The Financial Modeling Aspects of the Oil and Gas Industry

Posted on Dec 12, 2022 at 08:12 PM

Financial modeling in companies requires that you have the experience and information to prepare and develop it and then review and analyse it, especially if you want to work in a financial career in the oil and gas industry.

In this article, we will introduce you more to financial modeling in general and how it differs in the oil and gas industry from other industries. Read on, so you can start a successful oil and gas investment.

What is Financial Modeling?

Financial modeling represents a set of effective operations that provide a summary report on the company's expenses and profits in spreadsheets. Financial modeling helps anticipate and calculate any impact of any event or decision that may occur in the future and predicting the actual performance of the company.

Financial modeling is a mathematical representation of some or all of a company's expected operations, past, present, or future, and its primary objective. The purpose of these models is that they can be used as a decision-making tool and compare the company with its competitors in the industry.

It is worth noting that corporate executives are the ones who use financial modeling. Its usefulness lies in forecasting profits and estimating production costs for proposed new projects, as well as in strategic planning, setting outputs and budgets, and allocating company resources.

Likewise, financial modeling helps financial analysts explain or analyse listings or predict the impact of significant events on their company's stock in the future. By influence, we mean internal factors such as changing company strategies or business models or external factors such as countries' economic policies.

How does financial modeling work in the oil and gas industry?

Oil & gas, mining, and other natural resource companies have a simple business model. This model aims to seek out and find valuable stuff to begin extracting from the ground, turning them into useful products, and then selling them to customers.

However, once you read this statement carefully, you’ll immediately see how it gets more complex. In other words, there are some special considerations that we have to take into account.

So, what do you focus on? Finding and extracting valuable stuff? Turning it into something useful? Transporting and selling it to customers? All of those?

Let's think a bit and ask ourselves, what should we focus on? Finding and extracting valuable stuff? Processing and Turning it into something useful? Transporting and selling it to customers? All of those?

To know the answer, let us discuss the point of the previous point by point to see how the industry is divided:

• Let's start with the Upstream Companies: they focus on finding and extracting minerals and resources around the world from the ground
• Secondly, Midstream Companies: Focus on safely transporting oil, gas, and other commodities to companies that will sell them. This is mainly done via “pipelines” that carry these commodities long distances.
• Finally, Downstream Companies. They are the companies responsible for refining and marketing petroleum derivatives and converting them into valuable products that customers benefit from. For example, gasoline, diesel, oils, and others.

To remind you of an important point, the auxiliary companies in the oil field are   Oil Field Services: They don’t transport or process oil but instead provide services to companies that do. 

They might maintain their oil & gas fields, repair broken spots in lines, upgrade the technology, modernise work techniques, or even provide security for workers to work in companies with integrated Majors. These companies do everything above, just in different proportions. 

The most common combination is to focus on upstream and downstream and then leave the rest to dedicated specialists.

How is modeling in the oil and gas industry different from other industries?

The preparation of financial modeling is based directly on the company's exports and imports, which are related to the prices at which those assets are sold or bought. In oil, the price is uncontrollable, which is the big difference that most other differences result from.

If you make software, widgets, or clothes, you can set prices according to the individual piece.. within reason. Some products sell for $1000, and some for $10. But that is entirely different in the oil and gas industry; it is impossible because you can’t determine the price – “the market” does.

The second difference is the Balance of the oil companies, which is linked to the Balance Sheet of the countries, like all banks and insurance companies. Unlike other technology or industrial companies that depend on sales, the Balance Sheet depends on its most important assets, which are the reserves that can increase revenues and profits for it in the future.

Furthermore, there is Another difference in the accounting career. You see different line items and two accounting methodologies: total cost and successful efforts.

Notably, one of the most important differences is the Depleting Assets Galore on a daily and instantaneous basis in most normal companies. The assets tend to move in an upward trend, which affects the company's growth.

 However, the situation in the oil and gas company is entirely different. The daily extraction of oil resources and the realisation of revenues and profits from them cause the depletion of assets due to the consumption of those precious resources without compensation.

Oil & Gas Financial Statements | Projecting Revenue and Expenses

Before you begin projecting the financial data and modelling of the oil and gas companies, you need to know the units used.

Oil is typically measured in Barrels even by countries that use the metric system. 1 barrel = 42 gallons, while natural gas is measured in Cubic Feet. Everything that makes sense includes coal or metals such as iron, aluminium, copper, lead, zinc, nickel, manganese, or uranium, usually measured in tons, diamonds in carats, and gold and silver in ounces.

Similarly, the company’s reserves and production can be measured in terms of these units. The term "reserves" means the number of resources on a company's balance sheet ready for extraction, production, and sale. The term “production” means the amount of production and sale of resources on a daily, monthly, quarterly, or annual basis.

Once you begin projecting the statements of an oil company, you begin by projecting its production by segment based on its reserves and its historical patterns on the previously prepared lists.

To cite an example, assume that the company has reserves of 12,000 billion cubic feet of natural gas and produces 500 billion cubic feet annually. Here we can expect a modest increase in production, especially if the company is spending excessive money to find new resources.

Accordingly, we will assume that it will increase by 50 billion cubic feet, so the annual production will be 550 billion cubic feet, then 600 billion cubic feet in the following year. After that, we will deduct this production from its reserves and hope to replace it with sufficient capital spending. We will then link the amount spent in dollars to a specific amount of reserves.

Well, that's for production, but what about revenue? The issue is a bit difficult here because, as we mentioned earlier, the company cannot set prices. However, there is a simple solution, which is using Microsoft Excel to develop multiple scenarios.

With Excel, one can easily create a first scenario in which prices are "low". For example, calculating the price of a barrel at 40 dollars, then a scenario with a "middle" price of 70 dollars per barrel, for example, and the third scenario with "high" prices, where the price of a barrel is 100 dollars.

By taking advantage of these scenarios, a possible evaluation can be reached to predict the results of future sales operations in the company based on commodity prices to make appropriate decisions.

However, some other aspects need to be considered, such as the company not getting total market price due to intermediaries and commissions, production-linked expenses – which you estimate on a dollar per barrel of oil or per cubic foot of gas basis – and then non-production-linked expenses, such as stock-based compensation and smaller, miscellaneous items.

Generally, you should look at a company’s filings and figure out what is production-linked and what isn’t. This is so that you can then assume an increasing dollar value for the production-linked ones over time and make the non-production-linked expenses a percentage of revenue or other items, to obtain fruitful financial modeling.

In Conclusion,

With a simple thought in our article, we have tried to make you sufficiently aware of what financial modeling is in the oil and gas industry. However, you can learn finer details about this specialisation by attending the Oil and Gas Financial and Modelling course at the London Premier Centre. 

This course helps to enrich the participant with skills and a good understanding of these models while applying them to a realistic and actual model in the work environment.