14 May 2002

Global
Oil & Gas
Equity Research

research team

Brian M. Gibbons, Jr., CFA

212 325 3101
[email protected]

Catherine Arnfield
44 20 7888 1881
[email protected]

Peter Best
852 2101 6121
[email protected]

Daniel Blanchard
852 2101 7319
[email protected]

Henry Cohen, CFA

416 352 4585
[email protected]

David Dudlyke
44 20 7888 4381
[email protected]

Daniel Eggers, CFA

713 890 1659
[email protected]

Mark Flannery
212 325 7446
[email protected]

Oil and Gas Primer Emerson Leite, CFA

55 11 3841 6290
[email protected]

Rod Maclean
Introduction to the Oil and Gas Business 44 20 7888 1395
[email protected]

Vadim Mitroshin
7 501 967 8355
THE OIL AND GAS CHAIN—FROM UPSTREAM TO DOWNSTREAM [email protected]
The CSFB Global Oil and Gas Team’s first Oil and Gas Primer provides an introduction to the David Niewood
dynamics of the oil and gas business and our framework for investing in the sector. 212 538 1158
[email protected]
We describe our approach to analyzing global oil and gas markets, evaluating macro oil market
conditions; forecasting supply and demand, commodity prices, and refining margins; and valuing Phil Pace, CFA
713 890 1655
and investing in the various industries throughout the oil and gas chain. [email protected]

RETURNS ON CAPITAL DRIVE OIL AND GAS EQUITY VALUATIONS Ken Sill
713 890 1678
Critical for investors is understanding which businesses within the oil and gas chain accrue the [email protected]
highest financial value in the market and where investment opportunities lie within the energy chain
based on variations in the oil and gas cycle. Tracy Todaro, CFA
713 890 1666
[email protected]
The Integrated Oil business dominates global equity market capitalization among publicly traded oil
and gas equities, at roughly $1.2 trillion, versus Independent E&Ps at $215 billion, Oilfield Service
and Equipment companies at $135 billion, and Independent Refiners at $79 billion.
Returns on capital drive valuation throughout the oil and gas chain, with the Oilfield Service group
achieving the highest historical returns (12%) compared with the most consistent returns
performer—the Integrated Oils (9%)—the Independent E&P group (11%), and the lowest-returns-
generating group—the Independent Refiners (8%).
Oil and Gas Primer 14 May 2002

Table of Contents
Global Oil and Gas Equity Research ................................................................................4

Executive Summary ..........................................................................................................5

Introduction: Oil and Gas Chain Overview........................................................................7

Oil Markets ......................................................................................................................12

Oil Supply .................................................................................................................... 14
Demand ....................................................................................................................... 19
CSFB Supply and Demand Model, Marginal Cost Curve ........................................... 21
Refining ....................................................................................................................... 23

Natural Gas Markets .......................................................................................................28

Global Natural Gas Supply and Demand Framework ................................................. 28
North American Natural Gas Market ........................................................................... 31

The Upstream .................................................................................................................36

Value Creation............................................................................................................. 36
The E&P Process ........................................................................................................ 38

The Downstream.............................................................................................................44
Refining ....................................................................................................................... 44
Marketing..................................................................................................................... 47

Integrated Oils.................................................................................................................50

Independent Refining ......................................................................................................57

Independent E&P ............................................................................................................61

Oilfield Services and Equipment .....................................................................................67

Investment Conclusions ..................................................................................................78

Valuation Framework................................................................................................... 80
Investing through the Cycle......................................................................................... 83

Appendix I: The Physical Process ..................................................................................87

Exploration and Production ......................................................................................... 87
Storage and Transportation....................................................................................... 108
Refining ..................................................................................................................... 111
Offshore Oilfield Services and Equipment ................................................................ 121

Appendix II: Case Study—U.S. Energy Markets ..........................................................129

Market Overview........................................................................................................ 129
End Markets .............................................................................................................. 131
Energy Expenditures ................................................................................................. 133

Glossary ........................................................................................................................135

Energy Conversion Guide .............................................................................................151

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Oil and Gas Primer 14 May 2002

Global Oil and Gas Equity Research

United States Europe

Integrated Oils Integrated Oils
Mark Flannery +1 212 325 7446 Rod Maclean +44 20 7888 1395
Joseph Bustros +1 212 325 3045 Cathy Arnfield +44 20 7888 1881
Oil Services Thomas Martin +44 20 7888 1544
Ken Sill +1 713 890 1678 Oil Services/ Exploration and Production
Daniel Eggers +1 713 890 1659 David Dudlyke +44 20 7888 4381
John Lawrence +1 713 890 1652 Marketing Analysts
Brad Smith +1 713 890 1681 Colin Smith +44 20 7888 0151
Bradley Ruhoff +1 713 890 1672 John Besant-Jones +44 20 7888 0152
Exploration and Production Emily Matthews +44 20 7888 0868
Phil Pace +1 713 890 1655 Asia-Pacific
Tracy Todaro +1 713 890 1666 Peter Best (Hong Kong) +852 2101 6121
Arun Jayaram +1 713 890 1677 Daniel Blanchard (Hong Kong) +852 2101 7319
Refining and Marketing Theodore Pun (Hong Kong) +852 2101 7178
David Niewood +1 212 538 1158 Sarinee Sernsukskul (Thailand) +66 2 614 6218
Canada Prashant Gokhale (India) +91 22 230 6230
Henry Cohen +1 416 352 4585 Pankaj Kadu (India) +91 22 230 6227
Viren Wong +1 416 352 4546 S. Varatharajan (India) +91 22 230 6221
Latin America Haizan K. Johari (Malaysia) +65 214 30 366
Emerson Leite (Sao Paulo) +55 11 3841 6290 Sonia Song (Korea) +82 2 37 07 3733
Gustavo Santos (Sao Paulo) +55 11 3841 6305 A-Hyung Cho (Korea) +82 2 37 07 3735
Australia M. Esig Ben-Menachem (New Zealand) +64 9 360 1531
Simon Davis +61 3 9280 1768 Russia/Emerging Europe
South Africa Vadim Mitroshin (Moscow) +7 501 967 8355
Paul Carter +27 11 343 2202 Global
Brian Gibbons +1 212 325 3101

Global Reports Industry Reports

Global Oil Daily Integrated Oils and Independent Refining
Global Integrated Oils Order of Merit (formerly Global Integrated Oils Almanac) Weekly Refining Indicators
IEA Monthly Update U.S. Weekly Retail Margin Tracker
Global Independent E&P Order of Merit Measurement While Reporting
Qualrig—Worldwide Spending Update Independent E&P
North American E&P Weekly
Independent E&P F&D Cost Study
Measurement While Reporting
Oilfield Services
Oilfield Services Weekly Statistical Update
Monthly Oilfield Drilling Update
U.S. Drilling Permits Monthly
Measurement While Reporting

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Oil and Gas Primer 14 May 2002

Executive Summary
This report provides a The CSFB Global Oil and Gas Team’s first Oil and Gas Primer provides an introduction
reference guide to the to the dynamics of the oil and gas business and our framework for investing in the
dynamics of the oil and sector. We describe our approach to analyzing global oil and gas markets, evaluating
gas business and CSFB’s macro oil market conditions, and forecasting supply and demand, commodity prices,
framework for investing in and refining margins, and finally our approach to valuing and investing in the various
the sector industries throughout the oil and gas chain.

There are several different industries involved in finding, producing, transporting,

storing, and distributing crude oil and refined petroleum products, and natural gas. It is
critical for investors to understand which businesses within the oil and gas chain accrue
the highest financial value in the market and where investment opportunities lie within
the energy chain based on variations in the oil and gas cycle.

The $770-billion-a-year global oil and gas commodity market involves upstream producers
(Integrated Oils, Independent Exploration & Production [E&P]), upstream service providers
(Oilfield Service and Equipment [OFS]), and downstream refiners and distributors
(Integrated Oils, Independent Refiners) throughout the oil and gas chain. While there
exist numerous other industries (Pipelines, Tankers, Chemicals, Petrochemicals)
throughout the chain, these groups make up the majority of global “energy” equity
market capitalization, and are traditionally viewed to be the most directly related to the
energy business because of their close connection to hydrocarbon production and refining.
The $770-billion-a-year The upstream is the largest part of the chain in terms of net sales and net profits and in
global oil and gas terms of equity market capitalization. It also generates the highest financial returns. The
commodity market is Integrated Oils business dominates global equity market capitalization among publicly
dominated by Integrated traded oil and gas equities, at roughly $1.2 trillion, versus Independent E&Ps at $215
Oils, which make up the billion and Oilfield Service and Equipment companies at $135 billion. The Integrated
lion’s share of publicly business model provides a much steadier earnings and cash flow stream than the other
traded global energy groups given the diversity of businesses. Integrateds are also a classic defensive
equities at $1.2 trillion investment class that generally outperforms during broad market downturns. They are
viewed to be the most conservative oil and gas investment compared with the more
volatile Independent E&Ps and the hypervolatile Oilfield Service companies. Integrated
Oils stocks therefore often perform better than the other oil and gas industries as the
cycle shifts from peak to trough, but tend to underperform the highly leveraged E&Ps
and Service companies when oil and gas fundamentals improve.

The downstream is substantially smaller than the upstream in terms of equity market
capitalization, as the business has historically been dominated by the Integrated Oils.
We estimate the global equity market capitalization of the pure-play (ex-Integrateds)
downstream Refining and Marketing business to be roughly $79 billion, concentrated
most heavily in Emerging Markets and to a lesser extent in the U.S. The Emerging
Markets aspect of most publicly traded global Refiners makes investment comparisons
difficult to assess given the high degree of country risk and minority interest discount
(i.e., most Emerging Markets refiners are controlled by government entities) reflected in
valuations. The U.S. market is the largest developed market for Refining and Marketing

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Oil and Gas Primer 14 May 2002

equities, with no other real comparison. U.S. refining equities tend to outperform on a
seasonal basis from November to April in anticipation of the summer driving season and
underperform from May to October. Valuation is still the critical factor in analyzing these
stocks, however.
Returns on capital drive In valuing each industry group we use a proprietary, returns-based methodology
valuation throughout the oil throughout the global energy research team. We focus on return on gross invested
and gas industries; capital (ROGIC) among the Integrated Oils, Independent Refiners, and Oilfield Service
Integrated Oils are the companies. For the Oilfield Equipment stocks (Assets or Drillers), we use return on
most consistent returns replacement cost, and for the Independent E&P stocks we use return on replacement
performers through the cost capital, although the calculations and interpretations of replacement cost for the
cycle, but the Oilfield two groups are substantially different.
Service group generates
Our research suggests the Integrated Oils have the most consistent long-term returns
the highest returns during
performance (9%) owing to their diversified business profile. Oilfield Service and
up markets and cyclical
Equipment companies have also been able to achieve high returns on capital (12%)
peaks
through various market periods, particularly during market upturns when returns often
far exceed those of the Integrateds and E&Ps owing to the technological differentiation
and niche, specialist services they offer. The Independent E&P group returns profile
(11%) is more volatile than the Integrateds’ as a result of the upstream-only business
model, but is less volatile than the Service stocks. Independent Refiner returns (8%) are
consistently the lowest among the traditional oil and gas groups.

This report is broadly structured in four main sections: commodity markets, upstream
and downstream businesses (operational and financial performance measurement);
industries within the oil and gas chain; and investment conclusions. We hope this report
provides the novice and the experienced energy investor with a user-friendly reference
manual to understanding the oil and gas business and CSFB’s methods for evaluating
oil and gas equities.

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Oil and Gas Primer 14 May 2002

Introduction: Oil and Gas Chain Overview

The oil and gas chain The oil and gas chain begins with the exploration for and discovery of hydrocarbons and
begins with the exploration concludes with their retail distribution to end-use markets. There are two distinct parts of
and discovery of the oil chain: the supply of crude oil (the upstream) and the supply of refined crude
hydrocarbons and products (the downstream). Exhibit 1 details the chain of events, from exploration to
concludes with the retail end-use consumption, and shows the size of each market and the investment
distribution to end-use opportunities within each segment.
markets
The upstream is the largest business in the oil and gas chain, comprising the Integrated
Oils, Independent Exploration and Production, and Oilfield Service and Equipment
industries. The downstream comprises Integrated Oils, which are involved in all aspects
There are two distinct parts
of the energy chain, and Independent Refiners, which engage only in refining and
of the chain: supply of
marketing. Excluding the Integrateds, the downstream is a much smaller segment of the
crude (the upstream) and
chain in terms of equity market capitalization and has historically generated lower
supply of refined crude
returns on capital than the upstream.
products (the downstream)
Integrated Oils and Independent Exploration and Production companies engage in
finding and producing oil and gas. This is a five-stage process, beginning with the
exploration for hydrocarbons and ending with the final stage of decommissioning and
abandonment of mature wells. The exploration for hydrocarbons can take several weeks
to acquire topical and geological data and then several months to process, while
development and first production from a successful field may take two to five years.
The full development and production stage can go on for several decades before
final decommissioning. Oilfield Service companies play an integral role in all aspects
of the upstream process, as producers effectively outsource much of their service and
equipment needs to the OFS industry. Producers sell their crude oil and gas into
wholesale markets, to Independent Refiners and distributors, and to themselves, using
spot and futures market transactions.
The oil market is a truly global market. Oil is produced on nearly every continent and a
complex transportation and refining system exists to move crude and products to end-
use markets. Oil is sold everywhere in U.S. dollars and traded on major exchanges.
Differences in quality grades of oil are arbitraged out through efficient market pricing
mechanisms. Oil, in one form or another, can be bought and/or sold by any individual,
corporation, or country—the market is very efficient.
We estimate the physical We estimate the physical global crude oil market to be a $570-billion-per-year business
global crude oil market to based on an average historical West Texas Intermediate (WTI) crude price of $20.50
be a $570-billion-per-year per barrel (bbl) and recent demand of 76-77 million barrels of oil per day (MMBD).
business and the natural These figures only address the size of the physical, or spot, market for crude without
gas market to be $200 considering the vast amounts of financial derivatives (i.e., futures, options, swaps) that
billion are traded and negotiated every day. We have also assumed for simplicity sake that all
oil is WTI when the reality is that there are numerous crude grades and qualities that
have either higher or lower values than WTI.

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 Oil and Gas Primer
Exhibit 1: Oil and Gas Chain

Natural Gas
LNG Liquefaction LNG Regasification
Upstream - $770b
Power plant/
Oil: $570b Natural Gas: $200b
large industry
Transportation
Power plant/
large industry

Distribution
8

Gas households/
Development Production
Pipeline smaller industry

Condensate
Transportation
Exploration Midstream
Processing
(NGL)

Downstream - $1,100b
Discovery
Transportation
Petroleum
Development products
Retail
Cars, trucks etc

Oil Petroleum
Production Wholesale industry
products

Refining industry
Bulk
products
Global Equity Market Capitalization Petrochem
Integrated Oil - $1,162b feedstock Petrochemical Specialty industry
Independent E&P - $215b products
plant
Oilfield Services - $135b
Global Equity Market Capitalization
Independent Refiner - $79b

14 May 2002
Source: Company data, CSFB estimates.
Oil and Gas Primer 14 May 2002

Unlike the global oil market, the gas business is regional mainly because of the difficulty
in physically transporting gas. However, we can still estimate the aggregate dollar value
of worldwide gas markets using regional consumption and pricing data. We believe the
global gas business is approximately $200 billion per year, assuming demand of 230
billion cubic feet per day [bcf/d]) and natural gas prices of $3.00 per thousand cubic
feet (mcf). While there is not yet a global gas market comparable to the oil market,
technologies that convert natural gas into liquefied natural gas (LNG) or natural gas to
liquids (GTL) have made major inroads to establishing the long-haul transportation for
stranded natural gas reserves. Several energy companies are currently attempting to
increase the viability of each technology that will facilitate global trade.
Oil is transported by Oil is transported by pipelines, ocean tankers, and tanker trucks to refineries for
pipelines, ocean tankers, conversion into end-use products (gasoline, diesel, heating oil). Integrated Oil
and tanker trucks to companies and Independent Refiners process the crude oil (refining) into products and
refineries for conversion sell them into wholesale and retail markets (marketing). Refining and Marketing are two
into end-use products distinct parts of the downstream chain despite often being referred to in the same
(gasoline, diesel, breath. Refiners purchase crude from Independent E&Ps, Integrateds, and National Oil
heating oil) Companies (NOCs) whereas Integrateds can either buy crude from other producers or
use their own equity crude supply from their producing fields. Independent fuel
distributors or retailers purchase oil and gas products (gasoline, heating oil) at the
wholesale level to sell to end-use markets (industrial, commercial, residential,
transportation) for final consumption. We estimate annual global petroleum products
consumption to be $1.1 trillion. While this number is greater than the upstream $770
billion amount, the $770 billion upstream business effectively represents the cost of
goods sold for the products market.

Exhibit 2 provides a closer look into the oil and gas chain through the economic flow of
one barrel of oil, from the exploration stage through final sale at the gasoline pump,
using 2000 data for the US market. Producers find and develop hydrocarbon reserves
and undertake production operations that have associated overhead and other costs,
leading to a marginal cost per barrel ($18.50 in this example). They can then sell into
the wholesale market (New York Mercantile Exchange [NYME] or International
Petroleum Exchange [IPE]) for $26.75, generating a 31% profit.
Refiners therefore pay $26.75 for the crude and $0.85 to transport it to their refinery. It
then costs $6.00 to refine the crude into products for a total cost of $33.60. Refiners can
then sell the refined products into the wholesale products market for $37.00, for a profit
of $3.40, or 10% ($37.00 less $33.60).

Continuing the chain, retail operations pay the $37.00 wholesale price for refined
products, which includes all the associated costs of finding, developing, and producing
the crude oil plus a producer profit, the costs associated with the refining process, and
the refiner’s profit. In addition, the retailer pays $5.25/bbl in transportation, distribution,
and marketing costs for a total cost of $42.25. Retail product prices (gasoline) averaged
$44.60/bbl in 2000, allowing retailers to generate a $2.35 profit, or 6%. However, this is
not quite the end price for the consumer, as it excludes taxes.

U.S. federal, state, and local taxes of $17.40 (28% of total price) imposed on this $44.60
price bring the total cost for the consumer to $62.00 per barrel, or in this example, $1.48
per gallon of gasoline. In Europe, by contrast, taxation on refined products tends to be
much higher, approaching 85% of the total price paid in some instances.

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 Oil and Gas Primer
Exhibit 2: Economic Flow of One Barrel of Crude Oil
(Subset Represents Conversion of One Barrel of Oil to One Gallon of Gasoline)
US$ per barrel

$70.00
Final Sales Price to
End-Use Consumer =
$62.00

$60.00
Fed. Taxes = $8.30
10

Retail Product
$50.00 Price (ex-Taxes) = State Taxes = $9.10
$44.60

Wholesale
Retail Marketing Profit = $2.35 = 6%
Product Price =
$40.00 $37.00 Marketing Costs = $3.00
Retail Operating Costs = $2.00
Transportation Costs = $0.25
Refinery Profit = $3.40 = 10%
Crude Oil Price Other Costs = $2.00
$30.00 = $26.75 Refining Cash Costs = $4.00
Transportation Costs = $0.85

Profit = $8.250 = 31%

$20.00 $18.50 Marginal Cost Curve

Other/Overhead Costs = $4.70

DD&A Costs = $3.70

$10.00
Operating Costs = $4.50

Finding & Developing Costs = $5.60

$0.00
Upstream Refining Retail Final Sales Price

14 May 2002
Source: EIA, CSFB estimates.
Oil and Gas Primer 14 May 2002

We combine the research Understanding the macro oil environment provides insight into the direction of the oil
of our global Integrated cycle and potentially which industries will benefit most as the cycle changes. We
Oils, Independent E&P, combine the research of our global Integrated Oils, Independent E&P, Oilfield Service
Oilfield Service, and and Equipment, and Refining teams to develop a mosaic of the energy landscape. We
Refining teams to develop analyze historical oil and gas prices, inventory data, seasonal supply and demand
a coherent mosaic of the trends; evaluate producer and service spending patterns; and apply industry economics
energy landscape and pricing patterns.
After we form a macro opinion and evaluate the current stage (trough, middle, peak) of
the oil cycle, we look at the specific industries within the chain. Cyclical shifts to the
upside will favor all oil and gas equities while shifts to the downside will be negative.
However, the level of up/downside performance will be different for each industry group,
with some groups outperforming or underperforming others.

Our investment process During cyclical upturns and periods of extended upward momentum, Oilfield Service
begins with a macro oil and Equipment stocks tend to outperform the wider energy group because of their high
market view, which leverage to producer spending, and substantial returns on capital. The Independent
supports our industry E&Ps also perform well given their single pursuit of upstream operations. The Integrated
preferences, and business, however, tends to lag these other upstream groups because of the
concludes with our stock diversification of the other businesses. One might assume that Independent Refiners
preferences might be hurt by rising crude prices because higher prices translate into a higher cost of
goods sold, but refiners actually perform better in this environment because of implied
high product demand and a greater ability to pass on high crude costs to consumers.
Integrateds outperform the Oil market downturns result from excess supply, weakened demand, or a combination
broad energy group during of both factors, which hurts each group. In a downturn, Integrateds tend to outperform
cyclical downturns while because their diversified business model provides a steadier earnings and cash flow
Oilfield Services stream versus the other groups. They are viewed as the most conservative oil and gas
outperform during cyclical investment compared with the more volatile Independent E&Ps and the hypervolatile
upturns and during peak Oilfield Services companies. Integrated Oils stocks therefore will likely perform better
periods than the other oil and gas industries as the cycle shifts from peak to trough. Energy
equities are also a classic defensive investment class, which generally outperforms
during broad market downturns. This is because cyclical upturns or high commodity
price environments generally coincide with economic downturns. Once we identify the
appropriate industry(ies) to invest in given the stage of the cycle, we take a bottom-up
approach to stock selection.

Business models, balance sheet strength, operating leverage, and—most important—

valuation are key components to our analysis. We focus on return on gross invested
capital (ROGIC) among the Integrated Oils, Independent Refiners, and Oilfield Service
companies. For the Oilfield Equipment (Asset, or Drillers) stocks, we use return on
replacement cost, and for the Independent E&P stocks we use return on replacement
cost capital, although the calculations and interpretations of replacement cost for the
two groups are substantially different.

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Oil and Gas Primer 14 May 2002

Oil Markets
The oil market is truly The macro oil market forecast is the foundation of our analysis, forecasts, and industry
global; oil is produced on and stock selection opinions within the broad energy landscape. In this section, we
nearly every continent and describe the major macro oil market drivers: crude prices (spot and futures, crude grade
a complex transportation differentials), inventories, supply (global reserves and production), demand (global
and refining system exists demand trends), the role of OPEC, the marginal cost curve and midcycle conditions,
to physically move refining, and the distinct role of product markets.
products to end-use
The oil market is truly global. Oil is produced on nearly every continent and a complex
markets
transportation and refining system exists to move oil to end-use markets. Oil is sold
everywhere in U.S. dollars and traded on major exchanges (New York Mercantile
Exchange, International Petroleum Exchange). Oil comes in many different quality
grades, reflecting among other things levels of sulfur and its propensity to create higher
volumes of more valuable light products (such as gasoline). Oil, in one form or another,
can be bought and/or sold by any individual, corporation, or country—the market is
very efficient. We list various major global crude grades and their price differentials in
Exhibit 3.

Exhibit 3: Global Crude Grades and Price Differentials

as of March 2002, US$ per bbl

WTI WTI Lt. La ANS Dated Bonny Dubai

Crude: Cush Nymex Sweet USWC Brent Light Fateh
($/barrel) Price: 26.17 25.88 26.02 24.22 24.24 24.39 23.07
Alaska North Slope USWC 24.22 -1.95 -1.66 -1.80 - -0.02 -0.17 1.15
WTI Cushing 26.17 - 0.29 0.15 1.95 1.93 1.78 3.10
WTI Midland 25.85 -0.32 -0.03 -0.17 1.63 1.61 1.46 2.78
WTS Midland 24.62 -1.55 -1.26 -1.40 0.40 0.38 0.23 1.55
Wyoming Sweet 25.60 -0.57 -0.28 -0.42 1.38 1.36 1.21 2.53
Urals Med. 22.94 -3.23 -2.94 -3.08 -1.28 -1.30 -1.45 -0.13
Flotta 23.24 -2.93 -2.64 -2.78 -0.98 -1.00 -1.15 0.17
Arab Light 23.67 -2.50 -2.21 -2.35 -0.55 -0.57 -0.72 0.60
Arab Heavy 22.37 -3.80 -3.51 -3.65 -1.85 -1.87 -2.02 -0.70

Source: Bloomberg, CSFB.

We estimate the physical global crude oil market to be a $570-billion-per-year business

based on an average historical WTI crude price of $20.50/bbl and recent demand of
76-77MMBD. These figures only address the size of the physical, or spot, market for
crude without considering the vast amounts of financial derivatives (i.e., futures, options,
swaps) that are traded and negotiated every day. We have also assumed for simplicity
sake that all oil is WTI when the reality is that there are numerous crude grades and
qualities that have either higher or lower values than WTI.
WTI and Brent are the two As stated above, the major international exchanges for oil and gas trade are the New
benchmark crude grades; York Mercantile Exchange and the International Petroleum Exchange in London. Both
however, we closely exchanges trade spot, or physical (dated), contracts for immediate delivery and futures
monitor light/heavy and for delivery at a later date, providing hedging, speculating, and price discovery
sweet/sour grades to opportunities for producers and speculators. Price quotes are most often for the front
understand underlying month or for oil to be delivered one month out. Given the difficulty in following every
trends in the broad oil traded crude grade in the world, two benchmark crude contracts are widely used: West
market Texas Intermediate crude on the NYMEX and Brent crude on the IPE. While these two
crude grades provide the general market direction of oil prices, they do not necessarily

12
Oil and Gas Primer 14 May 2002

represent the direction of all crude grades and types. In order to track the rest of the oil
market, we define crude by two sets of measures: light or heavy as defined by API
gravity (see Glossary), and sweet or sour grade as measured by percent sulfur content,
and compare the pricing spreads (light versus heavy and sweet versus sour). We also
take into consideration common trade movements. Exhibit 4 shows the light/heavy
spread represented by WTI (light) and Kern River (heavy) crude and the sweet/sour
spread using Brent (sweet) and Dubai (sour) crude.

Exhibit 4: Global Crude Light/Heavy and Sweet/Sour Spreads

US$ per bbl

WTI (Light) versus Kern River (Heavy) Prices Brent (Sweet) and Dubai (Sour) Prices

$35 WTI Kern River 35.00

Brent Dubai
$30 30.00

$25 25.00

$20 20.00

$15 15.00

$10 10.00

$5 5.00
Apr-97
Jul-97
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
Jan-00
Apr-00
Jul-00
Oct-00
Jan-01
Apr-01
Jul-01
Oct-01
Jan-02
Apr-02

Apr-97
Jul-97
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
Jan-00
Apr-00
Jul-00
Oct-00
Jan-01
Apr-01
Jul-01
Oct-01
Jan-02
Apr-02
Source: Reuters, CSFB estimates.

In addition to receiving different prices in the market (revenue impact), each crude grade
can also have different finding and developing cost structures, leading to different levels
of economic viability for various fields. Producers, depending on their asset base, can
be levered more or less to light or heavy, sweet or sour crude production. Similar to
producers, refinery operations are geared to process particular crude grades, and
pricing provides insight into refiner cost structures. On the refining side of the business,
a wide heavy/light oil price differential has the ability to soften the impact of weak
refining margins for complex refiners that process heavy crude. As we show in Exhibit 4,
there were several times when the differential grew quite large, providing an opportunity
for complex refiners to generate additional income. When light/heavy spreads contract,
complex refineries that traditionally profit from the discount are less able to offset the
general weakness in refining margins. We discuss refinery operations in greater detail at
the end of this section.

Equally important to following light/heavy and sweet/sour spreads, we follow the

12-month futures curve, including the 12-month strip price, which is the average price
for the next 12 months of futures contracts. The shape of the 12-month futures curve
plays an important role in analyzing the state of the market.
The shape of the curve The shape of the curve portends current price expectations for the next 12 months,
portends price reflecting the current view of supply and demand. An upward sloping curve, contango,
expectations over the next with future months priced higher than near months, suggests expected higher prices,
12 months, and reflects the and implicitly higher demand relative to supply in the future. The market is essentially
current view of supply and putting a premium on oil 12 months out or conversely a discount on current oil prices. A
demand downward sloping curve, backwardation, with the front-month contracts commanding a
premium over the future months’ contracts suggests current demand is outpacing

13
Oil and Gas Primer 14 May 2002

current supply, with the expectation that the imbalance will become less pronounced in
the coming time period. Put another way, the shape of the curve reflects the current
view of supply and demand, but not necessarily the underlying reality, which becomes
apparent at a later date. Exhibit 5 shows the recent futures curve (as of January 2002)
for WTI and Brent is in contango—the market expects higher prices 12 months out
(current supply is greater than demand). The right hand chart shows the recent history
of the spread between front-month WTI and 12-month WTI. A positive spread, or
backwardation, indicates the oil market is tight (i.e., current prices are higher than future
months’), and demand is likely in excess of supply as in the case from early 1999
through mid-2001 when oil prices were high and the spread was positive. Similarly,
when supply begins to exceed demand, the near-term premium dissipates and the
spread narrows, or becomes negative, as in the 1997 through mid-1998/early-1999 time
period and much of 2000-01.

Exhibit 5: WTI and Brent Futures

WTI and Brent 12-Month Futures Curves WTI Historical Futures Spread versus WTI Front Month
Spread WTI
$21.00 $10 $40
$8 $35
$20.50
WTI WTI Spread ($/bbl) $6 $30
$20.00 $4 $25

WTI ($/bbl)
Brent $2 $20
$19.50
$0 $15
$19.00 -$2 $10
-$4 $5
$18.50
-$6 $0
$18.00 Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan-
M A M J J A S O N D J F 97 97 98 98 99 99 00 00 01 01 02

Source: Reuters, CSFB estimates.

Oil Supply
The majority of the world’s The majority of the world’s current proved oil reserves are found in three regions: the
proved oil reserves are Middle East (684 billion barrels [BB]), Latin America (95BB), and Africa (75BB). (See
found in the Middle East, Exhibit 6.) While these regions dominate the global reserve base, the world production
Latin America, and Africa profile is quite different. The Middle East (21.7MMBD), North America (15.0MMBD), and
the Former Soviet Union (FSU)/Eastern Europe (7.9MMBD) rank as the top three
producing regions. (See Exhibit 7.)

We anticipate the recent trends in the production profile will largely continue, with the
one notable exception the FSU/Eastern Europe. Over the past three years, after a
decade of underinvestment and neglect, Russian producers (the bulk of FSU/Eastern
Europe) have heavily invested in field development, which we expect will lead to
substantially higher production rates going forward.

14
Oil and Gas Primer 14 May 2002

Exhibit 6: Global Proved Oil Reserves, 2000

Source: BP Statistical Review of World Energy 2001.

Exhibit 7: Global Crude Oil Production

25
G lobal Production, 1980-1999
M illion barrels per day

M iddle East
20

North Am erica
15

FSU/E. Europe

10

Asia-Pacific
Africa
Latin Am erica
5

W . Europe

0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Source: EIA, CSFB estimates.

15
Oil and Gas Primer 14 May 2002

The geological The geological characteristics of oil- and gas-producing basins can vary substantially,
characteristics of oil- and which can lead to disparate cost structures for finding, developing, and producing oil
gas-producing basins can reserves. The type of oil found in each region (light or heavy, sweet or sour) also varies
vary substantially, which and can be more or less valuable than oil in other regions. In addition to geological
can lead to disparate cost characteristics when evaluating the economics of oil and gas projects throughout the
structures for finding, world, the relative maturity of each basin is an important consideration.
developing, and producing
In Exhibit 8, we demonstrate the effect geological characteristics and basin maturities
oil reserves
have on the number of productive wells and on individual well productivity. There is an
inverse relationship between the number of producing wells (indicating relative maturity)
and individual well productivity. The U.S. has the highest number of producing wells, at
535,000, and the lowest productivity per well, at 14 barrels of oil per day, compared with
the most productive region, the Middle East, at 6,500 wells each producing 3,800
barrels of oil per day.
U.S. oil- and gas-producing regions have relatively low porosity and low permeability
rocks that make extraction difficult, if not costly. The region is also the most mature area
in the world, with several oil and gas basins that have been drilled at varying levels of
intensity for the past 100-plus years. As a result of extensive drilling over such a long
time period, reserves have declined, exploration opportunities have declined, the size of
discoveries has declined, and field sizes have declined.
The U.S. experience of declining productive wells and well productivity compares
negatively with other regions of the world, such as the Middle East, which have
abundant reserves (10 times greater than North America’s) and are relatively young.
These regions have large, untapped reserves, numerous exploration and production
opportunities, large reservoirs, and large fields. We next consider the major producer
groups and the impact their behavior has on global oil markets.

16
Oil and Gas Primer 14 May 2002

Exhibit 8: Global Oil Well Productivity Comparisons

United States Canada

Producing Wells and Well Productivity Producing Wells and Well Productivity
700,000 16.0 70,000 60

650,000
15.0 60,000
Productivity per Well 55
Productivity per Well

Productivity per Well

Productivity per Well

600,000 50
Producing Wells

Producing Wells
14.0 50,000
550,000 45

500,000 13.0 40,000 40

450,000 35
Producing Wells 12.0 30,000 Producing Wells
400,000 30
11.0 20,000
350,000 25

300,000 10.0 10,000 20

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Latin America Africa (Non OPEC)

Producing Wells and Well Productivity Producing Wells and Well Productivity
45,000 200 4,250 1,000

Productivity per Well 3,750 900

40,000 175 Productivity per Well
800

Productivity per Well

Productivity per Well

3,250
35,000
Producing Wells

Producing Wells
150 700
2,750
30,000 600
125 2,250
25,000 500
Producing Wells 1,750
100 Producing Wells 400
20,000
1,250 300
15,000 75
750 200
10,000 50 250 100
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Southeast Asia Europe / Mediterranean

Producing Wells and Well Productivity Producing Wells and Well Productivity
11,000 500 7,000 1,600
10,000
Productivity per Well
450
6,000
9,000 Productivity per Well
Productivity per Well

Productivity per Well

400
Producing Wells

Producing Wells

8,000 5,000 1,100

350
7,000
300 4,000
6,000
250 Producing Wells
5,000 3,000 600
Producing Wells 200
4,000
2,000
3,000 150

2,000 100 1,000 100

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Key Middle East Producers World

Producing Wells and Well Productivity Producing Wells and Well Productivity
7,500 6,500 750,000 110
Productivity per Well 6,000 Productivity per Well
6,500 700,000 100
5,500
Productivity per Well

Productivity per Well

5,500 650,000
Producing Wells

Producing Wells

5,000 90
4,500 4,500 600,000
80
3,500 4,000 550,000
3,500 Producing Wells 70
2,500 500,000
Producing Wells 3,000
1,500 450,000 60
2,500
500 2,000 400,000 50
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Source: Company data, CSFB estimates.

17
Oil and Gas Primer 14 May 2002

We evaluate the supply side of global oil markets using quantitative and qualitative
measures. Quantitatively, we analyze reserve profiles, productive capacity, and rig
capacity. Worldwide productive capacity is a function of all of the major variables of
supply determinants: available production, drilling rig capacity, rig capacity utilization,
times to completion, and estimated reserves. (See Exhibit 9.) Periods of high capacity
utilization result when demand exceeds supply and producers push to get as much oil to
the market as possible to capture high prices.

Exhibit 9: Worldwide Crude Oil Capacity Utilization

105.0%

2002E Utilization = 94.4%

100.0% Iran-Iraq War
Saudi Capacity Underestimated

Impacted by Iraq-
Kuwait Conflict
Long-term Average = 93.8%
Capacity Utilization

95.0%

90.0%

85.0%

80.0%
1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002
Source: CSFB, IEA.

Qualitative factors such as Qualitatively, we analyze producer behavior. It is important to consider the diverse
producer behavior play a needs of the producer groups—Independent E&Ps, Integrated Oils, national oil
big role in understanding companies, and the Organization of Petroleum Exporting Countries (OPEC)—in
global oil supply analyzing the supply side. OPEC is made up of a subset of NOCs; however, not all
NOCs are in OPEC.
Integrateds and Independents are typically price takers, selling into the market at any
OPEC is a major force on
price. They focus on incremental free cash flow generation, on balance sheet stability,
the world oil market,
and increasingly on earning returns in excess of the cost of capital.
controlling nearly 40% of
crude supply NOCs, including OPEC members, are typically located in emerging economies, which
are short on skilled labor and capital and hence a revenue-generating tax base, but are
long on natural resources. Petrodollars, or the money from oil sales, are thus the key to
fiscal stability.

Changes in producer behavior are often the result of extrapolations from current
conditions—i.e., Integrateds and Independents often get mired in the current price
environment and “straight line” prices to one extreme or another. This, of course, leads
to the cyclical nature of the business.

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Oil and Gas Primer 14 May 2002

Producer behavior can be A high price environment tends to increase capital spending designed to raise
a cycle of extreme ups and production and to bring additional supplies to market to take advantage of the high
downs prices. If existing production capacity is inadequate, then investments in new,
aggressive exploration and development programs will take place. Once supply
increases beyond the demand point, prices correct downward. As prices retrace to
“normal” levels or continue to fall below “normal” levels, producers curtail spending and
investment. High prices also result in lower rates of oil demand, which have the same
effect of lowering prices.

The interplay between the different producer groups is critical, and is generally not seen
in other commodities businesses. OPEC is the difference—the group accounts for
roughly 40% of the global oil supply, a sharp increase in market concentration from
1985 (Exhibit 10), but much lower than its historical level of 55%-plus before 1973-74.
OPEC’s ability as a cartel to agree to and adhere to supply quotas can be a very
powerful force, affecting the short-term global supply of crude oil. The cartel’s inability to
adhere to its own quota, 70% historic compliance, has traditionally been OPEC’s
undoing.

Exhibit 10: OPEC Crude Oil Production and Market Share History

35 60%

55%

Production
30
50%
Market Share
Crude Oil Production (MMBD)

Global Market Share

45%

25

40%

35%
20

30%

15 25%
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Source: EIA, CSFB estimates.

Demand
On the demand side of the equation, we analyze regional economic indicators to
There is a high correlation
provide insight into potential demand. Historically, oil demand growth has been
between oil demand
correlated to GDP growth. (See Exhibit 11.) As one might expect, countries with higher
growth and GDP growth
rates of economic growth have seen higher rates of oil demand growth and vice versa
for slower-growth countries. The 1990s showed this to a surprising degree, as 80% of
all global oil demand growth came from the fast-growing Asia-Pacific region. Oil price
swings can create sizable demand shifts for developing nations, which are often the

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Oil and Gas Primer 14 May 2002

highest-growth consumers. An important demand consideration is the sensitivity of end-

use product prices to crude oil prices, which can be driven to a large extent by tax
structures (i.e., a lower tax component in end-use prices results in high sensitivity to oil
prices, as in the U.S., or a high tax component results in a low sensitivity to crude
prices, as in Europe).

Exhibit 11: Global Oil Demand Growth and Real GDP Growth
5 .0%

200 0
1 994 19 88
2
R = 45.8%
4 .5%
19 96

19 95 19 87 199 7
4 .0% 199 9
Worldwide Real GDP Growth

198 9

3 .5% 19 86
19 92
1 990

3 .0%
199 3

1 991

2 .5%

19 98

2 .0%
-1 .0% -0.5 % 0 .0% 0.5 % 1.0 % 1 .5% 2 .0% 2.5% 3.0% 3.5%
W o rld w id e O il C o n su m p tio n G ro w th

Source: CSFB.

We analyze global demand from the bottom up, using a regional approach that gives us
clearer insight into the overall demand picture. However, forecasting moves in GDP is
not enough to derive accurate year-over-year oil demand changes, as the oil price itself
often creates single-year or multiyear distortions. North America is the biggest
consumer of oil and oil-related products, consuming nearly 24MMBD. We estimate the
North American market to be worth about $180 billion per year, or 31% of world
demand, using the 15-year historical average WTI crude price ($20.50) and 2001
demand of 23.9 MMBD. Asia and Europe round out the top three oil-consuming regions,
taking in 27% and 21% of global oil demand, respectively. (See Exhibit 12.)

Exhibit 12: World Oil Demand Recent History

millions of barrels a day

5-Year % World
Region 1997 1998 1999 2000 2001 CAGR Demand 2001
North America 22.7 23.1 23.8 24.1 23.9 1.3% 31.5%
USA 18.6 18.9 19.5 19.7 19.6 1.3% 25.8%
Latin America 4.7 4.8 4.9 4.9 4.8 0.4% 6.3%
Europe 15.8 16.1 15.9 15.8 16.0 0.2% 21.0%
FSU 3.8 3.7 3.7 3.6 3.7 -0.8% 4.8%
Middle East 4.0 4.2 4.3 4.4 4.5 3.1% 5.9%
Africa 2.3 2.3 2.4 2.4 2.4 1.0% 3.2%
Asia-Pacific 19.4 19.4 20.4 20.7 20.8 1.7% 27.3%
World Demand 72.7 73.5 75.2 75.9 76.0 1.1% 100.0%

Source: IEA, CSFB estimates.

20
Oil and Gas Primer 14 May 2002

CSFB Supply and Demand Model, Marginal Cost Curve

We form macro We form macro assumptions regarding supply and demand to provide support for an oil
assumptions regarding price forecast. Formulation of an oil price view is critical to our earnings and cash flow
supply and demand to forecasting, not just for the Integrateds but for the Independent Refiners, Independent
provide support for an oil E&Ps, and the Oilfield Service companies that depend on producer capital spending.
price forecast
Our estimates for global oil supply and demand through 2003, using the International
Energy Association (IEA) forecasts as a guide combined with our analysis of regional
indicators, are shown in Exhibit 13. Every month, the IEA reports and forecasts oil
supply and demand of OECD (Organization for Economic Cooperation and
Development) and non-OECD countries, and its numbers are widely watched by the
industry.

Oil demand grew at about 1.2% annually on average over the past decade before
slowing in 2000-01. We expect demand growth to pick up slightly in 2002-03. Supply, on
the other hand, grew about 1.3% on average the last ten years and is estimated to grow
only modestly through 2003—this is a low-growth business.

