CHAPTER 2 FROM EXTRACTION TO END USE: THE MARKETING BACKGROUND

• Jurisdiction: United States

PRIVATE OIL & GAS ROYALTIES
(Sept 2003)
CHAPTER 2
FROM EXTRACTION TO END USE: THE MARKETING BACKGROUND
By J.T. (Tom) Mitchell
Mitchell & Mitchell
Dallas, Texas

The purpose of this paper is to discuss three points concerning the marketing of crude oil and natural gas:

— How oil and gas are marketed

— How marketing of these commodities has changed

— How these changes have affected valuation for royalty purposes

These changes have largely occurred in the last 20-25 years, i.e. since the "energy crisis" of the 1970's. Ultimately the marketing and regulatory changes that developed from the situation in the 1970's resulted in many, if not most, of the disputes concerning royalty valuation that are encountered today.

Differences in the Marketing of Oil and Gas

First, it is useful to point out the fundamental differences in the marketing of oil and gas as these affect the valuation of the products for royalty purposes. In order to do this, we need to start with the production of the two products.

There are basically two kinds of producing wells - oil wells and gas wells. The difference is largely determined by the relative quantities of liquid and vapor produced from the well. Oil wells, after initial separation, produce crude oil and associated, or casinghead, gas. Gas wells, after initial separation, produce gas well gas and condensate. The gas from both types of wells is normally processed to produce residue gas and natural gas liquids (NGL's).

Crude oil and condensate are liquids at normal conditions of temperature and pressure. They can both be stored at the lease in tanks at atmospheric pressure and transported by truck, railcar, barge, ship, or pipeline. Condensate is, in fact, simply a very light crude oil. Crude oils generally have a gravity in the range of 20-45 °API while condensate is 50 °API or more.

Gas is a vapor at normal conditions and in essentially all cases is transported by pipeline. NGL's are liquid when kept under pressure or at low temperature and are normally transported by pipeline. These physical properties have a distinct effect on the marketing of crude oil and natural gas.

The fact that gas must be transported by pipeline from the well to the ultimate consumer was the single most important factor affecting the marketing of natural gas until the post deregulation period. In order to produce and market gas a fixed and very capital-intensive infrastructure of pipelines, compressor stations, underground storage, and distribution piping was required. This led to the development of specialized pipeline companies that purchased gas in the field and resold it in market areas. In order to support the heavy capital investment involved, most gas was purchased under long-term contracts. At least

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for interstate sales, the pipeline companies were heavily regulated. Oil companies while involved in production were mostly not interested in the regulated downstream aspects and a somewhat bifurcated industry developed.

Crude oil on the other hand was the lifeblood of the petroleum industry. Much crude oil production was controlled by integrated petroleum companies also involved in refining and petroleum product marketing. The crude oil or "liquid" side of the industry was generally not regulated in the same way as natural gas.

Markets for Crude Oil and Condensate

The only market for crude oil is as a feedstock for petroleum refineries. Refineries then process the crude oil into finished petroleum products, such as gasoline, jet fuel, diesel fuel, heating oil, and heavy fuel oil. In the United States most refineries are located near major population or industrial areas, such as the Texas-Louisiana Gulf Coast, the Northeast, and the West Coast.

There are a very large number of producers of crude oil and a relatively small number of consumers, i.e. refiners. Many major producers are also refiners. In fact involvement in production, refining, and product marketing is what defines an "integrated" oil company. Such companies have traditionally attached importance to maintaining some degree of balance between their crude oil supplies and refinery requirements. For this reason, exchanges have always been very common for crude oil.

Major refineries process dozens of different crude oils. Complex linear programming models are used by refiners to optimize the selection and valuation of crude oils. Such models take into account the availability and pricing of crude oils, the processing capabilities of the refinery, and the demand and pricing for products in the optimization process.

Imports are a significant proportion of U.S. crude oil supplies. These include imports from Canada by pipeline and waterborne imports from overseas. Crude oil prices for domestic production are then directly determined by worldwide crude oil markets.

There are significant quality differences between crude oils and these affect their value. Some of these differences are as follows:

— Light versus heavy - indicated by API gravity

— Low versus high sulfur content - indicated by weight percent sulfur

— Paraffinic versus naphthenic - chemical composition differences

— Other differences - asphaltic, metals, etc.

Some of these differences are utilized in the quality banks employed by many crude oil pipelines. The most prevalent quality banks account only for gravity differences while some also take sulfur content into account. A few, such as the Trans Alaska Pipeline System Quality Bank, use a more complex distillation-based methodology.

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In addition to independent producers and refiners and integrated companies there are also independent gather/marketers involved in crude oil marketing. These companies purchase crude oil at the lease, transport it to central locations, and resell it to refiners.

Prices for Crude Oil

Domestic crude oil pricing has gradually...