Paddling “Downstream” for Energy Sector Profits
Yesterday, we began our look at the energy sector by looking at upstream stocks (companies involved in the actual extraction of oil and gas). Today, we’re shifting focus to the “downstream” energy industry. Instead of production, the downstream market segment focuses on transportation, processing, and ultimate sale of oil and gas products. We’re not trying to force complex companies into oversimplified boxes. Rather, we’re trying to identify the basic market structure of this sector, understand how it fits into the broader economy, and think about how news events are likely to affect its different types of firm. Some companies will be involved in each of these segments; integrated firms provide for diversification but also cloud some more uniquely profitable dynamics of more specialized stocks.
Which Stream is ‘Midstream’?
We should note that some analysts use a third category here, “midstream.” This refers simply to the transportation aspect of post-extraction activities (this includes major markets for pipelines, shipping, and storage). In the end, these divisions are just a tool for understanding: you can use midstream category if you like; the important point is that companies closer to extraction are further upstream and companies closer to end user sales are further downstream. Like Drilling & Service companies in the upstream market segment, transportation and storage companies have to maintain costly infrastructure and typically rely on a fee for service model. That means they’re less vulnerable to oil/gas price shocks, with profits tuned to overall capacity utilization in the energy sector.
Because they’re not speculating on potential production, these firms aren’t likely to have the explosive growth potential (and risk) of Upstream-focused stocks. They make up for it with fat dividends, however, generated from their much more stable long-term cash flows.
It can be easy for those of us without energy expertise to start imagining all of
While large integrated oil companies are involved in all aspects of the energy supply “stream,” firms specializing in downstream activities offer some unique strategic dynamics for investors. These companies buy oil and gas, process them, and sell them for a profit. This business model means that lower oil prices typically result in increased profit margins for downstream activities—the price of manufactured products is far stickier than that of raw petroleum and gas. Rising oil prices can push on the other side of this dynamic, squeezing margins for manufacturers of petroleum-based products (and often favoring the integrated supply lines of larger firms with a presence in upstream).
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