Exhibit 13: CSFB and IEA Demand/Supply Model

million barrels per day

M B D u n le s s s p ec ifie d 1999 2000 2001 20 0 2 2003

O E C D D e m a n d (C S F B ) 4 7 .7 4 7 .8 4 7 .8 47 .8 4 8 .2
% G ro w th (C S F B ) 1 .9 % 0 .3 % -0 .1 % 0.0 % 0 .9 %
M M B D G ro w th (C S F B ) 0 .1 (0 .0 ) 0 .0 0 .4
IE A O E C D d e m a n d 4 7 .7 4 7 .8 4 7 .6 47 .7
IE A O E C D D e m a n d g ro w th 1 .9 % 0 .3 % -0 .4 % 0.3 %
T O T A L W O R L D D E M A N D (C S F B ) 7 5 .3 7 5 .9 7 6 .0 76 .5 7 7 .6
% W o rld D e m a n d G ro w th (C S F B ) 2 .4 % 0 .9 % 0 .1 % 0.6 % 1 .4 %
M M B D W o rld D em a n d g ro w th 1 .8 0 .6 0 .1 0 .4 1 .1
IE A W o rld d e m a n d 7 5 .3 7 5 .9 7 6 .0 76 .6
IE A W o rld D e m a n d g ro w th 2 .3 % 0 .9 % 0 .1 % 0.8 %

N o n -O P E C s u p p ly (C S F B ) 4 4 .6 4 5 .8 4 6 .5 47 .2 4 8 .0
% n o n -O P E C G ro w th (C S F B ) -0.1 % 2 .7 % 1 .5 % 1.4 % 1 .7 %
M M B D G ro w th (C S F B ) 1 .2 0 .7 0 .6 0 .8
IE A n o n O P E C 4 4 .8 4 5 .9 4 6 .5 47 .4
IE A n o n -O P E C su p p ly g ro w th -0.1 % 2 .5 % 1 .4 % 2.0 %
OPEC CRUDE 2 6 .6 2 8 .0 2 7 .4 26 .3 2 6 .3
c a ll o n O P E C c ru d e 2 6 .6 2 8 .0 2 6 .5 26 .3 2 6 .6
O PEC NG Ls 2 .8 2 .9 3 .0 3 .0 3 .0
T o ta l O P E C 2 9 .4 3 0 .9 3 0 .3 29 .3 2 9 .3
TOTAL SUPPLY 7 4 .0 7 6 .7 7 6 .9 76 .5 7 7 .3
% S u p p ly G ro w th (C S F B ) -2.0 % 3 .6 % 0 .2 % -0.5 % 1 .8 %
M M B D S u p p ly G ro w th (C S F B ) 2 .7 0 .2 (0.4 ) 0 .8
IE A W o rld su p ply 7 4 .2 7 6 .8 7 6 .9 76 .7
IE A W o rld su p ply g ro w th -1.9 % 3 .5 % 0 .1 %

Im p lie d In v e n to ry C h a n g e e tc (1 .3 ) 0 .8 0 .8 0 .0 (0 .3 )
C S F B a d j. In v e n to ry c h a n g e (1 .5 ) (0 .0 ) 0 .6 (0.1 ) (0 .5 )
R e p o rte d in ve n tory ch a n g e
M issin g B a rre ls' M M B
C o m m e rcia l O E C D In ve n to rie s C S F B 2,4 7 1 2 ,5 4 8 2 ,7 7 6 2 ,77 7 2 ,6 7 0
C o m m e rcia l O E C D In ve n to rie s IE A 2,4 7 1 2 ,5 4 8 2 ,7 1 8 2 ,71 9 2 ,6 1 2
Source: IEA, CSFB estimates.

21
Oil and Gas Primer 14 May 2002

A key component to our A key component to our global oil supply and demand model and oil price forecast is our
global oil supply and analysis of midcycle conditions, which normalizes oil cycle extremes. (See Exhibit 14.)
demand model and oil Our midcycle price forecast of $18.50 is based on the marginal cost curve, derived from
price forecast is our the oil price required for a break-even return on capital for our Integrated Oils company
analysis of midcycle universe. Our cost curve analysis provides the backbone of our forecasting process.
conditions, which The first chart in Exhibit 14 shows cost curves for 1992, 1999, and 2000 to demonstrate
normalizes oil cycle the short-term trend in cost structures (1999-2000) and a distant prior-year data point to
extremes show how private industry costs have moved over time (1992-2000). Break-even cost
structures moved higher in 2000 over 1999 but remain well below 1992 levels. Costs will
generally move higher or lower with the cycle; cyclical upturns and peaks have higher
costs as producers bid service prices higher versus trough periods when high service
costs and lower commodity prices make projects uneconomical. Beyond the short-term
fluctuations, however, Oilfield Service and Equipment companies continually develop
new technologies aimed at lowering finding and development and production costs. The
most important factor in reducing costs in the 1990s was the emergence of 3-D seismic
mapping, which greatly decreased the number of unsuccessful wells drilled by the
private industry.

We plotted the $18.50 midcycle oil price estimate against our midcycle supply and
demand expectations (Exhibit 14, right chart). At the bottom of the cost curve lies
OPEC, which has the lowest finding and development and ongoing production costs
($6/bbl) of any major region or producer group. The extremely high OPEC well
productivity—in the Middle East, in particular—demonstrates this fact. Non-OPEC
supply is more costly and therefore starts at a higher point on the cost curve $9/bbl, in
our model. Rising capital intensity as non-OPEC costs push upwards is likely to have
the effect of increasing the marginal cost, or clearing price, of crude oil.

Exhibit 14: Upstream Cost Curves, Midcycle Supply and Demand

Upstream Cost Curves, 1992, 1999, 2000 Mid-Cycle Crude Oil Market Supply/Demand Dynamics

$20 $27

$24 D1
S2
$18
Oil Price per Barrel (WTI spot)

MRO $21 Demand

MRO AHC $18.50 P1
$16 $18
UCL Theoretical OPEC Price
$15.14 P'1
TX COC BP $15 S3
$14
CHV E TOTF OXY $12 Non-OPEC Supply
P
$12 XO NHY $9
PCA
REP
PCA S1
RDSC $6 OPEC Supply
$10 OPEC Capacity (12
months out)
$3
$8
$0
0 5,000 10,000 15,000 20,000 25,000
0 10 20 30 40 50 60 70 80

1992 1999 2000 Millions of Barrels of Oil (including NGLs)

Source: Company data, CSFB estimates.

22
Oil and Gas Primer 14 May 2002

The demand for crude oil Within the context of the supply and demand discussion lies the petroleum products
is a function of the demand (gasoline, distillate, fuel oil) market we briefly discussed earlier. The demand for crude
for products, but the supply oil is a function of the demand for products. But the supply of products is reliant on both
of products is reliant on available crude supply and available refining capacity—two distinct parts of the overall
both available crude supply chain. It is important to differentiate the two parts of the supply chain to
supply and available understand where bottlenecks can occur and which factors drive crude and product
refining capacity—two pricing trends. The refining business links the supply of crude to the supply of products
distinct parts of the overall used for end-use consumption.
supply chain
Refining
Refined petroleum products are found almost everywhere in everyday life, whether in
the form of gasoline, heating oil, jet fuel, road surfaces, or fabrics for clothing. In
general, a barrel of oil can be broken down into four broad, refined parts: liquefied
petroleum gases (LPGs), light distillates, middle distillates, and residual fuel. Within
each class of fuel are various products (propane, gasoline, heating oil, asphalt) that
serve many different uses. Exhibit 15 shows a typical product slate for a refined barrel of
oil and the various uses.

Exhibit 15: Oil Barrel Products and Uses

Products Uses
Ethane, Propane, Heating, cooking, chemical
Butane feedstocks, motor gasoline blending
LPGs - 10%

Gasolines, Naphthas Petrochemical feedstocks, reforming

Light Distillates - 35%
into gasoline, automotive fuel

Jet Kerosene, Diesel, Aviation fuel, automotive fuel,

Heating/Gasoil, domestic heating fuel, distilled to
Middle Distillates - 35% Vacuum Gasoil lighter product

Cracked FO, SR FO, Power generation, ship fuel, fuel oil,

Asphalt, Bitumes, road surfacing, roofing, chemical
Residual Fuel Oil - 20% Coke, Sulfur industry

Source: Bloomberg, CSFB.

Pricing for products is very similar to the crude markets (i.e., spot and futures contracts,
arbitrage opportunities, transportation costs, tax-exempt status). While crude almost
always is priced in U.S. dollars per barrel, products are often quoted in U.S. dollars per
the relevant measurement system (i.e., U.S. products are priced in U.S. cents per
gallon, European products are priced in U.S. dollars per metric tonne, and Asian
products are priced in U.S. dollars per barrel or per metric tonne). In Exhibits 16 and 17,
we demonstrate the variations in global gasoline prices on an equivalent basis (U.S.
cents per gallon) and historical U.S. composite wholesale product prices.
As we mentioned, price variances lead to arbitrage opportunities. Premium NYH (New
York Harbor) gasoline at 59.25c/gal, in the example, has a 7.55c/gal premium price over
the comparable premium FOB (free on board) Northwest Europe (NWE, also known as
Rotterdam) gasoline at 51.70c/gal, suggesting an opportunity may exist for European
premium gasoline producers to profitably export to the U.S. (should transportation costs

23
Oil and Gas Primer 14 May 2002

be less than 7.55c/gal). Relative refining margins between regions is also a major
consideration.

Exhibit 17 shows historical prices of the major refined products, with gasoline clearly
being the most valuable product followed by distillate. Narrow spreads between the
products suggest complex refiners are unable to command premium prices for their
products despite high levels of invested capital versus simple refiners who have
invested less capital and are able to get similar prices for their historically lower-end
products.

Exhibit 16: Global Wholesale Gasoline Prices Exhibit 17: U.S. Historical Composite Wholesale Product
as of March 2002 Prices
c /g a l 100
P ro d u c t Loc B id Ask
E u ro p e : 90
P r e m iu m F O B N W E NW E 5 1 .7 0 5 2 .9 5
80
R e g u la r F O B N W E NW E 4 7 .9 4 4 9 .1 9
Gasoline
70
U S G u lf C o a s t:

US cents per gallon

P r e m iu m U S G USG 5 4 .8 5 5 5 .3 5 60
R e g u la r U S G USG 5 1 .1 0 5 1 .3 5 Distillate
50
US NY:
40
P r e m iu m N Y H NYH 5 9 .2 5 5 9 .7 5
R e g u la r N Y H NYH 5 2 .5 0 5 2 .7 5
30
Fuel Oil
U S W e s t C o a s t: 20
P r e m iu m S a n F r a n USSF 6 6 .0 0 6 7 .0 0
R e g u la r S a n F r a n USSF 6 0 .0 0 6 1 .0 0 10

A s ia : 0
G A S O L IN E 9 5 U N L S IN G 4 9 .5 2 5 0 .0 0 1985 1988 1991 1994 1997 2000

Source: Reuters, CSFB. Source: IEA, CSFB.

Refining Capacity
Global refining capacity Using the BP Statistical Review 2001 as a guide, we estimate global refining throughput
utilization has average capacity to be over 81MMBD, clearly in excess of the 76MMBD global oil demand. Over
83% over the past the past ten years global capacity utilization has averaged 83% with most of the excess
ten years capacity located in Asia, Europe, and the FSU while the U.S., the biggest product
consumer, has had a relatively high utilization rate. (See Exhibit 18.)

24
Oil and Gas Primer 14 May 2002

Exhibit 18: Global Refining Capacity Utilization, Ten-Year Average, Weighted

C a p a c ity U tiliz a tio n

100%

94%
90%
88%
86%
83%
81% 81%
80%

60%
56%

40%
N o rth S . & C e n t. E u ro p e F o rm e r M id d le E a s t A fr ic a A s ia P a c ific G lo b a l
A m e r ic a A m e r ic a S o v ie t U n io n

Source: BP Statistical Review of World Energy 2001, CSFB estimates.

The capacity glut in Asia and Europe has been negative for refining margins in those
Refining margins are the
areas over the past five years, whereas margins in the U.S. have moved higher than in
number one indicator of
the first part of the 1990s. (See Exhibit 19.) Refining margins, which are widely
the health of the refining
published by various industry trade papers and magazines, are the number one
business
indicator of the health of the refining business. We discuss refining margins in greater
detail in the Downstream section. Below, we show historical refining margins for the
three major markets: U.S. Gulf Coast, Rotterdam (Northwest Europe [NWE]), and
Singapore.

Exhibit 19: Global Refining Margins

Global refining margins
US$/bbl
and returns have generally
trended lower as a result of
excess capacity NW E G ulf C oast Singapore
$11

$9

$7

$5

$3

$1

($1)
Apr 91 Apr 92 Apr 93 Apr 94 Apr 95 Apr 96 Apr 97 Apr 98 Apr 99 Apr 00 Apr 01 Apr 02

Source: Platt’s Oilgram, CSFB estimates.

25
Oil and Gas Primer 14 May 2002

Product Demand
We list global consumption numbers for the major product families in Exhibit 20. We can
see that consumption of refined products nearly equates the crude oil consumption
figures we presented in Exhibit 12, with minor differences attributable to processing
gains and losses, and inventory changes.

Exhibit 20: Oil Consumption by Products, 2000

million barrels daily

Middle Total
Region Gasoline Distillate Fuel Oil Others Demand
North America 10.0 6.8 1.4 4.1 22.3
USA 8.8 5.8 0.9 3.5 18.9
Latin America 1.3 1.7 0.7 0.7 4.4
FSU 5.5
Europe 4.2 6.6 1.9 2.6 15.3
Middle East 0.9 1.5 1.2 0.6 4.1
Africa 0.6 1.0 0.5 0.3 2.3
Asia-Pacific 5.4 7.7 3.3 3.2 19.6
World Oil Product Demand 22.3 25.3 9.0 11.5 73.5

Source: BP Statistical Review of World Energy 2001, CSFB estimates. Individual product data excludes the
FSU and Central Europe.

We forecast product demand based on expectations for industrial production and GDP
Product demand is driven
growth forecasts as we did for determining crude demand estimates. Overall product
by industrial production in
demand is closely correlated to industrial production, particularly in the U.S. (See Exhibit
addition to GDP growth
21.) Like crude demand, product demand is price elastic. Sustainably high prices curb
consumption while low prices entice consumption.

Exhibit 21: Correlation between U.S. Gasoline Demand and Industrial Production
1 8 0 9 ,0 0 0

1 7 0 8 ,7 5 0

1 6 0 8 ,5 0 0
Industrial Product Index (SA, 1992=100)

Gasoline Consumption (MBD)

1 5 0 8 ,2 5 0

1 4 0 8 ,0 0 0

1 3 0 7 ,7 5 0
2
1 2 0 R = 98% 7 ,5 0 0

1 1 0 7 ,2 5 0

1 0 0 7 ,0 0 0

9 0 6 ,7 5 0

8 0 6 ,5 0 0
1 9 8 5 1 9 86 1 9 8 7 19 8 8 1 9 89 1 9 9 0 19 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 96 1 9 9 7 1 9 9 8 1 9 99 2 0 0 0 20 0 1 2 0 02

In d u s tr ia l P r o d u c tio n In d e x ( 1 9 9 2 = 1 0 0 ) G a s o lin e C o n s u m p t io n

Source: Company data, CSFB estimates.

Consumption of many petroleum products displays seasonal patterns. For instance,

U.S. consumption of gasoline peaks in the summer when most people take vacations
(i.e., the driving season), and demand for middle distillates usually peaks in winter
owing to a rise in demand for heating fuel. Refiners typically adjust their output to offset
changes in these demand patterns, shifting between gasoline or distillate production,
depending on the season. Commensurate with the peak summer driving season, U.S.
refining margins are highest during the second and third quarters and lowest in the first
and fourth.

26
Oil and Gas Primer 14 May 2002

Crude and Product Inventories

Crude inventories lead The difference between production and consumption of crude and refinery products
product inventories by five results in changes to inventory levels. Every week the American Petroleum Institute
to six months (API) reports levels of and changes in U.S. crude and product inventories. Our research
suggests crude inventories lead product inventories by five to six months in the U.S.
(See Exhibit 22, left chart.) European oil stocks data are released on a monthly basis by
the IEA and Euroilstock, while Asia and Latin America stock data are more difficult to
come by—the level of coordination and sophistication of data collection are less robust
than in the U.S. and Europe. Data from these regions largely come from national oil
companies, quasi-government agencies, and estimates from local industry sources.

Exhibit 22: U.S. Crude and Product Inventories and Refining Margins

Crude Inventories lead Product Inventories US Refining Margins correlation to Product Inventories
25% Gasoline & Distillate weighted average deviation from mid-cycle inventory levels
Crude Product 40% ($10)
Deviation from mid-cycle level of 3-2-1 Gross refining margin ($/bbl)
20%
($8)
30%
15%
($6)

% from 5-yr avg level

$/bbl inverse RH scale

20%
10% ($4)
5% 10%
($2)
0% 0% $0

-5% $2
-10%
-10% $4
-20%
-15% $6
-30%
-20% 66% correlation $8
Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02
Jul-90

Jul-91

Jul-92

Jul-93

Jul-94

Jul-95

Jul-96

Jul-97

Jul-98

Jul-99

Jul-00

Jul-01

-40% $10
Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02

Source: Company data, CSFB estimates.

Industry turnarounds or Inventory levels are also a major factor behind refining margins in addition to and
maintenance, which takes related to throughput capacity, demand growth, and seasonal patterns. Below-average
capacity offline, also inventories tend to result in above-average margins and vice versa. The right chart in
impact inventories and Exhibit 22 shows the correlation of U.S. refining margins to changes in inventory levels
product pricing from 1998 through early 2002. As the chart shows, inventories were below historical
norms from mid-1999 through mid-2001, leading to extremely high refining margins
(inverted scale).

The level of industry turnarounds can have a sizable impact on inventories, as they
reduce available refining capacity. Given the level of intensity refinery equipment
operates under, refiners must take plants offline (turnaround) to fully repair damaged or
rundown machinery in order to maintain optimum operating productivity and optimum
safety levels. Refinery operators typically schedule turnarounds up to several months in
advance, and most often schedule for periods expected to have low demand when
product prices are lowest.
Commensurate with our evaluation of the global oil market, including oil products, is our
analysis of the natural gas markets. While different commodities, they both serve the
same end markets and can be substituted for one another in various applications. This
substitution or arbitrage factor limits oil and gas prices from decoupling over extended
periods of time. We discuss natural gas markets in the next section.

27
Oil and Gas Primer 14 May 2002

Natural Gas Markets

In the Oil Markets section we presented the global oil reserves landscape and
production trends, and described our forecasting methods for the macro oil
environment: supply and demand, leading indicators, inventories, and capacity
utilization. However, we spent little time addressing natural gas markets.
The gas business is The gas business is regional owing to the limitations of regional infrastructure, regional
regional owing to the transportation (i.e., gas does not go easily on/in a ship), and regional currency pricing.
limitations of regional While there is not yet a global gas market comparable with the oil market, technologies
infrastructure, regional that convert natural gas into liquefied natural gas (LNG) or natural gas-to-liquids (GTL)
transportation, and have made major inroads to establishing the long-haul transportation for stranded
regional currency pricing natural gas reserves. Several Integrateds, Gas and Power companies, and Independent
E&Ps are currently attempting to increase the viability of each technology to facilitate
global trade.
The aggregate global The aggregate global value of natural gas markets is approximately $200 billion per
value of natural gas year based on recent demand of 232 bcf/d and average recent prices of $3.00/mcf. The
markets is approximately U.S. is the largest single wholesale producer market, at $75-plus billion, accounting for
$200 billion per year based 33% of the aggregate global market. We expect global natural gas use to increase in
on recent demand of the coming years for the reasons we discussed plus gas’s clean environmental
232 bcf/d and average attributes relative to other fuel sources, and its abundant, relatively untapped reserve
recent prices of $3.00/mcf base. Additionally, oil and gas companies worldwide project their natural gas production
profiles to increase at higher rates than their oil growth rates in the years to come.

Given the regional nature of the natural gas market, we introduce the business in terms
of global reserves and supply/demand to provide a framework; however, we will focus
on the North American market, which is the most definable single marketplace. Keep in
mind that the analysis of the oil markets serves to underpin and support our forecasts
and outlook for the natural gas markets.

Global Natural Gas Supply and Demand Framework

The Middle East, the FSU, The distribution of global proved natural gas reserves is somewhat different than the
and Africa contain the distribution of the world’s proved oil reserves. (See Exhibit 23.) While the Middle East is
largest amount of global again the leader, its reserve base is not nearly as dominant as in oil reserves, which, as
proved natural gas we discussed, is 10 times larger than the next closest region, Latin America. The Middle
reserves; however, East has an estimated 2,464 trillion cubic feet (Tcf) (68.9 trillion cubic meters [Tcm]) of
production is dominated by proved reserves, followed closely by the FSU—led by Russia—at 2,047Tcf (56.8Tcm).
North America The third largest reserve region, Africa at 395Tcf (11.2Tcm), is a sharp drop-off from the
Middle East and the FSU.

The natural gas production profile is vastly different than the proved reserves profile as
was the case with global oil reserves and production. (See Exhibit 24.) North America
produces 72 bcf/d, followed by the FSU at 70 bcf/d. The FSU production profile matches
nearly perfectly to the oil production profile that shows a sharp drop in production
following the collapse of the Soviet Union. We believe this trend has bottomed and has
begun to reverse, and we anticipate gas production to increase in the coming years
following heavy investment in the upstream sector in the latter half of the 1990s and into
the 2000s. Western Europe, while resource poor compared with the other regions of the
world, has the third highest natural gas production, at 27 Bcf/d, as befits a mature

28
Oil and Gas Primer 14 May 2002

producing and consuming market. As the natural gas business becomes increasingly
global, albeit at a slow pace, through the application of new technologies, and distant
sources of supply become more heavily relied upon to meet growing demand, we
expect the Middle East, Africa, and Asia-Pacific to supply an increasing amount of the
world’s gas needs.
The world’s consumption The world’s consumption makeup closely follows the production profile, with North
makeup closely follows the America, FSU, and Western Europe making up the majority of total global demand.
production profile, with (See Exhibit 24.) The charts also demonstrate that North American supply and demand
North America, FSU, and is relatively well-balanced, while the FSU has excess production, which can be
Western Europe making exported. Europe, however, has faced an increasing supply deficit for the past 20 years.
up the majority of total
global demand

Exhibit 23: Global Natural Gas Proved Reserves, 2000

Source: BP Statistical Review of World Energy 2001.

29
Oil and Gas Primer 14 May 2002

Exhibit 24: Global Natural Gas Production and Consumption

bcf/d

Production Consumption

90 90

80 80
FSU/E. Europe FSU/E. Europe
70 70

60 60
North America North America
50 50

40 40
W. Europe
30 30
W. Europe Asia-Pacific
20 20 Middle East
Asia-Pacific Middle East
Latin America
10 Africa 10
Latin America Africa
0 0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Source: BP Statistical Review of World Energy 2001, CSFB estimates.

Before fully addressing the North American natural gas market, we briefly discuss the
two other regional markets—Europe and Asia-Pacific. Europe, with a long-time focus on
oil projects, has fewer natural resources on the continent than other regions and is
faced with a maturing North Sea. Given Europe’s focus on oil investments, there exists
a limited infrastructure to transport natural gas from distant sources (FSU, Middle East).
Further hindering the development of the natural gas business in Europe has been the
balkanized markets and natural gas pricing mechanisms. Until 2000, natural gas prices
had been tied to oil prices, limiting competitive pricing mechanisms and free market
dynamics. European E&Ps have undergone significant consolidation, largely into bigger
Integrated Oils companies, and the industry offers little to investors in terms of supply
growth potential and equity market opportunities.

Asia-Pacific is altogether a different story than the North American and European
markets. It is a geographically diverse market, making transportation from supply source
to end-market difficult and costly. Natural gas price regulation throughout Asia-Pacific
has also been an issue similar to that in Europe. Oil consumption/reliance makes up a
greater percent of overall energy consumption than in North America and Europe,
leading to a currently small end market for gas. Despite these challenging dynamics, the
resource base is substantially greater than in North America and Europe and is also
less developed than the other regions. Furthermore, natural gas discoveries have
occurred at an increasing rate the past ten years and there has been substantial
progress in infrastructure investments, which should serve to change the oil
dependence dynamic in the future.

30
Oil and Gas Primer 14 May 2002

North American Natural Gas Market

North America is the Given its maturity, the level of oil and gas consumption, free market structure, and the sheer
largest single natural gas number of publicly traded Independent companies, the North American market is the
market based on the level largest natural gas market. We estimate the North America wholesale market to be a
of oil and gas roughly $75-plus billion annual market based on recent gas prices of $3.00/mcf and
consumption, free market annual U.S. and Canadian production of 72 bcf/d. The market is driven by the U.S., which
structure, and the sheer accounts for over 50% of supply and over 80% of consumption. This U.S. supply/demand
number of publicly traded imbalance leads to a very large role for Canada in meeting U.S. gas needs. We formulate
Independent companies supply and demand estimates for the U.S. and Canadian markets and resultant price
expectations based on several factors, including current inventories, seasonal demand
patterns, productive capacity, competing fuels prices, and marginal costs. (See Exhibit 25.)

U.S. Natural Gas Supply

Beginning with productive capacity, we determined that wellhead utilization has been
running near 100% for the past few years and stands to remain at full capacity in the
years to come. This high utilization rate is directly related to demand growth outstripping
supply growth and a lack of opportunities to dramatically increase supply given the
maturity of the U.S. market. Prices have risen through the time period as a result. High
utilization has not only pushed up gas prices, but has forced producers to search for
new ways to increase capacity (i.e., unconventional sources, marginal wells).
Given resource constraints In addition to high productive capacity utilization rates, the U.S. market is characterized
in the U.S., we expect by high decline rates (i.e., the rate of reserve decline in the first year of production is very
imports from Canada and high). The maturity of the U.S. market limits producers’ ability to increase traditional sources
LNG imports from around and has forced them to take on nontraditional, riskier, costlier sources of natural gas
the world to counter exploration and development. These nontraditional sources of gas production include
increasing supply deficits coal-bed methane, coal seams, shallow gas, and natural gas hydrates. Despite efforts
to increase domestic reserves through nontraditional sources, imports have become an
important source of U.S. natural gas needs. Imports account for 18% of U.S. demand
and are growing, with Canada making up the vast bulk of the import load. In addition to
increased Canadian pipeline imports from recent infrastructure builds, liquefied natural
gas has increased as an import source.

Exhibit 25: CSFB U.S. Supply-Demand Model

bcf/d, unless noted otherwise

Supply 1999 2000 2001 2002E
U.S. 51.0 50.1 50.9 50.1
Canada and Other (LNG) 9.4 9.7 10.5 10.8
Total Supply 60.4 59.8 61.4 60.9
U.S. % change -0.5% -1.7% 1.5% -1.5%
Canada & Other % change 14.3% 3.4% 8.3% 2.5%
Total supply % change 1.6% -0.9% 2.6% -0.8%
Demand 59.5 62.3 60.0 60.5
% change 2.1% 4.8% -3.6% 0.8%
Wellhead Utilization 98.4% 104.1% 97.8% 99.4%
Excess capacity (bcf/d) 0.9 (2.5) 1.4 0.4

Net storage change (bcf/d) (207) (845) 817 200

Storage change (bcf/d) (0.6) (2.3) 2.2 0.5
Effective utilization 97.5% 100.2% 101.4% 100.3%
Source: CSFB estimates.

31
Oil and Gas Primer 14 May 2002

Given the increasing U.S. supply shortfall and higher U.S. gas prices, we expect the
once cost-prohibitive LNG to become a bigger source in the coming years, with Africa,
Asia-Pacific, and Latin America becoming prominent LNG suppliers. The LNG business
represents the first steps in the globalization of the natural gas business. The ability to
transport LNG long haul in tankers provides a major outlet for stranded gas reserves in
remote areas.
U.S. gas prices, similar to U.S. gas prices, similar to oil prices, are negatively correlated to inventories, as Exhibit
oil prices, are negatively 26 demonstrates. As inventories shrink from surplus to deficit, gas prices rise. In Exhibit
correlated to inventories 26, we graph the 12-month strip price to inventory changes (inverted) to understand the
near-term outlook for price expectations, not simply the current physical spot price.

Exhibit 26: U.S. Natural Gas Storage versus 12-Month Natural Gas Strip Prices
-1,000 $7
Y-o-Y Change Strip

$6
-500
Y-o-Y Inventory Change (Bcf) Inverted

$5

Natural Gas Price ($/mcf)

0
$4

$3
500

$2

1,000
$1

1,500 $0
Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr-
95 95 96 96 97 97 98 98 99 99 00 00 01 01 02

Source: EIA, Reuters, CSFB estimates.

The 12-month strip is an average of the 12-month futures curve and is driven to a large
degree by the current inventory picture and current demand; however, the back end of
the futures curve is driven more by expectations several months to a year or two out.
This set of expectations impacts our supply forecasts because strip pricing is a valuable
tool for producers that plan to raise production levels in an attempt to take advantage of
high strip prices or lower production to wait for inventories to return to normal. Gas wells
take much less time to drill and bring to market than oil projects, and producers can
make decisions that impact the market in a short time period.
High North American The big jump in U.S. natural gas prices over the past two years has been characterized
decline rates, low by a period of inventory deficits, increased demand, and diminished supplies. U.S.
inventories, and higher production has not kept pace with consumption, and new discoveries have been hard to
demand have led to higher come by. The reserve life (reserve base/production) for the U.S. has been flat to
gas prices declining for years. Canadian production and increased export capacity, which have
both increased over the past decade, have eased the U.S. supply burden, but Canada

32
Oil and Gas Primer 14 May 2002

also faces a declining reserve life. Canadian reserve life has fallen from 20 years in
1990 to just under 10 years in 2000, very close to the U.S.’s 9-year reserve life. (See
Exhibits 27-28.)

Exhibit 27: U.S. Production and Reserve Life Exhibit 28: Canada Production and Reserve Life
20,000 14 7,000 35.0

18,000
12 6,000 30.0
16,000
10

Reserve Life (Years)

14,000 5,000 25.0
Production (Bcf)

Reserve Life (Years)

Production (bcf)
12,000
8
10,000 4,000 20.0

6
8,000
3,000 15.0
6,000 4
4,000 2,000 10.0
2
2,000
1,000 5.0
0 0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
- 0.0

1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
U.S. Production U.S. Reserve Life

Source: EIA, CSFB estimates. Source: CAPP, CSFB estimates.

U.S. Natural Gas Demand

U.S. natural gas demand is We can broadly define four types of end markets: commercial, industrial, residential,
driven by the Industrial and and electric generation. The U.S. natural gas business is driven by industrial (41%) and
Residential sectors residential (22%) demand.

Exhibit 29: U.S. Natural Gas Market Statistics

Industry Uses Composition of Natural Gas Demand, % based on Tcf

50%
space heating, water heating, cooking, air
Residential
conditioning, appliances 41%
40%

Commercial heating, ventilation, air conditioning 30%

22%
20%
15%
process heating, cooling, refrigeration, 13%
Industrial
machine drive, on-site electricity generation
9%
10%

0%
feedstock, process heating, electrochemical
Electric Generation Industrial Residential Commercial Electric Other
processes
Generation

Source: EIA, CSFB estimates.

33
Oil and Gas Primer 14 May 2002

As U.S. natural gas is largely used for heating and cooling, the business has
traditionally been very seasonal. (See Exhibit 30.) One noticeable trend, dating back to
the early 1990s, is the higher rate of consumption through the summer periods. This has
largely been a result of increased electric generation sector demand for natural gas. A
large base of new gas-fired electric generators were built in the 1990s leading to
increased natural gas use for generators meeting air conditioning and cooling needs in
the summer months.

Exhibit 30: Seasonality of Natural Gas Demand

90.0

80.0 Consum ption

Production+Im ports
Bcf per day

70.0

60.0

50.0

40.0
Jul-91

Jul-92

Jul-93

Jul-94

Jul-95

Jul-96

Jul-97

Jul-98

Jul-99

Jul-00

Jul-01
Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01
Source: Company data, CSFB estimates.

Another piece of the gas price forecast puzzle is the price of competing fuels, largely oil
products. Natural gas competes with fuel oil for electric generation and industrial use
and as well as with heating oil for residential, industrial, and commercial heating needs.
While only a certain amount of capacity in the electric generation and industrial markets
is able to switch from one fuel source to another, long-term arbitrage possibilities exist if
prices remain disparate over extended periods of time.

Exhibit 31 charts recent competing fuel prices and the long-term comparison of WTI to
natural gas. Heating oil has historically commanded a premium to natural gas as
evidenced by the first chart, whereas resid and natural gas have tended to move
together. The late-2000 to early-2001 period when natural gas prices increased to the
highest levels ever represented the greatest historical gas premium pricing versus
competing fuels and was the only time in the past decade that gas traded at a premium
to WTI. (See Exhibit 31, right-hand chart.) The WTI premium to natural gas has
gradually declined over time and we expect this trend to continue.

34
Oil and Gas Primer 14 May 2002

Exhibit 31: Competing Fuel Prices

Natural Gas versus Heating Oil and Resid (per mmbtu) WTI Premium to Natural Gas (% mmbtu basis)
$12.00 Natural Gas Heating Oil Resid 1.0% 300%

$10.00

$8.00 200%

$6.00
100%
$4.00

$2.00
0%
$0.00 Mar- Mar- Mar- Mar- Mar- Mar- Mar- Mar- Mar- Mar- Mar-
Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 92 93 94 95 96 97 98 99 00 01 02

Source: Reuters, CSFB estimates.

The final component to our gas price forecast is our analysis of the marginal cost of
production. Similar to applying the cost structures of the Integrated Oils to develop a
marginal cost curve for oil, we use U.S. Independent E&P cost data to construct a
natural gas marginal cost curve. (See Exhibit 32.)

Exhibit 32: U.S. Natural Gas Marginal Cost Curve, 2001

$4.00

$3.50

$3.00

$2.50

$2.00

$1.50

$1.00
NFX
1999 Ave.

2000 Ave.

2001 Ave.
SKE

FST
DVN

CHK

EOG

COG
APC

SGY

BR

THX

Source: Company data, CSFB estimates.

Using the above data (production, consumption, seasonality, inventory, resource

potential, market uses, competing fuel prices, marginal cost curve), we formulate a price
forecast for Henry Hub (U.S.) and Alberta (Canada) gas. We believe limited U.S. supply
growth and higher demand will likely lead to higher natural gas prices as producers seek
marginal, more costly, nontraditional sources of production. These nontraditional
sources will continue to grow and support higher prices. The resulting higher price
environment will make distant sources of natural gas more cost competitive (LNG, GTL).
An increasing import environment will facilitate the globalization of natural gas and allow
countries with excess natural gas supply to monetize gas assets.

35
Oil and Gas Primer 14 May 2002

The Upstream
The upstream business The upstream business is the largest part of the oil and gas chain in terms of net sales
involves Integrated Oils and net profits, returns performance, and security market liquidity. The business
and Independent E&P involves the finding, developing, and producing of oil and gas. Private (i.e., nonnational
companies involved in oil company) oil and gas producers fall into two general categories or business models:
finding, developing, and Integrateds, which participate in each part of the energy chain from production through
producing hydrocarbons, retail distribution, and Independent Exploration and Production companies, which solely
and Oilfield Service pursue production opportunities. A third party involved in the upstream process is the
companies Oilfield Services and Equipment industry, which provides producers the necessary
products and services to find, develop, and produce oil and gas as efficiently and as
cost effectively as possible. In this section, we explain the economics of the upstream
business as they pertain to producers. We address the Oilfield Services and Equipment
industry in a later section.

Value Creation
Producers create value by Producers create value by adding oil and gas reserves to the balance sheet, and by
adding low-cost oil and gas producing and selling these to generate a return above the cost of capital. Oil and gas
reserves to the balance reserves represent the true, tangible value of a company. Profitably adding reserves
sheet and by increasing increases the producer’s net asset value. This is why large discoveries can have such a
production while dramatic impact on the valuation of a producer, and depending on the size of the new
maintaining return resource relative to the existing company, can be a transforming event or “company
on capital maker.” Producers add reserves in several ways: through drilling (by the drill-bit), and
through reserve acquisitions, either by acquiring fields (properties) or acquiring whole
companies (M&A).

The preferred or more profitable method to achieving reserve growth at a given time
depends on the stage of the oil cycle and the relative cost of pursuing each strategy.
Cyclical peaks coincide with peak equity valuations, making equity acquisitions costly in
absolute terms and generally in relative terms when compared with the cost of
increasing reserves through the drillbit (i.e., organic growth). The cost of pursuing an
aggressive drilling program depends on the degree of access to new sources of oil and
gas reserves, the level of oilfield service costs, and the ability of service companies to
meet demand. In cyclical trough periods, equity valuations become depressed,
generally to a level below the cost of adding reserves through the drillbit. Reserve
acquisitions through property acquisitions or equity merger and acquisition activity are
thus optimal during periods of depressed valuations (i.e., low commodity price
environment).
Producers add reserves In Exhibit 33, we chart the values of each type of method using a universe of Canadian
several ways through the Independent E&Ps and Integrated Oils. The chart clearly shows how commodity prices
drillbit (organic growth), and equity prices rise and fall within a fairly close time period while finding and
and through acquisitions development (F&D) costs remain sticky, or maintain high levels despite deteriorating
(either property pricing environments. In the late-1997 to early-1999 downturn, finding and developing
acquisitions or equity costs were substantially higher than property acquisitions and equity acquisitions—a
mergers and acquisitions) period where drilling activity fell sharply and merger and acquisition activity increased. In
the most recent cycle from trough levels in early 1999 to peak conditions in mid-2000,
mergers and acquisitions were the cheapest method of adding reserves early in the
cycle, before commodity prices and stock prices ran higher.

36
Oil and Gas Primer 14 May 2002

Exhibit 33: Reserves Growth Opportunities

$13

$29
$11

$10.25

$24

$/BOE of Edmonton Par Equivalent

$9 $9.50

WTI Oil Price

$7.32
$19
$7

$5 $14

WTI Oil Price (Right) M&A (EV) Property Acq. Drilling (F&D)
$3 $9
Feb-98

Feb-99

Feb-00

Feb-01
Dec-97

Apr-98

Jun-98

Aug-98

Dec-98

Apr-99

Jun-99

Aug-99

Dec-99

Apr-00

Jun-00

Aug-00

Dec-00

Apr-01

Jun-01

Aug-01
Oct-97

Oct-98

Oct-99

Oct-00

Oct-01
Source: CAPP, CSFB estimates.

A production company or upstream operation can be considered an asset gatherer,

because it is a collection of properties, wells, and fields. Each well is part of a specific
field and each field has specific characteristics or profiles (amount of reserves, type of
reserves, cost structures, timelines, production rates, decline rates). The fields are then
aggregated into a portfolio, which is the production operation. The portfolio concept is
important in valuing whole upstream businesses.
The intrinsic value of a The intrinsic value of a producer is the discounted free cash flow or net asset value
producer is the discounted (NAV) of all fields. A discounted cash flow can be constructed for each field using
cash flow or net asset estimates for oil prices, production rates, finding and development costs, production
value (NAV) of all fields costs, and time frames for the phases of the cycle (from exploration to abandonment).
currently producing and The aggregate sum of the discounted cash flows is the portfolio value of the assets
expected to produce in the (fields). Conceptually, a producer is similar to an investment manager. Both run diverse
future portfolios of assets (stocks, fields) with different risk levels, payout schemes, and
timelines. Both evaluate the assets in a portfolio context (in relation to one another), not
in isolation.

In a commodity industry where all producers are price-takers, returns across companies
are principally generated by different cost structures. A large driver of cost structures is
the degree of difficulty in finding and producing the commodity. For example, easy-to-
find-and-produce oil and gas will normally have lower costs than E&P projects in un-
proven, undeveloped, and remote areas.

An additional and very important consideration to the value-creation potential and

economics of upstream projects is the type and nature of contracts producers agree on
with host governments, which are often protective of domestic natural resources. Oil
and gas resources represent a large source of revenue for many developing countries.

37
Oil and Gas Primer 14 May 2002

Therefore, many governments view the control of domestic oil and gas resources as a
matter of national security and prohibit or limit foreign ownership of oil and gas assets.
Countries that limit foreign ownership but lack national infrastructure to develop oil and
gas assets may partner with more capable foreign producers. These international E&P
arrangements come in many forms and are often more complex than the traditional E&P
leases and working interest arrangements, which we will be focusing on throughout this
report.
Governments and Governments and producers can form several different types of partnerships or
producers can form agreements to explore for and produce oil and gas:
several different types of
• Concession agreement. Government grants a permit allowing the producer to explore
partnerships or
for oil and gas for a fixed time period and to develop any found reserves through the
agreements to explore for
life of the discovery. The producer agrees to pay the government a percentage of the
and produce oil and gas:
profits, a flat bonus, or a royalty payment, or production tax. In a concession
concession agreements,
agreement, the government will not have any role in operations and the foreign
joint venture agreements,
producer takes economic ownership of the assets.
or PSCs
• Joint venture agreement. Government-controlled or state-owned oil company partners
with a foreign producer, with the foreign producer bearing exploratory costs and risks.
• Production sharing contract (PSC). Foreign producers agree to spend a specified
amount of money on exploratory operations over a predetermined time period;
however, the government retains ownership of discovered reserves. The foreign
producer is entitled to a share of production proceeds that may be tied to oil prices
and production levels.
Each of these types of arrangements shifts the risk and return balance from one party to
another. The producer and the host government need to come to terms that are
acceptable to both parties so that the economic benefit of undertaking a project(s) is
acceptable to each.

In order to more fully understand the value drivers (returns, cost structures, reserve and
production growth) within the upstream, it is necessary to discuss the E&P process from
beginning to end.

The E&P Process

The E&P process The E&P process comprises five major phases and each of these phases has its own
comprises five major identifiable cost structure and timeline. The timing of the E&P phases is an important
phases and each of these part of the financial planning of a producer because of the potentially long lead times
phases has its own from initial capital expenditures to cost recovery through the sale of the oil and gas.
identifiable cost structure
As Exhibit 34 shows, the exploration through development phases could take three
and timeline
years or more of capital spending before production comes online and producers begin
receiving cash inflows. Given these lead times, producers need to carefully evaluate
and analyze the economics of a field to ensure the profitable recovery of costs and the
generation of adequate returns on capital. The most important considerations for
producers include the following:

• estimated acquisition and finding costs;

• quantity of recoverable oil and gas;

38
Oil and Gas Primer 14 May 2002

• estimated development costs;

• timing of future production;

• estimated production costs; and

• estimated future oil and gas sales prices.

We illustrate the flow pattern of the cost and value structure as it matches the upstream
process in Exhibit 34.
Cost structures can be • Acquisition costs are the costs of acquiring an economic interest for the right to
divided into exploration explore, drill, and produce oil and gas.
costs, development costs,
• Exploration and appraisal costs represent the costs involved in identifying prospects,
production costs, and
seismic costs, and exploratory drilling costs. These are also known as finding costs.
decommissioning costs
• Development costs are the costs of development planning, reservoir modeling and
optimization, well design plans, drilling and completion of wells, and installing the
gathering and processing infrastructure. Exploration costs are often linked to
development costs and the two are referred to as finding and development costs
(F&D).

F&D costs are a significant part of the cost structure for producers, and are largely
comprised of drilling (development) costs. They also provide a key metric for evaluating
operating and financial performance.
• Production costs are the costs associated with lifting the oil and gas to the surface
and gathering and processing the hydrocarbons for transportation. Depreciation,
depletion, and amortization (DD&A) costs are often added to or incorporated in
production costs given that capitalized F&D costs represent the asset value of
reserves on the balance sheet. We provide an example of this concept on page 42.
• Decommissioning and abandonment costs are the costs involved with plugging and
abandoning (P&A) a dry-hole appraisal well or a mature field that is no longer in
production.

Each of the above costs varies depending on the field characteristics (type of rock
formation, the porosity, and permeability), location of the field, and supply and demand
for drilling rigs and drilling services. High porosity, high permeability fields are less
expensive than low porosity, low permeability fields because they require less extensive
extraction methods—the abundance of hydrocarbons and the natural pressures force
the hydrocarbons to the surface. Periods of high drilling activity lead to high rig
utilization rates and increased costs for drilling services, pushing drilling costs higher.

