Crude oil 101

Breakeven price, lifting costs, API gravity...WTF?

In the 1970s, Venezuela was the largest importer of premium alcohol in the world. At the end of that decade, the Hunt brothers bought 100 million ounces of silver, equivalent to 25-30% of the world's silver stock at the time. What do these two facts have in common? Oil.

Orinoco oil deposits made Venezuela one of the wealthiest countries in the world, as measured by GDP per capita. Accordingly, oil is the source of the Hunt clan's wealth.

Steel, cement, ammonia, and plastic are the foundational elements of our material world. Oil is seemingly absent from the list, yet it is the prime OPEX commodity.

Oil has been known to man since antiquity, while its industrial properties were discovered 200 hundred years ago. The invention of oil as a transportation fuel radically changes the course of human civilization. Its discovery, alongside the introduction of metric standards, the telegraph, and Bessemer's steel furnaces, laid the foundations for global industrial civilization.

Today, it’s time for another Industry 101 article. I covered gold mining, shipping, and banking. The next is the oil industry.

Oil's history is extraordinary. Powerful businessmen and politicians have been heavily involved in oil for the last two hundred years. The Rothschilds, the Nobels, the Rockefellers, and the Hunts made a lot of money from oil. That being said, let’s hop on a historical trip.

History of oil in 598 words

Crude oil has been known since Babylon and Sumer when it was used as tar and waterproofing boats. In the middle of the 19th century, a Scottish gentleman named James Young established the first refinery to process crude oil. Initially, he produced light fuel for lamps and lubricating oils for machinery.

A few years later, the first oil wells and refineries on a larger scale also began to be established in the USA and Canada. In 1870, John Rockefeller Sr. founded the Standard Oil Company.

It marked the beginning of the Rockefeller empire and the crude oil extraction and refining industry. Standard Oil was the first fully integrated company, from exploration through refining to supply and marketing. Standard sets the framework for the industry, which is subsequently divided into downstream, midstream, and upstream.

After 1911, Standard Oil was restructured into 43 companies, including Chevron, Exxon, Conoco, Phillips, and Marathon Oil. They are among the current industry leaders. Many of the other companies, after a series of mergers and acquisitions, still exist.

In the meantime, the Nobels and the Rothschilds invested in Russian oil fields. Ludvig Nobel developed the concept of an oil-transporting ship. The first oil tanker, Zoroaster, was designed and built at the request of the Nobel Oil Company. Baku was the hot post for oil exploration and production in Russia.

Next came many discoveries worldwide—Venezuela, Iran, Iraq, and Indonesia. In 1933, Chevron and Texaco formed ARAMCO. The active development of the oil reserves began, and the Saudi kingdom became one of the largest oil producers in the following decades.

The discovery and development of the Gulf fields led to the consolidation of vast amounts of capital and power in a handful of companies called the Seven Sisters during this period. These are:

• Royal Dutch Shell

• Texaco

• Anglo Persian petrol company

• Gulf Oil

• Standard Oil California

• New Jersey's Standard Oil

• Standard Oil New York

They controlled over 50% of global oil production during their prime. The following chart shows annual oil production for the last 120 years:

For every two barrels, one comes from one of these seven companies.

The peak of their power was in the 1970s, a turbulent decade that abruptly changed the course of the oil industry. From being overly concentrated, it became significantly more fragmented.

1960 Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela created OPEC. Their alliance aimed to coordinate the oil market, stimulate investment in the oil industry, and ensure access to oil for all economies.

Over the years, OPEC's membership has grown, and the organization's role has become increasingly significant. The countries of North Africa and the Middle East set up their internal organization, OAPEC, with the same objectives.

The emergence of these two organizations is linked to the nationalization of many oil fields. This process was particularly intense in the Middle East, and the influence of the Seven Sisters cartel waned. The industry has become increasingly fragmented. Oil discoveries were made in the North Sea in the 1960s and 1970s.

Technological advances are accelerating the development of fields that were, until recently, uneconomic. Examples include deepwater oil, oil sands, and shale oil.

Since 2008, shale oil has dramatically impacted the global energy market. The Bakken in North Dakota and the Permian Basin in New Mexico/Texas are becoming some of the world's most significant shale gas and oil fields.

The new hot spot for exploration and production in West Africa and the Atlantic coast of South America. Brazil, Guyana, and Argentina lead in LatAm, while Nigeria, Namibia, and Angola are in West Africa.

From the oil well to the gas station

Although it may appear homogeneous, the oil industry is highly diverse. It brings together segments that play different roles in the process and react differently to the oil price.

Graphically, the three main segments are as follows:

Let’s discuss briefly each segment:

• Upstream - companies exploring, developing, and exploiting oil fields. They are often referred to as E&P exploration and production.

• Midstream companies transport and store crude oil and petrol products. They include pipeline and tanker operators and dedicated cargo terminals.

• Downstream - companies that refine, distribute, and sell fuels and other derivatives.

• Oilfield services—This category includes companies providing everything the upstream segment needs. They offer services from evaluating potential fields to oil rigs, plant maintenance, and process optimization.

• Fully integrated companies—these are companies that operate in more than two segments. They often operate at each stage—from discovering and exploiting the field through transport and storage to refining and distributing the fuel.

• Oil and gas equipment manufacturing—these companies produce the equipment needed for the industry, from individual components like valves and pipes to oil rigs and everything in between.

Each segment reacts differently to the changes in oil prices. Upstream companies have the most direct exposure. They have no pricing power. Thus, their profits are the first derivative of the oil price. At the same time, if we expect oil prices to rise, pure upstream companies are the best option.

