We see BP gasoline stations all over the place, but this is just the tip of the iceberg when it comes to integrated oil and gas companies.

If you were to transport someone from 100 years ago to today, he or she would not recognize much, except perhaps the oil and gas industry. The basic principles of this industry have remained the same over the last century, and the largest players in the space -- ExxonMobil, Chevron, Royal Dutch Shell -- were just as prominent then as they are now.  

Despite initiatives such as electric vehicles and alternative energy generation, oil and gas remain critical pillars of the global economy and will likely remain that way for many years to come. Since they are such critical aspects to our everyday lives, integrated oil and gas companies are an ideal place for long-term investors to park their money and not worry about it for decades. Why else would Warren Buffet invest billions in ExxonMobil?

Integrated oil and gas companies look like difficult companies to analyze, but in reality just a couple select areas are key for monitoring the health of the industry or a company. Let's take a brief look at this industry and what you absolutely need to know about it before investing a single dollar in the space. 

What is the integrated oil and gas industry?

There are several names for this particular industry -- Big Oil, super majors, integrated majors -- but essentially any company that is considered part of this space deals with the entire value chain of oil and gas. Their roles stretch from finding the initial oil or gas reservoir all the way to putting gasoline in your vehicle to supplying natural gas to your local utility. They have assets related to exploring and drilling for new sources of hydrocarbons, pipelines and other transportation infrastructure, refining and petrochemical manufacturing, and retail sales from the gas stations we see all over the place.

The concept of the integrated oil and gas company began in the 1890s with the formation of the Standard Oil Trust. Many of today's integrated oil and gas companies, including ExxonMobil, Chevron, and Amoco (now part of BP), emerged when Standard Oil was broken up by the Sherman Antitrust Act in 1911. Today, integrated oil and gas companies have operations on every continent aside from Antarctica, and spend billions of dollars every year to grow production. You can bet that once someone finds oil or gas somewhere in the world, integrated oil and gas companies will be the first to set up shop.  

How big is integrated oil and gas in the world of oil?

The global oil and gas market is complex. It involves publicly traded companies that can operate in just one sub-industry, or they can be behemoth national oil companies that are responsible for every hydrocarbon molecule in that particular country from the day it is taken from the ground to the day it is exported or consumed. ExxonMobil is one of the largest integrated oil and gas company, with a market capitalization of nearly half a trillion dollars; however, it's still only the fourth-largest oil company in the world, behind a few of these national oil giants.

Since integrated oil and gas companies have their fingers in so many pies, it's difficult to give a full market size when compared to the entire oil and gas market. Instead, here are a few factoids that will give an idea of their size and scale. The 10 largest integrated oil and gas companies traded on the U.S. stock exchanges are responsible for approximately one-fifth of the world's oil and gas production and nearly one-fourth of global refining capacity. 

How does the integrated oil and gas industry work? 

Integrated oil and gas companies operate in several business segments. Here is a brief description of each segment of the business:

  • Exploration and production units -- known as the upstream side of the business -- extract hydrocarbons from the ground and sell them to refineries and petrochemical manufacturers under either supply contracts or on the spot market.
  • Pipelines and other transportation infrastructure segments - called the midstream business -- charge fees to move or store crude oil, natural gas, or even refined products. These fees are normally based on long-term contracts.
  • Refining and petrochemical manufacturing operations -- called the downstream business -- produce the usable products from crude, ranging from gasoline and diesel to plastics and asphalt, and get profit on the margins between the price of crude and the price of refined products.
  • Retail and marketing units -- also part of the downstream business -- buy from refiners and then sell to companies and everyday consumers through wholesale contracts or retail purchases at gas stations.

Since production at integrated oil and gas companies is so large, they have to bring on hundreds of thousands of barrels per day of new production just to replace the declining production at older wells. This means they take on huge development projects that can cost billions of dollars. As the easy-to-access oil and gas reservoirs have become fewer and farther between, the per-barrel development costs of these projects have been slowly eating at the rates of returns of these companies for the past several years. 

What are the drivers of integrated oil and gas?

Integrated majors take on major development projects like this one, Gorgon LNG, to boost production and profitability. Phtoto credit: Chevron Media Relations.

The price of oil and gas, plain and simple.

OK, so that is probably a little too simplistic, but it is by far the most important driver of their business. All integrated oil and gas companies generate at least 75% of their total profits from oil and gas drilling and production. For these companies, a $1 change in the price of Brent crude -- the international benchmark price -- can alter hundreds of millions of dollars' worth of net operating income. This means that just about every decision related to capital allocation is linked to the price of oil and gas. 

There are way too many things that can impact the price of oil on a daily, weekly, or even monthly basis to keep track of, and correctly predicting that price is just dumb luck. So for investors, it's better to focus on two simple things: demand and development costs. Global oil demand has grown 2.2% on a compounded annual basis since 1965; that growth level appears likely to persist for many years, as demand in non-OECD countries is expected to double between now and 2030. Oil demand is basically the bellwether for economic health, so as long as global economic health is maintained, oil demand will increase.

Development costs will be the major determining factor in profitability for an individual company. There are plenty of sources of oil out there, but it is becoming more expensive to develop them, and several companies in the space have seen major development project costs blow past original estimates. These expenses can have a profound impact on the return on capital for these companies, so investors should keep a watchful eye on whether companies are delivering new projects on time and on or near budget. 

Tyler Crowe has no position in any stocks mentioned. You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter, @TylerCroweFool. 

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