Chapter 1 Petroleum Economics – Introduction

*Describe general financial aspects of the petroleum industry

General financial aspects of the petroleum industry.

Basically there is an opportunity to profit. Companies are formed to exploit reserves, they perform due diligence, take into account risks and make a decision on whether or not to drill and produce. Investment can come from venture capital companies, private investment or equity raising. Petroleum products can be sold in several different markets such as options, futures contracts or directly through shares of a company.

*Describe briefly the nature and evolution of demand for oil

Since 1900 the use of petroleum products has gone from 5% to 60% of market share of total energy products. The cause for this growth stems from several areas:

  • Petroleum industry was incredibly successful at finding and manufacturing fuel
  • Fluids are easier to handle than solids
  • The advent of the internal combustion engine
  • Economies of scale reduced the price of oil comparatively to other fuels
  • Economic and military systems became progressively dependent

Finally, one of the biggest influences has been the astronomical growth of motor vehicles – cars.

*Describe briefly the evolution of oil supply

There has been an increase in both quantity and geographical diversity of oil. USA and Russia dominated the market in the early 20th century accounting for 95% of oil on the market supplying around half a million barrels per day.

USA started gaining the majority of the market share in 1945 with 65% of oil supplied on the market. The total supply of oil had grown to seven millions barrels per day at this stage in history. Oil production continued at a rampant rate up until the 1970s to a rate of 65 million barrels per day due to massive discoveries in the Middle East.

*Describe two situations where an attempt was made to control the market for petroleum

Standard Oil

The brainchild of John D Rockefeller in 1870, the company quickly achieved market domination using questionable and aggressive tactics. Growth was explosive and the company performed a series of acquisitions to become the market maker in the downstream sector of North-East USA. The company circumvented Federal laws relating to inter-state ownership and was eventually split into more than 30 companies in 1911.

Red Line Agreement

On the other side of the globe in Turkey a company was established in 1912 by the name of Turkish Petroleum. The company sought to gain petroleum concessions in the Middle East. Inspired by Armenian entrepreneur, Calouste Gulbenkian, Turkish Petroleum was convinced of the prospects that existed in Iraq. Due to much political and commercial interest a Red Line Agreement was signed between the French, German, American and British nations. The idea was that the signatories could not compete with each other within the Red Line which encompassed Saudi Arabia, Turkey, Syria and Iraq – The Ottoman Empire.

Achnacarry Agreement

In 1928 there was overcapacity and falling oil prices, a couple of executives met from Standard New Jersey, Standard Indiana, Anglo Iranian, Shell and Gulf met over a round of hunting to chew the fat and came up with the Pool Association. This agreement meant that:

  • Companies would share production and markets on the basis of the balance then prevailing
  • New facilities would be constructed only as necessary and to supply in the most efficient manner
  • Price would be Gulf Plus. Which means that the market price would be based on USA export price plus the shipping cost from the Gulf of Mexico to the US.

*Explain how the role of the National Oil Company versus the International Petroleum Company has changed since 1974


*Describe briefly the history of the company


*Describe briefly the Foinaven project

Foinaven is a deep sea project west of Shetland with a low capex. FPSO (Floating Production Storage and Offloading) is leased rather than purchased which saves around $1bn. Foinaven has estimated recoverable reserves of 323 million barrels of oil and 221 billion cubic feet of gas. The project experienced production delays of around 18 months due to FPSO conversion and issues with sub-sea manifold, also resulting in increased costs.

*List ten financial parameters or statistics that may be used to explain or to monitor the performance of a petroleum company

  1. Refinery Margin
  2. Finance Debt
  3. Net Income per boe
  4. Share price
  5. ROACE
  6. Historical Cost Profit
  7. Turnover
  8. Oil/Gas production
  9. Development Cost
  10. Reserves replacement

*Describe five of these statistics or parameters


Return On Average Capital Employed. This is profit as a proportion of capital employed (a measure of total corporate funding).

Share Price

Share price multiplied by the number of shares on the market both public and private gives market capitalization. This is essentially a forward looking valuation of the company taking into account all public and private information known about the company at that point in time. The price may also reflect the general attitude towards the stock market in general.

Dividend Per Share

This can be a measure of profitability of the company. Usually, companies will pay out a portion of their free cash via dividends, the greater the value of the dividend then typically the more profitable the company has been.

Net Income Per boe


Historical Cost Profit


*List and describe the five principal sectors of petroleum activity

Exploration and Appraisal

This process outlines the search for oil and characterization of the reservoir. We drill exploratory wells and perform seismic surveys to provide insight into the sedimentary structure, formation and potential reservoir. Throughout exploration we consider unsuccessful wells as Opex and successful wells as Capex. It is also possible to record all exploration costs as Capex, the differences come down to accounting methods.

Field Development and Operation

An investment decision is made and Capex required to develop the field by drilling wells, building structures, production facilities and export processes. Field development costs range significantly from the expensive depths of ultra-deep water fields to the cheaper onshore fields.

Once operation is underway and production starts, Opex is required to operate the system. Upstream by definition is the exploration and production of petroleum products while downstream is the processing and refinement.


Transportation methods range from direct via pipeline or can be through a series of stages including pipeline, storage and tanker. Infrastructure can be owned by the oil producer or it can be leased – ownership means the company has invested Capex whereas leasing means the company is paying tariffs (Opex). Transportation from wellhead to point of sale can come within the boundary of upstream taxes, however production beyond this point does not.


Refineries take the crude produced from the well and refine this to create various petroleum products. The gross refining margin is an important parameter and refers to the difference between unit selling and unit purchase price.

Distribution and Marketing

Materials produced at the refinery can then travel down two paths: firstly, they may be transported further downstream to produce other products or secondly,  they may be sent directly to a distribution network such as a fuel station.

Sales tax applies to fuel at the point of sale. The government will call it whatever they please, in the US it comes out to be around $20 per barrel, while in the UK it can be around $140 per barrel.

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