Finding Value in Mid and Downstream Energy Companies

Intro

In last week’s blog, we discussed one simple, yet effective means of how the novice investor can quickly filter for potential investments by screening for quality companies using the “2-10-10” screen. These companies meet our criteria of having a market cap of at least USD 2 billion, a historical 5-year average ROE of at least 10% and a 5-year historical average of 10% growth in EPS. This is what we at the Perceptive Investor often use to quickly screen for potential quality investments at any given time. This week, we’ll carry those thoughts forward and share our screen with you in the oil & gas space to identify which companies may be sound investments and how to think about taking positions in these organizations.

The “2-10-10” Results in Oil & Gas

There are over 500 publicly listed oil & gas companies one could choose from and in order to narrow the scope of focus and limit our risk of absolute loss of capital, we like to use what we’ve dubbed the “2-10-10” criteria to filter out what could fit the bill as “best in class” companies.

Our results produced the following list of 12 companies sorted in decreasing order by ROE. We’ll limit this list to 10 companies, as we will ignore Novatek and Surgutneftegas, both Russian companies. Nothing against the Russians, it’s just that their economy is in shambles at the moment so investing in a company in that sort of environment is a very risky game we don’t want to play.

O&G Screen

If you look closely, you’ll notice there is not a single exploration and production (E&P) company on this list. Why is that? It’s simple. Oil prices tanked in the second half of 2014 and have yet to recover, destroying the value of a lot of E&P companies whose revenue is directly tied to the price at which they can sell the commodity. Since our view on oil prices is bearish (range bound between $30~$60/bbl) we will focus on companies who have performed with above average results in the recent past, understand why that is and how we can position ourselves to benefit in this environment by owning one or more of these companies.

The Candidates

When looking over the screener results above, we will notice there are only two types of oil & gas companies who have managed to perform well in this low oil price environment. They are: (1) storage & transportation (or midstream) companies and (2) refining & marketing (or downstream) companies. As this blog is written primarily for novice investors, we’ll briefly, and in very simple terms, cover what these companies do and how their profitability is driven. When we get down to the recommendations on whom we’d like to own, we’ll dive into more details on the driving factors behind why.

But first, let’s discuss the chart below which compares the crude oil price to E&P companies, midstream companies and a large downstream company (a refiner, in this case as there is no refiner ETF that’s been around long enough to draw a comparison) and try to illustrate how share prices of each sub-sector of the oil & gas industry acts in relation to crude oil prices.

Oil vs MLPs vs Refiner

The black line in the graph above represents the price for crude oil, West Texas Intermediate, the U.S. benchmark for crude. The green line represents XOP, an Exchange Traded Fund (ETF) made up of oil & gas E&P companies. The purple line represents MLPA, an ETF consisting of Master Limited Partnership (MLP) companies, or simply midstream companies. Finally, the blue line represents the largest (by market cap) and closest “pure” refiner in our screen, Valero Energy.

There are a few key things to note here. First, as crude oil prices declined over time, we can see how E&P companies’ stock prices also declined. This is due to the reason that E&P companies make their money by producing and selling crude, so for the price of their shares to have a strong correlation with crude oil price makes perfect sense. As an ETF, E&P companies’ share prices have declined by about 50% since mid-2014. The purple line, or midstream companies, experienced a similar drop in value as crude prices declined, but as we can see here, they’ve only lost about 30% of their value. Lastly, our refiner example, Valero Energy, has done quite the opposite. They had actually showed a 20% gain earlier this year compared to losses in E&P and midstream companies until crude price rallied to where it is today and subsequently driving a decline in their share price. They key here is that E&P companies’ stock prices will be tied directly to the price of crude and since we are not bullish crude at this point we do not see much value in owning E&P companies at this time. However, given that midstream companies’ and refiners’ share prices are negatively correlated to crude, we want to explore why this is and look for value in those companies as potential additions to our portfolio. Let’s get into what drives the profitability of midstream and downstream companies.

