CSFB OG Industry Primer

14 May 2002
Global
Equity Research
Oil & Gas
research team
Brian M. Gibbons, Jr., CFA

212 325 3101 brian.gibbons@csfb.com
Catherine Arnfield
44 20 7888 1881 catherine.arnfield@csfb.com
Peter Best
852 2101 6121 peter.best@csfb.com
Daniel Blanchard
852 2101 7319 daniel.blanchard@csfb.com
Henry Cohen, CFA

416 352 4585 henry.cohen@csfb.com
David Dudlyke
44 20 7888 4381 david.dudlyke@csfb.com
Daniel Eggers, CFA

713 890 1659 daniel.eggers@csfb.com
Mark Flannery
212 325 7446 mark.flannery@csfb.com
Oil and Gas Primer

Introduction to the Oil and Gas Business
THE OIL AND GAS CHAINFROM UPSTREAM TO DOWNSTREAM
The CSFB Global Oil and Gas Teams first Oil and Gas Primer provides an introduction to the dynamics of the oil and gas business and our framework for investing in the sector. We describe our approach to analyzing global oil and gas markets, evaluating macro oil market conditions; forecasting supply and demand, commodity prices, and refining margins; and valuing and investing in the various industries throughout the oil and gas chain.
Emerson Leite, CFA

55 11 3841 6290 emerson.leite@csfb.com
Rod Maclean
44 20 7888 1395 rod.maclean@csfb.com
Vadim Mitroshin
7 501 967 8355 vadim.mitroshin@csfb.com
David Niewood
212 538 1158 david.niewood@csfb.com
Phil Pace, CFA

713 890 1655 phil.pace@csfb.com
RETURNS ON CAPITAL DRIVE OIL AND GAS EQUITY VALUATIONS

Critical for investors is understanding which businesses within the oil and gas chain accrue the highest financial value in the market and where investment opportunities lie within the energy chain based on variations in the oil and gas cycle. The Integrated Oil business dominates global equity market capitalization among publicly traded oil and gas equities, at roughly $1.2 trillion, versus Independent E&Ps at $215 billion, Oilfield Service and Equipment companies at $135 billion, and Independent Refiners at $79 billion. Returns on capital drive valuation and share price performance throughout the oil and gas chain. Integrated Oils are the most conservative oil and gas investment compared with the more volatile Independent E&Ps and the hypervolatile Oilfield Service companies. The Independent Refiner group has historically generated the lowest returns.
Ken Sill
713 890 1678 ken.sill@csfb.com
Tracy Todaro, CFA

713 890 1666 tracy.todaro@csfb.com
Oil and Gas Primer
14 May 2002
Table of Contents
Global Oil and Gas Equity Research ................................................................................4 Executive Summary ..........................................................................................................5 Introduction: Oil and Gas Chain Overview........................................................................7 Oil Markets ......................................................................................................................12 Oil Supply .................................................................................................................... 14 Demand ....................................................................................................................... 19 CSFB Supply and Demand Model, Marginal Cost Curve ........................................... 21 Refining ....................................................................................................................... 23 Natural Gas Markets .......................................................................................................28 Global Natural Gas Supply and Demand Framework ................................................. 28 North American Natural Gas Market ........................................................................... 31 The Upstream .................................................................................................................36 Value Creation............................................................................................................. 36 The E&P Process ........................................................................................................ 38 The Downstream.............................................................................................................44 Refining ....................................................................................................................... 44 Marketing..................................................................................................................... 47 Integrated Oils.................................................................................................................50 Independent Refiners......................................................................................................57 Independent E&P ............................................................................................................61 Oilfield Services and Equipment .....................................................................................67 Investment Conclusions ..................................................................................................78 Valuation Framework................................................................................................... 80 Investing through the Cycle......................................................................................... 83 Appendix I: The Physical Process ..................................................................................87 Exploration and Production ......................................................................................... 87 Storage and Transportation....................................................................................... 108 Refining ..................................................................................................................... 111 Offshore Oilfield Services and Equipment ................................................................ 121 Appendix II: Case StudyU.S. Energy Markets ..........................................................129 Market Overview........................................................................................................ 129 End Markets .............................................................................................................. 131 Energy Expenditures ................................................................................................. 133 Glossary ........................................................................................................................135 Energy Conversion Guide .............................................................................................151
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14 May 2002
Global Oil and Gas Equity Research

United States Integrated Oils Mark Flannery Joseph Bustros Oil Services Ken Sill Daniel Eggers John Lawrence Brad Smith Bradley Ruhoff Exploration and Production Phil Pace Tracy Todaro Arun Jayaram Refining and Marketing David Niewood Canada Henry Cohen Viren Wong Latin America Emerson Leite (Sao Paulo) Gustavo Santos (Sao Paulo) Australia Simon Davis South Africa Paul Carter Europe Integrated Oils +1 212 325 7446 Rod Maclean +44 20 7888 1395 +1 212 325 3045 Cathy Arnfield +44 20 7888 1881 Thomas Martin +44 20 7888 1544 +1 713 890 1678 Oil Services/ Exploration and Production +1 713 890 1659 David Dudlyke +44 20 7888 4381 Marketing Analysts +1 713 890 1652 +1 713 890 1681 Colin Smith +44 20 7888 0151 +1 713 890 1672 John Besant-Jones +44 20 7888 0152 Emily Matthews +44 20 7888 0868 +1 713 890 1655 Asia-Pacific +1 713 890 1666 Peter Best (Hong Kong) +852 2101 6121 +1 713 890 1677 Daniel Blanchard (Hong Kong) +852 2101 7319 Theodore Pun (Hong Kong) +852 2101 7178 +1 212 538 1158 Sarinee Sernsukskul (Thailand) +66 2 614 6218 Prashant Gokhale (India) +91 22 230 6230 +1 416 352 4585 Pankaj Kadu (India) +91 22 230 6227 +1 416 352 4546 S. Varatharajan (India) +91 22 230 6221 Haizan K. Johari (Malaysia) +65 214 30 366 +55 11 3841 6290 Sonia Song (Korea) +82 2 37 07 3733 +55 11 3841 6305 A-Hyung Cho (Korea) +82 2 37 07 3735 M. Esig Ben-Menachem (New Zealand) +64 9 360 1531 +61 3 9280 1768 Russia/Emerging Europe Vadim Mitroshin (Moscow) +7 501 967 8355 +27 11 343 2202 Global Brian Gibbons +1 212 325 3101
Global Reports
Global Oil Daily Global Integrated Oils Order of Merit (formerly Global Integrated Oils Almanac) IEA Monthly Update Global Independent E&P Order of Merit QualrigWorldwide Spending Update
Industry Reports
Integrated Oils and Independent Refining
Weekly Refining Indicators U.S. Weekly Retail Margin Tracker Measurement While Reporting
Independent E&P
North American E&P Weekly Independent E&P F&D Cost Study Measurement While Reporting
Oilfield Services
Oilfield Services Weekly Statistical Update Monthly Oilfield Drilling Update U.S. Drilling Permits Monthly Measurement While Reporting
Oil and Gas Primer
14 May 2002
Executive Summary
This report provides a reference guide to the dynamics of the oil and gas business and CSFBs framework for investing in the sector
The CSFB Global Oil and Gas Teams first Oil and Gas Primer provides an introduction to the dynamics of the oil and gas business and our framework for investing in the sector. We describe our approach to analyzing global oil and gas markets, evaluating macro oil market conditions, and forecasting supply and demand, commodity prices, and refining margins, and finally our approach to valuing and investing in the various industries throughout the oil and gas chain. There are several different industries involved in finding, producing, transporting, storing, and distributing crude oil and refined petroleum products, and natural gas. It is critical for investors to understand which businesses within the oil and gas chain accrue the highest financial value in the market and where investment opportunities lie within the energy chain based on variations in the oil and gas cycle. The $770-billion-a-year global oil and gas commodity market involves upstream producers (Integrated Oils, Independent Exploration & Production [E&P]), upstream service providers (Oilfield Service and Equipment [OFS]), and downstream refiners and distributors (Integrated Oils, Independent Refiners) throughout the oil and gas chain. While there exist numerous other industries (Pipelines, Tankers, Chemicals, Petrochemicals) throughout the chain, these groups make up the majority of global energy equity market capitalization, and are traditionally viewed to be the most directly related to the energy business because of their close connection to hydrocarbon production and refining.
The $770-billion-a-year global oil and gas commodity market is dominated by Integrated Oils, which make up the lions share of publicly traded global energy equities at $1.2 trillion
The upstream is the largest part of the chain in terms of net sales and net profits and in terms of equity market capitalization. It also generates the highest financial returns. The Integrated Oils business dominates global equity market capitalization among publicly traded oil and gas equities, at roughly $1.2 trillion, versus Independent E&Ps at $215 billion and Oilfield Service and Equipment companies at $135 billion. The Integrated business model provides a much steadier earnings and cash flow stream than the other groups given the diversity of businesses. Integrateds are also a classic defensive investment class that generally outperforms during broad market downturns. They are viewed to be the most conservative oil and gas investment compared with the more volatile Independent E&Ps and the hypervolatile Oilfield Service companies. Integrated Oils stocks therefore often perform better than the other oil and gas industries as the cycle shifts from peak to trough, but tend to underperform the highly leveraged E&Ps and Service companies when oil and gas fundamentals improve. The downstream is substantially smaller than the upstream in terms of equity market capitalization, as the business has historically been dominated by the Integrated Oils. We estimate the global equity market capitalization of the pure-play (ex-Integrateds) downstream Refining and Marketing business to be roughly $79 billion, concentrated most heavily in Emerging Markets and to a lesser extent in the U.S. The Emerging Markets aspect of most publicly traded global Refiners makes investment comparisons difficult to assess given the high degree of country risk and minority interest discount (i.e., most Emerging Markets refiners are controlled by government entities) reflected in valuations. The U.S. market is the largest developed market for Refining and Marketing
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equities, with no other real comparison. U.S. refining equities tend to outperform on a seasonal basis from November to April in anticipation of the summer driving season and underperform from May to October. Valuation is still the critical factor in analyzing these stocks, however.
Returns on capital drive valuation throughout the oil and gas industries; Integrated Oils are the most consistent returns performers through the cycle, but the Oilfield Service group generates the highest returns during up markets and cyclical peaks
In valuing each industry group we use a proprietary, returns-based methodology throughout the global energy research team. We focus on return on gross invested capital (ROGIC) among the Integrated Oils, Independent Refiners, and Oilfield Service companies. For the Oilfield Equipment stocks (Assets or Drillers), we use return on replacement cost, and for the Independent E&P stocks we use return on replacement cost capital, although the calculations and interpretations of replacement cost for the two groups are substantially different. Our research suggests the Integrated Oils have the most consistent long-term returns performance (9%) owing to their diversified business profile. Oilfield Service and Equipment companies have also been able to achieve high returns on capital (12%) through various market periods, particularly during market upturns when returns often far exceed those of the Integrateds and E&Ps owing to the technological differentiation and niche, specialist services they offer. The Independent E&P group returns profile (11%) is more volatile than the Integrateds as a result of the upstream-only business model, but is less volatile than the Service stocks. Independent Refiner returns (8%) are consistently the lowest among the traditional oil and gas groups. This report is broadly structured in four main sections: commodity markets, upstream and downstream businesses (operational and financial performance measurement); industries within the oil and gas chain; and investment conclusions. We hope this report provides the novice and the experienced energy investor with a user-friendly reference manual to understanding the oil and gas business and CSFBs methods for evaluating oil and gas equities.
Oil and Gas Primer
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Introduction: Oil and Gas Chain Overview

The oil and gas chain begins with the exploration and discovery of hydrocarbons and concludes with the retail distribution to end-use markets
The oil and gas chain begins with the exploration for and discovery of hydrocarbons and concludes with their retail distribution to end-use markets. There are two distinct parts of the oil chain: the supply of crude oil (the upstream) and the supply of refined crude products (the downstream). Exhibit 1 details the chain of events, from exploration to end-use consumption, and shows the size of each market and the investment opportunities within each segment. The upstream is the largest business in the oil and gas chain, comprising the Integrated Oils, Independent Exploration and Production, and Oilfield Service and Equipment industries. The downstream comprises Integrated Oils, which are involved in all aspects of the energy chain, and Independent Refiners, which engage only in refining and marketing. Excluding the Integrateds, the downstream is a much smaller segment of the chain in terms of equity market capitalization and has historically generated lower returns on capital than the upstream. Integrated Oils and Independent Exploration and Production companies engage in finding and producing oil and gas. This is a five-stage process, beginning with the exploration for hydrocarbons and ending with the final stage of decommissioning and abandonment of mature wells. The exploration for hydrocarbons can take several weeks to acquire topical and geological data and then several months to process, while development and first production from a successful field may take two to five years. The full development and production stage can go on for several decades before final decommissioning. Oilfield Service companies play an integral role in all aspects of the upstream process, as producers effectively outsource much of their service and equipment needs to the OFS industry. Producers sell their crude oil and gas into wholesale markets, to Independent Refiners and distributors, and to themselves, using spot and futures market transactions. The oil market is a truly global market. Oil is produced on nearly every continent and a complex transportation and refining system exists to move crude and products to enduse markets. Oil is sold everywhere in U.S. dollars and traded on major exchanges. Differences in quality grades of oil are arbitraged out through efficient market pricing mechanisms. Oil, in one form or another, can be bought and/or sold by any individual, corporation, or countrythe market is very efficient.
There are two distinct parts of the chain: supply of crude (the upstream) and supply of refined crude products (the downstream)
We estimate the physical global crude oil market to be a $570-billion-per-year business and the natural gas market to be $200 billion
We estimate the physical global crude oil market to be a $570-billion-per-year business based on an average historical West Texas Intermediate (WTI) crude price of $20.50 per barrel (bbl) and recent demand of 76-77 million barrels of oil per day (MMBD). These figures only address the size of the physical, or spot, market for crude without considering the vast amounts of financial derivatives (i.e., futures, options, swaps) that are traded and negotiated every day. We have also assumed for simplicity sake that all oil is WTI when the reality is that there are numerous crude grades and qualities that have either higher or lower values than WTI.
Oil and Gas Primer
Exhibit 1: Oil and Gas Chain
Natural Gas Upstream - $770b

Oil: $570b Natural Gas: $200b
Transportation Power plant/ large industry Distribution Gas Exploration Development Production Condensate Pipeline Transportation Midstream Processing (NGL) households/ smaller industry
8
LNG Liquefaction
LNG Regasification Power plant/ large industry
Downstream - $1,100b
Discovery Development Transportation
Petroleum products
Retail Cars, trucks etc
Oil
Petroleum
Production
products Refining
Wholesale
industry
Global Equity Market Capitalization Integrated Oil - $1,162b Independent E&P - $215b Oilfield Services - $135b
Bulk products Specialty products
industry
Petrochem feedstock Petrochemical
industry
plant
Global Equity Market Capitalization Independent Refiner - $79b

14 May 2002 Source: Company data, CSFB estimates.
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Unlike the global oil market, the gas business is regional mainly because of the difficulty in physically transporting gas. However, we can still estimate the aggregate dollar value of worldwide gas markets using regional consumption and pricing data. We believe the global gas business is approximately $200 billion per year, assuming demand of 230 billion cubic feet per day [bcf/d]) and natural gas prices of $3.00 per thousand cubic feet (mcf). While there is not yet a global gas market comparable to the oil market, technologies that convert natural gas into liquefied natural gas (LNG) or natural gas to liquids (GTL) have made major inroads to establishing the long-haul transportation for stranded natural gas reserves. Several energy companies are currently attempting to increase the viability of each technology that will facilitate global trade.
Oil is transported by pipelines, ocean tankers, and tanker trucks to refineries for conversion into end-use products (gasoline, diesel, heating oil)
Oil is transported by pipelines, ocean tankers, and tanker trucks to refineries for conversion into end-use products (gasoline, diesel, heating oil). Integrated Oil companies and Independent Refiners process the crude oil (refining) into products and sell them into wholesale and retail markets (marketing). Refining and Marketing are two distinct parts of the downstream chain despite often being referred to in the same breath. Refiners purchase crude from Independent E&Ps, Integrateds, and National Oil Companies (NOCs) whereas Integrateds can either buy crude from other producers or use their own equity crude supply from their producing fields. Independent fuel distributors or retailers purchase oil and gas products (gasoline, heating oil) at the wholesale level to sell to end-use markets (industrial, commercial, residential, transportation) for final consumption. We estimate annual global petroleum products consumption to be $1.1 trillion. While this number is greater than the upstream $770 billion amount, the $770 billion upstream business effectively represents the cost of goods sold for the products market. Exhibit 2 provides a closer look into the oil and gas chain through the economic flow of one barrel of oil, from the exploration stage through final sale at the gasoline pump, using 2000 data for the US market. Producers find and develop hydrocarbon reserves and undertake production operations that have associated overhead and other costs, leading to a marginal cost per barrel ($18.50 in this example). They can then sell into the wholesale market (New York Mercantile Exchange [NYME] or International Petroleum Exchange [IPE]) for $26.75, generating a 31% profit. Refiners therefore pay $26.75 for the crude and $0.85 to transport it to their refinery. It then costs $6.00 to refine the crude into products for a total cost of $33.60. Refiners can then sell the refined products into the wholesale products market for $37.00, for a profit of $3.40, or 10% ($37.00 less $33.60). Continuing the chain, retail operations pay the $37.00 wholesale price for refined products, which includes all the associated costs of finding, developing, and producing the crude oil plus a producer profit, the costs associated with the refining process, and the refiners profit. In addition, the retailer pays $5.25/bbl in transportation, distribution, and marketing costs for a total cost of $42.25. Retail product prices (gasoline) averaged $44.60/bbl in 2000, allowing retailers to generate a $2.35 profit, or 6%. However, this is not quite the end price for the consumer, as it excludes taxes. U.S. federal, state, and local taxes of $17.40 (28% of total price) imposed on this $44.60 price bring the total cost for the consumer to $62.00 per barrel, or in this example, $1.48 per gallon of gasoline. In Europe, by contrast, taxation on refined products tends to be much higher, approaching 85% of the total price paid in some instances. 9
Oil and Gas Primer
Exhibit 2: Economic Flow of One Barrel of Crude Oil (Subset Represents Conversion of One Barrel of Oil to One Gallon of Gasoline)
US$ per barrel
$70.00
Final Sales Price to End-Use Consumer = $62.00
$60.00 Fed. Taxes = $8.30
10
$50.00 Retail Product Price (ex-Taxes) = $44.60 Wholesale Product Price = $37.00 Refinery Profit = $3.40 = 10% Other Costs = $2.00 Refining Cash Costs = $4.00 Transportation Costs = $0.85 Profit = $8.250 = 31% $20.00 $18.50 Marginal Cost Curve Other/Overhead Costs = $4.70 DD&A Costs = $3.70 $10.00 Operating Costs = $4.50 Finding & Developing Costs = $5.60 $0.00 Upstream Refining Retail Final Sales Price
14 May 2002
State Taxes = $9.10
$40.00
Retail Marketing Profit = $2.35 = 6% Marketing Costs = $3.00 Retail Operating Costs = $2.00 Transportation Costs = $0.25
$30.00
Crude Oil Price = $26.75
Source: EIA, CSFB estimates.
Oil and Gas Primer

We combine the research of our global Integrated Oils, Independent E&P, Oilfield Service, and Refining teams to develop a coherent mosaic of the energy landscape
14 May 2002
Understanding the macro oil environment provides insight into the direction of the oil cycle and potentially which industries will benefit most as the cycle changes. We combine the research of our global Integrated Oils, Independent E&P, Oilfield Service and Equipment, and Refining teams to develop a mosaic of the energy landscape. We analyze historical oil and gas prices, inventory data, seasonal supply and demand trends; evaluate producer and service spending patterns; and apply industry economics and pricing patterns. After we form a macro opinion and evaluate the current stage (trough, middle, peak) of the oil cycle, we look at the specific industries within the chain. Cyclical shifts to the upside will favor all oil and gas equities while shifts to the downside will be negative. However, the level of up/downside performance will be different for each industry group, with some groups outperforming or underperforming others.
Our investment process begins with a macro oil market view, which supports our industry preferences, and concludes with our stock preferences
During cyclical upturns and periods of extended upward momentum, Oilfield Service and Equipment stocks tend to outperform the wider energy group because of their high leverage to producer spending, and substantial returns on capital. The Independent E&Ps also perform well given their single pursuit of upstream operations. The Integrated business, however, tends to lag these other upstream groups because of the diversification of the other businesses. One might assume that Independent Refiners might be hurt by rising crude prices because higher prices translate into a higher cost of goods sold, but refiners actually perform better in this environment because of implied high product demand and a greater ability to pass on high crude costs to consumers. Oil market downturns result from excess supply, weakened demand, or a combination of both factors, which hurts each group. In a downturn, Integrateds tend to outperform because their diversified business model provides a steadier earnings and cash flow stream versus the other groups. They are viewed as the most conservative oil and gas investment compared with the more volatile Independent E&Ps and the hypervolatile Oilfield Services companies. Integrated Oils stocks therefore will likely perform better than the other oil and gas industries as the cycle shifts from peak to trough. Energy equities are also a classic defensive investment class, which generally outperforms during broad market downturns. This is because cyclical upturns or high commodity price environments generally coincide with economic downturns. Once we identify the appropriate industry(ies) to invest in given the stage of the cycle, we take a bottom-up approach to stock selection. Business models, balance sheet strength, operating leverage, andmost important valuation are key components to our analysis. We focus on return on gross invested capital (ROGIC) among the Integrated Oils, Independent Refiners, and Oilfield Service companies. For the Oilfield Equipment (Asset, or Drillers) stocks, we use return on replacement cost, and for the Independent E&P stocks we use return on replacement cost capital, although the calculations and interpretations of replacement cost for the two groups are substantially different.
Integrateds outperform the broad energy group during cyclical downturns while Oilfield Services outperform during cyclical upturns and during peak periods
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Oil Markets
The oil market is truly global; oil is produced on nearly every continent and a complex transportation and refining system exists to physically move products to end-use markets
The macro oil market forecast is the foundation of our analysis, forecasts, and industry and stock selection opinions within the broad energy landscape. In this section, we describe the major macro oil market drivers: crude prices (spot and futures, crude grade differentials), inventories, supply (global reserves and production), demand (global demand trends), the role of OPEC, the marginal cost curve and midcycle conditions, refining, and the distinct role of product markets. The oil market is truly global. Oil is produced on nearly every continent and a complex transportation and refining system exists to move oil to end-use markets. Oil is sold everywhere in U.S. dollars and traded on major exchanges (New York Mercantile Exchange, International Petroleum Exchange). Oil comes in many different quality grades, reflecting among other things levels of sulfur and its propensity to create higher volumes of more valuable light products (such as gasoline). Oil, in one form or another, can be bought and/or sold by any individual, corporation, or countrythe market is very efficient. We list various major global crude grades and their price differentials in Exhibit 3.
Exhibit 3: Global Crude Grades and Price Differentials
as of March 2002, US$ per bbl
Crude: Price: 24.22 26.17 25.85 24.62 25.60 22.94 23.24 23.67 22.37 WTI WTI Lt. La ANS Dated Bonny Dubai Cush Nymex Sweet USWC Brent Light Fateh 26.17 25.88 26.02 24.22 24.24 24.39 23.07 -1.95 -1.66 -1.80 -0.02 -0.17 1.15 0.29 0.15 1.95 1.93 1.78 3.10 -0.32 -0.03 -0.17 1.63 1.61 1.46 2.78 -1.55 -1.26 -1.40 0.40 0.38 0.23 1.55 -0.57 -0.28 -0.42 1.38 1.36 1.21 2.53 -3.23 -2.94 -3.08 -1.28 -1.30 -1.45 -0.13 -2.93 -2.64 -2.78 -0.98 -1.00 -1.15 0.17 -2.50 -2.21 -2.35 -0.55 -0.57 -0.72 0.60 -3.80 -3.51 -3.65 -1.85 -1.87 -2.02 -0.70
($/barrel) Alaska North Slope USWC WTI Cushing WTI Midland WTS Midland Wyoming Sweet Urals Med. Flotta Arab Light Arab Heavy
Source: Bloomberg, CSFB.
We estimate the physical global crude oil market to be a $570-billion-per-year business based on an average historical WTI crude price of $20.50/bbl and recent demand of 76-77MMBD. These figures only address the size of the physical, or spot, market for crude without considering the vast amounts of financial derivatives (i.e., futures, options, swaps) that are traded and negotiated every day. We have also assumed for simplicity sake that all oil is WTI when the reality is that there are numerous crude grades and qualities that have either higher or lower values than WTI.
WTI and Brent are the two benchmark crude grades; however, we closely monitor light/heavy and sweet/sour grades to understand underlying trends in the broad oil market
As stated above, the major international exchanges for oil and gas trade are the New York Mercantile Exchange and the International Petroleum Exchange in London. Both exchanges trade spot, or physical (dated), contracts for immediate delivery and futures for delivery at a later date, providing hedging, speculating, and price discovery opportunities for producers and speculators. Price quotes are most often for the front month or for oil to be delivered one month out. Given the difficulty in following every traded crude grade in the world, two benchmark crude contracts are widely used: West Texas Intermediate crude on the NYMEX and Brent crude on the IPE. While these two crude grades provide the general market direction of oil prices, they do not necessarily
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represent the direction of all crude grades and types. In order to track the rest of the oil market, we define crude by two sets of measures: light or heavy as defined by API gravity (see Glossary), and sweet or sour grade as measured by percent sulfur content, and compare the pricing spreads (light versus heavy and sweet versus sour). We also take into consideration common trade movements. Exhibit 4 shows the light/heavy spread represented by WTI (light) and Kern River (heavy) crude and the sweet/sour spread using Brent (sweet) and Dubai (sour) crude.
Exhibit 4: Global Crude Light/Heavy and Sweet/Sour Spreads
US$ per bbl
WTI (Light) versus Kern River (Heavy) Prices $35 $30 $25 $20 $15 $10 $5 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Apr-02 Oct-97 Oct-98 Oct-99 Oct-00 Oct-01 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 WTI Kern River Brent (Sweet) and Dubai (Sour) Prices 35.00 Brent 30.00 25.00 20.00 15.00 10.00 5.00 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Apr-02 Oct-97 Oct-98 Oct-99 Oct-00 Oct-01 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Dubai
Source: Reuters, CSFB estimates.
In addition to receiving different prices in the market (revenue impact), each crude grade can also have different finding and developing cost structures, leading to different levels of economic viability for various fields. Producers, depending on their asset base, can be levered more or less to light or heavy, sweet or sour crude production. Similar to producers, refinery operations are geared to process particular crude grades, and pricing provides insight into refiner cost structures. On the refining side of the business, a wide heavy/light oil price differential has the ability to soften the impact of weak refining margins for complex refiners that process heavy crude. As we show in Exhibit 4, there were several times when the differential grew quite large, providing an opportunity for complex refiners to generate additional income. When light/heavy spreads contract, complex refineries that traditionally profit from the discount are less able to offset the general weakness in refining margins. We discuss refinery operations in greater detail at the end of this section. Equally important to following light/heavy and sweet/sour spreads, we follow the 12-month futures curve, including the 12-month strip price, which is the average price for the next 12 months of futures contracts. The shape of the 12-month futures curve plays an important role in analyzing the state of the market.
The shape of the curve portends price expectations over the next 12 months, and reflects the current view of supply and demand
The shape of the curve portends current price expectations for the next 12 months, reflecting the current view of supply and demand. An upward sloping curve, contango, with future months priced higher than near months, suggests expected higher prices, and implicitly higher demand relative to supply in the future. The market is essentially putting a premium on oil 12 months out or conversely a discount on current oil prices. A downward sloping curve, backwardation, with the front-month contracts commanding a premium over the future months contracts suggests current demand is outpacing 13
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current supply, with the expectation that the imbalance will become less pronounced in the coming time period. Put another way, the shape of the curve reflects the current view of supply and demand, but not necessarily the underlying reality, which becomes apparent at a later date. Exhibit 5 shows the recent futures curve (as of January 2002) for WTI and Brent is in contangothe market expects higher prices 12 months out (current supply is greater than demand). The right hand chart shows the recent history of the spread between front-month WTI and 12-month WTI. A positive spread, or backwardation, indicates the oil market is tight (i.e., current prices are higher than future months), and demand is likely in excess of supply as in the case from early 1999 through mid-2001 when oil prices were high and the spread was positive. Similarly, when supply begins to exceed demand, the near-term premium dissipates and the spread narrows, or becomes negative, as in the 1997 through mid-1998/early-1999 time period and much of 2000-01.
Exhibit 5: WTI and Brent Futures
WTI and Brent 12-Month Futures Curves
$21.00
WTI Historical Futures Spread versus WTI Front Month
$10 $8
WTI Spread ($/bbl)
WTI
Spread
WTI
$40 $35 $30

WTI ($/bbl)
$20.50
$6 $4 $2 $0 -$2 -$4
$20.00 Brent $19.50
$25 $20 $15 $10 $5
$19.00
$18.50
$18.00 M A M J J A S O N D J F
-$6 $0 Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan97 97 98 98 99 99 00 00 01 01 02
Oil Supply
The majority of the worlds proved oil reserves are found in the Middle East, Latin America, and Africa
The majority of the worlds current proved oil reserves are found in three regions: the Middle East (684 billion barrels [BB]), Latin America (95BB), and Africa (75BB). (See Exhibit 6.) While these regions dominate the global reserve base, the world production profile is quite different. The Middle East (21.7MMBD), North America (15.0MMBD), and the Former Soviet Union (FSU)/Eastern Europe (7.9MMBD) rank as the top three producing regions. (See Exhibit 7.) We anticipate the recent trends in the production profile will largely continue, with the one notable exception the FSU/Eastern Europe. Over the past three years, after a decade of underinvestment and neglect, Russian producers (the bulk of FSU/Eastern Europe) have heavily invested in field development, which we expect will lead to substantially higher production rates going forward.
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Oil and Gas Primer

Exhibit 6: Global Proved Oil Reserves, 2000
14 May 2002
Source: BP Statistical Review of World Energy 2001.
Exhibit 7: Global Crude Oil Production

25
G lobal Production, 1980-1999

M illion barrels per day M iddle East 20
North Am erica 15
FSU/E. Europe 10 Asia-Pacific Africa 5 Latin Am erica
W . Europe 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
15
Oil and Gas Primer

The geological characteristics of oil- and gas-producing basins can vary substantially, which can lead to disparate cost structures for finding, developing, and producing oil reserves
14 May 2002
The geological characteristics of oil- and gas-producing basins can vary substantially, which can lead to disparate cost structures for finding, developing, and producing oil reserves. The type of oil found in each region (light or heavy, sweet or sour) also varies and can be more or less valuable than oil in other regions. In addition to geological characteristics when evaluating the economics of oil and gas projects throughout the world, the relative maturity of each basin is an important consideration. In Exhibit 8, we demonstrate the effect geological characteristics and basin maturities have on the number of productive wells and on individual well productivity. There is an inverse relationship between the number of producing wells (indicating relative maturity) and individual well productivity. The U.S. has the highest number of producing wells, at 535,000, and the lowest productivity per well, at 14 barrels of oil per day, compared with the most productive region, the Middle East, at 6,500 wells each producing 3,800 barrels of oil per day. U.S. oil- and gas-producing regions have relatively low porosity and low permeability rocks that make extraction difficult, if not costly. The region is also the most mature area in the world, with several oil and gas basins that have been drilled at varying levels of intensity for the past 100-plus years. As a result of extensive drilling over such a long time period, reserves have declined, exploration opportunities have declined, the size of discoveries has declined, and field sizes have declined. The U.S. experience of declining productive wells and well productivity compares negatively with other regions of the world, such as the Middle East, which have abundant reserves (10 times greater than North Americas) and are relatively young. These regions have large, untapped reserves, numerous exploration and production opportunities, large reservoirs, and large fields. We next consider the major producer groups and the impact their behavior has on global oil markets.
16
Oil and Gas Primer

Exhibit 8: Global Oil Well Productivity Comparisons
United States
Producing Wells and Well Productivity
700,000 650,000 Producing Wells 600,000 550,000 500,000 450,000 400,000 350,000 300,000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 11.0 10.0 14.0 13.0 16.0 70,000 60,000 Producing Wells 50,000 40,000 30,000 20,000 10,000 90 91 92 93 94 95 96 97 98 99 00 01 02
14 May 2002
Canada
60
Productivity per Well
15.0
55 Productivity per Well 50 45 40
Producing Wells
12.0
Producing Wells
35 30 25 20 03 04
Latin America
45,000 40,000 Producing Wells 35,000 30,000 125 25,000 200 4,250 3,750 Productivity per Well Producing Wells 3,250 2,750 2,250 1,750 1,250 750 250 90 91 92 93 94
Africa (Non OPEC)

1,000
175 150
900 800 700 600 500 Productivity per Well
Producing Wells
20,000 15,000 10,000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
100 75 50
Producing Wells
400 300 200 100
95
96
97
98
99
00
01
02
03
04
Southeast Asia
11,000 10,000 9,000 Producing Wells 8,000 7,000 6,000 5,000 4,000 3,000 2,000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 500 450 7,000
Europe / Mediterranean
1,600

6,000 Producing Wells 5,000 4,000 3,000 2,000 1,000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 100 1,100 Productivity per Well Productivity per Well
400 350 300 250
Producing Wells
Producing Wells
600
200 150 100
Key Middle East Producers

7,500 6,500 Producing Wells 5,500 4,500 3,500 2,500 6,500 750,000 700,000 Productivity per Well Producing Wells 650,000 600,000
World
110
6,000 5,500 5,000 4,500 4,000 3,500

100 90 80 Productivity per Well
550,000 500,000 450,000 400,000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Producing Wells
70 60 50
Producing Wells
1,500 500 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
3,000 2,500 2,000
Source: Company data, CSFB estimates.
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Oil and Gas Primer
14 May 2002
We evaluate the supply side of global oil markets using quantitative and qualitative measures. Quantitatively, we analyze reserve profiles, productive capacity, and rig capacity. Worldwide productive capacity is a function of all of the major variables of supply determinants: available production, drilling rig capacity, rig capacity utilization, times to completion, and estimated reserves. (See Exhibit 9.) Periods of high capacity utilization result when demand exceeds supply and producers push to get as much oil to the market as possible to capture high prices.
Exhibit 9: Worldwide Crude Oil Capacity Utilization
105.0%
2002E Utilization = 94.4%

100.0%
Iran-Iraq War Saudi Capacity Underestimated Impacted by IraqKuwait Conflict
Long-term Average = 93.8%

Capacity Utilization 95.0%
90.0%
85.0%
80.0% 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Source: CSFB, IEA.
Qualitative factors such as producer behavior play a big role in understanding global oil supply
Qualitatively, we analyze producer behavior. It is important to consider the diverse needs of the producer groupsIndependent E&Ps, Integrated Oils, national oil companies, and the Organization of Petroleum Exporting Countries (OPEC)in analyzing the supply side. OPEC is made up of a subset of NOCs; however, not all NOCs are in OPEC. Integrateds and Independents are typically price takers, selling into the market at any price. They focus on incremental free cash flow generation, on balance sheet stability, and increasingly on earning returns in excess of the cost of capital. NOCs, including OPEC members, are typically located in emerging economies, which are short on skilled labor and capital and hence a revenue-generating tax base, but are long on natural resources. Petrodollars, or the money from oil sales, are thus the key to fiscal stability. Changes in producer behavior are often the result of extrapolations from current conditionsi.e., Integrateds and Independents often get mired in the current price environment and straight line prices to one extreme or another. This, of course, leads to the cyclical nature of the business.
OPEC is a major force on the world oil market, controlling nearly 40% of crude supply
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Oil and Gas Primer

Producer behavior can be a cycle of extreme ups and downs
14 May 2002
A high price environment tends to increase capital spending designed to raise production and to bring additional supplies to market to take advantage of the high prices. If existing production capacity is inadequate, then investments in new, aggressive exploration and development programs will take place. Once supply increases beyond the demand point, prices correct downward. As prices retrace to normal levels or continue to fall below normal levels, producers curtail spending and investment. High prices also result in lower rates of oil demand, which have the same effect of lowering prices. The interplay between the different producer groups is critical, and is generally not seen in other commodities businesses. OPEC is the differencethe group accounts for roughly 40% of the global oil supply, a sharp increase in market concentration from 1985 (Exhibit 10), but much lower than its historical level of 55%-plus before 1973-74. OPECs ability as a cartel to agree to and adhere to supply quotas can be a very powerful force, affecting the short-term global supply of crude oil. The cartels inability to adhere to its own quota, 70% historic compliance, has traditionally been OPECs undoing.
Exhibit 10: OPEC Crude Oil Production and Market Share History
35 60%
55% Production 30 50% Crude Oil Production (MMBD) Market Share Global Market Share
45% 25 40%
35% 20
30%
15 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
25%
Demand
There is a high correlation between oil demand growth and GDP growth
On the demand side of the equation, we analyze regional economic indicators to provide insight into potential demand. Historically, oil demand growth has been correlated to GDP growth. (See Exhibit 11.) As one might expect, countries with higher rates of economic growth have seen higher rates of oil demand growth and vice versa for slower-growth countries. The 1990s showed this to a surprising degree, as 80% of all global oil demand growth came from the fast-growing Asia-Pacific region. Oil price swings can create sizable demand shifts for developing nations, which are often the 19
Oil and Gas Primer
14 May 2002
highest-growth consumers. An important demand consideration is the sensitivity of enduse product prices to crude oil prices, which can be driven to a large extent by tax structures (i.e., a lower tax component in end-use prices results in high sensitivity to oil prices, as in the U.S., or a high tax component results in a low sensitivity to crude prices, as in Europe).
Exhibit 11: Global Oil Demand Growth and Real GDP Growth
5 .0% 200 0 1 994 4 .5% R = 45.8% 19 96
2
19 88
19 95 Worldwide Real GDP Growth 4 .0% 199 9
19 87
199 7
198 9 3 .5% 19 92 1 990 19 86
3 .0% 199 3 1 991 2 .5% 19 98
2 .0% -1 .0%
-0.5 %
0 .0%
0.5 %
1.0 %
1 .5%
2 .0%
2.5%
3.0%
3.5%
W o rld w id e O il C o n su m p tio n G ro w th
Source: CSFB.
We analyze global demand from the bottom up, using a regional approach that gives us clearer insight into the overall demand picture. However, forecasting moves in GDP is not enough to derive accurate year-over-year oil demand changes, as the oil price itself often creates single-year or multiyear distortions. North America is the biggest consumer of oil and oil-related products, consuming nearly 24MMBD. We estimate the North American market to be worth about $180 billion per year, or 31% of world demand, using the 15-year historical average WTI crude price ($20.50) and 2001 demand of 23.9 MMBD. Asia and Europe round out the top three oil-consuming regions, taking in 27% and 21% of global oil demand, respectively. (See Exhibit 12.)
Exhibit 12: World Oil Demand Recent History
millions of barrels a day Region North America USA Latin America Europe FSU Middle East Africa Asia-Pacific World Demand Source: IEA, CSFB estimates. 1997 22.7 18.6 4.7 15.8 3.8 4.0 2.3 19.4 72.7 1998 23.1 18.9 4.8 16.1 3.7 4.2 2.3 19.4 73.5 1999 23.8 19.5 4.9 15.9 3.7 4.3 2.4 20.4 75.2 2000 24.1 19.7 4.9 15.8 3.6 4.4 2.4 20.7 75.9 2001 23.9 19.6 4.8 16.0 3.7 4.5 2.4 20.8 76.0 5-Year CAGR 1.3% 1.3% 0.4% 0.2% -0.8% 3.1% 1.0% 1.7% 1.1% % World Demand 2001 31.5% 25.8% 6.3% 21.0% 4.8% 5.9% 3.2% 27.3% 100.0%
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Oil and Gas Primer
14 May 2002
CSFB Supply and Demand Model, Marginal Cost Curve

We form macro assumptions regarding supply and demand to provide support for an oil price forecast
We form macro assumptions regarding supply and demand to provide support for an oil price forecast. Formulation of an oil price view is critical to our earnings and cash flow forecasting, not just for the Integrateds but for the Independent Refiners, Independent E&Ps, and the Oilfield Service companies that depend on producer capital spending. Our estimates for global oil supply and demand through 2003, using the International Energy Association (IEA) forecasts as a guide combined with our analysis of regional indicators, are shown in Exhibit 13. Every month, the IEA reports and forecasts oil supply and demand of OECD (Organization for Economic Cooperation and Development) and non-OECD countries, and its numbers are widely watched by the industry. Oil demand grew at about 1.2% annually on average over the past decade before slowing in 2000-01. We expect demand growth to pick up slightly in 2002-03. Supply, on the other hand, grew about 1.3% on average the last ten years and is estimated to grow only modestly through 2003this is a low-growth business.
Exhibit 13: CSFB and IEA Demand/Supply Model
million barrels per day
M B D u n le s s s p ec ifie d O E C D D e m a n d (C S F B ) % G ro w th (C S F B ) M M B D G ro w th (C S F B ) IE A O E C D d e m a n d IE A O E C D D e m a n d g ro w th T O T A L W O R L D D E M A N D (C S F B ) % W o rld D e m a n d G ro w th (C S F B ) M M B D W o rld D em a n d g ro w th IE A W o rld d e m a n d IE A W o rld D e m a n d g ro w th N o n -O P E C s u p p ly (C S F B ) % n o n -O P E C G ro w th (C S F B ) M M B D G ro w th (C S F B ) IE A n o n O P E C IE A n o n -O P E C su p p ly g ro w th OPEC CRUDE c a ll o n O P E C c ru d e O PEC NG Ls T o ta l O P E C TOTAL SUPPLY % S u p p ly G ro w th (C S F B ) M M B D S u p p ly G ro w th (C S F B ) IE A W o rld su p ply IE A W o rld su p ply g ro w th Im p lie d In v e n to ry C h a n g e e tc C S F B a d j. In v e n to ry c h a n g e R e p o rte d in ve n tory ch a n g e M issin g B a rre ls' M M B C o m m e rcia l O E C D In ve n to rie s C S F B C o m m e rcia l O E C D In ve n to rie s IE A
Source: IEA, CSFB estimates.
1999 4 7 .7 1 .9 % 4 7 .7 1 .9 % 7 5 .3 2 .4 % 1 .8 7 5 .3 2 .3 % 4 4 .6 -0.1 % 4 4 .8 -0.1 % 2 6 .6 2 6 .6 2 .8 2 9 .4 7 4 .0 -2.0 % 7 4 .2 -1.9 % (1 .3 ) (1 .5 )
2000 4 7 .8 0 .3 % 0 .1 4 7 .8 0 .3 % 7 5 .9 0 .9 % 0 .6 7 5 .9 0 .9 % 4 5 .8 2 .7 % 1 .2 4 5 .9 2 .5 % 2 8 .0 2 8 .0 2 .9 3 0 .9 7 6 .7 3 .6 % 2 .7 7 6 .8 3 .5 % 0 .8 (0 .0 )
2001 4 7 .8 -0 .1 % (0 .0 ) 4 7 .6 -0 .4 % 7 6 .0 0 .1 % 0 .1 7 6 .0 0 .1 % 4 6 .5 1 .5 % 0 .7 4 6 .5 1 .4 % 2 7 .4 2 6 .5 3 .0 3 0 .3 7 6 .9 0 .2 % 0 .2 7 6 .9 0 .1 % 0 .8 0 .6
20 0 2 47 .8 0.0 % 0 .0 47 .7 0.3 % 76 .5 0.6 % 0 .4 76 .6 0.8 % 47 .2 1.4 % 0 .6 47 .4 2.0 % 26 .3 26 .3 3 .0 29 .3 76 .5 -0.5 % (0.4 ) 76 .7
2003 4 8 .2 0 .9 % 0 .4
7 7 .6 1 .4 % 1 .1
4 8 .0 1 .7 % 0 .8
2 6 .3 2 6 .6 3 .0 2 9 .3 7 7 .3 1 .8 % 0 .8
0 .0 (0.1 )
(0 .3 ) (0 .5 )
2,4 7 1 2,4 7 1
2 ,5 4 8 2 ,5 4 8
2 ,7 7 6 2 ,7 1 8
2 ,77 7 2 ,71 9
2 ,6 7 0 2 ,6 1 2
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Oil and Gas Primer

