The Oil and Gas Industry Explained: From Exploration to Distribution

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The oil and gas industry finds crude oil and natural gas underground, brings them to the surface, moves them to processing plants, and turns them into fuels and raw materials such as gasoline, jet fuel, heating oil, asphalt and natural gas for power and heating. It is usually divided into three segments: upstream (exploration and production), midstream (transportation and storage) and downstream (refining and distribution). Each earns money differently and carries different risks.

Where oil and gas come from

Crude oil and natural gas are both hydrocarbons, compounds of hydrogen and carbon formed from the remains of ancient plants and animals. That material was buried in sediment that hardened into rock such as sandstone, limestone and shale. Heat and pressure at depth converted it into oil and gas. Because they are less dense than water, they migrate upward through porous rock until they are trapped beneath a layer of less porous cap rock. That trapped accumulation is a reservoir.

To produce from a reservoir, a company drills through the cap rock. If the drill bit reaches a commercially viable accumulation, the hole is completed as a producing well and the hydrocarbons are brought to the surface. If it does not, the well is a dry hole, which is typically plugged and abandoned.

Not all hydrocarbons sit in conventional reservoirs. Oil and gas locked in tight formations such as shale can be released through hydraulic fracturing, or fracking: fluid is pumped into the rock at high pressure to crack it open so the hydrocarbons can flow to the well.

Upstream, midstream and downstream: how the industry is organized

Upstream: exploration and production

Upstream companies are known as E&P firms, short for exploration and production. They locate reservoirs worldwide, acquire the rights to develop them, drill, and extract the oil and gas. The work is technologically intensive and takes years. A company may spend heavily on geological surveys and test wells before a field produces anything, and some of that spending ends in dry holes, one reason the segment is considered so risky.

Revenue equals volumes produced multiplied by the prices received, so nearly every line of an E&P company’s income statement and cash flow statement traces back to production levels and commodity prices.

E&P companies generally do not own drilling rigs. They hire contract drillers, which typically charge for the time their rigs and crews work. A driller’s revenue therefore depends on how much drilling is going on, not on how many barrels a well later produces.

Once a well is drilled, it needs ongoing work to bring it into production and keep it producing. These activities, called well servicing, include:

• Logging (measuring the properties of the rock and fluids along the well)
• Casing and cementing (lining the well and sealing it in place)
• Perforating (opening the casing to the reservoir)
• Fracturing
• Routine maintenance

Drilling and servicing are separate businesses, and many publicly traded companies specialize in one or the other. Like drillers, service companies earn revenue that rises and falls with industry activity, so U.S. rig counts and rig utilization rates are widely watched indicators of demand for both.

Midstream: transportation and storage

Midstream companies connect production to processing. They move raw oil and gas from the field to refineries and processing plants through pipelines, tanker ships, rail and trucks, and they store it along the way.

The midstream segment is heavily regulated, especially pipeline transmission. In the United States, for example, interstate pipeline rates are overseen by federal regulators. The segment carries lower capital risk than exploration, because a pipeline or storage terminal earns money by moving or holding product rather than by finding it. It still depends on upstream output: if producers in a region cut back, that region’s pipeline volumes fall too.

Downstream: refining and distribution

Downstream businesses are refineries and the networks that sell finished products, including gas stations. Refineries remove impurities from crude oil and convert it into products the public uses, such as gasoline, diesel, jet fuel, heating oil and asphalt. Natural gas is also processed downstream before it reaches homes, power plants and industrial users.

A refiner buys crude oil as its main input and sells refined products as its output, so its profit depends on the gap between the two. That gap is often called the crack spread. A refiner can do well when crude prices fall faster than product prices, and poorly when the opposite happens, which is why refining earnings do not always move in step with oil prices.

How oil production is measured

Oil production is reported in barrels, abbreviated bbl. One barrel equals 42 U.S. gallons. Companies usually state production as barrels per day or barrels per quarter.

The industry uses Roman-numeral-style prefixes that can confuse newcomers:

Here “M” stands for one thousand, not one million. An E&P company reporting production of 7 Mbbl per day is producing 7,000 barrels a day.

