There’s an awful lot to wrap your brain around when it comes to understanding oil and gas production, not to mention trying to comprehend how the commodity is traded.  So I thought I’d offer a little primer to those interested.

Measurement
Crude oil (wiki) is measured in barrels.  There are 42 gallons to a barrel (as it was stored in 42 gallon wooden barrels in the 19th century), and in the field, all quantities, with a few exceptions, are be referred to in terms of barrels.  For instance, a frac job could take as many as 10,000 barrels to complete, depending on the type of frac job and the depth of the well.

Natural gas (wiki) is measured in two ways, by volume (thousand cubic feet, MCF) and by heat content (Btu). One Btu is the amount of heat required to raise the temperature of one pound of water by one degree Fahrenheit.  Not all gas contains the same heat content, and hence the same amount of energy, giving reason as to why it is also measured in Btu’s.

For instance, 10 burning kitchen matches release 10 Btu’s.

For all practical purposes, pipeline companies measure natural gas in terms of volume.

Production
Typically crude oil is produced from standard pump jacks much like you see in Texas and Oklahoma. Contrary to popular belief, crude oil (and associated liquids and gasses) are not sitting in giant underground caverns, just waiting to be sucked out of the ground.  Geologic formations are much like a sponge, porous in nature and under extreme pressure.  The pressure from the earth above the formation is trying to squeeze out the contents of the sponge, but until a hole is drilled into the formation, the contents have no where to go.

When a well is drilled, the pressure from the formation pushes the contents to the well bore, and in many cases in new wells, up the bore to the surface.  If the pressure is extremely high and the drilling crew doesn’t contain the pressure, a blowout can occur, much like you see in old pictures and movies, with oil shooting straight up into the air.  Fortunately, technology and a basic understanding of formation characteristics make blow outs infrequent.

As you can imagine, there is a finite amount of pressure in the formation and that pressure decreases as the contents of the sponge are squeezed out.  Depending on the porosity of the formation (i.e. how big the holes are in the sponge) and the size of the producing zone, the pressure can decrease slowly or fairly quickly. 

Once the pressure falls to a point where it is no longer sufficient to push the oil and gas up to the surface of the Earth, a pump must be placed in the well to pull the liquids and gas to the surface.  At this point, the condensate (mixture of oil, gas and water) is pumped into a separator which separates the water from the gas from the oil, and each component is pumped into a holding tank, or in the case of gas, pumped through a meter and sent down a pipeline for sale.

Depending on the location, oil may be pumped into a pipeline, or stored in giant holding tanks.  When the tanks fill up, a transport truck takes the oil to a refining facility.

Water, which is high in chlorides (salt) must be disposed of properly so as not to present an erosion problem.  Dumping the salty water out into a field will kill crops and increase the rate of erosion, so typically this water is pumped back into the ground.

Distribution
Natural gas is typically sent down a pipeline (otherwise called a gathering system) which could be owned by an independent gas company, or the production company itself.  The gas is metered right after it’s pumped from the well, but also by the gas company.  The gas company determines the amount of hydrates left in the gas (i.e. how much water is still present in the gas) and also the heat content.  Naturally, the drier the gas and the higher the heat content, the more valuable the gas is per unit volume.

Natural gas is difficult to store outside of a processing facility, and it can not be trucked or shipped like oil or other liquids.  However, the advent of Liquefied Natural Gas (LNG) is changing that (wiki).  LNG facilities cool natural gas into a liquid by lowering the temperature to -168 degrees Celsius.  This process turns the gas into a liquid, but also lowers the volume of the gas so it can be shipped in large quantities.

Oil is taken, typically by tanker truck to a distribution facility, and then on to the Cushing, Oklahoma facility where it is distributed to the market.  At one point, a vast majority of the United States oil production was filtered through the Cushing facilty, which made it a convenient place to assign a market price.  This is why the price of crude oil is referred to as the WTI Cushing Spot Price.

Trading and The NYMEX
Both natural gas and crude oil are traded on the NYMEX, and as mentioned earlier, oil is traded in barrels, and natural gas is traded in $/MMBtu.  What is the relationship between MCF and MMBtu? While gas differs in heat content from location to location, for all practical purposes, one cubic foot of natural gas contains 1,000 btu’s.  Therefore, 1 MCF of gas contains 1 MMBtu, or 1,000,000 Btu’s.  Consequently, it is convenient to say 1 MCF is traded on the same scale as 1 MMBtu.

Depending on heat content of the gas from a well, some gas trades at a discount to the NYMEX and other gas trades at a premium.  If a well in your backyard is “hotter” than the standard heat content, you will receive more money for that gas than is traded on the NYMEX, and vice versa is the gas does not contain as much energy as standard.

Crude oil also trades at a premium or discount based on it’s energy content.  Sour crude, or crude oil that contains significant amounts of hydrogen sulfide, carbon dioxide or marcaptans, is more difficult to refine, and trades at a discount to light sweet crude.  There are other weight standards that follow this same principle.

My Thoughts on the Future
Obviously the oil futures are volatile in nature, and being a world wide commodity, it is highly influenced by forces outside of the United States.  Additionally, supply and demand are in complete control of the market, no matter what influence geopolitics and speculation play at a local level.

I believe oil prices will stay high for the foreseeable future until an alternative source of energy comes along that will replace it.  At this point in time I see hydrogen fuel cells as the next big step in technology.  Hydrogen contains nearly 2.6 times the amount of energy per unit volume as gasoline, and produces an eco-friendly by product: water.

The disadvantage of hydrogen as a fuel is that it does not occur freely in nature in useful quantities.  Therefore it must be processed and refined into a free element in a quantity that can be readily used for energy production. Naturally, it must not take as much energy to produce hydrogen as it produces when burned, as a negative net energy effect would result.

Until hydrogen can be produced in such a way that the net energy content still exceeds gasoline, gasoline will be the fuel of choice in our lives.

While ethanol is a viable fuel, the net energy content has not proven to be a sufficient replacement for gasoline.  In addition, the ethanol market, a commodity in and of itself, is based on another commodity, corn.  Some can argue that switch grass and cellulose may also be used in production of ethanol, but those two sources are also available in limited quantities.  In short, it would take 98% of the United States land mass to grow enough corn to replace our entire demand for gasoline with ethanol.  I don’t plan on leveling my house to grow corn, and I suspect that you don’t either.

In short, the demand for petroleum based products is high, and will remain high until new technology emerges not only to replace oil and gasoline, but also exceede the efficiency and energy capacity of oil and gasoline products.

That said, when we have a technological breakthrough that produces free hydrogen in mass quantities at low cost, I wouldn’t be holding on to many oil and gas stocks! Until then, oil and gas should produce solid returns for many years.

Additional Resources:
NaturalGas.org
The President’s Hydrogen Fuel Initiative
Natural Gas Basics (EIA)
The Corner Office Post on Peak Oil
Energy Information Administration

Oil & Gas