In this video, I describe some of the fundamentals of the oil and gas industry, including production and financing.
First off, I want to note that what I’m talking about is crude oil and natural gas. Both are naturally occurring minerals distributed around the world. The specific geology of a region determines how easy it is to extract oil or gas from the ground.
Next, I want to clarify what we mean by oil (or gas) reserves. This is the estimated amount of oil (or gas) a country has remaining underground. Proven reserves are estimates believed to be 90% accurate. Reserves (or capacity) are different from actual production, which is the amount of oil pumped out of the ground on a given day.
When we talk about oil production, we describe it as a stream. Upstream activities involve finding the oil and gas and pumping it out of the ground. These activities are the riskiest (in terms of economic risk) and most expensive, particularly since current extraction tends to use specialized technology to extract more difficult-to-reach pockets of oil and gas.
Midstream activities involve moving crude oil and liquified natural gas (LNG) to production facilities and markets. Pipelines are the most common way to do this, but ground and sea routes remain important as well.
Finally, downstream activities involve actually processing oil and gas, refining crude oil into gasoline and other useable products (like plastics).
Today, a lot of attention is given to so-called unconventional techniques for the extraction of oil and gas. Conventional extraction involves sinking a well vertically into a relatively contained pocket of oil or gas (as pictured on the right in the graphic). Unconventional extraction involves horizontal drilling into a narrow band of oil or gas (called shale oil). When oil companies pump water into that band of gas to break up its structure and make more available to pump out, that is called hydraulic fracturing or fracking. Unconventional production has opened up new oil and gas resources for exploitation (particularly in North America), but is more expensive and technology-dependent than conventional drilling.
To shift to the economics of the oil industry, I want to highlight four different aspects of industry finances: ownership, investment, profits, and field services.
Ownership is straightforward, except to note that the rights to extract oil and gas (mineral rights) are a specific form of property right (distinct from land ownership in many countries). Around the world, many countries reserve mineral rights for the state, making National Oil Companies (or NOCs) an important state-owned asset. As noted earlier, oil and gas exploration and extraction are by far the costliest activities, and attracting investment is essential. Most international oil companies are Integrated Oil Companies. This means they are vertically integrated – they handle upstream, midstream, and downstream activities. Investment agreements between NOCs and IOCs take a wide variety of forms, and you should evaluate the joint ventures or Production Sharing Agreements (PSAs) they come to based on the ownership rights granted to each partner as well as their profit-sharing arrangements.
Because despite the financial risk, the oil and gas industries are of course extremely lucrative. The current best practice is for countries to establish Natural Resource Funds (sometimes called Sovereign Wealth Funds) to invest the proceeds of profits from national oil and gas companies. This is considered best practice because it can enhance the transparency of national accounts in this area, letting outside observers know exactly where the money is going. Countries adopt different strategies for their natural resource funds and have varying degrees of success. Norway primarily invests its money, using a small amount each year to offset its national budget. Azerbaijan uses its fund for national development projects, including pipelines and railways. Venezuela’s fund was meant to protect its budget from oil price volatility by rolling excess profits from the good years into the lean years, but ended up being raided by the Chavez administration.
As you can see, global oil prices have been increasingly volatile in recent years. This particular graph is for West Texas Intermediate (WTI) prices, but they track with global prices. There were big drops in oil prices during the 2008 global financial crisis and the 2020 drop was a combination of reduced demand during the pandemic and a particularly ill-timed price war between Saudi Arabia and Russia. The 2014 decline was due to increased production – the U.S. dramatically increased its production at this time, finally reaching self-sufficiency, while Saudi Arabia kept its production levels high. This is generally perceived as a strategic move to decrease prices, reducing oil revenues to Iran in particular as part of the pressure campaign to have Iran negotiate a nuclear deal.
The last thing I wanted to note is a more technical issue that comes up in the context of Eurasia. When we think of the oil and gas industry we tend to think of the IOCs (like Exxon-Mobil, BP, and Royal Dutch Shell). But field services companies are also important players in the game. When countries shun broader investment deals with international corporations, they may still work with services companies like Baker-Hughes and Halliburton to provide the technology and expertise for advanced extraction.