A key component to our global oil supply and demand model and oil price forecast is our analysis of midcycle conditions, which normalizes oil cycle extremes
14 May 2002
A key component to our global oil supply and demand model and oil price forecast is our analysis of midcycle conditions, which normalizes oil cycle extremes. (See Exhibit 14.) Our midcycle price forecast of $18.50 is based on the marginal cost curve, derived from the oil price required for a break-even return on capital for our Integrated Oils company universe. Our cost curve analysis provides the backbone of our forecasting process. The first chart in Exhibit 14 shows cost curves for 1992, 1999, and 2000 to demonstrate the short-term trend in cost structures (1999-2000) and a distant prior-year data point to show how private industry costs have moved over time (1992-2000). Break-even cost structures moved higher in 2000 over 1999 but remain well below 1992 levels. Costs will generally move higher or lower with the cycle; cyclical upturns and peaks have higher costs as producers bid service prices higher versus trough periods when high service costs and lower commodity prices make projects uneconomical. Beyond the short-term fluctuations, however, Oilfield Service and Equipment companies continually develop new technologies aimed at lowering finding and development and production costs. The most important factor in reducing costs in the 1990s was the emergence of 3-D seismic mapping, which greatly decreased the number of unsuccessful wells drilled by the private industry. We plotted the $18.50 midcycle oil price estimate against our midcycle supply and demand expectations (Exhibit 14, right chart). At the bottom of the cost curve lies OPEC, which has the lowest finding and development and ongoing production costs ($6/bbl) of any major region or producer group. The extremely high OPEC well productivityin the Middle East, in particulardemonstrates this fact. Non-OPEC supply is more costly and therefore starts at a higher point on the cost curve $9/bbl, in our model. Rising capital intensity as non-OPEC costs push upwards is likely to have the effect of increasing the marginal cost, or clearing price, of crude oil.
Exhibit 14: Upstream Cost Curves, Midcycle Supply and Demand

Upstream Cost Curves, 1992, 1999, 2000 $20 Oil Price per Barrel (WTI spot) $18 $16 $14 $12 REP $10 $8 0 5,000 10,000 1992 15,000 1999 2000 20,000 25,000 RDSC XO TX COC CHV E TOTF PCA PCA NHY P OXY MRO UCL BP MRO AHC Mid-Cycle Crude Oil Market Supply/Demand Dynamics $27 $24 $21 $18.50 $18 $15.14 $15 $12 $9 $6 $3 $0 0 10 20 30 40 50 60 70 80 OPEC Supply S1 OPEC Capacity (12 months out) P'1 P1 Theoretical OPEC Price S3 Non-OPEC Supply D1 Demand S2
Millions of Barrels of Oil (including NGLs)
22
Oil and Gas Primer

The demand for crude oil is a function of the demand for products, but the supply of products is reliant on both available crude supply and available refining capacitytwo distinct parts of the overall supply chain
14 May 2002
Within the context of the supply and demand discussion lies the petroleum products (gasoline, distillate, fuel oil) market we briefly discussed earlier. The demand for crude oil is a function of the demand for products. But the supply of products is reliant on both available crude supply and available refining capacitytwo distinct parts of the overall supply chain. It is important to differentiate the two parts of the supply chain to understand where bottlenecks can occur and which factors drive crude and product pricing trends. The refining business links the supply of crude to the supply of products used for end-use consumption.
Refining
Refined petroleum products are found almost everywhere in everyday life, whether in the form of gasoline, heating oil, jet fuel, road surfaces, or fabrics for clothing. In general, a barrel of oil can be broken down into four broad, refined parts: liquefied petroleum gases (LPGs), light distillates, middle distillates, and residual fuel. Within each class of fuel are various products (propane, gasoline, heating oil, asphalt) that serve many different uses. Exhibit 15 shows a typical product slate for a refined barrel of oil and the various uses.
Exhibit 15: Oil Barrel Products and Uses
LPGs - 10%
Products Ethane, Propane, Butane
Uses Heating, cooking, chemical feedstocks, motor gasoline blending
Light Distillates - 35%
Gasolines, Naphthas
Petrochemical feedstocks, reforming into gasoline, automotive fuel Aviation fuel, automotive fuel, domestic heating fuel, distilled to lighter product Power generation, ship fuel, fuel oil, road surfacing, roofing, chemical industry
Middle Distillates - 35%
Jet Kerosene, Diesel, Heating/Gasoil, Vacuum Gasoil Cracked FO, SR FO, Asphalt, Bitumes, Coke, Sulfur
Residual Fuel Oil - 20%
Source: Bloomberg, CSFB.
Pricing for products is very similar to the crude markets (i.e., spot and futures contracts, arbitrage opportunities, transportation costs, tax-exempt status). While crude almost always is priced in U.S. dollars per barrel, products are often quoted in U.S. dollars per the relevant measurement system (i.e., U.S. products are priced in U.S. cents per gallon, European products are priced in U.S. dollars per metric tonne, and Asian products are priced in U.S. dollars per barrel or per metric tonne). In Exhibits 16 and 17, we demonstrate the variations in global gasoline prices on an equivalent basis (U.S. cents per gallon) and historical U.S. composite wholesale product prices. As we mentioned, price variances lead to arbitrage opportunities. Premium NYH (New York Harbor) gasoline at 59.25c/gal, in the example, has a 7.55c/gal premium price over the comparable premium FOB (free on board) Northwest Europe (NWE, also known as Rotterdam) gasoline at 51.70c/gal, suggesting an opportunity may exist for European premium gasoline producers to profitably export to the U.S. (should transportation costs
23
Oil and Gas Primer
14 May 2002
be less than 7.55c/gal). Relative refining margins between regions is also a major consideration. Exhibit 17 shows historical prices of the major refined products, with gasoline clearly being the most valuable product followed by distillate. Narrow spreads between the products suggest complex refiners are unable to command premium prices for their products despite high levels of invested capital versus simple refiners who have invested less capital and are able to get similar prices for their historically lower-end products.
Exhibit 16: Global Wholesale Gasoline Prices
as of March 2002
c /g a l P ro d u c t E u ro p e : P r e m iu m F O B N W E R e g u la r F O B N W E U S G u lf C o a s t: P r e m iu m U S G R e g u la r U S G US NY: P r e m iu m N Y H R e g u la r N Y H U S W e s t C o a s t: P r e m iu m S a n F r a n R e g u la r S a n F r a n A s ia : G A S O L IN E 9 5 U N L Loc NW E NW E B id 5 1 .7 0 4 7 .9 4 Ask
90
Exhibit 17: U.S. Historical Composite Wholesale Product Prices

100
5 2 .9 5 4 9 .1 9
US cents per gallon
80 Gasoline 70
USG USG
5 4 .8 5 5 1 .1 0
5 5 .3 5 5 1 .3 5
60 Distillate 50 40 30 Fuel Oil 20
NYH NYH
5 9 .2 5 5 2 .5 0
5 9 .7 5 5 2 .7 5
USSF USSF
6 6 .0 0 6 0 .0 0
6 7 .0 0 6 1 .0 0
10 0
S IN G
4 9 .5 2
5 0 .0 0
1985
1988
1991
1994
1997
2000
Source: Reuters, CSFB.
Source: IEA, CSFB.
Refining Capacity
Global refining capacity utilization has average 83% over the past ten years
Using the BP Statistical Review 2001 as a guide, we estimate global refining throughput capacity to be over 81MMBD, clearly in excess of the 76MMBD global oil demand. Over the past ten years global capacity utilization has averaged 83% with most of the excess capacity located in Asia, Europe, and the FSU while the U.S., the biggest product consumer, has had a relatively high utilization rate. (See Exhibit 18.)
24
Oil and Gas Primer

Exhibit 18: Global Refining Capacity Utilization, Ten-Year Average, Weighted
C a p a c ity U tiliz a tio n 100% 94% 90% 88% 86% 81% 80% 81%
14 May 2002
83%
60% 56%
40% N o rth A m e r ic a S . & C e n t. A m e r ic a E u ro p e F o rm e r S o v ie t U n io n M id d le E a s t A fr ic a A s ia P a c ific G lo b a l
Source: BP Statistical Review of World Energy 2001, CSFB estimates.
Refining margins are the number one indicator of the health of the refining business
The capacity glut in Asia and Europe has been negative for refining margins in those areas over the past five years, whereas margins in the U.S. have moved higher than in the first part of the 1990s. (See Exhibit 19.) Refining margins, which are widely published by various industry trade papers and magazines, are the number one indicator of the health of the refining business. We discuss refining margins in greater detail in the Downstream section. Below, we show historical refining margins for the three major markets: U.S. Gulf Coast, Rotterdam (Northwest Europe [NWE]), and Singapore.
Exhibit 19: Global Refining Margins
US$/bbl
Global refining margins and returns have generally trended lower as a result of excess capacity
NW E $11
G ulf C oast
Singapore
$9
$7
$5
$3
$1
($1) Apr 91
Apr 92
Apr 93
Apr 94
Apr 95
Apr 96
Apr 97
Apr 98
Apr 99
Apr 00
Apr 01
Apr 02
Source: Platts Oilgram, CSFB estimates.
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Oil and Gas Primer
14 May 2002
Product Demand
We list global consumption numbers for the major product families in Exhibit 20. We can see that consumption of refined products nearly equates the crude oil consumption figures we presented in Exhibit 12, with minor differences attributable to processing gains and losses, and inventory changes.
Exhibit 20: Oil Consumption by Products, 2000
million barrels daily
Region North America USA Latin America FSU Europe Middle East Africa Asia-Pacific World Oil Product Demand
Gasoline 10.0 8.8 1.3 4.2 0.9 0.6 5.4 22.3
Middle Distillate 6.8 5.8 1.7 6.6 1.5 1.0 7.7 25.3
Fuel Oil 1.4 0.9 0.7 1.9 1.2 0.5 3.3 9.0
Others 4.1 3.5 0.7 2.6 0.6 0.3 3.2 11.5
Total Demand 22.3 18.9 4.4 5.5 15.3 4.1 2.3 19.6 73.5
Source: BP Statistical Review of World Energy 2001, CSFB estimates. Individual product data excludes the FSU and Central Europe.
Product demand is driven by industrial production in addition to GDP growth
We forecast product demand based on expectations for industrial production and GDP growth forecasts as we did for determining crude demand estimates. Overall product demand is closely correlated to industrial production, particularly in the U.S. (See Exhibit 21.) Like crude demand, product demand is price elastic. Sustainably high prices curb consumption while low prices entice consumption.
Exhibit 21: Correlation between U.S. Gasoline Demand and Industrial Production
1 8 0 1 7 0 1 6 0 1 5 0 1 4 0 1 3 0
2
9 ,0 0 0 8 ,7 5 0 8 ,5 0 0 8 ,2 5 0 8 ,0 0 0 7 ,7 5 0 R
= 98%
Industrial Product Index (SA, 1992=100)
1 2 0 1 1 0 1 0 0 9 0 8 0
7 ,5 0 0 7 ,2 5 0 7 ,0 0 0 6 ,7 5 0 6 ,5 0 0
1 9 8 5 1 9 86 1 9 8 7 19 8 8 1 9 89 1 9 9 0 19 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 96 1 9 9 7 1 9 9 8 1 9 99 2 0 0 0 20 0 1 2 0 02 In d u s tr ia l P r o d u c tio n In d e x ( 1 9 9 2 = 1 0 0 ) G a s o lin e C o n s u m p t io n
Consumption of many petroleum products displays seasonal patterns. For instance, U.S. consumption of gasoline peaks in the summer when most people take vacations (i.e., the driving season), and demand for middle distillates usually peaks in winter owing to a rise in demand for heating fuel. Refiners typically adjust their output to offset changes in these demand patterns, shifting between gasoline or distillate production, depending on the season. Commensurate with the peak summer driving season, U.S. refining margins are highest during the second and third quarters and lowest in the first and fourth.
26
Gasoline Consumption (MBD)
Oil and Gas Primer
14 May 2002
Crude and Product Inventories

Crude inventories lead product inventories by five to six months
The difference between production and consumption of crude and refinery products results in changes to inventory levels. Every week the American Petroleum Institute (API) reports levels of and changes in U.S. crude and product inventories. Our research suggests crude inventories lead product inventories by five to six months in the U.S. (See Exhibit 22, left chart.) European oil stocks data are released on a monthly basis by the IEA and Euroilstock, while Asia and Latin America stock data are more difficult to come bythe level of coordination and sophistication of data collection are less robust than in the U.S. and Europe. Data from these regions largely come from national oil companies, quasi-government agencies, and estimates from local industry sources.
Exhibit 22: U.S. Crude and Product Inventories and Refining Margins
Crude Inventories lead Product Inventories
25%
Crude Product
US Refining Margins correlation to Product Inventories

40% 30%
Gasoline & Distillate weighted average deviation from mid-cycle inventory levels Deviation from mid-cycle level of 3-2-1 Gross refining margin ($/bbl)
($10) ($8) ($6)
20% 15%
% from 5-yr avg level
10% 5% 0% -5% -10% -15% -20% Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01
20% ($4) 10% 0% ($2) $0 $2 $4 $6
-10% -20% -30%
66% correlation
Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02
$8 $10
-40% Jan-98
Industry turnarounds or maintenance, which takes capacity offline, also impact inventories and product pricing
Inventory levels are also a major factor behind refining margins in addition to and related to throughput capacity, demand growth, and seasonal patterns. Below-average inventories tend to result in above-average margins and vice versa. The right chart in Exhibit 22 shows the correlation of U.S. refining margins to changes in inventory levels from 1998 through early 2002. As the chart shows, inventories were below historical norms from mid-1999 through mid-2001, leading to extremely high refining margins (inverted scale). The level of industry turnarounds can have a sizable impact on inventories, as they reduce available refining capacity. Given the level of intensity refinery equipment operates under, refiners must take plants offline (turnaround) to fully repair damaged or rundown machinery in order to maintain optimum operating productivity and optimum safety levels. Refinery operators typically schedule turnarounds up to several months in advance, and most often schedule for periods expected to have low demand when product prices are lowest. Commensurate with our evaluation of the global oil market, including oil products, is our analysis of the natural gas markets. While different commodities, they both serve the same end markets and can be substituted for one another in various applications. This substitution or arbitrage factor limits oil and gas prices from decoupling over extended periods of time. We discuss natural gas markets in the next section.
27
$/bbl inverse RH scale
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Natural Gas Markets

In the Oil Markets section we presented the global oil reserves landscape and production trends, and described our forecasting methods for the macro oil environment: supply and demand, leading indicators, inventories, and capacity utilization. However, we spent little time addressing natural gas markets.
The gas business is regional owing to the limitations of regional infrastructure, regional transportation, and regional currency pricing
The gas business is regional owing to the limitations of regional infrastructure, regional transportation (i.e., gas does not go easily on/in a ship), and regional currency pricing. While there is not yet a global gas market comparable with the oil market, technologies that convert natural gas into liquefied natural gas (LNG) or natural gas-to-liquids (GTL) have made major inroads to establishing the long-haul transportation for stranded natural gas reserves. Several Integrateds, Gas and Power companies, and Independent E&Ps are currently attempting to increase the viability of each technology to facilitate global trade. The aggregate global value of natural gas markets is approximately $200 billion per year based on recent demand of 232 bcf/d and average recent prices of $3.00/mcf. The U.S. is the largest single wholesale producer market, at $75-plus billion, accounting for 33% of the aggregate global market. We expect global natural gas use to increase in the coming years for the reasons we discussed plus gass clean environmental attributes relative to other fuel sources, and its abundant, relatively untapped reserve base. Additionally, oil and gas companies worldwide project their natural gas production profiles to increase at higher rates than their oil growth rates in the years to come. Given the regional nature of the natural gas market, we introduce the business in terms of global reserves and supply/demand to provide a framework; however, we will focus on the North American market, which is the most definable single marketplace. Keep in mind that the analysis of the oil markets serves to underpin and support our forecasts and outlook for the natural gas markets.
The aggregate global value of natural gas markets is approximately $200 billion per year based on recent demand of 232 bcf/d and average recent prices of $3.00/mcf
Global Natural Gas Supply and Demand Framework

The Middle East, the FSU, and Africa contain the largest amount of global proved natural gas reserves; however, production is dominated by North America
The distribution of global proved natural gas reserves is somewhat different than the distribution of the worlds proved oil reserves. (See Exhibit 23.) The Former Soviet Union (FSU)led by Russiaat 2,002 trillion cubic feet (Tcf) (56.7 trillion cubic meters [Tcm]) is the worlds natural gas reserves leader, followed by the Middle East with an estimated 1,854 Tcf (52.5 Tcm) of proved reserves and Africa with 395Tcf (11.2Tcm). Technological improvements, new discoveries, depletions, and prior year reserve revisions can lead to yearly fluctuations in these estimates with some regions, particularly the FSU and Middle East, showing varying reserves from year to year. The natural gas production profile is vastly different than the proved reserves profile as was the case with global oil reserves and production. (See Exhibit 24.) North America produces 72 bcf/d, followed by the FSU at 70 bcf/d. The FSU production profile matches nearly perfectly to the oil production profile that shows a sharp drop in production following the collapse of the Soviet Union. We believe this trend has bottomed and has begun to reverse, and we anticipate gas production to increase in the coming years following heavy investment in the upstream sector in the latter half of the 1990s and into the 2000s. Western Europe, while resource poor compared with the other regions of the world, has the third highest natural gas production, at 27 Bcf/d, as befits a mature 28
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producing and consuming market. As the natural gas business becomes increasingly global, albeit at a slow pace, through the application of new technologies, and distant sources of supply become more heavily relied upon to meet growing demand, we expect the Middle East, Africa, and Asia-Pacific to supply an increasing amount of the worlds gas needs.
The worlds consumption makeup closely follows the production profile, with North America, FSU, and Western Europe making up the majority of total global demand
The worlds consumption makeup closely follows the production profile, with North America, FSU, and Western Europe making up the majority of total global demand. (See Exhibit 24.) The charts also demonstrate that North American supply and demand is relatively well-balanced, while the FSU has excess production, which can be exported. Europe, however, has faced an increasing supply deficit for the past 20 years.
Exhibit 23: Global Natural Gas Proved Reserves, 2000
Source: BP Statistical Review of World Energy 2001.
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Oil and Gas Primer

Exhibit 24: Global Natural Gas Production and Consumption
bcf/d
Production
90 80 70 60
14 May 2002
Consumption
90 80
FSU/E. Europe
70 60
FSU/E. Europe
North America
50 40 30 20 10 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 50 40
North America
W. Europe W. Europe Asia-Pacific Middle East Africa Latin America

0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 30
Asia-Pacific
20 10
Middle East Latin America Africa
Before fully addressing the North American natural gas market, we briefly discuss the two other regional marketsEurope and Asia-Pacific. Europe, with a long-time focus on oil projects, has fewer natural resources on the continent than other regions and is faced with a maturing North Sea. Given Europes focus on oil investments, there exists a limited infrastructure to transport natural gas from distant sources (FSU, Middle East). Further hindering the development of the natural gas business in Europe has been the balkanized markets and natural gas pricing mechanisms. Until 2000, natural gas prices had been tied to oil prices, limiting competitive pricing mechanisms and free market dynamics. European E&Ps have undergone significant consolidation, largely into bigger Integrated Oils companies, and the industry offers little to investors in terms of supply growth potential and equity market opportunities. Asia-Pacific is altogether a different story than the North American and European markets. It is a geographically diverse market, making transportation from supply source to end-market difficult and costly. Natural gas price regulation throughout Asia-Pacific has also been an issue similar to that in Europe. Oil consumption/reliance makes up a greater percent of overall energy consumption than in North America and Europe, leading to a currently small end market for gas. Despite these challenging dynamics, the resource base is substantially greater than in North America and Europe and is also less developed than the other regions. Furthermore, natural gas discoveries have occurred at an increasing rate the past ten years and there has been substantial progress in infrastructure investments, which should serve to change the oil dependence dynamic in the future.
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North American Natural Gas Market

North America is the largest single natural gas market based on the level of oil and gas consumption, free market structure, and the sheer number of publicly traded Independent companies
Given its maturity, the level of oil and gas consumption, free market structure, and the sheer number of publicly traded Independent companies, the North American market is the largest natural gas market. We estimate the North America wholesale market to be a roughly $75-plus billion annual market based on recent gas prices of $3.00/mcf and annual U.S. and Canadian production of 72 bcf/d. The market is driven by the U.S., which accounts for over 50% of supply and over 80% of consumption. This U.S. supply/demand imbalance leads to a very large role for Canada in meeting U.S. gas needs. We formulate supply and demand estimates for the U.S. and Canadian markets and resultant price expectations based on several factors, including current inventories, seasonal demand patterns, productive capacity, competing fuels prices, and marginal costs. (See Exhibit 25.)
U.S. Natural Gas Supply

Beginning with productive capacity, we determined that wellhead utilization has been running near 100% for the past few years and stands to remain at full capacity in the years to come. This high utilization rate is directly related to demand growth outstripping supply growth and a lack of opportunities to dramatically increase supply given the maturity of the U.S. market. Prices have risen through the time period as a result. High utilization has not only pushed up gas prices, but has forced producers to search for new ways to increase capacity (i.e., unconventional sources, marginal wells).
Given resource constraints in the U.S., we expect imports from Canada and LNG imports from around the world to counter increasing supply deficits
In addition to high productive capacity utilization rates, the U.S. market is characterized by high decline rates (i.e., the rate of reserve decline in the first year of production is very high). The maturity of the U.S. market limits producers ability to increase traditional sources and has forced them to take on nontraditional, riskier, costlier sources of natural gas exploration and development. These nontraditional sources of gas production include coal-bed methane, coal seams, shallow gas, and natural gas hydrates. Despite efforts to increase domestic reserves through nontraditional sources, imports have become an important source of U.S. natural gas needs. Imports account for 18% of U.S. demand and are growing, with Canada making up the vast bulk of the import load. In addition to increased Canadian pipeline imports from recent infrastructure builds, liquefied natural gas has increased as an import source.
Exhibit 25: CSFB U.S. Supply-Demand Model
bcf/d, unless noted otherwise
Supply
1999
2000
2001
2002E
U.S. Canada and Other (LNG) Total Supply U.S. % change Canada & Other % change Total supply % change Demand % change Wellhead Utilization Excess capacity (bcf/d) Net storage change (bcf/d) Storage change (bcf/d) Effective utilization
Source: CSFB estimates.
51.0 9.4 60.4 -0.5% 14.3% 1.6% 59.5 2.1% 98.4% 0.9 (207) (0.6) 97.5%
50.1 9.7 59.8 -1.7% 3.4% -0.9% 62.3 4.8% 104.1% (2.5) (845) (2.3) 100.2%
50.9 10.5 61.4 1.5% 8.3% 2.6% 60.0 -3.6% 97.8% 1.4 817 2.2 101.4%
50.1 10.8 60.9 -1.5% 2.5% -0.8% 60.5 0.8% 99.4% 0.4 200 0.5 100.3%
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Given the increasing U.S. supply shortfall and higher U.S. gas prices, we expect the once cost-prohibitive LNG to become a bigger source in the coming years, with Africa, Asia-Pacific, and Latin America becoming prominent LNG suppliers. The LNG business represents the first steps in the globalization of the natural gas business. The ability to transport LNG long haul in tankers provides a major outlet for stranded gas reserves in remote areas.
U.S. gas prices, similar to oil prices, are negatively correlated to inventories
U.S. gas prices, similar to oil prices, are negatively correlated to inventories, as Exhibit 26 demonstrates. As inventories shrink from surplus to deficit, gas prices rise. In Exhibit 26, we graph the 12-month strip price to inventory changes (inverted) to understand the near-term outlook for price expectations, not simply the current physical spot price.
Exhibit 26: U.S. Natural Gas Storage versus 12-Month Natural Gas Strip Prices
-1,000 Y-o-Y Change Strip $6 -500 Y-o-Y Inventory Change (Bcf) Inverted $5 Natural Gas Price ($/mcf) $7
0 $4
$3 500
$2
1,000 $1
1,500 Apr95
$0 Oct95 Apr96 Oct96 Apr97 Oct97 Apr98 Oct98 Apr99 Oct99 Apr00 Oct00 Apr01 Oct01 Apr02
Source: EIA, Reuters, CSFB estimates.
The 12-month strip is an average of the 12-month futures curve and is driven to a large degree by the current inventory picture and current demand; however, the back end of the futures curve is driven more by expectations several months to a year or two out. This set of expectations impacts our supply forecasts because strip pricing is a valuable tool for producers that plan to raise production levels in an attempt to take advantage of high strip prices or lower production to wait for inventories to return to normal. Gas wells take much less time to drill and bring to market than oil projects, and producers can make decisions that impact the market in a short time period.
High North American decline rates, low inventories, and higher demand have led to higher gas prices
The big jump in U.S. natural gas prices over the past two years has been characterized by a period of inventory deficits, increased demand, and diminished supplies. U.S. production has not kept pace with consumption, and new discoveries have been hard to come by. The reserve life (reserve base/production) for the U.S. has been flat to declining for years. Canadian production and increased export capacity, which have both increased over the past decade, have eased the U.S. supply burden, but Canada
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also faces a declining reserve life. Canadian reserve life has fallen from 20 years in 1990 to just under 10 years in 2000, very close to the U.S.s 9-year reserve life. (See Exhibits 27-28.)
Exhibit 27: U.S. Production and Reserve Life
20,000 18,000 12 16,000 Production (Bcf) 14,000 12,000 10,000 8,000 6,000 4,000 2 2,000 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 0
1,000 5.0 6,000 30.0
Exhibit 28: Canada Production and Reserve Life

14
7,000 35.0
Reserve Life (Years)
10 8 6 4
4,000
20.0
3,000
15.0
2,000
10.0
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
U.S. Production
U.S. Reserve Life
Source: CAPP, CSFB estimates.
U.S. Natural Gas Demand

U.S. natural gas demand is driven by the Industrial and Residential sectors
We can broadly define four types of end markets: commercial, industrial, residential, and electric generation. The U.S. natural gas business is driven by industrial (41%) and residential (22%) demand.
Exhibit 29: U.S. Natural Gas Market Statistics

Industry Uses space heating, water heating, cooking, air conditioning, appliances
40%
Composition of Natural Gas Demand, % based on Tcf

50%
Residential
41%
Commercial
heating, ventilation, air conditioning
30% 22% 20% 15% 10%
Industrial
process heating, cooling, refrigeration, machine drive, on-site electricity generation
13% 9%
Electric Generation
feedstock, process heating, electrochemical processes
0% Industrial Residential Commercial Electric Generation Other
33
1999
0.0
Reserve Life (Years)
5,000 Production (bcf)
25.0
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14 May 2002
As U.S. natural gas is largely used for heating and cooling, the business has traditionally been very seasonal. (See Exhibit 30.) One noticeable trend, dating back to the early 1990s, is the higher rate of consumption through the summer periods. This has largely been a result of increased electric generation sector demand for natural gas. A large base of new gas-fired electric generators were built in the 1990s leading to increased natural gas use for generators meeting air conditioning and cooling needs in the summer months.
Exhibit 30: Seasonality of Natural Gas Demand
90.0
80.0
Consum ption Production+Im ports
Bcf per day
70.0
60.0
50.0
40.0
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Another piece of the gas price forecast puzzle is the price of competing fuels, largely oil products. Natural gas competes with fuel oil for electric generation and industrial use and as well as with heating oil for residential, industrial, and commercial heating needs. While only a certain amount of capacity in the electric generation and industrial markets is able to switch from one fuel source to another, long-term arbitrage possibilities exist if prices remain disparate over extended periods of time. Exhibit 31 charts recent competing fuel prices and the long-term comparison of WTI to natural gas. Heating oil has historically commanded a premium to natural gas as evidenced by the first chart, whereas resid and natural gas have tended to move together. The late-2000 to early-2001 period when natural gas prices increased to the highest levels ever represented the greatest historical gas premium pricing versus competing fuels and was the only time in the past decade that gas traded at a premium to WTI. (See Exhibit 31, right-hand chart.) The WTI premium to natural gas has gradually declined over time and we expect this trend to continue.
34
Jan-01
Jul-01
Oil and Gas Primer

Exhibit 31: Competing Fuel Prices
Natural Gas versus Heating Oil and Resid (per mmbtu) WTI Premium to Natural Gas (% mmbtu basis)
Resid 1.0%
14 May 2002
$12.00 $10.00 $8.00 $6.00 $4.00 $2.00
Natural Gas
Heating Oil
300%
200%
100%
$0.00 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02
0% Mar92
Mar93
Mar94
Mar95
Mar96
Mar97
Mar98
Mar99
Mar00
Mar01
Mar02
The final component to our gas price forecast is our analysis of the marginal cost of production. Similar to applying the cost structures of the Integrated Oils to develop a marginal cost curve for oil, we use U.S. Independent E&P cost data to construct a natural gas marginal cost curve. (See Exhibit 32.)
Exhibit 32: U.S. Natural Gas Marginal Cost Curve, 2001
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
$1.00 1999 Ave. 2000 Ave. 2001 Ave. DVN CHK NFX SKE FST COG EOG APC SGY BR THX
Using the above data (production, consumption, seasonality, inventory, resource potential, market uses, competing fuel prices, marginal cost curve), we formulate a price forecast for Henry Hub (U.S.) and Alberta (Canada) gas. We believe limited U.S. supply growth and higher demand will likely lead to higher natural gas prices as producers seek marginal, more costly, nontraditional sources of production. These nontraditional sources will continue to grow and support higher prices. The resulting higher price environment will make distant sources of natural gas more cost competitive (LNG, GTL). An increasing import environment will facilitate the globalization of natural gas and allow countries with excess natural gas supply to monetize gas assets.
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The Upstream
The upstream business involves Integrated Oils and Independent E&P companies involved in finding, developing, and producing hydrocarbons, and Oilfield Service companies
The upstream business is the largest part of the oil and gas chain in terms of net sales and net profits, returns performance, and security market liquidity. The business involves the finding, developing, and producing of oil and gas. Private (i.e., nonnational oil company) oil and gas producers fall into two general categories or business models: Integrateds, which participate in each part of the energy chain from production through retail distribution, and Independent Exploration and Production companies, which solely pursue production opportunities. A third party involved in the upstream process is the Oilfield Services and Equipment industry, which provides producers the necessary products and services to find, develop, and produce oil and gas as efficiently and as cost effectively as possible. In this section, we explain the economics of the upstream business as they pertain to producers. We address the Oilfield Services and Equipment industry in a later section.
Value Creation
Producers create value by adding low-cost oil and gas reserves to the balance sheet and by increasing production while maintaining return on capital
Producers create value by adding oil and gas reserves to the balance sheet, and by producing and selling these to generate a return above the cost of capital. Oil and gas reserves represent the true, tangible value of a company. Profitably adding reserves increases the producers net asset value. This is why large discoveries can have such a dramatic impact on the valuation of a producer, and depending on the size of the new resource relative to the existing company, can be a transforming event or company maker. Producers add reserves in several ways: through drilling (by the drill-bit), and through reserve acquisitions, either by acquiring fields (properties) or acquiring whole companies (M&A). The preferred or more profitable method to achieving reserve growth at a given time depends on the stage of the oil cycle and the relative cost of pursuing each strategy. Cyclical peaks coincide with peak equity valuations, making equity acquisitions costly in absolute terms and generally in relative terms when compared with the cost of increasing reserves through the drillbit (i.e., organic growth). The cost of pursuing an aggressive drilling program depends on the degree of access to new sources of oil and gas reserves, the level of oilfield service costs, and the ability of service companies to meet demand. In cyclical trough periods, equity valuations become depressed, generally to a level below the cost of adding reserves through the drillbit. Reserve acquisitions through property acquisitions or equity merger and acquisition activity are thus optimal during periods of depressed valuations (i.e., low commodity price environment).
Producers add reserves several ways through the drillbit (organic growth), and through acquisitions (either property acquisitions or equity mergers and acquisitions)
In Exhibit 33, we chart the values of each type of method using a universe of Canadian Independent E&Ps and Integrated Oils. The chart clearly shows how commodity prices and equity prices rise and fall within a fairly close time period while finding and development (F&D) costs remain sticky, or maintain high levels despite deteriorating pricing environments. In the late-1997 to early-1999 downturn, finding and developing costs were substantially higher than property acquisitions and equity acquisitionsa period where drilling activity fell sharply and merger and acquisition activity increased. In the most recent cycle from trough levels in early 1999 to peak conditions in mid-2000, mergers and acquisitions were the cheapest method of adding reserves early in the cycle, before commodity prices and stock prices ran higher. 36
Oil and Gas Primer

Exhibit 33: Reserves Growth Opportunities
$13
14 May 2002
$29 $11
$10.25
$24
$/BOE of Edmonton Par Equivalent
$9
$9.50
WTI Oil Price
$7.32
$7
$19
$5
$14
WTI Oil Price (Right)
M&A (EV)
Property Acq.
Drilling (F&D)
$3 Feb-98 Feb-99 Feb-00 Feb-01 Jun-98 Jun-99 Jun-00 Aug-98 Aug-99 Aug-00 Jun-01 Aug-01 Dec-97 Dec-98 Dec-99 Dec-00 Apr-98 Apr-99 Apr-00 Oct-97 Oct-98 Oct-99 Oct-00 Apr-01 Oct-01
$9
Source: CAPP, CSFB estimates.
A production company or upstream operation can be considered an asset gatherer, because it is a collection of properties, wells, and fields. Each well is part of a specific field and each field has specific characteristics or profiles (amount of reserves, type of reserves, cost structures, timelines, production rates, decline rates). The fields are then aggregated into a portfolio, which is the production operation. The portfolio concept is important in valuing whole upstream businesses.
The intrinsic value of a producer is the discounted cash flow or net asset value (NAV) of all fields currently producing and expected to produce in the future
The intrinsic value of a producer is the discounted free cash flow or net asset value (NAV) of all fields. A discounted cash flow can be constructed for each field using estimates for oil prices, production rates, finding and development costs, production costs, and time frames for the phases of the cycle (from exploration to abandonment). The aggregate sum of the discounted cash flows is the portfolio value of the assets (fields). Conceptually, a producer is similar to an investment manager. Both run diverse portfolios of assets (stocks, fields) with different risk levels, payout schemes, and timelines. Both evaluate the assets in a portfolio context (in relation to one another), not in isolation. In a commodity industry where all producers are price-takers, returns across companies are principally generated by different cost structures. A large driver of cost structures is the degree of difficulty in finding and producing the commodity. For example, easy-tofind-and-produce oil and gas will normally have lower costs than E&P projects in unproven, undeveloped, and remote areas. An additional and very important consideration to the value-creation potential and economics of upstream projects is the type and nature of contracts producers agree on with host governments, which are often protective of domestic natural resources. Oil and gas resources represent a large source of revenue for many developing countries.
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Therefore, many governments view the control of domestic oil and gas resources as a matter of national security and prohibit or limit foreign ownership of oil and gas assets. Countries that limit foreign ownership but lack national infrastructure to develop oil and gas assets may partner with more capable foreign producers. These international E&P arrangements come in many forms and are often more complex than the traditional E&P leases and working interest arrangements, which we will be focusing on throughout this report.
Governments and producers can form several different types of partnerships or agreements to explore for and produce oil and gas: concession agreements, joint venture agreements, or PSCs
Governments and producers can form several different types of partnerships or agreements to explore for and produce oil and gas:
Concession agreement. Government grants a permit allowing the producer to explore
for oil and gas for a fixed time period and to develop any found reserves through the life of the discovery. The producer agrees to pay the government a percentage of the profits, a flat bonus, or a royalty payment, or production tax. In a concession agreement, the government will not have any role in operations and the foreign producer takes economic ownership of the assets.
Joint venture agreement. Government-controlled or state-owned oil company partners
with a foreign producer, with the foreign producer bearing exploratory costs and risks.
Production sharing contract (PSC). Foreign producers agree to spend a specified
amount of money on exploratory operations over a predetermined time period; however, the government retains ownership of discovered reserves. The foreign producer is entitled to a share of production proceeds that may be tied to oil prices and production levels. Each of these types of arrangements shifts the risk and return balance from one party to another. The producer and the host government need to come to terms that are acceptable to both parties so that the economic benefit of undertaking a project(s) is acceptable to each. In order to more fully understand the value drivers (returns, cost structures, reserve and production growth) within the upstream, it is necessary to discuss the E&P process from beginning to end.
The E&P Process

The E&P process comprises five major phases and each of these phases has its own identifiable cost structure and timeline
The E&P process comprises five major phases and each of these phases has its own identifiable cost structure and timeline. The timing of the E&P phases is an important part of the financial planning of a producer because of the potentially long lead times from initial capital expenditures to cost recovery through the sale of the oil and gas. As Exhibit 34 shows, the exploration through development phases could take three years or more of capital spending before production comes online and producers begin receiving cash inflows. Given these lead times, producers need to carefully evaluate and analyze the economics of a field to ensure the profitable recovery of costs and the generation of adequate returns on capital. The most important considerations for producers include the following:
estimated acquisition and finding costs; quantity of recoverable oil and gas;
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Oil and Gas Primer

estimated development costs; timing of future production; estimated production costs; and estimated future oil and gas sales prices.
14 May 2002
We illustrate the flow pattern of the cost and value structure as it matches the upstream process in Exhibit 34.
Cost structures can be divided into exploration costs, development costs, production costs, and decommissioning costs
Acquisition costs are the costs of acquiring an economic interest for the right to
explore, drill, and produce oil and gas.

Exploration and appraisal costs represent the costs involved in identifying prospects,
seismic costs, and exploratory drilling costs. These are also known as finding costs.
Development costs are the costs of development planning, reservoir modeling and
optimization, well design plans, drilling and completion of wells, and installing the gathering and processing infrastructure. Exploration costs are often linked to development costs and the two are referred to as finding and development costs (F&D). F&D costs are a significant part of the cost structure for producers, and are largely comprised of drilling (development) costs. They also provide a key metric for evaluating operating and financial performance.
Production costs are the costs associated with lifting the oil and gas to the surface
and gathering and processing the hydrocarbons for transportation. Depreciation, depletion, and amortization (DD&A) costs are often added to or incorporated in production costs given that capitalized F&D costs represent the asset value of reserves on the balance sheet. We provide an example of this concept on page 42.
Decommissioning and abandonment costs are the costs involved with plugging and
abandoning (P&A) a dry-hole appraisal well or a mature field that is no longer in production. Each of the above costs varies depending on the field characteristics (type of rock formation, the porosity, and permeability), location of the field, and supply and demand for drilling rigs and drilling services. High porosity, high permeability fields are less expensive than low porosity, low permeability fields because they require less extensive extraction methodsthe abundance of hydrocarbons and the natural pressures force the hydrocarbons to the surface. Periods of high drilling activity lead to high rig utilization rates and increased costs for drilling services, pushing drilling costs higher.
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Exhibit 34: E&P Process
Land Acq. & Exploration
Appraisal
Development Design
Production & Maintenance Abandonment Fabricate Install Produce Maintain Abandonment
Prospect Target Acquire Appraisal Drill Appraisal Test
Prospect identification & evaluation
Identify potential partners

40
Geological & Geophysical data interpretation
Finalize partnership (JVs, PSC, Concession) agreements
Manage drilling operations Reservoir appraisal Economic appraisal Development plan
Implement plan & Install Infrastucture
Ongoing Operations
12
3-4 Time (Years)
45
5 - beyond
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Oil and Gas Primer

Equally important to the recognition of costs is the estimated quantity and value of discovered reserves recorded as a fixed asset on the balance sheet
14 May 2002
In addition to accounting for the costs of the E&P process on the income statement, producers capitalize the cost of finding and developing reserves on the balance sheet. These capitalized costs represent the asset value of the reserves. Producers also record the estimated quantity and value of discovered reserves as a supplement to their financial statements. There are several ways for a producer to recognize reserves:
Proven reserves (P1). Estimated quantities of oil and gas, which are reasonably
certain (90% probability or P90) to be recovered as certified by geological and engineering data.
Probable reserves (P2). Estimated quantities of oil and gas, which have a better-than-
50% probability (P50) of being recoverable.

