Energy Investing DeMystified: A Self-Teaching Guide

Energy Investing DeMystified: A Self-Teaching Guide

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by Davis Edwards

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Build profits and shore up your portfolio by taking advantage of volatile energy prices and changing government legislation

Simple enough for a novice but challenging enough for a veteran, Energy Investing Demystified introduces you to the physical energy market, how government policies affect investment opportunities, and how investors can benefit from


Build profits and shore up your portfolio by taking advantage of volatile energy prices and changing government legislation

Simple enough for a novice but challenging enough for a veteran, Energy Investing Demystified introduces you to the physical energy market, how government policies affect investment opportunities, and how investors can benefit from those policies.

  • Easy-to-use reference guide written in an accessible style
  • Filled with tips, insights, strategies, and techniques to drive home key energy investing principles and theories
  • Each chapter concludes with practice exercises and a quiz to test your knowledge
  • Allows you to learn at your own pace, drill on the most challenging accounting concepts, practice your skills and understanding of the topic, and verify your retention with quizzes and final exams

Davis W. Edwards is a senior manager of the Energy and Commodities Pricing Center at Deloitte & Touche and author of Energy Trading and Investing.

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McGraw-Hill Professional Publishing
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Demystified Series
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7.30(w) x 9.00(h) x 0.40(d)

Read an Excerpt

Energy Investing DeMYSTiFieD

A Self-Teaching Guide

By Davis Edwards

McGraw-Hill Education

Copyright © 2013 McGraw-Hill Education
All rights reserved.
ISBN: 978-0-07-181274-0


Petroleum, Refined Products, and Biofuels

This chapter introduces fossil fuels and discusses the relationship between solid, liquid, and gaseous fuels. It then goes on to focus on one type of fuel (liquid fuels). The next chapter discusses fuels that exist in gas and solid forms at standard temperature and pressure.

Over 90$$$ of the world's energy is supplied by fossil and biofuels. These fuels are composed of hydrocarbon molecules that produce heat when combined in a chemical reaction with oxygen. The length and structure of the molecules determine the property of each fuel. The shortest molecules, called natural gases, exist as gases at standard temperature and pressure conditions. The mid-length molecules exist as liquids. These are called petroleum products. The longest chains are solids and called coal.


After completing this chapter, the student should have an understanding of

• The major types of fuels

• Oil and gas exploration and drilling

• Types of crude oil

• Crude oil transport

• Petroleum refining

• Refined products like diesel, gasoline, and jet fuel

Hydrocarbon Fuels

Almost all fuels used to produce energy are composed of hydrogen and carbon. In chemistry classes, they would be called hydrocarbons. The principle difference between different types of fuels is the length of the carbon–carbon chains. Very short chains of carbon exist as gases, longer ones as liquids, and the longest of all as solids. Hydrocarbons release energy when their carbon and hydrogen bonds are broken and combined with oxygen in the process of combustion. In other words, hydrocarbons are fuels that release energy when burned. Hydrocarbon fuels exist as solids, liquids, and gases (see Figure 1-1).

Small hydrocarbon molecules—those that have one, two, three, or four carbon atoms—exist as a gas under standard conditions. The smallest hydrocarbon (methane, chemical formula CH4) is called natural gas. Longer gaseous molecules are collectively called natural gas liquids or liquefied petroleum gas. Even longer molecules—those with five to approximately sixty carbon atoms—exist as liquids under standard conditions. These are collectively called petroleum. The shorter chain liquids flow readily and can easily vaporize into gas. Longer chains are very viscous and may need to be heated before they flow easily. Once molecules get very large, they no longer turn into liquids under any normal conditions. These solid fuels are called "coal." There are many varieties of coal which vary in hardness and composition.

The relative value of each fuel is affected by a large number of factors. Fuels with a high energy density (heat content) and that are easy to use, transport, and store are the most valuable. For example, vehicular fuels, like gasoline (petrol), diesel, and jet fuel tend to have high energy density (see Table 1-1). Lighter fuels, like propane and butane, may be equally easy to use but have less energy content than gasoline. Heavier fuels, like Bunker Fuel (Fuel Oil No. 6) are typically more difficult to use than gasoline. As a result, these fuels are typically less expensive than common vehicular fuels. Even more difficult to use, and less expensive, is a solid fuel like coal. While it would be possible to burn any of these fuels for energy, some fuels are easier than others to use, and are correspondingly more valuable.

The relative value of fuels affects prices throughout the fossil fuel value chain. For example, when fossils fuels are removed from the ground, they exist as a mixture of fuels and unwanted substances that must be separated from one another. The value of that mixture is heavily dependent on the components and the effort necessary to remove pollutants. Raw fuel has to be refined into usable products. For a variety of reasons, this is typically done at a refinery or a processing plant located a long distance from the oil well or coal mine. There is typically one distribution system to get raw materials (like crude oil) to the refinery or processing plant, and a separate distribution system to get the refined products (like gasoline) to consumers.

Exploration & Production

Energy investing starts with exploration and production. While it's possible to produce renewable energy, the easiest and most cost effective way to meet consumer demand for energy is often to use existing fossil fuel sources. This requires identifying the location of potential resources and extracting them from the ground.

