Overview
If there’s one thing the world will always need, it’s energy. Without reliable forms of energy to harness, very little, if anything, can be done.
Thanks to advances in science and engineering, we can harness energy from a variety of sources. Fossil fuels, wind, solar, hydro, geothermal, nuclear, biomass: this energy mix continues to expand as different forms of energy are discovered and new technologies are developed to help harness it.
Despite the diversity of our modern energy mix, the predominant form of energy that many countries continue to use is fossil fuels, in particular oil, coal, and gas.
From an investment standpoint, the oil and gas industry has, in recent years, largely been shunned by all sorts of investors, from some of the world’s most prominent sovereign wealth funds all the way down to the humblest retail investor. Arguably, this decline can primarily be attributed to increased climate concerns in recent years.
However, not all investors share the same sentiment, with many continuing to maintain, or even expand, their oil and gas holdings. If you find yourself looking to commit some capital in oil and gas, this article will serve as an introduction to understanding how the industry works, as well as what to look for from an investment point of view.
Understanding the Oil and Gas Value Chain
Just like any other industry, oil and gas companies follow a specific value chain that outlines how raw materials/inputs are converted into useful products/services. In this case, the value chain can be broken into three major areas: Upstream, Midstream, and Downstream.
Some companies choose to do business in just one of these areas, while others may have the capital, expertise, and workforce needed to operate across all three – they are known as “integrated” oil and gas companies.
Based on which stream(s) a company operates in, the specific factors that investors may want to pay attention to will also differ – this will be covered later. To understand why that’s the case, let’s first go over what each component of the oil and gas value chain entails.
To avoid making this article too technical, the descriptions will be relatively high-level but will contain enough detail such that the role of each stream is clearly understood.
Upstream Operations
At the top of the oil and gas value chain is the upstream, which covers the discovery and extraction of unrefined hydrocarbons, namely crude oil and natural gas. Oil and gas extraction operations take on a variety of forms such as oil sands, shale oil, offshore drilling, and conventional oil wells. Companies that have upstream operations are usually known as “oil and gas producers” (or “producers” for short).
It’s important to reiterate that this stage deals strictly with the extraction of raw material. Crude oil is a mixture of liquid hydrocarbons which has very little, if any, use as a final product, and must undergo a refining process to separate the various hydrocarbons into useful products. Natural gas, in its raw form, contains all sorts of impurities, and must also undergo further refining to extract useful products from it.
Oil and gas companies that operate solely in the upstream will therefore sell their raw crude oil and natural gas to downstream companies. Integrated companies can opt to use this raw material in their own downstream operations or sell it to other downstream companies.
Midstream Operations
As was briefly touched on in the preceding section, after raw hydrocarbons have been extracted, this raw material must be further refined before it can have any sort of commercial value and use.
It may seem like refining comes immediately after extraction, but that isn’t always the case. Oil refineries are distinct sites that have their own unique equipment and processes, which are completely different from those found on production sites. Because of this, unrefined crude oil and natural gas must be transported from production sites to the refineries. Some refineries may be in relatively close proximity, while others may be several hundred, or even thousands, of kilometres away.
Not only does raw material need to be transported, but there’s also the problem of storage. Unrefined crude oil and natural gas will need to be stored somewhere before it’s time for them to get refined, and final products will need to be stored somewhere before they’re ready to be purchased by customers.
So how does the transport and storage of crude oil and natural gas take place? This is what midstream operations deal with.
Midstream operations deal with the intermediate step of connecting producers with refineries, and by extension, final customers. When it comes to land-based options, oil and gas are usually transported via pipeline or rail. If the hydrocarbons need to be transported to another country, then specialized ships known as tankers will transport them.
In terms of storage, crude oil is kept in above-ground storage tanks, while gas can either be kept in an underground reservoir or can be liquefied and kept in specialized storage tanks.
Midstream companies earn their revenue by charging their customers (usually producers or downstream companies) to use their transport and/or storage infrastructure.