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 Oil and Gas Primer
Exhibit 34: E&P Process

Land Acq. & Exploration Appraisal Development Production & Maintenance Abandonment

Prospect Target Acquire Appraisal Drill Appraisal Test Design Fabricate Install Produce Maintain Abandonment

Prospect identification & evaluation

Identify potential partners

40

Geological & Geophysical data interpretation

Finalize partnership (JV’s, PSC, Concession) agreements

Manage drilling operations

Reservoir appraisal

Economic appraisal

Development plan

Implement plan & Install Infrastucture

Ongoing Operations

1–2 3-4 4–5 5 - beyond

Time (Years)

14 May 2002
Source: Company data, CSFB estimates.
Oil and Gas Primer 14 May 2002

Equally important to the In addition to accounting for the costs of the E&P process on the income statement,
recognition of costs is the producers capitalize the cost of finding and developing reserves on the balance sheet.
estimated quantity and These capitalized costs represent the asset value of the reserves. Producers also
value of discovered record the estimated quantity and value of discovered reserves as a supplement to their
reserves recorded as a financial statements. There are several ways for a producer to recognize reserves:
fixed asset on the balance
• Proven reserves (P1). Estimated quantities of oil and gas, which are reasonably
sheet
certain (90% probability or P90) to be recovered as certified by geological and
engineering data.
• Probable reserves (P2). Estimated quantities of oil and gas, which have a better-than-
50% probability (P50) of being recoverable.
• Possible reserves (P3). Estimated quantities of oil and gas, which have a 10%
probability (P10) of being recoverable.
• Proven developed reserves. Estimated quantities of oil and gas, which are expected
to be recovered from existing wells, existing equipment, and/or improved recovery
techniques.
• Proven undeveloped reserves. Estimated quantities of oil and gas, which are
expected to be recovered from undrilled acreage, existing wells that require large
recompletion work, and improved recovery techniques.

The process of assigning a monetary value to the reserves differs from country to
country. In the U.S., only proven reserves can be stated in the reserves accounts, while
in the U.K., values can be recorded for all types of reserves, but generally only P1 and
P2. Reserves are valued using current market prices and revalued every quarter or
year-end to account for revised reserve estimates, extensions, discoveries, and other
additions, purchases, and sales. When the market prices fall below the recorded book
value of the reserves, producers must write down the value of the asset base to current
market expectations (ceiling test write-down).

The fixed asset amount producers book on the balance sheet is based on the respective
reserve level and current market prices. The concept of booking reserves is important in
the valuation of producers because some producers may be more conservative (only
book proven reserves) than others that book proven, probable, and/or possible
reserves. Not all asset values are created equal; accounting vagaries can distort the
picture of a producer’s true net asset value.

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Oil and Gas Primer 14 May 2002

Economics of One Barrel of Oil

In Exhibit 35 we provide an example of how one barrel of oil is accounted. Additionally,
we include a return on capital employed (ROCE) calculation to demonstrate the
economics of a barrel of oil.

Exhibit 35: Economics of One Barrel of Oil

capex $/bbl
Unsuccessful exploration 1.00

a Successful exploration 1.00 Balance sheet

b Development costs 3.00
a+b 4.00 4 Cost of unit addition to fixed assets

Profit and loss

Sale of barrel 20.00
Royalty/production tax -1.00
Production cost -4.00
Depreciation -4.00
Exploration expense -1.00
Operating income/ EBIT 10.00
Income tax @35% -3.50
Net profit 6.50 10 Reserve life ie how many units left for each unit produced

x Net profit 6.50

y Capital exmployed 40 40 Capital employed = actual cost of adding barrels to reserves

x/y Return on capital employed 16.3%

Source: CSFB estimates.

The example follows the beginning of the E&P chain—a producer has a capital
expenditure budget to find oil and gas. Successful exploration and development costs
are capitalized on the balance sheet and dry-holes (unsuccessful exploration) are
expensed immediately (under successful efforts accounting). The successful exploration
and development costs added together (a + b in Exhibit 35) represent the cost of adding
one unit to the reserve base.

In the example above, F&D costs are $4.00 per barrel as is the DD&A, which is
expensed on the income statement. Since F&D costs are added to the historical cost
base, each time a barrel is sold, it must be removed from the balance sheet (i.e.,
depreciated). The F&D costs represent an approximation of depreciation rates (DD&A)
in real world scenarios. They are not exact as we show in this example. This is primarily
because F&D costs decrease over time because of new technology, while DD&A rates
are averaged throughout the reserve lifetime. F&D costs are evaluated on three- to five-
year averages to smooth out potentially wide varying yearly numbers.
In the example, the producer has a $4.00 F&D cost structure and has successfully
found 10 barrels (10-year reserve life = 10 barrels of reserves divided by 1 barrel per
year production). The capital employed therefore is $40 ($4.00 F&D x 10 barrels). The
return on capital employed is the net profit per barrel, $6.50, divided by the capital
employed (cost of finding and developing all barrels, $4.00 x 10 = $40/bbl), or 16.3%.

Applying recent Integrated Oils industry cost structures helps to frame the discussion. In
the overall F&D cost component, development costs are substantially higher than the
finding cost component, as Exhibit 36 demonstrates. Over the past ten years, finding
costs have accounted for roughly 25-30% of the overall F&D component despite a
general decline in industry finding costs from nearly $2.00 per barrel in the early 1990s
to about $1.25 the past few years. Development costs have substantially varied from
year to year but have also declined from over $6.00 in the early 1990s to the $4.50-5.50
range recently.

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Oil and Gas Primer 14 May 2002

Exhibit 36: Global Integrated Oils F&D Costs Exhibit 37: Global Integrated Oils Lifting Costs
US$ per barrel US$ per barrel

8.00 7.78 10.00

5.71
5.62
7.21
4.83
4.96 4.67 4.58
6.54 4.58 4.82
6.33 4.23
6.19 8.00
6.00 3.85
5.56 5.59

5.11
4.95
6.00
4.32

4.00

4.00 3.84 3.78 3.67 3.67

3.63 3.57 3.56
3.45 3.36 3.47

2.00
2.00

0.00 0.00
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Finding Finding & development Reserve replacement DD&A OPEX

Source: Company data, CSFB estimates. Source: Company data, CSFB estimates.

Production costs (Exhibit 37) have also declined in the past ten years, from over $5.00
per barrel to about $4.00, while depreciation rates have remained fairly constant in the
mid to high $3.00 range. Depreciation rates (DD&A) are the total F&D cost divided by
the estimated recoverable reserves. As we discussed, F&D costs should serve as a
proxy for DD&A rates, as they represent the book value of oil and gas reserves sold. An
additional type of cost we have yet to discuss is reserve replacement costs. Reserve
replacement costs measure the total cost of adding reserves, both from drilling and from
acquisitions. Finding and developing costs plus acquisition costs divided by the net
reserve additions (i.e., reserve adds less production) provide the reserve replacement
cost on a per barrel basis. These cost measurements are key operating and financial
metrics for evaluating and comparing oil and gas equities.
The sale of oil and gas production represents the revenue line and is highly affected by
commodity prices and cost structures—namely, commodity prices need to be higher
than the all-in costs associated with producing a barrel of oil or a million cubic feet
(mmcf) of natural gas. Higher production growth rates leading to higher sales combined
with low cost structures enable higher returns performance. Production growth rates will
vary from company to company; however, in aggregate the global supply growth rate is
historically a small 1-2%. This is why cost structures are so important. Given a low
production growth rate and equivalent exposure to commodity prices, differential returns
between companies lie within their cost structures.

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Oil and Gas Primer 14 May 2002

The Downstream
The downstream business comprises refining, marketing, chemicals, and
petrochemicals. We will concentrate on the largest, traditional sector within the energy
business—refining and marketing (R&M). Integrated Oil companies and Independent
Refiners are the main participants in the business. The biggest difference between
Integrated companies’ refinery operations and Independent Refiners’ operations is that
Integrateds have the ability to supply their refinery operations with their own equity
crude supply, while Independent Refiners must purchase crude supplies from
producers. This leaves Independent Refiners open to crude price spikes and potential
supply problems. A benefit, however, is the opportunity for Independent Refiners to
procure crude supply from different producers as well as to shop for the best possible
crude price.

While often referred to in the same breath, refining and marketing are two distinct
businesses with distinct economics and returns potential. The refining business is the
bigger profit center of the refining and marketing complex, and it generally garners
higher returns, albeit at a greater capital commitment. When discussing R&M
operations, it is with a heavily emphasis on the “R.” In this section we will describe how
we evaluate both operations, focusing mainly on refining.

Refining
Refiners create value by Refiners create value by selling refined petroleum products at prices higher than the
selling refined petroleum cost of acquiring crude oil and transforming it into products. The most easily observed
products at prices higher measure of the current health of the industry is by measuring refining margins, or the
than their per-unit capital difference between product sales prices and operating and nonoperating costs including
and operating costs the cost of crude oil as the main input. Refining margins incorporate a number of
important variables. At its most basic, a refining margin, or gross refining margin, is the
difference in the value of the crude oil that goes into a refinery and the products that
come out the other end. The value of the refined products is referred to as the netback.
After subtracting the cash operating costs of a refinery, one is left with a cash refining
margin, sometimes known as an EBITDA margin. The major determinants to refining
margins include the following:
• Cost of crude. Effectively the cost of goods sold. Crude grades (light/heavy,
sweet/sour) have varying price levels and can have a major impact on a refiner’s cost
structure.
• Product prices. Refineries will enjoy higher margins when their production slate is
geared toward higher-valued products (gasoline and distillate versus low-valued
residual).
• Refinery complexity. All refineries have a basic distillation unit, simple refineries have
a distillation unit with few additional units, while complex refineries have additional
refining equipment that allows for increased production of higher-value products and
allows for the processing of different crude grades.
• Regional supply/demand. The cost of crude, product pricing, refining complexity and
capacity, and supply and demand are interrelated.

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Oil and Gas Primer 14 May 2002

Refinery throughput The first step in evaluating a refinery operation is to understand the amount of
capacity and complexity productive capacity, or the throughput of the refinery (refinery runs). The second
are major variables in the variable and arguably the more important variable is the complexity of the refinery. The
value-creation process complexity of a refinery (simple or complex) is directly related to its initial cost to build
and represents the primary level of capital investment on which we base our returns on
capital analysis. Refinery configuration and product price spreads are key determinants
of profitability. The distilling column is the bare essential for a refinery; additional parts—
hydrocrackers, cat crackers, and reformers—are value-added components that allow
refiners to produce higher-end product slates and process different crude grades.

We refer to the different levels of product output as the yield, which we showed in
Exhibit 15. Refiners shift between products depending on market conditions for each
product. This is largely driven by seasonal factors (i.e., U.S. refiners shift production
from gasoline to distillate in September following the end of the summer driving season,
as gasoline demand wanes and distillate demand starts to build ahead of the winter
heating oil season, and vice versa heading into the summer driving season).

The additional parts of a complex refinery can be very costly to install and maintain;
however, they allow a refinery greater flexibility to produce a greater variety of products.
When evaluating refining operations, we analyze the type of refinery, its location and
proximity to market, and the mesh between the product slate and regional demand
patterns. When the spread between light and heavy crudes is high, complex refiners
that process heavy crudes enjoy relative cost savings versus refiners that use light
crude. The same dynamics work in the product markets; wide light-heavy product
spreads generate greater profits for complex refiners that can produce more light
products than heavy products. (See Exhibit 38.)

Exhibit 38: Crude and Product Differentials, Quarterly Average

$0.40 $8

$0.35 $7

$0.30 $6
Gasoline-Resid Spread (US$/gal)

WTI-Maya Spread (US$/bbl)

$0.25 $5

$0.20 $4

$0.15 $3

$0.10 $2

$0.05 $1

$0.00 $0
1Q97 2Q97 3Q97 4Q97 1Q98 2Q98 3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01

Gasoline-Resid WTI-Maya

Source: Reuters, CSFB estimates.

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Oil and Gas Primer 14 May 2002

The different types of refineries lead to simple margins and complex margins. Refineries
of different complexity will give different percentage yields of the various refined
products at the end of the process. This will affect the margin, which a refinery is able to
generate, and for this reason we quote margins for two different illustrative refineries: a
simple plant and a complex plant. The difference between these two essentially comes
down to the yield of the higher-value products, which is greater at a complex refinery.
Both refineries pay the same for the crude input, and despite the higher operating costs
of a complex refinery, this generally means that complex plants generate higher
margins.

This is shown via two examples below. The crude and product prices used are an
average of the prices applicable in April-September of 1998. The first example is for a
simple refinery in Singapore running Dubai crude.

Exhibit 39: Singapore Simple Refining

Singapore sim ple
U S$/bbl D ubai Product O utput C rude G ross O perating C ash
R efined products yield % prices va lue C ost m argin C ost m argin
G asoline 11.9% x 17.39 = 2.07
N aphtha 5.1% x 14.55 = 0.75
Jet/Kerosene 9.9% x 16.43 = 1.63
G as oil 24.4% x 15.36 = 3.74
Fuel O il 46.2% x 10.70 = 4.94
97.5% 13.1 - 12.4 6 = 0.67 - 0.35 = 0.32

Source: Reuters, CSFB estimates.

The product outputs do not add up to 100%, as some energy is used as refinery fuel
and some energy is lost through the various processes. We have not adjusted for
transportation charges on the crude, to simplify the illustration. The simple refiner
produces a large proportion of low-value fuel oil, which reduces the value of the output
or netback.

The next example shows a complex refiner in Singapore running the same feedstock,
Dubai crude, but earning a bigger margin owing to the refinery’s ability to produce more
of the higher-value products and less low-value fuel oil.

Exhibit 40: Singapore Complex Refining

Singapore complex
US$/bbl Dubai Product Output Crude Gross Operating Cash
Refined products yield % prices value Cost margin Cost margin
Gasoline 26.6% x 17.39 = 4.62
Naphtha 7.4% x 14.55 = 1.08
Jet/Kerosene 4.0% x 16.43 = 0.65
Gas oil 38.6% x 15.36 = 5.92
Fuel Oil 22.3% x 10.70 = 2.38
Total % 98.7% 14.6 - 12.46 = 2.19 - 0.45 = 1.74
Source: CSFB

Source: Reuters, CSFB estimates.

The difference in margins is appreciable, but so is the cost of building a complex plant
as opposed to a simple plant. In practice, complex refiners adapt their yield patterns to
suit the market conditions prevailing at the time. The above example is illustrative only,
but will approximate an average year’s yields. Simple refineries are unable to vary their
outputs very much and consequently are more market constrained. The theoretical
returns to a complex versus a simple refinery are usually expressed as the difference
between these two margins.

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Oil and Gas Primer 14 May 2002

Marketing
The Marketing business can be separated into two parts: wholesale marketing and retail
marketing. Wholesale marketing essentially refers to trade with large-scale customers
and trade in global markets or on the various exchanges (NYMEX, IPE). Large-scale
customers may be commercial or industrial users, or wholesale distributors, or even
marketing subsidiaries of the refining operators themselves.
Retail marketing represents the final part of the oil and gas chain. Retail encompasses
the sale of petroleum products to the end-use markets. Unlike the wholesale markets
that involve numerous contract types and product types, retail markets serve end users
on a spot, transactional basis, typically offer only one product, and have a tax
component. For example, we go to retail gas stations to fill our cars with gasoline, we
contact a heating oil company to fill our heating oil tanks, and we go to a propane
distributor to refill our barbecue or cooking fuel tanks. Each transaction is a separate,
taxable event for the consumer. We will concentrate the discussion on the retail
gasoline business, as it is the largest single product business and the one with which
people are most familiar.

Retail margins are the key to profitability in the marketing business. (See Exhibit 41.)
We monitor retail margins (excluding taxes) on a regular basis to gain an understanding
of how marketing operations are performing. The retail business is highly competitive
and operators compete both on price and gasoline quality.

Exhibit 41: Retail Marketing Margins

US Composite: Weekly Conventional Regular Retail Margin (cents/gal) European Retail Margin (cents/gal)
45 5YR Avg 2002 2001 5-Yr Avg 2002 2001
60
40
50
35
30 40
25
30
20
15 20
10
10
5
- 0
Jan Feb Mar Apr Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: EIA, CSFB estimates.

Gasoline sales, apart from location, are driven by competitive pricing, facilities and
equipment, a low-cost structure, and focused marketing. Wholesale gasoline costs can
also have a major impact on retail operations, depending on the ability of the retail
operator to pass costs on to the consumer. The demand for gasoline not only affects
gasoline sales, but also affects other parts of the retail operation. Decreases in demand
would tend to coincide with lower store traffic and therefore lower sales of higher-margin
merchandise and ancillary products.

The retail gasoline business has dramatically changed over the past several decades as
retail operators have searched for ways to increase profit opportunities and increase
value-added services for consumers. This has brought a shift in the business away from
the traditional, independently owned service station offering full-service pump

47
Oil and Gas Primer 14 May 2002

attendants, and on-site mechanics for tune-ups and repairs, to more modern stations
offering cleanliness, merchandise, food, and gas geared to the quick refill and customer
convenience. Modern retail operations have both a merchandise component and the
traditional gasoline component. Merchandising, or the provision and sale of food
service, candy, beer, other beverages, and tobacco products, has become an important
source of higher-margin sales. Successful merchandising efforts revolve around
stocking brand-name, high-demand items, presenting appealing promotional displays,
having an aesthetic store presentation, and most important, attracting customers to the
location, which is driven by the purchase of gasoline.
Branded gasoline is Retail operators purchase their gasoline supplies under long-term or short-term supply
generally more expensive agreements with oil companies (branded) or from independently owned distributors
than unbranded given the (unbranded). Rack prices refer to the market price or stated price quoted at each
level of R&D and regional terminal.
marketing spending that
Gasoline pricing, as stated above, is a major competitive factor for a retail operation.
goes into the successful
The pricing scheme may be driven by the type of retail operator (company-owned and
distribution of a name
operated, franchisee, independent owner) and the marketing program employed.
brand product
Integrated Oils and Refiners generally commit substantial research and development
dollars into improving the quality of gasoline and determining different price breaks and
grades of gasoline (regular, mid-grade, premium) to support their brands. Branded
gasoline is generally more expensive than unbranded, straight run gasoline sold at
wholesale prices. Independent retail owners may elect to enter into agreements with
Integrated Oils companies or Refiners to market and sell branded gasoline, or may elect
to buy unbranded gasoline from a regional terminal. This second method allows the
independent operator to eliminate the R&D component and marketing and distribution
costs from his wholesale purchase price, which he can then pass the savings on to his
consumers or try to widen his profit margins. The decision to sell branded or unbranded
gasoline is largely a function of the local or regional price elasticity for gasoline and the
general economic wealth of the region.
The largest component of The final sale of gasoline to the end user is the end of the oil and gas chain. Exhibit 42
gasoline prices in the U.S. shows the economic flow of one barrel of oil from the upstream process to the refining
is the cost of crude, stage to the retail stage. As a subset, we convert the per barrel economic flow into a per
followed by taxes; the gallon flow of gasoline to more easily portray the components of retail gasoline pump
refining and distribution prices. Clearly, crude prices will fluctuate with wholesale global energy markets, as we
and marketing components previously mentioned, and retail operators will at times be able to pass on higher costs
are relatively small to consumers. The retail cost of gasoline largely comprises crude oil costs and federal
and state taxes; surprisingly, the refining and distribution/marketing components are
much less of the cost than might be expected. In the U.S., federal, state, and local taxes
fluctuate with changing wholesale and retail prices (28% of the total cost in 2000) and
are generally less than in Europe and other regions, which have much higher tax
components, in some cases reaching 85% of the total cost.

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 Oil and Gas Primer
Exhibit 42: Economic Chain of One Barrel of Oil (Lower Right Subset Is a Conversion of One Barrel into One Gallon of Gasoline)

$70.00
Final Sales Price to
End-Use Consumer =
$62.00

$60.00
Fed. Taxes = $8.30

Retail Product
$50.00 Price (ex-Taxes) = State Taxes = $9.10
49

$44.60

Wholesale
Retail Marketing Profit = $2.35 = 6%
Product Price =
$40.00 $37.00 Marketing Costs = $3.00
Retail Operating Costs = $2.00
Transportation Costs = $0.25
Refinery Profit = $3.40 = 10%
Crude Oil Price Other Costs = $2.00
$30.00 = $26.75 Refining Cash Costs = $4.00
Transportation Costs = $0.85

Profit = $8.250 = 31%

$20.00 $18.50 Marginal Cost Curve

Other/Overhead Costs = $4.70

DD&A Costs = $3.70

$10.00
Operating Costs = $4.50

Finding & Developing Costs = $5.60

$0.00
Upstream Refining Retail Final Sales Price

14 May 2002
Source: Company data, CSFB estimates.
Oil and Gas Primer 14 May 2002

Integrated Oils
The Integrated Oil industry The Integrated Oils industry is characterized by large, predominantly global oil
is characterized by large, companies with operations throughout the oil and gas chain. Integrateds have E&P
predominantly global oil operations, refining and marketing operations, chemical operations, and, in some
companies with operations instances, petrochemicals business. The maturity of the U.S. oil and gas market has
throughout the oil and gas forced the largest Integrateds to increase their focus on new, high potential, highly
chain capital-intensive international areas, leading to a period of considerable consolidation
since the mid-1990s. Throughout this time, National Oil Companies in resource-rich
regions have emerged as major global players, given home market monopolies.

Our coverage universe of Integrated Oils companies comprises the Super Majors,
regional companies (U.S., Europe), and National Oil Companies, or Emerging Markets
Integrateds. (See Exhibit 45.) The traditional breakdown between U.S. and International
Integrateds is no longer useful given the cross-border nature of the M&A activity and the
increasing focus on international operations by all companies. Our analytical framework
for the Integrated Oils is based on several key tenets, listed below.
Our research suggests • Returns on capital (particularly relative to market returns) drive valuation ratings and
shareholder performance shareholders’ returns.
among the Integrateds is
• Reinvestment rates and capital discipline are the key drivers of returns on capital.
largely driven by
companies’ ability to • Oil is a low-growth industry, and it is extremely difficult for large companies to show
generate high returns on substantially above-average growth rates without compromising returns on capital.
gross invested capital Our research suggests shareholder performance among the Integrateds is largely
driven by companies’ ability to generate higher returns on gross invested capital
(ROGIC) rather than ability to generate high production growth and cash flow. (See
Exhibits 43-44.) ROGIC evaluates a company’s ability to generate value-added returns
on its investment at original cost. Along with superior shareholder performance is a
commensurately higher valuation premium on higher return companies.

Exhibit 43: Global Integrateds Performance versus ROGIC Exhibit 44: Global Integrateds Performance versus Cash Flow
30 30

25 TOT 25
TOT
XOM
XOM

BP BP
20 MOB 20 SC
Avg TSR % 1995-2000

SC MOB
Avg TSR % 1995-2000

RD RD
TX
TX REP ENI ENI REP

15 PCA CHV PCA

ARC 15 CHV
ARC MRO
MRO P P
OXY
NHY NHY OMV
OMV OXY
10 AHC
10 AHC

5
5

0
0
4% 5% 6% 7% 8% 9% 10% 11% 12%
0% 5% 10% 15% 20% 25% 30%
Average ROGIC 1995-2000 CFPS growth 1995-2000

Source: Company data, Reuters, CSFB estimates. Source: Company data, Reuters, CSFB estimates.

50
Oil and Gas Primer 14 May 2002

The Super Majors have had greater success generating excess returns on capital than
their industry peers because of their ability to spread costs over a larger fixed-asset base
and their cost-cutting efforts brought about mainly by consolidation. The Super Majors
have also enjoyed better access to select new producing areas such as West Africa; this
is due to the requirements of host governments to deal with well-funded, technologically
advanced entities. The other Integrateds are generally much smaller from a capital
perspective than the monolithic Super Majors and have a higher concentration of assets
in select regions (U.S., North Sea). The other Integrateds also are generally more
leveraged to commodity prices than the Super Majors. The Emerging Markets
companies are the partially or formerly state-run oil companies that have floated public
equity within the past ten years, have begun to expand their operations beyond
domestic borders, and have also begun to realize efficiency gains from being privately
run.

Exhibit 45: Global Integrated Oils

MARKET DATA DAILY CLEAN EARNINGS LEVERED CASHFLOW UNLEVERED CASH FLOW VALUE ADDED
PRICE MKT STOCK PERF. EPS P/E CFPS P/CF EBIDAX EV/EBIDAX EV/GIC ROGIC
TICKER FX 5/13/02 CAP EV % REL. % 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 02E 03E
MAJORS
BP USD 52.05 194,810 221,333 2.0% 3.7% 2.50 2.69 20.8 19.3 4.67 4.98 11.2 10.5 19,090 20,343 11.6 10.9 104.2% 9.1% 9.2%
ChevronTexaco USD 90.10 95,513 113,584 2.4% 4.2% 4.42 5.68 20.4 15.9 9.44 10.96 9.5 8.2 10,877 12,369 10.4 9.2 91.0% 9.1% 9.8%
ExxonMobil* USD 40.01 271,796 279,010 2.7% 4.5% 1.75 2.07 22.8 19.3 3.10 3.36 12.9 11.9 23,905 25,505 11.7 10.9 102.4% 9.1% 9.5%
Royal Dutch* USD 55.26 116,040 122,382 2.3% 4.1% 2.69 2.78 20.5 19.9 4.86 5.06 11.4 10.9 11,576 11,819 10.6 10.4 109.7% 10.1% 9.8%
Shell* USD 45.47 73,822 78,050 2.0% 3.8% 2.35 2.49 19.4 18.3 4.23 4.53 10.7 10.0 7,717 7,880 10.1 9.9 104.9% 10.1% 9.8%
TotalFinaElf USD 77.73 104,625 113,523 1.9% 3.7% 4.43 4.41 17.5 17.6 8.42 8.60 9.2 9.0 11,929 12,169 9.5 9.3 95.8% 9.6% 9.5%
AVERAGE 2.2% 4.0% 20.2 18.4 10.8 10.1 10.7 10.1 101.3% 9.5% 9.6%
OTHER INTEGRATEDS
Amerada Hess USD 80.79 7,166 12,794 3.0% 4.8% 6.31 6.47 12.8 12.5 19.71 17.86 4.1 4.5 1,938 1,772 6.6 7.2 56.5% 8.0% 6.9%
Conoco USD 28.35 17,756 26,960 1.5% 3.3% 1.48 1.66 19.1 17.1 5.39 5.34 5.3 5.3 3,427 3,453 7.9 7.8 71.0% 8.9% 8.5%
ENI USD 75.00 58,567 66,634 1.7% 3.5% 5.78 5.49 13.0 13.7 11.82 11.99 6.3 6.3 8,434 8,281 7.9 8.0 83.8% 10.6% 9.8%
Marathon Oil USD 28.84 8,926 13,232 1.8% 3.5% 1.66 1.91 17.3 15.1 7.54 8.02 3.8 3.6 2,129 2,226 6.2 5.9 54.0% 7.9% 7.5%
Norsk Hydro USD 51.70 13,308 17,938 1.1% 2.9% 3.20 3.04 16.2 17.0 9.88 9.59 5.2 5.4 2,697 2,617 6.7 6.9 49.0% 6.8% 6.5%
Phillips USD 60.96 23,243 32,143 1.6% 3.3% 2.47 3.59 24.7 17.0 7.66 8.85 8.0 6.9 3,271 3,741 9.8 8.6 74.9% 7.1% 7.6%
PetroCanada CAD 43.36 11,369 15,189 1.3% 1.8% 2.52 2.43 17.2 17.8 7.00 6.91 6.2 6.3 2,003 1,905 7.6 8.0 95.1% 10.9% 8.5%
PetroCanada USD 27.97 7,334 9,930 0.6% 2.4% 1.60 1.54 17.5 18.2 4.43 4.37 6.3 6.4 1,268 1,206 7.8 8.2 98.2% 10.9% 8.5%
Repsol YPF** USD 11.93 14,563 30,945 1.9% 3.7% 1.00 0.88 11.9 13.6 3.34 3.32 3.6 3.6 4,312 4,242 7.2 7.3 57.1% 7.6% 6.9%
Statoil USD 8.49 18,377 23,009 1.9% N/A 0.64 0.59 13.4 14.5 1.67 1.69 5.1 5.0 3,875 3,926 5.9 5.9 57.1% 8.8% 8.5%
AVERAGE 1.6% 3.2% 16.3 15.6 5.4 5.3 7.4 7.4 69.7% 8.8% 7.9%
EUROPEAN INTEGRATEDS (Local Currency)
BG Group GBP 304.8 10,755 12,521 -0.8% -1.5% 14.17 17.45 21.5 17.5 29.11 34.02 10.5 9.0 1,232 1,422 10.2 8.8 111.9% 10.7% 11.1%
BP GBP 590.0 132,493 150,702 0.9% 0.2% 28.95 31.14 20.4 18.9 54.13 57.59 10.9 10.2 13,166 14,030 11.4 10.7 102.9% 9.1% 9.2%
ENI EUR 16.3 63,760 70,473 0.7% 0.0% 1.28 1.22 12.7 13.4 2.63 2.66 6.2 6.1 9,371 9,201 7.5 7.7 79.8% 10.6% 9.8%
Norsk Hydro NOK 429.0 110,430 148,716 0.5% 0.5% 28.68 27.37 15.0 15.7 88.73 86.28 4.8 5.0 24,211 23,554 6.1 6.3 45.2% 6.8% 6.5%
OMV EUR 101.2 2,726 3,330 -0.5% -1.2% 14.45 14.28 7.0 7.1 29.75 28.87 3.4 3.5 882 904 3.8 3.7 28.1% 6.9% 6.6%
Repsol YPF** EUR 12.9 15,735 33,711 1.7% 1.0% 1.11 0.98 11.6 13.2 3.71 3.69 3.5 3.5 4,791 4,713 7.0 7.2 56.0% 7.6% 6.9%
Royal Dutch* EUR 60.2 126,309 133,268 0.6% -0.2% 3.05 3.14 19.7 19.2 5.50 5.71 10.9 10.5 12,862 13,133 10.4 10.1 107.5% 10.1% 9.8%
Shell* GBP 516.0 50,265 53,167 0.8% 0.1% 27.23 28.82 18.9 17.9 49.12 52.47 10.5 9.8 5,322 5,434 10.0 9.8 103.6% 10.1% 9.8%
Statoil NOK 70.0 151,521 189,821 1.4% 1.5% 5.72 5.28 12.2 13.3 15.02 15.24 4.7 4.6 34,788 35,330 5.5 5.4 52.3% 8.8% 8.5%
TotalFinaElf EUR 168.6 113,468 123,232 0.7% -0.1% 9.85 9.79 17.1 17.2 18.72 19.10 9.0 8.8 13,254 13,521 9.3 9.1 93.6% 9.6% 9.5%
AVERAGE 0.8% 0.2% 15.4 15.1 7.3 6.9 8.0 7.7 76.4% 9.0% 8.7%
EMERGING INTEGRATEDS
LUKOIL USD 17.14 14,579 15,643 N/A N/A 2.12 2.02 8.1 8.5 3.25 3.20 5.3 5.4 2,825 2,784 5.5 5.6 45.6% 8.4% 7.7%
Surgut*** USD 0.39 16,720 6,847 N/A N/A 0.03 0.03 11.4 13.6 0.05 0.04 8.3 9.0 1,867 1,686 3.7 4.1 N/A N/A N/A
YUKOS USD 10.10 22,594 17,371 N/A N/A 1.06 0.92 9.5 10.9 1.17 1.06 8.7 9.6 3,435 3,036 5.1 5.7 80.5% 13.7% 10.5%
MOL USD 21.51 2,099 2,911 0.4% 0.8% 2.49 3.04 8.7 7.1 4.53 4.99 4.7 4.3 470 579 6.2 5.0 0.1% 3.5% 5.2%
Perez Companc USD 6.10 1,301 3,516 1.8% 2.6% 1.21 1.30 5.0 4.7 1.77 2.33 3.5 2.6 834 874 4.2 4.0 40.1% 9.0% 8.2%
Petrobras USD 21.78 23,655 35,384 -3.5% -1.7% 3.23 2.88 6.7 7.6 4.92 5.14 4.4 4.2 6,563 6,640 5.4 5.3 63.9% 9.5% 9.2%
PTT THB 31.75 90,488 183,035 0.0% 0.4% 6.59 6.68 4.8 4.8 8.74 13.50 3.6 2.4 35,838 35,537 5.1 5.2 64.1% 12.0% 11.6%
Petrochina USD 19.70 34,637 41,530 -0.2% 1.6% 2.23 1.79 8.8 11.0 5.35 4.57 3.7 4.3 9,069 8,319 4.6 5.0 47.1% 9.5% 8.0%
Petrochina HKD 1.53 269,011 322,776 0.7% -0.1% 0.17 0.14 8.8 11.0 0.42 0.36 3.7 4.3 70,738 64,888 4.6 5.0 46.9% 9.5% 8.0%
Sinopec USD 16.15 14,002 25,277 1.9% 1.1% 1.83 2.35 8.8 6.9 6.16 6.00 2.6 2.7 5,821 6,587 4.3 3.8 32.3% 6.2% 6.5%
Sinopec HKD 1.26 109,245 197,190 0.8% 0.0% 0.14 0.18 8.8 6.9 0.48 0.47 2.6 2.7 45,402 51,377 4.3 3.8 32.3% 6.2% 6.5%
Sasol ZAR 119.00 72,947 80,947 -0.8% -1.1% 15.58 15.28 7.6 7.8 21.65 21.53 5.5 5.5 13,690 13,439 5.9 6.0 106.6% 18.0% 16.0%
AVERAGE 0.1% 0.4% 8.4 8.7 4.8 5.0 4.9 4.9 49.5% 9.6% 8.9%

GLOBAL INTEGRATED AVERAGE 14.4 13.9 6.7 6.5 7.4 7.2 71.7% 9.2% 8.7%

Source: Company data, Reuters, CSFB estimates.

51
Oil and Gas Primer 14 May 2002

Large scale is vital, as it We believe that large scale is vital in this global commodity industry, as it allows
allows companies to lower companies to lower their aggregate unit costs and their overall project risk profile
their aggregate unit costs through greater diversification. Valuation multiples tend to reflect this (and other factors)
and overall project risk as shown by significantly higher valuations for the Super Majors over the other
profile through greater Integrateds and Emerging Markets players.
diversification
Among the Integrated Oils, we utilize four major traditional valuation metrics and our
value-added framework. We evaluate price to earnings (P/E), price to cash flow (P/CF),
enterprise value to earnings before interest, taxes, depreciation, and exploration
®
expense (EV/EBIDAX), and EVA (fair value) measures plus our value-added enterprise
value (EV)/gross invested capital (GIC) and return on gross invested capital (ROGIC)
valuation and performance metrics. Our preference is for a combination of EV/GIC, cash
®
flow multiple analysis, and EVA -derived DCF analysis throughout the cycle.

A key component of any valuation analysis is one’s view on midcycle conditions, which
eliminate the high/low distortions that can occur over a cycle. It makes little sense to
value companies using unsustainably high or low commodity prices, so we use a
midcycle average to gain perspective on a normalized basis.
The Super Majors have a A quick glance at our Global universe (Exhibit 45) shows the Super Majors have a
commanding valuation gap commanding valuation gap over the other Integrateds and an even bigger lead over the
over the other Integrateds Emerging Markets Integrateds. The consolidation and asset restructuring of the industry
and an even bigger lead have not only blurred the lines between traditional Domestic and International
over the Emerging Market Integrateds, but have also clearly trifurcated the group. The Super Majors enjoy
Integrateds substantially higher valuation multiples and exhibit different characteristics than the others
and Emerging Market players. The differences generally arise from the points we listed
above; the Super Majors have higher returns on capital (Exhibit 46), have lower
reinvestment rates (greater capital discipline), and have focused on higher returns other
than higher production and cash flow growth. Some Emerging Market players, however,
have achieved even higher returns on gross invested capital than the Super Majors and
Others. However, while their ROGICs may be higher than the peer group in some
cases, their commensurately higher costs of capital leads to a narrow ROGIC - WACC
spread, or lower net return.

52
Oil and Gas Primer 14 May 2002

Exhibit 46: Global Integrated Oils Return on Gross Invested Capital, Ten Years
15%

14.0%

12.0% 11%

10% 10%
10%
10.0%
9% 9% 9%
9% 9% 9% 9%
8%
8% 8%
8% 8%
8.0% 7% 7%
7%
6%

6.0%

4.0%

2.0%

0.0%

ps
ll

il
I

PF
c

as
il

BP

il

V
na

on

ro

a
lf

s
o
oi
EN

he

ob

O
ko
pe

es
aE
oc
ag

ad
ac

M
yd
at

illi

br
hi

vr
lY

O
Lu

n
/S

nM

H
no

on

x
er

an
in
St
C

Ph
he

tro

H
ho
Te
so
D

lF
Av

a
tro

Si

-C
xo

sk
C

Pe

ad
R

at
ta
ep
Pe

tro
or
Ex

ar
To

er
R

N
-M

Pe
Am
SX
U
Source: Company data, CSFB estimates.

In addition to historically maintaining high returns on capital, the Super Majors have also
improved their underlying midcycle ROGIC performance more than have the growth-
oriented other Integrateds and Emerging Market Integrateds. (See Exhibit 47.) This is
largely due to excellent capital discipline versus the peer group. Capital discipline refers
to a company’s ability to selectively pursue investment opportunities, with a reasonable
set of expectations regarding long-term capital costs and returns potential.

Exhibit 47: Global Integrated Oils Improvement in Midcycle ROGIC, 2000

8 .0%

6%
6 .0%
5%
4% 4% 4%
4 .0%
3%
2% 2%
2 .0% 1% 1%
0% 0%
0 .0%
0% -1%
-2 .0% -2% -2 %
-2%
-3%
-4 .0% -3%

-5%
-6 .0%

-8 .0%

-10 .0%

-11%
-12 .0%
s
PF

as

c
BP

il

il

ll

il
on

ro

a
lf

s
co

oi
EN
ob

he
O

ko
p

pe
es
aE

oc
ad

ag

in
M
yd

at
illi

br
xa
vr

lY

ch
O
n

Lu
/S
nM

no
H

on
an

er
in

St
he

Ph

tro
H
ho

Te

tro
so
D
lF

Av
a

Si
C
-C
xo

sk
C

Pe
ad
at

R
ta

ep

Pe
tro

or
Ex

ar
To

er

R
N
-M

Pe
Am
SX
U

Source: Company data, CSFB estimates.

53
Oil and Gas Primer 14 May 2002

We have demonstrated that the Super Majors enjoy superior returns on gross invested
capital, but it is necessary to understand which segments of the Integrated business
model are driving these returns.
Upstream operations have Total returns are being driven by the upstream, which has generally earned in excess of
generated the highest its cost of capital. The downstream and chemicals segment performances have not
returns for the Integrateds been so impressive in most cases. Over the past ten years, the upstream has averaged
while downstream and an 11.2% return on gross invested capital versus 7.5% for the downstream and only
chemical operations have 7.4% for chemicals.
struggled to earn their cost
of capital Exhibit 48: Integrated Oils Segment Returns
2 0 .0 %

1 8 .0 %

1 6 .0 %

1 4 .0 %

1 2 .0 %

1 0 .0 %

8 .0 %

6 .0 %

4 .0 %

2 .0 %

0 .0 %
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

U p s tre a m D o w n s tre a m C h e m ic a ls G as and P o w er

Source: Company data, CSFB estimates.

The upstream has been a consistent outperformer while the chemicals business has
shown deteriorating returns for the past five years. The relative outperformance of the
upstream has led integrated companies to increase their reinvestment spending in the
business at the expense of the downstream and chemicals businesses.

As a result of higher return Exhibit 49: Integrated Oil Segment Reinvestment Rates
opportunities in the 100%

upstream, the Integrateds

90%
have steadily redeployed
an increasing amount of 80%

capital to the business 70% 26% 21%

20% 18% 21%
27% 30% 28% 24%
27%

60%

50%

40%

30% 62% 62% 61%

57% 59%
55% 54% 55%
52% 52%

20%

10%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

E&P R &M Chem s G as and Power O ther

Source: Company data, CSFB estimates.

54
Oil and Gas Primer 14 May 2002

The downstream business has been transformed as a result of the recent consolidation
activity in the industry. The Integrateds have mostly decreased their commitment to the
business by divesting refinery operations throughout the 1990s and reinvesting less
capital into the business. (See Exhibit 49.) The Super Majors are more balanced in the
split of gross invested capital between upstream and downstream operations than are
the other Integrated groups, which is why the Super Majors are less leveraged to
commodity prices. NOCs or Emerging Markets Integrateds have the highest
concentration of upstream assets versus downstream. This is normally a result of
historical central planning and clearly delineated functions of upstream and downstream
businesses, as there are several national refining companies as well.
Super Majors have been The Super Majors, even given their significant reserve bases (Exhibit 50), have found it
slow growers hard to grow production the past ten years versus their peers. While the Super Majors
dominate the returns performance categories, the Emerging Integrateds and national oil
companies dominate the production growth rankings. (See Exhibit 51.)
NOCs are the biggest The Super Majors are focused on ”big elephant” projects that can substantially increase
challenge to the Super their reserve base and development backlog—small finds do not add much to the
Majors existing, sizable reserve base. As Exhibit 50 shows, the Super Majors’ reserve base is
on average 2-5 times greater than the other groups. However, the NOCs, with large
resource potential and relatively closed home markets, offer a serious challenge to the
Super Majors. Petrobras, Lukoil, and PetroChina have all demonstrated substantial
reserve growth the past several years and their reserve bases now rival or exceed those
of the Super Majors.

Exhibit 50: Global Integrated Oils Reserve Base, 2000

Mmboe

2 5 ,0 0 0

2 2 ,5 0 0

2 0 ,0 0 0

1 7 ,5 0 0

1 5 ,0 0 0

1 2 ,5 0 0

1 0 ,0 0 0

7 ,5 0 0

5 ,0 0 0

2 ,5 0 0

0
s
lf

co

o
il

ll

l
na

as

il
s

a
on

F
P

V
oi

oi
EN

es
ob

ip

ad
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he

pe
aE

oc

dr
YP

M
B

br
hi

xa

at
vr

ill

O
n
Hy

an
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Lu

no
nM

on
in
oc

St
tro

he

ol

ho
Ph

Te

a
RD

lF

C
Si

C
ps

sk

ad
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tr

C
Pe

at
ta

o-
Pe

or
Re

ar

er
Ex

To

tr
Pe
M
N

m
X-

A
US

O il G as

Source: Company data, CSFB estimates.

55
Oil and Gas Primer 14 May 2002

The Super Majors, given Production growth of the other Integrateds and NOCs has led to higher earnings and
their significant reserve cash flow growth versus the Super Majors as well. However, despite the Super Majors’
bases, have found it hard lower production growth over the period, their focus on cost-cutting and efficiency gains
to grow production the past has allowed them to sustain appreciably higher returns on capital than their peers, as
ten years versus their we noted earlier.
peers
Exhibit 51: Integrated Oils Production Growth, Ten Years
16%

14%
14%

12% 12%

10%
10%

8%

6%
6%
5%
5% 5%
4% 4%
4%

2% 1% 1% 1% 1% 1%
1% 1%
0% 0%
0%
0%
0%

-2 %
s

il
ro

PF

on
s

na

c
lf
il

il

il

P
o

co
a
EN

l
ko

ip

to

ob
ra

es

he

pe
ad
aE

oc

B
M
yd

hi
vr

xa
lY

ill
ob

O
a

H
Lu

no
/S
an

nM
on
in

oc
St

he
H

ho
Ph

Te
so

RD
lF
tr

-C

Si
C
sk

ad

xo
tr
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Pe

at
ta
ep

Pe
ro
or

ar

er

Ex
To
R

t
N

-M

Pe

m
A
SX
U

Source: Company data, CSFB estimates.

