What it means
E&P companies sit at the start of the energy supply chain, which people often call the upstream segment. They acquire the rights to drill on land or at sea, study the geology, drill wells and then operate those that find something.
Refining and selling fuel to motorists are handled by other companies further down the chain. The business model is a bet on two things: finding reserves and selling them at a good price.
Exploration is risky because many wells find nothing, so the cost of the failures has to be paid for by the successes. This makes capital spending very large relative to revenue, and it can swing sharply from year to year.
Reserves are the central asset, and they are not the same as oil sitting in a tank. Reserves are the volumes the company can expect to recover economically from known fields at current prices and costs.
Analysts value E&P companies largely on the size, quality and cost of those reserves, not just on this year's profit. Accounting for the costs of drilling is a distinctive feature.
Under the successful efforts method, the cost of dry wells is expensed (charged to profit) straight away, while under full cost accounting all drilling costs are capitalised (recorded as an asset) and written off over time. The choice changes reported profit materially, so you must know which method a company uses before comparing it with a rival.
Commodity prices and hedging also shape results. Many E&P firms use derivative contracts to lock in a future price for part of their output, which makes cash flow steadier.
Leverage (the use of borrowed money) is common in the sector, and a price fall can quickly squeeze a heavily indebted producer. For a non-specialist, the practical test is cost per barrel.
A company that can find and produce oil more cheaply than the market price earns a healthy margin, while one with high costs may only survive when prices are high. Ask what a barrel costs to find, develop and lift, then compare it with the selling price.
In practice
Real-world examples.
Example
A mid-sized producer drills in a shale basin and reports that its cost to add a barrel of reserves has fallen from $35 to $28. Investors treat this as a sign of improving efficiency and mark up the share price. The CFO highlights the figure in every earnings call.
Example
A bank lends to an E&P company against its proven reserves. The loan size is reviewed twice a year as the bank recalculates the value of those reserves at updated oil prices. When prices drop, the borrowing limit drops with them.
Example
A pension fund analyst compares two producers and finds that one uses full cost accounting and the other successful efforts. She adjusts the figures so both are on the same basis before judging which is more profitable.
Formula
Calculation
Finding and development cost per barrel = (exploration costs + development costs) / barrels of reserves added
Suppose an E&P company spends $200,000,000 on exploration and $400,000,000 on development in a year, and adds 20,000,000 barrels of proven reserves. Finding and development cost = (200,000,000 + 400,000,000) / 20,000,000 = 600,000,000 / 20,000,000 = $30 per barrel. If it can sell oil for $70 per barrel and lifting costs are $15 per barrel, the margin before overheads and tax is 70 - 30 - 15 = $25 per barrel.Case study
Seen in the real world.
Redstone Basin Energy is an illustrative, fictional E&P company with three producing fields and a heavy debt load. When oil prices fell by about a third, its revenue dropped sharply while loan repayments stayed the same.
The finance team responded in three ways: it paused two exploration projects, hedged half of next year's output at a fixed price, and sold a minority stake in one field for cash. Debt was reduced from a level that worried lenders to one that fitted its covenants (the conditions attached to its loans).
In this fictional story the company survived the downturn because it treated cash and balance sheet strength as seriously as drilling success. The lesson is that in upstream energy, survival through the low point in the price cycle matters as much as discovery.
Watch out
Common mistakes.
- Treating an E&P company like a refiner or a petrol retailer, when its profit depends on the price of the raw commodity rather than the margin on fuel sales.
- Comparing two E&P companies without checking whether they use successful efforts or full cost accounting.
- Counting every barrel in the ground as an asset, when only economically recoverable reserves count.
Questions
People also ask.
What does upstream mean in the oil and gas industry?
It means the exploration and production stage, before oil is transported, refined or sold to consumers.
Why do E&P share prices swing so much?
Revenue and the value of reserves move with commodity prices, and heavy fixed costs and debt magnify the effect on profit.
How do E&P companies reduce price risk?
Many use hedging contracts that fix a selling price for part of future production, which makes cash flow more predictable.
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