Possible reserves (P3). Estimated quantities of oil and gas, which have a 10%
probability (P10) of being recoverable.

Proven developed reserves. Estimated quantities of oil and gas, which are expected
to be recovered from existing wells, existing equipment, and/or improved recovery techniques.
Proven undeveloped reserves. Estimated quantities of oil and gas, which are
expected to be recovered from undrilled acreage, existing wells that require large recompletion work, and improved recovery techniques. The process of assigning a monetary value to the reserves differs from country to country. In the U.S., only proven reserves can be stated in the reserves accounts, while in the U.K., values can be recorded for all types of reserves, but generally only P1 and P2. Reserves are valued using current market prices and revalued every quarter or year-end to account for revised reserve estimates, extensions, discoveries, and other additions, purchases, and sales. When the market prices fall below the recorded book value of the reserves, producers must write down the value of the asset base to current market expectations (ceiling test write-down). The fixed asset amount producers book on the balance sheet is based on the respective reserve level and current market prices. The concept of booking reserves is important in the valuation of producers because some producers may be more conservative (only book proven reserves) than others that book proven, probable, and/or possible reserves. Not all asset values are created equal; accounting vagaries can distort the picture of a producers true net asset value.
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Economics of One Barrel of Oil

In Exhibit 35 we provide an example of how one barrel of oil is accounted. Additionally, we include a return on capital employed (ROCE) calculation to demonstrate the economics of a barrel of oil.
Exhibit 35: Economics of One Barrel of Oil
capex Unsuccessful exploration a b Successful exploration Development costs a+b Profit and loss Sale of barrel Royalty/production tax Production cost Depreciation Exploration expense Operating income/ EBIT Income tax @35% Net profit $/bbl 1.00 1.00 3.00 4.00 Balance sheet 4 Cost of unit addition to fixed assets
20.00 -1.00 -4.00 -4.00 -1.00 10.00 -3.50 6.50
10 Reserve life ie how many units left for each unit produced
x y
Net profit Capital exmployed
6.50 40 16.3%
40 Capital employed = actual cost of adding barrels to reserves
x/y Return on capital employed
Source: CSFB estimates.
The example follows the beginning of the E&P chaina producer has a capital expenditure budget to find oil and gas. Successful exploration and development costs are capitalized on the balance sheet and dry-holes (unsuccessful exploration) are expensed immediately (under successful efforts accounting). The successful exploration and development costs added together (a + b in Exhibit 35) represent the cost of adding one unit to the reserve base. In the example above, F&D costs are $4.00 per barrel as is the DD&A, which is expensed on the income statement. Since F&D costs are added to the historical cost base, each time a barrel is sold, it must be removed from the balance sheet (i.e., depreciated). The F&D costs represent an approximation of depreciation rates (DD&A) in real world scenarios. They are not exact as we show in this example. This is primarily because F&D costs decrease over time because of new technology, while DD&A rates are averaged throughout the reserve lifetime. F&D costs are evaluated on three- to fiveyear averages to smooth out potentially wide varying yearly numbers. In the example, the producer has a $4.00 F&D cost structure and has successfully found 10 barrels (10-year reserve life = 10 barrels of reserves divided by 1 barrel per year production). The capital employed therefore is $40 ($4.00 F&D x 10 barrels). The return on capital employed is the net profit per barrel, $6.50, divided by the capital employed (cost of finding and developing all barrels, $4.00 x 10 = $40/bbl), or 16.3%. Applying recent Integrated Oils industry cost structures helps to frame the discussion. In the overall F&D cost component, development costs are substantially higher than the finding cost component, as Exhibit 36 demonstrates. Over the past ten years, finding costs have accounted for roughly 25-30% of the overall F&D component despite a general decline in industry finding costs from nearly $2.00 per barrel in the early 1990s to about $1.25 the past few years. Development costs have substantially varied from year to year but have also declined from over $6.00 in the early 1990s to the $4.50-5.50 range recently.
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Oil and Gas Primer

Exhibit 36: Global Integrated Oils F&D Costs
US$ per barrel
8.00 7.21 6.54 6.19 5.56 5.11 4.32 4.00 4.00 3.84 3.78 3.67 3.36 4.95 6.00 5.59 8.00 7.78
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Exhibit 37: Global Integrated Oils Lifting Costs

US$ per barrel
10.00 5.71 5.62 4.83 4.96 4.67 4.58 4.23 3.85
6.33 6.00
4.58
4.82
3.63
3.45
3.57
3.56
3.47
3.67
2.00 2.00
0.00 1991 1992 1993 Finding 1994 1995 1996 1997 1998 1999 2000
0.00 1991 1992 1993 1994 1995 DD&A 1996 OPEX 1997 1998 1999 2000
Finding & development
Reserve replacement
Production costs (Exhibit 37) have also declined in the past ten years, from over $5.00 per barrel to about $4.00, while depreciation rates have remained fairly constant in the mid to high $3.00 range. Depreciation rates (DD&A) are the total F&D cost divided by the estimated recoverable reserves. As we discussed, F&D costs should serve as a proxy for DD&A rates, as they represent the book value of oil and gas reserves sold. An additional type of cost we have yet to discuss is reserve replacement costs. Reserve replacement costs measure the total cost of adding reserves, both from drilling and from acquisitions. Finding and developing costs plus acquisition costs divided by the net reserve additions (i.e., reserve adds less production) provide the reserve replacement cost on a per barrel basis. These cost measurements are key operating and financial metrics for evaluating and comparing oil and gas equities. The sale of oil and gas production represents the revenue line and is highly affected by commodity prices and cost structuresnamely, commodity prices need to be higher than the all-in costs associated with producing a barrel of oil or a million cubic feet (mmcf) of natural gas. Higher production growth rates leading to higher sales combined with low cost structures enable higher returns performance. Production growth rates will vary from company to company; however, in aggregate the global supply growth rate is historically a small 1-2%. This is why cost structures are so important. Given a low production growth rate and equivalent exposure to commodity prices, differential returns between companies lie within their cost structures.
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The Downstream
The downstream business comprises refining, marketing, chemicals, and petrochemicals. We will concentrate on the largest, traditional sector within the energy businessrefining and marketing (R&M). Integrated Oil companies and Independent Refiners are the main participants in the business. The biggest difference between Integrated companies refinery operations and Independent Refiners operations is that Integrateds have the ability to supply their refinery operations with their own equity crude supply, while Independent Refiners must purchase crude supplies from producers. This leaves Independent Refiners open to crude price spikes and potential supply problems. A benefit, however, is the opportunity for Independent Refiners to procure crude supply from different producers as well as to shop for the best possible crude price. While often referred to in the same breath, refining and marketing are two distinct businesses with distinct economics and returns potential. The refining business is the bigger profit center of the refining and marketing complex, and it generally garners higher returns, albeit at a greater capital commitment. When discussing R&M operations, it is with a heavily emphasis on the R. In this section we will describe how we evaluate both operations, focusing mainly on refining.
Refining
Refiners create value by selling refined petroleum products at prices higher than their per-unit capital and operating costs
Refiners create value by selling refined petroleum products at prices higher than the cost of acquiring crude oil and transforming it into products. The most easily observed measure of the current health of the industry is by measuring refining margins, or the difference between product sales prices and operating and nonoperating costs including the cost of crude oil as the main input. Refining margins incorporate a number of important variables. At its most basic, a refining margin, or gross refining margin, is the difference in the value of the crude oil that goes into a refinery and the products that come out the other end. The value of the refined products is referred to as the netback. After subtracting the cash operating costs of a refinery, one is left with a cash refining margin, sometimes known as an EBITDA margin. The major determinants to refining margins include the following:
Cost of crude. Effectively the cost of goods sold. Crude grades (light/heavy,
sweet/sour) have varying price levels and can have a major impact on a refiners cost structure.
Product prices. Refineries will enjoy higher margins when their production slate is
geared toward higher-valued products (gasoline and distillate versus low-valued residual).
Refinery complexity. All refineries have a basic distillation unit, simple refineries have
a distillation unit with few additional units, while complex refineries have additional refining equipment that allows for increased production of higher-value products and allows for the processing of different crude grades.
Regional supply/demand. The cost of crude, product pricing, refining complexity and
capacity, and supply and demand are interrelated.
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Refinery throughput capacity and complexity are major variables in the value-creation process
14 May 2002
The first step in evaluating a refinery operation is to understand the amount of productive capacity, or the throughput of the refinery (refinery runs). The second variable and arguably the more important variable is the complexity of the refinery. The complexity of a refinery (simple or complex) is directly related to its initial cost to build and represents the primary level of capital investment on which we base our returns on capital analysis. Refinery configuration and product price spreads are key determinants of profitability. The distilling column is the bare essential for a refinery; additional parts hydrocrackers, cat crackers, and reformersare value-added components that allow refiners to produce higher-end product slates and process different crude grades. We refer to the different levels of product output as the yield, which we showed in Exhibit 15. Refiners shift between products depending on market conditions for each product. This is largely driven by seasonal factors (i.e., U.S. refiners shift production from gasoline to distillate in September following the end of the summer driving season, as gasoline demand wanes and distillate demand starts to build ahead of the winter heating oil season, and vice versa heading into the summer driving season). The additional parts of a complex refinery can be very costly to install and maintain; however, they allow a refinery greater flexibility to produce a greater variety of products. When evaluating refining operations, we analyze the type of refinery, its location and proximity to market, and the mesh between the product slate and regional demand patterns. When the spread between light and heavy crudes is high, complex refiners that process heavy crudes enjoy relative cost savings versus refiners that use light crude. The same dynamics work in the product markets; wide light-heavy product spreads generate greater profits for complex refiners that can produce more light products than heavy products. (See Exhibit 38.)
Exhibit 38: Crude and Product Differentials, Quarterly Average
$0.40 $8
$0.35
$7
$0.30
Gasoline-Resid Spread (US$/gal)
$6
$0.25
$5
$0.20
$4
$0.15
$3
$0.10
$2
$0.05
$1
$0.00 1Q97 2Q97 3Q97 4Q97 1Q98 2Q98 3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 Gasoline-Resid WTI-Maya
$0
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WTI-Maya Spread (US$/bbl)
Oil and Gas Primer
14 May 2002
The different types of refineries lead to simple margins and complex margins. Refineries of different complexity will give different percentage yields of the various refined products at the end of the process. This will affect the margin, which a refinery is able to generate, and for this reason we quote margins for two different illustrative refineries: a simple plant and a complex plant. The difference between these two essentially comes down to the yield of the higher-value products, which is greater at a complex refinery. Both refineries pay the same for the crude input, and despite the higher operating costs of a complex refinery, this generally means that complex plants generate higher margins. This is shown via two examples below. The crude and product prices used are an average of the prices applicable in April-September of 1998. The first example is for a simple refinery in Singapore running Dubai crude.
Exhibit 39: Singapore Simple Refining
Singapore sim ple U S$/bbl R efined products G asoline N aphtha Jet/Kerosene G as oil Fuel O il D ubai yield % 11.9% 5.1% 9.9% 24.4% 46.2% 97.5% Product prices 17.39 14.55 16.43 15.36 10.70 O utput va lue 2.07 0.75 1.63 3.74 4.94 13.1 C rude C ost G ross m argin O perating C ost C ash m argin
x x x x x
= = = = =
12.4 6 =
0.67 -
0.35 =
0.32
The product outputs do not add up to 100%, as some energy is used as refinery fuel and some energy is lost through the various processes. We have not adjusted for transportation charges on the crude, to simplify the illustration. The simple refiner produces a large proportion of low-value fuel oil, which reduces the value of the output or netback. The next example shows a complex refiner in Singapore running the same feedstock, Dubai crude, but earning a bigger margin owing to the refinerys ability to produce more of the higher-value products and less low-value fuel oil.
Exhibit 40: Singapore Complex Refining
Singapore complex US$/bbl Refined products Gasoline Naphtha Jet/Kerosene Gas oil Fuel Oil Total % Source: CSFB Dubai yield % 26.6% 7.4% 4.0% 38.6% 22.3% 98.7% Product prices 17.39 14.55 16.43 15.36 10.70 Output value 4.62 1.08 0.65 5.92 2.38 14.6 Crude Cost Gross margin Operating Cost Cash margin
x x x x x
= = = = =
12.46 =
2.19 -
0.45 =
1.74
The difference in margins is appreciable, but so is the cost of building a complex plant as opposed to a simple plant. In practice, complex refiners adapt their yield patterns to suit the market conditions prevailing at the time. The above example is illustrative only, but will approximate an average years yields. Simple refineries are unable to vary their outputs very much and consequently are more market constrained. The theoretical returns to a complex versus a simple refinery are usually expressed as the difference between these two margins. 46
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Marketing
The Marketing business can be separated into two parts: wholesale marketing and retail marketing. Wholesale marketing essentially refers to trade with large-scale customers and trade in global markets or on the various exchanges (NYMEX, IPE). Large-scale customers may be commercial or industrial users, or wholesale distributors, or even marketing subsidiaries of the refining operators themselves. Retail marketing represents the final part of the oil and gas chain. Retail encompasses the sale of petroleum products to the end-use markets. Unlike the wholesale markets that involve numerous contract types and product types, retail markets serve end users on a spot, transactional basis, typically offer only one product, and have a tax component. For example, we go to retail gas stations to fill our cars with gasoline, we contact a heating oil company to fill our heating oil tanks, and we go to a propane distributor to refill our barbecue or cooking fuel tanks. Each transaction is a separate, taxable event for the consumer. We will concentrate the discussion on the retail gasoline business, as it is the largest single product business and the one with which people are most familiar. Retail margins are the key to profitability in the marketing business. (See Exhibit 41.) We monitor retail margins (excluding taxes) on a regular basis to gain an understanding of how marketing operations are performing. The retail business is highly competitive and operators compete both on price and gasoline quality.
Exhibit 41: Retail Marketing Margins
US Composite: Weekly Conventional Regular Retail Margin (cents/gal) 45 40 35 30 25 20 15 10 5 Jan Feb Mar Apr Apr May Jun Jul Aug Sep Oct Nov Dec 10 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 30 20 50 40
5YR Avg 2002 2001
European Retail Margin (cents/gal) 60

5-Yr Avg 2002 2001
Gasoline sales, apart from location, are driven by competitive pricing, facilities and equipment, a low-cost structure, and focused marketing. Wholesale gasoline costs can also have a major impact on retail operations, depending on the ability of the retail operator to pass costs on to the consumer. The demand for gasoline not only affects gasoline sales, but also affects other parts of the retail operation. Decreases in demand would tend to coincide with lower store traffic and therefore lower sales of higher-margin merchandise and ancillary products. The retail gasoline business has dramatically changed over the past several decades as retail operators have searched for ways to increase profit opportunities and increase value-added services for consumers. This has brought a shift in the business away from the traditional, independently owned service station offering full-service pump
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attendants, and on-site mechanics for tune-ups and repairs, to more modern stations offering cleanliness, merchandise, food, and gas geared to the quick refill and customer convenience. Modern retail operations have both a merchandise component and the traditional gasoline component. Merchandising, or the provision and sale of food service, candy, beer, other beverages, and tobacco products, has become an important source of higher-margin sales. Successful merchandising efforts revolve around stocking brand-name, high-demand items, presenting appealing promotional displays, having an aesthetic store presentation, and most important, attracting customers to the location, which is driven by the purchase of gasoline.
Branded gasoline is generally more expensive than unbranded given the level of R&D and marketing spending that goes into the successful distribution of a name brand product
Retail operators purchase their gasoline supplies under long-term or short-term supply agreements with oil companies (branded) or from independently owned distributors (unbranded). Rack prices refer to the market price or stated price quoted at each regional terminal. Gasoline pricing, as stated above, is a major competitive factor for a retail operation. The pricing scheme may be driven by the type of retail operator (company-owned and operated, franchisee, independent owner) and the marketing program employed. Integrated Oils and Refiners generally commit substantial research and development dollars into improving the quality of gasoline and determining different price breaks and grades of gasoline (regular, mid-grade, premium) to support their brands. Branded gasoline is generally more expensive than unbranded, straight run gasoline sold at wholesale prices. Independent retail owners may elect to enter into agreements with Integrated Oils companies or Refiners to market and sell branded gasoline, or may elect to buy unbranded gasoline from a regional terminal. This second method allows the independent operator to eliminate the R&D component and marketing and distribution costs from his wholesale purchase price, which he can then pass the savings on to his consumers or try to widen his profit margins. The decision to sell branded or unbranded gasoline is largely a function of the local or regional price elasticity for gasoline and the general economic wealth of the region. The final sale of gasoline to the end user is the end of the oil and gas chain. Exhibit 42 shows the economic flow of one barrel of oil from the upstream process to the refining stage to the retail stage. As a subset, we convert the per barrel economic flow into a per gallon flow of gasoline to more easily portray the components of retail gasoline pump prices. Clearly, crude prices will fluctuate with wholesale global energy markets, as we previously mentioned, and retail operators will at times be able to pass on higher costs to consumers. The retail cost of gasoline largely comprises crude oil costs and federal and state taxes; surprisingly, the refining and distribution/marketing components are much less of the cost than might be expected. In the U.S., federal, state, and local taxes fluctuate with changing wholesale and retail prices (28% of the total cost in 2000) and are generally less than in Europe and other regions, which have much higher tax components, in some cases reaching 85% of the total cost.
The largest component of gasoline prices in the U.S. is the cost of crude, followed by taxes; the refining and distribution and marketing components are relatively small
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Exhibit 42: Economic Chain of One Barrel of Oil (Lower Right Subset Is a Conversion of One Barrel into One Gallon of Gasoline)
$70.00
Final Sales Price to End-Use Consumer = $62.00
$60.00 Fed. Taxes = $8.30
$50.00
Retail Product Price (ex-Taxes) = $44.60 Wholesale Product Price = $37.00 Refinery Profit = $3.40 = 10% Other Costs = $2.00 Refining Cash Costs = $4.00 Transportation Costs = $0.85 Profit = $8.250 = 31%
State Taxes = $9.10
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$40.00 $30.00 Crude Oil Price = $26.75 $20.00 $18.50 Marginal Cost Curve Other/Overhead Costs = $4.70 DD&A Costs = $3.70 $10.00 Operating Costs = $4.50 Finding & Developing Costs = $5.60 $0.00 Upstream Refining
Retail Marketing Profit = $2.35 = 6% Marketing Costs = $3.00 Retail Operating Costs = $2.00 Transportation Costs = $0.25
Retail
Final Sales Price
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Oil and Gas Primer
14 May 2002
Integrated Oils
The Integrated Oil industry is characterized by large, predominantly global oil companies with operations throughout the oil and gas chain
The Integrated Oils industry is characterized by large, predominantly global oil companies with operations throughout the oil and gas chain. Integrateds have E&P operations, refining and marketing operations, chemical operations, and, in some instances, petrochemicals business. The maturity of the U.S. oil and gas market has forced the largest Integrateds to increase their focus on new, high potential, highly capital-intensive international areas, leading to a period of considerable consolidation since the mid-1990s. Throughout this time, National Oil Companies in resource-rich regions have emerged as major global players, given home market monopolies. Our coverage universe of Integrated Oils companies comprises the Super Majors, regional companies (U.S., Europe), and National Oil Companies, or Emerging Markets Integrateds. (See Exhibit 45.) The traditional breakdown between U.S. and International Integrateds is no longer useful given the cross-border nature of the M&A activity and the increasing focus on international operations by all companies. Our analytical framework for the Integrated Oils is based on several key tenets, listed below.
Our research suggests shareholder performance among the Integrateds is largely driven by companies ability to generate high returns on gross invested capital
Returns on capital (particularly relative to market returns) drive valuation ratings and
shareholders returns.
Reinvestment rates and capital discipline are the key drivers of returns on capital. Oil is a low-growth industry, and it is extremely difficult for large companies to show
substantially above-average growth rates without compromising returns on capital. Our research suggests shareholder performance among the Integrateds is largely driven by companies ability to generate higher returns on gross invested capital (ROGIC) rather than ability to generate high production growth and cash flow. (See Exhibits 43-44.) ROGIC evaluates a companys ability to generate value-added returns on its investment at original cost. Along with superior shareholder performance is a commensurately higher valuation premium on higher return companies.
Exhibit 44: Global Integrateds Performance versus Cash Flow
30
Exhibit 43: Global Integrateds Performance versus ROGIC

30
25
TOT XOM
25 XOM
TOT
Avg TSR % 1995-2000
20 TX 15 OXY OMV 10 PCA MRO NHY AHC ARC P
Avg TSR % 1995-2000
MOB REP CHV
BP SC RD ENI
20
MOB
SC RD TX
BP
ENI 15 CHV ARC NHY 10 AHC MRO P OMV OXY
REP PCA
0 4% 5% 6% 7% 8% 9% 10% 11% 12%

0 0% 5% 10% 15% CFPS growth 1995-2000 20% 25% 30%
Average ROGIC 1995-2000
Source: Company data, Reuters, CSFB estimates.
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The Super Majors have had greater success generating excess returns on capital than their industry peers because of their ability to spread costs over a larger fixed-asset base and their cost-cutting efforts brought about mainly by consolidation. The Super Majors have also enjoyed better access to select new producing areas such as West Africa; this is due to the requirements of host governments to deal with well-funded, technologically advanced entities. The other Integrateds are generally much smaller from a capital perspective than the monolithic Super Majors and have a higher concentration of assets in select regions (U.S., North Sea). The other Integrateds also are generally more leveraged to commodity prices than the Super Majors. The Emerging Markets companies are the partially or formerly state-run oil companies that have floated public equity within the past ten years, have begun to expand their operations beyond domestic borders, and have also begun to realize efficiency gains from being privately run.
Exhibit 45: Global Integrated Oils
MARKET DATA PRICE MKT FX 5/13/02 CAP USD USD USD USD USD USD 52.05 90.10 40.01 55.26 45.47 77.73 194,810 95,513 271,796 116,040 73,822 104,625 DAILY STOCK PERF. % REL. % 2.0% 2.4% 2.7% 2.3% 2.0% 1.9% 2.2% 80.79 28.35 75.00 28.84 51.70 60.96 43.36 27.97 11.93 8.49 7,166 17,756 58,567 8,926 13,308 23,243 11,369 7,334 14,563 18,377 12,794 26,960 66,634 13,232 17,938 32,143 15,189 9,930 30,945 23,009 3.0% 1.5% 1.7% 1.8% 1.1% 1.6% 1.3% 0.6% 1.9% 1.9% 1.6% -0.8% 0.9% 0.7% 0.5% -0.5% 1.7% 0.6% 0.8% 1.4% 0.7% 0.8% N/A N/A N/A 0.4% 1.8% -3.5% 0.0% -0.2% 0.7% 1.9% 0.8% -0.8% 0.1% 3.7% 4.2% 4.5% 4.1% 3.8% 3.7% 4.0% 4.8% 3.3% 3.5% 3.5% 2.9% 3.3% 1.8% 2.4% 3.7% N/A 3.2% -1.5% 0.2% 0.0% 0.5% -1.2% 1.0% -0.2% 0.1% 1.5% -0.1% 0.2% 6.31 1.48 5.78 1.66 3.20 2.47 2.52 1.60 1.00 0.64 6.47 1.66 5.49 1.91 3.04 3.59 2.43 1.54 0.88 0.59 CLEAN EARNINGS EPS P/E 02E 03E 02E 03E 2.50 4.42 1.75 2.69 2.35 4.43 2.69 5.68 2.07 2.78 2.49 4.41 20.8 20.4 22.8 20.5 19.4 17.5 20.2 12.8 19.1 13.0 17.3 16.2 24.7 17.2 17.5 11.9 13.4 16.3 21.5 20.4 12.7 15.0 7.0 11.6 19.7 18.9 12.2 17.1 15.4 8.1 11.4 9.5 8.7 5.0 6.7 4.8 8.8 8.8 8.8 8.8 7.6 8.4 14.4 19.3 15.9 19.3 19.9 18.3 17.6 18.4 12.5 17.1 13.7 15.1 17.0 17.0 17.8 18.2 13.6 14.5 15.6 17.5 18.9 13.4 15.7 7.1 13.2 19.2 17.9 13.3 17.2 15.1 8.5 13.6 10.9 7.1 4.7 7.6 4.8 11.0 11.0 6.9 6.9 7.8 8.7 13.9 19.71 5.39 11.82 7.54 9.88 7.66 7.00 4.43 3.34 1.67 17.86 5.34 11.99 8.02 9.59 8.85 6.91 4.37 3.32 1.69 LEVERED CASHFLOW CFPS P/CF 02E 03E 02E 03E 4.67 9.44 3.10 4.86 4.23 8.42 4.98 10.96 3.36 5.06 4.53 8.60 11.2 9.5 12.9 11.4 10.7 9.2 10.8 4.1 5.3 6.3 3.8 5.2 8.0 6.2 6.3 3.6 5.1 5.4 10.5 10.9 6.2 4.8 3.4 3.5 10.9 10.5 4.7 9.0 7.3 5.3 8.3 8.7 4.7 3.5 4.4 3.6 3.7 3.7 2.6 2.6 5.5 4.8 6.7 10.5 8.2 11.9 10.9 10.0 9.0 10.1 4.5 5.3 6.3 3.6 5.4 6.9 6.3 6.4 3.6 5.0 5.3 9.0 10.2 6.1 5.0 3.5 3.5 10.5 9.8 4.6 8.8 6.9 5.4 9.0 9.6 4.3 2.6 4.2 2.4 4.3 4.3 2.7 2.7 5.5 5.0 6.5 1,938 3,427 8,434 2,129 2,697 3,271 2,003 1,268 4,312 3,875 1,772 3,453 8,281 2,226 2,617 3,741 1,905 1,206 4,242 3,926 UNLEVERED CASH FLOW VALUE ADDED EBIDAX EV/EBIDAX EV/GIC ROGIC 02E 03E 02E 03E 02E 02E 03E 19,090 20,343 10,877 12,369 23,905 25,505 11,576 11,819 7,717 7,880 11,929 12,169 11.6 10.4 11.7 10.6 10.1 9.5 10.7 6.6 7.9 7.9 6.2 6.7 9.8 7.6 7.8 7.2 5.9 7.4 10.2 11.4 7.5 6.1 3.8 7.0 10.4 10.0 5.5 9.3 8.0 5.5 3.7 5.1 6.2 4.2 5.4 5.1 4.6 4.6 4.3 4.3 5.9 4.9 7.4 10.9 9.2 10.9 10.4 9.9 9.3 10.1 7.2 7.8 8.0 5.9 6.9 8.6 8.0 8.2 7.3 5.9 7.4 8.8 10.7 7.7 6.3 3.7 7.2 10.1 9.8 5.4 9.1 7.7 5.6 4.1 5.7 5.0 4.0 5.3 5.2 5.0 5.0 3.8 3.8 6.0 4.9 7.2 104.2% 91.0% 102.4% 109.7% 104.9% 95.8% 101.3% 56.5% 71.0% 83.8% 54.0% 49.0% 74.9% 95.1% 98.2% 57.1% 57.1% 69.7% 111.9% 102.9% 79.8% 45.2% 28.1% 56.0% 107.5% 103.6% 52.3% 93.6% 76.4% 45.6% N/A 80.5% 0.1% 40.1% 63.9% 64.1% 47.1% 46.9% 32.3% 32.3% 106.6% 49.5% 71.7% 9.1% 9.1% 9.1% 10.1% 10.1% 9.6% 9.5% 8.0% 8.9% 10.6% 7.9% 6.8% 7.1% 10.9% 10.9% 7.6% 8.8% 8.8% 10.7% 9.1% 10.6% 6.8% 6.9% 7.6% 10.1% 10.1% 8.8% 9.6% 9.0% 8.4% N/A 13.7% 3.5% 9.0% 9.5% 12.0% 9.5% 9.5% 6.2% 6.2% 18.0% 9.6% 9.2% 9.2% 9.8% 9.5% 9.8% 9.8% 9.5% 9.6% 6.9% 8.5% 9.8% 7.5% 6.5% 7.6% 8.5% 8.5% 6.9% 8.5% 7.9% 11.1% 9.2% 9.8% 6.5% 6.6% 6.9% 9.8% 9.8% 8.5% 9.5% 8.7% 7.7% N/A 10.5% 5.2% 8.2% 9.2% 11.6% 8.0% 8.0% 6.5% 6.5% 16.0% 8.9% 8.7%
TICKER MAJORS BP ChevronTexaco ExxonMobil* Royal Dutch* Shell* TotalFinaElf AVERAGE
EV 221,333 113,584 279,010 122,382 78,050 113,523
OTHER INTEGRATEDS Amerada Hess USD Conoco USD ENI USD Marathon Oil USD Norsk Hydro USD Phillips USD PetroCanada CAD PetroCanada USD Repsol YPF** USD Statoil USD AVERAGE
EUROPEAN INTEGRATEDS (Local Currency) BG Group GBP 304.8 10,755 BP GBP 590.0 132,493 ENI EUR 16.3 63,760 Norsk Hydro NOK 429.0 110,430 OMV EUR 101.2 2,726 Repsol YPF** EUR 12.9 15,735 Royal Dutch* EUR 60.2 126,309 Shell* GBP 516.0 50,265 Statoil NOK 70.0 151,521 TotalFinaElf EUR 168.6 113,468 AVERAGE EMERGING INTEGRATEDS LUKOIL USD Surgut*** USD YUKOS USD MOL USD Perez Companc USD Petrobras USD PTT THB Petrochina USD Petrochina HKD Sinopec USD Sinopec HKD Sasol ZAR AVERAGE 17.14 0.39 10.10 21.51 6.10 21.78 31.75 19.70 1.53 16.15 1.26 119.00 14,579 16,720 22,594 2,099 1,301 23,655 90,488 34,637 269,011 14,002 109,245 72,947
12,521 150,702 70,473 148,716 3,330 33,711 133,268 53,167 189,821 123,232
14.17 28.95 1.28 28.68 14.45 1.11 3.05 27.23 5.72 9.85
17.45 31.14 1.22 27.37 14.28 0.98 3.14 28.82 5.28 9.79
29.11 54.13 2.63 88.73 29.75 3.71 5.50 49.12 15.02 18.72
34.02 57.59 2.66 86.28 28.87 3.69 5.71 52.47 15.24 19.10
1,232 13,166 9,371 24,211 882 4,791 12,862 5,322 34,788 13,254
1,422 14,030 9,201 23,554 904 4,713 13,133 5,434 35,330 13,521
15,643 6,847 17,371 2,911 3,516 35,384 183,035 41,530 322,776 25,277 197,190 80,947
N/A 2.12 2.02 N/A 0.03 0.03 N/A 1.06 0.92 0.8% 2.49 3.04 2.6% 1.21 1.30 -1.7% 3.23 2.88 0.4% 6.59 6.68 1.6% 2.23 1.79 -0.1% 0.17 0.14 1.1% 1.83 2.35 0.0% 0.14 0.18 -1.1% 15.58 15.28 0.4%
3.25 0.05 1.17 4.53 1.77 4.92 8.74 5.35 0.42 6.16 0.48 21.65
3.20 0.04 1.06 4.99 2.33 5.14 13.50 4.57 0.36 6.00 0.47 21.53
2,825 1,867 3,435 470 834 6,563 35,838 9,069 70,738 5,821 45,402 13,690
2,784 1,686 3,036 579 874 6,640 35,537 8,319 64,888 6,587 51,377 13,439
GLOBAL INTEGRATED AVERAGE
51
Oil and Gas Primer

Large scale is vital, as it allows companies to lower their aggregate unit costs and overall project risk profile through greater diversification
14 May 2002
We believe that large scale is vital in this global commodity industry, as it allows companies to lower their aggregate unit costs and their overall project risk profile through greater diversification. Valuation multiples tend to reflect this (and other factors) as shown by significantly higher valuations for the Super Majors over the other Integrateds and Emerging Markets players. Among the Integrated Oils, we utilize four major traditional valuation metrics and our value-added framework. We evaluate price to earnings (P/E), price to cash flow (P/CF), enterprise value to earnings before interest, taxes, depreciation, and exploration expense (EV/EBIDAX), and EVA (fair value) measures plus our value-added enterprise value (EV)/gross invested capital (GIC) and return on gross invested capital (ROGIC) valuation and performance metrics. Our preference is for a combination of EV/GIC, cash flow multiple analysis, and EVA -derived DCF analysis throughout the cycle. A key component of any valuation analysis is ones view on midcycle conditions, which eliminate the high/low distortions that can occur over a cycle. It makes little sense to value companies using unsustainably high or low commodity prices, so we use a midcycle average to gain perspective on a normalized basis.
The Super Majors have a commanding valuation gap over the other Integrateds and an even bigger lead over the Emerging Market Integrateds
A quick glance at our Global universe (Exhibit 45) shows the Super Majors have a commanding valuation gap over the other Integrateds and an even bigger lead over the Emerging Markets Integrateds. The consolidation and asset restructuring of the industry have not only blurred the lines between traditional Domestic and International Integrateds, but have also clearly trifurcated the group. The Super Majors enjoy substantially higher valuation multiples and exhibit different characteristics than the others and Emerging Market players. The differences generally arise from the points we listed above; the Super Majors have higher returns on capital (Exhibit 46), have lower reinvestment rates (greater capital discipline), and have focused on higher returns other than higher production and cash flow growth. Some Emerging Market players, however, have achieved even higher returns on gross invested capital than the Super Majors and Others. However, while their ROGICs may be higher than the peer group in some cases, their commensurately higher costs of capital leads to a narrow ROGIC - WACC spread, or lower net return.
52
Oil and Gas Primer

Exhibit 46: Global Integrated Oils Return on Gross Invested Capital, Ten Years
15% 14.0%
14 May 2002
12.0%
11% 10% 10% 10% 9% 9% 9% 9% 9% 9% 9% 8% 8% 8% 8% 8% 7% 7%
10.0%
8.0%
7% 6%
6.0%
4.0%
2.0%
0.0%
St at oi l C he vr on Ph illi ps Pe tro br as To ta lF in aE lf U Te SX x -M ac ar o at ho n O N il or sk H Am yd ro er ad a H Pe es s tro -C an ad a
0% 0 .0% 0% -2 .0% -1% -2% -2 % -2% -4 .0% -3% -3% -5% -6 .0% 0%
EN I R D /S he ll
Lu ko R il ep so lY PF
BP Ex xo nM ob il Av er ag e
Pe tro C hi na Si no pe c
on oc o
In addition to historically maintaining high returns on capital, the Super Majors have also improved their underlying midcycle ROGIC performance more than have the growthoriented other Integrateds and Emerging Market Integrateds. (See Exhibit 47.) This is largely due to excellent capital discipline versus the peer group. Capital discipline refers to a companys ability to selectively pursue investment opportunities, with a reasonable set of expectations regarding long-term capital costs and returns potential.
Exhibit 47: Global Integrated Oils Improvement in Midcycle ROGIC, 2000
8 .0% 6% 5% 4% 4 .0% 3% 2 .0% 2% 2% 1% 1% 4% 4%
6 .0%
-8 .0%
-10 .0% -11%

on Te Am xa co er ad a H es s R D /S Pe he tro ll -C an ad N a or sk H yd ro Av er ag R e ep so lY PF s Pe tro br as C on oc o BP To ta lF in aE lf Ex xo U SX nM -M ob ar il at ho n O il St at oi l Si no pe c Pe tro ch in a Ph illi p Lu ko il EN I M V
-12 .0%
C he vr O
53
M V
Oil and Gas Primer
14 May 2002
We have demonstrated that the Super Majors enjoy superior returns on gross invested capital, but it is necessary to understand which segments of the Integrated business model are driving these returns.
Upstream operations have generated the highest returns for the Integrateds while downstream and chemical operations have struggled to earn their cost of capital
Total returns are being driven by the upstream, which has generally earned in excess of its cost of capital. The downstream and chemicals segment performances have not been so impressive in most cases. Over the past ten years, the upstream has averaged an 11.2% return on gross invested capital versus 7.5% for the downstream and only 7.4% for chemicals.
Exhibit 48: Integrated Oils Segment Returns
2 0 .0 % 1 8 .0 % 1 6 .0 % 1 4 .0 % 1 2 .0 % 1 0 .0 % 8 .0 % 6 .0 % 4 .0 % 2 .0 % 0 .0 % 1991 1992 1993 U p s tre a m 1994 1995 1996 1997 1998 1999 2000
D o w n s tre a m
C h e m ic a ls
G as and P o w er
The upstream has been a consistent outperformer while the chemicals business has shown deteriorating returns for the past five years. The relative outperformance of the upstream has led integrated companies to increase their reinvestment spending in the business at the expense of the downstream and chemicals businesses.
As a result of higher return opportunities in the upstream, the Integrateds have steadily redeployed an increasing amount of capital to the business
Exhibit 49: Integrated Oil Segment Reinvestment Rates

100%
90%
80% 20%
70%
26% 27%
27%
30%
28%
24%
21%
18%
21%
60%
50%
40%
30%
57% 52%
55%
52%
54%
55%
59%
62%
62%
61%
20%
10%
0% 1991 1992 1993 1994 E&P R &M 1995 Chem s 1996 G as and Power 1997 O ther 1998 1999 2000
54
Oil and Gas Primer
14 May 2002
The downstream business has been transformed as a result of the recent consolidation activity in the industry. The Integrateds have mostly decreased their commitment to the business by divesting refinery operations throughout the 1990s and reinvesting less capital into the business. (See Exhibit 49.) The Super Majors are more balanced in the split of gross invested capital between upstream and downstream operations than are the other Integrated groups, which is why the Super Majors are less leveraged to commodity prices. NOCs or Emerging Markets Integrateds have the highest concentration of upstream assets versus downstream. This is normally a result of historical central planning and clearly delineated functions of upstream and downstream businesses, as there are several national refining companies as well.
Super Majors have been slow growers
The Super Majors, even given their significant reserve bases (Exhibit 50), have found it hard to grow production the past ten years versus their peers. While the Super Majors dominate the returns performance categories, the Emerging Integrateds and national oil companies dominate the production growth rankings. (See Exhibit 51.) The Super Majors are focused on big elephant projects that can substantially increase their reserve base and development backlogsmall finds do not add much to the existing, sizable reserve base. As Exhibit 50 shows, the Super Majors reserve base is on average 2-5 times greater than the other groups. However, the NOCs, with large resource potential and relatively closed home markets, offer a serious challenge to the Super Majors. Petrobras, Lukoil, and PetroChina have all demonstrated substantial reserve growth the past several years and their reserve bases now rival or exceed those of the Super Majors.
Exhibit 50: Global Integrated Oils Reserve Base, 2000
Mmboe
2 5 ,0 0 0 2 2 ,5 0 0 2 0 ,0 0 0 1 7 ,5 0 0 1 5 ,0 0 0 1 2 ,5 0 0 1 0 ,0 0 0 7 ,5 0 0 5 ,0 0 0 2 ,5 0 0 0
Hy dr ar o at ho n O A il m er ad a H es Pe s tr oC an ad a oi l lF in aE lf Pe tro br as C he vr on Te xa co Re ps ol YP F xo nM ob il RD /S he ll Pe tr oc hi na on oc o I at oi l no pe c ip s B P Lu k EN Ph ill O M V
NOCs are the biggest challenge to the Super Majors
St
Si
To ta
Ex
O il
G as
55
US
XM
or sk
Oil and Gas Primer