Because of the need for the Integrateds to make large discoveries and the capital
commitments required for large projects, the risk involved, the geological knowledge
required for particular regions or geologies, and regional laws and regulations governing
participation and development of natural resources, the Integrateds normally operate
their big upstream projects as joint ventures. Depending on the size of the project, a
consortium may have anywhere from two to five (or more) participants, but there is
always one designated operator that makes all final decisions on the project; the other
firms simply hold an economic interest and contribute to the capital costs. Early on in a
project’s life, ownership may change several times, as the project evolves and the
reserve potential becomes more clearly defined. The ownership structure shifts as each
participant decides for itself whether the project meets the individual company’s
investment criteria.
We expect consolidation to We expect consolidation to continue in the Integrated Oils sector as remaining smaller
continue throughout the players attempt to streamline their cost structures and combine their exploration
industry as remaining potential. The Super Majors should maintain their higher returns on capital versus the
smaller players attempt to other Integrateds and Emerging Markets Integrateds; however, the industry as a whole
streamline their cost could see upstream returns decline slightly in coming years. Despite the potential for
structures and combine lower upstream returns through rising capital intensity in the upstream business, the
exploration potential in E&P business will continue to be the main returns driver for Integrateds relative to
order to generate higher downstream and chemicals returns. This should also serve to keep reinvestment rates
returns on capital and capital allocation flowing to the upstream businesses.

56
Oil and Gas Primer 14 May 2002

Independent Refiners
The refining industry includes Integrated Oil companies and the Independent Refiners;
however, the Independent Refiners represent the pure-play exposure to the refining
business. Our global Independent Refiner universe essentially breaks down into U.S.
Refiners and Asia-Pacific Refiners. There exist very few publicly traded Independent
Refiners in Europe, Latin America, and the Middle East/Africa. Comparing U.S.
Independent Refiners with mostly emerging market Asia-Pacific Refiners presents
several valuation comparison difficulties—namely, minority discounts associated with
large government ownership stakes and emerging market discounts. We therefore do
not attempt to make valuation comparisons for the Refiners on a global basis, but on a
regional basis.
Our investment framework Our investment framework for the Independent Refiners is similar to the Integrated
for the Independent Oils—returns on capital drive valuation. We can plot EV/GIC multiples versus midcycle
Refiners is similar to the ROGIC expectations to demonstrate how investors look through peak or trough periods
Integrated Oils—returns on to normalized or midcycle conditions. As Exhibit 52 shows, there is a reasonable
capital drive valuation correlation between EV/GIC and midcycle returns for the global Refining universe. The
universe is heavily weighted to the Emerging Market Refiners in Asia-Pacific and this
impacts the results. There is a much higher correlation for the U.S. Independent
Refiners on a stand-alone basis.

Exhibit 52: Global Refiner EV/GIC versus 2003E ROGIC

160%
2 R e lia n c e
R = 0 .4 8 4 4

140%
FTO

120%
P e tro n a s
S -o il
TS O S K C o rp
100%
VLO
EV/2003E GIC

UDS B h a ra t
80%
ERG
H e lle n ic
ASH H in d u s ta n
60%
SUN
PKN
P e tro n
40%
C a lte x Zhenhai

20%

0%
0 .0 % 5 .0 % 1 0 .0 % 1 5 .0 % 2 0 .0 % 2 5 .0 %
2 0 0 3 E R O G IC

Source: Company data, CSFB estimates.

57
Oil and Gas Primer 14 May 2002

Our Global Independent Refining universe spans 17 companies in 3 regions—the U.S.,

Asia-Pacific, and Europe—with the U.S. and Asia-Pacific making up the large majority of
our coverage. (See Exhibit 53.) As the valuation comparison table shows (Exhibit 53),
the U.S. generally enjoys higher multiples than global peers, but as we said, making
such comparisons is difficult. The same valuation methods used for the Integrated Oils
are also applicable to the Independent Refiners. We use P/E and P/CF multiples among
traditional metrics and EV/GIC and ROGIC as our preferred value-added measures.

Exhibit 53: Global Independent Refiners

MARKET DATA DAILY CLEAN EARNINGS LEVERED CASHFLOW UNLEVERED CASH FLOW VALUE ADDED
PRICE MKT STOCK PERF. EPS P/E CFPS P/CF EBIDAX EV/EBIDAX EV/GIC ROGIC
TICKER FX 5/13/02 CAP EV % REL. % 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 02E 03E
INDEPENDENT REFINERS
Caltex AUD 1.46 394 1,679 -3.9% -3.3% 0.19 0.20 7.7 7.1 1.11 0.84 1.3 1.7 269 259 6.2 6.5 45.3% 6.5% 6.2%
Bharat INR 299.80 89,940 124,839 0.1% -0.2% 31.39 37.69 9.6 8.0 45.56 54.38 6.6 5.5 16,713 19,809 7.5 6.3 103.5% 14.7% 15.8%
Hindustan INR 298.85 101,310 159,868 2.1% 1.7% 40.32 45.06 7.4 6.6 57.08 61.58 5.2 4.9 18,413 20,186 8.7 7.9 100.2% 13.7% 14.2%
Reliance Petro. INR 25.60 133,171 225,639 -0.2% -0.5% 3.46 5.93 7.4 4.3 5.06 7.58 5.1 3.4 25,141 37,714 9.0 6.0 117.8% 18.9% 22.8%
Petronas Gas MYR 7.00 13,860 16,599 2.2% 2.5% 0.25 0.34 N/M N/M 0.52 0.63 N/M N/M N/M N/M N/M N/M N/A 9.0% 10.0%
Zhenhai R. HKD 1.98 4,996 6,236 -0.5% -1.3% 0.50 0.52 4.0 3.8 0.77 0.80 2.6 2.5 2,136 2,350 2.9 2.7 43.4% 13.8% 9.3%
S-Oil KRW 24,550.00 2,712,898 3,849,898 N/A N/A 7.92 7.56 3.1 3.2 9.59 11.89 2.6 2.1 502 571 7.7 6.7 90.7% 13.5% 14.8%
SK Corp. KRW 21,100.00 2,809,321 10,111,621 N/A N/A 2.06 4.14 10.2 5.1 7.15 5.73 3.0 3.7 1,034 994 9.8 10.2 62.2% 5.7% 6.1%
Petron PHP 1.68 15,750 36,273 0.0% 0.4% 0.60 0.62 2.8 2.7 0.70 0.72 2.4 2.3 7,258 7,520 5.0 4.8 53.1% 9.8% 9.0%
ERG.MI EUR 4.33 692 1,019 1.7% 0.9% 0.43 0.35 10.0 12.5 0.82 0.74 5.3 5.9 138 125 7.4 8.2 72.3% 9.4% 9.5%
PKN PLN 18.50 7,773 9,684 1.6% 1.0% 1.49 1.97 12.4 9.4 4.31 5.00 4.3 3.7 1,995 2,293 4.9 4.2 45.5% 9.4% 9.6%
Ashland USD 39.75 2,755 4,465 0.5% 2.3% 3.46 4.99 11.5 8.0 6.36 8.98 6.3 4.4 712 828 6.3 5.4 51.3% 8.0% 8.5%
Frontier USD 20.61 527 632 1.0% 2.8% 1.47 2.07 14.0 9.9 2.54 3.12 8.1 6.6 78 90 8.1 7.0 103.7% 12.7% 13.8%
Sunoco USD 36.35 2,759 4,161 2.3% 4.1% 1.74 4.85 20.9 7.5 6.01 9.86 6.0 3.7 531 753 7.8 5.5 51.5% 6.4% 8.8%
Tesoro USD 8.70 565 2,665 -1.7% 0.1% (0.09) 2.67 N/M 3.3 1.96 5.40 4.4 1.6 300 482 8.9 5.5 69.1% 5.3% 10.0%
Valero USD 42.51 4,460 9,703 0.5% 2.3% 2.71 6.21 15.7 6.8 5.87 11.70 7.2 3.6 914 1,310 10.6 7.4 75.7% 7.7% 10.7%
AVERAGE 0.4% 0.8% 9.8 6.7 4.7 3.8 7.3 6.2 71.3% 10.3% 11.2%

Source: CSFB.

Refining operations are judged by geographic or market location and complexity factor,
as we discussed earlier in the Downstream section. Since Integrateds’ refining operations
are global in nature, we typically evaluate their refining results by global regions: North
America, Europe, and Asia-Pacific. U.S. Independent Refiners, however, are concentrated
in the U.S. We therefore look at U.S. Independent Refiners’ operations by geographic
region within the U.S. The U.S. market is divided into five regions or PADDs (Petroleum
Administration for Defense Districts) that are each widely followed. (See Exhibit 54.)

Exhibit 54: U.S. PADD Map

Source: EIA.

58
Oil and Gas Primer 14 May 2002

Disparate product The Gulf Coast (PADD III) is the largest refining market in the U.S., accounting for 46%
specifications lead to of U.S. refining capacity, followed by the Midwest (PADD II) and the West Coast (PADD
balkanized product V). The U.S. has various federal and state environmental regulations aimed at limiting
markets and disparate plant emissions and product emissions leading to different product specifications (sulfur
refining margins between content, blend contents), which have become a major contributor to regional differences
geographic regions in product pricing. The West Coast and Midwest have demonstrated the highest refining
margins over the past several years, as Exhibit 55 shows. The West Coast margins are
driven by extremely strict regulations imposed by the California Air Resources Board
(CARB) while the Midwest is short of refined products and has a different summer
gasoline standard than its main supply region, the Gulf Coast.

Exhibit 55: U.S. Gross Refining Margins, by Region

US$ per barrel

$16

$14

West Coast
$12

Midwest
$10

$8

$6

Gulf Coast
$4

$2
East Coast

$0
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002

Source: Reuters, CSFB estimates.

When we analyze refiners, we look at the distribution of their refining operations

(capacity) among regions and the margins in each region. The margin graph (Exhibit 55)
shows that East Coast refiners have had the lowest margins in the past several years
while West Coast refiners enjoyed the highest margins.
The structure of the The U.S. refining industry has undergone major changes over the past ten years similar
refining industry has to those of the upstream industry. In fact, the changes have been partly driven by the
dramatically changed over evolving landscape of the Integrated Oil companies. Refining operations were
the past ten years traditionally the domain of the Integrated Oil companies. However, increasing capital
intensity and excess refining capacity of the past 15 years diminished refining margins
and refining returns on capital, leading the Integrateds to shift capital away from refining,
as we discussed earlier. The Integrateds have divested refinery operations and have
reinvested a greater portion of their funds in upstream operations than toward
downstream refining, as we have already discussed.

59
Oil and Gas Primer 14 May 2002

The Integrateds’ divestment programs led to an expansion of the Independent Refining

industry, as Independent Refiners were the natural buyers of the cast-off refineries.
Consolidation among the Integrateds in the late 1990s resulted in further refinery
divestitures (some mandated by the Federal Trade Commission), providing a large
supply of assets for Independent Refiners to acquire. The Independent Refiner business
model was premised on growth through acquisition given that it was cheaper to buy a
refinery than to build a new one given the excess capacity already in the market and the
environmental and legal problems associated with constructing new plants.

Refining capacity has increased only marginally in recent years as the asset base has
simply shifted from one market participant to another, and both Integrateds and
Independent Refiners have closed low return refinery operations and increased capacity
at existing refineries only sparingly (capacity creep). (See Exhibits 56-57.) Additionally,
downstream capital budgets have been directed toward maintenance spending aimed at
meeting environmental regulations versus increasing capacity.

Exhibit 56: U.S. Refining Industry Market Share, 1996–2000 Exhibit 57: U.S. Refining Capacity and Number of Refineries
350 20
80%

71%
70% 325
18

60% 300
54%
Capacity
16

Refining Capacity (MMBD)

50%
46% 275
No. of Refineries

40%
250 14

29%
30%
225
12
20% Refineries

200

10%
10
175
0%
1996 2000
150 8
Integrateds Independents 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Source: Company data, CSFB estimates. Source: EIA, CSFB estimates.

The Integrateds not only divested refining assets but restructured existing assets
through mergers and joint ventures. The restructurings took place not just between
Integrateds (e.g., Equilon and Motiva–Texaco/Royal Dutch Shell) but also between
Independent Refiners (e.g., MAP–Marathon Oil/Ashland). The high fixed costs of
refinery operations and the ability to gain cost advantages through greater scale led
Integrated Oils to spread the costs and risks associated with downstream businesses
while simultaneously high grading their portfolio through selected divestments.

In summary, Integrated Oils and Independent Refiners are the main players in the
refining business. The Integrateds’ shift away from the low-relative-return refining
businesses allowed the Independent Refiners to expand. Independent Refiners have
grown through acquisitions and have focused on cost control, running plants more
efficiently and maximizing higher value product yield. Refiners configure their refineries
based on regional market demand, crude grades, regional product supply and demand
dynamics, and pricing. We form refining margins expectations based on historical
relationships between product demand, industrial production and GDP growth, crude
and product supply, inventories, and refining capacity utilization.

60
Oil and Gas Primer 14 May 2002

Independent E&P
Independent E&P companies in the broadest sense pursue geographic strategies that
allow for a leverage to natural gas or oil and/or they pursue a defined cost structure
cluster. Put in a simpler way, E&P companies pursue global markets (oil levered) or
regional (gas and oil split) markets.
The E&P business is a much more regional business than that of the Integrated Oils
and is generally broken down by North America (U.S., Canada), Europe, and Asia-
Pacific. (See Exhibit 59.) Given the maturity of the North American market, the level of
oil and gas consumption, free market structure, and the sheer number of publicly traded
Independent companies, the North American market is the largest for Independent E&P
companies. As we have already discussed in the Oil and Gas Markets sections, the gas
business is regional owing to the limitations of regional infrastructure, regional
transportation, and regional currency pricing. It is therefore necessary to frame the
discussion on a market-by-market basis. Our Global Independent E&P universe
comprises 41 companies, with the largest proportion of our coverage being the North
American market with 30 companies.
Relative cash returns Relative cash returns versus the peer group drive valuation, in our view. Cash return on
versus the peer group replacement cost capital, net return on replacement cost capital, cash return per barrel
drive valuation, in our view of oil equivalent (boe) of proven reserves, and net asset value growth are key indicators
of value-creation potential. However, near-term prices and price expectations are the
most important indicators of near-term performance potential versus net asset value
growth potential, which can be a longer-term measure subject to long-term price views.
We believe comparing EV/boe to EBITDA/boe (cash margin) is a large driver of
valuations in the group. (See Exhibit 58.)

Exhibit 58: Adjusted EV/boe to 2001 EBITDA/boe

$18
SKE 2
R = 0 .6 2 0 1
$16

$14
Adjusted EV/BOE

B N P .T O

$12

BG AX L .T O
$10
AE C .T O SGY
H S E .T O P P P O E I M ND HTR
$8 SFY FS T
P C P .T O R AX .T O
AP C
CHK
L D D VN AP A N X Y .T O
EOG T L M .T O
$6 NBL UCL KM G
S T O .AX B R E T P .L P W T .T O EPL
PXD WR C
$4 C N Q .T O
VP I CEO
GRL

$2
$ 0 .0 0 $ 0 .5 0 $ 1 .0 0 $ 1 .5 0 $ 2 .0 0 $ 2 .5 0 $ 3 .0 0 $ 3 .5 0 $ 4 .0 0 $ 4 .5 0 $ 5 .0 0

2 0 0 1 E E B IT D A /B O E

Source: Company data, CSFB estimates.

61
Oil and Gas Primer 14 May 2002

We also use an adjusted EV measure that more appropriately compares asset bases on
an equal basis. Reserve values are significantly influenced by the percentage developed
versus undeveloped owing to the significant capital associated with developed reserves.
To appropriately compare companies with varying developed/undeveloped reserve
bases, we adjust all the reserves to a fully developed basis by adding estimated future
development costs to the enterprise value.

Our value-added valuation measures capture the expectations for companies to earn
returns in excess of the cost of capital. Since cash-on-cash returns are a fundamental
valuation driver, they are more representative of true value and imbedded expectations
over traditional cash flow multiple analysis.

Exhibit 59: Global Independent E&P

MARKET DATA DAILY LEVERED CASH FLOW UNLEVERED CASH FLOW ASSET BASED
PRICE MKT STOCK PERF. CFPS P/CF DEBT/ EBITDAX EV/EBITDAX EBIDAX EV/EBIDAX *NAV/ PRICE/ EV$/
TICKER FX 5/13/02 CAP EV % REL. % 02E 03E 02E 03E 02E CF 02E 03E 02E 03E 02E 03E 02E 03E SHARE *NAV BOE
US E&P
Anadarko USD 53.97 13,493 18,654 1.8% 3.6% 6.74 7.83 8.0 6.9 1.7 2,072 2,423 9.0 7.7 1,961 2,249 9.5 8.3 48.66 111% 8.1
Apache USD 57.28 7,847 10,839 1.0% 2.8% 9.04 10.80 6.3 5.3 1.5 1,512 1,759 7.2 6.2 1,387 1,616 7.8 6.7 43.05 133% 8.6
Burlington Res. USD 44.03 8,850 13,190 1.8% 3.6% 5.02 7.01 8.8 6.3 2.4 1,310 1,719 10.1 7.7 1,317 1,671 10.0 7.9 45.63 96% 6.7
Chesapeake USD 8.05 1,369 2,609 4.0% 5.8% 1.70 1.79 4.7 4.5 2.5 436 435 6.0 6.0 433 433 6.0 6.0 7.31 110% 8.8
Devon Energy USD 49.30 7,888 15,888 2.2% 3.9% 9.74 12.02 5.1 4.1 3.6 2,076 2,529 7.7 6.3 2,033 2,433 7.8 6.5 47.53 104% 7.8
EOG Res. USD 43.64 5,106 6,148 2.1% 3.9% 5.28 6.77 8.3 6.4 0.9 690 881 8.9 7.0 783 862 7.9 7.1 31.89 137% 8.7
Encore Acquisition USD 16.75 508 618 0.1% 1.9% 2.32 2.20 7.2 7.6 1.3 81 77 7.6 8.0 80 76 7.7 8.1 14.67 114% 5.0
Energy Partners USD 8.10 219 324 -0.1% 1.7% 2.11 2.75 3.8 2.9 1.3 74 97 4.4 3.3 74 97 4.4 3.3 8.55 95% 7.0
Forest Oil USD 31.30 1,502 2,095 0.7% 2.5% 4.00 5.90 7.8 5.3 1.3 240 336 8.7 6.2 241 333 8.7 6.3 29.77 105% 8.1
Kerr-McGee USD 61.08 6,108 10,490 2.0% 3.7% 10.09 12.25 6.1 5.0 2.8 1,389 1,611 7.6 6.5 1,356 1,576 7.7 6.7 66.83 91% 7.0
Newfield Explor USD 38.50 1,719 2,259 0.6% 2.4% 7.50 8.95 5.1 4.3 1.1 405 482 5.6 4.7 395 464 5.7 4.9 21.49 179% 14.3
Noble Affiliates USD 39.90 2,234 3,042 2.1% 3.9% 6.76 9.21 5.9 4.3 1.3 419 593 7.3 5.1 434 575 7.0 5.3 37.43 107% 6.6
Ocean Energy USD 22.62 3,891 5,295 1.9% 3.7% 2.78 3.34 8.1 6.8 1.9 647 777 8.2 6.8 626 727 8.5 7.3 12.81 177% 8.8
Pioneer Natural USD 24.60 2,435 3,985 2.1% 3.9% 3.35 4.73 7.4 5.2 3.4 451 589 8.8 6.8 451 588 8.8 6.8 19.07 129% 5.9
Pogo Producing USD 34.32 1,853 2,693 1.0% 2.8% 5.73 6.47 6.0 5.3 2.5 419 465 6.4 5.8 415 454 6.5 5.9 19.05 180% 10.5
Spinnaker Expl. USD 40.53 1,159 1,179 -1.1% 0.7% 4.91 6.53 8.3 6.2 0.1 143 199 8.2 5.9 143 199 8.2 5.9 20.95 193% 23.0
Stone Energy USD 42.50 1,125 1,555 2.4% 4.2% 7.60 9.28 5.6 4.6 1.4 238 284 6.5 5.5 236 278 6.6 5.6 35.13 121% 12.1
Swift Energy USD 15.27 397 657 -1.5% 0.2% 2.79 3.57 5.5 4.3 2.1 90 117 7.3 5.6 90 116 7.3 5.7 22.07 69% 6.1
Unocal USD 38.42 9,336 13,139 1.8% 3.6% 6.56 7.89 5.9 4.9 1.7 2,037 2,378 6.5 5.5 1,857 2,155 7.1 6.1 35.82 107% 7.2
Vintage Pet. USD 11.97 766 1,816 -0.5% 1.3% 2.49 3.12 4.8 3.8 3.0 214 269 8.5 6.8 233 275 7.8 6.6 31.02 39% 3.4
Westport Res. USD 19.20 1,018 1,502 1.4% 3.2% 3.29 4.31 5.8 4.5 1.8 211 265 7.1 5.7 212 265 7.1 5.7 19.91 96% 9.7
AVERAGE 1.3% 3.0% 6.4 5.2 1.9 7.5 6.2 7.5 6.3 112% 7.9

EUROPEAN E&P
Cairn Energy GBP 332.0 490 524 0.2% -0.5% 31.8 34.1 10.4 9.7 0.6 67 69 7.8 7.6 49 52 10.7 10.0 331.7 100% 11.6
Enterprise GBP 723.5 3,485 4,441 N/A N/A 128.3 134.7 5.6 5.4 1.4 932 910 4.8 4.9 596 650 7.4 6.8 536.5 135% 6.4
Premier Oil GBP 24.8 383 694 0.0% -0.6% 8.1 7.9 3.1 3.1 4.2 173 169 4.0 4.1 137 134 5.1 5.2 34.2 72% 2.9
AVERAGE 0.1% -0.6% 6.4 6.1 2.1 5.5 5.5 7.7 7.3 102.4% 7.0

ASIA-PACIFIC E&P
CNOOC ADS USD 26.60 10,925 9,710 0.4% -0.4% 3.97 4.06 6.7 6.6 (0.8) 1,844 1,875 5.3 5.2 1,462 1,498 6.6 6.5 33.03 81% 5.3
CNOOC Ltd. HKD 10.40 85,427 75,954 0.0% -0.8% 1.55 1.58 6.7 6.6 (0.8) 14,385 14,623 5.3 5.2 11,407 11,684 6.7 6.5 12.85 81% 5.0
Gulf Indonesia USD 11.10 976 823 -0.4% 1.3% 1.42 1.75 7.8 6.3 (1.2) 156 199 5.3 4.1 110 135 7.5 6.1 16.00 69% 3.8
PTT EP THB 116.00 75,632 87,604 N/A N/A 15.48 16.01 7.5 7.2 0.8 15,387 14,579 5.7 6.0 11,084 10,819 7.9 8.1 149.13 78% 2.6
Novus Pet. AUD 2.20 403 542 -3.1% -2.4% 0.59 0.56 3.7 3.9 1.3 139 129 3.9 4.2 111 104 4.9 5.2 2.20 100% 2.5
Oil Search AUD 1.12 743 1,024 -0.9% -0.2% 0.29 0.23 3.8 4.9 1.8 262 202 3.9 5.1 188 156 5.4 6.6 1.46 77% 7.9
Santos AUD 6.07 3,513 4,811 -0.5% 0.2% 1.27 1.12 4.8 5.4 1.9 981 864 4.9 5.6 801 719 6.0 6.7 6.29 97% 3.6
Woodside AUD 13.88 9,253 10,729 -2.0% -1.3% 1.93 1.41 7.2 9.8 1.0 1,488 1,115 7.2 9.6 1,175 1,264 9.1 8.5 15.39 90% 6.4
AVERAGE -0.9% -0.5% 6.0 6.4 0.5 5.2 5.6 6.8 6.8 84% 4.6

CANADIAN E&P
Bonavista CAD 32.00 938 1,078 2.2% 2.7% 5.32 7.42 6.0 4.3 0.7 169 234 6.4 4.6 166 231 6.5 4.7 16.96 189% 10.7
Can. Nat. Res. CAD 50.95 6,242 9,030 -2.4% -1.9% 13.63 13.58 3.7 3.8 1.4 1,903 1,919 4.7 4.7 1,790 1,808 5.0 5.0 47.18 108% 4.7
EnCana CAD 48.10 22,804 30,149 -1.8% -1.3% 6.68 8.42 7.2 5.7 1.7 3,944 5,247 7.6 5.7 3,644 4,530 8.3 6.7 45.89 105% 8.5
Husky Energy CAD 16.61 6,924 9,222 2.2% 2.7% 3.37 3.15 4.9 5.3 1.2 1,637 1,681 5.6 5.5 1,528 1,453 6.0 6.3 18.33 91% 6.4
Nexen CAD 41.35 5,012 7,220 1.1% 1.6% 8.50 9.24 4.9 4.5 1.6 1,386 1,466 5.2 4.9 1,211 1,316 6.0 5.5 32.31 128% 7.8
Penn West CAD 43.36 2,272 2,867 0.8% 1.3% 7.39 9.45 5.9 4.6 1.0 487 612 5.9 4.7 437 544 6.6 5.3 41.84 104% 5.8
Rio Alto Exp. CAD 18.85 1,419 2,358 18.2% 18.7% 4.73 5.92 4.0 3.2 1.4 453 562 5.2 4.2 422 511 5.6 4.6 23.24 81% 6.9
Talisman Energy CAD 68.72 9,189 12,414 0.0% 0.5% 16.02 16.54 4.3 4.2 1.3 2,779 2,788 4.5 4.5 2,343 2,421 5.3 5.1 58.79 117% 5.4
AVERAGE 2.5% 3.0% 5.1 4.4 1.3 5.6 4.8 6.2 5.4 115% 7.0

GLOBAL E&P AVERAGE 6.1 5.3 1.5 6.5 5.8 7.1 6.3 50.5 110% 7.4

62
Oil and Gas Primer 14 May 2002

As Exhibit 59 shows and as we mentioned above, North America is the largest market
for E&P equities. We will concentrate our discussion on this market, but will first
summarize the other markets. Outside of the North American E&Ps, European
companies are much more oil leveraged and international in terms of their scope of
operations. This is not a matter of choice, as Europe has fewer natural resources on the
continent and is faced with a maturing North Sea, forcing European E&P companies to
search for reserves elsewhere. Rapid consolidation has swept through the Europe
E&Ps the past five to ten years, with only a small handful of independent companies
remaining. Consolidation has largely come in the form of Integrated Oils interested in
acquiring the international oil prospects of the Independents.
Asia-Pacific is altogether a different story; the market is cobbled together through
Natural gas use has yet to
incongruous lands separated by vast oceans, straits, and seas. The equity markets are
take hold as a dominant
both emerging and developed and the potential resource base is much less mature than
energy source in Asia-
North America and Europe. Oil consumption also makes up a greater percent of overall
Pacific; however, recent
energy consumption than in North America and Europe. (See Exhibit 60.) Natural gas
gas discoveries and
discoveries have occurred at an increasing rate over the past ten years as has the
infrastructure build-outs
infrastructure build-out and this may serve to change the oil dependence dynamic.
should change this over
Australia is the largest single market in Asia-Pacific for Independent E&P equities.
time
Exhibit 60: Natural Gas Share of Primary Energy Demand
% of total energy needs on oil equivalent basis

50%

45% 44%

40%

35%

30%
26%
25%
25%
23% 22%
20%
20%

15%
11%
10%

5%

0%
Middle East North America World Europe Latin America Africa Asia-Pacific

Source: BP Statistical Review of World Energy 2001, CSFB estimates.

63
Oil and Gas Primer 14 May 2002

Concentrating on the North American market, the U.S. and Canadian E&P industries
are dominated by small cap and mid cap, public and private players focused largely on
North American natural gas production. The average market capitalization of the CSFB
North America E&P coverage universe is slightly over US$4.0 billion while the median
market cap is only US$2.2 billion. The industry can be characterized as very
entrepreneurial, as many of the participants trace their roots to family businesses.

Exhibit 61: North American Market Capitalization Exhibit 62: North American Industry Production Leverage
US$ millions simple average

$4,500
$4,242
$4,063
$3,997
$4,000

$3,433
$3,500 Oil/Gas split
15-20%
$3,000

$2,500
$2,258

$1,954
$2,000 Oil levered
25-30% Gas levered
55-60%
$1,500

$1,000

$500

$0
US Canada North America

Average Median

Source: Reuters, Priced at April, 17, 2002. Source: Company data, CSFB estimates.

Highlighting the natural gas leverage and continental focus of the industry, roughly 55-
60% of the companies in our North American coverage universe are heavily weighted
toward natural gas production (> 60% natural gas production) while only 25-30% are
levered toward oil production. The remaining 15-20% are fairly evenly split between oil
and gas (45-55% either way).
Consolidation has been as The maturity of the U.S. oil and gas market that brought about the dramatic
big a factor in the North transformation of the Integrated Oil industry has affected the North American
America E&P business as Independent group in numerous ways, and in a larger context the global group. Similar
it has in the Integrated to the relationship the Integrateds had with the Refiners throughout the 1990s, North
business American Independents were the main buyers amidst the Integrated Oil industry’s
upstream portfolio restructuring throughout the 1990s. At the same time the
Independents bulked up their size in the U.S., a few began to follow the lead of the
major Integrateds and invest more heavily in new international, global projects. Those
that remained committed to the continental North America market consolidated their
market share in their core areas and others expanded their operations beyond the
borders into either the U.S. or Canada. More often, U.S. E&Ps have pursued property
acquisitions and M&A opportunities in Canada as natural gas exploration and
development opportunities in Canada have outpaced the mature U.S. market and new
transportation infrastructure has been brought online. (See Exhibit 63.) This has
occurred at an increased pace over the past three to five years. Consolidation has been
as big a factor in the North America E&P business as it has in the Integrated business.

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Oil and Gas Primer 14 May 2002

Exhibit 63: U.S.–Canada Cross-Border M&A Activity

US$ in millions, unless otherwise stated, equity value

$10,000 $9,683

$9,000

$8,000

$7,000
$6,414

$6,000

$5,000

$4,000
$3,439

$3,000
$2,472

$2,000
$1,435
$1,051
$1,000 $768
$532
$357 $273
$84 $180
$0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: SDC.

The health of the industry The health of the E&P industry hinges first on resource potential or the ability to grow
hinges on the ability to reserves, and second, on the ability to attract capital to develop the reserves. The latter
grow reserves and to is affected by oil and gas prices and cost structures (i.e., the economics of drilling and
attract capital to develop producing). As we discussed earlier, there are three main ways to increase reserve
the reserves growth: drilling, property acquisitions, or equity acquisitions. Prospects and service
costs are critical to successfully adding low-cost reserve value through drilling, while
value-added property acquisitions and property turnover occur most frequently in down
markets and in periods of major asset restructurings. Equity acquisitions can become
very costly at cycle peaks.
Well-capitalized Geographic scale and scope are directly related to a company’s size and ability to
companies are better able spread costs over the asset base, as we discussed in the Integrated Oils section. Well-
to diversify their capitalized companies are more able to diversify their geographic reach within and
geographic reach versus outside North America versus smaller entities that rely more heavily on lower-risk,
smaller entities exploitation projects in long-lived areas. These smaller companies essentially develop
core competencies, exploiting one particular geological area. The largest Independents
have increasingly pushed into new, unexploited global growth markets with high
potential.
Global Independents have Large-scale, international operations are most often geared toward oil exploration and
emerged in the wake of the production over gas, as they have higher-margin potential given the size of the global oil
oil industry restructuring market versus regional gas markets. International E&P also has significantly greater
and the maturation of the opportunities to tap undeveloped, unexplored areas; lease concessions are typically
U.S. asset base much larger; and it provides diversity of operations and tax incentives.

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Oil and Gas Primer 14 May 2002

Oil and natural gas mix is only one way to evaluate the composition of companies in the
industry. Other major considerations into the overall attributes and health of companies
in the industry include the size and breakdown of the reserve base and the opportunity
to grow reserves.
There are several types of business models being pursued. The business mix may take
hold in any one or more of the following forms:
• Business stage. Exploration (growth), exploitation, and development (mature).

• Growth strategy. Property acquisition, internal (drillbit), M&A.

• Geographic diversity. Specific, long-lived basins or “plays” versus diverse continental

and international “plays”; cost structures also play a role.
• Reserves or production mix. Oil or natural gas focus.

The E&P industry is inherently capital and asset intensive given the physical
exploration, development, and production processes. In a low-growth industry where
demand closely tracks GDP growth, attempts to outgrow the industry through production
increases have historically resulted in lower returns and commensurate value
destruction. Excess production growth often leads to capacity expansion beyond the
long-term demand function, not necessarily in the short run, but as market conditions
change and the supply/demand balance shifts.
The capital-intensive The capital-intensive nature of the Independent E&P group creates an ongoing need to
nature of the Independent access capital, whether it is debt or shareholders’ equity. However, given the different
E&P group creates an legs of the cycle and the growth orientation of a particular company, debt is most often
ongoing need to access used in times of aggressive expansion. As the cycle progresses and moves into trough
capital periods, debt levels become burdensome and asset rationalizations follow. Industry-
wide productive capacity does not change, but merely shifts from one owner to another.

Clearly each strategy in and of itself has benefits and drawbacks, but importantly, the
relative value of one over another differs depending on the stage of the cycle. Isolating
companies pursuing a pure-play strategy versus companies pursuing combinations of
all three strategies can provide value for leverage or deleverage to particular shifts in
the cycle and added investment return potential.

In summary, returns on capital drive valuation among the Independent E&Ps, similar to
the other oil and gas industries. Returns, however, cannot be fully evaluated in isolation;
risk levels obviously play a large and equally important role in the return function.
Reinvestment risk is a key component of these relative returns measures and it varies
on a company-by-company basis based on asset life (reserves/production) and
depending on the strategy being pursued. The level of risk is clearly greater for
companies with shorter-lived asset lives, when industry portfolio turnover and
consolidation are low and drilling success is the most cost-effective growth vehicle. We
expect consolidation throughout the industry and in every region to continue as
producers seek to lower unit costs and profitably add reserves.

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Oil and Gas Primer 14 May 2002

Oilfield Services and Equipment

Oilfield Service companies Finding and developing hydrocarbons requires expensive capital equipment, specialized
deliver cost savings and tools and technologies, and unique skill-sets for delivering necessary services.
efficiency gains that stand- However, owning and maintaining all of the equipment, products, and services required
alone producers could not to explore for and produce oil and natural gas is inefficient for producers. Instead,
realize specialized Oilfield Service and Equipment (Asset) companies fill this gap. (Equipment
companies are also called Assets, or Drillers.) As outside providers, they are better
positioned because they can allocate resources to a broader group of producers,
increasing asset productivity and better spreading the costs associated with developing
new tools and technologies. Through product and service focus, the Oilfield Service
companies also deliver cost savings and efficiency gains that stand-alone producers
could not realize.
Service companies Service companies provide an array of different products and services. Oilfield Asset
participate in essentially companies or drillers own rigs and lease them to producers while other Service
every step of the companies manufacture capital equipment (drilling rig equipment, production
hydrocarbon process equipment, natural gas compressors, etc.) or consumable products (bits, fluids, drillpipe,
etc.) for sale or rent, depending on application. In addition, some companies maintain
an inventory of tools and equipment for rent, primarily in North America. As their name
implies, most Service companies provide some aspect of service (pressure pumping,
machinery operation, reservoir description, tubular inspection, etc.) in addition to
equipment, with some more service focused than others. Oil Service companies are
involved in essentially every step of the hydrocarbon process from exploration to
development to production, and finally abandonment of fields. A more complete
discussion of the products and services that Oil Service companies provide can be
found in Appendix I: The Physical Process.

Our global OFS universe comprises 35 companies, primarily based in the United States
but with a global operating structure. Our coverage group includes 3 large-cap, oil
Service Majors, 14 mid-cap U.S. Service companies, 6 mid-cap European companies,
and 12 Oilfield Asset companies. The Major Service companies provide a breadth of
services spanning the E&P process, and serve most or all of the major producing
regions. Most mid-cap Service companies are more focused on a particular facet (or
facets) of the upstream chain, and may be more limited in geographic scope. Oilfield
Asset companies own and operate the onshore and offshore drilling rigs and the supply
vessels that support them, and most have the ability to deploy assets around the world.

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Oil and Gas Primer 14 May 2002

Exhibit 64: Global Oilfield Services Valuation

MARKET DATA DAILY EARNINGS ADJUSTED EARNINGS LEVERED CF UNLEVERED CF VALUE ADDED
PRICE MKT STOCK PERF. EPS P/E EPS P/E CFPS P/CF EBITDA EV/EBITDA 2002E EV /
TICKER FX 5/13/02 CAP EV % Rel. % 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E ROGIC GIC
MAJORS
Baker Hughes USD 37.48 12,672 14,403 0.9% 2.7% 1.01 1.50 37.1 25.0 1.01 1.50 37.1 25.0 2.29 2.78 16.4 13.5 1,050 1,291 13.7 11.2 13.7% 200%
Halliburton USD 17.00 7,361 8,623 2.4% 4.2% 0.88 1.43 19.3 11.9 0.88 1.43 19.3 11.9 2.03 2.60 8.4 6.5 1,272 1,648 6.8 5.2 11.3% 75%
Schlumberger USD 56.54 32,856 38,750 1.9% 3.7% 1.55 2.20 36.5 25.7 1.55 2.20 36.5 25.7 3.50 4.22 16.2 13.4 2,201 2,766 17.6 14.0 10.2% 173%
AVERAGE 1.7% 3.5% 31.0 20.9 31.0 20.9 13.6 11.1 12.7 10.1 11.7% 149%

US MID-CAP
BJ Services USD 38.36 6,142 6,158 1.2% 2.9% 1.09 1.62 35.2 23.7 1.09 1.62 35.2 23.7 1.71 2.26 22.4 17.0 378 516 16.3 11.9 17.9% 292%
Cooper Cameron USD 58.70 3,499 3,878 1.9% 3.7% 1.82 2.67 32.3 22.0 1.82 2.67 32.3 22.0 3.18 4.10 18.5 14.3 225 314 17.3 12.4 11.6% 196%
CoreLab USD 14.50 492 573 0.0% 1.8% 0.80 1.17 18.1 12.4 0.80 1.17 18.1 12.4 1.38 1.75 10.5 8.3 64 80 9.0 7.2 14.1% 126%
FMC Technologies USD 23.00 1,500 1,759 0.2% 2.0% 0.96 1.34 24.0 17.2 0.96 1.34 24.0 17.2 1.66 2.06 13.9 11.2 162 201 10.9 8.7 15.0% 176%
Global Industries USD 9.18 957 1,080 -0.4% 1.3% 0.35 0.53 26.2 17.3 0.35 0.53 26.2 17.3 0.84 1.04 10.9 8.8 122 152 8.9 7.1 14.0% 125%
Grant Prideco USD 16.10 1,798 2,046 5.4% 7.1% 0.30 0.62 53.7 26.0 0.30 0.62 53.7 26.0 0.59 0.97 27.3 16.6 112 167 18.3 12.3 12.1% 222%
Hanover USD 15.77 1,296 2,854 -4.6% -2.8% 1.02 1.45 15.5 10.9 1.02 1.45 15.5 10.9 2.19 2.67 7.2 5.9 343 419 8.3 6.8 10.2% 84%
Hydril USD 25.90 589 571 0.5% 2.2% 0.98 1.29 26.4 20.1 0.98 1.29 26.4 20.1 1.45 1.82 17.9 14.2 48 60 12.0 9.5 13.9% 159%
Oil States International USD 11.80 574 629 4.9% 6.7% 0.72 0.92 16.4 12.8 0.72 0.92 16.4 12.8 1.17 1.37 10.1 8.6 71 93 8.9 6.7 14.0% 126%
Smith International USD 76.06 3,797 4,421 2.5% 4.3% 2.59 3.30 29.4 23.0 2.59 3.30 29.4 23.0 3.53 4.83 21.5 15.7 330 391 13.4 11.3 16.3% 169%
Superior Energy USD 11.04 787 1,070 0.4% 2.1% 0.46 0.76 24.0 14.5 0.46 0.76 24.0 14.5 1.00 1.28 11.0 8.6 116 151 9.2 7.1 17.5% 159%
Technip-Coflexip USD 35.20 3,575 4,363 -0.8% 0.9% 1.81 2.38 19.5 14.8 1.81 2.38 19.5 14.8 3.45 4.16 10.2 8.5 495 596 8.8 7.3 14.4% 98%
Varco USD 20.99 2,033 2,298 1.7% 3.5% 0.89 1.14 23.6 18.4 0.89 1.14 23.6 18.4 1.59 1.89 13.2 11.1 233 274 9.9 8.4 15.8% 153%
Weatherford** USD 53.10 7,105 8,014 2.1% 3.8% 1.60 2.17 33.2 24.5 1.60 2.17 33.2 24.5 3.00 3.77 17.7 14.1 596 720 13.4 11.1 12.2% 163%
W-H Energy Services USD 22.64 622 718 -0.3% 1.5% 0.98 1.63 23.1 13.9 0.98 1.63 23.1 13.9 2.08 2.63 10.9 8.6 81 109 8.9 6.6 20.2% 180%
AVERAGE 1.0% 2.7% 26.7 18.1 26.7 18.1 14.9 11.4 11.6 9.0 14.6% 162%

EUROPEAN
DSND NOK 23.20 1,399 3,593 -3.3% -3.3% 1.55 2.29 15.0 10.1 1.76 2.50 13.2 9.3 6.19 7.05 3.7 3.3 496 546 7.3 6.6 11.4% 83%
IHC Caland EUR 61.70 1,733 1,877 0.6% -0.2% 3.18 3.92 19.4 15.7 3.18 3.92 19.4 15.7 6.29 7.77 9.8 7.9 237 302 7.9 6.2 14.5% 95%
Ocean Rig NOK 7.90 443 3,374 -6.0% -5.9% (5.84) (3.01) N/M N/M (5.84) (3.01) N/M N/M N/M 2.31 N/M 3.4 542 706 6.2 4.8 6.8% 45%
Saipem EUR 7.30 3,213 3,786 -1.6% -2.3% 0.36 0.48 20.4 15.1 0.36 0.49 20.1 14.9 0.87 1.03 8.4 7.1 470 551 8.1 6.9 14.4% 105%
Smedvig NOK 75.50 6,264 9,818 -1.9% -1.9% 7.26 9.21 10.4 8.2 8.03 9.98 9.4 7.6 13.20 15.31 5.7 4.9 1,341 1,543 7.3 6.4 12.3% 96%
Technip-Coflexip EUR 153.00 3,885 4,761 -0.6% -1.4% 4.05 6.56 37.8 23.3 8.04 10.56 19.0 14.5 15.34 18.50 10.0 8.3 550 662 8.7 7.2 14.4% 107%
AVERAGE -2.1% -2.5% 20.6 14.5 16.2 12.4 7.5 5.8 7.6 6.3 12.3% 88%

MARKET DATA DAILY EARNINGS ADJUSTED EARNINGS LEVERED CF UNLEVERED CF VALUE ADDED
PRICE MKT STOCK PERF. EPS P/E EPS P/E CFPS P/CF EBITDA EV/EBITDA 2001E EV /
TICKER FX 5/13/02 CAP EV % Rel. % 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E 02E 03E RORC Repl
OILFIELD ASSETS
Atwood Oceanics USD 48.85 683 755 0.0% 1.8% 1.87 2.60 26.1 18.8 1.87 2.60 26.1 18.8 3.56 4.55 13.7 10.7 66 88 11.4 8.6 6.4% 70.3%
Chiles Offshore USD 23.88 486 604 -2.0% -0.2% 0.93 1.17 25.7 20.4 0.93 1.17 25.7 20.4 1.73 2.18 13.8 11.0 48 62 12.7 9.8 8.8% 146.1%
Diamond Offshore USD 34.68 4,570 4,540 2.2% 4.0% 0.51 1.40 68.0 24.8 0.51 1.40 68.0 24.8 1.76 2.67 19.7 13.0 255 463 17.8 9.8 5.8% 71.4%
Ensco USD 35.28 4,777 4,915 1.2% 3.0% 0.82 1.67 43.0 21.1 0.82 1.67 43.0 21.1 1.70 2.67 20.8 13.2 299 485 16.4 10.1 9.5% 119.8%
GlobalSantaFe USD 35.65 8,442 8,562 2.6% 4.4% 1.58 1.93 22.6 18.5 1.58 1.93 22.6 18.5 2.65 3.03 13.5 11.8 695 799 12.3 10.7 5.9% 99.8%
Grey Wolf USD 5.01 906 1,056 3.1% 4.9% (0.08) 0.15 N/M N/M (0.08) 0.15 (62.6) 33.4 0.19 0.43 26.4 11.7 50 116 21.1 9.1 13.2% 84.3%
Helmerich & Payne USD 42.45 2,134 2,139 0.6% 2.3% 1.06 2.25 40.0 18.9 1.06 2.25 40.0 18.9 3.29 4.58 12.9 9.3 195 303 10.9 7.0 10.2% 97.6%
1
Helmerich & Payne USD 35.96 0.94 2.14 38.3 16.8 0.94 2.14 38.3 16.8 3.17 4.47 11.3 8.0
Noble Corporation USD 43.19 5,757 6,122 3.2% 5.0% 1.94 3.00 22.3 14.4 1.94 3.00 22.3 14.4 2.87 4.05 15.0 10.7 459 629 13.3 9.7 9.0% 110%
Pride International USD 19.22 2,572 4,265 1.3% 3.0% 0.33 0.95 58.2 20.2 0.33 0.95 58.2 20.2 1.99 2.72 9.7 7.1 400 529 10.7 8.1 6.3% 70%
Rowan USD 26.84 2,557 2,792 2.8% 4.5% (0.06) 1.14 N/M 23.5 (0.06) 1.14 N/M 23.5 0.70 1.92 38.3 14.0 72 260 38.9 10.8 6.0% 87%
Seacor Smit USD 48.08 1,027 1,081 1.9% 3.7% 2.68 4.13 17.9 11.6 2.68 4.13 17.9 11.6 5.23 6.72 9.2 7.2 148 187 7.3 5.8 8.2% 57%
Tidewater USD 45.01 2,541 2,584 4.1% 5.8% 2.53 3.50 17.8 12.9 2.53 3.50 17.8 12.9 4.00 5.15 11.3 8.7 292 398 8.9 6.5 8.4% 80%
Transocean USD 38.50 12,439 16,448 0.0% 0.0% 1.07 1.83 36.0 21.0 1.07 1.83 36.0 21.0 2.54 3.31 15.2 11.6 1,104 1,427 14.9 11.5 6.4% 91%
AVERAGE 1.7% 3.4% 32.0 17.4 25.2 18.4 15.4 9.9 14.2 8.6 8.1% 86%

GLOBAL OFS AVERAGE 27.8 17.4 25.2 17.8 14.1 10.0 12.1 8.5 11.6% 122%

Investing in Oil Service Stocks

Oil Service stocks are the Oil Service stocks are the most volatile of the energy industry sectors. This volatility is a
most volatile of the energy function of leverage to commodity prices and the producer spending cycle, relatively
industry sectors small capitalizations (most less than $5 billion equity capitalization), and wide
fluctuations in cyclical cash flow generation. In the past, Oil Service companies
underperformed the broader market on a relative basis. However, playing the cycle and
taking advantage of volatility offers the opportunity for outsized returns. Additionally,
after 15 years of industry underinvestment as producers took advantage of excess
capacity, the group appears poised to end its underperformance relative to the market.
In general, there are three key drivers of Oil Service stock performance: commodity
prices/producer spending, valuation/timing, and differential opportunities and returns.

