We don’t want you to miss out, so here’s the link to Part 1. Otherwise, let’s jog! In this article, we explore the inner workings of each segment of the oil and gas industry. In addition, we summarise the key revenue drivers, business and investment characteristics for each sector.
Here's a quick recap of the oil and gas value chain.
How do upstream companies work?
Upstream companies are also known as Exploration and Production (E&P) companies. In a nutshell, they are in charge of searching, extracting and producing oil and gas.
Firstly, exploration. E&P companies start by conducting seismic surveys. Similar concept to ultrasound scans in pregnancy, seismic surveys aim to provide an idea of the content below the seabed and thereby reducing the risk of a dry oil well. For upstream, the ultimate goal is to determine if the area is economically viable.
After successful surveys have been carried out, drilling and extracting takes place. This is where Oilfield Services companies (OFS) come into play, especially in offshore assets. OFS provide technology expertise, drilling and extraction infrastructure to upstream operations.
Lastly, production. This phase includes segregating contents into those that can be and cannot be sold.
Business characteristics of upstream
Upstream segment is capital-intensive because of the substantial investment needed in infrastructure and technology to explore, locate and extract oil and gas. For investors, this is a high risk with high reward sector.
A price-taker, the nature of the business model means that it's highly dependent on oil prices. And since the price of oil is arguably politics, it’s challenging to build a fundamental story on the industry.
Lastly, upstream companies operate in a regulation heavy industry. Consequently, the cost of compliance has resulted in significant additional expenditure to its operations. An interesting observation: in its respective annual report, the word “regulation” or “law” was mentioned 169 times for ConocoPhillips, and only 73 times for JP Morgan.
How do upstream companies make money?
Upstream companies produce and sell crude oil and gas to customers. On the other hand, oilfield services companies generate revenue through services and infrastructure provided to E&P companies.
Key drivers of the upstream segment
For upstream, oil prices is a direct input of a company’s revenue. Hence, dependent on the supply and demand for oil.
As you can see, oil prices has a linear relationship with revenue generated. To a lesser extent, E&P companies protect themselves against fluctuations of oil prices through purchasing derivatives.
Oilfield services’ revenue stream is a function of global exploration and production activities. As a result, it depends on oil prices to some extent. OFS's services are a blend multi-year and short-term contracts. For this reason, its revenue streams are less volatile relative to the upstream segment.
Who are the key upstream companies?
The key players in the upstream segment are:
Independents E&P companies
National Oil Companies (NOC)
These are national government majority-owned oil and gas companies. NOC controls ~90% of the world’s proven oil reserves and are responsible for 75% of the world’s oil production.
- Saudi Aramco (2222.SR)
- National Iranian Oil Company
- China National Petroleum Corporation
International Oil Companies (IOC)
Also known as supermajors/oilmajors, are a group of integrated oil and gas companies, who has an outsized influence on the market due to its size and market position. IOC are key players in upstream, midstream and downstream segments.
Oilfield Services (OFS)
How do midstream companies work?
Midstream companies act as a link between producers and refineries. They're responsible for gathering, processing, storing and transportation of oil and gas.
In short, the midstream value chain process starts by gathering various sources of crude oil into a central storage processing facility. Subsequently, this is transported via transmission pipelines, trucks, oil tankers and rail cars.
Business characteristics of midstream
Because the midstream connects both upstream and downstream, it’s inherently exposed to both supply and demand for oil and gas. For this reason, its business model is indirectly influenced by oil prices.
Similar to upstream, midstream companies operate in a highly regulated sector. For example, in the US, most pipelines are regulated by the Federal Energy Regulatory Commission (FERC), which sets the tariff rates. This means that should FERC decide to lower tariff rates, midstream companies will be forced to charge less, and vice-versa.
Due to its significant infrastructure (transmission pipelines and storage facilities etc) and the lack of substitutes, midstream are regarded as a low risk play. Furthermore, the high cost and barriers to entry further discourages new entrants in to the market. For investors, midstream companies are particularly attractive because of its high dividend paying capabilities.
How do midstream companies make money?
Midstream companies generate income from the services they provide connecting upstream and downstream sector. Paying tolls to cross bridges is analogous to how midstream companies make money. A fee-based model, midstream companies tend to generate relatively predictable cash flows.
The three primary source of revenues are commodity sales, distribution and transportation. Commodity sales involves processing raw materials into valued-added products, which are sold on to end users. On the other hand, distribution and transportation revenue are driven by the amount of oil and gas involved.
Key drivers of the midstream segment
First, midstream businesses are geared towards the production volume/margin rather than the absolute price of commodities, because it’s largely (not 100%!) a fee-based model. This creates a chicken and egg situation, since volume is driven by supply and demand. It’s worth highlighting that while revenue may be impacted by commodity prices, net margins are relatively insensitive because of its fee-based model.
Optically, Enbridge's revenue growth seems to have a weak relationship to changes in oil prices.
Secondly, regulation. Regulated tariffs is a significant revenue generator for midstream companies. For this reason, any changes in tariffs may adversely affect its income profile. While climate change may be the main issue, tariff rate changes is often a consequence of politics. Keystone Pipeline is a case in point.
Lastly, pro-longed low oil prices. In the long term, this can negatively impact supply and demand and even lead to insolvencies of its customers. As a result, lower earnings power may ensue. Persistent low oil prices could force upstream companies to rethink the need to invest in its own midstream capabilities to be cost efficient, leading to potential competition.
Who are the key midstream companies?
How do downstream companies work?
Broadly, downstream companies refine and distribute petroleum products. Refining is a process of converting crude oil into usable products. Distribution also includes sales and marketing to its end users.
Business characteristics of downstream
There are a few similarities to midstream business. In particular, downstream is driven by the production margin rather than the absolute commodity prices in the medium term. For this reason, the downstream segment can be categorised as a margin business.
Similar to midstream, downstream is also politically sensitive. This is on top of its low growth and return characteristics. In addition, downstream is directly expose to shifting customer demands such as climate change initiatives.
How do downstream companies make money?
Downstream companies make money through refining crude oil and retail & marketing. Occasionally, downstream companies are also active in midstream operations such as transportation and processing.
A key metric in this segment is refining margin. This measures the value contribution of the refinery per unit of input. In mathematical terms, this is calculated by subtracting the cost of crude oil from the market value of the refined products it produced. This is also commonly known as crack spreads.
On the other hand, retail & marketing activities mainly involves distribution of products via its convenience retail stores. The commonly known names are the oil majors, BP, ExxonMobil, Total etc.
Key drivers of the downstream segment
Commodity prices remain one of the key drivers for the downstream segment.
More often than not, prices of refined products do not move in the same way as the cost of crude oil. As a result, crack spreads may fluctuate significantly. There is often a time lag before prices of refined products reflects the cost of crude oil.
Another key driver is the global supply and demand for its refined products. For example, the recent pandemic has prevented many from non-essential travelling. Consequently, gasoline demand diminished significantly. A structural shift into electric vehicles (EV) can also further decreased gasoline demand.
Who are the key downstream companies?
Finally, for investors, we summarise the following:
- Upstream is a high risk high reward business.
- Midstream is an attractive high dividend yield business.
- Global oil prices and politics dictate the fortune of the oil and gas industry.
Let us know what your views are on the oil and gas industry in the comment section below. Where do you think Brent crude prices will be at the end of the year?