Midstream companies are less sensitive to oil price changes because they neither produce nor sell oil. They organize its transport and storage for the benefit of third parties. Their profits depend, to a small extent, on the oil price and, to a much greater extent, on the volume of oil they handle.

The midstream segment includes tankers. As the world economy grows, demand for fuel increases, directly affecting tanker transport. Even with a low oil price, tanker companies can be profitable investments.

Downstream companies exhibit relatively low oil price sensitivity because their profits depend more on the margin between the price of crude oil and refined products. Unlike upstream companies, these firms can, to some extent, determine the price of the final product.

On the other hand, fully integrated companies are somewhere in between. They follow the oil price, but not as closely and volatilely as the upstream. At the same time, they don't have the flexibility of downstream or the advantages of tankers during a weak oil market.

Knowing these differences is essential if we want to play the oil market. We can choose the most appropriate segment depending on our hypothesis—direction, magnitude, volatility, time, and plausibility.

The goal is to give us maximum exposure to the oil price relative to our hypothesis. Tankers are a good option if we believe the price will remain in the $60-80 per barrel range and a healthy global economy. Accordingly, if we expect a sharp oil price increase, oil rigs are the better option.

Resources and reserves

The oil industry is similar to mining. Rule number one for both industries is that the reserve discovery rate must exceed the reserve depletion rate.

Crude oil reserves and resources are classified similarly to metal ores. The definitive variable is the probability of the project becoming operational. The higher the probability, the better. Chart via Research Gate/Professor Harraz presentation.

The table above sums it all up.

On the X-axis, we have a range of uncertainty. On the Y-axis, we have project odds to become operational, project maturity, and Petroleum Initially in Place (PIIP). There are two main categories of PIIP: discovered PIIP and undiscovered PIIP.

The discovered PIIP is divided into reserves and contingent resources. The former category is split into three types of reserves:

• 1P (P90), proved reserves, the chances to go into production are 90%

• 2P (P50), probable reserves, the chances to go into production are 50%

• 3P (P10), possible reserves, the chances to go into production are 10%

Oil companies usually declare their 2P reserves, including 1P. The reserves category defines the economic viability of the projects. It is the last stage before production. The project carries the lowest risk at the reserves stage because reserves are already defined. Hence, the project is confirmed as economically viable.

Contingent resource discovery precedes reserve definition. At that stage, resources are examined to determine if they are technically viable for extraction. Contingent resources are categorized into three types of resources:

• 1C, low estimate

• 2C, best estimate

• 3C, high estimate

At that stage, the company estimates the recovery factor. The risk of failure is still considerably high, yet way lower compared to prospective resources. At least we know there is something measurable, i.e., oil in the ground.

Undiscovered PIIP are prospective resources. Here is the highest risk of failure. Like mining, prospective oil fields most often end up as black holes for capital and hope. It’s worth mentioning that some of those projects may become attractive and even economically viable with the development of the technologies.

Types of oil

Crude oil can be categorized as sweet or sour and heavy or light. The former depends on sulfur content, while the latter depends on API gravity.

Sulfur content varies between oil fields. Sweet oil is considered oil with sulfur content below 1%. The oil is sour if the content is more than 1%. API gravity, or American Petroleum Institute gravity, is an inverse density measure. In other words, the higher the API gravity, the lighter the oil, and vice versa. As the base is accepted, 10. Oil with a gravity above 10 floats, while below 10 sinks.

API gravity and sulfur content are crucial variables for the oil industry. A case in point is the oil refineries. They can refine oil with specific parameters, i.e., gravity and sulfur can vary in a narrow range. In other words, the refineries specialize in treating oil with predefined parameters. If the company wants to process different types of oil, it must invest in CAPEX to adapt refinery equipment to the new crude oil parameters.

Crude oil parameters have further implications. Since refineries process a few types of oil, they can produce fuels with specific characteristics. The latter is vital for marine transport because of the air emissions regulations. Fuels in the marine industry deserve a separate article. Now, let’s continue with crude oil.

The following chart sums up the last few paragraphs (chart via EIA):

As you can see, crude oil specifications differ geographically by a wide margin. The best crude oil (light and sweet) is in the left-hand corner of the table. Two of the most popular sorts of crude oil fall in that category: Brent and West Texas Intermediate (WTI). They are considered for benchmarks in the industry.

Brent or Scottish Brent has an API of 38.3 and a sulfur content of 0.37%. WTI has an API of 39.6 and a sulfur content of 0.24%. The third benchmark is OPEC crude. It consists of a basket of crudes produced by OPEC members. OPEC crudes are generally heavier and sourer.

Lifting cost and Breakeven cost

Lifting cost is the cost of production of crude oil. It includes costs for operation, maintenance, development, and production taxes. It is calculated by dividing the company’s OPEX by the BOE produced for the same period.

Breakeven is the lowest production price at which the company will stay afloat. For FY24, the world median breakeven is $54/bbl; in the Middle East, it is $37/bbl. The chart below shows the crude oil cost curve by region. Chart via Goldman Sach.

The Middle East projects have the lowest breakeven. Saudi Aramco is the champion, with some assets having a breakeven price below $20/bbl. Nigeria's deepwater projects and Canadian oil sands are on the other side of the curve. The newcomers, Argentina with the Vaca Muerte shale basin and Brazil with the Santos deepwater basin are competitive compared to the US, Russia, and West Africa.

Today’s write-up is not a comprehensive guide on how to invest in oil. Treat it as a primer on the oil industry. Its goal is to make energy companies’ presentations more understandable or at least less confusing.