How oil and gas works: from the well to the fuel pump
The three parts of the industry, who buys what, how each part makes money, and the numbers the industry watches.
Industry brief, with a one-minute summary: Oil and gasKey takeaways
- Oil and gas has three parts. Upstream finds and produces crude oil and natural gas.
- Crude oil is a commodity: one barrel of a given quality is much like another, and the price is set on world markets (benchmarks such as Brent and WTI).
- Production: barrels (or boe) produced per day.
- Proved reserves: oil and gas that can very likely be produced at today's prices and technology.
- Lifting cost: the running cost to bring one barrel to the surface, in USD per barrel.
Key idea
Oil and gas has three parts. Upstream finds and produces crude oil and natural gas. Midstream moves and stores it. Downstream turns it into fuels and chemicals and sells them. Each part makes money in a different way, so the first question in any oil and gas case is: which part are we in?
Crude oil is the liquid that comes out of the ground. It is measured in barrels. One barrel is 159 litres. Production is quoted in barrels per day. Natural gas is measured in cubic metres, cubic feet, or in energy units such as MMBtu (one million British thermal units). To add oil and gas together, companies use barrels of oil equivalent (boe): the amount of gas that holds the same energy as one barrel of oil.
Crude oil on its own is almost useless. A refinery heats it and splits it into products: gasoline (called petrol in many countries), diesel, jet fuel, liquefied petroleum gas (LPG, used for cooking in India and Africa), naphtha (a raw material for chemicals), fuel oil for ships, and bitumen for roads. Customers are drivers, airlines, shipping lines, truck fleets, power plants, factories and chemical plants. Gas goes by pipeline to power plants, factories and homes, or it is cooled into liquefied natural gas (LNG) and shipped to buyers in Japan, Korea, China, India and Europe.
- Oil and gas value chain
- Upstream (exploration and production)Find, drill, produce
- Exploration: seismic surveys and exploration wells
- Development: drill production wells, build platforms and plants
- Production: run wells, process oil and gas at the field
- Midstream (transport and storage)Move and store
- Pipelines for crude oil, products and gas
- Tankers and storage terminals
- LNG: liquefaction plant, LNG ships, regasification terminal
- Downstream (refining and marketing)Convert and sell
- Refining crude into fuels
- Petrochemicals (see the Chemicals module)
- Wholesale, retail stations, aviation and marine fuel sales
Read it left to right: each step adds cost and, if run well, value. For general ideas on value chains, unit economics and supply chains, see the module "How industries work: the toolkit".
| Part | How it makes money | Biggest costs | What decides profit |
|---|---|---|---|
| Upstream | Sells crude oil and gas at market prices | Drilling and facilities (capex), running costs, royalties and taxes | The oil and gas price, and cost per barrel |
| Midstream | Charges a fee (tariff) per barrel or per unit of gas moved or stored | Building the pipeline or terminal, then fairly low running costs | Volume through the asset and length of contracts |
| Refining | Sells products for more than the crude costs (the refining margin) | Crude oil (by far the biggest), energy, staff, maintenance | Product prices minus crude price, and how full the refinery runs |
| Marketing and retail | Earns a margin per litre sold plus shop and service income | Stations, staff, delivery trucks | Volume per station and non-fuel sales |
So-what
Upstream profit swings with the oil price. Midstream profit is steadier because it is fee based. Refining profit depends on the gap between prices, not on the price level.
Three kinds of companies own most of this chain. National oil companies (NOCs) are owned fully or mostly by a government, for example Saudi Aramco, ADNOC in the UAE, and Petrobras in Brazil (partly listed). International oil companies (IOCs) are large listed companies that work in many countries, for example ExxonMobil, Shell, TotalEnergies, BP and Chevron. Independents are smaller companies, often focused on one part of the chain or one region. Many large companies are integrated: they own upstream, refining and retail together. This is vertical integration, and it smooths profit because a low crude price hurts upstream but helps refining.
In most countries the oil underground belongs to the state. Companies get the right to produce it through a contract. Under a concession, the company owns the oil it produces and pays royalties (a share of revenue) and taxes. Under a production sharing contract (PSC), the company first recovers its costs from the oil and then splits the remaining "profit oil" with the government. Under a service contract, the company is paid a fee and never owns the oil. Everything the government collects is called the government take. In a case, always ask which contract applies, because it changes how much of each dollar the company keeps.
Key metrics, in plain words
- Production: barrels (or boe) produced per day.
- Proved reserves: oil and gas that can very likely be produced at today's prices and technology. Reserve life = reserves divided by yearly production, in years.
- Lifting cost: the running cost to bring one barrel to the surface, in USD per barrel. It leaves out the cost of building the field.
- Finding and development cost: the capital spent to find and develop one barrel of new reserves.
- Breakeven oil price: the oil price at which a project or company makes zero profit (or zero cash). Always say which costs are included.
- Decline rate: how fast output from existing wells falls each year if nothing new is drilled.
- Refinery utilization: crude processed divided by capacity, in percent.
- Refining margin (or crack spread): the value of products made from one barrel minus the cost of that barrel.
- Netback: the price received minus transport, royalties and running costs, per barrel. It shows what a barrel really earns.
Crude oil is a commodity: one barrel of a given quality is much like another, and the price is set on world markets (benchmarks such as Brent and WTI). A single company cannot choose its price. So when an upstream company's profit falls, check the oil price first. Only then look at volume and cost per barrel, which the company does control.
A producer in West Africa has proved reserves of 2,000 million barrels and produces 250,000 barrels per day. What is its reserve life in years? Round to two decimals.
An oil pipeline company earns a fee per barrel moved. Oil prices fall by a third. What happens to its profit first?
Sources for this lesson (2)
- Recognized public explanations of case-interview concepts and frameworks
- US Energy Information Administration, Short-Term Energy Outlook
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