During this process, energy companies typically do not want to purchase land. Instead, they will usually lease the land or purchase the mineral rights for a piece of property. This allows them to extract the fuel from the ground and then move on to the next field. The owners of the land get paid royalties (usually a percentage of the profit). Exploration involves both finding potential reserves and negotiating contracts with the owners of the mineral rights.

In the U.S., the rights to oil and gas located under the surface are often owned by private individuals. In most other regions, fossil fuel resources are owned by the government of the host country. Regardless of who owns the land, exploration companies must typically get licenses to explore for new resources and other licenses to develop the resources for production.

There are several types of contracts that may be signed for the production of oil and gas reserves. Energy exploration and production is a speculative activity. It involves the risk that development costs will not be recovered because too little fuel is extracted or because commodity prices have fallen. In addition, there are a variety of specialized skills needed to make exploration projects run smoothly. A variety of contracts can be used depending on the interest and ability of the participants to take on the risk of development and the task of selling the fuel after it is extracted from the ground.

Tax and Royalty. The exploration company gives the owner of the oil and gas rights a percentage of the profit that it obtains for selling fuel. Typically, the exploration company will pay an upfront licensing fee and percentage of the gross profits. In this type of contract, the exploration company takes on all of the risk of developing resources. A typical contract will give the land owner one-eighth of the gross profits.

For example, if a well produces 10,000 barrels of oil at an $80 average price, the land owner will get (1/8th) (10,000 barrels) ($80/barrel) = $100,000 royalty payment.

Production Sharing. The exploration company gives the owner a percentage of the fossil fuels that are produced. In this type of contract, the exploration company takes on the risk of developing fossil fuel reserves, and passes on a portion of the output to the owner who must arrange to sell or use the output.

Service Contract. With a service contract, the oil company acts as a contractor. The oil company is paid a fee to produce oil and gas rather than taking ownership of the crude oil. This involves relatively little risk for the exploration and production company with most of the costs being paid by the land owner.

Traditional Wells

Fossil fuels are formed when decaying organic material is trapped in an area where it can't disperse. When material is trapped underground, it is placed under tremendous heat and pressure. Over millions of years, this heat and pressure splits the organic material into shorter hydrocarbon chains. These short hydrocarbon chains (fossil fuels) are typically less dense than the surrounding rock and start to rise to the surface. If they hit an impermeable layer of rock, the hydrocarbon fuels may pool underground and become trapped. When a hole in the impermeable rock is drilled by an exploration company, the fuel continues its journey to the surface (see Figure 1-2).

There are three density related mechanisms that force the migration of oil and gas to the surface. When hydrocarbons are broken into smaller pieces by heat and pressure, the newly matured hydrocarbons take up more space because smaller hydrocarbons are less dense than larger hydrocarbons. First, this raises the pressure in the location where this occurs and pushes the hydrocarbons out of the area. Second, oil and gas (and almost all other liquids and gases) expand when they get hot. Temperatures deep in the earth are higher than at the surface and this further increases the pressure when the hydrocarbons are forced downwards. As a result, the primary way to relieve this overpressure is to force the hydrocarbons upwards. Finally, because oil and gas are lighter than the surrounding rock and water, buoyancy will also force oil and gas upwards.

A large portion of oil and gas formed in this way will make its way to the surface where it will eventually dissipate into the atmosphere. The portions that get trapped are the oil and gas resources known as fossil fuel. Historically, oil and gas exploration focused on finding geological layers of rock that could trap hydrocarbons and drilling test wells to determine if any fossil fuels were trapped underneath. Modern technology has revolutionized that process. Geologists now use seismic waves to create three-dimensional underground maps using computers to interpret and collate test results. This is a much more effective way of looking for liquids and gas trapped underground.

In many cases, because the oil and gas are under substantial pressure underground, they will flow to the surface with little effort on behalf of the oil driller. In some cases, water can be pumped into the well to increase the underground pressure and force oil to flow out.

Oil Sands (Heavy Oil)

With traditional oil wells, the gas needs to flow from underground to the surface. However, this prevents the usage of heavy crude oil reserves because heavy crude oil does not flow well. Heavy crude is extremely viscous and ranges from the consistency of molasses to a solid at room temperature. If heavy oil deposits are located close to the surface, they can be removed by strip mining. Otherwise, high temperature steam has to be injected underground to convert the heavy oil into a liquid that is suitable for extraction.

Removing heavy oil from the ground is often destructive to the environment and requires immense amounts of energy and water. The petroleum produced by oil sands is less desirable than traditional sources of fuel. However, heavy oil deposits are much more abundant than traditional oil deposits.

Shale Gas (Hydraulic Fracking)

In a conventional well, hydrocarbons, stored in a layer of porous, permeable rock are trapped underneath an impermeable layer of rock. A porous rock has large cavities that contain hydrocarbons. Permeable rock has small cracks that allow gas to move between sections of the rock. A porous, permeable rock has cavities and cracks connecting a majority of the cavities to one another (see Figure 1-3).