Downstream Operations
At the end of the oil and gas value chain is the downstream operations, which deal with refining the raw hydrocarbons from the upstream and the subsequent delivery and marketing of final, useful products to the appropriate consumers.
As you may have guessed, downstream companies earn their revenue from the sale of these final products to consumers.
“Consumers” in this case don’t just include individuals. Independent gas stations or certain businesses (such as some grocery stores) will buy these final products, which they will then re-sell to individuals.
Which Investment Factors to Focus on When Looking at Oil and Gas
Now that we’ve performed a high-level overview of how the oil and gas value chain works, we can now start to look at what specific factors investors may want to focus on.
Because each stream operates so differently, it comes as no surprise that each one will have unique factors that investors will want to look at. We will go over what some of those different factors are.
Please note that the factors we will discuss are by no means comprehensive; in other words, not all of the factors discussed here will be the only ones that investors will want to focus on. That being said, the factors that will be covered will be the ones that we believe most investors will want to look at anyways.
Upstream Investment Factors
Oil and Natural Gas Prices
Even if you don’t follow the oil and gas industry very closely, chances are you’ve at least heard some discussion regarding barrels of oil, or more specifically, the price of one. There is an abundance of business and political discourse regarding the price of a barrel of oil, but how exactly does it concern investors?
First, it’s important to note that a “barrel” isn’t necessarily talking about physical barrels (though it can), but rather a standardized unit of measurement specific to the oil and gas industry. A barrel of oil is equivalent to 42 US gallons, or 158.987 litres, and is commonly used as a unit of measurement when talking about the size of a given oil reserve, a producer’s output capacity, or a rate of consumption, to name a few applications.
Another interesting feature when it comes to a barrel of oil is that the price will vary based on where a certain barrel originated from. A barrel of oil from Western Canada will have a different price from one that comes from Saudi Arabia. This is mostly attributed to how expensive it is to produce a given barrel of oil.
Canada’s oil comes primarily from oil sands, and extracting oil from them is an expensive and energy-intensive process. Saudi oil, however, is relatively easier to extract and produce, resulting in a lower price per barrel.
Additionally, different barrels of oil have different compositions, which also influence the price of a given barrel. These different mixtures of oil in a given barrel are known as blends.
When it comes to making money from upstream operations, the goal is to ensure that the difference between the market price of a barrel of oil and the cost to produce it is as wide as possible. The wider the gap, the greater the profit margin.
Different oil and gas companies produce different blends, so one of the factors investors will want to look at right away is understanding what sort of blend a given company produces, how much it costs to produce it, and what the market price for that blend currently is (or at least its historical pricing).
Natural gas, on the other hand, is typically reported in terms of volume (usually in millions of cubic metres) and is usually priced per unit of energy, most commonly MMBtu (1 million British Thermal Units) or GJ (Gigajoules). It follows a similar philosophy to how oil is sold in that natural gas costs a certain amount to produce and is sold at a certain market price. Unlike oil, however, natural gas does not come in different blends.
Capital Expenditures and the Effective Use of Assets
As we know, upstream operations deal with the extraction of raw crude and natural gas. This means appropriate tools and equipment are needed to perform this extraction.
We also know that there are a variety of ways to extract oil and gas, and because of this, different methods require different types of tools and equipment. The tools and equipment needed to extract oil from oil sands will be vastly different from what’s needed to extract oil out in open water.
Investors don’t need to know what those specific tools and equipment are (although this knowledge would be nice to have), but rather how much money is being spent to acquire and maintain those tools and equipment.
It’s hard to perform an apples-to-apples comparison between different companies because they may extract oil and gas in a variety of ways, so investors are probably better looking at a company’s capital expenditures over time.
Large capital expenditures may signal growing operations, a flurry of old equipment needing to be maintained/replaced, or out-of-control spending on equipment that may not even be used effectively – investors are responsible for finding out what the case is.