The Super Majors, given their significant reserve bases, have found it hard to grow production the past ten years versus their peers
14 May 2002
Production growth of the other Integrateds and NOCs has led to higher earnings and cash flow growth versus the Super Majors as well. However, despite the Super Majors lower production growth over the period, their focus on cost-cutting and efficiency gains has allowed them to sustain appreciably higher returns on capital than their peers, as we noted earlier.
Exhibit 51: Integrated Oils Production Growth, Ten Years
16%
14%
14%
12%
12%
10%
10%
8%
6% 5% 5% 5% 4% 4%
6%
4%
2%
1%
1%
1%
1%
1%
1%
1%
0%
0% 0%
0%
0%
-2 %
ip s I l yd ro lY PF tr oc hi na tr ob ra s ob il on s on oc o ar at ho n O il ep so er ad a xo nM C he RD Si no pe c lf O M V Lu ko il to il B P an ad a EN lF in aE /S he l H es vr Ph ill Te xa St a H co
or sk
To ta
ro -C
Pe
Pe
Pe t
-M
Because of the need for the Integrateds to make large discoveries and the capital commitments required for large projects, the risk involved, the geological knowledge required for particular regions or geologies, and regional laws and regulations governing participation and development of natural resources, the Integrateds normally operate their big upstream projects as joint ventures. Depending on the size of the project, a consortium may have anywhere from two to five (or more) participants, but there is always one designated operator that makes all final decisions on the project; the other firms simply hold an economic interest and contribute to the capital costs. Early on in a projects life, ownership may change several times, as the project evolves and the reserve potential becomes more clearly defined. The ownership structure shifts as each participant decides for itself whether the project meets the individual companys investment criteria.
We expect consolidation to continue throughout the industry as remaining smaller players attempt to streamline their cost structures and combine exploration potential in order to generate higher returns on capital
We expect consolidation to continue in the Integrated Oils sector as remaining smaller players attempt to streamline their cost structures and combine their exploration potential. The Super Majors should maintain their higher returns on capital versus the other Integrateds and Emerging Markets Integrateds; however, the industry as a whole could see upstream returns decline slightly in coming years. Despite the potential for lower upstream returns through rising capital intensity in the upstream business, the E&P business will continue to be the main returns driver for Integrateds relative to downstream and chemicals returns. This should also serve to keep reinvestment rates and capital allocation flowing to the upstream businesses.
56
U SX
Ex
Oil and Gas Primer
14 May 2002
Independent Refiners
The refining industry includes Integrated Oil companies and the Independent Refiners; however, the Independent Refiners represent the pure-play exposure to the refining business. Our global Independent Refiner universe essentially breaks down into U.S. Refiners and Asia-Pacific Refiners. There exist very few publicly traded Independent Refiners in Europe, Latin America, and the Middle East/Africa. Comparing U.S. Independent Refiners with mostly emerging market Asia-Pacific Refiners presents several valuation comparison difficultiesnamely, minority discounts associated with large government ownership stakes and emerging market discounts. We therefore do not attempt to make valuation comparisons for the Refiners on a global basis, but on a regional basis.
Our investment framework for the Independent Refiners is similar to the Integrated Oilsreturns on capital drive valuation
Our investment framework for the Independent Refiners is similar to the Integrated Oilsreturns on capital drive valuation. We can plot EV/GIC multiples versus midcycle ROGIC expectations to demonstrate how investors look through peak or trough periods to normalized or midcycle conditions. As Exhibit 52 shows, there is a reasonable correlation between EV/GIC and midcycle returns for the global Refining universe. The universe is heavily weighted to the Emerging Market Refiners in Asia-Pacific and this impacts the results. There is a much higher correlation for the U.S. Independent Refiners on a stand-alone basis.
Exhibit 52: Global Refiner EV/GIC versus 2003E ROGIC
160% R 140% FTO 120% P e tro n a s TS O 100% EV/2003E GIC UDS ERG 60% ASH SUN 40% C a lte x 20% H e lle n ic H in d u s ta n VLO B h a ra t S K C o rp S -o il
2
= 0 .4 8 4 4
R e lia n c e
80%
PKN P e tro n Zhenhai
0% 0 .0 %
5 .0 %
1 0 .0 % 2 0 0 3 E R O G IC
1 5 .0 %
2 0 .0 %
2 5 .0 %
57
Oil and Gas Primer
14 May 2002
Our Global Independent Refining universe spans 17 companies in 3 regionsthe U.S., Asia-Pacific, and Europewith the U.S. and Asia-Pacific making up the large majority of our coverage. (See Exhibit 53.) As the valuation comparison table shows (Exhibit 53), the U.S. generally enjoys higher multiples than global peers, but as we said, making such comparisons is difficult. The same valuation methods used for the Integrated Oils are also applicable to the Independent Refiners. We use P/E and P/CF multiples among traditional metrics and EV/GIC and ROGIC as our preferred value-added measures.
Exhibit 53: Global Independent Refiners
MARKET DATA PRICE MKT TICKER FX 5/13/02 CAP INDEPENDENT REFINERS Caltex AUD 1.46 394 Bharat INR 299.80 89,940 Hindustan INR 298.85 101,310 Reliance Petro. INR 25.60 133,171 Petronas Gas MYR 7.00 13,860 Zhenhai R. HKD 1.98 4,996 S-Oil KRW 24,550.00 2,712,898 SK Corp. KRW 21,100.00 2,809,321 Petron PHP 1.68 15,750 ERG.MI EUR 4.33 692 PKN PLN 18.50 7,773 Ashland USD 39.75 2,755 Frontier USD 20.61 527 Sunoco USD 36.35 2,759 Tesoro USD 8.70 565 Valero USD 42.51 4,460 AVERAGE DAILY STOCK PERF. % REL. % -3.9% 0.1% 2.1% -0.2% 2.2% -0.5% N/A N/A 0.0% 1.7% 1.6% 0.5% 1.0% 2.3% -1.7% 0.5% 0.4% CLEAN EARNINGS EPS P/E 02E 03E 02E 03E 7.7 7.1 9.6 8.0 7.4 6.6 7.4 4.3 N/M N/M 4.0 3.8 3.1 3.2 10.2 5.1 2.8 2.7 10.0 12.5 12.4 9.4 11.5 8.0 14.0 9.9 20.9 7.5 N/M 3.3 15.7 6.8 9.8 6.7 LEVERED CASHFLOW CFPS P/CF 02E 03E 02E 03E 1.11 45.56 57.08 5.06 0.52 0.77 9.59 7.15 0.70 0.82 4.31 6.36 2.54 6.01 1.96 5.87 0.84 54.38 61.58 7.58 0.63 0.80 11.89 5.73 0.72 0.74 5.00 8.98 3.12 9.86 5.40 11.70 1.3 6.6 5.2 5.1 N/M 2.6 2.6 3.0 2.4 5.3 4.3 6.3 8.1 6.0 4.4 7.2 4.7 UNLEVERED CASH FLOW VALUE ADDED ROGIC EBIDAX EV/EBIDAX EV/GIC 02E 03E 02E 03E 02E 02E 03E 6.2 7.5 8.7 9.0 N/M 2.9 7.7 9.8 5.0 7.4 4.9 6.3 8.1 7.8 8.9 10.6 7.3 6.5 6.3 7.9 6.0 N/M 2.7 6.7 10.2 4.8 8.2 4.2 5.4 7.0 5.5 5.5 7.4 6.2 45.3% 103.5% 100.2% 117.8% N/A 43.4% 90.7% 62.2% 53.1% 72.3% 45.5% 51.3% 103.7% 51.5% 69.1% 75.7% 71.3% 6.5% 14.7% 13.7% 18.9% 9.0% 13.8% 13.5% 5.7% 9.8% 9.4% 9.4% 8.0% 12.7% 6.4% 5.3% 7.7% 10.3% 6.2% 15.8% 14.2% 22.8% 10.0% 9.3% 14.8% 6.1% 9.0% 9.5% 9.6% 8.5% 13.8% 8.8% 10.0% 10.7% 11.2%
EV 1,679 124,839 159,868 225,639 16,599 6,236 3,849,898 10,111,621 36,273 1,019 9,684 4,465 632 4,161 2,665 9,703
-3.3% 0.19 0.20 -0.2% 31.39 37.69 1.7% 40.32 45.06 -0.5% 3.46 5.93 2.5% 0.25 0.34 -1.3% 0.50 0.52 N/A 7.92 7.56 N/A 2.06 4.14 0.4% 0.60 0.62 0.9% 0.43 0.35 1.0% 1.49 1.97 2.3% 3.46 4.99 2.8% 1.47 2.07 4.1% 1.74 4.85 0.1% (0.09) 2.67 2.3% 2.71 6.21 0.8%
1.7 269 259 5.5 16,713 19,809 4.9 18,413 20,186 3.4 25,141 37,714 N/M N/M N/M 2.5 2,136 2,350 2.1 502 571 3.7 1,034 994 2.3 7,258 7,520 5.9 138 125 3.7 1,995 2,293 4.4 712 828 6.6 78 90 3.7 531 753 1.6 300 482 3.6 914 1,310 3.8
Source: CSFB.
Refining operations are judged by geographic or market location and complexity factor, as we discussed earlier in the Downstream section. Since Integrateds refining operations are global in nature, we typically evaluate their refining results by global regions: North America, Europe, and Asia-Pacific. U.S. Independent Refiners, however, are concentrated in the U.S. We therefore look at U.S. Independent Refiners operations by geographic region within the U.S. The U.S. market is divided into five regions or PADDs (Petroleum Administration for Defense Districts) that are each widely followed. (See Exhibit 54.)
Exhibit 54: U.S. PADD Map
Source: EIA.
58
Oil and Gas Primer

Disparate product specifications lead to balkanized product markets and disparate refining margins between geographic regions
14 May 2002
The Gulf Coast (PADD III) is the largest refining market in the U.S., accounting for 46% of U.S. refining capacity, followed by the Midwest (PADD II) and the West Coast (PADD V). The U.S. has various federal and state environmental regulations aimed at limiting plant emissions and product emissions leading to different product specifications (sulfur content, blend contents), which have become a major contributor to regional differences in product pricing. The West Coast and Midwest have demonstrated the highest refining margins over the past several years, as Exhibit 55 shows. The West Coast margins are driven by extremely strict regulations imposed by the California Air Resources Board (CARB) while the Midwest is short of refined products and has a different summer gasoline standard than its main supply region, the Gulf Coast.
Exhibit 55: U.S. Gross Refining Margins, by Region
US$ per barrel
$16
$14 West Coast $12 Midwest $10
$8
$6 Gulf Coast $4
$2 East Coast $0 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002
When we analyze refiners, we look at the distribution of their refining operations (capacity) among regions and the margins in each region. The margin graph (Exhibit 55) shows that East Coast refiners have had the lowest margins in the past several years while West Coast refiners enjoyed the highest margins.
The structure of the refining industry has dramatically changed over the past ten years
The U.S. refining industry has undergone major changes over the past ten years similar to those of the upstream industry. In fact, the changes have been partly driven by the evolving landscape of the Integrated Oil companies. Refining operations were traditionally the domain of the Integrated Oil companies. However, increasing capital intensity and excess refining capacity of the past 15 years diminished refining margins and refining returns on capital, leading the Integrateds to shift capital away from refining, as we discussed earlier. The Integrateds have divested refinery operations and have reinvested a greater portion of their funds in upstream operations than toward downstream refining, as we have already discussed.
59
Oil and Gas Primer
14 May 2002
The Integrateds divestment programs led to an expansion of the Independent Refining industry, as Independent Refiners were the natural buyers of the cast-off refineries. Consolidation among the Integrateds in the late 1990s resulted in further refinery divestitures (some mandated by the Federal Trade Commission), providing a large supply of assets for Independent Refiners to acquire. The Independent Refiner business model was premised on growth through acquisition given that it was cheaper to buy a refinery than to build a new one given the excess capacity already in the market and the environmental and legal problems associated with constructing new plants. Refining capacity has increased only marginally in recent years as the asset base has simply shifted from one market participant to another, and both Integrateds and Independent Refiners have closed low return refinery operations and increased capacity at existing refineries only sparingly (capacity creep). (See Exhibits 56-57.) Additionally, downstream capital budgets have been directed toward maintenance spending aimed at meeting environmental regulations versus increasing capacity.
Exhibit 56: U.S. Refining Industry Market Share, 19962000
80% 71% 70%
325 18
Exhibit 57: U.S. Refining Capacity and Number of Refineries

350 20
60% 54% 50% 46% No. of Refineries
300
Capacity
275
40% 29%
250
14
30%
225 12
20%
200
Refineries
10%
175
10
0% 1996 Integrateds Independents 2000

150 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 8
The Integrateds not only divested refining assets but restructured existing assets through mergers and joint ventures. The restructurings took place not just between Integrateds (e.g., Equilon and MotivaTexaco/Royal Dutch Shell) but also between Independent Refiners (e.g., MAPMarathon Oil/Ashland). The high fixed costs of refinery operations and the ability to gain cost advantages through greater scale led Integrated Oils to spread the costs and risks associated with downstream businesses while simultaneously high grading their portfolio through selected divestments. In summary, Integrated Oils and Independent Refiners are the main players in the refining business. The Integrateds shift away from the low-relative-return refining businesses allowed the Independent Refiners to expand. Independent Refiners have grown through acquisitions and have focused on cost control, running plants more efficiently and maximizing higher value product yield. Refiners configure their refineries based on regional market demand, crude grades, regional product supply and demand dynamics, and pricing. We form refining margins expectations based on historical relationships between product demand, industrial production and GDP growth, crude and product supply, inventories, and refining capacity utilization. 60
Refining Capacity (MMBD)
16
Oil and Gas Primer
14 May 2002
Independent E&P
Independent E&P companies in the broadest sense pursue geographic strategies that allow for a leverage to natural gas or oil and/or they pursue a defined cost structure cluster. Put in a simpler way, E&P companies pursue global markets (oil levered) or regional (gas and oil split) markets. The E&P business is a much more regional business than that of the Integrated Oils and is generally broken down by North America (U.S., Canada), Europe, and AsiaPacific. (See Exhibit 59.) Given the maturity of the North American market, the level of oil and gas consumption, free market structure, and the sheer number of publicly traded Independent companies, the North American market is the largest for Independent E&P companies. As we have already discussed in the Oil and Gas Markets sections, the gas business is regional owing to the limitations of regional infrastructure, regional transportation, and regional currency pricing. It is therefore necessary to frame the discussion on a market-by-market basis. Our Global Independent E&P universe comprises 41 companies, with the largest proportion of our coverage being the North American market with 30 companies.
Relative cash returns versus the peer group drive valuation, in our view
Relative cash returns versus the peer group drive valuation, in our view. Cash return on replacement cost capital, net return on replacement cost capital, cash return per barrel of oil equivalent (boe) of proven reserves, and net asset value growth are key indicators of value-creation potential. However, near-term prices and price expectations are the most important indicators of near-term performance potential versus net asset value growth potential, which can be a longer-term measure subject to long-term price views. We believe comparing EV/boe to EBITDA/boe (cash margin) is a large driver of valuations in the group. (See Exhibit 58.)
Exhibit 58: Adjusted EV/boe to 2001 EBITDA/boe
$18
SKE
2
R = 0 .6 2 0 1
$16
$14
Adjusted EV/BOE
B N P .T O
$12
BG AX L .T O SGY HTR
$10
$8
SFY
$6
S T O .AX PXD
$4
VP I GRL
CEO
AE C .T O H S E .T O P P P O E I M ND FS T P C P .T O R AX .T O AP C CHK L D D VN AP A N X Y .T O EOG T L M .T O NBL UCL KM G EPL B R E T P .L P W T .T O WR C C N Q .T O
$2 $ 0 .0 0
$ 0 .5 0
$ 1 .0 0
$ 1 .5 0
$ 2 .0 0
$ 2 .5 0
$ 3 .0 0
$ 3 .5 0
$ 4 .0 0
$ 4 .5 0
$ 5 .0 0
2 0 0 1 E E B IT D A /B O E
61
Oil and Gas Primer
14 May 2002
We also use an adjusted EV measure that more appropriately compares asset bases on an equal basis. Reserve values are significantly influenced by the percentage developed versus undeveloped owing to the significant capital associated with developed reserves. To appropriately compare companies with varying developed/undeveloped reserve bases, we adjust all the reserves to a fully developed basis by adding estimated future development costs to the enterprise value. Our value-added valuation measures capture the expectations for companies to earn returns in excess of the cost of capital. Since cash-on-cash returns are a fundamental valuation driver, they are more representative of true value and imbedded expectations over traditional cash flow multiple analysis.
Exhibit 59: Global Independent E&P
MARKET DATA PRICE FX 5/13/02 USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD 53.97 57.28 44.03 8.05 49.30 43.64 16.75 8.10 31.30 61.08 38.50 39.90 22.62 24.60 34.32 40.53 42.50 15.27 38.42 11.97 19.20 MKT CAP 13,493 7,847 8,850 1,369 7,888 5,106 508 219 1,502 6,108 1,719 2,234 3,891 2,435 1,853 1,159 1,125 397 9,336 766 1,018 DAILY STOCK PERF. % REL. % 1.8% 1.0% 1.8% 4.0% 2.2% 2.1% 0.1% -0.1% 0.7% 2.0% 0.6% 2.1% 1.9% 2.1% 1.0% -1.1% 2.4% -1.5% 1.8% -0.5% 1.4% 1.3% LEVERED CASH FLOW CFPS P/CF DEBT/ 02E 03E 02E 03E 02E CF 8.0 6.3 8.8 4.7 5.1 8.3 7.2 3.8 7.8 6.1 5.1 5.9 8.1 7.4 6.0 8.3 5.6 5.5 5.9 4.8 5.8 6.4 6.9 5.3 6.3 4.5 4.1 6.4 7.6 2.9 5.3 5.0 4.3 4.3 6.8 5.2 5.3 6.2 4.6 4.3 4.9 3.8 4.5 5.2 1.7 1.5 2.4 2.5 3.6 0.9 1.3 1.3 1.3 2.8 1.1 1.3 1.9 3.4 2.5 0.1 1.4 2.1 1.7 3.0 1.8 1.9 EBITDAX 02E 03E 2,072 1,512 1,310 436 2,076 690 81 74 240 1,389 405 419 647 451 419 143 238 90 2,037 214 211 2,423 1,759 1,719 435 2,529 881 77 97 336 1,611 482 593 777 589 465 199 284 117 2,378 269 265 UNLEVERED CASH FLOW EV/EBITDAX EBIDAX 02E 03E 02E 03E 9.0 7.2 10.1 6.0 7.7 8.9 7.6 4.4 8.7 7.6 5.6 7.3 8.2 8.8 6.4 8.2 6.5 7.3 6.5 8.5 7.1 7.5 7.7 6.2 7.7 6.0 6.3 7.0 8.0 3.3 6.2 6.5 4.7 5.1 6.8 6.8 5.8 5.9 5.5 5.6 5.5 6.8 5.7 6.2 1,961 1,387 1,317 433 2,033 783 80 74 241 1,356 395 434 626 451 415 143 236 90 1,857 233 212 2,249 1,616 1,671 433 2,433 862 76 97 333 1,576 464 575 727 588 454 199 278 116 2,155 275 265 EV/EBIDAX 02E 03E 9.5 7.8 10.0 6.0 7.8 7.9 7.7 4.4 8.7 7.7 5.7 7.0 8.5 8.8 6.5 8.2 6.6 7.3 7.1 7.8 7.1 7.5 8.3 6.7 7.9 6.0 6.5 7.1 8.1 3.3 6.3 6.7 4.9 5.3 7.3 6.8 5.9 5.9 5.6 5.7 6.1 6.6 5.7 6.3 ASSET BASED *NAV/ PRICE/ EV$/ SHARE *NAV BOE 48.66 43.05 45.63 7.31 47.53 31.89 14.67 8.55 29.77 66.83 21.49 37.43 12.81 19.07 19.05 20.95 35.13 22.07 35.82 31.02 19.91 111% 133% 96% 110% 104% 137% 114% 95% 105% 91% 179% 107% 177% 129% 180% 193% 121% 69% 107% 39% 96% 112% 8.1 8.6 6.7 8.8 7.8 8.7 5.0 7.0 8.1 7.0 14.3 6.6 8.8 5.9 10.5 23.0 12.1 6.1 7.2 3.4 9.7 7.9
TICKER US E&P Anadarko Apache Burlington Res. Chesapeake Devon Energy EOG Res. Encore Acquisition Energy Partners Forest Oil Kerr-McGee Newfield Explor Noble Affiliates Ocean Energy Pioneer Natural Pogo Producing Spinnaker Expl. Stone Energy Swift Energy Unocal Vintage Pet. Westport Res. AVERAGE
EV 18,654 10,839 13,190 2,609 15,888 6,148 618 324 2,095 10,490 2,259 3,042 5,295 3,985 2,693 1,179 1,555 657 13,139 1,816 1,502
3.6% 6.74 7.83 2.8% 9.04 10.80 3.6% 5.02 7.01 5.8% 1.70 1.79 3.9% 9.74 12.02 3.9% 5.28 6.77 1.9% 2.32 2.20 1.7% 2.11 2.75 2.5% 4.00 5.90 3.7% 10.09 12.25 2.4% 7.50 8.95 3.9% 6.76 9.21 3.7% 2.78 3.34 3.9% 3.35 4.73 2.8% 5.73 6.47 0.7% 4.91 6.53 4.2% 7.60 9.28 0.2% 2.79 3.57 3.6% 6.56 7.89 1.3% 2.49 3.12 3.2% 3.29 4.31 3.0%
EUROPEAN E&P Cairn Energy GBP GBP Enterprise GBP Premier Oil AVERAGE ASIA-PACIFIC E&P CNOOC ADS USD CNOOC Ltd. HKD Gulf Indonesia USD PTT EP THB Novus Pet. AUD Oil Search AUD Santos AUD Woodside AUD AVERAGE CANADIAN E&P Bonavista Can. Nat. Res. EnCana Husky Energy Nexen Penn West Rio Alto Exp. Talisman Energy AVERAGE CAD CAD CAD CAD CAD CAD CAD CAD
332.0 723.5 24.8
490 3,485 383
524 4,441 694
0.2% N/A 0.0% 0.1%
-0.5% 31.8 34.1 N/A 128.3 134.7 -0.6% 8.1 7.9 -0.6%
10.4 5.6 3.1 6.4
9.7 5.4 3.1 6.1
0.6 1.4 4.2 2.1
67 932 173
69 910 169
7.8 4.8 4.0 5.5
7.6 4.9 4.1 5.5
49 596 137
52 650 134
10.7 7.4 5.1 7.7
10.0 6.8 5.2 7.3
331.7 536.5 34.2
100% 135% 72% 102.4%
11.6 6.4 2.9 7.0
26.60 10.40 11.10 116.00 2.20 1.12 6.07 13.88
10,925 85,427 976 75,632 403 743 3,513 9,253
9,710 75,954 823 87,604 542 1,024 4,811 10,729
0.4% 0.0% -0.4% N/A -3.1% -0.9% -0.5% -2.0% -0.9% 2.2% -2.4% -1.8% 2.2% 1.1% 0.8% 18.2% 0.0% 2.5%
-0.4% 3.97 4.06 -0.8% 1.55 1.58 1.3% 1.42 1.75 N/A 15.48 16.01 -2.4% 0.59 0.56 -0.2% 0.29 0.23 0.2% 1.27 1.12 -1.3% 1.93 1.41 -0.5% 2.7% 5.32 7.42 -1.9% 13.63 13.58 -1.3% 6.68 8.42 2.7% 3.37 3.15 1.6% 8.50 9.24 1.3% 7.39 9.45 18.7% 4.73 5.92 0.5% 16.02 16.54 3.0%
6.7 6.7 7.8 7.5 3.7 3.8 4.8 7.2 6.0 6.0 3.7 7.2 4.9 4.9 5.9 4.0 4.3 5.1 6.1
6.6 6.6 6.3 7.2 3.9 4.9 5.4 9.8 6.4 4.3 3.8 5.7 5.3 4.5 4.6 3.2 4.2 4.4 5.3
(0.8) 1,844 1,875 (0.8) 14,385 14,623 (1.2) 156 199 0.8 15,387 14,579 1.3 139 129 1.8 262 202 1.9 981 864 1.0 1,488 1,115 0.5 0.7 1.4 1.7 1.2 1.6 1.0 1.4 1.3 1.3 1.5 169 1,903 3,944 1,637 1,386 487 453 2,779 234 1,919 5,247 1,681 1,466 612 562 2,788
5.3 5.3 5.3 5.7 3.9 3.9 4.9 7.2 5.2 6.4 4.7 7.6 5.6 5.2 5.9 5.2 4.5 5.6 6.5
5.2 5.2 4.1 6.0 4.2 5.1 5.6 9.6 5.6 4.6 4.7 5.7 5.5 4.9 4.7 4.2 4.5 4.8 5.8
1,462 1,498 11,407 11,684 110 135 11,084 10,819 111 104 188 156 801 719 1,175 1,264
6.6 6.7 7.5 7.9 4.9 5.4 6.0 9.1 6.8 6.5 5.0 8.3 6.0 6.0 6.6 5.6 5.3 6.2 7.1
6.5 6.5 6.1 8.1 5.2 6.6 6.7 8.5 6.8 4.7 5.0 6.7 6.3 5.5 5.3 4.6 5.1 5.4 6.3
33.03 12.85 16.00 149.13 2.20 1.46 6.29 15.39
81% 81% 69% 78% 100% 77% 97% 90% 84% 189% 108% 105% 91% 128% 104% 81% 117% 115% 110%
5.3 5.0 3.8 2.6 2.5 7.9 3.6 6.4 4.6 10.7 4.7 8.5 6.4 7.8 5.8 6.9 5.4 7.0 7.4
32.00 50.95 48.10 16.61 41.35 43.36 18.85 68.72
938 6,242 22,804 6,924 5,012 2,272 1,419 9,189
1,078 9,030 30,149 9,222 7,220 2,867 2,358 12,414
166 1,790 3,644 1,528 1,211 437 422 2,343
231 1,808 4,530 1,453 1,316 544 511 2,421
16.96 47.18 45.89 18.33 32.31 41.84 23.24 58.79
GLOBAL E&P AVERAGE
50.5
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14 May 2002
As Exhibit 59 shows and as we mentioned above, North America is the largest market for E&P equities. We will concentrate our discussion on this market, but will first summarize the other markets. Outside of the North American E&Ps, European companies are much more oil leveraged and international in terms of their scope of operations. This is not a matter of choice, as Europe has fewer natural resources on the continent and is faced with a maturing North Sea, forcing European E&P companies to search for reserves elsewhere. Rapid consolidation has swept through the Europe E&Ps the past five to ten years, with only a small handful of independent companies remaining. Consolidation has largely come in the form of Integrated Oils interested in acquiring the international oil prospects of the Independents.
Natural gas use has yet to take hold as a dominant energy source in AsiaPacific; however, recent gas discoveries and infrastructure build-outs should change this over time
Asia-Pacific is altogether a different story; the market is cobbled together through incongruous lands separated by vast oceans, straits, and seas. The equity markets are both emerging and developed and the potential resource base is much less mature than North America and Europe. Oil consumption also makes up a greater percent of overall energy consumption than in North America and Europe. (See Exhibit 60.) Natural gas discoveries have occurred at an increasing rate over the past ten years as has the infrastructure build-out and this may serve to change the oil dependence dynamic. Australia is the largest single market in Asia-Pacific for Independent E&P equities.
Exhibit 60: Natural Gas Share of Primary Energy Demand
% of total energy needs on oil equivalent basis
50% 45% 40% 35% 30% 26% 25% 20% 15% 11% 10% 5% 0% Middle East North America World Europe Latin America Africa Asia-Pacific 25% 23% 22% 20% 44%
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Oil and Gas Primer
14 May 2002
Concentrating on the North American market, the U.S. and Canadian E&P industries are dominated by small cap and mid cap, public and private players focused largely on North American natural gas production. The average market capitalization of the CSFB North America E&P coverage universe is slightly over US$4.0 billion while the median market cap is only US$2.2 billion. The industry can be characterized as very entrepreneurial, as many of the participants trace their roots to family businesses.
Exhibit 61: North American Market Capitalization
US$ millions
$4,500 $4,242 $3,997 $4,000 $4,063
Exhibit 62: North American Industry Production Leverage

simple average
$3,500
$3,433
Oil/Gas split 15-20%
$3,000
$2,500 $2,258 $2,000 $1,954
Oil levered 25-30%
Gas levered 55-60%
$1,500
$1,000
$500
$0 US Canada Average Median North America
Source: Reuters, Priced at April, 17, 2002.
Highlighting the natural gas leverage and continental focus of the industry, roughly 5560% of the companies in our North American coverage universe are heavily weighted toward natural gas production (> 60% natural gas production) while only 25-30% are levered toward oil production. The remaining 15-20% are fairly evenly split between oil and gas (45-55% either way).
Consolidation has been as big a factor in the North America E&P business as it has in the Integrated business
The maturity of the U.S. oil and gas market that brought about the dramatic transformation of the Integrated Oil industry has affected the North American Independent group in numerous ways, and in a larger context the global group. Similar to the relationship the Integrateds had with the Refiners throughout the 1990s, North American Independents were the main buyers amidst the Integrated Oil industrys upstream portfolio restructuring throughout the 1990s. At the same time the Independents bulked up their size in the U.S., a few began to follow the lead of the major Integrateds and invest more heavily in new international, global projects. Those that remained committed to the continental North America market consolidated their market share in their core areas and others expanded their operations beyond the borders into either the U.S. or Canada. More often, U.S. E&Ps have pursued property acquisitions and M&A opportunities in Canada as natural gas exploration and development opportunities in Canada have outpaced the mature U.S. market and new transportation infrastructure has been brought online. (See Exhibit 63.) This has occurred at an increased pace over the past three to five years. Consolidation has been as big a factor in the North America E&P business as it has in the Integrated business.
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Exhibit 63: U.S.Canada Cross-Border M&A Activity
US$ in millions, unless otherwise stated, equity value
$10,000 $9,000 $8,000 $7,000 $6,414 $6,000 $5,000 $4,000 $3,000 $2,000 $1,051 $1,000 $357 $84 $0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 $273 $180 $532 $768
14 May 2002
$9,683
$3,439 $2,472
$1,435
2000
2001
Source: SDC.
The health of the industry hinges on the ability to grow reserves and to attract capital to develop the reserves
The health of the E&P industry hinges first on resource potential or the ability to grow reserves, and second, on the ability to attract capital to develop the reserves. The latter is affected by oil and gas prices and cost structures (i.e., the economics of drilling and producing). As we discussed earlier, there are three main ways to increase reserve growth: drilling, property acquisitions, or equity acquisitions. Prospects and service costs are critical to successfully adding low-cost reserve value through drilling, while value-added property acquisitions and property turnover occur most frequently in down markets and in periods of major asset restructurings. Equity acquisitions can become very costly at cycle peaks. Geographic scale and scope are directly related to a companys size and ability to spread costs over the asset base, as we discussed in the Integrated Oils section. Wellcapitalized companies are more able to diversify their geographic reach within and outside North America versus smaller entities that rely more heavily on lower-risk, exploitation projects in long-lived areas. These smaller companies essentially develop core competencies, exploiting one particular geological area. The largest Independents have increasingly pushed into new, unexploited global growth markets with high potential. Large-scale, international operations are most often geared toward oil exploration and production over gas, as they have higher-margin potential given the size of the global oil market versus regional gas markets. International E&P also has significantly greater opportunities to tap undeveloped, unexplored areas; lease concessions are typically much larger; and it provides diversity of operations and tax incentives.
Well-capitalized companies are better able to diversify their geographic reach versus smaller entities
Global Independents have emerged in the wake of the oil industry restructuring and the maturation of the U.S. asset base
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Oil and natural gas mix is only one way to evaluate the composition of companies in the industry. Other major considerations into the overall attributes and health of companies in the industry include the size and breakdown of the reserve base and the opportunity to grow reserves. There are several types of business models being pursued. The business mix may take hold in any one or more of the following forms:
Business stage. Exploration (growth), exploitation, and development (mature). Growth strategy. Property acquisition, internal (drillbit), M&A. Geographic diversity. Specific, long-lived basins or plays versus diverse continental
and international plays; cost structures also play a role.

Reserves or production mix. Oil or natural gas focus.
The E&P industry is inherently capital and asset intensive given the physical exploration, development, and production processes. In a low-growth industry where demand closely tracks GDP growth, attempts to outgrow the industry through production increases have historically resulted in lower returns and commensurate value destruction. Excess production growth often leads to capacity expansion beyond the long-term demand function, not necessarily in the short run, but as market conditions change and the supply/demand balance shifts.
The capital-intensive nature of the Independent E&P group creates an ongoing need to access capital
The capital-intensive nature of the Independent E&P group creates an ongoing need to access capital, whether it is debt or shareholders equity. However, given the different legs of the cycle and the growth orientation of a particular company, debt is most often used in times of aggressive expansion. As the cycle progresses and moves into trough periods, debt levels become burdensome and asset rationalizations follow. Industrywide productive capacity does not change, but merely shifts from one owner to another. Clearly each strategy in and of itself has benefits and drawbacks, but importantly, the relative value of one over another differs depending on the stage of the cycle. Isolating companies pursuing a pure-play strategy versus companies pursuing combinations of all three strategies can provide value for leverage or deleverage to particular shifts in the cycle and added investment return potential. In summary, returns on capital drive valuation among the Independent E&Ps, similar to the other oil and gas industries. Returns, however, cannot be fully evaluated in isolation; risk levels obviously play a large and equally important role in the return function. Reinvestment risk is a key component of these relative returns measures and it varies on a company-by-company basis based on asset life (reserves/production) and depending on the strategy being pursued. The level of risk is clearly greater for companies with shorter-lived asset lives, when industry portfolio turnover and consolidation are low and drilling success is the most cost-effective growth vehicle. We expect consolidation throughout the industry and in every region to continue as producers seek to lower unit costs and profitably add reserves.
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Oilfield Services and Equipment

Oilfield Service companies deliver cost savings and efficiency gains that standalone producers could not realize
Finding and developing hydrocarbons requires expensive capital equipment, specialized tools and technologies, and unique skill-sets for delivering necessary services. However, owning and maintaining all of the equipment, products, and services required to explore for and produce oil and natural gas is inefficient for producers. Instead, specialized Oilfield Service and Equipment (Asset) companies fill this gap. (Equipment companies are also called Assets, or Drillers.) As outside providers, they are better positioned because they can allocate resources to a broader group of producers, increasing asset productivity and better spreading the costs associated with developing new tools and technologies. Through product and service focus, the Oilfield Service companies also deliver cost savings and efficiency gains that stand-alone producers could not realize. Service companies provide an array of different products and services. Oilfield Asset companies or drillers own rigs and lease them to producers while other Service companies manufacture capital equipment (drilling rig equipment, production equipment, natural gas compressors, etc.) or consumable products (bits, fluids, drillpipe, etc.) for sale or rent, depending on application. In addition, some companies maintain an inventory of tools and equipment for rent, primarily in North America. As their name implies, most Service companies provide some aspect of service (pressure pumping, machinery operation, reservoir description, tubular inspection, etc.) in addition to equipment, with some more service focused than others. Oil Service companies are involved in essentially every step of the hydrocarbon process from exploration to development to production, and finally abandonment of fields. A more complete discussion of the products and services that Oil Service companies provide can be found in Appendix I: The Physical Process. Our global OFS universe comprises 35 companies, primarily based in the United States but with a global operating structure. Our coverage group includes 3 large-cap, oil Service Majors, 14 mid-cap U.S. Service companies, 6 mid-cap European companies, and 12 Oilfield Asset companies. The Major Service companies provide a breadth of services spanning the E&P process, and serve most or all of the major producing regions. Most mid-cap Service companies are more focused on a particular facet (or facets) of the upstream chain, and may be more limited in geographic scope. Oilfield Asset companies own and operate the onshore and offshore drilling rigs and the supply vessels that support them, and most have the ability to deploy assets around the world.
Service companies participate in essentially every step of the hydrocarbon process
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Exhibit 64: Global Oilfield Services Valuation
MARKET DATA PRICE FX 5/13/02 USD USD USD 37.48 17.00 56.54 MKT CAP 12,672 7,361 32,856 DAILY STOCK PERF. % Rel. % 0.9% 2.4% 1.9% 1.7% 2.7% 4.2% 3.7% 3.5% EARNINGS EPS P/E 02E 03E 02E 03E 1.01 0.88 1.55 1.50 1.43 2.20 37.1 19.3 36.5 31.0 25.0 11.9 25.7 20.9 ADJUSTED EARNINGS EPS P/E 02E 03E 02E 03E 1.01 0.88 1.55 1.50 1.43 2.20 37.1 19.3 36.5 31.0 25.0 11.9 25.7 20.9 LEVERED CF CFPS P/CF 02E 03E 02E 03E 2.29 2.03 3.50 2.78 2.60 4.22 16.4 8.4 16.2 13.6 UNLEVERED CF EBITDA EV/EBITDA 02E 03E 02E 03E 1,291 1,648 2,766 13.7 6.8 17.6 12.7 11.2 5.2 14.0 10.1
14 May 2002
TICKER MAJORS Baker Hughes Halliburton Schlumberger AVERAGE US MID-CAP BJ Services Cooper Cameron CoreLab FMC Technologies Global Industries Grant Prideco Hanover Hydril Oil States International Smith International Superior Energy Technip-Coflexip Varco Weatherford** W-H Energy Services AVERAGE EUROPEAN DSND IHC Caland Ocean Rig Saipem Smedvig Technip-Coflexip AVERAGE
EV 14,403 8,623 38,750
VALUE ADDED 2002E EV / ROGIC GIC 13.7% 11.3% 10.2% 11.7% 200% 75% 173% 149%
13.5 1,050 6.5 1,272 13.4 2,201 11.1
USD USD USD USD USD USD USD USD USD USD USD USD USD USD USD
38.36 58.70 14.50 23.00 9.18 16.10 15.77 25.90 11.80 76.06 11.04 35.20 20.99 53.10 22.64
6,142 3,499 492 1,500 957 1,798 1,296 589 574 3,797 787 3,575 2,033 7,105 622
6,158 3,878 573 1,759 1,080 2,046 2,854 571 629 4,421 1,070 4,363 2,298 8,014 718
1.2% 1.9% 0.0% 0.2% -0.4% 5.4% -4.6% 0.5% 4.9% 2.5% 0.4% -0.8% 1.7% 2.1% -0.3% 1.0%
2.9% 3.7% 1.8% 2.0% 1.3% 7.1% -2.8% 2.2% 6.7% 4.3% 2.1% 0.9% 3.5% 3.8% 1.5% 2.7%
1.09 1.82 0.80 0.96 0.35 0.30 1.02 0.98 0.72 2.59 0.46 1.81 0.89 1.60 0.98
1.62 2.67 1.17 1.34 0.53 0.62 1.45 1.29 0.92 3.30 0.76 2.38 1.14 2.17 1.63
35.2 32.3 18.1 24.0 26.2 53.7 15.5 26.4 16.4 29.4 24.0 19.5 23.6 33.2 23.1 26.7
23.7 22.0 12.4 17.2 17.3 26.0 10.9 20.1 12.8 23.0 14.5 14.8 18.4 24.5 13.9 18.1
1.09 1.82 0.80 0.96 0.35 0.30 1.02 0.98 0.72 2.59 0.46 1.81 0.89 1.60 0.98
1.62 2.67 1.17 1.34 0.53 0.62 1.45 1.29 0.92 3.30 0.76 2.38 1.14 2.17 1.63
35.2 32.3 18.1 24.0 26.2 53.7 15.5 26.4 16.4 29.4 24.0 19.5 23.6 33.2 23.1 26.7
23.7 22.0 12.4 17.2 17.3 26.0 10.9 20.1 12.8 23.0 14.5 14.8 18.4 24.5 13.9 18.1
1.71 3.18 1.38 1.66 0.84 0.59 2.19 1.45 1.17 3.53 1.00 3.45 1.59 3.00 2.08
2.26 4.10 1.75 2.06 1.04 0.97 2.67 1.82 1.37 4.83 1.28 4.16 1.89 3.77 2.63
22.4 18.5 10.5 13.9 10.9 27.3 7.2 17.9 10.1 21.5 11.0 10.2 13.2 17.7 10.9 14.9
17.0 14.3 8.3 11.2 8.8 16.6 5.9 14.2 8.6 15.7 8.6 8.5 11.1 14.1 8.6 11.4
378 225 64 162 122 112 343 48 71 330 116 495 233 596 81
516 314 80 201 152 167 419 60 93 391 151 596 274 720 109
16.3 17.3 9.0 10.9 8.9 18.3 8.3 12.0 8.9 13.4 9.2 8.8 9.9 13.4 8.9 11.6
11.9 12.4 7.2 8.7 7.1 12.3 6.8 9.5 6.7 11.3 7.1 7.3 8.4 11.1 6.6 9.0
17.9% 11.6% 14.1% 15.0% 14.0% 12.1% 10.2% 13.9% 14.0% 16.3% 17.5% 14.4% 15.8% 12.2% 20.2% 14.6%
292% 196% 126% 176% 125% 222% 84% 159% 126% 169% 159% 98% 153% 163% 180% 162%
NOK EUR NOK EUR NOK EUR
23.20 61.70 7.90 7.30 75.50 153.00
1,399 1,733 443 3,213 6,264 3,885
3,593 1,877 3,374 3,786 9,818 4,761
-3.3% 0.6% -6.0% -1.6% -1.9% -0.6% -2.1%
-3.3% 1.55 2.29 -0.2% 3.18 3.92 -5.9% (5.84) (3.01) -2.3% 0.36 0.48 -1.9% 7.26 9.21 -1.4% 4.05 6.56 -2.5%
15.0 19.4 N/M 20.4 10.4 37.8 20.6
10.1 1.76 2.50 15.7 3.18 3.92 N/M (5.84) (3.01) 15.1 0.36 0.49 8.2 8.03 9.98 23.3 8.04 10.56 14.5
13.2 19.4 N/M 20.1 9.4 19.0 16.2
9.3 6.19 7.05 15.7 6.29 7.77 N/M N/M 2.31 14.9 0.87 1.03 7.6 13.20 15.31 14.5 15.34 18.50 12.4
3.7 9.8 N/M 8.4 5.7 10.0 7.5
3.3 7.9 3.4 7.1 4.9 8.3 5.8
496 237 542 470 1,341 550
546 302 706 551 1,543 662
7.3 7.9 6.2 8.1 7.3 8.7 7.6
6.6 6.2 4.8 6.9 6.4 7.2 6.3
11.4% 14.5% 6.8% 14.4% 12.3% 14.4% 12.3%
83% 95% 45% 105% 96% 107% 88%
TICKER OILFIELD ASSETS Atwood Oceanics Chiles Offshore Diamond Offshore Ensco GlobalSantaFe Grey Wolf Helmerich & Payne 1 Helmerich & Payne Noble Corporation Pride International Rowan Seacor Smit Tidewater Transocean AVERAGE
MARKET DATA PRICE FX 5/13/02 USD USD USD USD USD USD USD USD USD USD USD USD USD USD 48.85 23.88 34.68 35.28 35.65 5.01 42.45 35.96 43.19 19.22 26.84 48.08 45.01 38.50
MKT CAP 683 486 4,570 4,777 8,442 906 2,134 5,757 2,572 2,557 1,027 2,541 12,439
EV 755 604 4,540 4,915 8,562 1,056 2,139 6,122 4,265 2,792 1,081 2,584 16,448
DAILY STOCK PERF. % Rel. % 0.0% -2.0% 2.2% 1.2% 2.6% 3.1% 0.6% 3.2% 1.3% 2.8% 1.9% 4.1% 0.0% 1.7% 1.8% -0.2% 4.0% 3.0% 4.4% 4.9% 2.3%
EARNINGS EPS P/E 02E 03E 02E 03E 1.87 0.93 0.51 0.82 1.58 (0.08) 1.06 2.60 1.17 1.40 1.67 1.93 0.15 2.25 2.14 3.00 0.95 1.14 4.13 3.50 1.83 26.1 25.7 68.0 43.0 22.6 N/M 40.0 38.3 22.3 58.2 N/M 17.9 17.8 36.0 32.0 27.8
ADJUSTED EARNINGS EPS P/E 02E 03E 02E 03E 2.60 1.17 1.40 1.67 1.93 0.15 2.25 2.14 3.00 0.95 1.14 4.13 3.50 1.83 26.1 25.7 68.0 43.0 22.6 (62.6) 40.0 38.3 22.3 58.2 N/M 17.9 17.8 36.0 25.2 25.2 18.8 20.4 24.8 21.1 18.5 33.4 18.9 16.8 14.4 20.2 23.5 11.6 12.9 21.0 18.4 17.8
LEVERED CF CFPS P/CF 02E 03E 02E 03E 3.56 1.73 1.76 1.70 2.65 0.19 3.29 3.17 2.87 1.99 0.70 5.23 4.00 2.54 4.55 2.18 2.67 2.67 3.03 0.43 4.58 4.47 4.05 2.72 1.92 6.72 5.15 3.31 13.7 13.8 19.7 20.8 13.5 26.4 12.9 11.3 15.0 9.7 38.3 9.2 11.3 15.2 15.4 14.1 10.7 11.0 13.0 13.2 11.8 11.7 9.3 8.0 10.7 7.1 14.0 7.2 8.7 11.6 9.9 10.0
UNLEVERED CF EBITDA EV/EBITDA 02E 03E 02E 03E 66 48 255 299 695 50 195 459 400 72 148 292 1,104 88 62 463 485 799 116 303 629 529 260 187 398 1,427 11.4 12.7 17.8 16.4 12.3 21.1 10.9 13.3 10.7 38.9 7.3 8.9 14.9 14.2 12.1 8.6 9.8 9.8 10.1 10.7 9.1 7.0 9.7 8.1 10.8 5.8 6.5 11.5 8.6 8.5
VALUE ADDED 2001E EV / RORC Repl 6.4% 8.8% 5.8% 9.5% 5.9% 13.2% 10.2% 9.0% 6.3% 6.0% 8.2% 8.4% 6.4% 8.1% 11.6% 70.3% 146.1% 71.4% 119.8% 99.8% 84.3% 97.6% 110% 70% 87% 57% 80% 91% 86% 122%
18.8 1.87 20.4 0.93 24.8 0.51 21.1 0.82 18.5 1.58 N/M (0.08) 18.9 1.06 16.8 14.4 20.2 23.5 11.6 12.9 21.0 17.4 17.4 0.94 1.94 0.33 (0.06) 2.68 2.53 1.07
0.94 5.0% 1.94 3.0% 0.33 4.5% (0.06) 3.7% 2.68 5.8% 2.53 0.0% 1.07 3.4%
GLOBAL OFS AVERAGE
Investing in Oil Service Stocks

