The energy industry is not any different than most commodity-based industries as it faces long periods of boom and bust. Drilling and other service firms are highly dependent on the price and demand for petroleum. These firms are some of the first to feel the effects of increased or decreased spending. If oil prices rise, it takes time for petroleum companies to size up land, setup rigs, take out the oil, transport it and refine it before the oil company sees any profit. On the other hand, oil services and drilling companies are the first on the scene when companies decide to start exploring.[Source: Investopedia, The Industry Handbook: The Oil Services Industry]

The refining business is not quite as fragmented as the drilling and services industry. This sector is dominated by a small handful of large players. In fact, much of the energy industry is ruled by large, integrated oil companies. Integrated refers to the fact that many of these companies look after all factors of production, refining and marketing.

For the most part, refining is a slow and stable business. The large amounts of capital investment means that very few companies can afford to enter this business. This handbook will try to focus more on oil equipment and services such as drilling and support services.

On the balance sheet, investors should keep an eye on debt levels. High debt puts a strain on credit ratings, weakening their ability to purchase new equipment or finance other capital expenditures. Poor credit ratings also make it difficult to acquire new business. If customers have the choice of going with a company that is strong versus one that is having debt problems, which do you think they will choose? To do a test for financial leverage, take a look at the debt/equity ratio. The working capital also tells us whether the company has enough liquid assets to cover short term liabilities. Rating agencies like Moody's and S&P say 50 percent is a prudent debt/equity ratio. Companies in more stable markets can afford slightly higher debt/equity ratios.

If profits are of the utmost importance, then the statement of cash flow is a close second. Oil companies are notorious for reporting non cash line items in the income statement. For this reason, you should try to decipher the cash EPS. By stripping away all the non-cash entities you will get a truer number because cash flow cannot be manipulated as easily as net income can.

Websites and Resources: American Petroleum Institute ; Investopedia Oil Handbook ; Petrostratgies Learning Institute ; U.S. Energy Information Administration ; New York Times article New York Times ; Wikipedia article Wikipedia ; Oil. com ; Petroleum Online ; Natural Book: “The Prize” by Daniel Yergin.

Petroleum Business Terms

BTUs: Short for "British Thermal Units." This is the amount of heat required to increase the temperature of one pound of water by one degree Fahrenheit. Different fuels have different heating values; by quoting the price per BTU it is easier to compare different types of energy. [Source: Investopedia, The Industry Handbook: The Oil Services Industry]

Dayrates: Oil and gas drillers usually charge oil producers on a daily work rate. These rates vary depending on the location, the type of rig and the market conditions. There are plenty of research firms that publish this information. Higher dayrates are great for drilling companies, but for refiners and distribution companies this means lower margins unless energy prices are rising at the same rate.

Meterage: Another type of contract that differs from dayrates is one based on how deep the rig drills. These are called meterage, or footage, contracts. These are less desirable because the depth of the oil deposits are unpredictable; it's really a gamble on the driller's part.

Petroleum Business Economics

Many analysts look at upstream expenditures from previous quarters to estimate future industry trends. For example, a decline in upstream expenditures usually trickles down to other areas such as transportation and marketing.

Analysts and investors often disagree on specific investment decisions, but one thing that they do agree on is their approach to analyzing energy companies. A top down investment approach is almost always the best strategy. We will go through the top down steps below.

The oil industry is easily influenced by economic and political conditions. If a country is in a recession, fewer products are being manufactured, not as many people drive to work, take vacations, etc. All of these variables factor into less energy use. The best time to invest in an oil company is when the economy is firing on all cylinders and oil companies are making so much money that using excessive amounts of energy themselves has little effect on their bottom line.

Some analysts believe that rather than analyzing energy companies, you should just predict the trend in energy prices. While more analysis is needed for a prudent investment than simply looking at price trends in oil, it's true that there is a strong correlation between the performance of energy companies and the commodity price for energy.

Supply and Demand, Rig Utilization Rates and Contracts

Oil and gas prices fluctuate on a minute by minute basis, taking a look at the historical price range is the first place you should look. Many factors determine the price of oil, but it really all comes down to supply and demand. Demand typically does not fluctuate too much (except in the case of recession), but supply shocks can occur for a number of reasons. When OPEC meets to determine oil supply for the coming months, the price of oil can fluctuate wildly. Day-to-day fluctuations should not influence your investment decision in a particular energy company, but long-term trends should be followed more closely. You can find the latest energy supply/demand statistics at the Energy Information Administration.

