The Energy Sector: Understanding Upstream
Last week, we took a break from our regularly scheduled programming to examine our founder and CEO’s talk at the Wealth 365 conference. This week, we’ll be returning to our look at understanding the sectors of the stock market.
Some fundamental sectoral knowledge is vital even for investors who aren’t looking to specialize. Even the most fundamental metrics for valuing stocks can vary wildly between sectors. Some industries are capital intensive, virtually guaranteeing higher average debt loads. Others, like tech, are all about sales growth at the expense of cash flow (with the assumption that users can always be monetized later). Sectors are very broad categories, and they all include firms with very different business models. The trick is identifying the salient structural characteristics that drive analysts to view each sector as a strategic unit.
Today, we’re focusing on the energy sector, which encompasses a vast vertical supply chain. First, there’s the actual exploration and development of oil/gas reserves. Then comes refining. Finally, integrated utility companies, including both renewable energy and fossil fuels, are folded into this category.
These activities are typically divided into two broad categories, Upstream (production operations) and Downstream (processing and sale). Today’s post focuses on the upstream portion of this sector.
Upstream: Exploration and Production
We extract oil and gas from special geological formations, but it’s not always simple to identify the most lucrative targets without an expensive drilling effort. Exploration efforts involve a plethora of sophisticated scanning techniques, which firms employ to prioritize high-potential sites for exploratory drilling.
If drilling results are promising, production begins. These firms end up with a bifurcated business model: current cash flows are tightly aligned with the productivity of active wells, while most growth will come from exploratory activities. The value of these firms often swings dramatically with single news announcements on exploratory drilling efforts: the success or failure of a given play can determine the financial future of a company for years to come.
In an effort to isolate the financial risks associated with owning mineral rights and owning expensive drilling equipment, E&P firms don’t usually own and operate their own rigs. That activity falls into the next category.
Upstream: Drilling and Service
These firms conduct the actual extraction operations and are paid on a contract basis by E&P firms. They maintain large workforces and own expensive production equipment. Unlike E&P firms, their revenues aren’t directly tied to the rate of oil extraction itself. Instead, this market segment is all about utilization. The hotter the world energy market, the more Drilling & Service firms will be employed. Keeping costly human and capital resources on paying contracts is essential for their overall profitability. While E&P firms remain sensitive to oil/gas price, these firms are sensitive to overall production.
Upstream Macroeconomic Dynamics
Energy constitutes one of the most truly global commodity markets in existence. While it’s plausible to trade some sectors based only on a “micro,” firm-specific analysis, there’s no simple method for valuing energy stocks without some method for evaluating the global energy market. And global market forces can have disparate effects different parts of the energy sector. Factors like production and price are closely related, but by no means the same thing; what’s more, hedge funds are spending serious dollars modeling these key variables.
The energy sector, therefore, represents a prototypical opportunity for new-based profits. A smaller investor can’t afford to hire quants to model global energy prices. But, using our Analyst Action dataset, seeing which analysts have the models that move markets takes seconds. We’ll explore the dynamics of this key sector in further detail tomorrow.
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