Beginner’s Guide to Upstream Crude Oil Fundamentals

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Moving goods to market requires fuel. Fuel, in its various forms, is just one of many refined products that come from a barrel of crude oil. To fully understand how fuel prices move and influence your transportation budget, it’s important to understand the full energy market supply chain.

 

Upstream market fundamentals refer to the entire process leading up to the production of crude oil and natural gas. The phases included in upstream crude oil economics processes include:

  • Drilling Rights

  • Resource Exploration

  • Physical Extraction and Drilling

  • Refining End-Use Products

At each phase regulations, technology, and the global economy affect the entire value chain associated with fuel.

1. OBTAINING THE RIGHTS TO DRILL

Before any extraction can take place, oil companies first need to obtain rights to the land they want to drill. These lands are primarily owned by Federal governments. There are two ways to secure these rights:

  • Mineral Leasing: typically, a cost per acre agreement with fixed royalties where an oil company is granted permission to use land that is still wholly owned and financially liable to the owner (or government).
  • Production Sharing Agreement (PSA): place all financial risk associated with oil extraction on the driller, insulating the affiliated government. This type of agreement is often used in under-developed nations that lack the technology and infrastructure needed to facilitate similar industrial operations.

A mineral lease is ultimately the first step for an oil producer to determine the financial structure of their upcoming operations – after which a PSA may or may not be adopted. Because the mineral owner has essentially nothing to lose and everything to gain financially, the PSA method is highly attractive.

2. Resource EXPLORATION

Not all land is created equal in the crude oil industry and finding parcels of land that are viable can be a challenge. Estimated Ultimately Recoverable Resources (EUR) is a metric used by oil producers to measure the economic feasibility of a potential drill site. EUR predicts the total amount of natural gas and oil that will ever be recovered, produced, and therefore consumed further down the oil supply chain. EURs break down into multiple categories, including:

  • Proven Reserves: strong potential for earnings potential
  • Probable Reserves: greater than 50 percent chance for earnings potential
  • Possible Reserves: less than 50 percent chance for earnings potential
  • Undiscoverable: “yet to find”

Within each category of EUR, oil companies calculate a recovery factor. This determines the ratio of recoverable oil or natural gas relative to the estimated reserves in each region. Increasing the recovery factor is the primary objective for oil drillers, though this changes with time based on operating history, technological advancements, and overall drilling economics.

When discussing the “yet to find” reserves, oil companies, and petroleum engineers estimate the cost of developing a discovery operation and predicting how long it would take to drain a well of all its oil and natural gas resources. Like conventional business fundamentals, the substantial capital expenditure necessary to accelerate such operations is offset by the profits achieved from oil or natural gas sales. With this in mind, it is important to note that oil companies are not trying to get the last barrel of oil or natural gas out of the ground, but rather aiming to extract the last profitable barrel.

After targeting a potential well, drillers establish a discovery well to reach the heart of the oil-rich deposits where seven additional layers of protective sealant are applied to create a barrier to prevent oil-rich material from penetrating the water table. If successful, oil producers establish additional wells to discover the boundaries of the oil formation, with cost efficiency being of key importance throughout the driller operation.

3. Physical Extraction and Drilling

In the source rock deep beneath the earth’s surface, pores are located between grains of sand and the source rock. These pores contain the oil and natural gas molecules targeted by drillers. Once drilled, the permeability of the material allows the lighter, less dense natural gas and oil molecules to escape upward. If nothing blocks the molecules from ascending, they will eventually reach Earth’s surface.

Simply put, drilling to access this rock can occur vertically or horizontally. Today, horizontal drilling predominates the crude oil landscape, because it allows a single oil rig to access a wider range of crude oil with limited surface area accessibility. The deeper a well is drilled, the more the Earth’s core temperature increases. This ultimately liquefies the hydrocarbon molecules that then escape out of the rock which converts into refinable crude oil.

Shale, located above the natural gas and oil layer, has low permeability making it difficult to break through. This means drillers are unable to access all the oil within a given deposit. Thanks to technology advancements, extracting oil from shale material has become exponentially more efficient in recent years. By leveraging a process commonly known as fracking, drillers inject high-pressure liquids into oil/gas-rich material to increase permeability within the shale for oil companies to maximize drilling yield. The chart above illustrates the disposition of US crude production since 2012, highlighting the emergence of shale output in recent years.

4. Refining End-Use products

After the crude oil is extracted, it is transported to refineries to be turned into a host of refined products. This process varies based on several key factors—and in the end, creates a portfolio of products we use every day.

 

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