Another factor that determines supply is the rig utilization rates; its close relationship to oil prices is not a coincidence. Higher utilization rates mean more revenue and profits. For drilling companies, it is important to take a close look at the company's rig fleet, because older rigs lack the ability to drill in remote locations or to bore deep holes. Some other factors to consider are the depth of water that the offshore rigs can drill in, hole depth and horsepower. Higher quality rigs will have higher utilization rates, especially during weak periods. This will lead to higher revenue growth. Sometimes this is a double-edged sword; while higher utilization is better, a company that is at its capacity will have difficulty increasing revenues further.

The contracts through which an oil services company is paid also play a large role in supply. Pay close attention to the dayrates, as falling dayrates can dramatically decrease revenues. The opposite is true should dayrates rise. This is because many of the drillers' costs are fixed.

After these wide scale factors have been considered, it's time to get down to the nitty gritty - the financials. And when it comes to the financials, the same old rules apply to oil services companies. Ideally, revenues and profits will be growing consistently, just as they do in any quality company. It's worth digging deeper to see if there are any one-time events that have dramatically increased revenues. Also, the P/E ratio and PEG ratios should be comparable to others within the industry.

Porter's 5 Forces Analysis

  1. Threat of New Entrants. There are thousands of oil and oil services companies throughout the world, but the barriers to enter this industry are enough to scare away all but the serious companies. Barriers can vary depending on the area of the market in which the company is situated. For example, some types of pumping trucks needed at well sites cost more than $1 million each. Other areas of the oil business require highly specialized workers to operate the equipment and to make key drilling decisions. Companies in industries such as these have higher barriers to entry than ones that are simply offering drilling services or support services. Having ample cash is another barrier - a company had better have deep pockets to take on the existing oil companies. [Source: Investopedia, The Industry Handbook: The Oil Services Industry]

  2. Power of Suppliers. While there are plenty of oil companies in the world, much of the oil and gas business is dominated by a small handful of powerful companies. The large amounts of capital investment tend to weed out a lot of the suppliers of rigs, pipeline, refining, etc. There isn't a lot of cut-throat competition between them, but they do have significant power over smaller drilling and support companies.

  3. Power of Buyers. The balance of power is shifting toward buyers. Oil is a commodity and one company's oil or oil drilling services are not that much different from another's. This leads buyers to seek lower prices and better contract terms.

  4. Availability of Substitutes. Substitutes for the oil industry in general include alternative fuels such as coal, gas, solar power, wind power, hydroelectricity and even nuclear energy. Remember, oil is used for more than just running our vehicles, it is also used in plastics and other materials. When analyzing an energy company it is extremely important to take a close look at the specific area in which the company is operating. Also, companies offering more obscure or specialized services such as seismic drilling or directional drilling tools are much more likely to withstand the threat of substitutes.

  5. Competitive Rivalry. Slow industry growth rates and high exit barriers are a particularly troublesome situation facing some firms. Until quite recently, oil refineries were a particularly good example. For a period of almost 20 years, no new refineries were built in the U.S. Refinery capacity exceeded the product demands as a result of conservation efforts following the oil shocks of the 1970s. At the same time, exit barriers in the refinery business are quite high. Besides the scrap value of the equipment, a refinery that does not operate has no value-adding capability. Almost every refinery can do one thing - produce the refined products they have been designed for.

Petroleum Producers

About 86 percent of the world’s produced by state-owned oil companies not big oil companies like Exxon Mobile, Shell or Chevron.

Thirty-eight countries in the world have reserves of more than 1 billion barrels. Sixteen have more than 10 billion barrels. Only three have ore than 100 billion barrels: Saudi Arabia, Iran and Iran. Kuwait and the United Arab Emirates have 99 billion and 98 billion respectively.

Two thirds of the world’s supply of oil is in five Persian Gulf countries: Saudi Arabia, Iraq, Iran, Kuwait and the United Arab Emirates. Saudi Arabia alone supplies about 40 percent of the world’s oil. OPEC supplies about 40 percent of the world’s oil (2006). Supplies in the United States and the North Sea are in decline.

Top World Oil Net Exporters (2006, million barrels per day): 1) Saudi Arabia 8.65; 2) Russia 6.57 ; 3) Norway, 2.54; 4) Iran, 2.52; 5) United Arab Emirates, 2.52; 6) Venezuela, 2.20; 7) Kuwait, 2.15; 8) Nigeria, 2.15; 9) Algeria, 1.85; 10) Mexico, 1.68; 11) Libya, 1.52; 12) Iraq, 1.43. [Source: Energy Information Administration]

The world's largest producers of oil and natural gas in 1995 (millions of barrels a day): 1) Saudi Arabia (8.8); 2) the U.S. (8.6); 3) former Soviet Union (7.1); 4) Iran (3.7); 5) China (3.0); 6) Mexico (3.0); 7) Norway (2.9); 8) Britain (2.8); 9) Venezuela (2.8); 10) Canada (2.4); 11) UAE (2.4).

