Investor's Guide to Oil and Gas Upstream – Motley's Fool

The oil and gas industry pumps, transports and processes more than 100 million barrels of crude oil and more than 355 billion cubic feet of natural gas per day worldwide. The upstream part of the oil and gas sector does most of the initial work; It is engaged in the exploration and production of hydrocarbons – oil, natural gas and natural gas liquids (NGLs). It then transfers this production to the intermediate sector, which focuses on the transportation, processing and storage of hydrocarbons. From there, oil and gas flow downstream, where oil is refined to give finished petroleum products such as gasoline and diesel, and then distributed to end users.

This guide will explain to investors the operation of the upstream oil and gas sector. We will explore the types of businesses needed to find and produce oil, how they earn money, and the role played by oil prices in this particular segment of the industry. This should help investors make more informed decisions when they buy upstream oil stocks.

What is the upstream oil and gas sector?

The upstream oil and gas sector contains two main components:

Exploration and production (E & P): The E & P sector includes companies that explore new sources of oil and gas and then drill wells to extract these resources. The size of E & P's businesses ranges from private, family-run businesses that tap a handful of wells to multinationals to global assets. E & Ps can also have a narrow focus – such as conventional drilled vertical wells – or multiple types of oil fields, including offshore, oil sands and unconventional wells drilled horizontally and hydraulically fractured (fractured) .

E & P generally leases land to individuals or the government and then drills exploration wells to see if the rocks below contain commercially viable hydrocarbons. If they make a discovery, they will invest more money to drill additional wells and build the necessary infrastructure for resource development. The E & P sector requires a lot of capital – oil companies must continually invest money to find and develop new oil and gas resources to replace the production of traditional wells, which are gradually declining and eventually exhausted.

Oil Field Services and EquipmentThis segment supports E & P companies by providing a range of services, equipment and products that enable them to find and produce oil. Oilfield services provide support throughout the three main stages of the drilling process:

1. Exploration services such as seismic and geophysical tests that help E & P companies to discover interesting prospects to explore. They also conduct tank tests to determine the commercial viability of a discovery as well as the development of resources.
2. Drilling services, including the operation of onshore and offshore drilling rigs.
3. Well completion services such as cementing and fracturing newly drilled wells so they can produce oil and gas.

The oil services sector also provides E & Ps and other service-based companies with a wide range of specialized products and equipment.

What are the different types of upstream oil and gas companies?

The upstream oil and gas industry includes four types of businesses:

1. Integrated oil companies

These are "end-of-well to end-user" operations that cover the upstream, middle and downstream segments of the oil market.

ExxonMobil (NYSE: XOM) is the largest publicly traded integrated oil company in the world. It operates one of the largest E & P companies, with assets around the world, a growing growth segment and a significant downstream portfolio of oil refineries, petrochemical plants and distribution operations. and marketing such as service stations. This diversification in the sector allows integrated oil and gas companies such as Exxon to maximize the value of each barrel that they produce. It also helps mitigate some of the effects of oil price volatility, with downstream assets benefiting from lower prices.

2. Independent E & P companies

These companies focus primarily on the upstream segment. Some independent E & P will exploit intermediate assets to support their production, but they derive most of their money from oil and gas production. Because of this, they are much more sensitive to changes in oil prices as their profits tend to rise and fall with commodity prices.

3. Diversified oil services companies

These companies provide a range of services, equipment and products to help their E & P customers. They are akin to a one-stop shop for the exploitation of oil and gas resources. In addition to providing a variety of indispensable services, they often manufacture mission-critical equipment, such as:

• Drilling apparatus.
• Oil production systems and pump jacks.
• Remote-controlled vehicles used in the development of deep-sea resources.
• Specialized drill rods, valves and fittings, and separation systems.
• Storage tanks.
• Raw materials such as sand used in fracturing wells.

4. Service companies or equipment of oil fields in the pure state

These companies focus on one aspect of the service sector. Some, for example, own and operate only offshore rigs. Others provide specific services for the construction of newly drilled oil wells or produce sand used in fracturing wells. This focus on one aspect of the oil services sector allows these pure companies to earn a lot of money in times of strong expansion. But they can be much more likely to be disrupted when market conditions deteriorate. This was the case during the slowdown in the oil market from 2014 to 2017, when several pure play oil services companies declared bankruptcy.

