"Formula for success: Rise Early, Work Hard, Strike Oil."
Understanding the Oil and Natural Gas Industry
The oil and natural gas business is a vast and complicated sector for investors. A general understanding of the oil and natural gas sector can help an investor in determining where to invest. A good place to start is to understand how this sector makes its money.
The oil and gas industry is normally divided into three sectors and most oil and gas companies fall into one these three sectors: upstream, midstream and downstream. There is also a fourth category of oil and gas companies referred to as integrated oil companies and these are usually large multinational companies that operate in all three sectors simultaneously. Examples of large integrated multinationals include BP, Chevron, Murphy Oil, Royal Dutch Shell, Total and ExxonMobil.
The upstream sector is usually referred to as the exploration and production (E&P) sector. The upstream sector includes searching for potential underground and/or underwater oil and natural gas, drilling exploratory wells, and operating wells that recover oil and gas from known fields. The midstream sector involves the pipelines and storage facilities for the transportation, storage, and wholesale marketing of crude and refined petroleum products. Midstream oil and gas companies move product from production sites to refineries and deliver refined products to downstream distributors, customers and utilities. The downstream sector refers to the refining of crude oil and processing of natural gas as well as the marketing and distribution of products derived from oil and gas. The downstream sector includes such products as gasoline, kerosene, jet fuel, diesel oil, heating oil, lubricants, waxes, asphalt, natural and liquified gas, and various petrochemical products.
Hydrocarbons as the basis of the Oil and Gas Industry
Oil and gas is created naturally when organic material decays. It consists of the remains of plants and animals that are compressed over the millennium in sedimentary rock such as sandstone, limestone and shale. As layers of sediment were deposited on the ocean floor millions of years ago, decaying remains of plants and animals were integrated into the sediments. This organic material eventually transforms over time into oil and gas after being exposed for an extended period of time to the high temperatures and pressures inside the earth's crust.
Since water is denser than oil and gas, the hydrocarbons tend to migrate through the relatively porous sedimentary rock upward toward the earth's surface. When the hydrocarbons become trapped beneath relatively more solid rock, an oil and gas reservoir is created. To bring these hydrocarbons to the surface, a well is usually drilled through the cap rock and down into the oil and gas deposits. Once drilling reaches the oil and gas these hydrocarbons are pumped to the surface. When the drilling activity doesn't find commercially viable quantities of hydrocarbons, the well is referred to as a dry hole and it's plugged and abandoned until some time in the future when technologies can be developed that will allow the hole to become commercially viable.
Upstream Exploration and Production Companies
E&P 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. 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 is commonly denoted as "mbbl" and 1 million barrels is denoted as "mmbbl." Gas production is described in terms of standard cubic feet, which is a measure of gas quantity 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 1 trillion cubic feet is denoted as "Tcf."
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."
Since the discovery and acquisition of new oil and gas deposits are the primary source of future revenue, E&P companies spend a lot of time, money 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.
Yields for these companies are excellent and currently range from 8.32% for LGCY to 11.31% for QRE. Since current yield is calculated based on and ever changing daily price, it's prudent to use these numbers for comparison only and it would also be prudent to calculate yield over a number of different days.
During the last three years the dividends for these companies have been increasing at varying amounts annually for all six of these companies. Unfortunately none of these companies have a long record of increased dividends so comparisons are difficult. The three year dividend growth rate for BBEP is 15.32%, for LGCY it's 3.52%, for LINE it's 4.33%, and for VNR it's 4.32%. QRE has a two year dividend growth rate of 23.42% and MEMP has a one year dividend growth rate of 35.06%.