How natural gas production is measured

Natural gas is measured in cubic feet, using the same prefix convention:

Natural gas futures on CME Group’s exchange are priced not per cubic foot but in MMBtu (1 million British thermal units), a measure of energy content. One MMBtu is roughly 1,000 cubic feet of gas, so a price per MMBtu approximates a price per Mcf, though the conversion depends on the energy content of the specific gas.

Barrels of oil equivalent

Many producers pump both oil and gas, so they need a single unit to report total output. The standard approach converts gas into barrels of oil equivalent (BOE) based on energy content: one BOE is roughly equal to 6,000 cubic feet of gas, or about one barrel to six Mcf.

Hypothetical example: a company produces 10,000 barrels of oil and 30,000 Mcf of gas per day. Its gas output converts to 30,000 ÷ 6 = 5,000 BOE, so total production is 15,000 BOE per day.

The conversion can also run the other way. Gas-focused producers often report production as Mcfe (thousand cubic feet equivalent), converting oil into gas terms. One caution: BOE is an energy equivalence, not a value equivalence. A barrel of oil and six Mcf of gas contain similar energy, but they have historically not sold for similar prices, so two companies with identical BOE production can have very different revenue depending on their oil and gas mix.

Reserves: what is still in the ground

Reserves are the oil and gas a company owns rights to that remain underground and have not yet been produced. They are reported in the same barrel and cubic-foot units as production and are central to valuing E&P companies, because they represent future production and therefore future revenue.

In the United States, public oil and gas companies must disclose quantities of proven reserves. That disclosure appears as supplementary information alongside the financial statements, not as a line in the statements themselves.

The three Ps of reserves

Reserves are classified by how likely they are to be produced:

• Proven (1P): about a 90% certainty of being produced, also called P90.
• Probable: about a 50% certainty, or P50.
• Possible: about a 10% certainty, or P10.

Why reserves deplete

Every barrel produced is a barrel removed from reserves. An E&P company that stops exploring and acquiring has a shrinking supply, and its revenue will eventually fall. Upstream companies can sustain or grow production only by finding or buying new reserves.

Metrics investors use to evaluate oil and gas companies

Because each segment makes money differently, the useful metrics differ too. For upstream companies, analysts typically look at:

• Production volume and growth, in bbl, Mcf or BOE per day, and how it changes over time.
• Production mix, the share of oil versus gas, since it affects revenue per BOE.
• Proven reserves, and how much of the total sits in each of the three P categories.
• Reserve life, calculated as proven reserves ÷ annual production. Hypothetical example: 150 MMBOE of proven reserves and annual production of 15 MMBOE gives a reserve life of 10 years at current output, assuming no new reserves are added.
• Reserve replacement ratio, calculated as reserves added in a year ÷ production in that year. A ratio below 100% means the company produced more than it replaced.

For drillers and service companies, rig counts and utilization rates indicate demand. For midstream firms, the volumes moving through their systems matter. For refiners, the crack spread drives margins. These measures sit alongside standard fundamental analysis of balance sheets, cash flow and valuation.

Integrated oil companies

An integrated oil company operates in two or more stages of the chain, for example both producing crude oil upstream and refining it downstream. Many of the world’s largest and most influential oil companies are integrated, with separate divisions for each segment.

Integration gives a company more control over its supply chain and can improve efficiency, since it can feed its own refineries with its own crude and move product through its own infrastructure. It also diversifies revenue. When crude prices fall, the upstream division earns less, but the refining division may benefit from cheaper input costs, partly offsetting the decline.

The scale required works against new competitors. Exploration and refining both demand very large capital investments, so barriers to entry are high, and the largest integrated players have few challengers at their size.

Which countries produce the most oil and gas

As of 2024, the United States was the world’s largest producer of crude oil, followed by Saudi Arabia, Russia, Canada and China. For natural gas, the top five producers were the United States, Russia, Iran, China and Canada.

Because a few countries account for a large share of supply, events in major producing regions and coordinated production decisions, such as OPEC’s, can move global prices. Those swings pass directly into upstream revenue and, through energy costs, into the wider economy, which ties oil prices closely to inflation.

FAQs

The Bottom Line

Anyone investing in oil and gas companies should first identify which segment a company operates in, since producers, drillers, pipelines and refiners earn money in different ways. Upstream results hinge on production, prices and replacing reserves, midstream on volumes moved, and refining on the crack spread. Integrated companies spread these risks across segments, so a drop in crude prices can hurt one division while helping another.