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Oil and Gas Primer 14 May 2002

Commodity Prices/Producer Spending

The prospects for oil The prospects for Oil Service companies are closely tied to the fortunes of their
service companies are Integrated Oil, Independent E&P, and national oil company customers. Producer
closely tied to the fortunes revenues, in turn, are proportional to commodity prices. The rise and fall of commodity
of producers prices defines upstream spending cycles, as incentive to spend hinges on the expected
level of oil and gas prices and the ability to generate adequate returns on incremental
investment. Higher commodity prices generate more cash and increase producers’
capacity to reinvest in replacing and growing reserves.
Relative stock Spending cycles have generally lasted three to four years, depending on a variety of
performance follows factors including the global economy, OPEC policy, productive capacity utilization, and
changes in producer gross weather. There is some evidence of emerging North American gas cycles that could be
cash flows slightly shorter. Historically, relative service stock performance has closely followed
changes in producer gross revenues (as defined by commodity price times volume),
which foreshadow changes in producer spending. We will discuss the spending cycle
and the tools we use to forecast spending levels in greater detail in a moment.

Exhibit 65: Relative Service Stock Performance, Worldwide Gross Revenues, Worldwide
Drilling, and Completion Spending
US$ in millions, unless otherwise stated

WW Spending Relative Stock Performance WW Gross Revenue

4.00 80

3.50 70

3.00 60

2.50 50

2.00 40

1.50 30

1.00 20

0.50 10
1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Source: Company data, CSFB estimates.

Oil Service companies can Spending cycles are characterized by different phases. Exploration-related services
be classified according to lead the cycle, followed by completion and development services and later by
the stage(s) of the cycle production services and investment in capital equipment. This being the case, Oil
they serve Service companies can be classified according to the stage(s) of the cycle they serve.
While the stocks tend to move as a group, individual stocks have the potential to

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Oil and Gas Primer 14 May 2002

outperform during different stages of the spending cycle. In particular, early-cycle stocks
are often the beneficiaries of an influx of momentum money in reaction to surging
earnings and cash flow at the front end of the cycle.

Timing/Valuation
Timing is critical to Given the cyclical nature of the industry and the volatility of the stocks, timing is critical
successful investing in Oil to successful investing in Oil Service stocks. Oil Service stocks are generally not
Service stocks considered “buy and hold” investments. Importantly, Service stocks move in anticipation
of improving fundamentals, so investment decisions should be made in advance of
activity and spending changes in order to maximize returns. Fortunately, there are a
number of leading indicators, including drilling permits, oil and gas prices, producer
budgets, and oil and gas inventories that help forecast future spending and activity
levels.
OFS stocks are Oil Service stocks demonstrate broad annual trading ranges, which are generally much
susceptible to extreme wider than actual changes in financial results. Consequently, it is often possible to
valuations in both identify a disconnect between valuations and fundamentals. Interestingly and in contrast
directions to traditionally defined cyclical stocks, Oil Service stocks have historically achieved peak
multiples on peak earnings and trough multiples on trough earnings, amplifying the
group’s cyclical leverage. In essence, OFS stocks assume secular characteristics during
times of extremely positive or negative fundamentals, as unsustainable conditions are
extrapolated into the future to both the upside and the downside.

Returns Analysis
As with other oil and gas Our approach to Oilfield Service valuation is similar to that used for other oil and gas
sectors, returns are a key industries, focusing on the correlation between valuation and returns. We use return on
component in stock gross invested capital (ROGIC) to evaluate a service company’s capacity to generate
valuation value-added returns on its investments at original cost. Gross invested capital (GIC)
represents the total capital invested in the business over the company’s history. We use
this broadened asset base since service companies often continue to generate cash
from depreciated assets, making them an important piece of the company assets that
equity holders are buying. Also, GIC eliminates effects of different depreciation methods
and lives, yielding a more comparable asset base.

For the Oilfield Asset companies, we prefer to use replacement cost as the denominator
in returns calculations. Replacement cost values each rig or vessel in a company’s fleet
at estimated present day construction costs, incorporating adjustments for specific
capabilities and equipment. We prefer this measure over GIC because it places all of
the Oilfield Asset companies on comparable footing and eliminates the balance sheet
distortions attributable to asset write-downs, bankruptcies, and bargain asset
purchases/combinations over the past 20-plus years. The market should be willing to
pay “fair value” for comparable assets, regardless of whether the company built them
new or bought them cheaply.

Exhibits 66 and 67 demonstrate the intuitive principle that the market affords higher
asset valuations to companies that generate higher returns on those assets.

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Oil and Gas Primer 14 May 2002

Exhibit 66: Oilfield Service EV/GIC to ROGIC Exhibit 67: EV/Estimated Replacement Cost to Return on
Replacement Cost
160%
280.0%

BJS
260.0% COD

140%
240.0%

220.0%

EV/Replacement Cost
GRP 120%
200.0% SII
BHI NE
ESV
180.0% CAM WHES
SLB 100%
EV/GIC

160.0% WFT
SPN GSF

140.0% HYDLVRC GW HP
FTI SPII RDC
CLB 80% TDW
RIG
GLBL
120.0%
OIS
TKP
SPMI ATW CKH
100.0%
HC DO SMVB
IHC 60%
80.0%
HAL
60.0%
40%
40.0% 1% 3% 5% 7% 9% 11% 13%
10.0% 14.0% 18.0% 22.0%
2002E Pre-Tax ROGIC
Return on Replacement Cost

Source: Company data, CSFB estimates. Source: Company data, CSFB estimates.

The market rewards As would be expected, the market rewards companies for increasing returns and
growth in returns and penalizes companies for deteriorating returns. Companies that have been able to both
assets grow assets and maintain or increase returns have typically demonstrated the strongest
stock performance over time, meaning accretive growth via reinvestment or acquisition
is key to outperformance.

Valuation Parameters
Traditional multiple In addition to return metrics, we also employ traditional multiple analysis to evaluate a
analysis helps compare company’s current valuation relative to the peer group and in the context of likely future
valuations to peers, the valuation levels. We prefer to concentrate on cash flow when valuing companies, for the
market, and history following reasons:
• Comparability across asset bases. Given the capital-intensive nature of most Oil
Service businesses, the historical propensity for bankruptcy, asset writedowns, cheap
countercyclical acquisitions, and purchase versus pooling accounting, comparability
among the stocks based on earnings is not very effective because of different
depreciation loads.
• Cyclicality. During trough periods many service companies fail to generate meaningful
(if any) earnings (cash flow only), distorting historical trading ranges. Cash flows
provide a better representation of full-cycle trading ranges.
The group’s relative cash Historically, the group has traded at a small premium on cash flow to the broader
flow multiple fluctuates market. However, the group’s relative cash flow multiple fluctuates considerably with the
considerably with the cycle cycle, achieving large premiums during times of favorable prospects and trading at a
large discount when the fundamental outlook is negative.

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Oil and Gas Primer 14 May 2002

Exhibit 68: Oilfield Service Relative Cash Flow Premium/(Discount) to S&P Industrials
50%
GREATEST PREMIUM
49.2%
40%

30%

20%

10%

0%

-10%

-20% Market Multiple

-30%
CURRENT: -2.9% DISCOUNT

-40%

-50%
GREATEST DISCOUNT -61.1%

-60%

-70%
Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Source: Company data, CSFB estimates.

Asset-Based Valuation
Asset-based valuation is Asset-based valuation is typically most useful at extremes: in trough/near-trough
typically most useful at valuation conditions, at peaks, and during event-driven sell-offs.
valuation extremes
• At the lows, this analysis provides a fairly reliable method for determining if you are
buying the assets cheap.
• At the peaks, they provide a check to traditional multiple analysis, which tends to be
distorted by the “it’s different this time” syndrome.

• During emotional event-driven sell-offs, asset valuations help identify opportunities

where a stock has significantly broken from rational valuations.

Historically, buying assets when they are cheap, with the approach of taking a longer-
term holding position, has yielded dramatically outsized returns.

Differentiating Factors
Oil Service companies can While the majority of Service stock performance can be explained by cyclical variability,
differentiate themselves Service companies can outperform their peers through differentiated opportunities and
via opportunistic returns. Among the ways Oil Service companies differentiate themselves are via
acquisitions or new opportunistic acquisitions and new technologies. Opportunistic acquisitions, often made
technologies during market downturns, can lead to superior returns on capital, which the market has
demonstrated a willingness to pay for. Development and commercialization of emerging
technologies offer secular growth opportunities on top of cyclical appreciation potential,
providing the potential for outsized growth.

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Oil and Gas Primer 14 May 2002

Secular Trends
Despite its cyclical nature, Despite its cyclical nature, the Oilfield Service sector does have certain secular trends
the Oilfield Service sector working in its favor. Over the next several years, OFS companies should benefit from
has certain secular trends rising capital intensity, 15 years of upstream underinvestment, an increasing share of
working in its favor oilfield-related intellectual property, and perhaps consolidation.
As reserve bases mature, producers are having to run harder and harder just to keep up
with increasing decline rates. This phenomenon is particularly apparent in the
relationship between the North American natural gas rigcount and production—a
dramatic increase in activity failed to generate any volume response. Increasingly,
producers are testifying that the cost of growth is trending upward. As production growth
becomes more expensive, wealth is transferred from producers to service companies.

Exhibit 69: U.S. Natural Gas Rigcount versus Production

1,200 1,800

1,000 1,500

Production (mmcf/mo.)
800 1,200
Rigcount

600 900

400 600

200 300
F-00

F-01

F-02
M-99
A-99
M-99
J-99
J-99
A-99
S-99

N-99
D-99
J-00

M-00
A-00
M-00
J-00
J-00
A-00
S-00

N-00
D-00
J-01

M-01
A-01
M-01
J-01
J-01
A-01
S-01

N-01
D-01
J-02
O-99

O-00

O-01
U.S. Gas Rigcount U.S. Gas Production

Source: Company data, CSFB estimates.

Capital intensity is rising Evidence of rising finding and development costs also highlights the challenges facing
for producers oil companies. Announcements of and changes to production plans at the Super Majors
illustrate recent recognition of these trends, with lower volume forecasts coming on
unchanged spending budgets. Rising drilling intensity and the challenges associated
with overcoming depletion curves offer tremendous opportunities for service companies.
Commodity markets are at As discussed in previous sections, the oil market is close to and the natural gas market
or near full capacity is at full capacity utilization, implying the need for significant capital investment in
utilization productive capacity. As the market approaches full utilization, investment levels must
trend or shift up to a level where capacity growth keeps pace with, or exceeds, demand
growth. Otherwise, commodity prices will rise to a level that limits demand growth, as
happened in the North American gas market in 2001.

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Oil and Gas Primer 14 May 2002

Exhibit 70: World Oil Production Capacity Utilization

105.0%

2002E Utilization = 94.4%

100.0% Iran-Iraq War
Saudi Capacity Underestimated

Impacted by Iraq-
Kuwait Conflict
Long-term Average = 93.8%

Capacity Utilization
95.0%

90.0%

85.0%

80.0%
1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002
Source: Company data, CSFB estimates.

Service companies control The last several years have seen a shift in the allocation of intellectual property in the
an increasing share of oilpatch. Producer spending on technology has waned, due in part to aggressive cost-
oilfield-related intellectual cutting efforts associated with the recent and ongoing wave of industry consolidation.
property Meanwhile, Service companies have continued to invest in research and development,
resulting in greater value-added potential for the Service companies. Intellectual
property rights represent a significant barrier to entry for many Service companies,
protecting attractive returns on proprietary technologies.
Consolidation could Another potential driver for Oil Service stocks is consolidation. While most of the smaller
facilitate improved capital service companies focus on a particular niche product or service, service companies are
discipline and capacity increasingly focused on providing a bundled cross-section of products and services.
utilization throughout Consolidation is often a faster and cheaper way to expand product offerings than
the cycle internal development. In addition, consolidation facilitates improved capital discipline
and capacity utilization throughout the cycle. Most of the markets served by Oil Service
companies are relatively small, so a limited number of players is ideal to facilitate
adequate pricing and returns.

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Oil and Gas Primer 14 May 2002

The Spending Cycle

Given the leverage of service companies to the producer spending cycle, we invest
considerable energy analyzing and forecasting spending activity. We use several
approaches to forecast the level of producer spending, looking at activity by customer
group and by region.

Spending by Customer Group

Integrateds, Independent Different producer groups exhibit different behavior in response to movements in
E&Ps, and national oil commodity prices. Once estimated, spending deltas by group can be weighted and
companies exhibit different combined to yield an overall spending forecast. We look at three primary spending
behavior in response to groups: Integrated Oils, Independent E&Ps, and National Oil Companies.
changes in commodity
• Integrateds are the steadiest spenders, slow to commit capital when conditions are
prices
improving, and slow to retract when things turn down. This is partly due to the larger
scope of the projects that Integrateds participate in versus smaller companies with
less available capital. The long-life and deepwater projects that Integrateds often
pursue require substantial investment and are budgeted to provide ample returns on
capital even at the bottom of the cycle. Such projects generally require long lead times
and can last several years, spanning the entirety of a given cycle. Integrateds typically
represent 45-50% of total upstream spending.

• Independents are the quickest to react to changing commodity prices given their
smaller size. With their predominantly North American exposure, Independents are
particularly levered to changes in natural gas prices. As a group, Independents
demonstrate the most volatile spending patterns, historically spending beyond their
cash generation in high-price environments, but well below cash flow in low-price
environments. Independents typically represent 20-30% of total spending.

• The spending patterns of national oil companies are more difficult to predict, affected
by government policy and fiscal budgetary considerations as well as industry
conditions, and clouded in many cases by cartel interests. Following a sustained
period without meaningful reinvestment, however, many of the NOCs are presently
capacity constrained (or on the verge of being so) and in need of investment in
productive capacity. NOCs typically represent 25-30% of total spending.

Spending by Region
International markets are Commodity price fluctuations do not affect all regions equally, owing primarily to
highly levered to oil, while different production profiles. International markets are more levered to oil prices, given
North America is the vast untapped deepwater reserves throughout the world and the prolific oil
predominantly gas driven reservoirs in the Middle East. With its oil base significantly depleted, North America has
become a predominantly natural-gas-driven market. Natural gas is typically an
indigenous commodity (not transportable except as LNG or GTL), so markets tend to be
limited to specific geographic regions subject to their own spending and demand
patterns. To forecast spending by region, we examine current and expected drilling
activity levels. Our rigcount forecast is based primarily on our commodity price
forecasts, which are in turn driven by expected supply/demand trends. To help quantify
this relationship, we employ our proprietary QualRig model that estimates worldwide
drilling and completion spending based on regional rigcounts, incorporating service
intensity variations by rig type and region.

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Oil and Gas Primer 14 May 2002

Exhibit 71: Qualrig—Worldwide Drilling and Completion Expenditures

US$ in billions, unless otherwise stated

4.0 4.0

3.5 3.5

3.0 3.0

2.5 2.5

2.0 2.0

1.5 1.5
1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: Company data, CSFB estimates.

The destination of In terms of implications for the Service companies, the destination of producer spending
producer spending has dollars is as important as the absolute spending level. Given the high concentration of
significant implications for Independents, North America generally leads the spending cycle. Thus, Service
Oil Service stocks companies levered to North American gas production perform well during the early
stages of the spending cycle. Service companies with more oil leverage are buoyed by
the ramp in spending from Integrateds and NOCs in international markets, which tends
to be a slower process.

Reinvestment Rates
We also look at industry reinvestment rates, which compare spending levels to cash
flow generation (as measured by production volumes times commodity prices). By
evaluating current reinvestment rates in the context of historical ranges and the long-
term average, we have a better picture of where spending could go and what levels of
spending tend to generate supply growth. However, we should point out that the long
period of underinvestment in the industry could push reinvestment rates higher in the
future as producers operate in a more fully loaded cost environment.

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Oil and Gas Primer 14 May 2002

Exhibit 72: Reinvestment Rate and Gross Cash Flow

16% 80
Reinvestment Gross Cash Flows

14% 70

12% 60

Gross Cash Flows ($bil)

Reinvestment Rate
10% 50

8% 40

6% 30

4% 20

2% 10
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: Company data, CSFB estimates.

By combining spending expectations with the parameters that drive stock valuation, we
are able to devise our investment strategy for the group.

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Oil and Gas Primer 14 May 2002

Investment Conclusions
Building on our analysis of global oil and gas markets, value creation in the upstream
and downstream, and industry structures and conditions, we will conclude with a
discussion on investing through the oil cycle, comparing the various industry groups.

As we have stated, the upstream is the largest part of the chain in terms of net sales
and net profits, as well as equity market capitalization and liquidity, and it generates the
highest financial returns. The Integrated Oils dominate global equity market
capitalization among publicly traded oil and gas equities at roughly $1.2 trillion versus
Independent E&Ps at $215 billion, Oilfield Service and Equipment companies at $135
billion, and Independent Refiners at $79 billion.

Exhibit 73: Global Oil and Gas Equity Market Capitalization

US$ billions, as of April 25, 2002

$1,400

$1,200 $1,162

$1,000

$800

$600

$400

$215
$200
$135
$79

$0
Integrated E&P Oilfield Service Independent Refining

Source: Company data, FactSet, CSFB estimates.

Integrateds are the most In terms of returns on capital, the Integrated Oils have demonstrated the most
conservative oil and gas consistent long-term returns performance at 9%; however, the Oilfield Services group
investment compared with has generated the highest average returns over the long term at 12%, followed by the
the more volatile Independent E&P group. The Independent Refiner group has historically garnered the
Independent E&Ps and the lowest financial returns, 8%. We use a return on gross invested capital (ROGIC)
hypervolatile Oilfield framework for the Integrateds, Refiners, and Oilfield Service companies. However, we
Service companies use different returns metrics for the Oilfield Assets and Independent E&P groups,
reducing the comparability of cross-industry returns. We use return on replacement cost
for the Asset companies and use return on replacement cost capital for the Independent
E&P group. Exhibit 74 shows historical returns on capital by sector using the
appropriate returns metrics for each industry.

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Oil and Gas Primer 14 May 2002

Exhibit 74: Oil Sector Return on Capital

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Integrated Oil 9.0% 8.3% 8.5% 8.5% 9.6% 9.3% 9.5% 9.5% 8.4% 12.5%
Ind. Refiner 8.4% 6.7% 9.2% 8.0% 7.8% 7.3% 9.5% 9.1% 7.0% 12.5%
Oilfield Service 12.0% 10.3% 10.3% 9.2% 10.3% 11.9% 17.1% 16.2% 10.1% 13.2%
Independent E&P 8.7% 10.2% 8.7% 9.0% 7.7% 11.6% 11.0% 1.6% 5.0% 18.1%
Source: Company data, CSFB estimates.

Integrateds are the most conservative oil and gas investment compared with the more
volatile Independent E&Ps and the hypervolatile Oilfield Service companies. Therefore,
Integrated Oil stocks tend to perform better than the other oil and gas industries as the
cycle shifts from peak to trough, but will likely underperform the highly leveraged E&Ps
and Service companies when oil and gas fundamentals improve. Exhibit 75 charts the
annual share price performance for each industry group against the relatively staid
performance of the Integrateds and against oil prices.

While the Integrateds have demonstrated superior performance relative to the group
during down markets and the most consistent performance through the full cycle, the
Oilfield Services group has exhibited higher long-term share price performance followed
by the Independent E&P group. The Independent Refiners, however, have had the
lowest share price returns. In the right-hand chart of Exhibit 75, the disparate five-year
and ten-year price performance for both the OFS and E&P group is striking, highlighting
the dramatic shifts through the full cycle.

Exhibit 75: U.S. Oil and Gas Sector Share Price Performance History

US Oil and Gas Sector Annual Share Price Performance, 1990-2001 US Oil and Gas Sector Compound Annual Share Price Performance, 1991-2001
120% $35 16.0% 5-Year 10-Year
14.9%

100% 14.0%
$30

80% 12.0% 11.1%

$25
WTI Oil Price (Average)

60% 10.0%
8.2%
40% $20
8.0%
6.5%
20% $15 6.0%
4.8% 5.1%
0%
4.0% 3.3%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 $10
-20%
2.0%
$5
-40%
0.0%
-0.3%
-60% $0
-2.0%
Intgd E&P OFS Ref WTI
Integrated E&P Oilfield Services Ind. Refining

Source: FactSet, CSFB estimates. Integrated data includes USD share price performance of international Super Majors (BP, RD/SC, TOT).

Oil and gas stocks, particularly the Integrateds, are a classic defensive investment class
and generally outperform during broad market downturns. This is because economic
downturns often coincide with rising energy price environments, leading to superior
returns opportunities for energy stocks on a relative basis. As Exhibit 76 shows, the
Integrateds outperformed the market during periods of generally weak economic and
stock market performance—1990, 1993-94, 1996, and 2000-01.

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Oil and Gas Primer 14 May 2002

Exhibit 76: Integrated Oil Relative Performance versus S&P 500

30.0%

23.5%

20.0%

11.9% 11.2%
10.0% 8.5%
7.1%

3.0%

0.0%
-1.0%

-10.0% -8.3%

-13.9% -13.2%

-20.0%

-25.1%
-30.0%

-33.8%

-40.0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: FactSet, CSFB estimates.

Valuation Framework
We utilize a range of traditional valuation metrics and value-added metrics in our
analysis of the oil and gas industry. (See Exhibit 77.) While traditional metrics remain
widely used by the market given their simplicity and commonality, they have limitations
that can be overcome with our value-added framework. Our value-added, return-on-
capital-based framework for energy stocks is based on capturing the cash on cash
economics of a particular business and imbedded investor expectations. The value-
added framework attempts to account for accounting distortions, capital intensity,
business risk, competitive advantage, and investor expectations.
Value-added returns
Exhibit 77: Valuation Metrics by Industry
measures that focus on
Industry Traditional Value-added
cash-on-cash economics
of a business enhance Integrated Oils P/E, P/CF, EV/EBIDAX, DCF, Yield EV/GIC, ROGIC
traditional multiple analysis Independent Refiners P/E, P/CF, Yield EV/GIC, ROGIC
Independent E&P P/E, P/CF, EV/EBITDAX, EV/EBIDAX P/NAV, EV/BOE, EV/RCC
Oilfield Service P/E, P/CF, EV/EBITDA EV/GIC, ROGIC
Oilfield Assets P/E, P/CF, EV/EBITDA EV/RORC, RORC

Source: CSFB

As Exhibit 77 shows, we use P/E multiple analysis for each of the industry groups.
However, given the wide fluctuations of P/E ranges throughout the full cycle, the
disparate relevance between industry groups, and the accounting distortions that come
with the analysis, we prefer to focus on cash-flow- and asset-based measures for full
cycle analysis.

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Oil and Gas Primer 14 May 2002

We also use levered cash flow multiples across industry sectors (P/CF). Our unlevered
cash flow metrics are adjusted for specific industry segments, with the exception of the
Oilfield Service and Asset groups, for which we use the traditional EV/EBITDA metric.
We add back exploration We make adjustments to the EBITDA measure for the Integrated Oils and the
expense (EBITDAX) to Independent E&P groups to better incorporate the dynamics of the upstream business.
accommodate the various We adjust the EBITDA measure by adding back exploration expense (EBITDAX) to
upstream business models accommodate the various business models (i.e. exploration focus versus development
focus) being pursued throughout the industry. Some companies are more heavily
focused on exploration opportunities than others (and thus have higher exploration
expenses, and lower EBITDA), which allows us to more appropriately compare
companies regardless of the level of, and focus on, exploration.
Post tax cash flow is useful While we use the EV/EBITDAX measure for both the Integrateds and E&Ps, we also
for smoothing out very use an unlevered posttax cash flow measure for the E&P group—EV/EBIDAX. Because
different tax rates of the various types of international tax structures, royalty arrangements, and PSC
arrangements, taxes can play an important role in producers’ economic value creation
and cash-flow-generation potential.
Among value-added measures, we focus on EV/GIC, or enterprise value to gross
invested capital. The EV/GIC valuation measures the total firm value as a multiple of the
historical invested capital base. Our research suggests valuation multiples and
shareholder performance are driven by returns on capital. Among the Integrated Oils,
Independent Refiners, and Oilfield Service groups, we use the EV/GIC metric and our
ROGIC framework. We use EV/estimated replacement cost for the Oilfield Asset stocks
and we use two measures for the Independent E&P group, EV/boe and EV/replacement
cost capital. Each of these measures is based on a measurement of the capital (or
asset) base in one form or another.
Beginning with our EV/GIC and ROGIC framework, we list the comprehensive formulas
for our GIC and ROGIC calculations.

Components to ROGIC Calculation

Net associate adjustment to NOPAT: Associate DD&A = associates total assets x
(DD&A as % of net assets)
Cash NOPAT = recurring net income + recurring DD&A and exploration adjustment +
after-tax interest expense + net associate adjustments

The Oilfield Service group uses traditional EBITDA in place of cash NOPAT as the
numerator in its ROGIC calculation.

Components to GIC Calculation

Net associate adjustments to GIC = associates accumulated DD&A + associates
total assets minus non-interest-bearing current liabilities (NIBCLS) or (associates net
assets plus debt)
Gross invested capital = the historical capital put into the business as defined by:

Total assets - non-interest-bearing current liabilities + accumulated depreciation

+ any adjustments for acquisitions + net associate adjustments

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Oil and Gas Primer 14 May 2002

From these components we derive value-added valuation metrics:

Enterprise value/GIC. This is similar to the price-book ratio, but it fully reflects the
market value of the entire company and the entire invested capital base. EV/GIC ratios
generally reflect the expectation of a company’s ability to generate returns in excess of
capital costs.
Return on gross invested capital (ROGIC) = cash NOPAT (or EBITDA)
gross invested capital

Our value-added valuation metric for the Oilfield Assets companies is EV/estimated
replacement cost. Our replacement cost methodology is built on valuing each rig or
vessel in a company’s fleet at our estimated construction costs, incorporating
adjustments for specific capabilities and equipment. We prefer this measure to EV/GIC
because it places all of the Oilfield Asset companies on comparable footing, and
eliminates the balance sheet distortions attributable to asset write-downs and bargain
asset purchases/combinations over the long lives of the assets.
®
Fair value calculations We also use an EVA -derived discounted cash flow (fair value) based metric for the
require a view on Integrated Oils. Fair value methods are difficult to derive for highly cyclical industries
normalized industry such as the energy business; however, there is certainly an underlying asset value for
conditions upstream reserves. Using conservative midcycle (normalized) price forecasts and
reasonable, historical growth rates in production and cost structures, we can derive a
®
reasonable calculation of fair value. For the Integrateds, we calculate an EVA -driven
DCF that incorporates the WACC, a five-year time frame, capital requirements, and
reserve estimates to derive a fair value target price. For the Independent E&P group, we
use a similar approach to arrive at a fair value of the assets, or net asset value (NAV),
which we will discuss. It is more difficult to perform a DCF on Oilfield Services, Assets,
and Independent Refiners given the extreme volatility of cash flows.
Net Asset Value (NAV) is Our framework for the E&P group is slightly different than for the other groups. We
the preferred method for derive a NAV per share and evaluate each company’s share price (P) to NAV to
E&P valuation determine the stock’s premium/discount to fair value. Companies with high P/NAVs
have high expectations built into the stock price, whereas low P/NAVs imply low
confidence in visible production and future production capabilities. High P/NAVs indicate
an expectation of the ability to earn excess returns on capital, and vice versa for low
P/NAVs.
The P/NAV is different from EV/GIC in that the NAV denominator represents the
discounted future value of the capital base versus the current historical capital base
represented by GIC. Also, the numerator (P) only captures the equity price of the
company and not the total firm value (EV).

We analyze reserve valuations, EV/boe, to measure firm value per barrel of oil
equivalent. EV/boe indicates reinvestment efficiency; the higher the multiple, the more
efficient the company and vice versa. We also use EV/replacement cost capital to
measure total firm value relative to the cost of replacing the existing asset base using
recent cost structure data. The RCC represents current events and eliminates
accounting vagaries and historical write-offs.

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Oil and Gas Primer 14 May 2002

Replacement cost capital = proven reserves at the beginning of the period x three-year
average F&D costs
Return on replacement cost capital = EBITDA/RCC

Investing through the Cycle

The cyclical nature and capital intensity of the business make reliance on any one
consistent valuation metric less useful than in other industries. As the oil price cycle and
investor expectations shift from one phase to another, the relevant valuation methods
also shift. The changing nature of investor expectations over the course of the cycle
makes some valuation methods more or less valuable, depending on the stage of the
cycle.
We prefer cash flow We prefer levered (P/CF) and unlevered (EV/EBITDA) cash flow multiple analysis, and
multiple analysis as the its permutations (EV/EBITDAX, EV/EBIDAX), at cyclical turning points and through
main valuation metric upswings in the market. These measures are most valuable during periods of upstream
through the full cycle momentum (as the cycle turns up), but still hold value during certain phases of
downturns. During a market upturn, investors focus on companies with earnings and
cash flow leverage to the impending upturn. Cash flow multiples reflect the market’s
perception of companies’ leverage and ability to capitalize on market conditions. The
most levered companies typically show the greatest share price performance and
receive a higher multiple, all else being equal.

As earnings expectations and actual performance rise through the upturn, multiple
expansion occurs as investors extrapolate further gains. However the business is
cyclical so there is inevitably a time when multiples become distorted. At this point
investors turn to asset-based measures as a “sanity check” and begin to focus on how
these metrics compare to the potential earnings and cash flows in the next down leg of
the cycle. There becomes a need to balance the weighting of cash flow multiples and
these longer-term, measures of value.
However, asset-based Should the cycle begin to turn down, the weighting of longer-term or asset-based
measures provide measures over cash flow multiples increases as investor expectations shift from
excellent guidance at and capturing leverage to the cycle to capturing a fair valuation based on the long-term
approaching cyclical peaks tangible value of a company (i.e., the stock has no earnings and cash flow power, but
and troughs it’s cheap on valuation). Buying “cheap” assets with a willingness to hold typically
generates opportunities for outsized performance. The timing, extent of, and duration of
the downturn are important considerations, particularly to the more volatile groups.
We prefer to use asset support measures during downturns and prolonged troughs. The
concept is similar to the price truncation of callable bonds. Prices will only rise to a
certain point no matter how low interest rates fall, because the call price acts as an
upper limit—interest rates become less meaningful. Price to cash flow multiples may fall
beyond any reasonable point, but the inherent asset value of the ongoing entity will
support a fair market price, making cash flow multiples much less relevant.
The value-added components are similar in concept across the industry groups. Our
goal in using value-added metrics is to understand and evaluate the cash-on-cash
returns and economics of the respective businesses, business models, and consequent
value within the oil and gas chain. Given our application of the ROGIC framework to the

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Oil and Gas Primer 14 May 2002

Integrateds and Oilfield Service companies, we can compare their historical EV/GIC
trading ranges (Exhibits 78-79), which demonstrates the wide trading ranges for Oilfield
Service stocks versus the narrow ranges for the Integrateds.

We rely heavily on the analysis of past cycle performance and historical multiple
analysis to provide reference points for upside/downside potential relative to the current
market environment. Timing the cycle is key. Given the volatility in the sector as a whole
and the great unlikelihood of entering/exiting at the absolute tops or bottoms, we also
look at trading bands based on the average of the annual high and low valuations. The
average trading ranges provide interesting supplemental data, but we believe the
absolute ranges provide better indicators of the valuation floors for the group. And, since
asset-based valuation is typically reserved for extreme situations, the floor or peak is the
most important consideration.

Exhibit 78: Integrated Oil EV/GIC Exhibit 79: Oilfield Service EV/GIC

4.0
1.6

1.4 3.5

1.2 3.0

1.0
2.5

0.8
2.0

0.6
1.5
0.4

1.0
0.2

- 0.5

ENI Norsk OMV Repsol TFE BP Shell RD XOM AHC MRO

Hydro (ADR) (ADR) (ADR) -
CXIP TECF IHC SPMI BHI HAL SLB BJS CAM CLB GLBL HC HP SII SPN VRC WFT
Range Average EV/GIC Current EV/GIC
95-01 Trading Range Avg 95-01 EV/GIC Current 02E EV/GIC

Source: Company data, CSFB estimates. Source: Company data, CSFB estimates.

In addition to using the above exhibits as historical guidelines for each company, they
provide a good peer comparison. Some stocks have historically been valued below, at a
premium or a discount to the overall group.
We use a similar approach for the Independent E&P group. However, instead of using
EV/GIC we use EV/boe. As we discussed in the Independent E&P section, our research
shows a strong correlation between valuation and cash flows during market upswings
and high correlations to returns on replacement cost capital through the full cycle.
Companies that consistently earn less than the cost of capital generally trade at
discounts to peers that are able to earn their cost of capital.
In Exhibit 80 we show the industry’s estimated historical EV/boe trading ranges. We
compare the current environment, as signified by the dark circle, to each stock’s
respective history, as well as to the peer group.

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Oil and Gas Primer 14 May 2002

Exhibit 80: U.S. Independent E&P Historical Industry EV/boe

$20

$18

$16

$14

$12

$10

$8

$6

$4

$2
APC APA BR CHK DVN EOG FST KMG NFX NBL OEI OXY PXD PPP SGY SFY UCL VPI W RC

Source: Company data, CSFB estimates.

While we apply the ROGIC framework to our Independent Refiner universe, we have
also found another very important investing pattern in the group. Refining stocks often
outperform the market from August to April, on expectations for a successful summer
driving season. As reality and actual results override expectations in the late
spring/early summer, refiners typically underperform in the summer months. The
summer driving season, or the second and third quarters, is the opportunity for Refiners
to make most of their profits for the year given the greater use and margin associated
with gasoline over heating oil.

Exhibit 81: U.S. Independent Refiner Seasonal Trading

7 0 .0 % In 1 1 o f th e p a s t 1 5 ye a rs th e
"S e a s o n a l T ra d in g P a tte rn "
e a rn e d p o s itiv e re tu rn s re la tiv e to th e S & P 5 0 0
6 0 .0 %

5 0 .0 %
In a ll b u t 2 o f th e p a s t 1 5 ye a rs th e "S e a s o n a l T ra d in g
P a tte rn " h a s re s u lte d in p o s itiv e a b s o lu te re tu rn s
4 0 .0 %

3 0 .0 %

2 0 .0 %

1 0 .0 %

0 .0 %

-1 0 .0 %

-2 0 .0 %

-3 0 .0 %
R e la tiv e to S & P 5 0 0 R e fin e rs

-4 0 .0 %
'87-88

'88-89

'89-90

'90-91

'91-92

'92-93

'93-94

'94-95

'95-96

'96-97

'97-98

'98-99

'99-00

'00-01

'01-02

15-yr

Source: Company data, CSFB estimates.

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Oil and Gas Primer 14 May 2002

We also find it useful to compare our coverage universe cash flow multiple with the
broader S&P Industrial cash flow multiple to determine any discount or premium to the
broad market. We do this for each of our industry groups, but focus most heavily on this
type of analysis within our Oilfield Service universe, as Exhibits 82-83 demonstrate. We
use the broader S&P Oil Services Index to compare the relative performance of Oilfield
Service stocks with the S&P Industrial Average.

Exhibit 82: Relative Cash Flow Multiple: Oil Service Exhibit 83: S&P Oil Service Index versus S&P Industrials
50%
700% 700%
OIL SERVICE CFFO MULTIPLE RELATIVE TO S&P

40% GREATEST PREMIUM

49.2% 650%
30%
600% 600%
20% 550%

10% 500% 500%

450%
0%
400% 400%
-10%
350%
-20% Market Multiple 300% 300%
CURRENT: -33.4% DISCOUNT
-30% 250%
Reversion to:
200% 200%
-40% Trend Line 11%
85% Confidence Interval
GREATEST DISCOUNT -61.1% - Up 54% 150%
-50% - Down -32%
100% Cyclical Peak 93% 100%
-60% 50%
Equal Weighted Oil Service Index
-70% 0% 0%
Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 1985 1987 1989 1991 1993 1995 1997 1999 2001

Source: S&P, CSFB estimates. Source: S&P, CSFB estimates.

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Oil and Gas Primer 14 May 2002

Appendix I: The Physical Process

Exploration and Production

Oil and natural gas are the Oil and natural gas are the remains of tiny organisms (plankton and plants) after millions
remains of tiny organisms of years of decomposition. The remains generally sifted down rivers and streams into
(plankton and plants) after low-lying basins with other rock, mud, and silt. As time passed, increasing amounts of
millions of years of remains or sediments were deposited in the basins, and as the earth’s surface shifted,
decomposition became trapped between rock layers and thus became a permeable, sedimentary layer.
The extreme pressures and heat of the rock layers “cooked” the remains until they
formed oil and gas.
Oil and gas are chains of Oil and gas are chains of hydrogen and carbon atoms called hydrocarbons. Oil is a
hydrogen and carbon viscous, liquid substance with varying levels of thickness and colors. (It can be yellow,
atoms called hydrocarbons green, brown, black, or combinations of these colors.) Gas or methane is clean burning,
colorless, and generally odorless.
H H H H H H H H H H

H C H H C C H H C C C H H C C C C H

H H H H H H H H H H

Methane (CH4) Ethane (C2H6) Propane (C3H8) Normal butane (C4H10)

The difference between the formation of oil or gas lies mainly in the depth of the
sedimentary basin and the type of hydrocarbon chain. Crude oil is a combination of
several, long hydrocarbon chains. The three major chains are paraffins, napthenes, and
aromatics.
• Paraffins. Consist of methane, ethane, propane, and butane. Paraffins are gaseous at
normal temperatures and pressures, and they constitute over 50% of the composition
of crude oil.
• Napthenes. Consist of cyclopentane and cyclohexane, which are liquid at normal
temperatures and pressures, and constitute roughly 40% of the composition of crude
oil.
• Aromatics. Consist of benzene, alkyl benzene, naphthalene, and anthracene. They
are the third major compound found in crude oil, constituting anywhere from 10-30%
The difference between depending on the density of the crude (inverse relationship). They are liquid at normal
the formation of oil or gas temperatures and pressures.
lies mainly in the depth of Natural gas chains are the paraffin group—methane, ethane, butane, and propane;
the sedimentary basin and however, about 90% of natural gas is methane. We can therefore deduce from the
the type of hydrocarbon above information that crude oil is composed of 50% or more natural gas components.
chain; crude oil is a
The temperature and pressure of the sedimentary layer determine the type of
combination of several,
hydrocarbon chain that develops. Temperatures and pressures increase at greater
long hydrocarbon chains
depths into the earth’s surface. Oil is formed in temperatures ranging from 60-100
degrees Celsius while gas forms at temperatures of 120-225 degrees Celsius. Since
temperatures and pressures rise deeper into the earth, we can determine that oil forms
closer to the surface than natural gas. Given the relatively wide range of temperatures

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that lead to oil generation, there can be different grades of crude that form based on the
actual temperature within the range. Temperature and pressure also determine crude
density, with an inverse relationship.
Close to the surface, Close to the surface, relatively low temperatures and low pressures create long
relatively low temperatures hydrocarbon chains to form heavy crude. Further down below the surface, the earth’s
and low pressures create temperatures and pressures rise and break apart the long hydrocarbon chains into
long hydrocarbon chains to shorter chains to form light crude, natural gas, and natural gas condensate. Natural gas
form heavy crude; further and gas condensate chains are shorter than light crude chains. The weight or density of
down below the surface, crude is measured in relation to water and is often expressed in degrees API. (See the
the earth’s temperatures Glossary for a full definition of API.) Light crudes have APIs of 40 degrees or higher
and pressures rise and while heavy oils have 10 degrees or lower. Another distinction between crude grades is
break apart the long the sulfur content. Sweet crude has a much lower (0.5%) sulfur content than sour crude
hydrocarbon chains into (2.5%).
shorter chains to form light
Oil is rarely found at depths greater than 10,000 feet whereas most gas is found greater
crude, natural gas, and
than 10,000 feet—again, because of the high pressures and temperatures deeper down
natural gas condensate
in the earth’s surface that break apart the hydrocarbon chains. However, associated
gas, or gas condensate, is typically found with light oil (given crude’s large composition
of natural gas) closer to the surface than natural gas. The associated gas provides a
natural pressure and lift to push the oil closer to the surface. Therefore, oil is rarely
found without at least some nearby natural gas. Gas, on the other hand, can be and
usually is found separate to oil. Water is also found in sedimentary layers that contain oil
and gas. Similar to the natural lift natural gas provides a reservoir, water also provides
lift and can affect the flow of the hydrocarbons.