The world's largest exporters of oil and natural gas in 1995 (millions of barrels a day): 1) Saudi Arabia (7.7); 2) Norway (2.7); 3) former Soviet Union (2.6); 4) Iran (2.5); 5) Venezuela (2.4); 6) UAE (2.0); 7) Kuwait (1.9); 8) Nigeria (1.8); 9) Libya (1.2); 10) Mexico (1.2).

Top 10 petroleum producers (billions of tons per years): 1) former USSR (584); 2) USA (417); 3) Saudi Arabia (327); 4) Iran (155); 5) Mexico (145); 6) China (139); 7) Venezuela (119); 8) Iraq (98); 9) Canada (93); 10) UK (91).

Top 10 petroleum consumers (billions of tons per years): 1) USA (778); 2) former USSR (402); 3) Japan (245); 4) Germany (126): 5) Italy (92); 6) France (88); 7) UK (82); 8) Canada (74); 9) Mexico (73); 10) Brazil (57).

Many exporting oil countries are using revenues from the sale of oil at home to buy stakes in refining and marketing companies outside their borders.

Petroleum Companies

Large oil companies tend to make their money upstream: the profits in finding and producing oil can be enormous. Refining and fuel production on the other hand have small profit margins, and great potential for loss. It is surprising that the oil companies haven’t just dumped the refining sector especially when making cut backs compromises safety and put lives at risk. Some companies are holding on to their most sophisticated operations and trying to sell the rest.

Traditionally, their profit margins have been around 7 percent, compared to 15 percent in the computer software business, known for its high profit margins. Oil company profits are linked very closely to oil prices. When oil prices are high are the oil companies rake it in. When oil prices skyrocketed in the mid and late 2000s the major oil companies made large profits but the output actually declines

The oil companies are arguably the best at find new deposits and developing them efficiently — that is how they grew to be giants after all. They have developed advanced exploration technologies and can put together the financing to develop new fields. With the decline of their influence, exploration and production increases need to keep up with demand have slowed. The oil companies are suffering as the deposits they manage begun to decline they are no finding new deposits to take their place.

In recent years Asian companies have built huge new refineries with plans to cash in on local demand and generate foreign exports.

Large Petroleum Companies

The five largest oil companies are Exxon-Mobile, Royal Dutch Shell, BP, Chevron-Texaco and ConocoPhillips.

In the July 2009 Fortune 500 list of the world’s top companies oil companies took seven of the top 10 spots with Shell in first (revenues of $458 billion), Exxon Mobile in second (revenues of $442.8 billion), BP in forth (revenues of $367 billion), Chevron in fifth (revenues of $263 billion), Total in sixth (revenues of $234.6 billion), ConocoPhilips (revenues of $230.7 billion) in seventh, and Sinopec (revenues of $207.8 billion) in ninth.

Exxon-Mobile is the largest publically-traded oil company, with revenues of $390 billion and profits of $40.6 billion in fiscal 2006-2007. Royal Dutch Shell has revenues of $355.8 billion in fiscal 2006-2007).

Problems for Petroleum Companies

One the eyas the company have lost their influences and their ability to affect supplies. The oil companies are often flush with cash for high oil prices and want to expand and invest in new projects but find they are shut out by the controlling state companies.

In the 1970s the world top Western oil companies controlled well over half of the world’s production. Now they produce just 13 percent. Increasing the national oil companies are trying to shut them out. Even when they have a long tern contact, the national companies are trying to renegotiated the contracts to get a larger share of the profits. The oil companies have also not stepped up to the plate through the 199-s and early 2000s, they spent a good portion of their profits on share buyback, which essentially is means of propping up their stock. And less on exploration.

Producing countries are beginning to call the shots not the oil companies. Oil consultant John Hall told the New York Times, “When oil was $20 a barrel most producers wanted all the outside help they could get. When it’s $60, outsiders are told to go. Not many people are expecting a significant price decline, so life for the majors will get much more difficult from here.”

Refineries are being squeezed by high oil prices and shrinking demand for oil products. In many cases they are responsible for some of the biggest losses suffered by oil companies. Some of the biggest loses have been recorded by companies in Europe, where there are too many refineries and many are inefficient, with some equipped to process expensive light North Sea crude not cheaper crudes from Russia and the Middle East with higher sulfur content. In 2010, the margin for cracking crude oil into gasoline was around $2 a barrel, down from $5 to $7 a barrel a year before.

