” sector.  

Another important sector in the oil industry is the “Oil Equipment, Services, and Distribution” sector.  Getting millions and millions of gallons of oil and natural gas refined and to retail markets is a massive undertaking.  Many companies provide tools, equipment, chemicals and so forth to the oil exploration and production companies. E&P companies often farm out the actual drilling of the wells to drilling companies.  Drilling companies earn profits based on contracts and are not tied directly to the price of oil as are the E&P companies. Most such companies get lumped together into the “Oil Equipment and Services” subsector, but “Pipelines” are such a big deal that they get a subsector designation.

Most of the companies that explore for oil and gas also drill down to find it and bring it to the surface, a process called production.  Exploration and Production (E&P) company stocks sell at a premium when oil prices are high, and tend to sell at a discount when oil prices are low.  The balance sheets of these companies are composed of line items directly related to drilling for oil and gas and getting it out of the ground once it is found.  This means that investors in this sector must be familiar with the terminology and jargon of E&P as part of their homework on investing in the “oil patch.” As with any commodity, profits are made by volume of sales.  Wheat and corn sell by the bushel, and oil sells by the barrel (42 U.S. Gallons). Natural gas, on the other hand, is sold by the Cubic Foot (at a standard temperature and pressure).

Another important set of jargon you need to understand before investing in the oil patch is the difference between upstream, midstream, and downstream.  The term “upstream” is used to refer to the source of the oil or gas; the E&P side of things. The midstream is focused on storage and transportation. Finally, the downstream side refers to the refining and distribution of refined products.  For example, a drilling rig in Alaska would represent an “upstream” activity. The transportation of the oil from that well via a pipeline would be midstream activity. The refining and sale of gasoline would be downstream activity. These distinctions are important because they provide different potential risks and rewards for the investor.       

Just as with any other company, the value of an E&P company stock is directly related to its predicted future earning capacity.  These companies have a finite amount of oil or gas that they can pull out of the ground given all of the wells they have currently producing.  These still in the ground reservoirs are key to the valuation of E&P companies. Oil companies must always be exploring for new reserves or face bankruptcy.  Note that reserves in the oil patch are different than a company’s expected earnings.

Curiously, oil patch investors pay close attention to the “netback.” or profit per barrel of a particular production operation.  That is what it costs to get a barrel of oil to the retail market is subtracted from what the products sold for. Companies with a higher netback tend to sell at a premium while companies with a low netback tend to sell at a discount.  Netback rises when costs can be cut at any point from initial exploration to the final sale at the gas pump. These factors have historically been very predictable, with the American oil industry suffering when the sale price of a barrel of oil was low.  If it takes an American company $75 to get a barrel of oil to market and the price of oil is at $50, then obviously these companies cannot be profitable on the domestic side of the business.

Technology has already played a major role in improving the viability of American E&P companies.  We have become better at finding oil and gas, we’ve gotten better at getting it out of the ground, and we’ve become more economical at getting it to market.  When American E&P CEOs are telling investors that they can make a comfortable profit in the $45 per barrel range and oil is selling at $50, then it is a potentially exciting time for investors.

Note that the “Oil and Gas” industry would probably have been better named the “Energy” sector, and that’s what a lot of investors call it.  One reason for this is the fact that the “Alternative Energy” sector is within the “Oil and Gas” sector, creating an oxymoron. When we talk about “Alternative Energy” we are talking about alternatives to oil and gas.  The two major subsectors in this sector are “Renewable Energy Equipment” and “Alternative Fuels.”

Most companies tied to solar and wind will be tied to the equipment subsector, and oil and gas alternatives such as ethanol and fuel cells will be tied to the fuels subsector.  Most of the companies in this sector are very speculative and not suitable for the long-term value investor. So long as crude is selling for $50 or less, then the alternative sector has a long way to go before it can become broadly competitive. During periods of “environmentally friendly” politics and policy, government incentives make this sector seem more attractive.  During periods of pro-business policy and deregulation, oil and gas will be king, at least for the foreseeable future.

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