There are several common types of sedimentary layers that contain hydrocarbons:
shale formations, sandstone beds, coal seams, and salt water aquifers. These are the
rock layers geologists will evaluate when they find traps in the earth’s surface.
There are several common Once the oil and gas is formed, the pressure and heat within the sedimentary layers
types of sedimentary force the oil and gas up through the pores of the source rocks. The oil or gas migrates
layers that contain (primary migration) through permeable layers and water levels until it reaches an
hydrocarbons: shale impermeable rock layer or carrier bed, and becomes trapped. The oil and gas cannot
formations, sandstone rise through these traps and the hydrocarbons begin to separate owing to their different
beds, coal seams, and salt densities. As we mention above, natural gas and/or natural gas condensate is a shorter
water aquifers hydrocarbon chain, similar to light crude. When the oil and gas do separate, they will
typically not stray very far from one another; however, they will migrate (secondary
migration) into and from different reservoirs. Heavy crude is rarely found together with
natural gas, as it forms at lower temperatures and pressures, closer to the earth’s
The three most common surface.
traps or rock formations The three most common traps or rock formations containing oil and gas are faults,
containing oil and gas anticlines, and salt domes.
are faults, anticlines,
• Faults. Fractured layers of rock created by movements in the earth's crust/plates.
and salt domes
• Anticlines. Flat rock layers shift and fold over, creating dome shapes where
hydrocarbons can become trapped.
• Salt domes. Beds of nonporous salt, pushing up through overlying formations.

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Oil and Gas Primer 14 May 2002

A reservoir is a sizable Exhibit 84: Sedimentary Layers: Faults, Domes, Anticlines

rock layer containing
hydrocarbons; the
hydrocarbons are present
in the rocks themselves,
not, as commonly
imagined, in a pool-like
structure beneath the
surface between rock
layers

Source: NGSA.
There are five major
characteristics that A reservoir is a sizable rock layer containing hydrocarbons. The hydrocarbons are
determine reservoir present in the rocks themselves, not, as commonly imagined, in a pool-like structure
behavior: porosity, beneath the surface between rock layers. There are five major characteristics that
saturation, hydrocarbon determine reservoir behavior:
type, permeability, and 1. Porosity—how much space is in the rock
thickness
2. Saturation—how much of the space contains fluid

3. Hydrocarbon type—oil or natural gas

4. Permeability—how easily does the fluid come out of the rock

5. Thickness—what is the vertical extent (size) of the reservoir

The porosity and permeability of the sedimentary rock layers determine the amount of
oil and gas contained in the rock. Porosity indicates the amount of space in the rock and
potentially how much hydrocarbon can be held by the rock. Permeability gauges how
easily the hydrocarbon comes out of the rock. An attractive reservoir will have high
porosity, high saturation, high permeability, and will be large. Understanding reservoir
behavior is a critical function of oil and gas extraction.

The E&P Process

The exploration for and production of (E&P) hydrocarbons is the very beginning of the
oil and gas chain. The E&P process consists of five primary areas of operation:

• Exploration

• Appraisal

• Development

• Production

• Decommissioning and abandonment

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Land Acquisition and Exploration

The exploration phase The exploration phase begins with the acquisition of acreage, either from government
begins with the acquisition auctions or from private land or mineral owners. Producers rarely own the land they drill;
of acreage, either from rather, they lease land from private land/mineral owners or through government
government auctions or auctions (lease sales). The type of government auction varies from country to country.
from private land or In general, as part of a lease sale, a government agency will offer an extensive amount
mineral owners of acreage, which it subdivides into tracts, or blocks.
In the U.S., producers bid on the various blocks in a silent auction and the agency
reviews the bids to determine the highest bid and winner of the block. The process in
the U.K. is different; the government agency announces the acreage and blocks it will
offer and then it selects the producer or consortium it believes is most qualified. A third
common type of licensing in emerging market countries involves production-sharing
contracts (PSCs), which we discuss below. These are very common in Indonesia.
In a lease auction, particularly the U.S., not all of the blocks are bid, as some blocks are
more or less desirable than others. The percent of blocks receiving bids is often
indicative of market fundamentals—a high bid percentage is usually the result of a
strong oil and gas pricing environment and robust producer development plans. The
producer and the property or mineral rights owner agree to specific terms of the lease
(acreage, time period, and royalty fees) and sign a leasehold agreement.
The high fixed costs of and The high fixed costs of and risks associated with exploratory drilling make exploration
risks associated with and development a costly process for a single producer. A producer who owns the
exploratory drilling make rights to a property may sell working interests to other interested producers while
exploration and maintaining a majority share. The producer with the highest working interest often
development a costly becomes the operator of the field and makes the final decisions on field exploration,
process for a single development, and production planning and budgeting. As we discussed earlier in the
producer Upstream section, production-sharing contracts, concession agreements, and other
arrangements with host governments in international E&P operations are an important
part of the cost equation and value-creation potential of a producer.
Land or acreage acquisition costs are the lowest costs associated with an E&P
operation, and are capitalized on the balance sheet. Producers continually attempt to
acquire acreage to build a backlog of potential development projects.
Exploration prospects are Once a producer has secured property rights, it can begin to explore for hydrocarbons.
identified using seismic The exploration prospects are identified using seismic methods that indicate geological
methods that indicate formations and potential oil or gas reservoirs. Producers undertake seismic data
geological formations and acquisition, seismic data processing, and seismic data interpretation—three distinct
potential oil or gas functions. The two main forms of seismic data collection are two dimensional (2-D) and
reservoirs three dimensional (3-D) seismic. The difference between the two is that 3-D provides
more information by recording a grid over the surface and 2-D records only a cross
section (single line) of the formation.

Three dimensional seismic allows producers to view the earth’s crust to identify
promising formations that may ultimately lead to the retrieval of hydrocarbons.
Geologists process and analyze data using powerful computers to form a model of a
potential reservoir. 3-D seismic data will show geologists if multiple zones are present,
how many feet of net pay exist, and the type of rock layers that will help determine
which type of equipment to use.

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Oil and Gas Primer 14 May 2002

The biggest advantage of 3-D seismic over prior methods including 2-D is its greater
level of accuracy at identifying pay-bearing structures. This allows for greater drilling
success rates and substantially reduced dry-hole costs for producers.

Exhibit 85: Recording Seismic, Land Exhibit 86: Recording Seismic, Offshore

Source: API. Source: UKOAA.

Seismic data only point to During seismic data acquisition, producers or independent Oilfield Service companies
potential reservoirs based record or “shoot” 3-D seismic over large areas, maintaining an inventory/database of
on the historical results of potential areas with hydrocarbons. In onshore seismic, seismologists lay electro-
similar rock formations; magnetic cables, wires, and geophones attached in square blocks across a field. A
the only way to confirm the “thumper” then thumps the ground to produce vibrations in the earth’s surface. In
presence of an oil- or offshore seismic data collection, boats or vessels tow air guns that produce short sound
natural-gas-bearing bursts. Hydrophone lines are also attached to the boat to collect and record the length
reservoir is to drill an of the sound waves.
appraisal well
The sound waves vary in length, depending on the rock type and layer being
penetrated, and the geo or hydrophones pick up the signals and send them to an onsite
truck or boat that is essentially a mobile supercomputer. The supercomputer records the
data and eventually forms a picture of the rock types and layers based on the
size/length of the sound waves.
Processing the seismic data is a time-consuming process, sometimes taking up to two
years. Land seismic data take from two to eight months to process while some offshore
seismic activities can take up to two years.
A team of geologists analyzes the seismic data to interpret or find formations (faults,
anticlines, salt domes) that may contain oil and gas reservoirs. The seismic data only
point to potential reservoirs based on the historical results of similar rock formations.
The only way to confirm the presence of an oil- or natural-gas-bearing reservoir is to drill
an appraisal well.

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Oil and Gas Primer 14 May 2002

Exhibit 87: 3-D Seismic Computer Image

Source: NGSA.

Seismic data costs are a Seismic data costs are a significant nondrilling cost incurred by the producer, but are
significant nondrilling cost only a small component of total producer costs. The price of seismic varies by the type
incurred by the producer, used and the amount of acreage involved. 3-D seismic is more expensive than other
but are only a small survey methods and takes an extended period of time to process; however, it is the
component of total most advanced method and generally results in the most accurate pictures. An average
producer costs seismic survey for a 1,000-acre block in the shallow waters of the Gulf of Mexico may
cost $200,000 and take four months to process. The same size block in the deepwater
of the South China Sea may cost $500,000 and take up to a year to process.

Appraisal—Prospect Evaluation
Appraisal drilling attempts to confirm the physical presence of hydrocarbons and
ascertain the other characteristics of the field: reservoir size, porosity, permeability, and
saturation. Producers gather this information by drilling one or several exploratory/
appraisal wells.
Appraisal drilling attempts The first appraisal well will confirm the physical presence of oil and gas. A producer may
to confirm the physical then drill delineation wells around the first appraisal well and possibly drill to different
presence of hydrocarbons depths. This will help determine the lateral size of the field and the depth of the reservoir
and the other (pay zone, or pay bearing sands). Some sedimentary areas have multiple completion
characteristics of the field layers (multiple pay zones) where oil and gas are present at different depths of the rock
formation. This is highly desirable, as well depth can be readjusted to different target
depths each time a reservoir depletes. Once the producer estimates the size of the
reservoir or field and recoverability of hydrocarbons, it can record or book reserves on
the balance sheet.
Appraisal drilling requires an extensive and sophisticated set of oilfield drilling systems
to collect and analyze well data. The process of well data collection and analysis is
similar for both exploratory drilling and development drilling. It is critical to characterize
the reservoir as accurately as possible to calculate the reserves and determine the most
effective and economic way of recovering the hydrocarbons. Computer simulation can
help predict the potential impact of different well spacings, production rates, and
enhanced recovery schemes.

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To drill a single well can Exploratory drilling costs are much higher than survey or seismic costs, as the drilling
cost upward of $500,000 in process is much more capital and labor intensive. As we discussed earlier, the cost of
an average U.S. onshore, drilling a single well can be very expensive depending on the drilling environment. An
mature basin, and up to average U.S. onshore well can cost more than $500,000 while the cost of a deepwater
$20 million for an well in an international market can well exceed $20 million. Therefore, thorough analysis
international deepwater is required before proceeding with such a significant investment.
well; the analysis of the
There are three primary ways to drill a land well: vertical, horizontal, or directional. First,
data and the decision to
we focus on the straightforward vertical land well. A rig drives a drill bit down through
drill are therefore critical to
the earth’s surface to a target depth where the hydrocarbons are believed to exist.
the producer’s economics
Exhibit 88: Drilling Techniques

Surface

Vertical Directional Horizontal

Source: Fundamentals of Oil and Gas Accounting.

Vertical wells are drilled Vertical wells are drilled straight down into the ground, with the rig placed directly over
straight down into the the reservoir. It is imperative that the wellbore does not deviate from its vertical position,
earth, with the rig placed otherwise the drill may not reach the reservoir. Vertical drilling can thus be limiting if a
directly over the reservoir rig cannot be placed directly over the reservoir site. Directional drilling and/or horizontal
drilling are appropriate in applications when the rig cannot be located over the reservoir.
Advances in directional and horizontal techniques have made both technologies more
widespread, albeit more expensive than traditional vertical wells.
The wellbore must be In directionally drilled wells, operators can change the direction of the well from vertical
straight and not slant in to almost 90 degrees horizontal within a few feet. The directional flexibility of these wells
any direction to allow the generally provides greater exposure to the reservoir, allowing for higher production rates
drill to reach the reservoir since the wellbore can angle through the reservoir, increasing surface area exposure.

While land and offshore drilling have certain similarities, offshore drilling requires more
complex drilling systems, as described on page 121.

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Oil and Gas Primer 14 May 2002

Exhibit 89: Drilling Rigs

Land Rig Land Rig—Aerial View Tension Leg Platform

Source: Helmerich and Payne, Royal Dutch Shell.

Broadly speaking, there are three main rig components: drilling equipment, power
equipment, and pressure control equipment. We will concentrate on the drilling
equipment and pressure control equipment. Briefly, the power equipment is either a
diesel engine or an electric generator (AC or DC powered), and the amount of
horsepower will dictate the type of formations and depth of wells on which the rig is
capable of drilling. The type of power system used is an important determinant of total
rig weight, maintenance requirements, power efficiency, and instrumentation
compatibility.
On the rig floor are the The most noticeable component of a rig is the derrick, which is the tower-like portion
drawworks, which contain that extends from the rig floor high into the air. On the rig floor are the drawworks, which
the controls, and lever and contain the controls and lever and pump system that drives the drill stem and drill bit
pump system that drive the down into the wellbore. A rotary table on the rig floor, with a hole in the center, provides
drill stem and drill bit down an entry point for the drill bit and drill stem to bore into the ground. The rotary table on
into the wellbore the drill floor drives the rotating motion of the drillstring. When new pipe needs to be
added to extend the drillstring deeper into the ground, the drillstring is raised and a new
pipe is placed into or extended on to the drillstring and the drilling process can continue.

In this manual process, two roughnecks work the drill string and the moving parts while
a third roughneck controls the drawworks machinery at the side of the rig floor. (See
Exhibit 90.)

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Oil and Gas Primer 14 May 2002

Exhibit 90: Adding Drill Pipe to the Drillstring

Source: UKOOA.

Some rigs are semiautomatic, utilizing pipehandling equipment and a top drive system
to reduce the necessary crew from the normal three- or four-man configuration to a two-
man configuration. Service companies that can provide technology and equipment that
reduces labor costs are able to charge a premium to producers given the potential
savings. A top drive system within the derrick turns the drill stem and provides the
torque necessary to bore into the ground. New drill pipe is hoisted and connected at the
rotary table by the roughneck or an automated roughneck. These rigs are smaller than
typical rigs, so transport times and rigging times are shorter. Top drives effectively
replaced the rotary table. The pipehandling systems allow for several pieces of drill pipe
to be added to the drill string at once, rather than one at a time. This saves valuable
drilling time and improves the efficiency of the operation.

Exhibit 91: Drill Pipe at Well Site

Source: Helmerich and Payne.

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Oil and Gas Primer 14 May 2002

The drill string is the The drill stem, or drill string, is the main tool, aside from the rig, used to drill a well. The
connections of drill pipe drill string is the connected drill pipe that extends the drill bit from the rig to the target
that extend the drill bit from depth, which can reach thousands of feet below the surface. Drill pipe is considered a
the rig to the target depth tubular product. Tubular products encompass a wide family of cylindrical drilling
thousands of feet below products, including drill pipe, casing, and tubing, used in the appraisal, development,
the surface; drill pipe is the and production phases of the upstream process.
most commonly used
Drill pipe is a hollow cylinder of metal that comes in many different sizes, weights, and
tubular product
materials. It is typically 30 feet long, and its diameter varies from 19 inches to 5 inches.
The widest diameter drill pipe (19 inches) is used at the initial wellbore, while
incrementally smaller diameter drill pipe is used as different depths are encountered.
Changing tubular diameters are associated with the different types of casing and
cement that will be put into the wellbore. An average rig operation will maintain 10,000-
20,000 feet of drill pipe with different diameters at the well site, depending on the depth
of the well.

Drill pipe is reusable and may last several years, depending on the intensity of use
before it wears out or breaks. The material used (steel, aluminum, composite, titanium)
is highly dependent on the drilling environment. Key considerations follow:
Working conditions Pipe characteristics Considerations

Subsurface pressure Pipe corrosion characteristics Weight

Temperature Pipe Expandability Size
Depth of well Lifespan of drill pipe Space
Intensity of use Torque capability Manuveurability
Penetration rate Sealability
Cuttings removal Hydraulic performance

Associated with the tubulars business is the required tubular connections or engineered
connections. These connections join pieces of drill pipe and casing components to
create a seal that can withstand high pressures, temperatures, and conditions to
prevent blowouts or well destruction. The connections business involves cutting thread
profiles on tubulars. High-end premium connections are used in deep drilling, high
pressure, extended reach, and other critical application wells. Premium connections
typically use proprietary thread designs that offer increased torsional capacity.

In higher-end well applications, the tubulars and the threads account for approximately
30% and 6% of the cost of the well, respectively. Since connections are critical to the
success and safety of the operation but are not an excessive cost, operators have some
degree of flexibility to select connections based on capabilities rather than on the lowest
price. Operators employ stringent product qualification procedures and often
demonstrate significant brand loyalty.
Different drill bits are used Different drill bits are appropriate for different rock formations so that several different
for different rock bits may be used on a given well as different rock layers are encountered. Bits are
formations either diamond, which are constructed of specially fabricated synthetic diamonds, or tri-
cone. Exhibit 92 shows three Baker Hughes diamond drill bits, demonstrating various
shapes and designs. Tri-cone bits are very common and are used in more basic
applications, given the lower cost. Drill collars are positioned directly above the bit and
add weight, generating better control and penetration.

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Oil and Gas Primer 14 May 2002

Exhibit 92: Drill Bits

Source: Baker Hughes.

Drilling fluids, or muds, are Drilling fluids, or muds, are chemical compounds that react with shale, gravel, sand, and
chemical compounds that drill cuttings to cool the bit as it drills in order to extend the life of the bit and prevent
cool the bit as it drills to damage. They also serve to contain formation pressures, remove rock cuttings, and
prevent damage and maintain wellbore stability. Mud systems can be very expensive and require extensive
extend its life research and development on the part of the Oilfield Service company developing the
product line. There are three types of drilling fluids:
• Oil-based fluids reduce torque and are most often used in stuck pipe situations.

• Water-based fluids are the most widely used fluids, are environmentally friendly, and
contain specifically engineered weighting materials geared toward maintaining
formation pressures.
• Synthetic fluids are used in place of oil-based fluids when oil-based fluids are
prohibited because of environmental concerns.

Drilling fluids are highly specialized for specific conditions, so service companies
provide considerable value through their guidance on picking the appropriate fluids in
certain conditions.
Solids controls systems Solids controls systems are used to separate rock cuttings from the muds. Mud pumps
are used to separate rock inject and reinject valuable drilling fluids throughout the drilling process. As mud is
cuttings from the muds; continuously pumped into the wellbore to cool the drill bit and provide pressure control,
mud pumps inject and it resurfaces through the wellbore and back to the surface. The constant flow of mud
re-inject drilling fluids also serves to pull cuttings out of the hole. A shaker is a solids control system that
separates the drilling mud from the core samples, or cuttings. The core samples still
contain portions of drilling mud, which are then analyzed for the presence of
hydrocarbon compounds. The expensive drilling fluids are cleaned of drilling residue
and then reinjected into the wellbore. Cuttings that are not sent to a lab for evaluation
are either deposited in a waste area at the wellsite or reinjected into the wellbore.

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Pressure control Pressure control equipment is designed to control the flow of oil and gas throughout the
equipment is designed to drilling and production process to prevent gushers or blowouts. The most commonly
control the flow of oil and used pressure control devices include the following:
gas throughout the drilling
• Annular blowout preventers (BOPs) use a rubber collar to create a seal between the
and production process to
drill pipe and the wellbore to control the flow of hydrocarbons within the well.
prevent gushers or
blowouts • Ram BOPs use metal rams or rubber seals to either seal around the drillpipe (pipe
rams), completely seal off the wellbore (blind rams), or cut through the drillpipe to
create a seal (shear rams).
• Diverters and gas handlers. Diverters redirect natural gas encountered while drilling
away from the rig and are typically used in offshore applications where pressurized
gas zones are common. Gas handlers, used in subsea operations, vent and contain
expanding natural gas bubbles at the subsea wellhead, slowing them in order to avoid
potential blowouts, which could damage the well, the rig, and personnel.
• Drill stem valves are located in the drill string, typically below the kelly, and are
manually operated to prevent blowouts and fluid spillage while installing and removing
drill pipe.
• Chokes are used to control the flow of drilling mud.

In appraisal drilling, after During appraisal drilling, which occurs after the well is drilled but before the casing is
the well is drilled (before installed, operators use wireline logging devices to gather information about the
the casing is installed) characteristics of the reservoir. Open-hole logging helps operators decide whether or
operators use wireline not to proceed with completion of a well. Cased-hole logging, which occurs in new or
logging devices to gather existing wells, is used to locate casing perforation. Electric wireline, or slickline, uses
information on the electro-mechanical cable to deliver information regarding reservoir formation and
characteristics of the producing zones from the wellbore to the surface. The wireline can be delivered from a
reservoir truck on the surface, or from a rig platform for offshore operations. From this operating
base, the wireline is lowered or spooled into the wellbore. Attached to the wireline
device is a sonde, which contains the measuring equipment. The sonde takes and
transmits several measurements to the surface where they are recorded and interpreted
by sophisticated computers. Field operators use these data to manipulate producing
zones based on flow rates and formation composition.

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Exhibit 93: Wireline Logging, Onshore Exhibit 94: Wireline Logging, Offshore

Source: Baker Hughes. Source: UKOOA.

Logging measurements include the following:

• Resistivity measurements. Resistivity sensors are used to determine the fluid content
of a formation (saturation). Three common fluids—oil, water, and salt water—all have
different abilities to conduct electricity. Salt water provides little resistance to electrical
flow, while oil will not conduct electricity at all.
• Gamma ray measurements. Gamma ray sensors measure the natural radioactivity of
the formation. Using gamma ray readings, information on the lithology (rock’s
composition) may be obtained.
• Neutron porosity measurements. Neutron sensors indicate the formation’s porosity by
measuring the quantity of hydrogen atoms (found principally in water and oil). The
greater the number of hydrogen atoms found, the more porous the rock is assumed to
be. The count is based on the response to neutron bombardment.
• Density measurements. Density sensors reveal the bulk density (weight per unit
volume) of the formation. The porosity may be approximated by determining the
relative content of rock and fluid. The more dense a formation, the lower the porosity
or fluid content.
After measurements are taken, operators print out and analyze the logs. A standard log
is shown in Exhibit 95.

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Oil and Gas Primer 14 May 2002

Exhibit 95: Wireline Log

Source: UKOOA.

Different drilling techniques In addition to the nature of the reservoir, the equipment required for a particular project
(vertical, horizontal, or also depends on the chosen drilling technique (vertical, horizontal, or directional).
directional) require Horizontal and directional techniques require more technologically advanced
different equipment measurement products. Measurement while drilling (MWD) and logging while drilling
(LWD) are two such technologies.

Measurement while drilling systems utilize computers and gearing mechanisms to allow
a rig operator to control the trajectory of the drillstem and the direction of the wellbore.
MWD measurements typically include gamma readings, which provide data on the type
of formation that is being penetrated. Dynamic measurements such as temperature and
pressure may also be taken in order to optimize the drilling approach. The data
gathered downhole are transmitted to the surface via a mudpulse telemetry system.
Measurement while drilling Logging while drilling measurements were developed to provide real-time geological
and logging while drilling and geophysical data that are wireline equivalent. More frequently, these measurements
provide real-time are being used in place of wireline logs in basic applications and are an excellent
information throughout the complement to wireline in high-end or exploratory applications. The economic benefits
drilling process of LWD can be significant. Traditional wireline logging data retrieval require drilling
activity to be stopped and the drill string pulled from the hole. However, the LWD tool is
part of the drill string, so measurements can be made with the string in place, providing
considerable savings over wireline, with reduced rig time because of the fewer trips.
LWD also benefits the drilling process by providing real-time information, often helping
to shape drilling decisions and thereby enhancing recovery efforts.
Multiple types of casing Throughout the drilling and completion process, different types of casing (i.e., liner or
(i.e., liner or tubing) are tubing) are installed and cemented throughout the well bore to prevent well collapse,
installed and cemented allow for cuttings to flow through to the surface, and prevent environmental damage
throughout the wellbore from escaping hydrocarbons. Wide diameter (about 20 inches) conductor casing is
installed at the surface extending through the mud line (50 feet below the surface) and

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is followed by surface casing (about 15 inches diameter), which can extend several
thousand feet into the earth. The wellbore diameter narrows as the drill penetrates
deeper into the ground. Intermediate, or protection casing (about 10 inches diameter,
typically the longest), is installed between surfaced production casing to support the
hole and seal off more dangerous formations.

The last type of casing to be installed is production tubing, which is the smallest in
diameter and thickness. It is run through the production casing and is sealed off with
packers to test flow rates at various intervals.

Exhibit 96: Casing

Surface
Sample 5,000 Sample 15,000
Foot Well (Oil) Foot Well (Gas)
800’ 3,000’

Surface Casing

Protection Casing
11,000’
Production Casing

5000’ Production Tubing 15,000’

Source: Grant Prideco, CSFB.

After each new depth level After each new depth level has been drilled and the respective casing has been
has been drilled and the installed, the casing is cemented into place. The type of cement depends on the
respective casing has physical properties of the well, but generally, it is blended with water and combined with
been installed, the casing various additives to create a slurry that is pumped between the casing and the wellbore.
is cemented into place Cementing services are also used when recompleting wells and when plugging and
abandoning wells, and can be an expensive part of overall well completion costs.

Completions
The decision on whether or not to complete a well is based on all of the data collected
before (survey and seismic) and during the drilling process (core samples, mud logs,
wireline logs, reservoir behavior, reserve recovery). The producer considers these data
along with completion, development, and production costs, and current and expected oil
and gas market prices. The final decision on the field development is based on whether
the returns exceed the hurdles established by the producers.

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Pressure pumping is a Completion follows appraisal drilling and is the process of developing a well for
term that broadly includes production. A producer and an Oilfield Service company study the reservoir behavior
cementing and stimulation and determine which equipment and processes will yield the most effective production
services in the completion results.
of new wells and in
The first part of the process is to perforate the casing, allowing the natural gas or oil to
remedial work
flow from the reservoir into the production tubing. Perforating entails the use of a
perforating gun that sets off a shaped explosive charge, cutting through the casing and
cement into the reservoir and bringing the hydrocarbons and wellbore into contact.

Pressure pumping is a term that broadly includes cementing and stimulation services in
the completion of new wells and remedial work. Pressure pumping services utilize
equipment mounted on trucks, skids, or vessels, enabling flexibility to complete multiple
jobs within a region.

Exhibit 97: Pressure Pumping Trucks, Mobile Units

Source: Varco.

Stimulation services are Stimulation services are designed to improve the flow of oil and gas from the producing
designed to improve the formation. Typically referred to as a frac job, the fracturing process consists of pumping
flow of oil and gas from the a fluid gel (frac fluid) into the formation at sufficient pressure to fracture the formation.
producing formation The goal is to fracture low porosity, low permeability layers of a formation to improve
hydrocarbon flow and reservoir recovery. Sand, bauxite, or other synthetic proppants (a
very tiny pebble-like, or bead-like, substance) are suspended in the gel to keep the
fractures open when the fluid is removed. The size of a frac job is often expressed in
terms of the proppant weight, which can exceed 200,000 pounds.

The primary pieces of equipment used include the following:

• a blender, which blends the proppant into the frac fluid;

• a pumping unit, which pumps the proppant into the wellbore; and

• monitoring systems with real-time capabilities to evaluate and control the frac
process.

Acidizing is another type of fracturing service, and involves pumping large volumes of
specially formulated acids into reservoirs to dissolve blockages and enlarge crevices in
the formation, increasing the flow of oil and gas.

Through the drilling process, cavities are created within the wellbore, providing room for
sand buildup. Sand buildup can reduce the stability and strength of the wellbore, and
ultimately reduce the flow of oil and gas through the producing region. One way to
control this is through gravel packing in which gravel is pumped into the wellbore to fill
the cavities, excluding sand, but it still permits the flow of oil and gas.

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Downhole tools are used In addition to the capital equipment and expenses required for computer processes, Oil
for gravel pack and frac Service companies also provide various downhole tools. Downhole tools are sometimes
completions, reservoir flow purchased, but usually rented, and include drill-string-related tools such as stabilizers
testing, well stimulation, and collars, as well as fishing tools. Fishing primarily involves removing obstructions
and well servicing (lost equipment, drill pipe, or debris) from the wellbore that may become caught during
applications the drilling, completion, or workover during a well’s production phase. Fishing requires
the use of a variety specialty tools, including fishing jars, milling tools, casing cutters,
overshots, and spears.
The final step is installation The final step is installation of a wellhead. Wellheads are application-specific and vary
of a wellhead and the based on oil or gas, onshore or offshore, and type of offshore (surface or subsea).
construction of gathering Exhibit 98 shows a natural gas well, or Christmas tree as it is often called, and Exhibit
and processing lines 99 shows an oil well with a pumpjack. Several Oilfield Service and Equipment
companies design, manufacture, and sell a variety of wellheads.

Exhibit 98: Wellheads—Natural Gas Exhibit 99: Wellheads—Oil

Source: NGSA. Source: NGSA.

Recall that the successful results of appraisal drilling will allow the producer to record
reserves on the balance sheet. However, the producer may or may not decide to
develop the field right away. It may classify the field as undeveloped and postpone
development based on several factors, largely economic ones. In most cases,
development closely follows drilling and completion and typically requires more drilling
than the initial exploration and appraisal wells.

Development
The decision to develop a field is based on the field’s characteristics, the current and
expected commodity price environment, and the relative economics of the field
compared with other fields in a producer’s development portfolio:

• Is the field large enough to be commercially viable?

• Is there a high enough level of porosity and permeability for the hydrocarbons to be
easily extracted?

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• How much oil and or gas in the reservoir is recoverable?

• Is there adequate infrastructure to move the hydrocarbons to market?

• Do current or expected market prices for oil and gas provide an adequate return over
the cost of development?
• Will the cost of maintaining production remain reasonable to ensure an ongoing fair
rate of return?

The development process involves maximizing the economic recovery of confirmed

hydrocarbons from a field. Development planning begins with analysis of the seismic,
appraisal well, and wireline data. Petroleum engineers combine the data to form a
model of the reservoir. The reservoir model allows the producer to predict reservoir
behavior based on different recovery methods and to select the best strategy for
developing the field.

After the reservoir has Once the reservoir is modeled, the producer can determine the number, type, and
been modeled and the location of wells to be drilled. Once a development plan has been established, the
development plan has producer begins an expanded drilling program. In the appraisal process, only one or two
been established, the wells were drilled with the purpose of providing information on the characteristics of the
producer begins a field. In the development stage, multiple wells may be drilled as part of an ongoing
continuous drilling program development or exploitation program. The physical drilling process, equipment and
services used, and costs are the same for development drilling.
Over time producers will In an effort to optimize production, producers will often drill a number of new wells in a
alter their development field every year, monitor existing well performance, inspect and maintain wells, and
plans to improve repair or workover existing wells. Monitoring well and reservoir performance is a critical
productions characteristics function for a producer because reservoir problems could cause hydrocarbon areas to
be missed entirely or damaged owing to to well problems. Depending on field size,
number of wells, flow rates, market demand, etc., field development and exploitation
can last years or decades until the reservoir is depleted to a level that is no longer
economical to produce. Over time, as fields deplete and reservoir behavior changes,
producers will alter their development plans to improve productions characteristics.
If well-spacing constraints are reached and/or reservoir conditions change so that the
existing spacing between wells fails to capture the full potential of the reservoir,
producers sometimes choose to decrease the well-spacing dimensions and drill new
wells closer to existing wells in the field, called infill drilling.
Gathering pipelines are When wells are ready to produce, gathering pipelines are installed to connect the
installed to connect the productive wells to a central gathering and processing facility. Oil and/or gas pumped to
productive wells to a the surface is not necessarily ready for end-use consumption—refinements need to be
central gathering and made. Natural gas needs to be processed to become “pipeline quality” so that it can
processing facility safely and conveniently be transported across a pipeline network. Oil must be
transported to a refinery to be converted into products (gasoline, diesel, heating oil).

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Production
Production refers to the Production refers to the ongoing collection of hydrocarbons from a field and the
ongoing collection of preparation of the hydrocarbons for transportation. At the very beginning of a well’s life
hydrocarbons from a field or a field’s life, the reserve base is at its maximum size and reserve life. Once
and the preparation of the production commences, the reserve base continually depletes. The initial productive
hydrocarbons for years are characterized by high flow rates, as the natural pressures in the rock layers
transportation easily force hydrocarbons to the surface. These primary recovery methods, or natural
drive mechanisms, are water drive, gas drive, and dissolved gas drive. Over time, high
flow rates give way to high decline rates (rapid depletion) as the well or field moves into
a mature stage where natural pressures subside and a lower flow pattern emerges.
Exhibit 100 demonstrates the typical life span of a basin. The beginning of a basin’s life
is characterized by a small number of fields, high average field sizes, and high
maximum field sizes given the few initial prospectors in the region. As a basin matures,
more producers explore and develop in the region, increasing the number of fields;
however, they crowd each other out and the average field size falls rapidly, as does the
maximum field size.

Exhibit 100: Oklahoma Gas Field Size by Decade of Discovery

700 7.0

600 6.0

500 5.0

400 4.0
Bcf

Tcf
300 3.0

200 2.0

100 1.0

- -
1930-39 1940-49 1950-59 1960-69 1970-79 1980-89 1990-98

# Fields Avg Field Size (Bcf) Max Field Size (Tcf)

Source: Anadarko Petroleum, NRG.

As a field matures, the As a field matures, the effectiveness of primary recovery methods diminishes and
effectiveness of primary production rates decline, forcing producers to implement secondary, or tertiary, recovery
recovery methods methods. The most common secondary recovery methods are water flooding and gas
diminishes, requiring injection. Tertiary, or enhanced recovery techniques, include the use of chemicals, gas,
secondary and enhanced, or heat injections to alter the fluid properties of the rock. Two common enhanced
or tertiary, recovery recovery methods used in the oilpatch are compression and artificial lift.
methods

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Compression helps to compensate for diminished wellhead pressure and is used

primarily on gas wells. Artificial lift systems are used to supplement reservoir pressures
in oil wells and include the following:
• Progressive cavity pumps. Downhole pumps connected to a sucker rod that runs from
a surface electric system.
• Gas lift systems. Natural gas injection into the well from above ground to provide the
necessary pressure to push oil to the surface.
• Hydraulic lift systems. Hydraulic pumps installed at the bottom of the wellbore to lift oil
from the reservoir.
• Steam injection. Steam is forced into the reservoir, creating enough pressure to force
oil to the surface.

Exhibit 101: Steam Injection

Source: U.S. DOE.

Each of the above methods increases the flow of hydrocarbons to the wellbore.
Enhanced recovery methods are expensive and are normally used only when market
dynamics (high prices) justify the high costs. During their productive lives, wells
sometimes require a workover to stimulate hydrocarbon flow.
A workover is essentially a Workovers involve one of several types of remedial work. The well could be re-
recompletion of the well; fractured, stimulated, or even drilled to a new depth. A workover typically requires that
the well is refractured, production be stopped, usually for at least a couple of days when using a workover rig.
stimulated, and or possibly However, a coiled tubing unit, which inserts coiled tubing into the well through the
drilled to a new depth to wellhead, can recomplete a well in one day without shutting in production in certain
increase hydrocarbon applications. In more difficult operating conditions or to accomplish some services, a
production workover rig remains the only option. Coiled tubing units can therefore save a producer

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valuable time and money by recompleting the well in a short time without disrupting
production. The advantages of coiled tubing units come at a higher price than average
workover rigs, and therefore are not as widely used.

Exhibit 102: Coiled Tubing Unit Exhibit 103: Workover Rig

Source: Varco International. Source: Baker Hughes.

Hydraulic drilling is another workover method. Hydraulic drilling utilizes smaller,

specifically designed rigs for more basic workover drilling work—primarily deepening
and sidetracking existing wells and re-entry work. While more limited in the scope of
drilling applications supported, hydraulic rigs are smaller and cheaper than traditional
drilling rigs, making them well suited for workover applications. Given the smaller size
and ease to move, hydraulic rigs are well served in fields where there is substantial
infrastructure and a smaller footprint is desired.
A more recent industry An increasingly utilized technique for increasing reservoir production rates and
technique for increasing maximizing recoverable reserves is underbalanced drilling. Overbalanced drilling uses
reservoir production rates drilling and completion fluids to control the pressure of the wellbore by forcing greater
and maximizing pressure on the reservoir than the reservoir exerts. It can result in formation damage as
recoverable reserves the fluids permeate the reservoir, hindering the flow of oil or gas into the wellbore.
is through underbalanced Underbalanced drilling reduces the pressure in the drilling column so that wellbore
drilling pressure is less than formation pressure. Underbalanced drilling, while more expensive
than overbalanced drilling methods, offers substantial cost savings potential in terms of
reduced formation damage and reduced workover costs.

Decommissioning and Abandonment

The final stage of the E&P When it is no longer possible to economically extract the remaining reserves from a
lifecycle is well, the producer must either temporarily or permanently plug and abandon the well.
decommissioning and The final stage of the E&P lifecycle is decommissioning and abandonment (plug and
abandonment (plug and abandon, or P&A). A producer will P&A appraisal wells and development wells,
abandon, or P&A) depending on the viability of the prospect. An appraisal well that appears uneconomical
to develop will be plugged and abandoned the same way productive wells are plugged
and abandoned when a field or prospect has been depleted to a level that is no longer
economical to produce. The wells are inspected and plugged, pipelines are removed,
equipment is removed and redeployed elsewhere, and the E&P process begins again.

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Storage and Transportation

Crude is stored in large Oil and gas collected from the various wells in a field and fields in a basin need to be
diameter, tall holding tanks stored and transported. Crude is stored in large diameter, tall holding tanks and is
and is transported by transported by pipeline, truck, and ocean tankers to refineries that turn crude into
pipeline, truck, and ocean products. Natural gas is stored underground in a variety of methods. Like crude, gas
tankers to refineries that can also be transported a number of ways; however, this depends on its physical state.
turn crude into products Dry gas, or methane, which is the most commonly used gas, can only be transported by
pipeline, while natural gas liquids can be transported either by pipeline or tanker truck.
Liquefied natural gas, which is used for long distance gas export, can only be shipped in
specially designed refrigerated, ocean tankers.

The major oil-producing basins of the world (see Exhibit 6 on page 15) are not closely
located to the major consuming regions. These long distances require the use of oil
tankers to transport the crude. Tankers are filled at major ports near the producing
regions and transport the crude to major coastal ports or hubs around the world.
Major global transocean In the U.S., the Houston Ship Channel, the Louisiana Offshore Oil Port (LOOP), and
import/export hubs are the New York Harbor are the major transocean import hubs where foreign oil is delivered.
Houston Ship Channel, Major European hubs include Rotterdam (NWE) and the Mediterranean, while
Rotterdam, and Singapore Singapore is a major hub in Asia-Pacific. Tankers can carry between 10,000 barrels and
1MMB of oil and take up to three weeks to deliver, depending on the travel route (i.e.,
Middle East to U.S. Gulf Coast). The crude is delivered to refineries that purchase the
crude on the open market or directly from producers.

Exhibit 104: Pipeline Exhibit 105: Oil Tanker

Source: Company data, CSFB estimates. Source: Stelmar Shipping Ltd.

Crude is delivered to Refineries are typically located near major import hubs to limit additional transportation
refineries, which are charges. Refiners pay transport costs associated with shipping crude to the refinery.
typically located near These costs vary depending on the origin and the destination of the shipment, as well
major import hubs to as on the amount of oil being shipped, and the market supply and demand for
limit additional transportation services.
transportation costs
Exhibit 106 illustrates the transportation costs for both dirty (crude) and clean (product)
tankers from certain origins to different destinations. For example, a dirty tanker from
the Arabian Gulf to the U.S. Gulf Coast costs $8.96 per ton of oil, or $1.20 per barrel of
oil. Similarly, the cost of shipping refined products in a clean tanker from the

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U.K./Continent to the U.S. Atlantic Coast is $18.55 per ton, or 5.54 cents per gallon of
oil. These prices are not fixed; they are quoted market rates that vary with overall oil
market conditions.

Exhibit 106: Tanker Route Assessments

Tanker Route Assessments - Dirty
Origin Destination DWT* WS $/Ton $/Bbl
Arabian Gulf Singapore 250 47.50 3.01 0.40
UK/Continent 250 45.00 8.31 1.12
Mediteranean 250 45.00 8.33 1.12
US Gulf Coast 250 45.00 8.96 1.20
UK/Continent US Gulf Coast 250 52.50 4.81 0.65
US Atlantic Coast 130 100.00 7.73 1.04

Tanker Route Assessments - Clean

Origin Destination DWT* WS $/Ton Cts/Gal
UK/Continent Mediteranean 30 195.00 11.02 3.29
US Atlantic Coast 30 240.00 18.55 5.54
UK/Continent 25 210.00 6.74 2.01
Caribbean US Atlantic Coast 30 240.00 11.69 3.49
US Gulf Coast 30 240.00 9.70 2.89
* In thousand tons
** Conversion Rate: Dirty = 7.45 bbl/ton, Clean = 8.00 bbl/ton

Source: Bloomberg.

Once the crude is unloaded at a hub, it is either stored in nearby tanks (Exhibit 107) or
transported (Exhibit 108) to refineries, which also use similar storage tanks. Refineries
located far away from the hub transport the crude by pipeline or truck, or again by
tankers (smaller, in-land barges, not oceanic tankers).

Exhibit 107: Oil Storage Tank Exhibit 108: Oil Tanker Truck

Source: Fab-Seal Industrial Liners, Inc. Source: Company reports

Natural gas is transported As we described above, natural gas can be transported a number of ways, depending
via pipeline from producing on its form. Dry gas, or methane gas (90% of consumed gas), is transported through
basins to local distribution long-haul pipelines, or intrastate and interstate pipelines. A pipeline network transports
companies at city gates the gas from major producing basins to major demand centers or city gates. The long-
haul pipeline transports and delivers the gas to storage operators for use at a later date,
or directly to local distribution utilities or companies (LDCs) at the city gate for
immediate delivery. Major long-haul pipelines can carry up to 1.5bcf/d, while smaller
laterals that branch off and connect to smaller city gates may carry 0.3-0.5bcf/d.