In some cases, organic matter may become trapped inside the cavities within porous, impermeable rock. In these cases, if the rock surrounding the hydrocarbons can be fractured, the hydrocarbons can be extracted. The most common way to create fractures in rock is to inject water or similar hydraulic fluid into a rock formation and then use the liquid to propagate compression waves caused by explosions deep into the formation. This process is known as hydraulic fracturing, or fracking. It has been proven commercially viable at removing hydrocarbons from shale rock formations.

The water used in this process can often be recovered and reused multiple times after it has been treated to remove pollution. Pollution is typically not due to the natural gas and lighter hydrocarbons that are being removed. Light hydrocarbons are nontoxic and already exist in the atmosphere. However, fracking has the potential to release anything that has been trapped in the shale layer. If heavy metals or other pollution are trapped in the shale, those can dissolve into the fracking liquid. These pollutants must be removed before they are allowed to contaminate drinking water.

Shale Oil (Shale Rock Processing)

Another way to extract hydrocarbons from porous, but impermeable, rock is to use traditional mining techniques and then crush the rock in a processing plant. Technology for producing fuel in this manner has been around for over 200 years; however, it is rarely economically viable. This process differs from shale gas extraction because, with shale rock processing, shale is removed from the ground prior to processing.

Deepwater Drilling

Deepwater drilling involves exploration and production of oil and gas resources which are located more than 500 feet (150 meters) underwater. Drilling for fossil fuels deep underwater provides a wide variety of technological challenges. Due to the high pressure, it is very difficult for humans to survive and work while deep underwater. As a result, humans typically have to work remotely from floating platforms above water. This places an increased burden on remote monitoring.

The risk of catastrophic equipment failure is also much higher. Deepwater drilling places a much higher stress on well components than traditional drilling. For example, gas bubbling out of crude oil is more likely to occur when drilling in deep water due to the pressure difference between the top and bottom of the pipe. A liquid will be forced to move given enough pressure. However, if a gas bubble becomes trapped, the pressure may continue to build until it destroys the pipe. Longer pipes have more surface area where a weak spot can occur. This problem is further compounded if shorter pipes are welded together to form a longer pipe or if the pipe needs to bend somewhere along the line because this creates a place for gas bubbles to form.

Oil and Gas Reserves

The actual amount of crude oil trapped underground is generally not known until a well is fully exhausted. As a result, crude oil reserves (the amount of oil remaining in a field) are typically described in terms of probability of it being extracted. For example, P90 refers to a 90$$$ to 100$$$ chance of recovery. P50 refers to 50$$$ to 100$$$ chance of recovery. P10 refers to a 10$$$ to 100$$$ chance of recovery (see Figure 1-4).

Typically, P90 reserves are much smaller than P50 and P10 reserves. For any given well, the distributions will not necessarily be normally distributed. However, when reserves are calculated over a large enough number of samples, a normal distribution becomes a much better approximation of reality. Another way to categorize reserves is by the terms proven, probable, and possible reserves.

Proven Reserves (1P). Proven reserves are generally defined as having a 90$$$ certainty of being produced with current technology and under current economic and political conditions.

Proven and Probable Reserves (2P). Probable reserves are generally defined as having a 50$$$ to 90$$$ probability of being produced with current technology and under current economic and political conditions.

Proven, Probably, and Possible Reserves (3P). Probable reserves are generally defined as having a 10$$$ to 50$$$ probability of being produced with current technology and under current economic and political conditions.

Related to the term oil and gas reserves is the term oil and gas resources. Oil and gas resources refer to the total volume of hydrocarbons present in a field regardless of whether they can be extracted or if it is profitable to do so. This term, and its associated meaning, is much less commonly used than the term reserves.

Another complication when comparing the oil and gas wells to one another is that each field will contain a different mix of natural gas, natural gas liquids, and crude oil. Either the ratio between gas and oil production can be reported, or the output can be converted into a single unit. The gas–oil ratio is commonly reported in cubic feet (ft3) of gas per barrel (BBL) of crude oil. For the purpose of calculating reserves, fossil fuels are typically represented as a single number called the Barrel of Oil Equivalent (BOE). Any nonliquid hydrocarbon, like natural gas, needs to be converted into these alternate units. The heating value of the crude oil and natural gas, measured in Btus or Joules, is typically used to make the conversion.

Crude Oil

In its natural state, crude oil is a mixture of different fossil fuels found underground where decaying plant life became trapped under a layer of nonporous rock. After millions of years, heat and pressure converted the decaying plant life into hydrocarbons. The mixture of hydrocarbons in these underground reservoirs can vary widely. For example, when it is first extracted from the ground, crude oil often contains gas that has to be siphoned off and particulates that need to be filtered out.

Excerpted from Energy Investing DeMYSTiFieD by Davis Edwards. Copyright © 2013 McGraw-Hill Education. Excerpted by permission of McGraw-Hill Education.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Energy Investing DeMystified: A Self-Teaching Guide 5 out of 5 based on 0 ratings. 1 reviews.
theBrainTrust More than 1 year ago
A how-to guide for personal and professional traders alike. It's great background for people taking GARP's Energy Risk Professional and NASD Series 3 exams too.