Procuring new tools and equipment is one thing, but are they producing any noticeable benefits? In other words, what’s the return on these physical assets?
Since an increase in physical assets will be marked by an increase in plant, property, and equipment (PPE) on the balance sheet, investors can perform a simple return on assets calculation.
Generally speaking, the higher the percentage, the better. That’s because this shows that an upstream company is making good use of its assets to generate revenue. But of course, a return on assets percentage is only as good as what it’s being compared to, which investors are responsible for performing.
Midstream Investment Factors
Tolls/Tariffs and Contractual Agreements
Unlike upstream oil and gas companies, which are heavily dependent on the market prices of crude oil and natural gas, midstream companies are not at the mercy of the same market vicissitudes. The argument can be made that midstream companies are indirectly affected by crude oil and natural gas prices, but the fact of the matter is that when it comes to generating revenue, commodity prices have no direct effect on them.
Instead of relying on the market prices of these commodities, midstream companies charge their customers tolls and/or tariffs to use their transport network.
Investors don’t need to overly concern themselves with the details of how these tolls/tariffs are charged (i.e., no need to fully understand the details of specific contracts). Instead, investors are better off understanding how the use of a midstream company’s transportation assets is administered.
To help secure their sources of revenue, many midstream companies choose to make their customers sign long-term contracts with them, which detail transport network usage and the tolls/tariffs they are expected to pay. This represents a win-win for both parties: the customer secures a certain allocation of the transport network for the long term, while the midstream company secures itself a long-term source of business.
From an investment standpoint, a midstream company that can successfully pen multiple, long-term contracts with its customers means investors can expect stable revenue in the near, and potentially distant, future. This revenue can make its way down to investors by way of generous dividends.
Midstream companies may also charge customers to use their storage capacities, but this usually doesn’t contribute a substantial amount to revenue, at least when compared to the revenue earned from transport.
Size and Scope of the Transport Network
Midstream companies exist because the locations where oil is extracted, and where they need to go for refining, usually aren’t side-by-side. For example, there is a lot of crude oil extraction going on in northern Alberta, but a sizeable quantity of this oil is refined in southern Texas near the Gulf of Mexico.
Crude oil and natural gas may need to travel thousands of kilometres from their point of origin before they can be refined, and midstream companies are responsible for ensuring they have the necessary infrastructure needed to complete that journey. The more extensive a midstream company’s transport network is, the more customers it can serve, meaning the more revenue it stands to earn.
Any worthwhile investment should have a wide economic “moat” to fend off competitors; that is, they should have a distinct competitive advantage that would prove very difficult for the competition to replicate or overcome. In the case of a midstream company, its moat is determined by the size and scope of its transport network.
Large midstream companies usually have thousands of kilometres of pipelines, several storage hubs, and other related assets under their ownership. Some midstream companies may choose to transport only crude oil or natural gas, while others may have the means to transport both.
The more extensive a midstream company’s operations are, the harder it is for competitors to try and replicate, meaning investors don’t have to worry about competitors taking away potential customers, and by extension, potential sources of revenue.
Keeping Capital Expenditures in Check
The larger a certain midstream company is, the more physical assets it’ll have to manage. Just like any other piece of equipment that’s subject to routine use, they wear out over time, and so must undergo routine maintenance to ensure they don’t unexpectedly fail.
If a midstream company plans to expand their operations, then this means capital will need to be spent buying new assets, not to mention to additional cost needed to maintain them.
Some capital expenditures can be reasonably expected every year, such as maintenance and the replacement of certain assets; however, it would be wise for investors to make sure these expenditures don’t spiral out of control.
Out-of-control capital expenditures may signal that a flurry of critical maintenance work needs to be performed, or that the company is in the middle of an asset-buying spree. Midstream companies that know how to keep their capital spending in check mean they aren’t recklessly spending their money on things they don’t need or dealing with problems that could’ve been avoided.