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Natural gas pipeline transportation costs, similar to oil transport costs, vary depending
on the origin, destination, and market supply and demand. For example, transporting
natural gas from the U.S. Gulf Coast to the New York city gate may cost $0.13/mcf,
versus only $0.06/mcf to transport gas from Appalachia to New York.
LDCs maintain the Natural gas is always stored in an underground facility with the characteristics of a
distribution network of reservoir. As a gas, not a liquid, it cannot simply be stored in a container or tank. The
pipes and laterals that facility must have a high level of porosity and permeability to hold the gas, as well as
connects homes and have enough primary drive to support the flow of the gas to the surface, and provide a
businesses to the gas grid permeable trap to contain the gas. Natural gas is stored underground in three forms:
• Depleted reservoirs. Natural gas is injected into depleted reservoirs, utilizing existing
production infrastructure (wells, gathering pipelines, and transportation pipelines).
Depleted reservoirs have lower development and operating costs than salt caverns
and aquifiers.
• Aquifiers. Water-only reservoirs that are made suitable for natural gas storage.
Aquifiers are the most expensive form of natural gas storage because of the large
amount of work and long completion times and the installation of costly infrastructure.
• Salt caverns. Smaller than depleted reservoirs, have a dome shape, and offer
effective and efficient injection and withdrawal methods.

Natural gas holding capacity is a key consideration for determining a facility’s ability to
have high deliverability—the ability to quickly withdraw gas to serve market needs. Two
forms of storage gas are base gas and working gas. Base gas provides the reserve
level that supports long-term market needs and the necessary pressure to provide lift for
efficient working gas withdrawal. Working gas is the amount of gas that can be
withdrawn to meet customer needs on a regular basis.

An ancillary component to natural gas storage is the level of compression in the natural
gas pipelines. Natural gas released into a pipeline would remain static if it were not
compressed using high horsepower compressors (about every 40 miles along a
pipeline) to force the gas to move from one end of the pipeline (Gulf of Mexico) to the
other (New York). When storage facilities reach maximum capacity and flowing gas
exceeds market demand, pipeline operators will lower the compression of the pipelines
and allow the gas to “sit” in the pipeline until it’s needed by the market or until storage
capacity becomes available. This is commonly referred to as linepack.

The local distribution companies maintain the relationship with end-use residential
(retail), and commercial and industrial customers (wholesale). The utility has a complex
web-like system of pipes that run from the city gate to every home, business, factory,
shopping mall, etc. The network consists of mains that connect regions within the city
gate to the city gate, and then laterals and smaller systems on the neighborhood or
sector level. LDCs pass on distribution charges to their customers for distributing gas
through their system.

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Exhibit 109 illustrates the flow of natural gas from the wellhead to the end markets. The
flow chart is different for oil, as oil needs to be refined before it can reach its end market.
In this section we discuss the storage and transportation of oil and gas and their role in
the energy chain. Natural gas is transported straight to market (after initial processing).
Crude, however, after it is transported and delivered to refiners, is refined into products,
and then transported to market.

Exhibit 109: From Well to Market

Source: Interstate Natural Gas Association of America.

Refining
The refining process The refining process entails manipulating the chemistry (density, sulfur content, and API
entails manipulating the pressure) of crude to produce valuable, end-use products (motor gasoline, heating oil,
chemistry (elements, jet fuel, distillate). Unlike the upstream process, which is very physical, can be seen,
atoms, and molecules) of and can be explained using pictures, the refining process is more conceptual.
crude to produce valuable,
The complex refining processes cannot be easily seen since the processes themselves
end-use products (motor
are chemical processes that take place inside various towers, chambers, and columns
gasoline, heating oil, jet
of a refinery complex. One can view the massive size of a refinery complex (Exhibit 110),
fuel, distillate)
the columns, towers, pipes, and storage tanks, but the spectacle itself offers little insight
into the processes taking place. We will describe the equipment used in refining, the types
of chemical reactions that take place to form products, the types of products, and the
economics of refining. We will first introduce the end products to simplify the discussion,
then describe the distillation process, and conclude with the secondary distilling processes
that involve blending, processing, and reforming and complete the refined products.

Exhibit 110: Phillips Borger Refinery

Source: Phillips Petroleum.

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Petroleum Products
A barrel of oil can be
We introduced the refined products groups in the Oil Markets section, but did not fully
broken down into four
elaborate on the differences between each product or group of products. Exhibit 111
broad, refined parts:
shows the product slate for a refined barrel of oil and the various uses discussed in the
liquefied petroleum gases,
Oil Markets section.
light distillates, middle
distillates, and residual fuel
Exhibit 111: Oil Barrel Products and Uses

Products Uses
Ethane, Propane, Heating, cooking, chemical
Butane feedstocks, motor gasoline blending
LPGs - 10%

Gasolines, Naphthas Petrochemical feedstocks, reforming

Light Distillates - 35%
into gasoline, automotive fuel

Jet Kerosene, Diesel, Aviation fuel, automotive fuel,

Heating/Gasoil, domestic heating fuel, distilled to
Middle Distillates - 35% Vacuum Gasoil lighter product

Cracked FO, SR FO, Power generation, ship fuel, fuel oil,

Asphalt, Bitumes, road surfacing, roofing, chemical
Residual Fuel Oil - 20% Coke, Sulfur industry

Source: CSFB.

At the top of the barrel are the LPGs, the lightest part of the refined stream. Ethane,
butane, and propane are often used as chemical feedstocks and for outdoor cooking
(gas barbecue grills).
Light distillates (gasoline, Light distillates (the gasolines and naphthas) are largely used as petrochemical
naphtha) represent roughly feedstocks and as automotive fuels, and represent roughly 35% of the refined products
35% of the refined product from one barrel of crude oil.
yield from one barrel of
Middle distillates are diesel fuel, jet fuel, kerosene, and heating oil. Diesel is common to
crude oil
gasoline in that both fuels are used to run cars and trucks; however, the similarities end
there. Diesel fuels come in several types and qualities similar to gasoline. Diesel
additives used in the blending process are generally the light gas oils. Light and heavy
gas oils, also middle distillates, are most commonly used as home heating oil and are
referred to as distillate fuel, heating oil, and number two fuel.

Heating oil is a common source of residential and commercial space heating and water
heating throughout the world given its ease to produce and low cost. It does, however,
have environmental effects similar to any other oil-based product. Other clean-burning
fuels such as natural gas have made inroads into the space and water heating market,
drawing from heating oil’s market share as a fuel source for boiler and heating systems.

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At the “bottom of the barrel” remains the residue (resid) from the various refinements
that have taken place. This residue is a very thick, tarry substance that remains of the
original crude oil. The resid is the lowest value product, but it still has economic value in
two forms—asphalt and resid fuel. Refiners generally produce more resid than asphalt,
as it can be used as a feedstock in the chemical industry, in electric power generation,
and can occasionally be used for space heating.

Processes
The crude distillation unit is As we described in the Storage and Transportation section (page 108), crude is
the primary unit in a physically delivered to a refinery by tanker or pipeline and is stored in a large holding
refinery used to separate tank. From the storage tank the crude is pumped into the refinery complex and sent
crude oil into its main through a furnace. The furnace heats and vaporizes the crude, which is then piped into
constituents or fractions a distilling column. The crude distillation unit (CDU) is the primary unit in a refinery used
to separate crude oil into its main constituents or fractions. (See Exhibit 112.) The
capacity throughput (i.e., how many barrels of oil can be processed each day) of a
refinery normally refers to the capacity of its CDU.
The temperatures at which The temperatures at which the crude elements vaporize into different cuts or fractions
the crude elements are referred to as cut points. (The fractions can generally be thought of as the different
vaporize into different cuts product families—LPGs, light distillates, middle distillates.) Within the distilling column
or fractions are referred to are holes or trays at varying heights where the different vapors collect. The heavier
as cut points vapors (more liquid than vapor) drop to the bottom of the column and the lighter vapors
(more vapor than liquid) rise to the top of the column where they are collected. The
holes in the distilling column collect and redistribute the vapors and liquids in the same
process several times to fully separate the fractions. The vapors may also be run
through a cooler to ensure that heavier liquids/vapors do not escape the top of the
column with the lighter vapors. After the vapors and remaining liquids are collected for
each specific fraction, the products are condensed into liquid form.

These condensed liquids (fractions) are also referred to as straight run distillates, and
there are several types.
• Butane. The lightest liquid of the refining process, it is a component of liquefied
petroleum gas.
• Gasoline. One of the lightest of the principal liquid fuels from the refining process.
Gasoline is the most important private transportation fuel and sometimes occurs
naturally as condensate.
• Naphtha. A light, liquid fraction, used mainly for the production of gasoline or as a
feedstock for the petrochemical industry.
• Kerosene. The medium to light fuel produced by the oil refining process, coming
between the gasoline and gasoil fractions. Kerosene was the original refined oil
product, used for lighting; its principal uses today are for heating and as jet fuel.
• Light gas oil. Similar to heating oil, low sulfur content.

• Heavy gas oil. Closer to resid or fuel oil than lower sulfur heating oil or diesel.

• Residue (resid). The heavy component of crude oil that resists distillation.

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The type of crude used The type of crude used has an impact on product yields and refining costs. Yield refers
has an impact on product to the amount of each product that can be produced from a barrel of oil. Light crudes
yields and refining costs; with low sulfur contents are easier to refine than heavy and high sulfur crudes. The
yield refers to the amount heavy, high sulfur content crudes require additional refining equipment that lead to a
of each product that can higher cost structure. Light crudes also yield or produce more of the higher value
be produced from a barrel products—butane, gasoline, naphtha, and kerosene—while heavy crudes produce more
of oil gas oil and residue (resid).
Exhibit 112 depicts the process as described so far; crude oil enters the distilling column
and is heated to varying temperatures, resulting in different fractions. Notice that the
flow chart of the distillation process is very similar to the layout of the barrel of oil
example in Exhibit 115. We will discuss the next step in the refining process, the
complex process, in a moment.

Exhibit 112: Distillation Process

in degrees fahrenheit

<90° BUTANE AND

LIGHTER GAS PROCESSING

D
I 90°-220° STRAIGHT MOTOR GASOLINE
S RUN GASOLINE BLENDING
T
I 220°-315°
NAPHTHA
L CAT REFORMING
L
I 315°-450°
N KEROSENE HYDROTREATING
CRUDE
OIL
G
450°-650° LIGHT DISTILLATE
C
GAS OIL FUEL BLENDING
O
L
U 650°-800° HEAVY CAT CRACKING
GAS OIL
M
N
800° + STRAIGHT RUN FLASHING
RESIDUE
Source: Petroleum Refining.

The temperature ranges naturally overlap with one another (i.e., 220 degrees F is the
end point for producing straight run gasoline and also the initial boiling point for straight
run naphtha). As a result, an equal amount of naphtha and gasoline, in this example, is
produced for the respective fraction at the cut points. Because of this, the cut points
may be slightly higher or lower than the actual ranges above to allow for more or less
production of a particular fraction.

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Controlling the cut points is Applying the gasoline/naphtha cut point example, at 220 degrees F an equal amount of
an important part of the gasoline and naphtha will be produced. Adjusting the cut point to 250 degrees F will
refining process; refinery result in a higher yield of naphtha than gasoline, as shown in Exhibit 113. The yield
managers constantly percentages are not exact but directionally correct to demonstrate the impact of
analyze the crude and changing cut points.
product markets to
Controlling the cut points is an important part of the refining process. Refinery managers
determine which products
constantly analyze the crude and product markets to determine which products to
to produce based on
produce based on market prices and operating costs at the refinery. In periods of low
market prices and
gasoline supplies and consequently high prices, refiners will control the cut point to
operating costs at the
maximize gasoline output. Plant managers’ expectations for market supply and demand
refinery
and future prices play a large role in how the refinery is run and which product slates are
produced. In Exhibit 113, we have extracted the gasoline and naphtha fractions from the
flow chart above to highlight the directional change in yields as plant managers adjust
the cut points.

Exhibit 113: Cut Points and Yields

Cut Point Fraction Yield
o
90-220 F Gasoline 50%
220-315o F Naphtha 50%

Gasoline 35%
250o F
Naphtha 65%

Source: CSFB.

The fractions are reprocessed until all vapors and liquids are fully and appropriately
separated. Then the fractions are sent to different parts of the refinery complex to
continue the specific refining process for each fraction.
This is a complex process, as depicted on the right side of Exhibit 115. Butanes go to a
gas-processing facility, gasoline goes to blending, naphtha to cat reforming, and heavy
gas oil to cat cracking. We will focus our discussion on the parts of the process that
result in the most valuable and widely used products (gasoline, distillate, resid).

Blending, Reforming, Processing, Cracking, Flashing

Gasoline Blending
The blending process Gasoline blending is one of the most important parts of the refinery process given
involves using feedstocks gasoline’s high market value and widespread uses. Gasoline for end-use consumption
and additives from the is the final stage in the oil and gas chain. Before gasoline is ready for end-use
other refining processes consumption, straight run gasoline needs to be further refined to meet stringent product
(cat cracking, flashing, specifications (environmental regulations and quality tests). The blending process
cat reforming) to involves using feedstocks and additives from the other refining processes (cat cracking,
meet specifications flashing, cat reforming) to meet specifications.
(environmental regulations
Vapor pressure and octane are the two most important characteristics of gasoline.
and quality tests)
High-quality gasolines have high vapor pressures, which means the gas does not
become ignitable until very high temperatures and pressures are reached. This is highly
desirable because low-vapor-pressure gasoline could self-ignite (i.e., blow up) under

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low temperatures and pressures and cause serious damage. This is the primary reason
refiners make different gasoline blends for the different seasons—to adjust for changing
temperatures. Refiners make winter blends to adjust the gasoline characteristics to
ignite in cold weather, and readjust to make summer blends for warm weather ignition.
Octane numbers are the Octane measures knocking, or essentially, the potential for the gasoline to self-ignite.
percent iso-octane of the Knocking occurs in a car engine when the gasoline vapors self-ignite and the pistons
gasoline blend; the higher drive against the crankshaft. Most cars have spark plugs that serve to compress and
numbers the better the ignite the vapors at the right time when the piston moves with the crankshaft, not
quality gasoline against it.

Octane numbers are the percent iso-octane of the gasoline blend, and higher octane
numbers typically correspond to low knock effects. Of the more common retail
gasolines—88-octane gasoline, for example—is 88% iso-octane and has low knock
effects.
Gasoline additives (lead, Gasoline additives are used to increase the octane number and come in many forms:
methanol, ethanol, TBA,
• Lead. Tetraethyl lead increases octane without changing the vapor pressure;
and MTBE) are used to
however, it is no longer used in the U.S. or EU because of detrimental environmental
increase the octane
and health effects.
number
• Methanol. An alcohol compound combined of methane gas and naphtha.

• Ethanol. An alcohol processed mostly from corn.

• TBA, or tertiary butyl alcohol. Used when methanol is the primary additive. It prevents
unblending caused by water mixing with gasoline.
• MTBE, or methyl tertiary butyl ether. An oxygenate, unlike the three alcohols
described above; it is produced by adding a catalyst to isobutylene and ethanol.

The blending process is not as straightforward as may appear. Determining which type
of additive to use depends on the expected temperatures the gas and expected
pressures where the gasoline will be used. Additionally, the types of alcohol and
oxygenate used can have different effects on each other, as the relationships change
with pressure and temperature.
The quality of the gasoline There are several types of gasoline blends as is readily observable at any retail service
leads to different grades station. There are regular blends, premium blends, and super-premium blends, each
and price points: regular, with different prices according to the quality level. The finished gasoline product can be
premium, and super stored in large gasoline tanks at a refinery complex until its needs to be transported to
premium market. It can be transported by truck, pipeline, or tanker to regional terminals, where it
is stored until local retail stations need to be filled, or it can be delivered straight to a
retail gas station, where it is pumped into on-site storage tanks that feed the pumps.

Distillate Blending
Distillate blending can be Following gasoline in the chain of high-value products is distillate. The distillate blending
more complex than process is similar in concept to gasoline blending, feedstocks, and additives from other
gasoline given the number refining processes (cat cracking, flashing, cat reforming) are used as blends. Distillate
of distillate products blending, however, is more complex given the number of distillate products (naphtha,
(naphtha, kerosene, light kerosene, light gas oil, heavy gasoil). Some parts of the refining process are more
gasoil, heavy gasoil) notable than others. We introduce each of the concepts or processes, but mainly focus
on the cracking process.

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Hydrotreating or hydrodesulphurisation refers to the removal of sulfur and other

contaminants from refined products using hydrogen as the catalyst. It ensures distillates
(diesel and fuel oil) meet environmental and sulfur specifications.

Catalytic reforming improves low octane naphthas into high grade reformates, or
blending components. However, there is a trade-off between increased octane and
decreased yield beyond a certain octane level.

Cracking Process and Flashing

After the straight run heavy gas oil is produced from the initial distilling process, it
is sent to a cracking unit to further refine the oil. At about 750-800 degrees F, several
characteristics of the crude have already changed (i.e., the fractions have been created
at different boiling temperatures), and only a few of the heaviest compounds remain. At
temperatures above 900 degrees F, the intensity of the heat cracks the remaining
heavy, crude elements into smaller, lighter elements (i.e., gasoline, propane). There are
Catalysts are substances
several cracking methods:
that speed up or otherwise
improve the efficiency of a • Thermal cracking or coking. Applies heat to the distilled fractions to break down larger
chemical reaction, without hydrocarbon molecules into smaller ones, or lighter distillates. Thermal cracking is the
forming part of the final predominant cracking method for refining straight run resid.
product
• Hydrocracking. Uses hydrogen as a catalyst to improve efficiency.

• Catalytic (cat) cracking. Applies heat and a catalyst to speed the process.

We will initially discuss the cat cracking of heavy gas oil. Within the refinery complex is a
cat-cracking unit that introduces a catalyst to the heavy gas oils to induce cracking.
Catalysts are substances that speed up or otherwise improve the efficiency of a
chemical reaction, without forming part of the final product. Catalysts allow cracking and
hydrotreating reactions to take place at lower temperatures than normal.

The cat-cracking unit comprises three parts: a reactor, a regenerator, and a fractionator.
The reactor introduces the catalyst to the heavy gas oil, the regenerator creates new
catalyst feed, and importantly, the fractionator separates the various cracked products.

The cracking process results in a full range of fractions. It essentially breaks down the
oil again, in a similar process to straight run distillation, into another set of fractions
ranging from natural gas to resid. In addition to the full range of fractions produced, coke
forms from the smaller molecules. The resultant fractions, or cat-cracked fractions (i.e.,
cat cracked butane, cat cracked gasoline, cat cracked naphtha), are different from the
straight run fractions, and they are referred to as olefins (ethylene, propylene, butylene).
The cracking process An important result of the cracking process at 900 degrees F is that the cracked
creates or yields more elements have a higher volume than before they were cracked. In essence, the cracking
fractions (by volume) than process creates, or yields, more fractions (by volume) than the original amount of crude
the original amount of that began the process (i.e., if 1.0 gallon of crude is distilled and cracked, it could
crude that began the produce 1.38 gallons of higher fractions). This is referred to as a processing gain.
process (i.e., if 1.0 gallon
The lightest cat-cracked fraction, isobutene, then goes to the gas-processing facility to
of crude is distilled and
recombine with other small olefins to form larger, valuable propane and butane
cracked it could produce
components. The other light cat-cracked fractions are used for blending gasoline (i.e.,
1.38 gallons of higher
gasoline additives), the middle cat-cracked fractions are used for blending distillate, and
fractions)

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the heavy gas oil and resid are recycled over and over until there is nothing remaining.
The remaining cat-cracked fractions, or olefins, are sent to an alkylation plant.

Fractionation, cat cracking, and gas processing each break apart hydrocarbon
molecules into smaller, lighter, more valuable parts. The reverse process, making larger
components from molecules that are too small and of too little value, is known as
alkylation. Alkylation occurs in a separate alkylation (alky) plant within the complex that
has several components—a chiller, a reactor, and three fractionation columns. The
alkylation plant turns the smallest gases into larger liquid forms—propane and butane—
which serve as an additional source of fuel output. Olefins are combined with paraffins
to form iso-paraffins, or alkylate. Recall that cat cracking not only breaks down large
molecules into smaller molecules, but the smaller molecules result in a higher yield
given their increased volume. Alkylation has the reverse effect; yields decrease as
smaller molecules combine to form larger, less voluminous molecules. This known as
shrinkage. Despite the shrinkage, alkylate is valuable since it forms an end-use product.

The cat-cracked lighter products that are used as blends and the alkylation process that
creates additional propane and butane represent the end of the cat-cracking chain.

Gas Processing
Gas processing involves Gas processing in a refinery complex is the same as gas processing in the midstream
compression, separation, segment of the natural gas industry. Midstream energy companies process natural gas
fractionation into its component parts (methane, ethane, propane, butane, hydrogen) the same way
refiners process the gas.

The lightest elements of crude that vaporize and condense into butane and other light
products are transported to a gas-processing facility within the refinery complex.
Processing the gas is very different than flashing and cat cracking. Gas processing
involves cooling rather than heating the components. These gases cool at varying
temperatures to form paraffins (isobutane, normal butane, propane, ethane, and
methane).

The process consists of the following:

• Compression. Removal of excess water.

• Separation. Liquefaction of gases at high pressure, low temperature.

• Fractionation. Extraction of liquid components, break down molecules.

Natural gases can be rich (wet) or lean (dry), depending on the amount of heavy
recoverable components. Special processes are also applied to remove acid and sour
gases, such as hydrogen sulfide and carbon dioxide, and other chemical treatments are
used to further refine the gas and recovered liquids. The wet components are referred to
as natural gas liquids.

Each of the paraffins has different uses, either within the refinery process or as
commercial products.

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Exhibit 114: LPG Types and Uses

Paraffin Type End-use
Isobutane alkylation feedstock
Normal butane gasoline blending
Propane chemical feedstock, heating fuel, cooking fuel
Ethane chemical feedstock
Methane fuel to run various other refinery operations

Source: CSFB.

Generally, after the gas has been through the distilling unit and then processed into the
products, it is ready for end-use consumption. (See Exhibit 114.) One exception is the
smallest element, isobutane, which is sent to the alkylation plant to be combined with
olefins from the cat-cracking process to form butane and propane.

Each of the above processes results in a product or blend or feedstock that is more
refined than the prior stage. The different elements are refined until they are fully broken
down, until every chemical process that can add value to the process has occurred.
Exhibit 115 provides a layout of the entire process.

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 Oil and Gas Primer
Exhibit 115: The Refining Process

Ethane
Methane
BUTANE GAS
PLANT Normal Butane PARAFFINS
STRAIGHT RUN Isobutane
GASOLINE BUTANE
D
I STRAIGHT RUN
S NAPHTHA CAT
STRAIGHT RUN REFORMER
T
REF
Ethylene
KEROSENE
120

I Ethane
STRAIGHT RUN Propylene
L LIGHT GAS OIL Normal
L Butane
STRAIGHT RUN Butylene ALKY
I HEAVY GAS OIL CAT
N CRACKER CAT CRACKED
GASOLINE
ALKY
G
CAT CRACKED
FLASHER LIGHT GAS OIL
C TOPS
O CAT CRACKED
HEAVY GAS OIL
L
U
M
N
STRAIGHT RUN OLEFINS
RESIDUE FLASHER Ethylene
Propylene

FLASHER Butylene
BUTANE
BOTTOMS THERMAL THERMAL CRACKED
CRACKER GASOLINE
THERMAL CRACKED HYDRO
LIGHT GAS OIL CRACKER
THERMAL CRACKED
HYDRO-
HEAVY GAS OIL
THERMAL CRACKED CRACKATE
RESIDUE

14 May 2002
Source: Petroleum Refining.
Oil and Gas Primer 14 May 2002

Offshore Oilfield Services and Equipment

Offshore operations call for We have fully detailed the E&P process for land drilling and the various oilfield services
a greater degree of and equipment used, but have not yet addressed the offshore drilling process. Since
specialization than many of the processes are similar for both onshore and offshore drilling operations and
onshore we have already discussed the onshore process in detail, we will focus less on the E&P
process and concentrate on the main offshore services and equipment for introductory
purposes.

The biggest difference between land drilling and completions and offshore drilling and
completions is the rig. A land rig can be mounted on a stable surface and placed directly
over the well site. In offshore drilling, the rig is above the ocean’s surface, and possibly
hundreds or thousands of feet above the drilling surface (the sea floor). Offshore
completions utilize many of the same tools and services we described in the land drilling
and completion process; however, some tools or services are specifically designed for
offshore use. Offshore E&P operations are described in terms of water depth—shallow
water, deepwater (greater than 3,000 feet), and ultradeepwater (greater than 5,000
feet). We will refer to these terms as we describe the different types of offshore rigs and
their characteristics. We will then describe the completion and production methods used
for both subsea and dry-deck operations.
Offshore drilling units can Offshore drilling units can be broadly defined as mobile offshore drilling units (MODUs)
be broadly defined as or stationary platform units. The major difference being the mobility factor. MODUs can
mobile offshore drilling be deployed and redeployed to different drill sites within a particular region or deployed
units or stationary into different regions altogether. Platforms are permanent structures, usually in less than
platform units 500 feet of water, built into the ocean floor, and are only usable in the field they are
installed. Common features of both MODUs and platforms are the helipad, the drilling
rig, living quarters, and production facilities. The four main classes of MODUs are
jackups, semisubmersibles (semis), submersibles, and drill ships. We will describe each
type of MODU and its characteristics, advantages, and drawbacks, and then briefly
describe the less-often-used platforms.

Before offshore drilling can begin, a subsea template needs to be installed and attached
to the ocean floor to provide a base for the drilling unit. The template has several open,
round holes that are used to install a number of wells on the ocean floor.

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Exhibit 116: Subsea Drilling Template

Source: API.

The most prevalent MODU The most prevalent MODU is the jackup, and approximately 60% of all MODUs are
is the jackup; jackups. They are mobile, self-elevating drilling platforms with legs that are lowered to
approximately 60% of all the ocean floor to provide a foundation for the drilling platform, which lies well above the
MODUs are jackups surface to allow storm waves to pass underneath; they are used in water depths of less
than 350 foot (shallow water). Jackups vary a great deal in size and capability. The
smaller units have 100-foot leg lengths and are mat supported on the bottom, while the
250-foot and 350-foot units typically have independent legs that jack down to the ocean
bottom. Jackups are very versatile and can drill exploratory wells in a variety of water
depths and weather conditions. Many units are cantilevered, meaning the drilling
package can be extended beyond the edge of the hull. This enables the drilling of
multiple exploratory or development wells from the same location over an existing fixed
production platform.

Exhibit 117: Jackup Exhibit 118: : Semisubmersible

Source: Diamond Offshore. Source: Diamond Offshore.

The second class of The second class of MODUs is semisubmersibles (semis), which are also mobile,
MODUs are semi- floating drilling platforms; however, the lower hull is partially submerged and the unit is
submersibles moored with wires and/or chains or is dynamically positioned. Semis are most often
used for development and exploration drilling in water depths up to 10,000 feet.

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(Deepwater is greater than 3,000 feet.) The water depth capability of a semi is
principally a function of the variable deck load, available deck area, and the mooring
system. The size and weight of the equipment used in the drilling process (riser, fluids,
tubulars, mooring equipment, etc.) increases as the water depth increases. In order to
increase water depth, the variable deck load and deck area must be increased.
Semisubmersibles are used worldwide and are particularly favored in harsh
environments because of their superior motion characteristics.
Semis are typically described by generation, or the time period they were built. As long-
lived assets, changes in technology have made the distinction necessary because of
Semis are typically new design and technological breakthroughs for newer units that are able to command
described by generation, premium rates over earlier, older models.
or the time period they
• First-generation semis were constructed in the early 1960s and were designed to drill
were built:
to depths approaching 20,000 feet in 400-800 feet of water. The variable load of these
first gen—early 1970s,
rigs is generally less than 2,500 tons. The vast majority of these semis have been
second gen—late 1970s,
retired.
third gen—early 1980s,
fourth gen—1980s-1990s, • Second-generation semis were constructed in the 1970s. These units are capable of
fifth gen—recent drilling to depths of 20,000-25,000 feet in water depths from 400 feet to 2,500 feet,
with some larger units capable of drilling up to 3,500 feet. The variable load of the
second-generation semis is typically above 2,000 tons. The second-generation
equipment varies substantially in capability and upgradability.
• Third-generation semis were built in the early 1980s. This generation has variable
loads that exceed 3,000 tons, and can drill in water depths generally up to 3,500 feet.
The third-generation units have premium equipment and generally command higher
dayrates. They are capable of working in the harsh environment areas of the world,
including the heavily regulated North Sea.
• Fourth-generation semis were built from the mid-1980s to the early 1990s. These are
among the most advanced drilling units in the world. They can drill in water depths up
to 5,000 feet, and many have harsh environment capability. Several of these units are
dynamically positioned to avoid the cumbersome size and weight of the mooring
systems they would need to drill at these depths.
• Fifth-generation semis, the current generation, have been developed to work in water
depths greater than 5,000 feet. These units have 5,000 tons or more of variable deck
load and can work in harsh environments.
Drillships are used in Drillships are used in various water depths where jackups and other bottom-supported
various water depths rigs are incapable of working. Generally, dynamically positioned drillships are used to
where jackups and other drill wells in the ultradeepwater, since these units are not constrained by the limitations
bottom-supported rigs are of conventional mooring systems. Dynamically positioned drillships have become the
incapable of working, tool of choice for exploration in ultradeepwaters and remote deepwater locations
generally, in the ultra- because their superior cargo-carrying capacities allow them to operate for long periods
deepwater (> 5,000 feet) without resupply. Conventionally moored drillships generally compete with second- and
third-generation semis in water depths up to 1,500 feet in certain market areas.

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Exhibit 119: Platform Exhibit 120: Submersible

Source: Royal Dutch Shell. Source: Noble Drilling.

Submersible units are the last type of offshore drilling unit. Unlike semisubmersible units
that have a partially lowered hull, submersible hulls are filled with water and lower to the
ocean floor.

A platform is a stationary drilling platform mounted into the seafloor that can only be
positioned over one well site. They can be much bigger than other types and they are
typically used in shallow waters. Platforms are mostly used in the harsh, North Sea
environment. (See Exhibit 119.)
Once the offshore rig is in place, the drilling process mirrors that of the land drilling
process. Similar drilling equipment, pressure control equipment, downhole tools, and
pipe handling equipment are used; however, they are specifically tailored for offshore
operating environments.
There are two forms of Offshore completion, development, and production systems have many different
offshore production features to onshore systems. Onshore production systems (wellheads, flow
systems: platform (dry) measurement systems, gathering lines, etc.) can be easily inspected and maintained on
systems and subsea (wet) a regular basis. Offshore production facilities are not as easily maintained. There are
systems two forms of offshore systems: platform systems and subsea systems. Platform systems
are the most common, but advances in technology and cost structures have made
subsea completion and production systems a viable alternative. Subsea systems work
on the seafloor as opposed to above the sea on the rig platform.

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Exhibit 121: Offshore Production Platform

Source: UKOOA.

Exhibit 121 presents a side profile of a drilling platform and includes the components we
discussed: derrick, helipad, living quarters, and production equipment.

After the subsea template has been installed, a jacket is anchored onto the template.
The jacket is a steel support that extends vertically from the template on the ocean floor
to above the ocean surface. It serves as the primary support for the production platform.
Offshore production Offshore production systems vary with water depth and conditions. Fixed platform and
systems vary with water compliant tower platforms are more physically and economically suited for shallow water
depth and conditions: operations, while deepwater and ultradeepwater operations require more flexible,
tension leg platforms, floating production systems (FPS). Each type of FPS is uniquely constructed to meet
SPARs, FPSOs the varying characteristics of a particular operation’s water depth, drilling depth, and
production amount. The most common floating systems include the following:
• Tension leg platforms (TLP) and minitension leg platforms (mini-TLP) consist of a
floating topside structure held in place by vertical, tensioned tendons connected to the
sea floor by subsea templates. Mini-TLPs are designed for smaller fields and satellite
field that would be uneconomical to develop using other equipment. TLPs and mini-
TLPs are used in water depths up to 4,000 feet.
• SPARs consist of a wide diameter single, vertical cylinder that supports the topside
and is anchored to the ocean floor. They can be used in water depths from 3,000 feet
to 7,000 feet.

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• Floating production systems (FPS), or semisubmersible units, are used in water

depths between 600 feet and 7,500 feet.
• Floating production, storage and offloading systems (FPSO) are tanker-like vessels
moored to the ocean floor. They are able to store oil produced from subsea wells and
offload the hydrocarbons to shuttle tankers, and are ideally suited for fields with
limited infrastructure. FPSOs are used mostly in deepwater and ultradeepwater
endeavors.
• Floating storage and offloading systems (FSO) are used when oil and gas processing
is performed at a separate facility.

Exhibit 122: Deepwater Development and Production Systems

Source: Minerals Management Service.

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Offshore development and production systems consist of many of the same equipment
as onshore operations; however, they also utilize unique equipment.
• Topsides are the platform structures above the ocean surface that house production
and storage equipment.
• Subsea wellheads are placed on the ocean floor as opposed to on the platform.

• Umbilicals control subsea wellheads from the surface.

• Flowlines transport the oil or gas from the various subsea wellheads to a centralized
subsea gathering facility.
• Risers transport the oil or gas from a central, subsea gathering facility to the surface.

Exhibit 123: Subsea Production Schematic

Metering & Control Floating Production Storage &

Systems Tension Leg
Offloading Vessels
Platforms

Surface Well
Systems Turret Mooring
Light Well Systems
Intervention

Subsea Drilling
Systems

Subsea Processing
Standard Subsea
Trees

Subsea Manifold
Smart Well Guidelineless
Control Systems Subsea Template Deepwater Trees
Systems
ROV Tie-In Systems

Source: FMC Technologies.

Marine services is a The offshore supply industry consists of several types of vessels used for various
segment of the offshore operations in the offshore services industry. These operations include towing, setting
drilling industry that anchors (mooring), transportation of supplies and crews, and other support services.
provides support service to The offshore supply vessel fleet consists of the following:
offshore tankers, drilling
• Anchor handling tow supply vessels (AHTSs) come in a wide variety of sizes,
rigs, and production
capacity, and power. They typically are equipped with large wenches used to set
facilities, as well as oil spill
anchors and require 6,000 horsepower or more to position and service semi-
response, cargo
submersible rigs. The large vessels also provide rig support and are used to tow rigs
transportation, and towing
and other equipment. Generally the largest and most powerful vessels of the fleet,
services
AHTSs generally receive the highest dayrates.
• Platform supply vessels (PSVs) are the workhorse of the industry. These general-
purpose vessels are designed to carry a wide variety of cargoes such as fuel, drilling
fluids, cement, water, casing, drill-pipe, and other miscellaneous items. They are
differentiated from other supply vessels by cargo flexibility and capacity.

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• Tugs have similar horsepower capabilities to AHTS vessels, but have less deck space
for supply functions. These vessels can assist in anything from the mobilization of a
semisubmersible to commercial towage. Tugs are common in every major region in
the world.
• Crew boats have the ability to transport up to 80 passengers as well as transport
moderate quantities of cargo to and from production platforms and rigs. Known for
their speed and maneuverability, these boats can reach speeds approximately twice
that of larger supply boats.
• Utility boats are all-purpose boats that can be altered to customer specifications.
These vessels generally support production and can be used for diving operations,
offshore structure maintenance, firefighting, and other miscellaneous operations.
• Liftboats are self-propelled, self-elevating vessels used in shallow water conditions to
construct production platforms and to provide a working area for coiled tubing, fluids
storage, and wireline operations, among other equipment.

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Appendix II: Case Study—U.S. Energy

Markets
The U.S. oil and gas The U.S. oil and gas market is the largest in the world, accounting for nearly 25% of oil
market is the largest in the demand and 25% of global natural gas consumption. Given the sizable demand base,
world, accounting for hydrocarbon reserves, infrastructure, wholesale and retail markets, and equity market
nearly 25% of oil demand capitalization, it is the most widely followed market for judging the direction of the macro
and 25% of global natural oil outlook.
gas consumption
Our discussion of the U.S. energy market revolves around market size, product pricing,
end uses, market segments, supply and demand, and the relationship between oil and
gas and other energy sources. We frame this discussion with the intent to provide a
broad overview of the role of oil and gas in the broad energy chain.

Market Overview
The U.S. has been faced with a declining oil and gas resource base, declining
production (oil), and increasing oil and gas demand for the past several decades. In
Exhibit 124 we chart the recent history of these key factors, which shows an increasing
reliance on oil and gas imports to meet growing demand needs.

Exhibit 124: U.S. Oil and Gas Profile

Crude Oil Profile Natural Gas Profile

35 25 250 70

Consumption 60
30
Consumption
200
Proved Reserve Base (Bbls)

20
Proved Reserve Base (Tcf)

25 50

15 150
20 Production 40
MMBD

Bcf/D
Production
15 30
10 100

10 20
Proved Reserve Base
5 50
5 Proved Reserve Base 10

0 0 0 0
1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 1977 1980 1983 1986 1989 1992 1995 1998

Source: EIA, CSFB estimates. Crude Oil Profile includes NGLs.

The U.S. has been faced The decline in oil and gas production has led to an increasing reliance on foreign
with a declining oil and gas sources for the country’s energy needs. The oil production shortfall results in about a
resource base, declining 55% oil import call, which is likely to increase in the coming years. The natural gas
production (oil), and industry is more limited than oil, however, in its ability to import, given the transportation
increasing oil and gas constraints we have discussed. Natural gas imports need to come from pipelines in
demand for the past adjacent countries, which is why Canada and Mexico are the largest gas exporters to
several decades the U.S. Again, LNG can be shipped from long distances by ocean tanker and delivered
to import hubs; however, processing LNG, transporting it in the specially designed
tankers, and regasifying it into pipeline gas upon receipt is costly. In fact, LNG use has
largely been prohibitive over the past 20 years because of these costs relative to the low
costs of pipeline gas. This has recently begun to change in the U.S. as gas prices have

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climbed from a 15-year average of $1.50-2.25/mcf to over $3.00/mcf. Sustainably higher

gas prices could increase the LNG business and result in a growing global export
business.

Oil and gas hydrocarbon use constitutes a large part of the total U.S. energy supply and
demand equation. To fully understand the broad energy chain, however, it is necessary
to put oil and gas into a wider context. Energy takes many forms—oil and gas, coal,
electricity, hydro power, and the list goes on—but essentially there are two forms of
energy: primary energy, which is hydrocarbons and renewable energy sources, and
secondary energy, like electricity, which derives its existence from primary energy
sources. Electricity, as it is most often used, is a product of coal, oil products, or natural
gas. In our discussion of U.S. energy supply and demand, we largely focus on the
primary sources of energy, as electricity is a by-product of these fuel sources.
We can analyze energy We can analyze energy sources on an equivalent basis using British thermal units
sources on an equivalent (BTUs), or the amount of energy required to raise one pound of water by one degree
basis using British thermal Fahrenheit. Exhibit 125 captures the breakdown of U.S. total energy production and
units (BTUs) consumption by fuel source to provide a better framework for understanding which fuel
sources account for the largest market share or have the highest growth potential. The
data are presented in quadrillion BTUs (quads), and we have included an Energy
Conversion Guide on page 154 as a useful reference. We can broadly define four types
of oil and gas end markets—commercial, industrial, residential, and transportation—
similar to the end markets we discussed in the Natural Gas Markets section.

The U.S. consumes 95 quadrillion BTUs of total energy while only producing 73
The U.S. consumes 95
quads—a large production shortfall made up by imports. U.S. primary energy
quadrillion BTUs (quads)
consumption is driven by petroleum products (39%) followed by natural gas and coal
of energy comprised of
(19% each). (See Exhibit 125.) Demand growth for petroleum products and natural gas
39% oil, and 19% each for
has far outstripped production, whereas coal demand growth and production growth
natural gas and coal
have kept relatively constant.

Crude oil and natural gas production have both peaked—crude in the late 1960s and
gas slightly later in the early 1970s. While crude production has been on a steady
decline since its peak, natural gas production has steadily risen in recent years after
initially declining from peak levels. Oil production in the U.S. accounts for 21% of total
energy production versus 27% for natural gas and 32% for coal.

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Exhibit 125: U.S. Energy Production and Consumption, Breakdown by Fuel Source
quadrillion BTUs

Production Consumption
40 40

35 35
Petroleum Products
30 30

25 25
Crude Oil Natural Gas
20 & NGLs 20
Natural Gas
15 15
Coal Coal
10 10
Nuclear Nuclear
5 5 Other
Other Hydroelectric Power
Hydroelectric Power
0 0
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999

Source: Company data, CSFB estimates.

Beyond evaluating aggregate production and consumption trends by fuel source, it is

important to analyze the various end-use markets for the different fuel sources. The first
chart of Exhibit 126 shows an overall breakdown of U.S. energy demand by sector and
clearly shows that the electric power industry and the transportation sector, closely
followed by the industrial sector, are the largest energy end markets. We closely monitor
these industries to determine the general direction of future energy demand.

End Markets
The electric power Once we determined which end markets consume the most energy, we then evaluate
generation industry is the each industry separately to determine its respective fuel source mix, and where
largest energy-consuming changes might occur. The electric power industry uses a wide variety of energy sources,
industry, followed by the with coal being the primary source. Petroleum use in the business, largely through fuel
transportation and oil or resid, has been on a steady decline for the past 20 years and this trend is likely to
industrial sectors continue given environmental constraints and relative pricing versus cheaper fuels.
Noticeably on the electric power sector industry chart in Exhibit 126 is a very sharp
spike in natural gas consumption in the latter part of the 1990s. The benign
environmental effects of natural gas use to generate electricity combined with attractive
pricing relative to other fuel sources made gas the fuel of choice for electric-generating
companies that went through a burst of new electric generation capacity development.
We expect the trend of higher natural gas use in electric generation to continue;
however, unusually high natural gas prices in 2000-01 coupled with an electric industry
slowdown have recently slowed the pace of growth.

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Exhibit 126: U.S. Energy Consumption, Breakdown by End-Use Market

Consumption by End-Use Sector Transportation Sector

30
45

40
Electric Power 25
35
Petroleum
30 20
Transportation
25
Industrial 15
20

15 10
10
Residential
5
5
Commercial Natural Gas
0
0
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999

Electric Power Sector Industrial Sector

25 12

Natural Gas
10
20

8
15
Coal Petroleum
Natural Gas 6
10
Nuclear
4
Hydroelectirc Coal
5
2
Other
Petro.
0 0
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999

Residential and Commercial

10

Natural Gas
8

4 Petroleum

2
Coal
Other
0
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999

Source: Company data, CSFB estimates.

Unlike the multifuel source electric power sector, the transportation sector, which
accounts for over 25% of overall U.S. energy demand, is predominantly a single-fuel-
source industry. Unsurprisingly, petroleum products gasoline and diesel drive the
sector’s energy demand. This is the largest reliance on any one fuel source for any end
market.

The industrial sector is the third largest energy-consuming group, accounting for nearly
25% of U.S. energy consumption. Petroleum products have maintained their relevance
to the industrial market as a fuel of choice, unlike coal. This is the complete reverse of
the dynamics that took place in the electric power sector.

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The electric power sector and industrial sector data may have some cross-
contamination because of the way the U.S. EIA, the source for our data, has classified
independent power producers over the past several years. The electric generation
sector data are based on historical usage among regulated electric utilities. Independent
power producers may be accounted for in the industrial sector data. We believe the data
to be a close, fair approximation of respective industry factors, and representative of
industry conditions for our purposes of demonstration.
The residential and commercial market accounts for 10% of overall U.S. energy demand
and is centered around space heating, water heating, air conditioning, and general
appliances.

Energy Expenditures
The $265 billion U.S. We can calculate the dollar value of the various fuel source markets using the
petroleum products market production and consumption data we discussed and then applying wholesale and retail
is the largest component of prices.
the $550-plus billion U.S.
Exhibit 127 shows the U.S. wholesale oil market to be roughly $55 billion, the natural
energy business
gas market to be almost $70 billion, and the coal market to be valued at $17 billion, for a
total U.S. energy production market valued at $142 billion. Note the decline in the dollar
value of the oil business and the slow and steady growth of the natural gas business—
the two have been nearly parallel in recent years.

