Oil and gas can be an industry full of mystery. Here, we will demystify how it works, starting from its smallest business unit: an oilfield.
The oil and gas industry has the air of secrecy and darkness around. The geopolitical tension and wars, the side-eye from environmental groups, and the downfall of Enron doesn’t help the reputation either.
Not to mention that to work in one, especially in the upstream sector, it seems like you need to be a part of an exclusive club.
The industry hires special types of engineers – petroleum engineers – alongside with special type of scientist – petroleum geoscientists. This is because finding the oil and getting it out of the ground requires specialized knowledge about rocks, organic chemistry, fluid dynamics, drilling, flow control, and many more.
Therefore, I’d like to put out this basic introduction to the production economics. I intentionally write using plain English (as usual) to make this seemingly complex subject (it is) more bearable.
To begin deciphering how we make money in this industry, let’s start with the basic business unit: a field.
Despite the appalling complexity, at the end of the day, it’s a business. And just like any other business since the dawn of time, the industry thrives on one thing: profit.
In its essence, profit is a technical term describes the amount of money you have left after subtracting all the revenue from the business with the cost of running it.
Profit = Revenue – Cost
To understand how to run a producing oilfield, we need to understand how these two items on the balance sheet – revenue and cost – come from.
Revenue – how do you make money?
Like any business, we make money by selling a product or service at a price. The revenue we make therefore is the volume of sales of such product/service times the price they are sold at.
In an oilfield, the product is oil, gas, or both. The sales volume is the production rate, measured by barrels of oil equivalent (BOE)/day. The price, however, is commoditized. This is one of the fundamental aspects that restrict the revenue – especially when we talk about oil.
Oil, more specifically crude oil, is a commodity – tradedas raw materials with set prices.
While there are differences in types of crude oil such as WTI and Brent, you cannot really differentiate the crude oil you produce from an oilfield as “the best WTI” or labels like that, then charges a premium to the buyer. You need to sell according to the benchmark price.
When the oil price as a whole goes down, you also need to sell at that price. Same goes when the oil price goes up. What determines the price is predominantly the basics of supply vs demand.
Since we cannot control the price of oil, the only way we can increase revenue in the short-term is by increasing the volume you pump out to sell. This sounds straightforward and directly translates to increasing production rate.
Obviously, when oil price is 40 USD/barrel, increasing production from 1,000 barrels/day to 2,000 barrels/day will give you an extra 40K USD revenue per day. You can either increase the rate of production of existing wells or add more wells. Of course, the latter will incur additional cost, which we will talk about in the cost section.
The other way to increase revenue is by reducing whatever it is that makes your wells cannot produce at their optimum capacity. So, not necessarily cranking up the rate of production per se. But also, reducing what we usually call “downtime”, which is the period during which a well stops producing.
Sometimes downtime is necessary – regular maintenance, for instance. Often, downtime is unplanned.
The pump (i.e. “artificial lift”) breaks. Wax deposit clogs the tubing. Your well suddenly produces sands.
When these things happen, well production has to be halted, and operation engineers need to fix the problem. Consequently, your revenue for the day – even for the month – will be less than what you should get if these things didn’t occur.
So what did we learn? To increase revenue, we need to maximize our production rate and/or minimize well’s downtime.
But you cannot produce too much, either
However, we cannot just crank up the meter and let oil flows at the maximum rate, every day. While it might be good for short-term revenue gains, it surely is bad for the long-term health of the business.
And running an oilfield is a long-term business for sure. An oilfield typically lasts 40 years or more. In fact, companies decide to fully develop an oilfield when the forecasted profit gain for the whole life of the field exceeds all the cost incurred before, during and after the development. So, you cannot screw this up.
The problem with cranking up production rate carelessly is the drop in reservoir pressure and excessive water production.
When you pump the oil too fast, you risk accelerating water production in the well you’re cranking up and in the surrounding wells, too. You also risk of depleting the reservoir sooner than it should. Your short-term revenue might increase, yes, but in the long-term, you get less than what you could out of the reservoir had you produce responsibly.
Totally a bad idea.
The concept of optimum production rate (not too low and not too high – just right), is especially true for unconventional assets.
During fracking, we pump sand-sized particles (i.e. proppant) into the newly formed fractures in order to hold them open. If you suck the oil too fast, you risk plucking those little fake sand particles out – effectively closing your fractures and significantly lower the net amount of oil you can get over the life of well.