How upstream oil and gas companies earn money

E & P companies are known to be price takers, which means that they sell their oil and gas at market rates. This price can fluctuate considerably and is strongly influenced by variations in supply and demand. If oil producers pump more oil than the market needs, crude prices can fall, which hurts E & Ps's profitability.

Petroleum service companies, meanwhile, earn money by providing services and equipment to E & P companies. Some service companies sign long-term contracts with E & Ps or D & P. Other service providers give them some visibility into their revenues, but most operate under short-term contracts or sell products, if any. This can be problematic: demand – and rates – for services, products and equipment for oil fields tend to fluctuate with oil prices. Indeed, capital expenditures are often based on projected cash flows, which also increase and decrease with oil. As a result, oil service companies – especially pure companies – tend to be very sensitive to oil prices.

Due to upstream oil industry exposure to price volatility, investors should look for low cost companies. For E & P, this means finding those who can maintain their current production rate at oil prices well below $ 50 per barrel. Meanwhile, low-cost service companies will have comparable margins. Although it takes a bit of time – including a review of investor relations presentations on corporate websites – this work will be worth it in the end. Indeed, low cost upstream companies can still earn money with lower oil prices, which allows them to generate a profusion of profits when they bounce back.

The 10 largest upstream oil and gas stocks, by market capitalization

The governments of several major oil-producing countries control many of the world's largest oil producers. However, given the gigantic size of the global oil industry, investors still have many options to choose from. The table below lists the 10 largest publicly traded upstream stocks that are not controlled by foreign governments:

Data Source: Business Investor Relations Web Sites.

To give investors an idea of ​​the different types of upstream securities, we will delve deeper into the most important of each group: ExxonMobil (integrated), ConocoPhillips (independent E & P) and Schlumberger (diversified oilfield services).

ExxonMobil: an investment covering the entire oil value chain

ExxonMobil is one of the largest oil and gas producers in the world. In 2017, it was the world's third largest producer of natural gas and the second largest oil producer in America. Exxon also has a significant footprint in the middle of the project and significant downstream activity, which includes the largest refining operation in the world and one of the largest chemical manufacturing operations.

This diversification gives the company three notable advantages:

1. It helps to generate more stable earnings and cash flow. Downstream activities tend to generate higher profits during periods of declining oil prices, helping to mitigate some of the effects of price volatility on upstream activities.
2. This helps the company maximize the value of its production. Instead of selling its production at the wellhead at the market price, Exxon can transport oil and gas via its intermediate assets to its downstream facilities, where it can convert that production into refined products or larger petrochemicals. value.
3. This opens up more opportunities for development, as the company can invest capital not only worldwide but also throughout the oil and gas value chain.

ExxonMobil plans to invest $ 50 billion in the development of its US integrated operations by 2025. This includes the drilling of more oil and gas wells in the Permian Basin and the construction of pipelines for the United States. move its production to the Gulf Coast, where it extends its footprint downstream. These projects are an essential part of Exxon's ambitious plan to double its earnings and cash flow by 2025 from the 2017 baseline without any help from higher oil prices. and gas.

Exxon's diversification makes it a less risky way to invest in the oil sector. It is favored by rising oil prices through its upstream activities, with less downside risk during periods of lower prices as its intermediate and downstream segments partially mitigate this impact. Add to that Exxon's leading balance sheet and attractive dividend, and it's an ideal way for investors to expose to the oil sector.

ConocoPhillips: A pure E-P upstream

ConocoPhillips had integrated operations such as Exxon, but the company is divesting of its downstream and production operations Phillips 66 to shareholders in 2012. This allowed ConocoPhillips to focus on expanding its global E & P business while freeing Phillips 66 from the development of refining, chemicals and intermediates.