Exhibit 127: U.S. Wholesale and Retail Markets

US Wholesale Markets US Retail Markets

$180 $300

$160 Petroleum Products $265b

$250
$140

$120 $200
Crude Oil $55b
$100 Electricity $215b
$150
$80
Natural Gas $70b
$60 $100
Natural Gas $90b
$40
$50
Coal $25b
$20
Coal $17b
$0 $0
1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995

Source: EIA, CSFB estimates. U.S. Wholesale Markets data is the value of U.S. domestic production in chained 1996 dollars through 2000. U.S. Retail
Markets is in nominal dollars through 1997, excluding taxes.

The retail markets, which represent final end-market demand and include both sources
of domestic production and foreign imports, are an all-inclusive $595 billion (nominal)
market, using recent demand and prices. Oil products at $265 billion and electricity at
$215 billion make up the majority of total energy expenditures while the natural gas
market is a distant third at $90 billion.

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We have demonstrated that petroleum demand in the U.S. far surpasses all other
primary fuel sources on an equivalent BTU basis and that it also surpasses all other fuel
sources, including electricity, in terms of market value. Given the number of petroleum
products within the energy complex, it is worthwhile to understand how the market
breaks down.

The $265 billion petroleum products market breaks down largely into the $150 billion
gasoline market and the $55 billion distillate (diesel and heating oil) market. Liquefied
petroleum gases (LPGs) and other products (including asphalt, kerosene, lubricants,
and petrochemical feedstocks) are each $15-20 billion markets while the jet fuel market
is worth nearly $15 billion. The resid market, comprising bunker fuel demand and
waning electric generation demand, is a $5 billion market and shrinking.

The $265 billion retail oil products market and $90 billion gas market combine to make
the single largest energy market in the world, accounting for nearly 25% of oil and 33%
of global end-market oil and gas expenditures.

Exhibit 128: U.S. Petroleum Product Consumption

US$ in billions

$160

Gasoline $150b

$140

$120

$100

$80

Distillate $55b

$60

$40

Other $20b
LPG $20b
$20
Jet Fuel $15

Resid $5
$0
1970 1975 1980 1985 1990 1995

Source: EIA, CSFB.

N.B.: CREDIT SUISSE FIRST BOSTON CORPORATION may have, within the last three years, served as a manager or co-manager
of a public offering of securities for or makes a primary market in issues of any or all of the companies mentioned.

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Glossary
Abandonment The point in time when all economic reserves have been extracted from an oil and gas
field and production is stopped.
Abiotic (abiogenic) theory A theory of hydrocarbon genesis that attributes the origins of a substantial portion of the
earth’s endowment of natural gas to inorganic processes; that is, methane is believed to
have been one of the earth’s primeval gases, which predated the beginnings of life and
which remained trapped (and unoxidized) within the earth as the crust cooled. (See also
Biotic Theory.)
Acidization A process of treating oil-bearing limestone or other formations with acid to increase
production.
Acoustic (sonic) well A process of recording the time required for sound to travel a specific distance through
logging rock, using a wireline of LWD instrument. The rate of travel varies with rock
composition, porosity, and fluid content.
Acreage The area of a lease or concession for oil and natural gas exploration. Can refer to the
total such holdings of a company.
Alkylation A process that involves the polymerization of propane and butane (LPGs) into iso-
octane.
American Petroleum An oil industry organization that is the leading standard-setting body for oilfield
Institute (API) equipment and products.
Anticline A geologic feature in which the constituent rock strata have been compressed laterally
into an inverted U-shaped fold. Anticlines are frequently traps for oil and gas. Structural
counterparts of anticlines are synclines, which are concave folds, as viewed from above.
API gravity The American Petroleum Institute’s variation of the measurement of specific gravity of
crude oil.
Appraisal Drilling or seismic activities that aim to delineate the range of reserves made after an
exploration well has first encountered hydrocarbons.
Appraisal well A well drilled for the purpose of determining the size or extent of an identified oil/gas
field. Part of the exploration and development process.
Arms-length transactions Transactions between unaffiliated companies—for example, sales by a gas producer to
a separate pipeline company.
Aromatics Hydrocarbons arranged in a ring structure with a good solvent properties. Benzene-
toluene-xylene is such a compound.
Associated gas Natural gas found in association with crude oil, rather as “dissolved” or “solution” gas
within the oil-bearing strata or as “gas cap” gas just above the oil zone. (See also
Nonassociated Gas.)
Atmospheric distillation The first and simplest distillation process in a refinery. Crude oil is heated to separate its
major compounds, which all evaporate at different temperatures. The process is carried
out at normal atmospheric pressure.
Atmospheric pressure The weight of the atmosphere at the surface of the earth. Measured at sea level this is
approximately 1.013 bars.

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Back-in The participation of a national oil company in an oil or gas development once an
exploration success has been made (“state back-in”).
Barrel The standard volume measure of oil products. Equal to 35 U.K. gallons, 42 American
gallons, or 159 liters.
Barrel of oil equivalent Often used to compare oil and gas volumes. Gas is converted to an approximate energy
equivalent in oil terms. The standard conversion ratio is 1 barrel of oil equivalent equals
6000 cubic feet of gas. This ratio will vary with the heat value of the gas in question.
Barrels per day (BD, Either the number of barrels produced daily by an oil well, or the number of barrels
b/d, bpd) processed by a refinery in one day. Generally will refer to an average taken over several
months or, in the case of refinery capacity, over one year.
Basin A geological province on land or offshore where hydrocarbons are generated and
trapped.
Billion cubic feet The standard volume measure of gas products. Equal to 0.028 billion cubic meters, 6.29
(bcf) million barrels oil equivalent, or 0.73 million tons LNG.
Benzene The simplest of the aromatic compounds. An important chemical industry feedstock.
Biomass Any body or accumulation of organic material. In the gas industry, biomass refers to the
organic waste products of agricultural processing, feedlots, timber operations, or urban
refuse from which methane can be derived.
Biotic (biogenic) theory A theory of hydrocarbon genesis that attributes the origins of the earth’s endowment of
natural gas (and other hydrocarbons) exclusively to biological processes; that is,
methane is believed to be a product of organic decomposition of the issues of once
living plants or animals. (See also Abiotic Theory.)
Bitumen Very heavy and tar-like semisolid by-product of the oil refining process. Used for road
construction and in roofing materials.
Black products The heavier products produced by the crude oil refining process (i.e., fuel oil, heavy
diesel). The lighter products are referred to as white products.
Blending The process of mixing different rude oil types in a refinery.
Boiler fuel Fuels suitable for the generation of steam (or hot water) in large industrial or electric-
utility boilers. Natural gas, residual oil, coal, and uranium are the dominant boiler fuels.
Border price The official price for gas sold at the U.S./Canadian border, as determined by the
Canadian government in consultation (in theory) with the United States.
British thermal unit (BTU) Equivalent to the heat required to raise one pound of water by one degree Fahrenheit. A
standard measure of natural gas for pricing purposes, particularly in the U.S.
Build-up period The period of rising production once a new oil or gas field has been brought on stream.
Bunker fuel Diesel, or more commonly fuel oil, used to run a ship’s engines.
Burner-tip Signifying delivery to the final customer. A burner-tip price, for example, is the price
charged the end user.
Butane A hydrocarbon component (C4H10) of produced natural gas and crude oil; one of the
natural-gas liquids (NGL), and a component of liquefied petroleum gas (LPG).

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By-product coke gas A fuel-rich vapor that is a by-product of the coking process. Also called coke-oven gas.
Candlepower An obsolete unit of luminous intensity used during the early decades of the gas industry.
A candle was originally defined in terms of a wax candle with standard composition and
equal to 1.02 candelas.
Cap (1) Nonpermeable rock found above oil and gas reservoirs, which through geologic time
prevented these hydrocarbons from dissipating. (2) Gas cap.
Carbon black A substantially pure from of finely divided carbon, usually produced from liquid or
gaseous hydrocarbons by controlled combustion with restricted air supply. Beginning as
lamp-black (named for its genesis in household kerosene lamps), it was used as a
pigment for printing inks and paints. Later, it became a valuable strengthening agent for
rubber products.
Carried interest An interest in an oil or gas field whereby all capital expenditure is paid by an additional
partner, who recovers the cost from the revenues from production.
Casing A borehole lining (pipe) separating the formation from the borehole, with or without
cement between pipe and formation.
Casinghead gas Natural gas that flows from an oil well along with the liquid petroleum. It is also called
associated, dissolved, or solution gas because it resides beneath the earth’s surface in
conjunction with crude oil. Casinghead gas is distinguished from gas cap gas, which is
another form of associated gas that accumulates above the oil-bearing strata and is
therefore produced from wells that do not tap the oil resource.
Catalyst A substance that speeds up or otherwise improves the efficiency of a chemical reaction
without forming part of the final product. In refining, catalysts allow cracking and
hydrotreating reactions to take place at lower temperatures than normal.
Catalytic cracking A process of breaking down larger hydrocarbon molecules into smaller ones by applying
heat and a catalyst to speed the process. A process common to complex refineries.
Crude distillation unit The primary unit in a refinery which distills crude oil and separates out the main
(CDU) fractions of oil, e.g., distillates from residual oil. The capacity of a refinery normally
refers to the capacity of its CDUs.
Cement A powder consisting of alumina, silica, lime, and other substances. It hardens when
missed with water and is used to bond casing to the walls of the borehole and to prevent
fluids from migrating between permeable zones.
Cost, insurance, and The delivered price of a commodity, as distinct from the free on board (FOB) price.
freight (CIF)

City gate A location at which gas ownership passes from a gas pipeline company to a local
distributor.
Coal gas Gas made by distilling bituminous coal. Normally around 50% hydrogen, 30% methane.
Historically also referred to as town gas.
Coiled tubing Long sections of small-diameter tubulars deployed in rolls and used to replace jointed
pipe in simulation, workover, and drilling operations.
Coke The solid carbonaceous residue produced from the destructive distillation of coal or oil;
a vital material for steelmaking.

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Coke-oven gas A fuel-rich vapor that is a by-product of the coking process. Also called by-product coke
gas.
Coking A thermal cracking process designed to reduce the size of hydrocarbon molecules,
thereby transforming heavier products (fuel oil, gas oil) into lighter ones (gasoline). The
process produces petroleum coke as a by-product.
Collar A device used to join two lengths of pipe.
Completion Technology used to bring a well to production. Matched to the reservoir and formation
for optimum production, completion technology includes perforating, gravel packing, and
flow control equipment (such as packers, inflatable tools, and sliding sleeves).
Compressed natural gas Natural gas that is highly compressed (though not to the point of liquefaction) so that it
(CNG) can be utilized by an operation not attached to a fixed pipeline. CNG is already used
extensively as a transportation fuel for automobiles, trucks, and buses in some parts of
Italy, in New Zealand, and in Western Canada, and has recently begun to penetrate
some regions of the United States.
Concession The granting of rights to a company to explore for oil and gas over a specific, defined
area.
Condensate A mixture of relatively light hydrocarbons that remains in liquid form at room
temperature. Condensate can be separated from natural gas as it is produced and
treated, can be produced separately to natural gas when both forms of hydrocarbon are
found together, or can be recovered from nonassociated gas when this is produced.
Conventional gas Gas that can be produced under current technologies at a cost that is no higher than its
current market value. (See also Unconventional Gas.)
Conventional production Wireline well logs run in vertical production wells for the purpose of determining the
logging wellbore oil, water, and gas inflow. Conventional production logging sensors include
center-sampling (center-of-the-borehole) measurements of temperature, pressure,
spinner velocity, fluid capacitance, differential pressure, and nuclear fluid density
coupled to gamma ray, casing collar locator, and caliper measurements.
Cost oil The portion of oil revenues that is used by companies to recover capital expenditure in
production-sharing contracts.
Cracking A process whereby larger molecules are broken down into smaller ones. There are
several ways of achieving this: through the application of heat alone (thermal cracking),
through the addition of a catalyst to this process (catalytic cracking), or through the
carrying out of this process in a hydrogen atmosphere (hydrocracking). Normally used
to refer to those units in a refinery that upgrade fuel oil and gas oil into lighter products.
Crude oil The most common liquid hydrocarbon produced from subsurface reservoirs. The basic
product of the oil industry.
Daily contracted quantity The average daily amount of gas that a buyer has contractually agreed to purchase and
(DCQ) that a seller has agreed to provide. Part of the take-or-pay contract system for gas.
Deep gas Natural gas located 15,000 feet or more below the earth’s surface, as defined (and
deregulated) in Section 107 of the Natural Gas Policy Act of 1978.
Deepwater Offshore operations in water depths that exceed the normal for fixed platform
operations.

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Deliverability The amount of gas that a pipeline or producer is able to deliver, limited either by the
terms of its supply contracts or its own plant capacity.
Depletion charge The charge in a profit and loss account that relates to the depreciation of fixed assets.
Desander Centrifugal device for removing sand from drilling fluid to prevent pump abrasion.
Development costs Capital expenditure required to bring oil and gas reserves on production.
Development well A well drilled in a proven field to complete a pattern or production.
Deviation The angle between the wellbore axis (in the direction of the end, or bottom, of the well)
and the downward vertical. Deviation values are always positive. Also called Inclination.
Devonian shales Shales originating from the muds of shallow seas deposited about 350 million years
ago, during the Devonian period of the Paleozoic era. Devonian shales from which
unconventional gas can be drawn are found relatively close to the earth’s surface in
parts of the Great Lakes region and areas to the west of the Appalachian divide.
Diesel A broad term generally referring to the transportation and machinery fuel derived from
the gasoil fraction in refining. Heavier than gasoline and kerosene, diesel may also be
used for heating purposes when it is more generally referred to as heating oil.
Dip The angle that a refractor or reflector makes with the horizontal. Also, the angle of
inclination of a geologic layer or sedimentary bed.
Direct sales Transactions in which a gas pipeline sells its gas directly to an end user, like a large
industrial plant, rather than to a distributor for resale. Direct sales by interstate gas
pipelines are not subject to federal rate regulation under the Natural Gas Act.
Directional drilling The method of guiding a well along a predetermined path to a specific target. A
directional drilling company provides technology and rig site supervision to efficiently
meet directional drilling objectives.
Dissolved gas A form of associated gas found in petroleum and, therefore, produced from oil wells as
casinghead gas. (See also Casinghead Gas.)
Distillates The products of the distillation process at an oil refinery (i.e., gaseous fuels, naphtha,
gasolines, kerosenes, gas oils, and the heavy fractions). Middle distillates refer
generally to kerosene, jet fuel, and diesel.
Distillation A process that separates a liquid into its component parts by exploiting their different
boiling points. The liquid, usually crude oil, is heated until it vaporizes, and the different
fractions then condense at different temperatures, allowing them to be separately
collected. This is the primary process in a refinery.
Downhole motor A tool directly above the drill bit in a drill string that converts the hydraulic energy of the
circulating drilling fluid into mechanical energy to turn the bit independently of drill string
rotation. May include a bent section to perform directional drilling. (See also Steerable
Motor.)
Downhole oil/water System comprising a downhole hydrocyclone and electrical submersible pump that
separation separates oil from water downhole, reinjects water, and produces oil to the surface.
Downstream Those parts of the oil business that occur after the crude has been produced. The term
can cover transportation or shipping but is more normally used to refer to refining,
distribution, and marketing of refined products.

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Drill bit The component at the end of the drill string that cuts the rock and makes hole. (See also
Tricone Bit and PDC Bit.)
Drill collar Heavy-walled sections of pipe included at the bottom of the drill string to apply weight to
the drill bit during drilling.
Drill ship A vessel designed for drilling in deep water without legs or anchors holding it to the sea
floor and using dynamic positioning to hold it over the subsea wellhead.
Drill stem All components in a rotary drilling assembly from the swivel to the bit.
Drill string The total string of drill pipe with attached tools and bit.
Drilling fluid Fluid used in the wellbore to lubricate and cool the bit, control bottom-hole pressures,
and remove cuttings. Also known as drilling mud.
Dry gas Gas that contains no other hydrocarbons, i.e., condensate, that will liquefy at room
temperature.
Dry hole An exploration well that has been unsuccessful and failed to find oil or gas in
commercial quantities.
Dual-fuel capacity The ability of an energy consumer (foremost, large industrial and electric-utility
customers) to utilize two kinds of fuels. Multifuel capacity allows even greater flexibility.
Elastomer An elastic synthetic rubber or plastic material—often the main component of packing
material in downhole packers.
Enhanced oil recovery Any means of recovering oil from the field without using the reservoir’s own internal
(EOR) pressure. Such techniques as increasing the reservoir pressure (secondary recovery) or
raising the reservoir temperature (tertiary recovery) fall under this category.
Equity oil The proportion of a project’s oil production that a company is entitled to based on its
share of ownership of the project.
Ethane A hydrocarbon component (C2H6) of produced natural gas and to a lesser extent of
pipeline gas. One of the natural gas liquids (NGLs).
Ethylene A light olefin compound made up of two carbon and four hydrogen atoms. Ethylene is
the most important feedstock for the petrochemical industry.
Exploration prospect A geological structure that may contain hydrocarbons but that has not been tested by
any exploration well.
Exploration well A well drilled in search of an undiscovered reservoir or to greatly extend the limits of a
known reservoir.
Feedstock The raw material that is introduced into a unit for further processing. Thus crude oil is
the feedstock for an oil refinery.
Fishing The process of recovering equipment lost or stuck in the wellbore. Tools and services
that perform specialty and repair work downhole. Fishing activities include retrieving lost
tools and repairing wellbore damage.
Flaring The controlled burning of natural gas that is surplus to requirements and cannot be sold.
Floating storage Oil tankers that are used to store crude oil.

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Fluid A substance that deforms continuously under the action of a shear force, however
small. Wellbore fluids include oil and water (with or without gas in solution) and free gas.
Foaming agent A chemical used in gas wells to lighten the water column to promote gas production.
Also, a chemical used while drilling wells with air or gas as the drilling fluid, to force
water with the air and cuttings.
Fold In seismic processing, the number of traces with different source-to-receiver separations
summed into a single trace.
Force majeure A legal principle by which contractual obligations are waived if a superior force (such as
the weather, a war, or an act of God) makes it impossible for those obligations to be
met.
Fossil fuels All fuels formed or generated from organic matter, e.g., oil, gas, coal.
Free on board (FOB) The price of a commodity when delivered to the purchasers’ means of transportation,
typically a ship. Most crude oil prices are quoted FOB, meaning that the cost of
transporting the oil to the final destination is borne by the purchaser, not the seller.
Fractionation A more general term for the separation process carried out by distillation.
Fractionating column Another name for a distillation unit or crude distillation unit (CDU). (See also Crude
Distillation Unit.)
Fracturing (frac) A method of stimulation production by opening new flow channels in the rock
surrounding a production well by pumping proppant and fluid into the well at high
pressure and volume.
Fuel gas Gaseous fuels that can be transported by pipeline. Such fuels include natural gas, LPG,
coal gas, and refinery gas.
Fuel oil Normally refers to the heaviest of the fuels produced by the refining process and used
principally in electricity generation to power ships, and for other industrial purposes.
Sometimes called mazoot in Europe.
Gamma-ray log Well log that records natural radioactivity of formations around the wellbore.
Gas cap Gas-rich strata overlying the oil-bearing strata of a petroleum reservoir. A gas cap forms
when the ratio of gas to oil in a particular reservoir is too high for all of the gas to remain
in solution with the oil. Gas-cap gas is produced from wells distinct from those producing
oil and casinghead gas.
Gas/condensate field A reservoir that contains natural gas and liquid hydrocarbon. Condensate normally
liquefies as the gas stream is extracted, but can be recovered separately. Often the
condensate is produced first, with the natural gas reinjected into the reservoir to assist
condensate recovery.
Gas (re)injection The process of injecting gas into a reservoir to aid the recovery of liquid hydrocarbons,
normally crude oil. A popular technique in enhanced oil recovery.
Gas liquids The hydrocarbon components of wet gas whose molecular structures are heavier than
methane but lighter than crude oil. Gas liquids include ethane (C2H6), propane (C3H8),
and butane (C4H10). Also called natural gas liquids (NGLs).

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Gasoil The medium fraction from the initial distillation process in a refinery, known as diesel
when further refined. Can also be used as chemical feedstock, though this is now less
popular.
Gasoline The lightest of the principal liquid fuels from the refining process. Gasoline is the most
important private transportation fuel and sometimes occurs naturally as condensate.
Known in the U.K. and other countries as petrol.
Gathering systems Pipelines owned and operated by gas producers that are considered an integral part of
gas production (rather than transmission) and are therefore usually exempt from state
and federal utility regulation.
Gauge The diameter of a bit or the hole drilled by the bit.
Geophone A device to transform seismic energy (movement) to an electrical voltage—voltage that
is proportional to the velocity of the seismic wave motion.
Gravel pack A completion technique used to control production of sand from loosely consolidated
formations.
Heavy fractions The products made up of the larger hydrocarbon molecules that remain after the rest of
the crude oil has been distilled into the principal fractions. Also known as heavy ends or
the bottom of the barrel.
Highly deviated wells A class of nonvertical wells where the deviation angle is approximately 30-80 degrees.
Horizontal drilling A subset of directional drilling in which the angle of deviation of the wellbore reaches at
least 80 degrees from the vertical, maximizing the length of wellbore exposed to the
formation.
Horizontal well A class of nonvertical wells where the wellbore axis is near horizontal (within
approximately ten degrees of the horizontal), or undulating (fluctuating above and below
90 degrees deviation).
Hydrocarbon A compound of carbon and hydrogen. Includes oil and natural gas, but also coal.
Loosely used to refer to petroleum.
Hydrocracking One of the cracking processes that uses hydrogen to improve efficiency.
Hydrodesulphurisation The removal of sulphur from refined products using hydrogen as the catalyst.
Sometimes known as hydrotreating or hydrofining and normally concerned with
ensuring diesel and fuel oil meet the correct sulphur specifications.
Hydrogen conversion unit An expensive unit in a refinery that can utilize almost any feed stock and crack it into a
relatively light range of distillates.
Hydrophone A pressure-sensitive sensor to transform changes in (water) pressure to an electrical
voltage—voltage that is proportional to the velocity of the seismic wave.
Hydroskimming Refers to a simple refinery that has very few cracking or other complex units.
Hydroskimming refineries will normally contain a distillation unit, a reformer, and a
desulphuriser of some sort.
Hydrotreating Normally refers to the hydrodesulphurisation process, but can mean any process using
hydrogen as a catalyst.

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Inclination The measurement of a well’s deviation from vertical, in degrees. Also the angle between
the direction of the produced fluid flow and the horizontal. Inclination values are positive
for fluid flowing upward and negative for fluid flowing downward.
Infill drilling/well Wells placed between known producing wells to further exploit a reservoir.
International Petroleum The major U.K. commodities exchange that trades crude oil and crude products.
Exchange (IPE)

Isomerisation An efficient process that produces high octane gasoline from naphtha.
Jackup drill rig A mobile, bottom-supported offshore drilling structure. Legs or columns rest on the
seafloor and the platform is raised or adjusted by moving up or down on the legs.
Kerosene The medium to light fuel produced by the oil refining process, coming between the
gasoline and gasoil fractions. Kerosene was the original refined oil product, used for
lighting. Its principal uses today are for heating and as jet fuel.
Lateral bore Normally referred to as the deviated or horizontal extension in the drilling of a horizontal
well or multilateral well.
License/licensing round A period during which a licensing body (normally a government) offers for tender certain
license or concession areas to be explored by oil companies.
Life-of-the-field contract A commitment by a producer to sell gas to a buyer for as long as the “dedicated” field is
capable of production.
Light crude oil Oil containing a high proportion of the lighter fractions and with a low specific gravity.
Light crude oil will produce more gasoline and less fuel oil in the first distillation process
in a refinery, and is therefore normally more expensive since gasoline is more valuable
than fuel oil.
Light fractions Those component parts of crude oil that vaporize at the lowest temperature and
condense to form naphtha and gasoline.
Liner A string of pipe used to case open hole below existing casing, overlapping inside the
upper string and held in place by a liner hanger packer.
Liquefied natural gas Natural gas that has been cooled to minus 161 degrees Celsius for transportation by
(LNG) ship. The cooling process reduces the volume of the gas by 600 times.
LNG carrier A ship specially designed to transport liquefied natural gas and maintain it at its very low
temperature.
LNG terminal A port facility where LNG can be loaded or unloaded to the LNG carrier.
LNG train A complete set of separating, purifying, and liquefying equipment within a LNG plant.
Expanding a LNG plant normally involves adding more trains, not constructing the whole
thing again.
Logging-while-drilling A variation of measurement-while-drilling in which the LWD tool gathers information
(LWD) (i.e., resistivity, density, porosity, gamma ray) about the formation while the well is being
drilled.
Main bore The main casing string from which subsequent directional drilling operations or
openhole operations are initiated. Lateral bores extend from the main bore to the
desired target depth.

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The majors A loose term describing the world’s principal private (i.e., nonstate) oil companies;
includes the three Super Majors (Royal Dutch-Shell, Exxon, BP Amoco) as well as more
middle-sized companies like Texaco, Chevron, ENI, Elf, TotalFina. Occasionally
referred to as the Seven Sisters, although this term is now redundant. (See also Super
Majors.)
Measurement while drilling Measuring directional information (azimuth, inclination, and tool orientation) downhole to
(MWD) adjust the drilling process and guide the wellbore to a specific target.
Methanation (1) A relatively simple form of controlled organic decomposition (primarily of urban
sludge and solid waste) that yields methane vapors. (2) Upgrading of low BTU gas
manufactured from coal (whose components are mainly hydrogen and carbon
monoxide) to a higher BTU gas composed mainly of methane.
Methane The principal constituent of natural gas and the smallest hydrocarbon molecule.
Methane is a light colorless, odorless, highly flammable gas.
Methane hydrates Gas frozen into a physical-chemical bond with water. Methane hydrates occur naturally
in permafrost regions of the arctic and deep sea sediments.
Methanol CH3OH, the simplest of the alcohols; usually manufactured from methane, though it can
be made from other hydrocarbons through more complex processes (wood alcohol).
Million BTU (MMBTU) A standard measure of natural gas for pricing purposes. (See also British Thermal Unit.)
Monomer A single molecule that can be joined to other similar molecules to form chains called
polymers. Refers normally to the building blocks for certain petrochemicals, e.g.,
ethylene before it is processed further into polyethylene.
Multilateral The construction of two or more wellbores into one or more reservoirs for the purpose of
managing and optimizing fluid movement within the reservoir(s). These lateral wellbores
are connected back to a common main bore that extends to surface. Various levels of
completion systems can be installed in a multilateral well to enable it to produce from
several zones simultaneously.
Naphtha The lightest of the liquid fractions from a refinery, naphtha is used mainly for the
production of gasoline or as a feedstock for the petrochemical industry.
Naphtha cracker The principal unit in a petrochemical plant, it cracks the naphtha molecules into smaller
and lighter components, the principal among which is ethylene.
Natural gas Several hydrocarbons that occur naturally underground in a gaseous state. Natural gas
is normally mostly methane, but other components also include ethane, propane, and
butane.
Natural gas liquid (NGL) Hydrocarbons that can be extracted in liquid form from natural gas as it is produced.
Ethane and LPG are the major NGLs. Also called gas liquids.
Netback (1) The recombined value of the products produced by the refining of one barrel of
crude oil using the wholesale prices of the various different fuels or less commonly. (2)
The value of gas delivered to a customer minus the cost of producing, transporting, and
distributing it.
Nonassociated gas Gas that is not produced as part of the oil production process, i.e., occurs separately or
where only the gas in the oil/gas reservoir can be extracted economically. (See also
Associated Gas.)

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North Sea Brent Crude oil produce from the Brent field in the British sector of the North Sea. Often
quoted as a benchmark for world oil prices.
New York Mercantile The main U.S. commodities exchange that deals in crude oil, heating oil, and platinum
Exchange (NYMEX) futures and options.
Oil gas Manufactured gas based on naphtha feedstocks.
Oilfield chemicals Chemicals used to treat produced fluids and control corrosion and deposition in
producing wells.
Oil-in-place The estimate of the total amount of oil existing in a reservoir. This is not the same as the
amount of oil that will eventually be recovered, which in generally will be a lot lower.
Chinese reserve reports often use the term proved reserves to refer to oil-in-place rather
than to recoverable reserves, which is more common in the West.
Olefins A type of refined hydrocarbon that has particular importance as a petrochemical
feedstock. Includes ethylene and propylene.
Open hole Any wellbore in which casing has not been set.
Operating costs Costs associated with running facilities and producing oil and gas.
Operator The company or organization that drills the wells and extracts the hydrocarbons at a
particular field or project. The operator may be one member of a consortium of field
owners, or can sometimes be a joint venture between two or more of these.
Organization for Economic The Organization for Economic Cooperation and Development is a 30-member,
Cooperation and international organization of industrialized, market-economy countries with a view to
Development (OECD) maximizing economic growth within member countries and assisting non-member
countries develop more rapidly.
Outer Continental Shelf A unit of defined area for purposes of management of offshore petroleum exploration
(OCS) block and production by the Minerals Management Service (MMS) of the U.S. Department of
Interior.
Packer Open and cased-hole devices used to create seals to control fluid flow.
PDC drill bits Use fixed position polycrystalline diamond compact cutters that shear the formation
instead of grinding it. In many applications, PDC bits offer higher penetration rates and
longer life than Tricone bits.
Perforate To open holes through casing walls and cement into a formation so that fluids can flow
into the borehole, or vice versa.
Perforating gun A device fitted with shaped charges or bullets that is lowered to a desired depth in a well
and fired to create penetrating holes in casing, cement, and formation.
Permeability A measure of the ease with which a fluid can pass through the pore spaces of a
formation.
Petrochemical A chemical compound derived from petroleum or natural gas.
Petrol Another term for gasoline.
Platform A fixed or floating offshore structure that is used either for drilling wells into the seabed
or for extracting the hydrocarbons, or both.

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Polyethylene A chemical compound formed by joining ethylene molecules together. One of the
principal plastic materials.
Polymer A chemical compound that has been formed by joining together single molecules
(monomers) into long chains. Plastics are polymers.
Polypropylene A chemical compound formed by joining propylene molecules together. One of the
principal plastic materials.
Possible reserves An estimate of oil/gas reserves based on geological data from undrilled or untested
areas. Also known as speculative reserves, or P3 reserves.
Primary distillation The initial process in a refinery where crude oil is separated into separated component
parts.
Primary recovery The extraction of oil or gas from a reservoir using only the pressure that is contained in
the reservoir itself.
Probable reserves An estimate of oil/gas reserves based on data from drilled structures, but which needs
more interpretation and/or drilling to be able to be classified as proved reserves. Also
known as indicated reserves, inferred reserves, or P2 reserves.
Propane A hydrocarbon component (C3H8) of produced natural gas; one of the natural gas liquids
(NGLs). Also an oil-refinery byproduct, and the principal constituent of liquefied
petroleum gas (LPG).
Proppant A granular substance that is carried into the formation by the fracturing fluid and helps
keep the cracks open after a fracture treatment.
Propylene A short chain of three carbon and six hydrogen atoms. An important base chemical for
the production of plastics.
Proven/proved reserves The quantity of oil/gas that is estimated to be recoverable from known structures or
fields under existing economic and operating assumptions. Also known as P1 reserves.
Pounds per square inch A standard measure of gas pressure.
(PSI)

Quad Abbreviation for quadrillion BTU. For natural gas, roughly one trillion cubic feed (tcf).
Rate of penetration (ROP) The speed (rate) with which the bit drills the formation, measured in feet or meters per
hour.
Recoverable reserves The proportion of hydrocarbons that can be recovered from a reservoir using existing
extraction technology.
Refinery An industrial complex that separates crude oil into its component fractions, which are
then converted into the principal refined products (gasoline diesel, etc.) as well as into
feedstocks for petrochemical plants.
Reforming A process that modifies the molecular structure of gasoline in order to improve its
combustion and antiknock characteristics. Reforming can be either thermally or
catalytically induced.
Reinject The process by which casinghead gas (a co-product of oil production) is returned to the
petroleum-bearing strata for pressure maintenance and enhanced oil recovery.

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Reserves With respect to oil and gas, that proportion of the resource that is commercially
recoverable under current economic conditions with current technology. Proved or
established reserves are the portion of the resource that is in known reservoirs and that
is believed to be recoverable with the highest degree of confidence. Indicated, inferred,
or probable reserves are the additional resources associated with known reservoirs that
are expected (in the statistical sense) to be recoverable. Speculative or possible
reserves are those resources (in addition to the foregoing), outside the vicinity of known
reservoirs, that are expected to be recoverable. Ultimate reserves or ultimate
recoverable resources are the sum of proved, indicated, and speculative reserves.
Reserves revisions A revision (up or down) made to the original estimate of recoverable reserves in an oil or
gas field.
Reserves-to-production The amount of time, normally in years, which existing oil/gas reserves would last if
produced constantly at the latest production level.
Reservoir An accumulation of oil or natural gas in a porous rock. Reservoirs normally contain oil,
gas, and water in varying quantities, and these normally separate into different areas
within the reservoir.
Residue The heavy component of crude oil that resists distillation. Because of its viscosity,
heterogeneity, impurities, and concentrations of sulphur, these bottoms (sometimes
called No. 6 oil) are burned primarily in electric-utility and industrial boilers or used as
bunker fuel on the high seas. Also known as residual oil.
Resistivity A measurement of a formation’s resistance to electrical current used to determine
whether the formation holds hydrocarbons or water.
Rotary drilling The method of drilling oil and gas wells in which the entire drill string is rotated from the
surface to turn the drill bit, and cuttings are removed from the hole by a circulating fluid.
Royalty A form of tax whereby a host government takes a share of the production in kind or,
more commonly, in cash.
Saturation The fraction of the effective porosity of the formation that contains a particular phase;
more specifically, oil saturation, water saturation, or gas saturation.
Secondary recovery The extraction of hydrocarbons from a reservoir by increasing reservoir pressure
through injecting either water or gas.
Sedimentary basins Large geographic areas that contain rock strata of a sedimentary nature, deposited
when the topography was conducive to sedimentation, as in lakes or shallow seas.
Seismic acquisition (2-D, Seismic data are used to map subsurface formations. A 2-D survey reveals a cross
3-D, 4-D) section of the subsurface. In a 3-D survey, seismic data are collected in the in-line and
cross-line directions to create a three-dimensional image of the subsurface. In a 4-D or
time-lapse 3-D survey, 3-D surveys are repeated over time to track fluid movement in
the reservoir.
Seismic survey A technique for mapping the subsurface structure of rocks by measuring the reflections
of acoustic waves at various depths. Seismic surveys are used to locate potential oil-
and gas-bearing structures. Seismic surveys can either be two dimensional or three
dimensional.
Semisubmersible rig

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A mobile offshore drilling unit that floats on the water’s surface above the subsea
wellhead and is anchored in place. The semisubmersible rig gets its name from
pontoons at its base, which are empty while being towed to the drilling location and are
partially filled with water to steady the rig over the well.
Shaped charge A small container of high explosive that is loaded into a perforating gun. The charge
releases a small, high-velocity stream (jet) of particles that penetrate the casing,
cement, and formation.
Shut-in gas A situation in which production is restrained either by order of a state conservation
authority (prorationing) or because the producer is unable to find a buyer at an
acceptable price.
Sonde A well logging tool.
Sonic log A well log of the travel time for acoustic waves per unit of distance.
Source rock Strata thought to have been the organic-rich parent rock for the genesis of a particular
accumulation of gas and/or oil, which later migrated to a permeable “reservoir rock,”
capped by some sort of trapping mechanism that prevents further movement.
Spot prices The daily price of crude oil.
Steerable motor A downhole motor used for directional drilling, which can turn the drill bit independently
of drill string rotation. Placed just above the bit, a steerable motor has a bend in its
housing that can be oriented to steer the well’s course. During rotary mode the entire
drill string is rotated from the surface, negating the effect of this bend and causing the
bit to drill a straight course. During sliding mode, drill string rotation is stopped and the
bit drills in the direction that it is oriented, gradually turning the well.
Supplementary gas Year-round supplies of liquefied natural gas, high-BTU coal gas, and Arctic gas sought
by interstate pipelines during the supply shortages of the 1970s.
Synthetic natural gas Energy-rich vapors manufactured from coal. Beginning in the 1970s, SNG projects were
(SNG) designed to produce high-BTU grades of coal gas on a year-round basis.
Take-or-pay A type of contract that obliges the buyer of gas to pay the seller for the contracted
amount of gas even if the buyer cannot take it.
Tectonic Of or related to movement of the earth’s crust, as in the faulting and folding attendant to
mountain building.
Tension-leg platform An offshore drilling platform attached to the seafloor with tensioned steel tubes. The
buoyancy of the platform applies tension to the tubes.
Tertiary recovery Recovery of hydrocarbons from a reservoir using sophisticated heating, enlarging, or
acidising techniques. Tertiary recovery extracts hydrocarbons that cannot be recovered
by primary or secondary methods.
Thru tubing Operations performed from inside the production tubing of an existing well.
Tight gas Gas contained in rock strata with low permeability, thereby necessitating enhanced (and
costly) production techniques like fracturing.
Tight sands Sandstones rich in hydrocarbons but of low permeability.
Tricone drill bit A rotary drill bit employing three cones and either hardened steel teeth or tungsten
carbide inserts (TCI). This bit works by grinding away at formation rock as it is turned.

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Trip Hoist (remove) the drill stem from the wellbore to perform one or more operations, such
as changing bits, running a logging tool, or taking a core sample, and then return the
drill stem to the wellbore.
Unconventional gas Gas whose costs of production (utilizing current technologies) would be higher than its
current market value.
Upstream Those parts of business that relate to the exploration, development, and production of
oil/gas. Also referred to as the E&P segment of the oil industry.
Vacuum distillation unit A unit in a refinery which distills the hydrocarbon residue that did not boil at atmospheric
pressure in the crude distillation unit.
Visbreaker A simple conversion process that relies solely on heat to crack the hydrocarbon
molecules.
Weight on bit (WOB) The amount of downward force placed on a bit by the weight of the drill stem.
Well A cylindrical hole drilled from the surface into the rock strata with the purpose of finding,
measuring, or extracting oil/gas.
Well log A record of one or more subsurface formation measurements as a function of depth in a
borehole.
White products The lighter and cleaner refined products from the top end of the distillation column in a
refinery. Typically comprises naphtha, gasoline, kerosene, and gasoil.
Wildcat An exploration well drilled without having collected detailed knowledge of the underlying
rock structure.
Wireline A slender rod-like or thread-like small-diameter piece of metal used to lower tools, such
as logging tools, perforating guns, valves, and fishing tools, into a well. May include
electrical conductors to power and control instruments and to convey data to the
surface.
Workover Maintenance procedures performed on a previously completed well to stimulate or
restore production or increase the life of the well.

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Energy Conversion Guide

Energy Volume to MMBTU

Product Mmbtu/bbl Crude Mmbtu/bbl API Gravity Sulfur Content
Propane 3.836 NYMEX-WTI 5.825 39.2 0.003%
Butane 4.326 Brent 5.870 38.0 0.000%
Gasoline 5.050 Dubai 6.092 31.8 2.000%
Gas oil 0.2% 5.825 Suez Blend 6.156 30.1 -
Heating oil 0.2% 5.825 Iran Heavy 6.130 30.8 0.016%
Jet/kerosene 5.501 Urals 6.085 32.0 0.014%
Fuel oil 0.5% 6.287 Oman 5.965 35.3 0.790%
Fuel oil 1.0% 6.298 Belida (Indonesia) 5.583 46.4 0.020%
Fuel oil 3.0% 6.302 Tapis (Malaysia) 5.583 46.7 0.100%
Fuel oil 3.5% 6.315

Natural gas (Mmbtu per Mcf) 1.03

Energy Volume to Weight

Product bbl/Metric ton Crude bbl/Metric ton API Gravity Sulfur Content
Propane 12.409 Wilmington 6.678 18.4 0.015%
Butane 10.983 Alaska North Slope 7.101 27.9 0.011%
U.S./Euro Gasoline 8.405 Dubai 7.275 31.8 2.000%
Asian Gasoline 8.519 Urals 7.284 32.0 0.014%
MTBE 8.460 Arab Light 7.351 33.5 1.900%
NWE Gas oil 7.460 WTS 7.378 34.1 0.016%
MED Gas oil 7.595 Bonny Light 7.418 35.0 0.001%
U.S. No. 2 heating oil 7.595 Brent 7.565 38.3 0.000%
U.S. Diesel 7.330 WTI 7.623 39.6 0.003%
Jet Fuel 7.880 Arun 8.260 53.9 -
Naphtha 9.006
Fuel oil 6.317

Energy Weight conversions

U.S. and Metric Systems UK gallon Liters U.S. gallon Barrels Cubic feet Cubic Meters
1 UK gallon= 1.00000 4.54610 1.20090 0.02859 0.16054 0.00455
1 Liter= 0.21997 1.00000 0.26417 0.00629 0.03531 0.00100
1 U.S. gallon= 0.83268 3.78540 1.00000 0.02381 0.13368 0.00379
1 Barrel= 37.97260 158.9900 42.00000 1.00000 5.61459 0.15899
1 Cubic foot= 6.22890 28.317 7.48050 0.17811 1.00000 0.02832
1 Cubic meter= 219.97000 1000.00000 264.17000 6.28980 35.31400 1.00000
Source: Reuters, CSFB estimates.

151
AMSTERDAM............. 31 20 5754 890 KUALA LUMPUR ........ 603 2143 0366 SÃO PAULO............. 55 11 3841 6000
ATLANTA ................... 1 404 656 9500 LONDON .................. 44 20 7888 8888 SEOUL........................ 82 2 3707 3700
AUCKLAND.................. 64 9 302 5500 MADRID..................... 34 91 423 16 00 SHANGHAI............... 86 21 6881 8418
BALTIMORE............... 1 410 659 8800 MELBOURNE............. 61 3 9280 1888 SINGAPORE ................. 65 6212 2000
BANGKOK....................... 62 614 6000 MEXICO CITY.............. 52 5 283 89 00 SYDNEY ..................... 61 2 8205 4433
BEIJING.................... 86 10 6410 6611 MILAN............................. 39 02 7702 1 TAIPEI ...................... 886 2 2715 6388
BOSTON..................... 1 617 556 5500 MOSCOW ................... 7 501 967 8200 TOKYO ....................... 81 3 5404 9000
BUDAPEST .................. 36 1 202 2188 MUMBAI ..................... 91 22 230 6333 TORONTO.................. 1 416 352 4500
BUENOS AIRES....... 54 11 4394 3100 NEW YORK ................ 1 212 325 2000 WARSAW................... 48 22 695 0050
CHICAGO ................... 1 312 750 3000 PALO ALTO ............... 1 650 614 5000 WASHINGTON ........... 1 202 354 2600
FRANKFURT ................. 49 69 75 38 0 PARIS ....................... 33 1 53 75 85 00 WELLINGTON.............. 64 4 474 4400
HOUSTON .................. 1 713 890 6700 PHILADELPHIA ......... 1 215 851 1000 ZURICH ....................... 41 1 333 55 55
HONG KONG............... 852 2101 6000 PRAGUE................... 420 2 210 83111
JOHANNESBURG...... 27 11 343 2200 SAN FRANCISCO ...... 1 415 836 7600

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