This is the fundamental driver behind maximizing reservoir recovery. It is a strategy to delay gratification by keeping the production rate to a number that still maintains a good balance with reservoir pressure or integrity. The strategy ensures that you can extract the fullest extent of the oil and gas available throughout the life of the field. Potentially, prolong the field life itself.
Speaking of delayed gratification, while we have talked about how we don’t really have the control of the price, we can totally decrease and delay the production pace or oilfield development to wait for or exploit high price period. Of course, as long as they can handle the fairly constant operating cost and can explain to the investors on the intentionally poor performance.
This is exactly what OPEC was doing in 2016 when they order their members to cut back production, in order to stabilize the plummeting oil price.
Cost – how do you become profitable?
Cost is what makes or breaks the oilfield.
There is only so much oil you can produce out of the ground. As the field becomes older, you produce less oil, while the operation becomes more complex. Like running a factory, operating as efficiently and effectively as possible is a priority in running an oilfield. That means lowering the production cost as much as possible without compromising safety or quality.
We call the cost of running an oilfield the Lease Operating Expense (LOE)*. It comprises of labor cost, equipment cost, land ownership fees, power, and material expenses. Basically the money you need to operate the lease. A field will break even if the LOE is equal with the revenue.
However, the direct operating cost is not the only thing that eats up your revenue and lowers your profit.
Tax, for instance, cuts a portion of the revenue, raising the price it takes to make the field break-even. And there are a lot of taxes going on. Property taxes, severance taxes, and ad valorem taxes. Delloitte finds that there are at least 6 kinds of taxes that oil and gas companies operating in the United States need to be aware of.
Working interest and royalties to investors or governments cut the pie even smaller. The amount of net interest depends on the profit-sharing agreement between investors and/or governments.
And then we have another inevitable component that will also affect your overall profitability: the DD&A. It stands for depreciation, depletion, and amortization. These are not directly production cost, but still, need to get into the grand total of the production cost: the lifting cost.
And when we talk beyond production but the overall profitability of the asset since its inception, finding cost then comes into the equation.
Finding cost, often also called pre-production cost, is the amount of money that we spend to find and lock down the oil.
The cost components include buying the acreage, doing some exploration activities, and developing the area into a fully operational field. The cost can also include buying existing reserves if we are buying from another company.
Now, you can see how oil and gas is a costly business. Therefore, the next topic becomes very important…
There are many aspects that we cannot control – oil price swings, for instance. What we can control, though, will be the dealbreaker of whether or not we can make money.
The cost of the technical program during production, for instance, is not cheap. There are around 40 technical activities necessary to make sure your oilfield runs well – from preparing the wells, getting the oil and gas out, to improving the well and field performance.
Therefore, the term lower price/BOE is all the rage right now. Even more so, when the prices take a dip during the recent 2014-2017 “dark years”. And how do we do that?
Efficiency is one thing. Theoretically, if we can do the same amount of work with fewer resources, then the cost goes down. This is the underlying premise of the surge of digital innovations in the oilfields. Now that digital technologies like the Internet of Things and edge analytics are more affordable, we can use some of them do more with less.
However, the digital innovations are not to replace workers. But rather, make them be more productive and valuable. Instead of doing repetitive tasks with little value, they can tackle more complex problems and make more important decisions.
The other thing is to come up with new techniques. Might be a risky move, but also brings great benefits if it works out. A company in the Netherlands, for instance, offers a service to monitor pipelines from space. And now the industry is toying with the idea to use blockchain technology to decipher the complexity of hydrocarbon accounting.
Running an oilfield is like living your life. Over time, your understanding of the field improves and you get better managing it. Along the way, the unexpected also happens. The best thing you can do is to take calculated risks. Not being too shy to move the needle, but not being stupid by ruining your reservoir recovery or putting safety at risk, either.
Hopefully, this article can give you an idea of running an oilfield business. Again, I simplify a lot of things intentionally, to demystify the whole premise of being a mysterious industry. Feel free to comment below if you’d like to dive down in more details on a certain aspect or ask a question.
Also, for further reading, I really recommend this book from PennWell. While the book doesn’t exactly use plain English, they can explain how oil and gas industry works in a way that is easy to follow for non-economist. The price tag is not cheap either. However, if your career tends to intersect with the oil and gas industry, the book will be a lifetime investment.
*Source: Inkpen, A., Moffett, M. H. 2011. The Global Oil and Gas Industry Management, Strategy, and Finance.