In the eyes of investors, this would certainly be an encouraging thing to see. Disciplined capital expenditures mean excess funds can be used elsewhere, such as being distributed back to investors.
Downstream Investment Factors
Oil and Natural Gas Prices
Earlier, we talked about how upstream oil and gas companies pay close attention to commodity prices because they sell their unrefined crude oil and natural gas to generate revenue. But who exactly do upstream companies sell their product to? Downstream companies – the ones, who we know, refine these raw hydrocarbons and act as the final point of sale before reaching end customers.
Downstream companies purchase unrefined material at a certain market price, refine it, add a markup to the refined products, then sell them.
From a business perspective, and by extension, an investment one too, higher commodity prices are favourable since that means more revenue can be earned per unit sold. However, if prices are too high then forces of supply and demand start to take over: people will begin to purchase less oil and gas, or may even start to look at alternatives to satiate their demand.
On the flip side, low commodity prices mean more people are willing to purchase oil and gas, but greater volumes will need to be sold in order to bring in adequate revenue. Of course, increasing the markup is also an option, but a dramatic increase will quickly have consumers look to other, cheaper sellers.
Refining Capabilities
Not all refineries are made equal. Not only do different refineries produce different products, but the type of raw material they choose to refine will also differ.
For example, some refineries may gladly accept heavy crude (crude oil that has a very high viscosity), while others may only accept light crude (has low viscosity). There are refineries that will gladly refine sour gas (natural gas containing significant amounts of hydrogen sulphide), while others may only accept sweet gas (contains very little, if any, hydrogen sulphide).
Understanding what sort of raw hydrocarbons a certain downstream company chooses to refine and the products they choose to produce is important because this will determine what sort of capital expenditures and related operating expenses are to be expected.
Certain hydrocarbons, such as heavy crude and sour gas, are more difficult to refine than their light and sweet counterparts, meaning more specialized equipment and expertise are required to properly refine them. This can potentially translate to higher capital expenditures needed to purchase and maintain the necessary equipment, which in turn could mean tighter profit margins due to higher operating expenses.
Some downstream companies may choose to refine only a handful of products, while others may choose to refine a wide variety of them. Investors don’t need to know what those specific products are; rather, they need to assess how a variety of products will affect capital expenditures, and if any increases are justified by a noticeable increase in revenue.
Retail Presence
When looking at midstream companies, we discussed how their economic moat lies in the size and scope of their transport network. The more kinds of hydrocarbons they can transport, the more destinations they can connect, meaning the more customers they can potentially serve.
Downstream companies follow a similar idea, but instead of pipelines, storage centres, and distribution hubs, their moat depends on the scale of their retail presence. By far the most common point of sale that people regularly see is gas stations.
Generally speaking, the more retail locations a downstream company has, the better. The more ground they cover and the greater their visibility is, the more customers they can potentially serve. While having high retail visibility is great, dotting every street corner with a gas station doesn’t necessarily mean revenue will roll in hand over fist.
Customers are also sensitive to other factors such as location and any incentives being offered. A handful of gas stations located in densely-populated areas stand to earn more revenue than several gas stations located along a sparsely-travelled road. To promote repeat business, some gas stations also offer their customers some sort of incentive, such as collectible points for every dollar spent, or even member-exclusive pricing.
Downstream companies that can find the right balance between retail visibility, excellent location, and enticing incentives are the ones that will stand to gain the most, and so too will their investors.
Risk Factors and Challenges Faced by Oil and Gas Companies
Because of their solid performance, relatively easy-to-understand value chain, and strong total shareholder returns, oil and gas equities are an integral part of countless portfolios.
Despite their strength and popularity, oil and gas equities face their fair share of challenges, risks, and other impediments which may want investors to think twice before deciding to commit any capital.
Just as there are too many potential investment factors that may be worth looking at, so too are there just as many risk factors to consider. Some risk factors overlap with other parts of the oil and gas value chain, so to help simplify our discussion we will not break down potential risk factors according to each stream.