Oil Service stocks are the most volatile of the energy industry sectors
Oil Service stocks are the most volatile of the energy industry sectors. This volatility is a function of leverage to commodity prices and the producer spending cycle, relatively small capitalizations (most less than $5 billion equity capitalization), and wide fluctuations in cyclical cash flow generation. In the past, Oil Service companies underperformed the broader market on a relative basis. However, playing the cycle and taking advantage of volatility offers the opportunity for outsized returns. Additionally, after 15 years of industry underinvestment as producers took advantage of excess capacity, the group appears poised to end its underperformance relative to the market. In general, there are three key drivers of Oil Service stock performance: commodity prices/producer spending, valuation/timing, and differential opportunities and returns.
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Commodity Prices/Producer Spending
14 May 2002
The prospects for oil service companies are closely tied to the fortunes of producers
The prospects for Oil Service companies are closely tied to the fortunes of their Integrated Oil, Independent E&P, and national oil company customers. Producer revenues, in turn, are proportional to commodity prices. The rise and fall of commodity prices defines upstream spending cycles, as incentive to spend hinges on the expected level of oil and gas prices and the ability to generate adequate returns on incremental investment. Higher commodity prices generate more cash and increase producers capacity to reinvest in replacing and growing reserves. Spending cycles have generally lasted three to four years, depending on a variety of factors including the global economy, OPEC policy, productive capacity utilization, and weather. There is some evidence of emerging North American gas cycles that could be slightly shorter. Historically, relative service stock performance has closely followed changes in producer gross revenues (as defined by commodity price times volume), which foreshadow changes in producer spending. We will discuss the spending cycle and the tools we use to forecast spending levels in greater detail in a moment.
Exhibit 65: Relative Service Stock Performance, Worldwide Gross Revenues, Worldwide Drilling, and Completion Spending
US$ in millions, unless otherwise stated
WW Spending 4.00 Relative Stock Performance WW Gross Revenue 80
Relative stock performance follows changes in producer gross cash flows
3.50
70
3.00
60
2.50
50
2.00
40
1.50
30
1.00
20
0.50
10
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Oil Service companies can be classified according to the stage(s) of the cycle they serve
Spending cycles are characterized by different phases. Exploration-related services lead the cycle, followed by completion and development services and later by production services and investment in capital equipment. This being the case, Oil Service companies can be classified according to the stage(s) of the cycle they serve. While the stocks tend to move as a group, individual stocks have the potential to
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outperform during different stages of the spending cycle. In particular, early-cycle stocks are often the beneficiaries of an influx of momentum money in reaction to surging earnings and cash flow at the front end of the cycle.
Timing/Valuation
Timing is critical to successful investing in Oil Service stocks
Given the cyclical nature of the industry and the volatility of the stocks, timing is critical to successful investing in Oil Service stocks. Oil Service stocks are generally not considered buy and hold investments. Importantly, Service stocks move in anticipation of improving fundamentals, so investment decisions should be made in advance of activity and spending changes in order to maximize returns. Fortunately, there are a number of leading indicators, including drilling permits, oil and gas prices, producer budgets, and oil and gas inventories that help forecast future spending and activity levels. Oil Service stocks demonstrate broad annual trading ranges, which are generally much wider than actual changes in financial results. Consequently, it is often possible to identify a disconnect between valuations and fundamentals. Interestingly and in contrast to traditionally defined cyclical stocks, Oil Service stocks have historically achieved peak multiples on peak earnings and trough multiples on trough earnings, amplifying the groups cyclical leverage. In essence, OFS stocks assume secular characteristics during times of extremely positive or negative fundamentals, as unsustainable conditions are extrapolated into the future to both the upside and the downside.
Returns Analysis
OFS stocks are susceptible to extreme valuations in both directions
As with other oil and gas sectors, returns are a key component in stock valuation
Our approach to Oilfield Service valuation is similar to that used for other oil and gas industries, focusing on the correlation between valuation and returns. We use return on gross invested capital (ROGIC) to evaluate a service companys capacity to generate value-added returns on its investments at original cost. Gross invested capital (GIC) represents the total capital invested in the business over the companys history. We use this broadened asset base since service companies often continue to generate cash from depreciated assets, making them an important piece of the company assets that equity holders are buying. Also, GIC eliminates effects of different depreciation methods and lives, yielding a more comparable asset base. For the Oilfield Asset companies, we prefer to use replacement cost as the denominator in returns calculations. Replacement cost values each rig or vessel in a companys fleet at estimated present day construction costs, incorporating adjustments for specific capabilities and equipment. We prefer this measure over GIC because it places all of the Oilfield Asset companies on comparable footing and eliminates the balance sheet distortions attributable to asset write-downs, bankruptcies, and bargain asset purchases/combinations over the past 20-plus years. The market should be willing to pay fair value for comparable assets, regardless of whether the company built them new or bought them cheaply. Exhibits 66 and 67 demonstrate the intuitive principle that the market affords higher asset valuations to companies that generate higher returns on those assets.
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Exhibit 66: Oilfield Service EV/GIC to ROGIC
14 May 2002
Exhibit 67: EV/Estimated Replacement Cost to Return on Replacement Cost

160%
280.0% BJS 260.0%
COD
140%
240.0% 220.0%
EV/Replacement Cost
GRP 200.0% 180.0% EV/GIC SLB 160.0% 140.0% 120.0% 100.0% 80.0% HAL 60.0% WFT SPII CLB OIS HC IHC HYDL VRC CAM BHI
SII
120%
NE ESV
WHES
100%
GSF GW RDC HP RIG TDW
SPN FTI GLBL TKP SPMI
80%
ATW
CKH SMVB
60%
DO
40%
40.0% 10.0%
1%
14.0% 2002E Pre-Tax ROGIC 18.0% 22.0%
3%
5% 7% 9% Return on Replacement Cost
11%
13%
The market rewards growth in returns and assets
As would be expected, the market rewards companies for increasing returns and penalizes companies for deteriorating returns. Companies that have been able to both grow assets and maintain or increase returns have typically demonstrated the strongest stock performance over time, meaning accretive growth via reinvestment or acquisition is key to outperformance.
Valuation Parameters
Traditional multiple analysis helps compare valuations to peers, the market, and history
In addition to return metrics, we also employ traditional multiple analysis to evaluate a companys current valuation relative to the peer group and in the context of likely future valuation levels. We prefer to concentrate on cash flow when valuing companies, for the following reasons:
Comparability across asset bases. Given the capital-intensive nature of most Oil
Service businesses, the historical propensity for bankruptcy, asset writedowns, cheap countercyclical acquisitions, and purchase versus pooling accounting, comparability among the stocks based on earnings is not very effective because of different depreciation loads.
Cyclicality. During trough periods many service companies fail to generate meaningful
(if any) earnings (cash flow only), distorting historical trading ranges. Cash flows provide a better representation of full-cycle trading ranges.
The groups relative cash flow multiple fluctuates considerably with the cycle
Historically, the group has traded at a small premium on cash flow to the broader market. However, the groups relative cash flow multiple fluctuates considerably with the cycle, achieving large premiums during times of favorable prospects and trading at a large discount when the fundamental outlook is negative.
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Exhibit 68: Oilfield Service Relative Cash Flow Premium/(Discount) to S&P Industrials
50%
GREATEST PREMIUM 49.2%
40%
30%
20%
10%
0%
-10%
-20%
Market Multiple
-30% CURRENT: -2.9% DISCOUNT -40%
-50%
GREATEST DISCOUNT -61.1%
-60%
-70% Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Asset-Based Valuation
Asset-based valuation is typically most useful at valuation extremes
Asset-based valuation is typically most useful at extremes: in trough/near-trough valuation conditions, at peaks, and during event-driven sell-offs.
At the lows, this analysis provides a fairly reliable method for determining if you are
buying the assets cheap.

At the peaks, they provide a check to traditional multiple analysis, which tends to be
distorted by the its different this time syndrome.

During emotional event-driven sell-offs, asset valuations help identify opportunities
where a stock has significantly broken from rational valuations. Historically, buying assets when they are cheap, with the approach of taking a longerterm holding position, has yielded dramatically outsized returns.
Differentiating Factors
Oil Service companies can differentiate themselves via opportunistic acquisitions or new technologies
While the majority of Service stock performance can be explained by cyclical variability, Service companies can outperform their peers through differentiated opportunities and returns. Among the ways Oil Service companies differentiate themselves are via opportunistic acquisitions and new technologies. Opportunistic acquisitions, often made during market downturns, can lead to superior returns on capital, which the market has demonstrated a willingness to pay for. Development and commercialization of emerging technologies offer secular growth opportunities on top of cyclical appreciation potential, providing the potential for outsized growth.
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Secular Trends
14 May 2002
Despite its cyclical nature, the Oilfield Service sector has certain secular trends working in its favor
Despite its cyclical nature, the Oilfield Service sector does have certain secular trends working in its favor. Over the next several years, OFS companies should benefit from rising capital intensity, 15 years of upstream underinvestment, an increasing share of oilfield-related intellectual property, and perhaps consolidation. As reserve bases mature, producers are having to run harder and harder just to keep up with increasing decline rates. This phenomenon is particularly apparent in the relationship between the North American natural gas rigcount and productiona dramatic increase in activity failed to generate any volume response. Increasingly, producers are testifying that the cost of growth is trending upward. As production growth becomes more expensive, wealth is transferred from producers to service companies.
Exhibit 69: U.S. Natural Gas Rigcount versus Production
1,200 1,800
1,000
1,500
800 Rigcount
1,200
600
900
400
600
200 M-99 A-99 M-99 J-99 J-99 A-99 S-99 O-99 N-99 D-99 J-00 F-00 M-00 A-00 M-00 J-00 J-00 A-00 S-00 O-00 N-00 D-00 J-01 F-01 M-01 A-01 M-01 J-01 J-01 A-01 S-01 O-01 N-01 D-01 J-02 F-02
300
U.S. Gas Rigcount
U.S. Gas Production
Capital intensity is rising for producers
Evidence of rising finding and development costs also highlights the challenges facing oil companies. Announcements of and changes to production plans at the Super Majors illustrate recent recognition of these trends, with lower volume forecasts coming on unchanged spending budgets. Rising drilling intensity and the challenges associated with overcoming depletion curves offer tremendous opportunities for service companies. As discussed in previous sections, the oil market is close to and the natural gas market is at full capacity utilization, implying the need for significant capital investment in productive capacity. As the market approaches full utilization, investment levels must trend or shift up to a level where capacity growth keeps pace with, or exceeds, demand growth. Otherwise, commodity prices will rise to a level that limits demand growth, as happened in the North American gas market in 2001.
Commodity markets are at or near full capacity utilization
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Production (mmcf/mo.)
Oil and Gas Primer

Exhibit 70: World Oil Production Capacity Utilization
105.0%
14 May 2002
2002E Utilization = 94.4%

100.0%
Iran-Iraq War Saudi Capacity Underestimated Impacted by IraqKuwait Conflict
Long-term Average = 93.8%

Capacity Utilization
95.0%
90.0%
85.0%
80.0%
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Service companies control an increasing share of oilfield-related intellectual property
The last several years have seen a shift in the allocation of intellectual property in the oilpatch. Producer spending on technology has waned, due in part to aggressive costcutting efforts associated with the recent and ongoing wave of industry consolidation. Meanwhile, Service companies have continued to invest in research and development, resulting in greater value-added potential for the Service companies. Intellectual property rights represent a significant barrier to entry for many Service companies, protecting attractive returns on proprietary technologies. Another potential driver for Oil Service stocks is consolidation. While most of the smaller service companies focus on a particular niche product or service, service companies are increasingly focused on providing a bundled cross-section of products and services. Consolidation is often a faster and cheaper way to expand product offerings than internal development. In addition, consolidation facilitates improved capital discipline and capacity utilization throughout the cycle. Most of the markets served by Oil Service companies are relatively small, so a limited number of players is ideal to facilitate adequate pricing and returns.
Consolidation could facilitate improved capital discipline and capacity utilization throughout the cycle
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The Spending Cycle

Given the leverage of service companies to the producer spending cycle, we invest considerable energy analyzing and forecasting spending activity. We use several approaches to forecast the level of producer spending, looking at activity by customer group and by region.
Spending by Customer Group
Integrateds, Independent E&Ps, and national oil companies exhibit different behavior in response to changes in commodity prices
Different producer groups exhibit different behavior in response to movements in commodity prices. Once estimated, spending deltas by group can be weighted and combined to yield an overall spending forecast. We look at three primary spending groups: Integrated Oils, Independent E&Ps, and National Oil Companies.
Integrateds are the steadiest spenders, slow to commit capital when conditions are
improving, and slow to retract when things turn down. This is partly due to the larger scope of the projects that Integrateds participate in versus smaller companies with less available capital. The long-life and deepwater projects that Integrateds often pursue require substantial investment and are budgeted to provide ample returns on capital even at the bottom of the cycle. Such projects generally require long lead times and can last several years, spanning the entirety of a given cycle. Integrateds typically represent 45-50% of total upstream spending.
Independents are the quickest to react to changing commodity prices given their
smaller size. With their predominantly North American exposure, Independents are particularly levered to changes in natural gas prices. As a group, Independents demonstrate the most volatile spending patterns, historically spending beyond their cash generation in high-price environments, but well below cash flow in low-price environments. Independents typically represent 20-30% of total spending.
The spending patterns of national oil companies are more difficult to predict, affected
by government policy and fiscal budgetary considerations as well as industry conditions, and clouded in many cases by cartel interests. Following a sustained period without meaningful reinvestment, however, many of the NOCs are presently capacity constrained (or on the verge of being so) and in need of investment in productive capacity. NOCs typically represent 25-30% of total spending.
Spending by Region
International markets are highly levered to oil, while North America is predominantly gas driven
Commodity price fluctuations do not affect all regions equally, owing primarily to different production profiles. International markets are more levered to oil prices, given the vast untapped deepwater reserves throughout the world and the prolific oil reservoirs in the Middle East. With its oil base significantly depleted, North America has become a predominantly natural-gas-driven market. Natural gas is typically an indigenous commodity (not transportable except as LNG or GTL), so markets tend to be limited to specific geographic regions subject to their own spending and demand patterns. To forecast spending by region, we examine current and expected drilling activity levels. Our rigcount forecast is based primarily on our commodity price forecasts, which are in turn driven by expected supply/demand trends. To help quantify this relationship, we employ our proprietary QualRig model that estimates worldwide drilling and completion spending based on regional rigcounts, incorporating service intensity variations by rig type and region. 75
Oil and Gas Primer

Exhibit 71: QualrigWorldwide Drilling and Completion Expenditures
US$ in billions, unless otherwise stated
4.0
14 May 2002
4.0
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5 1993 1994 1995 1996 1997 1998 1999 2000 2001
1.5
The destination of producer spending has significant implications for Oil Service stocks
In terms of implications for the Service companies, the destination of producer spending dollars is as important as the absolute spending level. Given the high concentration of Independents, North America generally leads the spending cycle. Thus, Service companies levered to North American gas production perform well during the early stages of the spending cycle. Service companies with more oil leverage are buoyed by the ramp in spending from Integrateds and NOCs in international markets, which tends to be a slower process.
Reinvestment Rates
We also look at industry reinvestment rates, which compare spending levels to cash flow generation (as measured by production volumes times commodity prices). By evaluating current reinvestment rates in the context of historical ranges and the longterm average, we have a better picture of where spending could go and what levels of spending tend to generate supply growth. However, we should point out that the long period of underinvestment in the industry could push reinvestment rates higher in the future as producers operate in a more fully loaded cost environment.
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Exhibit 72: Reinvestment Rate and Gross Cash Flow
16% Reinvestment 14% Gross Cash Flows
14 May 2002
80
70
12%
60
Gross Cash Flows ($bil)
Reinvestment Rate
10%
50
8%
40
6%
30
4%
20
2% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
10
By combining spending expectations with the parameters that drive stock valuation, we are able to devise our investment strategy for the group.
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Investment Conclusions
Building on our analysis of global oil and gas markets, value creation in the upstream and downstream, and industry structures and conditions, we will conclude with a discussion on investing through the oil cycle, comparing the various industry groups. As we have stated, the upstream is the largest part of the chain in terms of net sales and net profits, as well as equity market capitalization and liquidity, and it generates the highest financial returns. The Integrated Oils dominate global equity market capitalization among publicly traded oil and gas equities at roughly $1.2 trillion versus Independent E&Ps at $215 billion, Oilfield Service and Equipment companies at $135 billion, and Independent Refiners at $79 billion.
Exhibit 73: Global Oil and Gas Equity Market Capitalization
US$ billions, as of April 25, 2002
$1,400
$1,200
$1,162
$1,000
$800
$600
$400
$215 $200 $135 $79 $0 Integrated E&P Oilfield Service Independent Refining
Source: Company data, FactSet, CSFB estimates.
Integrateds are the most conservative oil and gas investment compared with the more volatile Independent E&Ps and the hypervolatile Oilfield Service companies
In terms of returns on capital, the Integrated Oils have demonstrated the most consistent long-term returns performance at 9%; however, the Oilfield Services group has generated the highest average returns over the long term at 12%, followed by the Independent E&P group. The Independent Refiner group has historically garnered the lowest financial returns, 8%. We use a return on gross invested capital (ROGIC) framework for the Integrateds, Refiners, and Oilfield Service companies. However, we use different returns metrics for the Oilfield Assets and Independent E&P groups, reducing the comparability of cross-industry returns. We use return on replacement cost for the Asset companies and use return on replacement cost capital for the Independent E&P group. Exhibit 74 shows historical returns on capital by sector using the appropriate returns metrics for each industry.
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Exhibit 74: Oil Sector Return on Capital
1991 1992 1993 1994 1995 1996 1997 1998
14 May 2002
1999
2000
Integrated Oil Ind. Refiner Oilfield Service Independent E&P
9.0% 8.4% 12.0% 8.7%
8.3% 6.7%
8.5% 9.2%
10.3% 10.3% 10.2% 8.7%
8.5% 8.0% 9.2% 9.0%
9.6% 9.3% 9.5% 7.8% 7.3% 9.5% 10.3% 11.9% 17.1% 7.7% 11.6% 11.0%
9.5% 8.4% 12.5% 7.0% 12.5% 9.1% 16.2% 10.1% 13.2% 1.6% 5.0% 18.1%
Integrateds are the most conservative oil and gas investment compared with the more volatile Independent E&Ps and the hypervolatile Oilfield Service companies. Therefore, Integrated Oil stocks tend to perform better than the other oil and gas industries as the cycle shifts from peak to trough, but will likely underperform the highly leveraged E&Ps and Service companies when oil and gas fundamentals improve. Exhibit 75 charts the annual share price performance for each industry group against the relatively staid performance of the Integrateds and against oil prices. While the Integrateds have demonstrated superior performance relative to the group during down markets and the most consistent performance through the full cycle, the Oilfield Services group has exhibited higher long-term share price performance followed by the Independent E&P group. The Independent Refiners, however, have had the lowest share price returns. In the right-hand chart of Exhibit 75, the disparate five-year and ten-year price performance for both the OFS and E&P group is striking, highlighting the dramatic shifts through the full cycle.
Exhibit 75: U.S. Oil and Gas Sector Share Price Performance History
US Oil and Gas Sector Annual Share Price Performance, 1990-2001
120% 100% 80% 60% 40% 20% 0% 1990 -20% -40% -60% Intgd E&P OFS Ref WTI $5 0.0% $0 -0.3% -2.0% Integrated E&P Oilfield Services Ind. Refining 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 $10 $20 WTI Oil Price (Average) $25 $35
US Oil and Gas Sector Compound Annual Share Price Performance, 1991-2001
16.0% 14.0% 12.0% 10.0% 8.2% 8.0% 6.5% 6.0% 4.0% 2.0% 3.3% 4.8% 5.1% 11.1% 5-Year 10-Year 14.9%
$30
$15
Source: FactSet, CSFB estimates. Integrated data includes USD share price performance of international Super Majors (BP, RD/SC, TOT).
Oil and gas stocks, particularly the Integrateds, are a classic defensive investment class and generally outperform during broad market downturns. This is because economic downturns often coincide with rising energy price environments, leading to superior returns opportunities for energy stocks on a relative basis. As Exhibit 76 shows, the Integrateds outperformed the market during periods of generally weak economic and stock market performance1990, 1993-94, 1996, and 2000-01.
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Exhibit 76: Integrated Oil Relative Performance versus S&P 500
30.0%
14 May 2002
23.5% 20.0%
11.9% 10.0%
11.2% 7.1% 3.0% 8.5%
0.0% -1.0%
-10.0% -13.9% -20.0% -13.2%
-8.3%
-25.1% -30.0% -33.8% -40.0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Source: FactSet, CSFB estimates.
Valuation Framework
We utilize a range of traditional valuation metrics and value-added metrics in our analysis of the oil and gas industry. (See Exhibit 77.) While traditional metrics remain widely used by the market given their simplicity and commonality, they have limitations that can be overcome with our value-added framework. Our value-added, return-oncapital-based framework for energy stocks is based on capturing the cash on cash economics of a particular business and imbedded investor expectations. The valueadded framework attempts to account for accounting distortions, capital intensity, business risk, competitive advantage, and investor expectations.
Value-added returns measures that focus on cash-on-cash economics of a business enhance traditional multiple analysis
Exhibit 77: Valuation Metrics by Industry

Industry Traditional Value-added
Integrated Oils Independent Refiners Independent E&P Oilfield Service Oilfield Assets
Source: CSFB
P/E, P/CF, EV/EBIDAX, DCF, Yield P/E, P/CF, Yield P/E, P/CF, EV/EBITDAX, EV/EBIDAX P/E, P/CF, EV/EBITDA P/E, P/CF, EV/EBITDA
EV/GIC, ROGIC EV/GIC, ROGIC P/NAV, EV/BOE, EV/RCC EV/GIC, ROGIC EV/RORC, RORC
As Exhibit 77 shows, we use P/E multiple analysis for each of the industry groups. However, given the wide fluctuations of P/E ranges throughout the full cycle, the disparate relevance between industry groups, and the accounting distortions that come with the analysis, we prefer to focus on cash-flow- and asset-based measures for full cycle analysis.
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We also use levered cash flow multiples across industry sectors (P/CF). Our unlevered cash flow metrics are adjusted for specific industry segments, with the exception of the Oilfield Service and Asset groups, for which we use the traditional EV/EBITDA metric.
We add back exploration expense (EBITDAX) to accommodate the various upstream business models
We make adjustments to the EBITDA measure for the Integrated Oils and the Independent E&P groups to better incorporate the dynamics of the upstream business. We adjust the EBITDA measure by adding back exploration expense (EBITDAX) to accommodate the various business models (i.e. exploration focus versus development focus) being pursued throughout the industry. Some companies are more heavily focused on exploration opportunities than others (and thus have higher exploration expenses, and lower EBITDA), which allows us to more appropriately compare companies regardless of the level of, and focus on, exploration. While we use the EV/EBITDAX measure for both the Integrateds and E&Ps, we also use an unlevered posttax cash flow measure for the E&P groupEV/EBIDAX. Because of the various types of international tax structures, royalty arrangements, and PSC arrangements, taxes can play an important role in producers economic value creation and cash-flow-generation potential. Among value-added measures, we focus on EV/GIC, or enterprise value to gross invested capital. The EV/GIC valuation measures the total firm value as a multiple of the historical invested capital base. Our research suggests valuation multiples and shareholder performance are driven by returns on capital. Among the Integrated Oils, Independent Refiners, and Oilfield Service groups, we use the EV/GIC metric and our ROGIC framework. We use EV/estimated replacement cost for the Oilfield Asset stocks and we use two measures for the Independent E&P group, EV/boe and EV/replacement cost capital. Each of these measures is based on a measurement of the capital (or asset) base in one form or another. Beginning with our EV/GIC and ROGIC framework, we list the comprehensive formulas for our GIC and ROGIC calculations.
Post tax cash flow is useful for smoothing out very different tax rates
Components to ROGIC Calculation

Net associate adjustment to NOPAT: Associate DD&A = associates total assets x (DD&A as % of net assets) Cash NOPAT = recurring net income + recurring DD&A and exploration adjustment + after-tax interest expense + net associate adjustments
The Oilfield Service group uses traditional EBITDA in place of cash NOPAT as the numerator in its ROGIC calculation.
Components to GIC Calculation

Net associate adjustments to GIC = associates accumulated DD&A + associates total assets minus non-interest-bearing current liabilities (NIBCLS) or (associates net assets plus debt) Gross invested capital = the historical capital put into the business as defined by:
Total assets - non-interest-bearing current liabilities + accumulated depreciation + any adjustments for acquisitions + net associate adjustments
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From these components we derive value-added valuation metrics:
14 May 2002
Enterprise value/GIC. This is similar to the price-book ratio, but it fully reflects the market value of the entire company and the entire invested capital base. EV/GIC ratios generally reflect the expectation of a companys ability to generate returns in excess of capital costs. Return on gross invested capital (ROGIC) = cash NOPAT (or EBITDA) gross invested capital
Our value-added valuation metric for the Oilfield Assets companies is EV/estimated replacement cost. Our replacement cost methodology is built on valuing each rig or vessel in a companys fleet at our estimated construction costs, incorporating adjustments for specific capabilities and equipment. We prefer this measure to EV/GIC because it places all of the Oilfield Asset companies on comparable footing, and eliminates the balance sheet distortions attributable to asset write-downs and bargain asset purchases/combinations over the long lives of the assets.
Fair value calculations require a view on normalized industry conditions
We also use an EVA -derived discounted cash flow (fair value) based metric for the Integrated Oils. Fair value methods are difficult to derive for highly cyclical industries such as the energy business; however, there is certainly an underlying asset value for upstream reserves. Using conservative midcycle (normalized) price forecasts and reasonable, historical growth rates in production and cost structures, we can derive a reasonable calculation of fair value. For the Integrateds, we calculate an EVA -driven DCF that incorporates the WACC, a five-year time frame, capital requirements, and reserve estimates to derive a fair value target price. For the Independent E&P group, we use a similar approach to arrive at a fair value of the assets, or net asset value (NAV), which we will discuss. It is more difficult to perform a DCF on Oilfield Services, Assets, and Independent Refiners given the extreme volatility of cash flows. Our framework for the E&P group is slightly different than for the other groups. We derive a NAV per share and evaluate each companys share price (P) to NAV to determine the stocks premium/discount to fair value. Companies with high P/NAVs have high expectations built into the stock price, whereas low P/NAVs imply low confidence in visible production and future production capabilities. High P/NAVs indicate an expectation of the ability to earn excess returns on capital, and vice versa for low P/NAVs. The P/NAV is different from EV/GIC in that the NAV denominator represents the discounted future value of the capital base versus the current historical capital base represented by GIC. Also, the numerator (P) only captures the equity price of the company and not the total firm value (EV). We analyze reserve valuations, EV/boe, to measure firm value per barrel of oil equivalent. EV/boe indicates reinvestment efficiency; the higher the multiple, the more efficient the company and vice versa. We also use EV/replacement cost capital to measure total firm value relative to the cost of replacing the existing asset base using recent cost structure data. The RCC represents current events and eliminates accounting vagaries and historical write-offs.
Net Asset Value (NAV) is the preferred method for E&P valuation
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Replacement cost capital = proven reserves at the beginning of the period x three-year average F&D costs Return on replacement cost capital = EBITDA/RCC
Investing through the Cycle

The cyclical nature and capital intensity of the business make reliance on any one consistent valuation metric less useful than in other industries. As the oil price cycle and investor expectations shift from one phase to another, the relevant valuation methods also shift. The changing nature of investor expectations over the course of the cycle makes some valuation methods more or less valuable, depending on the stage of the cycle.
We prefer cash flow multiple analysis as the main valuation metric through the full cycle
We prefer levered (P/CF) and unlevered (EV/EBITDA) cash flow multiple analysis, and its permutations (EV/EBITDAX, EV/EBIDAX), at cyclical turning points and through upswings in the market. These measures are most valuable during periods of upstream momentum (as the cycle turns up), but still hold value during certain phases of downturns. During a market upturn, investors focus on companies with earnings and cash flow leverage to the impending upturn. Cash flow multiples reflect the markets perception of companies leverage and ability to capitalize on market conditions. The most levered companies typically show the greatest share price performance and receive a higher multiple, all else being equal. As earnings expectations and actual performance rise through the upturn, multiple expansion occurs as investors extrapolate further gains. However the business is cyclical so there is inevitably a time when multiples become distorted. At this point investors turn to asset-based measures as a sanity check and begin to focus on how these metrics compare to the potential earnings and cash flows in the next down leg of the cycle. There becomes a need to balance the weighting of cash flow multiples and these longer-term, measures of value.
However, asset-based measures provide excellent guidance at and approaching cyclical peaks and troughs
Should the cycle begin to turn down, the weighting of longer-term or asset-based measures over cash flow multiples increases as investor expectations shift from capturing leverage to the cycle to capturing a fair valuation based on the long-term tangible value of a company (i.e., the stock has no earnings and cash flow power, but its cheap on valuation). Buying cheap assets with a willingness to hold typically generates opportunities for outsized performance. The timing, extent of, and duration of the downturn are important considerations, particularly to the more volatile groups. We prefer to use asset support measures during downturns and prolonged troughs. The concept is similar to the price truncation of callable bonds. Prices will only rise to a certain point no matter how low interest rates fall, because the call price acts as an upper limitinterest rates become less meaningful. Price to cash flow multiples may fall beyond any reasonable point, but the inherent asset value of the ongoing entity will support a fair market price, making cash flow multiples much less relevant. The value-added components are similar in concept across the industry groups. Our goal in using value-added metrics is to understand and evaluate the cash-on-cash returns and economics of the respective businesses, business models, and consequent value within the oil and gas chain. Given our application of the ROGIC framework to the
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Integrateds and Oilfield Service companies, we can compare their historical EV/GIC trading ranges (Exhibits 78-79), which demonstrates the wide trading ranges for Oilfield Service stocks versus the narrow ranges for the Integrateds. We rely heavily on the analysis of past cycle performance and historical multiple analysis to provide reference points for upside/downside potential relative to the current market environment. Timing the cycle is key. Given the volatility in the sector as a whole and the great unlikelihood of entering/exiting at the absolute tops or bottoms, we also look at trading bands based on the average of the annual high and low valuations. The average trading ranges provide interesting supplemental data, but we believe the absolute ranges provide better indicators of the valuation floors for the group. And, since asset-based valuation is typically reserved for extreme situations, the floor or peak is the most important consideration.
Exhibit 78: Integrated Oil EV/GIC
1.6 1.4 1.2 1.0
2.5
Exhibit 79: Oilfield Service EV/GIC

4.0
3.5
3.0
0.8
2.0
0.6
1.5
0.4 0.2 ENI Norsk Hydro OMV Repsol Range TFE BP (ADR) Shell (ADR) RD (ADR) XOM AHC MRO
CXIP TECF IHC SPMI BHI HAL SLB BJS CAM Avg 95-01 EV/GIC CLB GLBL HC HP SII SPN VRC WFT 1.0
0.5
Average EV/GIC
Current EV/GIC
95-01 Trading Range
Current 02E EV/GIC
In addition to using the above exhibits as historical guidelines for each company, they provide a good peer comparison. Some stocks have historically been valued below, at a premium or a discount to the overall group. We use a similar approach for the Independent E&P group. However, instead of using EV/GIC we use EV/boe. As we discussed in the Independent E&P section, our research shows a strong correlation between valuation and cash flows during market upswings and high correlations to returns on replacement cost capital through the full cycle. Companies that consistently earn less than the cost of capital generally trade at discounts to peers that are able to earn their cost of capital. In Exhibit 80 we show the industrys estimated historical EV/boe trading ranges. We compare the current environment, as signified by the dark circle, to each stocks respective history, as well as to the peer group.
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Exhibit 80: U.S. Independent E&P Historical Industry EV/boe
$20
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$18
$16
$14
$12
$10
$8
$6
$4
$2 APC APA BR CHK DVN EOG FST KMG NFX NBL OEI OXY PXD PPP SGY SFY UCL VPI W RC
While we apply the ROGIC framework to our Independent Refiner universe, we have also found another very important investing pattern in the group. Refining stocks often outperform the market from August to April, on expectations for a successful summer driving season. As reality and actual results override expectations in the late spring/early summer, refiners typically underperform in the summer months. The summer driving season, or the second and third quarters, is the opportunity for Refiners to make most of their profits for the year given the greater use and margin associated with gasoline over heating oil.
Exhibit 81: U.S. Independent Refiner Seasonal Trading
7 0 .0 % 6 0 .0 % 5 0 .0 %
In a ll b u t 2 o f th e p a s t 1 5 ye a rs th e "S e a s o n a l T ra d in g P a tte rn " h a s re s u lte d in p o s itiv e a b s o lu te re tu rn s In 1 1 o f th e p a s t 1 5 ye a rs th e "S e a s o n a l T ra d in g P a tte rn " e a rn e d p o s itiv e re tu rn s re la tiv e to th e S & P 5 0 0
4 0 .0 % 3 0 .0 % 2 0 .0 % 1 0 .0 % 0 .0 % -1 0 .0 % -2 0 .0 % -3 0 .0 %
R e la tiv e to S & P 5 0 0 R e fin e rs
-4 0 .0 % '87-88 '88-89 '89-90 '90-91 '91-92 '92-93 '93-94 '94-95 '95-96 '96-97 '97-98 '98-99 '99-00 '00-01 '01-02 15-yr
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We also find it useful to compare our coverage universe cash flow multiple with the broader S&P Industrial cash flow multiple to determine any discount or premium to the broad market. We do this for each of our industry groups, but focus most heavily on this type of analysis within our Oilfield Service universe, as Exhibits 82-83 demonstrate. We use the broader S&P Oil Services Index to compare the relative performance of Oilfield Service stocks with the S&P Industrial Average.
Exhibit 82: Relative Cash Flow Multiple: Oil Service
50%
OIL SERVICE CFFO MULTIPLE RELATIVE TO S&P
Exhibit 83: S&P Oil Service Index versus S&P Industrials

700% 700% 650% 600% 600% 550% 500% 500% 450% 400% 400% 350%
40% 30% 20% 10% 0% -10% -20% -30% -40%

Market Multiple
CURRENT: -33.4% DISCOUNT
GREATEST PREMIUM 49.2%
300%
300% 250%
200%
GREATEST DISCOUNT -61.1%
-50% -60%
100%
Reversion to: Trend Line 85% Confidence Interval - Up - Down Cyclical Peak
11% 54% -32% 93%
200% 150% 100% 50%
Equal Weighted Oil Service Index

0% 1985 1987 1989 1991 1993 1995 1997 1999 2001
-70% Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01
0%
Source: S&P, CSFB estimates.
Source: S&P, CSFB estimates.
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Appendix I: The Physical Process

Exploration and Production
Oil and natural gas are the remains of tiny organisms (plankton and plants) after millions of years of decomposition
Oil and natural gas are the remains of tiny organisms (plankton and plants) after millions of years of decomposition. The remains generally sifted down rivers and streams into low-lying basins with other rock, mud, and silt. As time passed, increasing amounts of remains or sediments were deposited in the basins, and as the earths surface shifted, became trapped between rock layers and thus became a permeable, sedimentary layer. The extreme pressures and heat of the rock layers cooked the remains until they formed oil and gas. Oil and gas are chains of hydrogen and carbon atoms called hydrocarbons. Oil is a viscous, liquid substance with varying levels of thickness and colors. (It can be yellow, green, brown, black, or combinations of these colors.) Gas or methane is clean burning, colorless, and generally odorless.
H H C H Methane (CH4) H H H C H H C H H H H C H H C H H C H H H H C H H C H H C H H C H H
Oil and gas are chains of hydrogen and carbon atoms called hydrocarbons
Ethane (C2H6)
Propane (C3H8)
Normal butane (C4H10)
The difference between the formation of oil or gas lies mainly in the depth of the sedimentary basin and the type of hydrocarbon chain. Crude oil is a combination of several, long hydrocarbon chains. The three major chains are paraffins, napthenes, and aromatics.
Paraffins. Consist of methane, ethane, propane, and butane. Paraffins are gaseous at
normal temperatures and pressures, and they constitute over 50% of the composition of crude oil.
Napthenes. Consist of cyclopentane and cyclohexane, which are liquid at normal
temperatures and pressures, and constitute roughly 40% of the composition of crude oil.
Aromatics. Consist of benzene, alkyl benzene, naphthalene, and anthracene. They
The difference between the formation of oil or gas lies mainly in the depth of the sedimentary basin and the type of hydrocarbon chain; crude oil is a combination of several, long hydrocarbon chains
are the third major compound found in crude oil, constituting anywhere from 10-30% depending on the density of the crude (inverse relationship). They are liquid at normal temperatures and pressures. Natural gas chains are the paraffin groupmethane, ethane, butane, and propane; however, about 90% of natural gas is methane. We can therefore deduce from the above information that crude oil is composed of 50% or more natural gas components. The temperature and pressure of the sedimentary layer determine the type of hydrocarbon chain that develops. Temperatures and pressures increase at greater depths into the earths surface. Oil is formed in temperatures ranging from 60-100 degrees Celsius while gas forms at temperatures of 120-225 degrees Celsius. Since temperatures and pressures rise deeper into the earth, we can determine that oil forms closer to the surface than natural gas. Given the relatively wide range of temperatures
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that lead to oil generation, there can be different grades of crude that form based on the actual temperature within the range. Temperature and pressure also determine crude density, with an inverse relationship.
Close to the surface, relatively low temperatures and low pressures create long hydrocarbon chains to form heavy crude; further down below the surface, the earths temperatures and pressures rise and break apart the long hydrocarbon chains into shorter chains to form light crude, natural gas, and natural gas condensate
Close to the surface, relatively low temperatures and low pressures create long hydrocarbon chains to form heavy crude. Further down below the surface, the earths temperatures and pressures rise and break apart the long hydrocarbon chains into shorter chains to form light crude, natural gas, and natural gas condensate. Natural gas and gas condensate chains are shorter than light crude chains. The weight or density of crude is measured in relation to water and is often expressed in degrees API. (See the Glossary for a full definition of API.) Light crudes have APIs of 40 degrees or higher while heavy oils have 10 degrees or lower. Another distinction between crude grades is the sulfur content. Sweet crude has a much lower (0.5%) sulfur content than sour crude (2.5%). Oil is rarely found at depths greater than 10,000 feet whereas most gas is found greater than 10,000 feetagain, because of the high pressures and temperatures deeper down in the earths surface that break apart the hydrocarbon chains. However, associated gas, or gas condensate, is typically found with light oil (given crudes large composition of natural gas) closer to the surface than natural gas. The associated gas provides a natural pressure and lift to push the oil closer to the surface. Therefore, oil is rarely found without at least some nearby natural gas. Gas, on the other hand, can be and usually is found separate to oil. Water is also found in sedimentary layers that contain oil and gas. Similar to the natural lift natural gas provides a reservoir, water also provides lift and can affect the flow of the hydrocarbons. There are several common types of sedimentary layers that contain hydrocarbons: shale formations, sandstone beds, coal seams, and salt water aquifers. These are the rock layers geologists will evaluate when they find traps in the earths surface.
There are several common types of sedimentary layers that contain hydrocarbons: shale formations, sandstone beds, coal seams, and salt water aquifers
The three most common traps or rock formations containing oil and gas are faults, anticlines, and salt domes
Once the oil and gas is formed, the pressure and heat within the sedimentary layers force the oil and gas up through the pores of the source rocks. The oil or gas migrates (primary migration) through permeable layers and water levels until it reaches an impermeable rock layer or carrier bed, and becomes trapped. The oil and gas cannot rise through these traps and the hydrocarbons begin to separate owing to their different densities. As we mention above, natural gas and/or natural gas condensate is a shorter hydrocarbon chain, similar to light crude. When the oil and gas do separate, they will typically not stray very far from one another; however, they will migrate (secondary migration) into and from different reservoirs. Heavy crude is rarely found together with natural gas, as it forms at lower temperatures and pressures, closer to the earths surface. The three most common traps or rock formations containing oil and gas are faults, anticlines, and salt domes.
Faults. Fractured layers of rock created by movements in the earth's crust/plates. Anticlines. Flat rock layers shift and fold over, creating dome shapes where
hydrocarbons can become trapped.