State-Run Petroleum Companies

National companies like Saudi Aramaco, Russia’s Lukoil and Gazprom, Iran’s national oil company, China’s CNOOC, have become larger and more powerful than the oil giants. See China.

About 86 percent of the world’s proven reserves are controlled by governments. There about 60 national oil companies. About half of them have investment from outside their borders. Those that allow international oil companies in often strictly limit their access.

In some cases the oil companies are welcomed by the state-owned energy firms when oil prices are low and are then kicked out when prices are high. High oil prices give the governments leverage over the oil companies. Low oil prices give the oil companies leverage over the governments, who need investments by the companies to develop their fields and look for new fields.

Governments operate according to a different set of rules than oil companies. They don’t have to respond to shareholder demands for profits and are willing to accept lower returns. But as a rule they are less efficient and do not extract as much oil as the large oil companies.

Control by the ste-owned companies has led to a lack of competition and lack of a drive to find new oil sources, Commenting on supply shortages and high oil prices in 2008, Arjun Murti of Goldman Sachs told the New York Times, “There is still a lot of oil to develop out there, which we don’t call this geological peak oil, especially in places like Venezuela, Russia, Iran and Iraq. What we have now is geopolitical peak oil.”

Petroleum Supplies and Consumption

There is about 1.1 trillion barrels of proven reserves Countries with largest reserves (2007, billions of barrels): 1) Saudi Arabia (262.3); 2) Canada (179.2 including 174.1 billion barrels of oil sands); 3) Iran (136.3); 4) Iraq (115); 5) Kuwait (101.5); 6) United Arab Emirates (97.8); 7) Venezuela (79.7); 8) Russia (60); 9) Libya (41.5); 10) Nigeria (36.2). A number of countries, particularly in the Middle East, overstate their reserves. [Source: U.S. Energy Information Service]

Proven reserves by region (billion of barrels in 2007): 1) Middle East (742.7); 2) Europe and Russia (144); 3) Africa ( 117.2); 4) Latin American (103.5); 5) North America (56.9); 6) Asia Pacific (40.5). [Source: BP]

World oil consumption was about 81.1 million barrels a day in 2004, compared with 60 million in 1980. Consumption rates are expected to increase as large countries like China, India and Brazil get richer and more people get cars. This will more than offset of people in Western countries trying to conserve energy. Consumption is expected to grow to 122 million barrels a day unless some radical changes are made.

Oil resources are finite but no one knows how much oil is still out there and the estimates vary greatly. There is a lot of talk about the oil supply “peaking” — reaching the upper limit of its supply and then diminishing from that point on. No one is sure when this will happen. Some say in five years. Some say in 30 years. The United States production peaked in 1970 and has been in slow decline ever since.

The pessimistic view presented by the Colorado School of Mines, based on the so-called Hubbert Curve, predicts that oil production will peak at around 83 million a day around 2007 to 2010 and then decline quickly to 35 million barrels day. Others estimate the peak with be reached in 2016 or 2030. The optimistic view of 2040 by the U.S. Geological Survey is based on estimates that 20 percent of the world oil has been produced and used to date, 32 percent remains in reserves, 23 percent is likely to be added from existing reserves and 24 percent has yet to be discovered but believed to exist

Consumption increased by 1.1 percent annually between 1998 and 2002, raising daily consumption by 4.2 million barrels, but between 2003 and 2007 it rise 2.1 percent annually, boosting consumption by 8.2 million barrels a day. The rise was attributed mostly to relatively low oil prices and laid the ground work for the oil shock in 2008, when prices reached $145 a barrel, as low prices also created a lack of incentives for new oil exploration and refineries, creating supply shortages.

Global demand for petroleum was 84.5 million barrels a day in 2006. The figure is expected to rise to 99 million barrels a day in 2015 and 116 million barrels a day in 2030.

Image Sources:

Text Sources: World Almanac, United States Geological Survey (USGS) Minerals Resources Program, Investopedia Industry Handbooks, U.S. Energy Information Administration, Department of Energy and National Geographic articles. Also the New York Times, Washington Post, Los Angeles Times, Smithsonian magazine, Natural History magazine, Discover magazine, Times of London, The New Yorker, Time, Newsweek, Reuters, AP, AFP, Lonely Planet Guides, Compton’s Encyclopedia and various books and other publications.

Last updated March 2011

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