Again, this is by no means a comprehensive list of risks/challenges that investors will need to consider; rather, the point here is to go over some of the major risks/challenges that most investors will likely hear of or encounter.
Net Zero and the Continued Push for Decarbonization
In recent years, the discourse surrounding climate change has drastically increased, and as a result, a whole plethora of initiatives are being undertaken to try and address this global issue.
One of the most popular initiatives that governments and industry have decided to undertake is trying to achieve “net zero” emissions by a certain date. Put simply, net zero means that any emissions that are produced (most notably, carbon emissions) are also offset by an equal amount. For example, if a country produces 100 tons of carbon emissions, then it will also remove that same amount. The result is that there are no surplus emissions that end up in the environment, hence the name “net zero”.
This push for net zero emissions is usually part of a larger initiative to greatly decarbonize entire economies.
It’s no secret that the oil and gas industry is consistently ranked as one of the largest emissions producers. Advancements in technology and engineering have helped the industry consistently lower its emissions over time, but there’s no denying that in absolute terms it still continues to produce a significant amount of emissions.
Aggressive net zero targets and overly ambitious decarbonization plans may significantly impact an oil and gas company’s operations by forcing them to significantly reduce output or scale back their operations in order to meet said targets. This can subsequently lead to a negative impact on a company’s financial performance and overall business health.
Now, it’s important to note that many oil and gas companies have presented plans to greatly reduce their emissions, or even achieve net zero; Canada’s largest oil producers formed the Pathways Alliance, pledging to achieve net zero by 2050. However, the engineering work and technological development needed to achieve that will take time – imposing these targets too soon may cause oil and gas companies to be caught by surprise, along with their investors.
The Rise of Alternative Sources of Energy
As efforts to achieve net zero and decarbonization have ramped up, this has also paved the way for alternative sources of energy such as wind, solar, nuclear, geothermal, and hydro to become more common sources of energy.
While hydrocarbons still remain one of the most common forms of energy, there exists a plethora of initiatives to either greatly reduce or outright stop the use of hydrocarbons. Such initiatives have been presented in the form of an “energy transition“.
There’s no shortage of debate regarding what society’s future energy mix will look like and the extent to which oil and gas will contribute to it. However, should society decide to drastically reduce hydrocarbon use to the point that it becomes obsolete, then oil and gas companies may be forced to substantially scale back their operations or shut down completely. Investors who don’t divest fast enough may be left with a very large hole in their portfolios.
Government/Regulatory Hurdles
Any major oil and gas project will require the involvement and input of several stakeholders. Arguably one of the largest stakeholders that will get involved will be the government – depending on the size and scope of the project, several levels of government may need to be involved.
Getting appropriate government involvement and following the necessary regulations is important for any sort of project, not just ones dealing with oil and gas. However, too much government involvement or overly draconian regulations may dramatically slow, or outright halt, the development of certain projects.
A classic example of this is the Keystone XL pipeline, which ran into all sorts of legal challenges, endless protests, government negotiations, and many other regulatory hurdles. After more than 10 years of bickering, the project was ultimately abandoned by TC Energy.
All that time, energy, and money was wasted because of the endless political jousting that took place.
Government/regulatory hurdles that prove to be too high to overcome can impact an oil and gas company’s ability to advance its growth initiatives and compromise other long-term business strategies.
Of course, one or two projects getting cancelled due to regulatory hurdles isn’t the end of the world, but if project after project is being rejected because of the political/regulatory environment, and if such a trend persists, then investors have a valid reason to start being worried.
Project Payback/Break-Even Point
In addition to the technical design and other engineering work that goes into a proposed oil and gas project, every proposition must also have an economic analysis to demonstrate its economic feasibility. After all, why would any company go through the trouble of creating a project if there was no financial benefit to be gained?