Salt domes. Beds of nonporous salt, pushing up through overlying formations.
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A reservoir is a sizable rock layer containing hydrocarbons; the hydrocarbons are present in the rocks themselves, not, as commonly imagined, in a pool-like structure beneath the surface between rock layers
Exhibit 84: Sedimentary Layers: Faults, Domes, Anticlines
14 May 2002
Source: NGSA.
There are five major characteristics that determine reservoir behavior: porosity, saturation, hydrocarbon type, permeability, and thickness
A reservoir is a sizable rock layer containing hydrocarbons. The hydrocarbons are present in the rocks themselves, not, as commonly imagined, in a pool-like structure beneath the surface between rock layers. There are five major characteristics that determine reservoir behavior: 1. Porosityhow much space is in the rock 2. Saturationhow much of the space contains fluid 3. Hydrocarbon typeoil or natural gas 4. Permeabilityhow easily does the fluid come out of the rock 5. Thicknesswhat is the vertical extent (size) of the reservoir The porosity and permeability of the sedimentary rock layers determine the amount of oil and gas contained in the rock. Porosity indicates the amount of space in the rock and potentially how much hydrocarbon can be held by the rock. Permeability gauges how easily the hydrocarbon comes out of the rock. An attractive reservoir will have high porosity, high saturation, high permeability, and will be large. Understanding reservoir behavior is a critical function of oil and gas extraction.
The E&P Process

The exploration for and production of (E&P) hydrocarbons is the very beginning of the oil and gas chain. The E&P process consists of five primary areas of operation:
Exploration Appraisal Development Production Decommissioning and abandonment
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Land Acquisition and Exploration

The exploration phase begins with the acquisition of acreage, either from government auctions or from private land or mineral owners
The exploration phase begins with the acquisition of acreage, either from government auctions or from private land or mineral owners. Producers rarely own the land they drill; rather, they lease land from private land/mineral owners or through government auctions (lease sales). The type of government auction varies from country to country. In general, as part of a lease sale, a government agency will offer an extensive amount of acreage, which it subdivides into tracts, or blocks. In the U.S., producers bid on the various blocks in a silent auction and the agency reviews the bids to determine the highest bid and winner of the block. The process in the U.K. is different; the government agency announces the acreage and blocks it will offer and then it selects the producer or consortium it believes is most qualified. A third common type of licensing in emerging market countries involves production-sharing contracts (PSCs), which we discuss below. These are very common in Indonesia. In a lease auction, particularly the U.S., not all of the blocks are bid, as some blocks are more or less desirable than others. The percent of blocks receiving bids is often indicative of market fundamentalsa high bid percentage is usually the result of a strong oil and gas pricing environment and robust producer development plans. The producer and the property or mineral rights owner agree to specific terms of the lease (acreage, time period, and royalty fees) and sign a leasehold agreement.
The high fixed costs of and risks associated with exploratory drilling make exploration and development a costly process for a single producer
The high fixed costs of and risks associated with exploratory drilling make exploration and development a costly process for a single producer. A producer who owns the rights to a property may sell working interests to other interested producers while maintaining a majority share. The producer with the highest working interest often becomes the operator of the field and makes the final decisions on field exploration, development, and production planning and budgeting. As we discussed earlier in the Upstream section, production-sharing contracts, concession agreements, and other arrangements with host governments in international E&P operations are an important part of the cost equation and value-creation potential of a producer. Land or acreage acquisition costs are the lowest costs associated with an E&P operation, and are capitalized on the balance sheet. Producers continually attempt to acquire acreage to build a backlog of potential development projects.
Exploration prospects are identified using seismic methods that indicate geological formations and potential oil or gas reservoirs
Once a producer has secured property rights, it can begin to explore for hydrocarbons. The exploration prospects are identified using seismic methods that indicate geological formations and potential oil or gas reservoirs. Producers undertake seismic data acquisition, seismic data processing, and seismic data interpretationthree distinct functions. The two main forms of seismic data collection are two dimensional (2-D) and three dimensional (3-D) seismic. The difference between the two is that 3-D provides more information by recording a grid over the surface and 2-D records only a cross section (single line) of the formation. Three dimensional seismic allows producers to view the earths crust to identify promising formations that may ultimately lead to the retrieval of hydrocarbons. Geologists process and analyze data using powerful computers to form a model of a potential reservoir. 3-D seismic data will show geologists if multiple zones are present, how many feet of net pay exist, and the type of rock layers that will help determine which type of equipment to use.
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The biggest advantage of 3-D seismic over prior methods including 2-D is its greater level of accuracy at identifying pay-bearing structures. This allows for greater drilling success rates and substantially reduced dry-hole costs for producers.
Exhibit 85: Recording Seismic, Land Exhibit 86: Recording Seismic, Offshore
Source: API.
Source: UKOAA.
Seismic data only point to potential reservoirs based on the historical results of similar rock formations; the only way to confirm the presence of an oil- or natural-gas-bearing reservoir is to drill an appraisal well
During seismic data acquisition, producers or independent Oilfield Service companies record or shoot 3-D seismic over large areas, maintaining an inventory/database of potential areas with hydrocarbons. In onshore seismic, seismologists lay electromagnetic cables, wires, and geophones attached in square blocks across a field. A thumper then thumps the ground to produce vibrations in the earths surface. In offshore seismic data collection, boats or vessels tow air guns that produce short sound bursts. Hydrophone lines are also attached to the boat to collect and record the length of the sound waves. The sound waves vary in length, depending on the rock type and layer being penetrated, and the geo or hydrophones pick up the signals and send them to an onsite truck or boat that is essentially a mobile supercomputer. The supercomputer records the data and eventually forms a picture of the rock types and layers based on the size/length of the sound waves. Processing the seismic data is a time-consuming process, sometimes taking up to two years. Land seismic data take from two to eight months to process while some offshore seismic activities can take up to two years. A team of geologists analyzes the seismic data to interpret or find formations (faults, anticlines, salt domes) that may contain oil and gas reservoirs. The seismic data only point to potential reservoirs based on the historical results of similar rock formations. The only way to confirm the presence of an oil- or natural-gas-bearing reservoir is to drill an appraisal well.
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Exhibit 87: 3-D Seismic Computer Image
14 May 2002
Source: NGSA.
Seismic data costs are a significant nondrilling cost incurred by the producer, but are only a small component of total producer costs
Seismic data costs are a significant nondrilling cost incurred by the producer, but are only a small component of total producer costs. The price of seismic varies by the type used and the amount of acreage involved. 3-D seismic is more expensive than other survey methods and takes an extended period of time to process; however, it is the most advanced method and generally results in the most accurate pictures. An average seismic survey for a 1,000-acre block in the shallow waters of the Gulf of Mexico may cost $200,000 and take four months to process. The same size block in the deepwater of the South China Sea may cost $500,000 and take up to a year to process.
AppraisalProspect Evaluation
Appraisal drilling attempts to confirm the physical presence of hydrocarbons and ascertain the other characteristics of the field: reservoir size, porosity, permeability, and saturation. Producers gather this information by drilling one or several exploratory/ appraisal wells.
Appraisal drilling attempts to confirm the physical presence of hydrocarbons and the other characteristics of the field
The first appraisal well will confirm the physical presence of oil and gas. A producer may then drill delineation wells around the first appraisal well and possibly drill to different depths. This will help determine the lateral size of the field and the depth of the reservoir (pay zone, or pay bearing sands). Some sedimentary areas have multiple completion layers (multiple pay zones) where oil and gas are present at different depths of the rock formation. This is highly desirable, as well depth can be readjusted to different target depths each time a reservoir depletes. Once the producer estimates the size of the reservoir or field and recoverability of hydrocarbons, it can record or book reserves on the balance sheet. Appraisal drilling requires an extensive and sophisticated set of oilfield drilling systems to collect and analyze well data. The process of well data collection and analysis is similar for both exploratory drilling and development drilling. It is critical to characterize the reservoir as accurately as possible to calculate the reserves and determine the most effective and economic way of recovering the hydrocarbons. Computer simulation can help predict the potential impact of different well spacings, production rates, and enhanced recovery schemes.
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To drill a single well can cost upward of $500,000 in an average U.S. onshore, mature basin, and up to $20 million for an international deepwater well; the analysis of the data and the decision to drill are therefore critical to the producers economics
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Exploratory drilling costs are much higher than survey or seismic costs, as the drilling process is much more capital and labor intensive. As we discussed earlier, the cost of drilling a single well can be very expensive depending on the drilling environment. An average U.S. onshore well can cost more than $500,000 while the cost of a deepwater well in an international market can well exceed $20 million. Therefore, thorough analysis is required before proceeding with such a significant investment. There are three primary ways to drill a land well: vertical, horizontal, or directional. First, we focus on the straightforward vertical land well. A rig drives a drill bit down through the earths surface to a target depth where the hydrocarbons are believed to exist.
Exhibit 88: Drilling Techniques
Surface
Vertical
Directional
Horizontal
Source: Fundamentals of Oil and Gas Accounting.
Vertical wells are drilled straight down into the earth, with the rig placed directly over the reservoir
Vertical wells are drilled straight down into the ground, with the rig placed directly over the reservoir. It is imperative that the wellbore does not deviate from its vertical position, otherwise the drill may not reach the reservoir. Vertical drilling can thus be limiting if a rig cannot be placed directly over the reservoir site. Directional drilling and/or horizontal drilling are appropriate in applications when the rig cannot be located over the reservoir. Advances in directional and horizontal techniques have made both technologies more widespread, albeit more expensive than traditional vertical wells. In directionally drilled wells, operators can change the direction of the well from vertical to almost 90 degrees horizontal within a few feet. The directional flexibility of these wells generally provides greater exposure to the reservoir, allowing for higher production rates since the wellbore can angle through the reservoir, increasing surface area exposure. While land and offshore drilling have certain similarities, offshore drilling requires more complex drilling systems, as described on page 121.
The wellbore must be straight and not slant in any direction to allow the drill to reach the reservoir
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Exhibit 89: Drilling Rigs
Land Rig Land RigAerial View Tension Leg Platform
14 May 2002
Source: Helmerich and Payne, Royal Dutch Shell.
Broadly speaking, there are three main rig components: drilling equipment, power equipment, and pressure control equipment. We will concentrate on the drilling equipment and pressure control equipment. Briefly, the power equipment is either a diesel engine or an electric generator (AC or DC powered), and the amount of horsepower will dictate the type of formations and depth of wells on which the rig is capable of drilling. The type of power system used is an important determinant of total rig weight, maintenance requirements, power efficiency, and instrumentation compatibility.
On the rig floor are the drawworks, which contain the controls, and lever and pump system that drive the drill stem and drill bit down into the wellbore
The most noticeable component of a rig is the derrick, which is the tower-like portion that extends from the rig floor high into the air. On the rig floor are the drawworks, which contain the controls and lever and pump system that drives the drill stem and drill bit down into the wellbore. A rotary table on the rig floor, with a hole in the center, provides an entry point for the drill bit and drill stem to bore into the ground. The rotary table on the drill floor drives the rotating motion of the drillstring. When new pipe needs to be added to extend the drillstring deeper into the ground, the drillstring is raised and a new pipe is placed into or extended on to the drillstring and the drilling process can continue. In this manual process, two roughnecks work the drill string and the moving parts while a third roughneck controls the drawworks machinery at the side of the rig floor. (See Exhibit 90.)
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Exhibit 90: Adding Drill Pipe to the Drillstring
14 May 2002
Source: UKOOA.
Some rigs are semiautomatic, utilizing pipehandling equipment and a top drive system to reduce the necessary crew from the normal three- or four-man configuration to a twoman configuration. Service companies that can provide technology and equipment that reduces labor costs are able to charge a premium to producers given the potential savings. A top drive system within the derrick turns the drill stem and provides the torque necessary to bore into the ground. New drill pipe is hoisted and connected at the rotary table by the roughneck or an automated roughneck. These rigs are smaller than typical rigs, so transport times and rigging times are shorter. Top drives effectively replaced the rotary table. The pipehandling systems allow for several pieces of drill pipe to be added to the drill string at once, rather than one at a time. This saves valuable drilling time and improves the efficiency of the operation.
Exhibit 91: Drill Pipe at Well Site
Source: Helmerich and Payne.
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The drill string is the connections of drill pipe that extend the drill bit from the rig to the target depth thousands of feet below the surface; drill pipe is the most commonly used tubular product
14 May 2002
The drill stem, or drill string, is the main tool, aside from the rig, used to drill a well. The drill string is the connected drill pipe that extends the drill bit from the rig to the target depth, which can reach thousands of feet below the surface. Drill pipe is considered a tubular product. Tubular products encompass a wide family of cylindrical drilling products, including drill pipe, casing, and tubing, used in the appraisal, development, and production phases of the upstream process. Drill pipe is a hollow cylinder of metal that comes in many different sizes, weights, and materials. It is typically 30 feet long, and its diameter varies from 19 inches to 5 inches. The widest diameter drill pipe (19 inches) is used at the initial wellbore, while incrementally smaller diameter drill pipe is used as different depths are encountered. Changing tubular diameters are associated with the different types of casing and cement that will be put into the wellbore. An average rig operation will maintain 10,00020,000 feet of drill pipe with different diameters at the well site, depending on the depth of the well. Drill pipe is reusable and may last several years, depending on the intensity of use before it wears out or breaks. The material used (steel, aluminum, composite, titanium) is highly dependent on the drilling environment. Key considerations follow: Working conditions Subsurface pressure Temperature Depth of well Intensity of use Penetration rate Cuttings removal Pipe characteristics Pipe corrosion characteristics Pipe Expandability Lifespan of drill pipe Torque capability Sealability Hydraulic performance Considerations Weight Size Space Manuveurability
Associated with the tubulars business is the required tubular connections or engineered connections. These connections join pieces of drill pipe and casing components to create a seal that can withstand high pressures, temperatures, and conditions to prevent blowouts or well destruction. The connections business involves cutting thread profiles on tubulars. High-end premium connections are used in deep drilling, high pressure, extended reach, and other critical application wells. Premium connections typically use proprietary thread designs that offer increased torsional capacity. In higher-end well applications, the tubulars and the threads account for approximately 30% and 6% of the cost of the well, respectively. Since connections are critical to the success and safety of the operation but are not an excessive cost, operators have some degree of flexibility to select connections based on capabilities rather than on the lowest price. Operators employ stringent product qualification procedures and often demonstrate significant brand loyalty.
Different drill bits are used for different rock formations
Different drill bits are appropriate for different rock formations so that several different bits may be used on a given well as different rock layers are encountered. Bits are either diamond, which are constructed of specially fabricated synthetic diamonds, or tricone. Exhibit 92 shows three Baker Hughes diamond drill bits, demonstrating various shapes and designs. Tri-cone bits are very common and are used in more basic applications, given the lower cost. Drill collars are positioned directly above the bit and add weight, generating better control and penetration.
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Exhibit 92: Drill Bits
14 May 2002
Source: Baker Hughes.
Drilling fluids, or muds, are chemical compounds that cool the bit as it drills to prevent damage and extend its life
Drilling fluids, or muds, are chemical compounds that react with shale, gravel, sand, and drill cuttings to cool the bit as it drills in order to extend the life of the bit and prevent damage. They also serve to contain formation pressures, remove rock cuttings, and maintain wellbore stability. Mud systems can be very expensive and require extensive research and development on the part of the Oilfield Service company developing the product line. There are three types of drilling fluids:
Oil-based fluids reduce torque and are most often used in stuck pipe situations. Water-based fluids are the most widely used fluids, are environmentally friendly, and
contain specifically engineered weighting materials geared toward maintaining formation pressures.
Synthetic fluids are used in place of oil-based fluids when oil-based fluids are
prohibited because of environmental concerns. Drilling fluids are highly specialized for specific conditions, so service companies provide considerable value through their guidance on picking the appropriate fluids in certain conditions.
Solids controls systems are used to separate rock cuttings from the muds; mud pumps inject and re-inject drilling fluids
Solids controls systems are used to separate rock cuttings from the muds. Mud pumps inject and reinject valuable drilling fluids throughout the drilling process. As mud is continuously pumped into the wellbore to cool the drill bit and provide pressure control, it resurfaces through the wellbore and back to the surface. The constant flow of mud also serves to pull cuttings out of the hole. A shaker is a solids control system that separates the drilling mud from the core samples, or cuttings. The core samples still contain portions of drilling mud, which are then analyzed for the presence of hydrocarbon compounds. The expensive drilling fluids are cleaned of drilling residue and then reinjected into the wellbore. Cuttings that are not sent to a lab for evaluation are either deposited in a waste area at the wellsite or reinjected into the wellbore.
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Pressure control equipment is designed to control the flow of oil and gas throughout the drilling and production process to prevent gushers or blowouts
14 May 2002
Pressure control equipment is designed to control the flow of oil and gas throughout the drilling and production process to prevent gushers or blowouts. The most commonly used pressure control devices include the following:
Annular blowout preventers (BOPs) use a rubber collar to create a seal between the
drill pipe and the wellbore to control the flow of hydrocarbons within the well.
Ram BOPs use metal rams or rubber seals to either seal around the drillpipe (pipe
rams), completely seal off the wellbore (blind rams), or cut through the drillpipe to create a seal (shear rams).
Diverters and gas handlers. Diverters redirect natural gas encountered while drilling
away from the rig and are typically used in offshore applications where pressurized gas zones are common. Gas handlers, used in subsea operations, vent and contain expanding natural gas bubbles at the subsea wellhead, slowing them in order to avoid potential blowouts, which could damage the well, the rig, and personnel.
Drill stem valves are located in the drill string, typically below the kelly, and are
manually operated to prevent blowouts and fluid spillage while installing and removing drill pipe.
Chokes are used to control the flow of drilling mud.
In appraisal drilling, after the well is drilled (before the casing is installed) operators use wireline logging devices to gather information on the characteristics of the reservoir
During appraisal drilling, which occurs after the well is drilled but before the casing is installed, operators use wireline logging devices to gather information about the characteristics of the reservoir. Open-hole logging helps operators decide whether or not to proceed with completion of a well. Cased-hole logging, which occurs in new or existing wells, is used to locate casing perforation. Electric wireline, or slickline, uses electro-mechanical cable to deliver information regarding reservoir formation and producing zones from the wellbore to the surface. The wireline can be delivered from a truck on the surface, or from a rig platform for offshore operations. From this operating base, the wireline is lowered or spooled into the wellbore. Attached to the wireline device is a sonde, which contains the measuring equipment. The sonde takes and transmits several measurements to the surface where they are recorded and interpreted by sophisticated computers. Field operators use these data to manipulate producing zones based on flow rates and formation composition.
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Exhibit 93: Wireline Logging, Onshore
14 May 2002
Exhibit 94: Wireline Logging, Offshore
Source: UKOOA.
Logging measurements include the following:

Resistivity measurements. Resistivity sensors are used to determine the fluid content
of a formation (saturation). Three common fluidsoil, water, and salt waterall have different abilities to conduct electricity. Salt water provides little resistance to electrical flow, while oil will not conduct electricity at all.
Gamma ray measurements. Gamma ray sensors measure the natural radioactivity of
the formation. Using gamma ray readings, information on the lithology (rocks composition) may be obtained.
Neutron porosity measurements. Neutron sensors indicate the formations porosity by
measuring the quantity of hydrogen atoms (found principally in water and oil). The greater the number of hydrogen atoms found, the more porous the rock is assumed to be. The count is based on the response to neutron bombardment.
Density measurements. Density sensors reveal the bulk density (weight per unit
volume) of the formation. The porosity may be approximated by determining the relative content of rock and fluid. The more dense a formation, the lower the porosity or fluid content. After measurements are taken, operators print out and analyze the logs. A standard log is shown in Exhibit 95.
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Exhibit 95: Wireline Log
14 May 2002
Source: UKOOA.
Different drilling techniques (vertical, horizontal, or directional) require different equipment
In addition to the nature of the reservoir, the equipment required for a particular project also depends on the chosen drilling technique (vertical, horizontal, or directional). Horizontal and directional techniques require more technologically advanced measurement products. Measurement while drilling (MWD) and logging while drilling (LWD) are two such technologies. Measurement while drilling systems utilize computers and gearing mechanisms to allow a rig operator to control the trajectory of the drillstem and the direction of the wellbore. MWD measurements typically include gamma readings, which provide data on the type of formation that is being penetrated. Dynamic measurements such as temperature and pressure may also be taken in order to optimize the drilling approach. The data gathered downhole are transmitted to the surface via a mudpulse telemetry system.
Measurement while drilling and logging while drilling provide real-time information throughout the drilling process
Logging while drilling measurements were developed to provide real-time geological and geophysical data that are wireline equivalent. More frequently, these measurements are being used in place of wireline logs in basic applications and are an excellent complement to wireline in high-end or exploratory applications. The economic benefits of LWD can be significant. Traditional wireline logging data retrieval require drilling activity to be stopped and the drill string pulled from the hole. However, the LWD tool is part of the drill string, so measurements can be made with the string in place, providing considerable savings over wireline, with reduced rig time because of the fewer trips. LWD also benefits the drilling process by providing real-time information, often helping to shape drilling decisions and thereby enhancing recovery efforts. Throughout the drilling and completion process, different types of casing (i.e., liner or tubing) are installed and cemented throughout the well bore to prevent well collapse, allow for cuttings to flow through to the surface, and prevent environmental damage from escaping hydrocarbons. Wide diameter (about 20 inches) conductor casing is installed at the surface extending through the mud line (50 feet below the surface) and
Multiple types of casing (i.e., liner or tubing) are installed and cemented throughout the wellbore
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is followed by surface casing (about 15 inches diameter), which can extend several thousand feet into the earth. The wellbore diameter narrows as the drill penetrates deeper into the ground. Intermediate, or protection casing (about 10 inches diameter, typically the longest), is installed between surfaced production casing to support the hole and seal off more dangerous formations. The last type of casing to be installed is production tubing, which is the smallest in diameter and thickness. It is run through the production casing and is sealed off with packers to test flow rates at various intervals.
Exhibit 96: Casing
Surface
Sample 5,000 Foot Well (Oil) Sample 15,000 Foot Well (Gas)
800
Surface Casing Protection Casing
3,000
11,000
Production Casing
5000
Source: Grant Prideco, CSFB.
Production Tubing
15,000
After each new depth level has been drilled and the respective casing has been installed, the casing is cemented into place
After each new depth level has been drilled and the respective casing has been installed, the casing is cemented into place. The type of cement depends on the physical properties of the well, but generally, it is blended with water and combined with various additives to create a slurry that is pumped between the casing and the wellbore. Cementing services are also used when recompleting wells and when plugging and abandoning wells, and can be an expensive part of overall well completion costs.
Completions
The decision on whether or not to complete a well is based on all of the data collected before (survey and seismic) and during the drilling process (core samples, mud logs, wireline logs, reservoir behavior, reserve recovery). The producer considers these data along with completion, development, and production costs, and current and expected oil and gas market prices. The final decision on the field development is based on whether the returns exceed the hurdles established by the producers.
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Pressure pumping is a term that broadly includes cementing and stimulation services in the completion of new wells and in remedial work
14 May 2002
Completion follows appraisal drilling and is the process of developing a well for production. A producer and an Oilfield Service company study the reservoir behavior and determine which equipment and processes will yield the most effective production results. The first part of the process is to perforate the casing, allowing the natural gas or oil to flow from the reservoir into the production tubing. Perforating entails the use of a perforating gun that sets off a shaped explosive charge, cutting through the casing and cement into the reservoir and bringing the hydrocarbons and wellbore into contact. Pressure pumping is a term that broadly includes cementing and stimulation services in the completion of new wells and remedial work. Pressure pumping services utilize equipment mounted on trucks, skids, or vessels, enabling flexibility to complete multiple jobs within a region.
Exhibit 97: Pressure Pumping Trucks, Mobile Units
Source: Varco.
Stimulation services are designed to improve the flow of oil and gas from the producing formation
Stimulation services are designed to improve the flow of oil and gas from the producing formation. Typically referred to as a frac job, the fracturing process consists of pumping a fluid gel (frac fluid) into the formation at sufficient pressure to fracture the formation. The goal is to fracture low porosity, low permeability layers of a formation to improve hydrocarbon flow and reservoir recovery. Sand, bauxite, or other synthetic proppants (a very tiny pebble-like, or bead-like, substance) are suspended in the gel to keep the fractures open when the fluid is removed. The size of a frac job is often expressed in terms of the proppant weight, which can exceed 200,000 pounds. The primary pieces of equipment used include the following:
a blender, which blends the proppant into the frac fluid; a pumping unit, which pumps the proppant into the wellbore; and monitoring systems with real-time capabilities to evaluate and control the frac
process. Acidizing is another type of fracturing service, and involves pumping large volumes of specially formulated acids into reservoirs to dissolve blockages and enlarge crevices in the formation, increasing the flow of oil and gas. Through the drilling process, cavities are created within the wellbore, providing room for sand buildup. Sand buildup can reduce the stability and strength of the wellbore, and ultimately reduce the flow of oil and gas through the producing region. One way to control this is through gravel packing in which gravel is pumped into the wellbore to fill the cavities, excluding sand, but it still permits the flow of oil and gas. 102
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Downhole tools are used for gravel pack and frac completions, reservoir flow testing, well stimulation, and well servicing applications
14 May 2002
In addition to the capital equipment and expenses required for computer processes, Oil Service companies also provide various downhole tools. Downhole tools are sometimes purchased, but usually rented, and include drill-string-related tools such as stabilizers and collars, as well as fishing tools. Fishing primarily involves removing obstructions (lost equipment, drill pipe, or debris) from the wellbore that may become caught during the drilling, completion, or workover during a wells production phase. Fishing requires the use of a variety specialty tools, including fishing jars, milling tools, casing cutters, overshots, and spears. The final step is installation of a wellhead. Wellheads are application-specific and vary based on oil or gas, onshore or offshore, and type of offshore (surface or subsea). Exhibit 98 shows a natural gas well, or Christmas tree as it is often called, and Exhibit 99 shows an oil well with a pumpjack. Several Oilfield Service and Equipment companies design, manufacture, and sell a variety of wellheads.
Exhibit 98: WellheadsNatural Gas Exhibit 99: WellheadsOil
The final step is installation of a wellhead and the construction of gathering and processing lines
Source: NGSA.
Source: NGSA.
Recall that the successful results of appraisal drilling will allow the producer to record reserves on the balance sheet. However, the producer may or may not decide to develop the field right away. It may classify the field as undeveloped and postpone development based on several factors, largely economic ones. In most cases, development closely follows drilling and completion and typically requires more drilling than the initial exploration and appraisal wells.
Development
The decision to develop a field is based on the fields characteristics, the current and expected commodity price environment, and the relative economics of the field compared with other fields in a producers development portfolio:
Is the field large enough to be commercially viable? Is there a high enough level of porosity and permeability for the hydrocarbons to be
easily extracted? 103
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How much oil and or gas in the reservoir is recoverable? Is there adequate infrastructure to move the hydrocarbons to market?
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Do current or expected market prices for oil and gas provide an adequate return over
the cost of development?

Will the cost of maintaining production remain reasonable to ensure an ongoing fair
rate of return? The development process involves maximizing the economic recovery of confirmed hydrocarbons from a field. Development planning begins with analysis of the seismic, appraisal well, and wireline data. Petroleum engineers combine the data to form a model of the reservoir. The reservoir model allows the producer to predict reservoir behavior based on different recovery methods and to select the best strategy for developing the field.
After the reservoir has been modeled and the development plan has been established, the producer begins a continuous drilling program Over time producers will alter their development plans to improve productions characteristics
Once the reservoir is modeled, the producer can determine the number, type, and location of wells to be drilled. Once a development plan has been established, the producer begins an expanded drilling program. In the appraisal process, only one or two wells were drilled with the purpose of providing information on the characteristics of the field. In the development stage, multiple wells may be drilled as part of an ongoing development or exploitation program. The physical drilling process, equipment and services used, and costs are the same for development drilling. In an effort to optimize production, producers will often drill a number of new wells in a field every year, monitor existing well performance, inspect and maintain wells, and repair or workover existing wells. Monitoring well and reservoir performance is a critical function for a producer because reservoir problems could cause hydrocarbon areas to be missed entirely or damaged owing to to well problems. Depending on field size, number of wells, flow rates, market demand, etc., field development and exploitation can last years or decades until the reservoir is depleted to a level that is no longer economical to produce. Over time, as fields deplete and reservoir behavior changes, producers will alter their development plans to improve productions characteristics. If well-spacing constraints are reached and/or reservoir conditions change so that the existing spacing between wells fails to capture the full potential of the reservoir, producers sometimes choose to decrease the well-spacing dimensions and drill new wells closer to existing wells in the field, called infill drilling.
Gathering pipelines are installed to connect the productive wells to a central gathering and processing facility
When wells are ready to produce, gathering pipelines are installed to connect the productive wells to a central gathering and processing facility. Oil and/or gas pumped to the surface is not necessarily ready for end-use consumptionrefinements need to be made. Natural gas needs to be processed to become pipeline quality so that it can safely and conveniently be transported across a pipeline network. Oil must be transported to a refinery to be converted into products (gasoline, diesel, heating oil).
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Production
Production refers to the ongoing collection of hydrocarbons from a field and the preparation of the hydrocarbons for transportation
Production refers to the ongoing collection of hydrocarbons from a field and the preparation of the hydrocarbons for transportation. At the very beginning of a wells life or a fields life, the reserve base is at its maximum size and reserve life. Once production commences, the reserve base continually depletes. The initial productive years are characterized by high flow rates, as the natural pressures in the rock layers easily force hydrocarbons to the surface. These primary recovery methods, or natural drive mechanisms, are water drive, gas drive, and dissolved gas drive. Over time, high flow rates give way to high decline rates (rapid depletion) as the well or field moves into a mature stage where natural pressures subside and a lower flow pattern emerges. Exhibit 100 demonstrates the typical life span of a basin. The beginning of a basins life is characterized by a small number of fields, high average field sizes, and high maximum field sizes given the few initial prospectors in the region. As a basin matures, more producers explore and develop in the region, increasing the number of fields; however, they crowd each other out and the average field size falls rapidly, as does the maximum field size.
Exhibit 100: Oklahoma Gas Field Size by Decade of Discovery
700 7.0
600
6.0
500
5.0
400
4.0
Bcf
300
3.0
200
2.0
100
1.0
1930-39 1940-49 # Fields 1950-59 1960-69 1970-79 1980-89 1990-98
Avg Field Size (Bcf)
Max Field Size (Tcf)
Source: Anadarko Petroleum, NRG.
As a field matures, the effectiveness of primary recovery methods diminishes, requiring secondary and enhanced, or tertiary, recovery methods
As a field matures, the effectiveness of primary recovery methods diminishes and production rates decline, forcing producers to implement secondary, or tertiary, recovery methods. The most common secondary recovery methods are water flooding and gas injection. Tertiary, or enhanced recovery techniques, include the use of chemicals, gas, or heat injections to alter the fluid properties of the rock. Two common enhanced recovery methods used in the oilpatch are compression and artificial lift.
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Compression helps to compensate for diminished wellhead pressure and is used primarily on gas wells. Artificial lift systems are used to supplement reservoir pressures in oil wells and include the following:
Progressive cavity pumps. Downhole pumps connected to a sucker rod that runs from
a surface electric system.

Gas lift systems. Natural gas injection into the well from above ground to provide the
necessary pressure to push oil to the surface.

Hydraulic lift systems. Hydraulic pumps installed at the bottom of the wellbore to lift oil
from the reservoir.

Steam injection. Steam is forced into the reservoir, creating enough pressure to force
oil to the surface.

Exhibit 101: Steam Injection
Source: U.S. DOE.
Each of the above methods increases the flow of hydrocarbons to the wellbore. Enhanced recovery methods are expensive and are normally used only when market dynamics (high prices) justify the high costs. During their productive lives, wells sometimes require a workover to stimulate hydrocarbon flow.
A workover is essentially a recompletion of the well; the well is refractured, stimulated, and or possibly drilled to a new depth to increase hydrocarbon production
Workovers involve one of several types of remedial work. The well could be refractured, stimulated, or even drilled to a new depth. A workover typically requires that production be stopped, usually for at least a couple of days when using a workover rig. However, a coiled tubing unit, which inserts coiled tubing into the well through the wellhead, can recomplete a well in one day without shutting in production in certain applications. In more difficult operating conditions or to accomplish some services, a workover rig remains the only option. Coiled tubing units can therefore save a producer
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valuable time and money by recompleting the well in a short time without disrupting production. The advantages of coiled tubing units come at a higher price than average workover rigs, and therefore are not as widely used.
Exhibit 102: Coiled Tubing Unit Exhibit 103: Workover Rig
Source: Varco International.
Hydraulic drilling is another workover method. Hydraulic drilling utilizes smaller, specifically designed rigs for more basic workover drilling workprimarily deepening and sidetracking existing wells and re-entry work. While more limited in the scope of drilling applications supported, hydraulic rigs are smaller and cheaper than traditional drilling rigs, making them well suited for workover applications. Given the smaller size and ease to move, hydraulic rigs are well served in fields where there is substantial infrastructure and a smaller footprint is desired.
A more recent industry technique for increasing reservoir production rates and maximizing recoverable reserves is through underbalanced drilling
An increasingly utilized technique for increasing reservoir production rates and maximizing recoverable reserves is underbalanced drilling. Overbalanced drilling uses drilling and completion fluids to control the pressure of the wellbore by forcing greater pressure on the reservoir than the reservoir exerts. It can result in formation damage as the fluids permeate the reservoir, hindering the flow of oil or gas into the wellbore. Underbalanced drilling reduces the pressure in the drilling column so that wellbore pressure is less than formation pressure. Underbalanced drilling, while more expensive than overbalanced drilling methods, offers substantial cost savings potential in terms of reduced formation damage and reduced workover costs.
Decommissioning and Abandonment

The final stage of the E&P lifecycle is decommissioning and abandonment (plug and abandon, or P&A)
When it is no longer possible to economically extract the remaining reserves from a well, the producer must either temporarily or permanently plug and abandon the well. The final stage of the E&P lifecycle is decommissioning and abandonment (plug and abandon, or P&A). A producer will P&A appraisal wells and development wells, depending on the viability of the prospect. An appraisal well that appears uneconomical to develop will be plugged and abandoned the same way productive wells are plugged and abandoned when a field or prospect has been depleted to a level that is no longer economical to produce. The wells are inspected and plugged, pipelines are removed, equipment is removed and redeployed elsewhere, and the E&P process begins again.
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Storage and Transportation

Crude is stored in large diameter, tall holding tanks and is transported by pipeline, truck, and ocean tankers to refineries that turn crude into products
Oil and gas collected from the various wells in a field and fields in a basin need to be stored and transported. Crude is stored in large diameter, tall holding tanks and is transported by pipeline, truck, and ocean tankers to refineries that turn crude into products. Natural gas is stored underground in a variety of methods. Like crude, gas can also be transported a number of ways; however, this depends on its physical state. Dry gas, or methane, which is the most commonly used gas, can only be transported by pipeline, while natural gas liquids can be transported either by pipeline or tanker truck. Liquefied natural gas, which is used for long distance gas export, can only be shipped in specially designed refrigerated, ocean tankers. The major oil-producing basins of the world (see Exhibit 6 on page 15) are not closely located to the major consuming regions. These long distances require the use of oil tankers to transport the crude. Tankers are filled at major ports near the producing regions and transport the crude to major coastal ports or hubs around the world.
Major global transocean import/export hubs are the Houston Ship Channel, Rotterdam, and Singapore
In the U.S., the Houston Ship Channel, the Louisiana Offshore Oil Port (LOOP), and New York Harbor are the major transocean import hubs where foreign oil is delivered. Major European hubs include Rotterdam (NWE) and the Mediterranean, while Singapore is a major hub in Asia-Pacific. Tankers can carry between 10,000 barrels and 1MMB of oil and take up to three weeks to deliver, depending on the travel route (i.e., Middle East to U.S. Gulf Coast). The crude is delivered to refineries that purchase the crude on the open market or directly from producers.
Exhibit 104: Pipeline Exhibit 105: Oil Tanker
Source: Stelmar Shipping Ltd.
Crude is delivered to refineries, which are typically located near major import hubs to limit additional transportation costs
Refineries are typically located near major import hubs to limit additional transportation charges. Refiners pay transport costs associated with shipping crude to the refinery. These costs vary depending on the origin and the destination of the shipment, as well as on the amount of oil being shipped, and the market supply and demand for transportation services. Exhibit 106 illustrates the transportation costs for both dirty (crude) and clean (product) tankers from certain origins to different destinations. For example, a dirty tanker from the Arabian Gulf to the U.S. Gulf Coast costs $8.96 per ton of oil, or $1.20 per barrel of oil. Similarly, the cost of shipping refined products in a clean tanker from the
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U.K./Continent to the U.S. Atlantic Coast is $18.55 per ton, or 5.54 cents per gallon of oil. These prices are not fixed; they are quoted market rates that vary with overall oil market conditions.
Exhibit 106: Tanker Route Assessments
Tanker Route Assessments - Dirty Origin Destination Arabian Gulf Singapore UK/Continent Mediteranean US Gulf Coast UK/Continent US Gulf Coast US Atlantic Coast Tanker Route Assessments - Clean Origin Destination UK/Continent Mediteranean US Atlantic Coast UK/Continent Caribbean US Atlantic Coast US Gulf Coast
* In thousand tons ** Conversion Rate: Dirty = 7.45 bbl/ton, Clean = 8.00 bbl/ton
DWT* WS $/Ton $/Bbl 250 47.50 3.01 0.40 250 45.00 8.31 1.12 250 45.00 8.33 1.12 250 45.00 8.96 1.20 250 52.50 4.81 0.65 130 100.00 7.73 1.04
DWT* 30 30 25 30 30
WS $/Ton Cts/Gal 195.00 11.02 3.29 240.00 18.55 5.54 210.00 6.74 2.01 240.00 11.69 3.49 240.00 9.70 2.89
Source: Bloomberg.
Once the crude is unloaded at a hub, it is either stored in nearby tanks (Exhibit 107) or transported (Exhibit 108) to refineries, which also use similar storage tanks. Refineries located far away from the hub transport the crude by pipeline or truck, or again by tankers (smaller, in-land barges, not oceanic tankers).
Exhibit 107: Oil Storage Tank Exhibit 108: Oil Tanker Truck
Source: Fab-Seal Industrial Liners, Inc.
Source: Company reports
Natural gas is transported via pipeline from producing basins to local distribution companies at city gates
As we described above, natural gas can be transported a number of ways, depending on its form. Dry gas, or methane gas (90% of consumed gas), is transported through long-haul pipelines, or intrastate and interstate pipelines. A pipeline network transports the gas from major producing basins to major demand centers or city gates. The longhaul pipeline transports and delivers the gas to storage operators for use at a later date, or directly to local distribution utilities or companies (LDCs) at the city gate for immediate delivery. Major long-haul pipelines can carry up to 1.5bcf/d, while smaller laterals that branch off and connect to smaller city gates may carry 0.3-0.5bcf/d.
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Natural gas pipeline transportation costs, similar to oil transport costs, vary depending on the origin, destination, and market supply and demand. For example, transporting natural gas from the U.S. Gulf Coast to the New York city gate may cost $0.13/mcf, versus only $0.06/mcf to transport gas from Appalachia to New York.
LDCs maintain the distribution network of pipes and laterals that connects homes and businesses to the gas grid
Natural gas is always stored in an underground facility with the characteristics of a reservoir. As a gas, not a liquid, it cannot simply be stored in a container or tank. The facility must have a high level of porosity and permeability to hold the gas, as well as have enough primary drive to support the flow of the gas to the surface, and provide a permeable trap to contain the gas. Natural gas is stored underground in three forms:
Depleted reservoirs. Natural gas is injected into depleted reservoirs, utilizing existing
production infrastructure (wells, gathering pipelines, and transportation pipelines). Depleted reservoirs have lower development and operating costs than salt caverns and aquifiers.
Aquifiers. Water-only reservoirs that are made suitable for natural gas storage.
Aquifiers are the most expensive form of natural gas storage because of the large amount of work and long completion times and the installation of costly infrastructure.
Salt caverns. Smaller than depleted reservoirs, have a dome shape, and offer
effective and efficient injection and withdrawal methods. Natural gas holding capacity is a key consideration for determining a facilitys ability to have high deliverabilitythe ability to quickly withdraw gas to serve market needs. Two forms of storage gas are base gas and working gas. Base gas provides the reserve level that supports long-term market needs and the necessary pressure to provide lift for efficient working gas withdrawal. Working gas is the amount of gas that can be withdrawn to meet customer needs on a regular basis. An ancillary component to natural gas storage is the level of compression in the natural gas pipelines. Natural gas released into a pipeline would remain static if it were not compressed using high horsepower compressors (about every 40 miles along a pipeline) to force the gas to move from one end of the pipeline (Gulf of Mexico) to the other (New York). When storage facilities reach maximum capacity and flowing gas exceeds market demand, pipeline operators will lower the compression of the pipelines and allow the gas to sit in the pipeline until its needed by the market or until storage capacity becomes available. This is commonly referred to as linepack. The local distribution companies maintain the relationship with end-use residential (retail), and commercial and industrial customers (wholesale). The utility has a complex web-like system of pipes that run from the city gate to every home, business, factory, shopping mall, etc. The network consists of mains that connect regions within the city gate to the city gate, and then laterals and smaller systems on the neighborhood or sector level. LDCs pass on distribution charges to their customers for distributing gas through their system.
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Exhibit 109 illustrates the flow of natural gas from the wellhead to the end markets. The flow chart is different for oil, as oil needs to be refined before it can reach its end market. In this section we discuss the storage and transportation of oil and gas and their role in the energy chain. Natural gas is transported straight to market (after initial processing). Crude, however, after it is transported and delivered to refiners, is refined into products, and then transported to market.
Exhibit 109: From Well to Market
Source: Interstate Natural Gas Association of America.
Refining
The refining process entails manipulating the chemistry (elements, atoms, and molecules) of crude to produce valuable, end-use products (motor gasoline, heating oil, jet fuel, distillate)
The refining process entails manipulating the chemistry (density, sulfur content, and API pressure) of crude to produce valuable, end-use products (motor gasoline, heating oil, jet fuel, distillate). Unlike the upstream process, which is very physical, can be seen, and can be explained using pictures, the refining process is more conceptual. The complex refining processes cannot be easily seen since the processes themselves are chemical processes that take place inside various towers, chambers, and columns of a refinery complex. One can view the massive size of a refinery complex (Exhibit 110), the columns, towers, pipes, and storage tanks, but the spectacle itself offers little insight into the processes taking place. We will describe the equipment used in refining, the types of chemical reactions that take place to form products, the types of products, and the economics of refining. We will first introduce the end products to simplify the discussion, then describe the distillation process, and conclude with the secondary distilling processes that involve blending, processing, and reforming and complete the refined products.
Exhibit 110: Phillips Borger Refinery
Source: Phillips Petroleum.
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A barrel of oil can be broken down into four broad, refined parts: liquefied petroleum gases, light distillates, middle distillates, and residual fuel
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Petroleum Products
We introduced the refined products groups in the Oil Markets section, but did not fully elaborate on the differences between each product or group of products. Exhibit 111 shows the product slate for a refined barrel of oil and the various uses discussed in the Oil Markets section.
Exhibit 111: Oil Barrel Products and Uses
LPGs - 10%
Products Ethane, Propane, Butane
Uses Heating, cooking, chemical feedstocks, motor gasoline blending
Light Distillates - 35%
Gasolines, Naphthas
Petrochemical feedstocks, reforming into gasoline, automotive fuel Aviation fuel, automotive fuel, domestic heating fuel, distilled to lighter product Power generation, ship fuel, fuel oil, road surfacing, roofing, chemical industry
Middle Distillates - 35%
Jet Kerosene, Diesel, Heating/Gasoil, Vacuum Gasoil Cracked FO, SR FO, Asphalt, Bitumes, Coke, Sulfur
Residual Fuel Oil - 20%
Source: CSFB.
At the top of the barrel are the LPGs, the lightest part of the refined stream. Ethane, butane, and propane are often used as chemical feedstocks and for outdoor cooking (gas barbecue grills).
Light distillates (gasoline, naphtha) represent roughly 35% of the refined product yield from one barrel of crude oil
Light distillates (the gasolines and naphthas) are largely used as petrochemical feedstocks and as automotive fuels, and represent roughly 35% of the refined products from one barrel of crude oil. Middle distillates are diesel fuel, jet fuel, kerosene, and heating oil. Diesel is common to gasoline in that both fuels are used to run cars and trucks; however, the similarities end there. Diesel fuels come in several types and qualities similar to gasoline. Diesel additives used in the blending process are generally the light gas oils. Light and heavy gas oils, also middle distillates, are most commonly used as home heating oil and are referred to as distillate fuel, heating oil, and number two fuel. Heating oil is a common source of residential and commercial space heating and water heating throughout the world given its ease to produce and low cost. It does, however, have environmental effects similar to any other oil-based product. Other clean-burning fuels such as natural gas have made inroads into the space and water heating market, drawing from heating oils market share as a fuel source for boiler and heating systems.
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At the bottom of the barrel remains the residue (resid) from the various refinements that have taken place. This residue is a very thick, tarry substance that remains of the original crude oil. The resid is the lowest value product, but it still has economic value in two formsasphalt and resid fuel. Refiners generally produce more resid than asphalt, as it can be used as a feedstock in the chemical industry, in electric power generation, and can occasionally be used for space heating.
Processes
The crude distillation unit is the primary unit in a refinery used to separate crude oil into its main constituents or fractions
As we described in the Storage and Transportation section (page 108), crude is physically delivered to a refinery by tanker or pipeline and is stored in a large holding tank. From the storage tank the crude is pumped into the refinery complex and sent through a furnace. The furnace heats and vaporizes the crude, which is then piped into a distilling column. The crude distillation unit (CDU) is the primary unit in a refinery used to separate crude oil into its main constituents or fractions. (See Exhibit 112.) The capacity throughput (i.e., how many barrels of oil can be processed each day) of a refinery normally refers to the capacity of its CDU. The temperatures at which the crude elements vaporize into different cuts or fractions are referred to as cut points. (The fractions can generally be thought of as the different product familiesLPGs, light distillates, middle distillates.) Within the distilling column are holes or trays at varying heights where the different vapors collect. The heavier vapors (more liquid than vapor) drop to the bottom of the column and the lighter vapors (more vapor than liquid) rise to the top of the column where they are collected. The holes in the distilling column collect and redistribute the vapors and liquids in the same process several times to fully separate the fractions. The vapors may also be run through a cooler to ensure that heavier liquids/vapors do not escape the top of the column with the lighter vapors. After the vapors and remaining liquids are collected for each specific fraction, the products are condensed into liquid form. These condensed liquids (fractions) are also referred to as straight run distillates, and there are several types.
Butane. The lightest liquid of the refining process, it is a component of liquefied
The temperatures at which the crude elements vaporize into different cuts or fractions are referred to as cut points
petroleum gas.
Gasoline. One of the lightest of the principal liquid fuels from the refining process.
Gasoline is the most important private transportation fuel and sometimes occurs naturally as condensate.
Naphtha. A light, liquid fraction, used mainly for the production of gasoline or as a
feedstock for the petrochemical industry.

