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Independent Oil and Gas: Investing Essentials

By Matthew DiLallo - Aug 4, 2014 at 11:00PM

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A primer on independent oil and gas companies.

The year was 1858 and Edwin Drake, a retired railway worker, was tasked by the Seneca Oil Co. to search for oil suspected to be in Titusville, Pa. Months later, and by this time abandoned by Seneca, Drake struck oil about 70 feet below the surface using a drive pipe. Since that day, wildcatters have been forming independent oil and gas companies to search for black gold across the nation.

Oil well in West Texas. Photo credit: Flickr user Britt Reints.

What are independent oil and gas companies?

An independent oil and gas company is basically an entity that only explores for and produces oil and gas. It typically doesn't own refining, processing, or marketing assets to prepare that oil and gas and then sell the product directly to end users. The IRS specifically defines an independent as a company with less than 50,000 barrels per day of refining capacity and less than $5 million per year in retail sales. 

How big is the independent oil and gas sector?

The independent oil and gas sector is made up of more than 500 publicly traded exploration and production companies, along with thousands of privately held companies. The number of independent oil and gas companies far outweighs the number of integrated oil and gas companies. In fact, there are just over 50 publicly traded integrated oil companies , along with a handful of integrated national oil companies held by foreign governments.

Oil wells in western Texas. Photo credit: Flickr user Edward Stojakovic

In the U.S., the total enterprise value of the independent exploration and production market is well over $800 billion. While that's big, the number is exceeded by just the combined market capitalizations of the top three integrated energy companies. Meanwhile, Saudi Aramco, which is the national oil company of Saudi Arabia, is thought to be worth several trillion dollars. 

How do independent oil and gas companies operate?

The operations of an independent oil and gas company can be as simple as owning and operating a handful of wells, and selling the oil and gas produced directly from the wellhead into the pipeline system. Top independent oil and gas companies, though, have operations that span the globe. These companies explore for oil from the depths of the sea to the farthest reaches of the globe. In some cases, oil and gas production is hedged with complex financial derivatives in an attempt to mitigate the volatility of commodity prices. This added complexity increases risk but also opens up the opportunity for greater rewards.

Independent oil and gas companies come in all shapes and sizes, and the aggressiveness by which they pursue their strategy can vary. Some are run by true Midwestern wildcatters that take big risks to find the next gusher. Other independents are run by geologists, engineers, or businessmen seeking a conservative return on their investments. Investors need to tread carefully in this sector, as not all independents are alike.

Photo credit: Flickr user Kool Cats Photography.

What are the drivers of independent oil and gas companies?

The biggest drivers of independent oil and gas companies are unquestionably oil and gas prices. When prices are high, independents can be aggressive in leasing mineral rights that are prospective for oil and gas and then aggressively drill new wells. Particularly aggressive independents will take on large amounts of debt to grow production and add to future drilling locations when energy prices are high.

The problems come when prices fall. Independents need to pull back on drilling and sometimes sell assets at fire-sale prices just to finance their heavy debt loads. Many independent oil and gas companies have gone belly up when an energy boom busts.

Investors need to be careful when investing in independents. Aggressive independents that outspend their cash flows could be in trouble when volatility in oil and gas prices returns. Furthermore, because refining and marketing assets tend to act a hedge, integrated oil companies are less affected by the volatility of oil and gas prices than independents. That being said, when an independent strikes oil the rewards can be well worth the risks.

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