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posted on 26 April 2017

Know Your Energy Sector

by Robert Rapier, Investing Daily

Investing Daily Article of the Week

The oil and gas industry can be broadly split into three segments. The "upstream" segment involves drilling for and producing oil and gas. This group includes oil and gas companies like ConocoPhillips (NYSE: COP) and Chesapeake Energy (NYSE: CHK), as well as supporting companies like equipment services bellwether Schlumberger Limited (NYSE: SLB), hydraulic fracturing sand provider U.S. Silica (NYSE: SLCA) and water and environmental services specialist Cypress Energy Partners (NYSE: CELP).

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"Midstream" businesses are those that transport oil and gas from the site of production to processing plants, storage facilities, and end customers. Midstream companies are normally the least volatile of the three segments. Many midstream companies have structured themselves as Master Limited Partnerships (MLPs) to generate stable, tax-advantaged income for investors. Enterprise Products Partners (NYSE: EPD), Magellan Midstream Partners (NYSE: MMP) and Plains All American Pipeline (NYSE: PAA) are three major midstream MLPs.

"Downstream" is where refining to finished products occurs. This segment frequently trades out of sync with the upstream segment. Falling oil prices are bad for upstream, but good for refining margins - and vice versa. Shares of Valero (NYSE: VLO), for example, surged as oil prices collapsed in the 2nd half of 2014 and then sold off as oil prices recovered last year.

Also, there are integrated companies that encompass multiple segments. ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) are the two largest U.S.-based examples that have upstream, midstream, and downstream assets.

Of critical importance when evaluating an energy company is to understand the metrics that are important for assessing the different types of companies. Certain factors are unique or more relevant for specific segments.

Consider the upstream segment. A company will typically be predominantly an oil producer or a gas producer. For example, pure Permian Basin producer Diamondback Energy (NASDAQ: FANG) derived 89% of its 2016 revenues from crude oil sales. On the other end of the spectrum are companies like Appalachian Basin natural gas producer Rice Energy (NYSE: RICE), which generated 99% of its 2016 revenues from natural gas. ConocoPhillips is pretty balanced, with 57% of its revenue from oil in 2016.

This is one important consideration when evaluating an oil or gas producer. It is inaccurate to compare certain metrics of companies that predominantly produce oil to those that primarily produce natural gas. The reserves will be valued differently, and the costs of production will be different.

Some of the other important metrics when evaluating oil and gas companies are:

  • The amount and type of proved reserves (oil, natural gas, and natural gas liquids)

  • The location of the reserves (U.S. versus international, onshore or offshore, etc.)

  • Current production rates and historical production growth rates

  • Enterprise value (EV)

  • Earnings before interest, taxes, depreciation and amortization (EBITDA)

  • Free cash flow

  • Net debt

Due to the complexities and special industry considerations of evaluating oil and gas producers, I developed a proprietary stock screen for The Energy Strategist. This screening tool is Excel-based and extracts data from the subscription-only S&P Global Market Intelligence database. It compares many metrics, including all of those mentioned above (except for the location of reserves). It is a great tool for being able to quickly find significant differences between companies.

Of course evaluating an oil and gas company involves more than distilling it down to a set of metrics. Sometimes there are legitimate extenuating circumstances that can explain an outlier, and sometimes a segment's outlook can change drastically from one quarter to the next (rendering some trailing metrics useless). Finally, successfully investing in the energy sector requires an understanding of the energy cycles so you can anticipate movements between up and down cycles. Or at least listening to someone who does.

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