Kerosene. The medium to light fuel produced by the oil refining process, coming
between the gasoline and gasoil fractions. Kerosene was the original refined oil product, used for lighting; its principal uses today are for heating and as jet fuel.
Light gas oil. Similar to heating oil, low sulfur content. Heavy gas oil. Closer to resid or fuel oil than lower sulfur heating oil or diesel. Residue (resid). The heavy component of crude oil that resists distillation.
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The type of crude used has an impact on product yields and refining costs; yield refers to the amount of each product that can be produced from a barrel of oil
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The type of crude used has an impact on product yields and refining costs. Yield refers to the amount of each product that can be produced from a barrel of oil. Light crudes with low sulfur contents are easier to refine than heavy and high sulfur crudes. The heavy, high sulfur content crudes require additional refining equipment that lead to a higher cost structure. Light crudes also yield or produce more of the higher value productsbutane, gasoline, naphtha, and kerosenewhile heavy crudes produce more gas oil and residue (resid). Exhibit 112 depicts the process as described so far; crude oil enters the distilling column and is heated to varying temperatures, resulting in different fractions. Notice that the flow chart of the distillation process is very similar to the layout of the barrel of oil example in Exhibit 115. We will discuss the next step in the refining process, the complex process, in a moment.
Exhibit 112: Distillation Process
in degrees fahrenheit
<90
BUTANE AND LIGHTER
GAS PROCESSING
CRUDE OIL
D I S T I L L I N G C O L U M N
90-220
STRAIGHT RUN GASOLINE
MOTOR GASOLINE BLENDING
220-315
NAPHTHA
CAT REFORMING
315-450
KEROSENE
HYDROTREATING
450-650
LIGHT GAS OIL
DISTILLATE FUEL BLENDING
650-800
HEAVY GAS OIL
CAT CRACKING
800 +
Source: Petroleum Refining.
STRAIGHT RUN RESIDUE
FLASHING
The temperature ranges naturally overlap with one another (i.e., 220 degrees F is the end point for producing straight run gasoline and also the initial boiling point for straight run naphtha). As a result, an equal amount of naphtha and gasoline, in this example, is produced for the respective fraction at the cut points. Because of this, the cut points may be slightly higher or lower than the actual ranges above to allow for more or less production of a particular fraction.
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Controlling the cut points is an important part of the refining process; refinery managers constantly analyze the crude and product markets to determine which products to produce based on market prices and operating costs at the refinery
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Applying the gasoline/naphtha cut point example, at 220 degrees F an equal amount of gasoline and naphtha will be produced. Adjusting the cut point to 250 degrees F will result in a higher yield of naphtha than gasoline, as shown in Exhibit 113. The yield percentages are not exact but directionally correct to demonstrate the impact of changing cut points. Controlling the cut points is an important part of the refining process. Refinery managers constantly analyze the crude and product markets to determine which products to produce based on market prices and operating costs at the refinery. In periods of low gasoline supplies and consequently high prices, refiners will control the cut point to maximize gasoline output. Plant managers expectations for market supply and demand and future prices play a large role in how the refinery is run and which product slates are produced. In Exhibit 113, we have extracted the gasoline and naphtha fractions from the flow chart above to highlight the directional change in yields as plant managers adjust the cut points.
Exhibit 113: Cut Points and Yields
Cut Point
Fraction
Yield
90-220 F 220-315o F
250o F
Source: CSFB.
Gasoline Naphtha Gasoline Naphtha
50% 50% 35% 65%
The fractions are reprocessed until all vapors and liquids are fully and appropriately separated. Then the fractions are sent to different parts of the refinery complex to continue the specific refining process for each fraction. This is a complex process, as depicted on the right side of Exhibit 115. Butanes go to a gas-processing facility, gasoline goes to blending, naphtha to cat reforming, and heavy gas oil to cat cracking. We will focus our discussion on the parts of the process that result in the most valuable and widely used products (gasoline, distillate, resid).
Blending, Reforming, Processing, Cracking, Flashing

Gasoline Blending
The blending process involves using feedstocks and additives from the other refining processes (cat cracking, flashing, cat reforming) to meet specifications (environmental regulations and quality tests)
Gasoline blending is one of the most important parts of the refinery process given gasolines high market value and widespread uses. Gasoline for end-use consumption is the final stage in the oil and gas chain. Before gasoline is ready for end-use consumption, straight run gasoline needs to be further refined to meet stringent product specifications (environmental regulations and quality tests). The blending process involves using feedstocks and additives from the other refining processes (cat cracking, flashing, cat reforming) to meet specifications. Vapor pressure and octane are the two most important characteristics of gasoline. High-quality gasolines have high vapor pressures, which means the gas does not become ignitable until very high temperatures and pressures are reached. This is highly desirable because low-vapor-pressure gasoline could self-ignite (i.e., blow up) under
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low temperatures and pressures and cause serious damage. This is the primary reason refiners make different gasoline blends for the different seasonsto adjust for changing temperatures. Refiners make winter blends to adjust the gasoline characteristics to ignite in cold weather, and readjust to make summer blends for warm weather ignition.
Octane numbers are the percent iso-octane of the gasoline blend; the higher numbers the better the quality gasoline
Octane measures knocking, or essentially, the potential for the gasoline to self-ignite. Knocking occurs in a car engine when the gasoline vapors self-ignite and the pistons drive against the crankshaft. Most cars have spark plugs that serve to compress and ignite the vapors at the right time when the piston moves with the crankshaft, not against it. Octane numbers are the percent iso-octane of the gasoline blend, and higher octane numbers typically correspond to low knock effects. Of the more common retail gasolines88-octane gasoline, for exampleis 88% iso-octane and has low knock effects.
Gasoline additives (lead, methanol, ethanol, TBA, and MTBE) are used to increase the octane number
Gasoline additives are used to increase the octane number and come in many forms:
Lead. Tetraethyl lead increases octane without changing the vapor pressure;
however, it is no longer used in the U.S. or EU because of detrimental environmental and health effects.
Methanol. An alcohol compound combined of methane gas and naphtha. Ethanol. An alcohol processed mostly from corn. TBA, or tertiary butyl alcohol. Used when methanol is the primary additive. It prevents
unblending caused by water mixing with gasoline.

MTBE, or methyl tertiary butyl ether. An oxygenate, unlike the three alcohols
described above; it is produced by adding a catalyst to isobutylene and ethanol. The blending process is not as straightforward as may appear. Determining which type of additive to use depends on the expected temperatures the gas and expected pressures where the gasoline will be used. Additionally, the types of alcohol and oxygenate used can have different effects on each other, as the relationships change with pressure and temperature.
The quality of the gasoline leads to different grades and price points: regular, premium, and super premium
There are several types of gasoline blends as is readily observable at any retail service station. There are regular blends, premium blends, and super-premium blends, each with different prices according to the quality level. The finished gasoline product can be stored in large gasoline tanks at a refinery complex until its needs to be transported to market. It can be transported by truck, pipeline, or tanker to regional terminals, where it is stored until local retail stations need to be filled, or it can be delivered straight to a retail gas station, where it is pumped into on-site storage tanks that feed the pumps.
Distillate Blending
Distillate blending can be more complex than gasoline given the number of distillate products (naphtha, kerosene, light gasoil, heavy gasoil)
Following gasoline in the chain of high-value products is distillate. The distillate blending process is similar in concept to gasoline blending, feedstocks, and additives from other refining processes (cat cracking, flashing, cat reforming) are used as blends. Distillate blending, however, is more complex given the number of distillate products (naphtha, kerosene, light gas oil, heavy gasoil). Some parts of the refining process are more notable than others. We introduce each of the concepts or processes, but mainly focus on the cracking process. 116
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Hydrotreating or hydrodesulphurisation refers to the removal of sulfur and other contaminants from refined products using hydrogen as the catalyst. It ensures distillates (diesel and fuel oil) meet environmental and sulfur specifications. Catalytic reforming improves low octane naphthas into high grade reformates, or blending components. However, there is a trade-off between increased octane and decreased yield beyond a certain octane level.
Cracking Process and Flashing
Catalysts are substances that speed up or otherwise improve the efficiency of a chemical reaction, without forming part of the final product
After the straight run heavy gas oil is produced from the initial distilling process, it is sent to a cracking unit to further refine the oil. At about 750-800 degrees F, several characteristics of the crude have already changed (i.e., the fractions have been created at different boiling temperatures), and only a few of the heaviest compounds remain. At temperatures above 900 degrees F, the intensity of the heat cracks the remaining heavy, crude elements into smaller, lighter elements (i.e., gasoline, propane). There are several cracking methods:
Thermal cracking or coking. Applies heat to the distilled fractions to break down larger
hydrocarbon molecules into smaller ones, or lighter distillates. Thermal cracking is the predominant cracking method for refining straight run resid.
Hydrocracking. Uses hydrogen as a catalyst to improve efficiency. Catalytic (cat) cracking. Applies heat and a catalyst to speed the process.
We will initially discuss the cat cracking of heavy gas oil. Within the refinery complex is a cat-cracking unit that introduces a catalyst to the heavy gas oils to induce cracking. Catalysts are substances that speed up or otherwise improve the efficiency of a chemical reaction, without forming part of the final product. Catalysts allow cracking and hydrotreating reactions to take place at lower temperatures than normal. The cat-cracking unit comprises three parts: a reactor, a regenerator, and a fractionator. The reactor introduces the catalyst to the heavy gas oil, the regenerator creates new catalyst feed, and importantly, the fractionator separates the various cracked products. The cracking process results in a full range of fractions. It essentially breaks down the oil again, in a similar process to straight run distillation, into another set of fractions ranging from natural gas to resid. In addition to the full range of fractions produced, coke forms from the smaller molecules. The resultant fractions, or cat-cracked fractions (i.e., cat cracked butane, cat cracked gasoline, cat cracked naphtha), are different from the straight run fractions, and they are referred to as olefins (ethylene, propylene, butylene).
The cracking process creates or yields more fractions (by volume) than the original amount of crude that began the process (i.e., if 1.0 gallon of crude is distilled and cracked it could produce 1.38 gallons of higher fractions)
An important result of the cracking process at 900 degrees F is that the cracked elements have a higher volume than before they were cracked. In essence, the cracking process creates, or yields, more fractions (by volume) than the original amount of crude that began the process (i.e., if 1.0 gallon of crude is distilled and cracked, it could produce 1.38 gallons of higher fractions). This is referred to as a processing gain. The lightest cat-cracked fraction, isobutene, then goes to the gas-processing facility to recombine with other small olefins to form larger, valuable propane and butane components. The other light cat-cracked fractions are used for blending gasoline (i.e., gasoline additives), the middle cat-cracked fractions are used for blending distillate, and
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the heavy gas oil and resid are recycled over and over until there is nothing remaining. The remaining cat-cracked fractions, or olefins, are sent to an alkylation plant. Fractionation, cat cracking, and gas processing each break apart hydrocarbon molecules into smaller, lighter, more valuable parts. The reverse process, making larger components from molecules that are too small and of too little value, is known as alkylation. Alkylation occurs in a separate alkylation (alky) plant within the complex that has several componentsa chiller, a reactor, and three fractionation columns. The alkylation plant turns the smallest gases into larger liquid formspropane and butane which serve as an additional source of fuel output. Olefins are combined with paraffins to form iso-paraffins, or alkylate. Recall that cat cracking not only breaks down large molecules into smaller molecules, but the smaller molecules result in a higher yield given their increased volume. Alkylation has the reverse effect; yields decrease as smaller molecules combine to form larger, less voluminous molecules. This known as shrinkage. Despite the shrinkage, alkylate is valuable since it forms an end-use product. The cat-cracked lighter products that are used as blends and the alkylation process that creates additional propane and butane represent the end of the cat-cracking chain.
Gas Processing
Gas processing involves compression, separation, fractionation
Gas processing in a refinery complex is the same as gas processing in the midstream segment of the natural gas industry. Midstream energy companies process natural gas into its component parts (methane, ethane, propane, butane, hydrogen) the same way refiners process the gas. The lightest elements of crude that vaporize and condense into butane and other light products are transported to a gas-processing facility within the refinery complex. Processing the gas is very different than flashing and cat cracking. Gas processing involves cooling rather than heating the components. These gases cool at varying temperatures to form paraffins (isobutane, normal butane, propane, ethane, and methane). The process consists of the following:
Compression. Removal of excess water. Separation. Liquefaction of gases at high pressure, low temperature. Fractionation. Extraction of liquid components, break down molecules.
Natural gases can be rich (wet) or lean (dry), depending on the amount of heavy recoverable components. Special processes are also applied to remove acid and sour gases, such as hydrogen sulfide and carbon dioxide, and other chemical treatments are used to further refine the gas and recovered liquids. The wet components are referred to as natural gas liquids. Each of the paraffins has different uses, either within the refinery process or as commercial products.
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Exhibit 114: LPG Types and Uses
14 May 2002
Paraffin Type Isobutane Normal butane Propane Ethane Methane

Source: CSFB.
End-use alkylation feedstock gasoline blending chemical feedstock, heating fuel, cooking fuel chemical feedstock fuel to run various other refinery operations
Generally, after the gas has been through the distilling unit and then processed into the products, it is ready for end-use consumption. (See Exhibit 114.) One exception is the smallest element, isobutane, which is sent to the alkylation plant to be combined with olefins from the cat-cracking process to form butane and propane. Each of the above processes results in a product or blend or feedstock that is more refined than the prior stage. The different elements are refined until they are fully broken down, until every chemical process that can add value to the process has occurred. Exhibit 115 provides a layout of the entire process.
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Exhibit 115: The Refining Process
Ethane Methane
BUTANE
STRAIGHT RUN GASOLINE STRAIGHT RUN NAPHTHA STRAIGHT RUN KEROSENE STRAIGHT RUN LIGHT GAS OIL STRAIGHT RUN HEAVY GAS OIL
GAS PLANT
BUTANE CAT REFORMER REF
Normal Butane Isobutane
PARAFFINS
D I S T I L L I N G C O L U M N
Ethylene Propylene Butylene

Ethane Normal Butane ALKY
120
CAT CRACKER FLASHER TOPS
ALKY
CAT CRACKED GASOLINE CAT CRACKED LIGHT GAS OIL CAT CRACKED HEAVY GAS OIL
STRAIGHT RUN RESIDUE
OLEFINS
FLASHER
Ethylene Propylene Butylene

THERMAL CRACKER
THERMAL CRACKED GASOLINE THERMAL CRACKED LIGHT GAS OIL THERMAL CRACKED HEAVY GAS OIL THERMAL CRACKED RESIDUE
FLASHER BOTTOMS
BUTANE HYDRO CRACKER
HYDROCRACKATE
14 May 2002
Source: Petroleum Refining.
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Offshore Oilfield Services and Equipment

Offshore operations call for a greater degree of specialization than onshore
We have fully detailed the E&P process for land drilling and the various oilfield services and equipment used, but have not yet addressed the offshore drilling process. Since many of the processes are similar for both onshore and offshore drilling operations and we have already discussed the onshore process in detail, we will focus less on the E&P process and concentrate on the main offshore services and equipment for introductory purposes. The biggest difference between land drilling and completions and offshore drilling and completions is the rig. A land rig can be mounted on a stable surface and placed directly over the well site. In offshore drilling, the rig is above the oceans surface, and possibly hundreds or thousands of feet above the drilling surface (the sea floor). Offshore completions utilize many of the same tools and services we described in the land drilling and completion process; however, some tools or services are specifically designed for offshore use. Offshore E&P operations are described in terms of water depthshallow water, deepwater (greater than 3,000 feet), and ultradeepwater (greater than 5,000 feet). We will refer to these terms as we describe the different types of offshore rigs and their characteristics. We will then describe the completion and production methods used for both subsea and dry-deck operations.
Offshore drilling units can be broadly defined as mobile offshore drilling units or stationary platform units
Offshore drilling units can be broadly defined as mobile offshore drilling units (MODUs) or stationary platform units. The major difference being the mobility factor. MODUs can be deployed and redeployed to different drill sites within a particular region or deployed into different regions altogether. Platforms are permanent structures, usually in less than 500 feet of water, built into the ocean floor, and are only usable in the field they are installed. Common features of both MODUs and platforms are the helipad, the drilling rig, living quarters, and production facilities. The four main classes of MODUs are jackups, semisubmersibles (semis), submersibles, and drill ships. We will describe each type of MODU and its characteristics, advantages, and drawbacks, and then briefly describe the less-often-used platforms. Before offshore drilling can begin, a subsea template needs to be installed and attached to the ocean floor to provide a base for the drilling unit. The template has several open, round holes that are used to install a number of wells on the ocean floor.
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Exhibit 116: Subsea Drilling Template
14 May 2002
Source: API.
The most prevalent MODU is the jackup; approximately 60% of all MODUs are jackups
The most prevalent MODU is the jackup, and approximately 60% of all MODUs are jackups. They are mobile, self-elevating drilling platforms with legs that are lowered to the ocean floor to provide a foundation for the drilling platform, which lies well above the surface to allow storm waves to pass underneath; they are used in water depths of less than 350 foot (shallow water). Jackups vary a great deal in size and capability. The smaller units have 100-foot leg lengths and are mat supported on the bottom, while the 250-foot and 350-foot units typically have independent legs that jack down to the ocean bottom. Jackups are very versatile and can drill exploratory wells in a variety of water depths and weather conditions. Many units are cantilevered, meaning the drilling package can be extended beyond the edge of the hull. This enables the drilling of multiple exploratory or development wells from the same location over an existing fixed production platform.
Exhibit 117: Jackup Exhibit 118: : Semisubmersible
Source: Diamond Offshore.
Source: Diamond Offshore.
The second class of MODUs are semisubmersibles
The second class of MODUs is semisubmersibles (semis), which are also mobile, floating drilling platforms; however, the lower hull is partially submerged and the unit is moored with wires and/or chains or is dynamically positioned. Semis are most often used for development and exploration drilling in water depths up to 10,000 feet.
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(Deepwater is greater than 3,000 feet.) The water depth capability of a semi is principally a function of the variable deck load, available deck area, and the mooring system. The size and weight of the equipment used in the drilling process (riser, fluids, tubulars, mooring equipment, etc.) increases as the water depth increases. In order to increase water depth, the variable deck load and deck area must be increased. Semisubmersibles are used worldwide and are particularly favored in harsh environments because of their superior motion characteristics. Semis are typically described by generation, or the time period they were built. As longlived assets, changes in technology have made the distinction necessary because of new design and technological breakthroughs for newer units that are able to command premium rates over earlier, older models.
First-generation semis were constructed in the early 1960s and were designed to drill
Semis are typically described by generation, or the time period they were built: first genearly 1970s, second genlate 1970s, third genearly 1980s, fourth gen1980s-1990s, fifth genrecent
to depths approaching 20,000 feet in 400-800 feet of water. The variable load of these rigs is generally less than 2,500 tons. The vast majority of these semis have been retired.
Second-generation semis were constructed in the 1970s. These units are capable of
drilling to depths of 20,000-25,000 feet in water depths from 400 feet to 2,500 feet, with some larger units capable of drilling up to 3,500 feet. The variable load of the second-generation semis is typically above 2,000 tons. The second-generation equipment varies substantially in capability and upgradability.
Third-generation semis were built in the early 1980s. This generation has variable
loads that exceed 3,000 tons, and can drill in water depths generally up to 3,500 feet. The third-generation units have premium equipment and generally command higher dayrates. They are capable of working in the harsh environment areas of the world, including the heavily regulated North Sea.
Fourth-generation semis were built from the mid-1980s to the early 1990s. These are
among the most advanced drilling units in the world. They can drill in water depths up to 5,000 feet, and many have harsh environment capability. Several of these units are dynamically positioned to avoid the cumbersome size and weight of the mooring systems they would need to drill at these depths.
Fifth-generation semis, the current generation, have been developed to work in water
depths greater than 5,000 feet. These units have 5,000 tons or more of variable deck load and can work in harsh environments.
Drillships are used in various water depths where jackups and other bottom-supported rigs are incapable of working, generally, in the ultradeepwater (> 5,000 feet)
Drillships are used in various water depths where jackups and other bottom-supported rigs are incapable of working. Generally, dynamically positioned drillships are used to drill wells in the ultradeepwater, since these units are not constrained by the limitations of conventional mooring systems. Dynamically positioned drillships have become the tool of choice for exploration in ultradeepwaters and remote deepwater locations because their superior cargo-carrying capacities allow them to operate for long periods without resupply. Conventionally moored drillships generally compete with second- and third-generation semis in water depths up to 1,500 feet in certain market areas.
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Exhibit 119: Platform Exhibit 120: Submersible
14 May 2002
Source: Royal Dutch Shell.
Source: Noble Drilling.
Submersible units are the last type of offshore drilling unit. Unlike semisubmersible units that have a partially lowered hull, submersible hulls are filled with water and lower to the ocean floor. A platform is a stationary drilling platform mounted into the seafloor that can only be positioned over one well site. They can be much bigger than other types and they are typically used in shallow waters. Platforms are mostly used in the harsh, North Sea environment. (See Exhibit 119.) Once the offshore rig is in place, the drilling process mirrors that of the land drilling process. Similar drilling equipment, pressure control equipment, downhole tools, and pipe handling equipment are used; however, they are specifically tailored for offshore operating environments.
There are two forms of offshore production systems: platform (dry) systems and subsea (wet) systems
Offshore completion, development, and production systems have many different features to onshore systems. Onshore production systems (wellheads, flow measurement systems, gathering lines, etc.) can be easily inspected and maintained on a regular basis. Offshore production facilities are not as easily maintained. There are two forms of offshore systems: platform systems and subsea systems. Platform systems are the most common, but advances in technology and cost structures have made subsea completion and production systems a viable alternative. Subsea systems work on the seafloor as opposed to above the sea on the rig platform.
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Exhibit 121: Offshore Production Platform
14 May 2002
Source: UKOOA.
Exhibit 121 presents a side profile of a drilling platform and includes the components we discussed: derrick, helipad, living quarters, and production equipment. After the subsea template has been installed, a jacket is anchored onto the template. The jacket is a steel support that extends vertically from the template on the ocean floor to above the ocean surface. It serves as the primary support for the production platform.
Offshore production systems vary with water depth and conditions: tension leg platforms, SPARs, FPSOs
Offshore production systems vary with water depth and conditions. Fixed platform and compliant tower platforms are more physically and economically suited for shallow water operations, while deepwater and ultradeepwater operations require more flexible, floating production systems (FPS). Each type of FPS is uniquely constructed to meet the varying characteristics of a particular operations water depth, drilling depth, and production amount. The most common floating systems include the following:
Tension leg platforms (TLP) and minitension leg platforms (mini-TLP) consist of a
floating topside structure held in place by vertical, tensioned tendons connected to the sea floor by subsea templates. Mini-TLPs are designed for smaller fields and satellite field that would be uneconomical to develop using other equipment. TLPs and miniTLPs are used in water depths up to 4,000 feet.
SPARs consist of a wide diameter single, vertical cylinder that supports the topside
and is anchored to the ocean floor. They can be used in water depths from 3,000 feet to 7,000 feet.
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Floating production systems (FPS), or semisubmersible units, are used in water
depths between 600 feet and 7,500 feet.

Floating production, storage and offloading systems (FPSO) are tanker-like vessels
moored to the ocean floor. They are able to store oil produced from subsea wells and offload the hydrocarbons to shuttle tankers, and are ideally suited for fields with limited infrastructure. FPSOs are used mostly in deepwater and ultradeepwater endeavors.
Floating storage and offloading systems (FSO) are used when oil and gas processing
is performed at a separate facility.

Exhibit 122: Deepwater Development and Production Systems
Source: Minerals Management Service.
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Offshore development and production systems consist of many of the same equipment as onshore operations; however, they also utilize unique equipment.
Topsides are the platform structures above the ocean surface that house production
and storage equipment.

Subsea wellheads are placed on the ocean floor as opposed to on the platform. Umbilicals control subsea wellheads from the surface. Flowlines transport the oil or gas from the various subsea wellheads to a centralized
subsea gathering facility.

Risers transport the oil or gas from a central, subsea gathering facility to the surface. Exhibit 123: Subsea Production Schematic
Metering & Control Systems
Tension Leg Platforms
Floating Production Storage & Offloading Vessels
Surface Well Systems
Light Well Intervention
Turret Mooring Systems
Subsea Drilling Systems Standard Subsea Trees Subsea Processing
Smart Well Control Systems
Subsea Template Systems
Subsea Manifold Guidelineless Deepwater Trees ROV Tie-In Systems
Source: FMC Technologies.
Marine services is a segment of the offshore drilling industry that provides support service to offshore tankers, drilling rigs, and production facilities, as well as oil spill response, cargo transportation, and towing services
The offshore supply industry consists of several types of vessels used for various operations in the offshore services industry. These operations include towing, setting anchors (mooring), transportation of supplies and crews, and other support services. The offshore supply vessel fleet consists of the following:
Anchor handling tow supply vessels (AHTSs) come in a wide variety of sizes,
capacity, and power. They typically are equipped with large wenches used to set anchors and require 6,000 horsepower or more to position and service semisubmersible rigs. The large vessels also provide rig support and are used to tow rigs and other equipment. Generally the largest and most powerful vessels of the fleet, AHTSs generally receive the highest dayrates.
Platform supply vessels (PSVs) are the workhorse of the industry. These general-
purpose vessels are designed to carry a wide variety of cargoes such as fuel, drilling fluids, cement, water, casing, drill-pipe, and other miscellaneous items. They are differentiated from other supply vessels by cargo flexibility and capacity.
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Tugs have similar horsepower capabilities to AHTS vessels, but have less deck space
for supply functions. These vessels can assist in anything from the mobilization of a semisubmersible to commercial towage. Tugs are common in every major region in the world.
Crew boats have the ability to transport up to 80 passengers as well as transport
moderate quantities of cargo to and from production platforms and rigs. Known for their speed and maneuverability, these boats can reach speeds approximately twice that of larger supply boats.
Utility boats are all-purpose boats that can be altered to customer specifications.
These vessels generally support production and can be used for diving operations, offshore structure maintenance, firefighting, and other miscellaneous operations.
Liftboats are self-propelled, self-elevating vessels used in shallow water conditions to
construct production platforms and to provide a working area for coiled tubing, fluids storage, and wireline operations, among other equipment.
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Appendix II: Case StudyU.S. Energy Markets

The U.S. oil and gas market is the largest in the world, accounting for nearly 25% of oil demand and 25% of global natural gas consumption
The U.S. oil and gas market is the largest in the world, accounting for nearly 25% of oil demand and 25% of global natural gas consumption. Given the sizable demand base, hydrocarbon reserves, infrastructure, wholesale and retail markets, and equity market capitalization, it is the most widely followed market for judging the direction of the macro oil outlook. Our discussion of the U.S. energy market revolves around market size, product pricing, end uses, market segments, supply and demand, and the relationship between oil and gas and other energy sources. We frame this discussion with the intent to provide a broad overview of the role of oil and gas in the broad energy chain.
Market Overview
The U.S. has been faced with a declining oil and gas resource base, declining production (oil), and increasing oil and gas demand for the past several decades. In Exhibit 124 we chart the recent history of these key factors, which shows an increasing reliance on oil and gas imports to meet growing demand needs.
Exhibit 124: U.S. Oil and Gas Profile
Crude Oil Profile Natural Gas Profile
35 30
Proved Reserve Base (Bbls)
25
250
Consumption
70 60 50
Consumption
25
MMBD
Proved Reserve Base (Tcf)
20
200
15 10
Production
10
100
30 20
5 5
Proved Reserve Base
50
Proved Reserve Base
10 0 1977 0 1980 1983 1986 1989 1992 1995 1998
0 0 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999
Source: EIA, CSFB estimates. Crude Oil Profile includes NGLs.
The U.S. has been faced with a declining oil and gas resource base, declining production (oil), and increasing oil and gas demand for the past several decades
The decline in oil and gas production has led to an increasing reliance on foreign sources for the countrys energy needs. The oil production shortfall results in about a 55% oil import call, which is likely to increase in the coming years. The natural gas industry is more limited than oil, however, in its ability to import, given the transportation constraints we have discussed. Natural gas imports need to come from pipelines in adjacent countries, which is why Canada and Mexico are the largest gas exporters to the U.S. Again, LNG can be shipped from long distances by ocean tanker and delivered to import hubs; however, processing LNG, transporting it in the specially designed tankers, and regasifying it into pipeline gas upon receipt is costly. In fact, LNG use has largely been prohibitive over the past 20 years because of these costs relative to the low costs of pipeline gas. This has recently begun to change in the U.S. as gas prices have 129
Bcf/D
20
15
150
Production
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climbed from a 15-year average of $1.50-2.25/mcf to over $3.00/mcf. Sustainably higher gas prices could increase the LNG business and result in a growing global export business. Oil and gas hydrocarbon use constitutes a large part of the total U.S. energy supply and demand equation. To fully understand the broad energy chain, however, it is necessary to put oil and gas into a wider context. Energy takes many formsoil and gas, coal, electricity, hydro power, and the list goes onbut essentially there are two forms of energy: primary energy, which is hydrocarbons and renewable energy sources, and secondary energy, like electricity, which derives its existence from primary energy sources. Electricity, as it is most often used, is a product of coal, oil products, or natural gas. In our discussion of U.S. energy supply and demand, we largely focus on the primary sources of energy, as electricity is a by-product of these fuel sources.
We can analyze energy sources on an equivalent basis using British thermal units (BTUs)
We can analyze energy sources on an equivalent basis using British thermal units (BTUs), or the amount of energy required to raise one pound of water by one degree Fahrenheit. Exhibit 125 captures the breakdown of U.S. total energy production and consumption by fuel source to provide a better framework for understanding which fuel sources account for the largest market share or have the highest growth potential. The data are presented in quadrillion BTUs (quads), and we have included an Energy Conversion Guide on page 154 as a useful reference. We can broadly define four types of oil and gas end marketscommercial, industrial, residential, and transportation similar to the end markets we discussed in the Natural Gas Markets section. The U.S. consumes 95 quadrillion BTUs of total energy while only producing 73 quadsa large production shortfall made up by imports. U.S. primary energy consumption is driven by petroleum products (39%) followed by natural gas and coal (19% each). (See Exhibit 125.) Demand growth for petroleum products and natural gas has far outstripped production, whereas coal demand growth and production growth have kept relatively constant. Crude oil and natural gas production have both peakedcrude in the late 1960s and gas slightly later in the early 1970s. While crude production has been on a steady decline since its peak, natural gas production has steadily risen in recent years after initially declining from peak levels. Oil production in the U.S. accounts for 21% of total energy production versus 27% for natural gas and 32% for coal.
The U.S. consumes 95 quadrillion BTUs (quads) of energy comprised of 39% oil, and 19% each for natural gas and coal
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Exhibit 125: U.S. Energy Production and Consumption, Breakdown by Fuel Source
quadrillion BTUs
Production Consumption
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40 35 30 25 20 15
Coal Crude Oil & NGLs Natural Gas
40 35
Petroleum Products
30 25
Natural Gas
20 15
Coal Nuclear
10 5 0 1949
Other Hydroelectric Power
10 5 0 1949
Nuclear Other Hydroelectric Power
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
Beyond evaluating aggregate production and consumption trends by fuel source, it is important to analyze the various end-use markets for the different fuel sources. The first chart of Exhibit 126 shows an overall breakdown of U.S. energy demand by sector and clearly shows that the electric power industry and the transportation sector, closely followed by the industrial sector, are the largest energy end markets. We closely monitor these industries to determine the general direction of future energy demand.
End Markets
The electric power generation industry is the largest energy-consuming industry, followed by the transportation and industrial sectors
Once we determined which end markets consume the most energy, we then evaluate each industry separately to determine its respective fuel source mix, and where changes might occur. The electric power industry uses a wide variety of energy sources, with coal being the primary source. Petroleum use in the business, largely through fuel oil or resid, has been on a steady decline for the past 20 years and this trend is likely to continue given environmental constraints and relative pricing versus cheaper fuels. Noticeably on the electric power sector industry chart in Exhibit 126 is a very sharp spike in natural gas consumption in the latter part of the 1990s. The benign environmental effects of natural gas use to generate electricity combined with attractive pricing relative to other fuel sources made gas the fuel of choice for electric-generating companies that went through a burst of new electric generation capacity development. We expect the trend of higher natural gas use in electric generation to continue; however, unusually high natural gas prices in 2000-01 coupled with an electric industry slowdown have recently slowed the pace of growth.
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Exhibit 126: U.S. Energy Consumption, Breakdown by End-Use Market
Consumption by End-Use Sector
45 40
14 May 2002
Transportation Sector 30
Electric Power
35 30 25 20 15 10 5
25 Petroleum
Transportation Industrial
20
15
10 Residential 5 Commercial Natural Gas 0 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999
0 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999
Electric Power Sector
Industrial Sector
25
12
Natural Gas
20
10
15
Coal
10
Petroleum
Natural Gas Nuclear
Hydroelectirc
5
4
Coal
0 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994
Petro.
0
Other
1999
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
Residential and Commercial
10
Natural Gas
Petroleum
Coal Other
0 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999
Unlike the multifuel source electric power sector, the transportation sector, which accounts for over 25% of overall U.S. energy demand, is predominantly a single-fuelsource industry. Unsurprisingly, petroleum products gasoline and diesel drive the sectors energy demand. This is the largest reliance on any one fuel source for any end market. The industrial sector is the third largest energy-consuming group, accounting for nearly 25% of U.S. energy consumption. Petroleum products have maintained their relevance to the industrial market as a fuel of choice, unlike coal. This is the complete reverse of the dynamics that took place in the electric power sector.
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The electric power sector and industrial sector data may have some crosscontamination because of the way the U.S. EIA, the source for our data, has classified independent power producers over the past several years. The electric generation sector data are based on historical usage among regulated electric utilities. Independent power producers may be accounted for in the industrial sector data. We believe the data to be a close, fair approximation of respective industry factors, and representative of industry conditions for our purposes of demonstration. The residential and commercial market accounts for 10% of overall U.S. energy demand and is centered around space heating, water heating, air conditioning, and general appliances.
Energy Expenditures
The $265 billion U.S. petroleum products market is the largest component of the $550-plus billion U.S. energy business
We can calculate the dollar value of the various fuel source markets using the production and consumption data we discussed and then applying wholesale and retail prices. Exhibit 127 shows the U.S. wholesale oil market to be roughly $55 billion, the natural gas market to be almost $70 billion, and the coal market to be valued at $17 billion, for a total U.S. energy production market valued at $142 billion. Note the decline in the dollar value of the oil business and the slow and steady growth of the natural gas business the two have been nearly parallel in recent years.
Exhibit 127: U.S. Wholesale and Retail Markets