There are many elements that go into a project’s economic analysis, and one of those elements is understanding when it’s expected to break even and finally start turning a profit. For some projects, this may only be a few years, while for others it may be several. It’s possible for projects with long payback periods to still get approved, assuming the rest of the economic analysis is sound.
Projects with long payback periods aren’t something that should immediately raise any red flags. That being said, a lot can happen between when a project is initially approved to when it finally starts making money.
Changes in economic conditions, a new political landscape, supply chain issues, labour issues, and changes in interest rates (assuming the project is financed with external sources of credit): there are so many variables that have the potential to either delay a project, increase its cost, or outright halt its development.
Many investors understand that these projects take time, but if a certain project is increasingly becoming more expensive and/or if the payback date constantly gets pushed back, a company’s financial health may start to take noticeable hits, and in turn, also affect its investment merit, whether it’s a constant decrease in stock price or repeated dividend slashes.
Constantly Needing to Maintain an Excellent Safety Record
Every step of the oil and gas value chain involves the use of certain types of equipment, many of which are large, complex to operate, and pose a certain level of risk, whether it’s to the people who operate the equipment or the environment in which it finds itself in.
Because of this, one of the last things any oil and gas company wants to deal with is any sort of major loss incident.
Not only do major incidents greatly impact a company’s reputation and erode public trust, but companies must also shoulder all the costs associated with it. A high-profile example of a loss incident that resulted in both of these happening was the Deepwater Horizon oil spill, which was operated by BP. Not only did BP’s reputation and public image tank, but they had to pay billions of dollars worth of penalties, settlements, and other fines.
Companies that find themselves in the midst of needing to pay hefty fines will result in a noticeable dent in their finances. Instead of being used to fund growth projects or increase dividends, this money is instead wasted on paying for the consequences of their incompetence.
If these major loss incidents continue to occur, and hefty fines need to be paid every time along with continued erosion of public trust, then what reason would investors have to keep their money tied up with such a company?
Other Considerations to Keep an Eye On
Earlier, we talked about there being an increasingly concerted effort to try and phase out fossil fuels as part of an “energy transition”. The hope is that, once this transition has been completed, fossil fuels will no longer be the world’s primary source of energy.
Therefore, one of the major developments that every oil and gas investor will want to keep a close eye on is how the energy transition will play out. Whether they like it or not, investors will need to deal with the reality that the types of energy that society will use in the future will change in response to climate change.
Some argue that hydrocarbons will have no place whatsoever in the future after the transition has been completed, while others say that hydrocarbons will still play an important role in the energy mix, just not to the same extent as they did in years past.
Of course, nobody knows for certain how this will all unfold, so investors will need to adapt their strategies accordingly as time goes on.
Another big question that’s up in the air is how the demand for hydrocarbons will change in the coming years. Depending on who you ask, the answer will differ. The International Energy Agency (IEA) projects that oil and gas demand will still remain strong throughout the 2020s, after which it will steadily decline up to 2050 (the end of their projection). Global consulting firm McKinsey predicts that oil and gas demand will peak in the early 2030s, and after that, will steadily decline.
Declining demand doesn’t necessarily mean oil and gas companies will need to shut down entirely, but it will certainly impact how much revenue they can potentially gain, and in turn, affect how attractive they are in the eyes of investors.
Wrapping Up
Oil and gas equities have long been a favourite for many investors, but trying to understand how this industry works and what exactly to focus on when assessing investment merit may prove to be a daunting task.
As we’ve discussed, the industry’s value chain can be split into three distinct “streams”, each performing a specific role. Naturally, when assessing the investment merit of a given oil and gas company, it’s important to understand which stream(s) they operate in because each one has different factors to focus on.
Increased discourse on ways to mitigate the worst effects of climate change, as well as ways to transition away from fossil fuels, have put oil and gas companies in a difficult situation of trying to maximize shareholder value while simultaneously addressing current realities. This can also prove to be troublesome to investors, especially since the long-term outlook of oil and gas demand, as well as the industry itself, is constantly changing.