Since then, ConocoPhillips has further streamlined its business by selling many non-core businesses in order to focus on its least expensive assets, using cash proceeds to pay off debt and buy back its shares. As a result, the Company controls a reduced portfolio of low-cost oil and gas assets, including unconventional shale properties in North America, conventional oil deposits such as those in Alaska, natural gas export facilities. liquefied in Australia and oil sands interests in Canada. This balanced portfolio allows the company to generate many cash flows at oil prices above $ 40 per barrel.

E & P companies have traditionally spent all their free cash flow drilling more and more wells. But ConocoPhillips has launched a new approach within the industry by investing its capital to obtain a high return on investment. As a result, he invests only in the best opportunities, which allows him to generate a surplus of cash. This allows it to pay a growing dividend and buy back shares, which can potentially create more value for shareholders.

ConocoPhillips has worked hard to reduce the impact of oil price volatility by focusing on low-cost oil and gas assets. This allows it to maintain its production rate with the cash flow it can produce with $ 40 worth of oil. As a result, the company is well positioned to benefit from higher prices, with the objective of returning a significant portion of its excess cash flow to investors through share buybacks. This should help the company generate healthy total returns for its shareholders throughout the ups and downs of the oil market.

Schlumberger: the other side of the upstream oil and gas sector

Schlumberger is the largest oilfield services company in the world. It provides E & P companies with a full range of services to research, drill and produce oil and gas. The company also manufactures a wide range of products and equipment, particularly to support offshore operations.

Schlumberger operates in four business segments:

• Tank characterization, which provides tools and services that help E & P companies understand rock and reservoir fluids.
• Drilling Services, which offers a range of services, equipment and tools to drill exploration and development wells.
• Production Services, which provides producers with the services, tools, products and equipment needed to maximize and extend the life of an oil and gas field.
• Cameron, which manufactures pressure control systems, drilling equipment, drilling tools and valves.

The Schlumberger diversification has several competitive advantages. For starters, this helps mitigate some of the effects of the deteriorating market conditions in an upstream industry sub-sector. This was evident in the fact that international and foreign markets took less time to recover from the slowdown in oil that began in 2014, which hurt companies concentrated in these areas. Schlumberger was able to offset some of this weakness as onshore shale drilling in North America experienced a much faster recovery. At the same time, its wide range also offers the advantage of allowing Schlumberger to offer full service contracts at competitive prices. This puts him in a better position to win the business of the big oil companies, who prefer to have only one service partner because it is easier to coordinate activities.

Due to its diversification and scale, Schlumberger is not as sensitive to market downturns as its smaller peers. While the company's revenues, margins, and cash flow all declined along with oil prices during the market downturn, they significantly outperformed their competitors as their financial performance fared much better. .

This ability to continue to earn money when market conditions deteriorated enabled Schlumberger to take advantage of the situation through acquisitions, including the purchase of Cameron, allowing it to further grow in the next quarter. recovery cycle. While pure service and equipment companies enjoy more and more money in times of economic prosperity, Schlumberger's diversified strategy, combined with its leading balance sheet, allows it to survive during periods slowing the oil market and prospering when conditions improve.

A word about upstream exchange traded funds (ETFs)

Choosing the right upstream oil stock can be difficult. Unforeseen business problems, such as poor drilling results, mismanagement or other problems, can result in a significantly lower oil stock than peers, even if oil prices are rising. That's why investors might consider buying an oil-traded, exchange-traded fund, a stock-like vehicle that invests in several oil companies.

An oil ETF to consider is the SPF S & P for exploration and production of oil and gas. This fund holds an equal number of approximately 70 companies in both the upstream E & P and downstream refining and marketing segments. This broader approach allows investors to benefit from higher prices because of their exposure to the insurance market. At the same time, it partially mitigates the shock of volatile oil prices through the inclusion of certain downstream activities.

Why investing in upstream stocks might make sense for your portfolio

As oil prices fluctuate, demand for crude oil has continued to rise and is not expected to stabilize for several years. The upstream oil and gas sector can therefore enrich investors. But they need to know what upstream shares they are buying, because the volatility of oil prices increases the risks. One of the best ways to reduce this risk is to focus on larger and more diverse companies. Their scale and diversification should help mitigate some of the impacts of the inevitable ups and downs of the oil market.