US Wholesale Markets $180 $160 $250 $140 $120 Crude Oil $55b $100 $150 $80 $60 $40 $50 $20 Coal $17b $0 1970 1975 1980 1985 1990 1995 2000 $0 1970 1975 1980 1985 1990 1995 Coal $25b Natural Gas $70b $100 Natural Gas $90b Electricity $215b $200 US Retail Markets $300 Petroleum Products $265b
Source: EIA, CSFB estimates. U.S. Wholesale Markets data is the value of U.S. domestic production in chained 1996 dollars through 2000. U.S. Retail Markets is in nominal dollars through 1997, excluding taxes.
The retail markets, which represent final end-market demand and include both sources of domestic production and foreign imports, are an all-inclusive $595 billion (nominal) market, using recent demand and prices. Oil products at $265 billion and electricity at $215 billion make up the majority of total energy expenditures while the natural gas market is a distant third at $90 billion.
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We have demonstrated that petroleum demand in the U.S. far surpasses all other primary fuel sources on an equivalent BTU basis and that it also surpasses all other fuel sources, including electricity, in terms of market value. Given the number of petroleum products within the energy complex, it is worthwhile to understand how the market breaks down. The $265 billion petroleum products market breaks down largely into the $150 billion gasoline market and the $55 billion distillate (diesel and heating oil) market. Liquefied petroleum gases (LPGs) and other products (including asphalt, kerosene, lubricants, and petrochemical feedstocks) are each $15-20 billion markets while the jet fuel market is worth nearly $15 billion. The resid market, comprising bunker fuel demand and waning electric generation demand, is a $5 billion market and shrinking. The $265 billion retail oil products market and $90 billion gas market combine to make the single largest energy market in the world, accounting for nearly 25% of oil and 33% of global end-market oil and gas expenditures.
Exhibit 128: U.S. Petroleum Product Consumption
US$ in billions
$160
Gasoline $150b
$140
$120
$100
$80
Distillate $55b
$60
$40
Other $20b LPG $20b Jet Fuel $15 Resid $5
$20
$0 1970 1975 1980 1985 1990 1995
Source: EIA, CSFB.
N.B.: CREDIT SUISSE FIRST BOSTON CORPORATION may have, within the last three years, served as a manager or co-manager of a public offering of securities for or makes a primary market in issues of any or all of the companies mentioned.
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Glossary
Abandonment Abiotic (abiogenic) theory
The point in time when all economic reserves have been extracted from an oil and gas field and production is stopped. A theory of hydrocarbon genesis that attributes the origins of a substantial portion of the earths endowment of natural gas to inorganic processes; that is, methane is believed to have been one of the earths primeval gases, which predated the beginnings of life and which remained trapped (and unoxidized) within the earth as the crust cooled. (See also Biotic Theory.) A process of treating oil-bearing limestone or other formations with acid to increase production. A process of recording the time required for sound to travel a specific distance through rock, using a wireline of LWD instrument. The rate of travel varies with rock composition, porosity, and fluid content. The area of a lease or concession for oil and natural gas exploration. Can refer to the total such holdings of a company. A process that involves the polymerization of propane and butane (LPGs) into isooctane. An oil industry organization that is the leading standard-setting body for oilfield equipment and products. A geologic feature in which the constituent rock strata have been compressed laterally into an inverted U-shaped fold. Anticlines are frequently traps for oil and gas. Structural counterparts of anticlines are synclines, which are concave folds, as viewed from above. The American Petroleum Institutes variation of the measurement of specific gravity of crude oil. Drilling or seismic activities that aim to delineate the range of reserves made after an exploration well has first encountered hydrocarbons. A well drilled for the purpose of determining the size or extent of an identified oil/gas field. Part of the exploration and development process. Transactions between unaffiliated companiesfor example, sales by a gas producer to a separate pipeline company. Hydrocarbons arranged in a ring structure with a good solvent properties. Benzenetoluene-xylene is such a compound. Natural gas found in association with crude oil, rather as dissolved or solution gas within the oil-bearing strata or as gas cap gas just above the oil zone. (See also Nonassociated Gas.) The first and simplest distillation process in a refinery. Crude oil is heated to separate its major compounds, which all evaporate at different temperatures. The process is carried out at normal atmospheric pressure. The weight of the atmosphere at the surface of the earth. Measured at sea level this is approximately 1.013 bars.
Acidization Acoustic (sonic) well logging Acreage Alkylation American Petroleum Institute (API) Anticline
API gravity Appraisal Appraisal well Arms-length transactions Aromatics Associated gas
Atmospheric distillation
Atmospheric pressure
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Back-in Barrel Barrel of oil equivalent
14 May 2002
The participation of a national oil company in an oil or gas development once an exploration success has been made (state back-in). The standard volume measure of oil products. Equal to 35 U.K. gallons, 42 American gallons, or 159 liters. Often used to compare oil and gas volumes. Gas is converted to an approximate energy equivalent in oil terms. The standard conversion ratio is 1 barrel of oil equivalent equals 6000 cubic feet of gas. This ratio will vary with the heat value of the gas in question. Either the number of barrels produced daily by an oil well, or the number of barrels processed by a refinery in one day. Generally will refer to an average taken over several months or, in the case of refinery capacity, over one year. A geological province on land or offshore where hydrocarbons are generated and trapped. The standard volume measure of gas products. Equal to 0.028 billion cubic meters, 6.29 million barrels oil equivalent, or 0.73 million tons LNG. The simplest of the aromatic compounds. An important chemical industry feedstock. Any body or accumulation of organic material. In the gas industry, biomass refers to the organic waste products of agricultural processing, feedlots, timber operations, or urban refuse from which methane can be derived. A theory of hydrocarbon genesis that attributes the origins of the earths endowment of natural gas (and other hydrocarbons) exclusively to biological processes; that is, methane is believed to be a product of organic decomposition of the issues of once living plants or animals. (See also Abiotic Theory.) Very heavy and tar-like semisolid by-product of the oil refining process. Used for road construction and in roofing materials. The heavier products produced by the crude oil refining process (i.e., fuel oil, heavy diesel). The lighter products are referred to as white products. The process of mixing different rude oil types in a refinery. Fuels suitable for the generation of steam (or hot water) in large industrial or electricutility boilers. Natural gas, residual oil, coal, and uranium are the dominant boiler fuels. The official price for gas sold at the U.S./Canadian border, as determined by the Canadian government in consultation (in theory) with the United States. Equivalent to the heat required to raise one pound of water by one degree Fahrenheit. A standard measure of natural gas for pricing purposes, particularly in the U.S. The period of rising production once a new oil or gas field has been brought on stream. Diesel, or more commonly fuel oil, used to run a ships engines. Signifying delivery to the final customer. A burner-tip price, for example, is the price charged the end user. A hydrocarbon component (C4H10) of produced natural gas and crude oil; one of the natural-gas liquids (NGL), and a component of liquefied petroleum gas (LPG).
Barrels per day (BD, b/d, bpd) Basin Billion cubic feet (bcf) Benzene Biomass
Biotic (biogenic) theory
Bitumen Black products Blending Boiler fuel Border price British thermal unit (BTU) Build-up period Bunker fuel Burner-tip Butane
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By-product coke gas Candlepower
14 May 2002
A fuel-rich vapor that is a by-product of the coking process. Also called coke-oven gas. An obsolete unit of luminous intensity used during the early decades of the gas industry. A candle was originally defined in terms of a wax candle with standard composition and equal to 1.02 candelas. (1) Nonpermeable rock found above oil and gas reservoirs, which through geologic time prevented these hydrocarbons from dissipating. (2) Gas cap. A substantially pure from of finely divided carbon, usually produced from liquid or gaseous hydrocarbons by controlled combustion with restricted air supply. Beginning as lamp-black (named for its genesis in household kerosene lamps), it was used as a pigment for printing inks and paints. Later, it became a valuable strengthening agent for rubber products. An interest in an oil or gas field whereby all capital expenditure is paid by an additional partner, who recovers the cost from the revenues from production. A borehole lining (pipe) separating the formation from the borehole, with or without cement between pipe and formation. Natural gas that flows from an oil well along with the liquid petroleum. It is also called associated, dissolved, or solution gas because it resides beneath the earths surface in conjunction with crude oil. Casinghead gas is distinguished from gas cap gas, which is another form of associated gas that accumulates above the oil-bearing strata and is therefore produced from wells that do not tap the oil resource. A substance that speeds up or otherwise improves the efficiency of a chemical reaction without forming part of the final product. In refining, catalysts allow cracking and hydrotreating reactions to take place at lower temperatures than normal. A process of breaking down larger hydrocarbon molecules into smaller ones by applying heat and a catalyst to speed the process. A process common to complex refineries. The primary unit in a refinery which distills crude oil and separates out the main fractions of oil, e.g., distillates from residual oil. The capacity of a refinery normally refers to the capacity of its CDUs. A powder consisting of alumina, silica, lime, and other substances. It hardens when missed with water and is used to bond casing to the walls of the borehole and to prevent fluids from migrating between permeable zones. The delivered price of a commodity, as distinct from the free on board (FOB) price.
Cap Carbon black
Carried interest Casing Casinghead gas
Catalyst
Catalytic cracking Crude distillation unit (CDU) Cement
Cost, insurance, and freight (CIF) City gate Coal gas Coiled tubing Coke
A location at which gas ownership passes from a gas pipeline company to a local distributor. Gas made by distilling bituminous coal. Normally around 50% hydrogen, 30% methane. Historically also referred to as town gas. Long sections of small-diameter tubulars deployed in rolls and used to replace jointed pipe in simulation, workover, and drilling operations. The solid carbonaceous residue produced from the destructive distillation of coal or oil; a vital material for steelmaking.
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Coke-oven gas Coking
14 May 2002
A fuel-rich vapor that is a by-product of the coking process. Also called by-product coke gas. A thermal cracking process designed to reduce the size of hydrocarbon molecules, thereby transforming heavier products (fuel oil, gas oil) into lighter ones (gasoline). The process produces petroleum coke as a by-product. A device used to join two lengths of pipe. Technology used to bring a well to production. Matched to the reservoir and formation for optimum production, completion technology includes perforating, gravel packing, and flow control equipment (such as packers, inflatable tools, and sliding sleeves). Natural gas that is highly compressed (though not to the point of liquefaction) so that it can be utilized by an operation not attached to a fixed pipeline. CNG is already used extensively as a transportation fuel for automobiles, trucks, and buses in some parts of Italy, in New Zealand, and in Western Canada, and has recently begun to penetrate some regions of the United States. The granting of rights to a company to explore for oil and gas over a specific, defined area. A mixture of relatively light hydrocarbons that remains in liquid form at room temperature. Condensate can be separated from natural gas as it is produced and treated, can be produced separately to natural gas when both forms of hydrocarbon are found together, or can be recovered from nonassociated gas when this is produced. Gas that can be produced under current technologies at a cost that is no higher than its current market value. (See also Unconventional Gas.) Wireline well logs run in vertical production wells for the purpose of determining the wellbore oil, water, and gas inflow. Conventional production logging sensors include center-sampling (center-of-the-borehole) measurements of temperature, pressure, spinner velocity, fluid capacitance, differential pressure, and nuclear fluid density coupled to gamma ray, casing collar locator, and caliper measurements. The portion of oil revenues that is used by companies to recover capital expenditure in production-sharing contracts. A process whereby larger molecules are broken down into smaller ones. There are several ways of achieving this: through the application of heat alone (thermal cracking), through the addition of a catalyst to this process (catalytic cracking), or through the carrying out of this process in a hydrogen atmosphere (hydrocracking). Normally used to refer to those units in a refinery that upgrade fuel oil and gas oil into lighter products. The most common liquid hydrocarbon produced from subsurface reservoirs. The basic product of the oil industry. The average daily amount of gas that a buyer has contractually agreed to purchase and that a seller has agreed to provide. Part of the take-or-pay contract system for gas. Natural gas located 15,000 feet or more below the earths surface, as defined (and deregulated) in Section 107 of the Natural Gas Policy Act of 1978. Offshore operations in water depths that exceed the normal for fixed platform operations.
Collar Completion
Compressed natural gas (CNG)
Concession Condensate
Conventional gas Conventional production logging
Cost oil Cracking
Crude oil Daily contracted quantity (DCQ) Deep gas Deepwater
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Deliverability Depletion charge Desander Development costs Development well Deviation Devonian shales
14 May 2002
The amount of gas that a pipeline or producer is able to deliver, limited either by the terms of its supply contracts or its own plant capacity. The charge in a profit and loss account that relates to the depreciation of fixed assets. Centrifugal device for removing sand from drilling fluid to prevent pump abrasion. Capital expenditure required to bring oil and gas reserves on production. A well drilled in a proven field to complete a pattern or production. The angle between the wellbore axis (in the direction of the end, or bottom, of the well) and the downward vertical. Deviation values are always positive. Also called Inclination. Shales originating from the muds of shallow seas deposited about 350 million years ago, during the Devonian period of the Paleozoic era. Devonian shales from which unconventional gas can be drawn are found relatively close to the earths surface in parts of the Great Lakes region and areas to the west of the Appalachian divide. A broad term generally referring to the transportation and machinery fuel derived from the gasoil fraction in refining. Heavier than gasoline and kerosene, diesel may also be used for heating purposes when it is more generally referred to as heating oil. The angle that a refractor or reflector makes with the horizontal. Also, the angle of inclination of a geologic layer or sedimentary bed. Transactions in which a gas pipeline sells its gas directly to an end user, like a large industrial plant, rather than to a distributor for resale. Direct sales by interstate gas pipelines are not subject to federal rate regulation under the Natural Gas Act. The method of guiding a well along a predetermined path to a specific target. A directional drilling company provides technology and rig site supervision to efficiently meet directional drilling objectives. A form of associated gas found in petroleum and, therefore, produced from oil wells as casinghead gas. (See also Casinghead Gas.) The products of the distillation process at an oil refinery (i.e., gaseous fuels, naphtha, gasolines, kerosenes, gas oils, and the heavy fractions). Middle distillates refer generally to kerosene, jet fuel, and diesel. A process that separates a liquid into its component parts by exploiting their different boiling points. The liquid, usually crude oil, is heated until it vaporizes, and the different fractions then condense at different temperatures, allowing them to be separately collected. This is the primary process in a refinery. A tool directly above the drill bit in a drill string that converts the hydraulic energy of the circulating drilling fluid into mechanical energy to turn the bit independently of drill string rotation. May include a bent section to perform directional drilling. (See also Steerable Motor.) System comprising a downhole hydrocyclone and electrical submersible pump that separates oil from water downhole, reinjects water, and produces oil to the surface. Those parts of the oil business that occur after the crude has been produced. The term can cover transportation or shipping but is more normally used to refer to refining, distribution, and marketing of refined products.
Diesel
Dip Direct sales
Directional drilling
Dissolved gas Distillates
Distillation
Downhole motor
Downhole oil/water separation Downstream
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Drill bit Drill collar Drill ship Drill stem Drill string Drilling fluid Dry gas Dry hole Dual-fuel capacity Elastomer Enhanced oil recovery (EOR) Equity oil Ethane Ethylene Exploration prospect Exploration well Feedstock Fishing
14 May 2002
The component at the end of the drill string that cuts the rock and makes hole. (See also Tricone Bit and PDC Bit.) Heavy-walled sections of pipe included at the bottom of the drill string to apply weight to the drill bit during drilling. A vessel designed for drilling in deep water without legs or anchors holding it to the sea floor and using dynamic positioning to hold it over the subsea wellhead. All components in a rotary drilling assembly from the swivel to the bit. The total string of drill pipe with attached tools and bit. Fluid used in the wellbore to lubricate and cool the bit, control bottom-hole pressures, and remove cuttings. Also known as drilling mud. Gas that contains no other hydrocarbons, i.e., condensate, that will liquefy at room temperature. An exploration well that has been unsuccessful and failed to find oil or gas in commercial quantities. The ability of an energy consumer (foremost, large industrial and electric-utility customers) to utilize two kinds of fuels. Multifuel capacity allows even greater flexibility. An elastic synthetic rubber or plastic materialoften the main component of packing material in downhole packers. Any means of recovering oil from the field without using the reservoirs own internal pressure. Such techniques as increasing the reservoir pressure (secondary recovery) or raising the reservoir temperature (tertiary recovery) fall under this category. The proportion of a projects oil production that a company is entitled to based on its share of ownership of the project. A hydrocarbon component (C2H6) of produced natural gas and to a lesser extent of pipeline gas. One of the natural gas liquids (NGLs). A light olefin compound made up of two carbon and four hydrogen atoms. Ethylene is the most important feedstock for the petrochemical industry. A geological structure that may contain hydrocarbons but that has not been tested by any exploration well. A well drilled in search of an undiscovered reservoir or to greatly extend the limits of a known reservoir. The raw material that is introduced into a unit for further processing. Thus crude oil is the feedstock for an oil refinery. The process of recovering equipment lost or stuck in the wellbore. Tools and services that perform specialty and repair work downhole. Fishing activities include retrieving lost tools and repairing wellbore damage. The controlled burning of natural gas that is surplus to requirements and cannot be sold. Oil tankers that are used to store crude oil.
Flaring Floating storage
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Fluid Foaming agent
14 May 2002
A substance that deforms continuously under the action of a shear force, however small. Wellbore fluids include oil and water (with or without gas in solution) and free gas. A chemical used in gas wells to lighten the water column to promote gas production. Also, a chemical used while drilling wells with air or gas as the drilling fluid, to force water with the air and cuttings. In seismic processing, the number of traces with different source-to-receiver separations summed into a single trace. A legal principle by which contractual obligations are waived if a superior force (such as the weather, a war, or an act of God) makes it impossible for those obligations to be met. All fuels formed or generated from organic matter, e.g., oil, gas, coal. The price of a commodity when delivered to the purchasers means of transportation, typically a ship. Most crude oil prices are quoted FOB, meaning that the cost of transporting the oil to the final destination is borne by the purchaser, not the seller. A more general term for the separation process carried out by distillation. Another name for a distillation unit or crude distillation unit (CDU). (See also Crude Distillation Unit.) A method of stimulation production by opening new flow channels in the rock surrounding a production well by pumping proppant and fluid into the well at high pressure and volume. Gaseous fuels that can be transported by pipeline. Such fuels include natural gas, LPG, coal gas, and refinery gas. Normally refers to the heaviest of the fuels produced by the refining process and used principally in electricity generation to power ships, and for other industrial purposes. Sometimes called mazoot in Europe. Well log that records natural radioactivity of formations around the wellbore. Gas-rich strata overlying the oil-bearing strata of a petroleum reservoir. A gas cap forms when the ratio of gas to oil in a particular reservoir is too high for all of the gas to remain in solution with the oil. Gas-cap gas is produced from wells distinct from those producing oil and casinghead gas. A reservoir that contains natural gas and liquid hydrocarbon. Condensate normally liquefies as the gas stream is extracted, but can be recovered separately. Often the condensate is produced first, with the natural gas reinjected into the reservoir to assist condensate recovery. The process of injecting gas into a reservoir to aid the recovery of liquid hydrocarbons, normally crude oil. A popular technique in enhanced oil recovery. The hydrocarbon components of wet gas whose molecular structures are heavier than methane but lighter than crude oil. Gas liquids include ethane (C2H6), propane (C3H8), and butane (C4H10). Also called natural gas liquids (NGLs).
Fold Force majeure
Fossil fuels Free on board (FOB)
Fractionation Fractionating column Fracturing (frac)
Fuel gas Fuel oil
Gamma-ray log Gas cap
Gas/condensate field
Gas (re)injection Gas liquids
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Gasoil
14 May 2002
The medium fraction from the initial distillation process in a refinery, known as diesel when further refined. Can also be used as chemical feedstock, though this is now less popular. The lightest of the principal liquid fuels from the refining process. Gasoline is the most important private transportation fuel and sometimes occurs naturally as condensate. Known in the U.K. and other countries as petrol. Pipelines owned and operated by gas producers that are considered an integral part of gas production (rather than transmission) and are therefore usually exempt from state and federal utility regulation. The diameter of a bit or the hole drilled by the bit. A device to transform seismic energy (movement) to an electrical voltagevoltage that is proportional to the velocity of the seismic wave motion. A completion technique used to control production of sand from loosely consolidated formations. The products made up of the larger hydrocarbon molecules that remain after the rest of the crude oil has been distilled into the principal fractions. Also known as heavy ends or the bottom of the barrel. A class of nonvertical wells where the deviation angle is approximately 30-80 degrees. A subset of directional drilling in which the angle of deviation of the wellbore reaches at least 80 degrees from the vertical, maximizing the length of wellbore exposed to the formation. A class of nonvertical wells where the wellbore axis is near horizontal (within approximately ten degrees of the horizontal), or undulating (fluctuating above and below 90 degrees deviation). A compound of carbon and hydrogen. Includes oil and natural gas, but also coal. Loosely used to refer to petroleum. One of the cracking processes that uses hydrogen to improve efficiency. The removal of sulphur from refined products using hydrogen as the catalyst. Sometimes known as hydrotreating or hydrofining and normally concerned with ensuring diesel and fuel oil meet the correct sulphur specifications. An expensive unit in a refinery that can utilize almost any feed stock and crack it into a relatively light range of distillates. A pressure-sensitive sensor to transform changes in (water) pressure to an electrical voltagevoltage that is proportional to the velocity of the seismic wave. Refers to a simple refinery that has very few cracking or other complex units. Hydroskimming refineries will normally contain a distillation unit, a reformer, and a desulphuriser of some sort. Normally refers to the hydrodesulphurisation process, but can mean any process using hydrogen as a catalyst.
Gasoline
Gathering systems
Gauge Geophone Gravel pack Heavy fractions
Highly deviated wells Horizontal drilling
Horizontal well
Hydrocarbon Hydrocracking Hydrodesulphurisation
Hydrogen conversion unit Hydrophone Hydroskimming
Hydrotreating
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Inclination
14 May 2002
The measurement of a wells deviation from vertical, in degrees. Also the angle between the direction of the produced fluid flow and the horizontal. Inclination values are positive for fluid flowing upward and negative for fluid flowing downward. Wells placed between known producing wells to further exploit a reservoir. The major U.K. commodities exchange that trades crude oil and crude products.
Infill drilling/well International Petroleum Exchange (IPE) Isomerisation Jackup drill rig Kerosene
An efficient process that produces high octane gasoline from naphtha. A mobile, bottom-supported offshore drilling structure. Legs or columns rest on the seafloor and the platform is raised or adjusted by moving up or down on the legs. The medium to light fuel produced by the oil refining process, coming between the gasoline and gasoil fractions. Kerosene was the original refined oil product, used for lighting. Its principal uses today are for heating and as jet fuel. Normally referred to as the deviated or horizontal extension in the drilling of a horizontal well or multilateral well. A period during which a licensing body (normally a government) offers for tender certain license or concession areas to be explored by oil companies. A commitment by a producer to sell gas to a buyer for as long as the dedicated field is capable of production. Oil containing a high proportion of the lighter fractions and with a low specific gravity. Light crude oil will produce more gasoline and less fuel oil in the first distillation process in a refinery, and is therefore normally more expensive since gasoline is more valuable than fuel oil. Those component parts of crude oil that vaporize at the lowest temperature and condense to form naphtha and gasoline. A string of pipe used to case open hole below existing casing, overlapping inside the upper string and held in place by a liner hanger packer. Natural gas that has been cooled to minus 161 degrees Celsius for transportation by ship. The cooling process reduces the volume of the gas by 600 times. A ship specially designed to transport liquefied natural gas and maintain it at its very low temperature. A port facility where LNG can be loaded or unloaded to the LNG carrier. A complete set of separating, purifying, and liquefying equipment within a LNG plant. Expanding a LNG plant normally involves adding more trains, not constructing the whole thing again. A variation of measurement-while-drilling in which the LWD tool gathers information (i.e., resistivity, density, porosity, gamma ray) about the formation while the well is being drilled. The main casing string from which subsequent directional drilling operations or openhole operations are initiated. Lateral bores extend from the main bore to the desired target depth.
Lateral bore License/licensing round Life-of-the-field contract Light crude oil
Light fractions Liner Liquefied natural gas (LNG) LNG carrier LNG terminal LNG train
Logging-while-drilling (LWD) Main bore
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The majors
14 May 2002
A loose term describing the worlds principal private (i.e., nonstate) oil companies; includes the three Super Majors (Royal Dutch-Shell, Exxon, BP Amoco) as well as more middle-sized companies like Texaco, Chevron, ENI, Elf, TotalFina. Occasionally referred to as the Seven Sisters, although this term is now redundant. (See also Super Majors.) Measuring directional information (azimuth, inclination, and tool orientation) downhole to adjust the drilling process and guide the wellbore to a specific target. (1) A relatively simple form of controlled organic decomposition (primarily of urban sludge and solid waste) that yields methane vapors. (2) Upgrading of low BTU gas manufactured from coal (whose components are mainly hydrogen and carbon monoxide) to a higher BTU gas composed mainly of methane. The principal constituent of natural gas and the smallest hydrocarbon molecule. Methane is a light colorless, odorless, highly flammable gas. Gas frozen into a physical-chemical bond with water. Methane hydrates occur naturally in permafrost regions of the arctic and deep sea sediments. CH3OH, the simplest of the alcohols; usually manufactured from methane, though it can be made from other hydrocarbons through more complex processes (wood alcohol). A standard measure of natural gas for pricing purposes. (See also British Thermal Unit.) A single molecule that can be joined to other similar molecules to form chains called polymers. Refers normally to the building blocks for certain petrochemicals, e.g., ethylene before it is processed further into polyethylene. The construction of two or more wellbores into one or more reservoirs for the purpose of managing and optimizing fluid movement within the reservoir(s). These lateral wellbores are connected back to a common main bore that extends to surface. Various levels of completion systems can be installed in a multilateral well to enable it to produce from several zones simultaneously. The lightest of the liquid fractions from a refinery, naphtha is used mainly for the production of gasoline or as a feedstock for the petrochemical industry. The principal unit in a petrochemical plant, it cracks the naphtha molecules into smaller and lighter components, the principal among which is ethylene. Several hydrocarbons that occur naturally underground in a gaseous state. Natural gas is normally mostly methane, but other components also include ethane, propane, and butane. Hydrocarbons that can be extracted in liquid form from natural gas as it is produced. Ethane and LPG are the major NGLs. Also called gas liquids. (1) The recombined value of the products produced by the refining of one barrel of crude oil using the wholesale prices of the various different fuels or less commonly. (2) The value of gas delivered to a customer minus the cost of producing, transporting, and distributing it. Gas that is not produced as part of the oil production process, i.e., occurs separately or where only the gas in the oil/gas reservoir can be extracted economically. (See also Associated Gas.)
Measurement while drilling (MWD) Methanation
Methane Methane hydrates Methanol Million BTU (MMBTU) Monomer
Multilateral
Naphtha Naphtha cracker Natural gas
Natural gas liquid (NGL) Netback
Nonassociated gas
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North Sea Brent New York Mercantile Exchange (NYMEX) Oil gas Oilfield chemicals Oil-in-place
14 May 2002
Crude oil produce from the Brent field in the British sector of the North Sea. Often quoted as a benchmark for world oil prices. The main U.S. commodities exchange that deals in crude oil, heating oil, and platinum futures and options. Manufactured gas based on naphtha feedstocks. Chemicals used to treat produced fluids and control corrosion and deposition in producing wells. The estimate of the total amount of oil existing in a reservoir. This is not the same as the amount of oil that will eventually be recovered, which in generally will be a lot lower. Chinese reserve reports often use the term proved reserves to refer to oil-in-place rather than to recoverable reserves, which is more common in the West. A type of refined hydrocarbon that has particular importance as a petrochemical feedstock. Includes ethylene and propylene. Any wellbore in which casing has not been set. Costs associated with running facilities and producing oil and gas. The company or organization that drills the wells and extracts the hydrocarbons at a particular field or project. The operator may be one member of a consortium of field owners, or can sometimes be a joint venture between two or more of these. The Organization for Economic Cooperation and Development is a 30-member, international organization of industrialized, market-economy countries with a view to maximizing economic growth within member countries and assisting non-member countries develop more rapidly. A unit of defined area for purposes of management of offshore petroleum exploration and production by the Minerals Management Service (MMS) of the U.S. Department of Interior. Open and cased-hole devices used to create seals to control fluid flow. Use fixed position polycrystalline diamond compact cutters that shear the formation instead of grinding it. In many applications, PDC bits offer higher penetration rates and longer life than Tricone bits. To open holes through casing walls and cement into a formation so that fluids can flow into the borehole, or vice versa. A device fitted with shaped charges or bullets that is lowered to a desired depth in a well and fired to create penetrating holes in casing, cement, and formation. A measure of the ease with which a fluid can pass through the pore spaces of a formation. A chemical compound derived from petroleum or natural gas. Another term for gasoline. A fixed or floating offshore structure that is used either for drilling wells into the seabed or for extracting the hydrocarbons, or both.
Olefins Open hole Operating costs Operator
Organization for Economic Cooperation and Development (OECD) Outer Continental Shelf (OCS) block Packer PDC drill bits
Perforate Perforating gun Permeability Petrochemical Petrol Platform
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Polyethylene Polymer Polypropylene Possible reserves Primary distillation Primary recovery Probable reserves
14 May 2002
A chemical compound formed by joining ethylene molecules together. One of the principal plastic materials. A chemical compound that has been formed by joining together single molecules (monomers) into long chains. Plastics are polymers. A chemical compound formed by joining propylene molecules together. One of the principal plastic materials. An estimate of oil/gas reserves based on geological data from undrilled or untested areas. Also known as speculative reserves, or P3 reserves. The initial process in a refinery where crude oil is separated into separated component parts. The extraction of oil or gas from a reservoir using only the pressure that is contained in the reservoir itself. An estimate of oil/gas reserves based on data from drilled structures, but which needs more interpretation and/or drilling to be able to be classified as proved reserves. Also known as indicated reserves, inferred reserves, or P2 reserves. A hydrocarbon component (C3H8) of produced natural gas; one of the natural gas liquids (NGLs). Also an oil-refinery byproduct, and the principal constituent of liquefied petroleum gas (LPG). A granular substance that is carried into the formation by the fracturing fluid and helps keep the cracks open after a fracture treatment. A short chain of three carbon and six hydrogen atoms. An important base chemical for the production of plastics. The quantity of oil/gas that is estimated to be recoverable from known structures or fields under existing economic and operating assumptions. Also known as P1 reserves. A standard measure of gas pressure.
Propane
Proppant Propylene Proven/proved reserves Pounds per square inch (PSI) Quad Rate of penetration (ROP) Recoverable reserves Refinery
Abbreviation for quadrillion BTU. For natural gas, roughly one trillion cubic feed (tcf). The speed (rate) with which the bit drills the formation, measured in feet or meters per hour. The proportion of hydrocarbons that can be recovered from a reservoir using existing extraction technology. An industrial complex that separates crude oil into its component fractions, which are then converted into the principal refined products (gasoline diesel, etc.) as well as into feedstocks for petrochemical plants. A process that modifies the molecular structure of gasoline in order to improve its combustion and antiknock characteristics. Reforming can be either thermally or catalytically induced. The process by which casinghead gas (a co-product of oil production) is returned to the petroleum-bearing strata for pressure maintenance and enhanced oil recovery.
Reforming
Reinject
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Reserves
14 May 2002
With respect to oil and gas, that proportion of the resource that is commercially recoverable under current economic conditions with current technology. Proved or established reserves are the portion of the resource that is in known reservoirs and that is believed to be recoverable with the highest degree of confidence. Indicated, inferred, or probable reserves are the additional resources associated with known reservoirs that are expected (in the statistical sense) to be recoverable. Speculative or possible reserves are those resources (in addition to the foregoing), outside the vicinity of known reservoirs, that are expected to be recoverable. Ultimate reserves or ultimate recoverable resources are the sum of proved, indicated, and speculative reserves. A revision (up or down) made to the original estimate of recoverable reserves in an oil or gas field. The amount of time, normally in years, which existing oil/gas reserves would last if produced constantly at the latest production level. An accumulation of oil or natural gas in a porous rock. Reservoirs normally contain oil, gas, and water in varying quantities, and these normally separate into different areas within the reservoir. The heavy component of crude oil that resists distillation. Because of its viscosity, heterogeneity, impurities, and concentrations of sulphur, these bottoms (sometimes called No. 6 oil) are burned primarily in electric-utility and industrial boilers or used as bunker fuel on the high seas. Also known as residual oil. A measurement of a formations resistance to electrical current used to determine whether the formation holds hydrocarbons or water. The method of drilling oil and gas wells in which the entire drill string is rotated from the surface to turn the drill bit, and cuttings are removed from the hole by a circulating fluid. A form of tax whereby a host government takes a share of the production in kind or, more commonly, in cash. The fraction of the effective porosity of the formation that contains a particular phase; more specifically, oil saturation, water saturation, or gas saturation. The extraction of hydrocarbons from a reservoir by increasing reservoir pressure through injecting either water or gas. Large geographic areas that contain rock strata of a sedimentary nature, deposited when the topography was conducive to sedimentation, as in lakes or shallow seas. Seismic data are used to map subsurface formations. A 2-D survey reveals a cross section of the subsurface. In a 3-D survey, seismic data are collected in the in-line and cross-line directions to create a three-dimensional image of the subsurface. In a 4-D or time-lapse 3-D survey, 3-D surveys are repeated over time to track fluid movement in the reservoir. A technique for mapping the subsurface structure of rocks by measuring the reflections of acoustic waves at various depths. Seismic surveys are used to locate potential oiland gas-bearing structures. Seismic surveys can either be two dimensional or three dimensional.
Reserves revisions Reserves-to-production Reservoir
Residue
Resistivity Rotary drilling Royalty Saturation Secondary recovery Sedimentary basins Seismic acquisition (2-D, 3-D, 4-D)
Seismic survey
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Semisubmersible rig
14 May 2002
A mobile offshore drilling unit that floats on the waters surface above the subsea wellhead and is anchored in place. The semisubmersible rig gets its name from pontoons at its base, which are empty while being towed to the drilling location and are partially filled with water to steady the rig over the well. A small container of high explosive that is loaded into a perforating gun. The charge releases a small, high-velocity stream (jet) of particles that penetrate the casing, cement, and formation. A situation in which production is restrained either by order of a state conservation authority (prorationing) or because the producer is unable to find a buyer at an acceptable price. A well logging tool. A well log of the travel time for acoustic waves per unit of distance. Strata thought to have been the organic-rich parent rock for the genesis of a particular accumulation of gas and/or oil, which later migrated to a permeable reservoir rock, capped by some sort of trapping mechanism that prevents further movement. The daily price of crude oil. A downhole motor used for directional drilling, which can turn the drill bit independently of drill string rotation. Placed just above the bit, a steerable motor has a bend in its housing that can be oriented to steer the wells course. During rotary mode the entire drill string is rotated from the surface, negating the effect of this bend and causing the bit to drill a straight course. During sliding mode, drill string rotation is stopped and the bit drills in the direction that it is oriented, gradually turning the well. Year-round supplies of liquefied natural gas, high-BTU coal gas, and Arctic gas sought by interstate pipelines during the supply shortages of the 1970s. Energy-rich vapors manufactured from coal. Beginning in the 1970s, SNG projects were designed to produce high-BTU grades of coal gas on a year-round basis. A type of contract that obliges the buyer of gas to pay the seller for the contracted amount of gas even if the buyer cannot take it. Of or related to movement of the earths crust, as in the faulting and folding attendant to mountain building. An offshore drilling platform attached to the seafloor with tensioned steel tubes. The buoyancy of the platform applies tension to the tubes. Recovery of hydrocarbons from a reservoir using sophisticated heating, enlarging, or acidising techniques. Tertiary recovery extracts hydrocarbons that cannot be recovered by primary or secondary methods. Operations performed from inside the production tubing of an existing well. Gas contained in rock strata with low permeability, thereby necessitating enhanced (and costly) production techniques like fracturing. Sandstones rich in hydrocarbons but of low permeability. A rotary drill bit employing three cones and either hardened steel teeth or tungsten carbide inserts (TCI). This bit works by grinding away at formation rock as it is turned. 148
Shaped charge
Shut-in gas
Sonde Sonic log Source rock
Spot prices Steerable motor
Supplementary gas Synthetic natural gas (SNG) Take-or-pay Tectonic Tension-leg platform Tertiary recovery
Thru tubing Tight gas Tight sands Tricone drill bit
Oil and Gas Primer

Trip
14 May 2002
Hoist (remove) the drill stem from the wellbore to perform one or more operations, such as changing bits, running a logging tool, or taking a core sample, and then return the drill stem to the wellbore. Gas whose costs of production (utilizing current technologies) would be higher than its current market value. Those parts of business that relate to the exploration, development, and production of oil/gas. Also referred to as the E&P segment of the oil industry. A unit in a refinery which distills the hydrocarbon residue that did not boil at atmospheric pressure in the crude distillation unit. A simple conversion process that relies solely on heat to crack the hydrocarbon molecules. The amount of downward force placed on a bit by the weight of the drill stem. A cylindrical hole drilled from the surface into the rock strata with the purpose of finding, measuring, or extracting oil/gas. A record of one or more subsurface formation measurements as a function of depth in a borehole. The lighter and cleaner refined products from the top end of the distillation column in a refinery. Typically comprises naphtha, gasoline, kerosene, and gasoil. An exploration well drilled without having collected detailed knowledge of the underlying rock structure. A slender rod-like or thread-like small-diameter piece of metal used to lower tools, such as logging tools, perforating guns, valves, and fishing tools, into a well. May include electrical conductors to power and control instruments and to convey data to the surface. Maintenance procedures performed on a previously completed well to stimulate or restore production or increase the life of the well.
Unconventional gas Upstream Vacuum distillation unit Visbreaker Weight on bit (WOB) Well Well log White products Wildcat Wireline
Workover
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Energy Conversion Guide
Energy Volume to MMBTU Product Propane Butane Gasoline Gas oil 0.2% Heating oil 0.2% Jet/kerosene Fuel oil 0.5% Fuel oil 1.0% Fuel oil 3.0% Fuel oil 3.5%
Mmbtu/bbl
Crude
Mmbtu/bbl
API Gravity
Sulfur Content
3.836 4.326 5.050 5.825 5.825 5.501 6.287 6.298 6.302 6.315 1.03
NYMEX-WTI Brent Dubai Suez Blend Iran Heavy Urals Oman Belida (Indonesia) Tapis (Malaysia)
5.825 5.870 6.092 6.156 6.130 6.085 5.965 5.583 5.583
39.2 38.0 31.8 30.1 30.8 32.0 35.3 46.4 46.7
0.003% 0.000% 2.000% 0.016% 0.014% 0.790% 0.020% 0.100%
Natural gas (Mmbtu per Mcf)

Energy Volume to Weight Product
bbl/Metric ton
Crude
bbl/Metric ton
API Gravity
Sulfur Content
Propane Butane U.S./Euro Gasoline Asian Gasoline MTBE NWE Gas oil MED Gas oil U.S. No. 2 heating oil U.S. Diesel Jet Fuel Naphtha Fuel oil
Energy Weight conversions U.S. and Metric Systems
12.409 10.983 8.405 8.519 8.460 7.460 7.595 7.595 7.330 7.880 9.006 6.317
Wilmington Alaska North Slope Dubai Urals Arab Light WTS Bonny Light Brent WTI Arun
6.678 7.101 7.275 7.284 7.351 7.378 7.418 7.565 7.623 8.260
18.4 27.9 31.8 32.0 33.5 34.1 35.0 38.3 39.6 53.9
0.015% 0.011% 2.000% 0.014% 1.900% 0.016% 0.001% 0.000% 0.003% -
UK gallon
1 UK gallon= 1 Liter= 1 U.S. gallon= 1 Barrel= 1 Cubic foot= 1 Cubic meter=

1.00000 0.21997 0.83268 37.97260 6.22890 219.97000
Liters 4.54610 1.00000 3.78540 158.9900 28.317 1000.00000
U.S. gallon
1.20090 0.26417 1.00000 42.00000 7.48050 264.17000
Barrels 0.02859 0.00629 0.02381 1.00000 0.17811 6.28980
Cubic feet
Cubic Meters
0.16054 0.03531 0.13368 5.61459 1.00000 35.31400
0.00455 0.00100 0.00379 0.15899 0.02832 1.00000
151
AMSTERDAM............. 31 20 5754 890 ATLANTA ................... 1 404 656 9500 AUCKLAND.................. 64 9 302 5500 BALTIMORE............... 1 410 659 8800 BANGKOK ...................... 62 614 6000 BEIJING.................... 86 10 6410 6611 BOSTON..................... 1 617 556 5500 BUDAPEST .................. 36 1 202 2188 BUENOS AIRES....... 54 11 4394 3100 CHICAGO ................... 1 312 750 3000 FRANKFURT ................. 49 69 75 38 0 HOUSTON .................. 1 713 890 6700 HONG KONG .............. 852 2101 6000 JOHANNESBURG ..... 27 11 343 2200
KUALA LUMPUR........ 603 2143 0366 LONDON .................. 44 20 7888 8888 MADRID .................... 34 91 423 16 00 MELBOURNE............. 61 3 9280 1888 MEXICO CITY ............. 52 5 283 89 00 MILAN ............................ 39 02 7702 1 MOSCOW................... 7 501 967 8200 MUMBAI ..................... 91 22 230 6333 NEW YORK ................ 1 212 325 2000 PALO ALTO ............... 1 650 614 5000 PARIS....................... 33 1 53 75 85 00 PHILADELPHIA ......... 1 215 851 1000 PRAGUE .................. 420 2 210 83111 SAN FRANCISCO...... 1 415 836 7600
SO PAULO ............ 55 11 3841 6000 SEOUL ....................... 82 2 3707 3700 SHANGHAI............... 86 21 6881 8418 SINGAPORE ................. 65 6212 2000 SYDNEY ..................... 61 2 8205 4433 TAIPEI ...................... 886 2 2715 6388 TOKYO ....................... 81 3 5404 9000 TORONTO.................. 1 416 352 4500 WARSAW................... 48 22 695 0050 WASHINGTON........... 1 202 354 2600 WELLINGTON.............. 64 4 474 4400 ZURICH ....................... 41 1 333 55 55
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CSFB OG Industry Primer

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14 May 2002

Oil & Gas

Brian M. Gibbons, Jr., CFA

Henry Cohen, CFA

Daniel Eggers, CFA

Oil and Gas Primer

Emerson Leite, CFA

Phil Pace, CFA

RETURNS ON CAPITAL DRIVE OIL AND GAS EQUITY VALUATIONS

Tracy Todaro, CFA

Oil and Gas Primer

Oil and Gas Primer

Global Oil and Gas Equity Research

Oil and Gas Primer

Oil and Gas Primer

Oil and Gas Primer

Introduction: Oil and Gas Chain Overview

Oil and Gas Primer

Exhibit 1: Oil and Gas Chain

Natural Gas Upstream - $770b

LNG Regasification Power plant/ large industry

Retail Cars, trucks etc

Bulk products Specialty products

Petrochem feedstock Petrochemical

Global Equity Market Capitalization Independent Refiner - $79b

Oil and Gas Primer

Oil and Gas Primer

Final Sales Price to End-Use Consumer = $62.00

$60.00 Fed. Taxes = $8.30

State Taxes = $9.10

Crude Oil Price = $26.75

Source: EIA, CSFB estimates.

Oil and Gas Primer

Oil and Gas Primer

Source: Bloomberg, CSFB.

Oil and Gas Primer

Source: Reuters, CSFB estimates.

Oil and Gas Primer

WTI Historical Futures Spread versus WTI Front Month

$40 $35 $30

$20.00 Brent $19.50

$25 $20 $15 $10 $5

Source: Reuters, CSFB estimates.

Oil and Gas Primer

Source: BP Statistical Review of World Energy 2001.

Exhibit 7: Global Crude Oil Production

G lobal Production, 1980-1999

FSU/E. Europe 10 Asia-Pacific Africa 5 Latin Am erica

Source: EIA, CSFB estimates.

Oil and Gas Primer

Oil and Gas Primer

Productivity per Well

Productivity per Well

55 Productivity per Well 50 45 40

Productivity per Well

Africa (Non OPEC)

Productivity per Well

Productivity per Well

900 800 700 600 500 Productivity per Well

400 300 200 100

Productivity per Well

Productivity per Well

400 350 300 250