Oil & Gas Storage and Transportation (or Midstream) Companies

 What Midstream Companies Do

Storage and transportation companies do exactly what it sounds like. They store and transport any one or more hydrocarbons whether crude oil, gas, refined products (ie. Gasoline, jet fuel, diesel, bitumen, LPG, etc.) or petrochemicals. Their assets (above ground storage tanks, underground salt caverns, pipelines, trucks, rail cars, barges or other marine vessels) are located in various locations around the country but their main purpose is to connect supply to demand in the most economic manner possible. These companies play a critical role in the economy for the following two reasons:

  1. Production of oil, gas, and all related refined products is typically carried out in remote areas or in industrial zones far from populated areas where the demand is. Producers need infrastructure to store or move their product to market because every day they are not producing is a day lost in revenue.
  2. The same can be said about consumers who need fuel as an input to conduct business or simply get by on a daily basis. Can you imagine a power plant not having access to natural gas or your local gas station short on gasoline? In brief, storage and transport companies provide a key service to ensure real-time balance of supply and demand and to ensure producers can produce and consumers can consume.

How They Make Money

Storage and transportation companies realize revenue through a variety of methods. Storage companies realize revenue when a customer’s product is “injected” or “withdrawn” from their storage assets. In many cases the storage space is leased to a third party, who pays a fixed fee for storage and usage. Pipelines are similar in nature as the capacity on pipelines is reserved for third parties who’ve subscribed to some long-term or firm capacity on the line. They pay their fees in accordance with tariffs (regulated by Federal Energy Regulatory Commission) set by the pipeline company. The same can be said about surface (trucks, barges, rail etc.) transportation companies’ tariffs (regulated the Surface Transportation Board and/or other state regulatory agencies). The tariff universe is large and complicated so we won’t get into the details, but many of these companies have set their tariffs in such a way to ensure minimum volumes of product are shipped and have applied additional penalties or fees for either under usage or over usage, obviously to incentivize consistent service and subsequently stable revenue. Lastly, because infrastructure is highly capital intensive, these companies depend on long-term agreements with producers and/or end-users to ensure a high utilization rate. This is necessary as it ensures a minimum rate of return can be met to incentivize development of these assets in the first place. Without long-term commitments there is no capital and with no capital there is no infrastructure.

As mentioned above, high utilization is key to the success of these companies and some factors that contribute to high utilization are: availability of ample supply (over many years, sometimes decades), oil & gas prices remaining above cost of production, sufficient demand from end-users, lack of substitutability of competing products or service providers, supportive government regulation, properly-sized capacity of assets and volatile prices. The current volatile price environment, which we foresee to continue, creates uncertainty and producers/consumers do not like uncertainty. This uncertainty also increases the demand for storage utilization, another primary reason (in addition to the revenue structure of these companies mentioned above) why midstream companies’ share prices have not been hurt as much as their E&P peers.

We should mention one last note on these midstream companies. You may be aware that many of these midstream companies are setup as Master Limited Partnerships. These are essentially publicly traded companies that receive the tax benefits of a limited partnership but have complicated tax consequences when owned by investors. We’ve decided to leave it up to others to explain the pros/cons of owning such companies from a tax perspective, but we will say this much: Be sure to understand the tax consequences of owning MLPs before buying them to ensure owning an MLP still fits within your investment goals. Below are two links to aid you in your understanding:

From Morningstar: http://news.morningstar.com/classroom2/course.asp?docId=145579&page=4

From Forbes: http://www.forbes.com/sites/baldwin/2010/12/02/tax-guide-to-master-limited-partnerships/#7b9edb1d7b60

Oil & Gas Refining and Marketing (or Downstream) Companies

 What Refining and Marketing Companies Do

Crude oil is exactly that, crude. It is a product that is useless in raw form and only useful to the market when it is processed through a refinery to make what’s known as refined products which include gasoline, diesel, jet fuel, propane/butane, wax, bitumen and fuel oil. The two most important components, however, are gasoline and diesel (aka distillate fuel oil) as those are the fuels used in our vehicles and just about every American household has at least one vehicle. The refining process is complicated and every refinery is slightly different as they are configured depending on two factors:

  1. The type of crude feedstock and
  2. The expected output of refined products. Some refineries are more “complex” and are built to consume various grades of crude.

Generally speaking, a more complex refinery tends to consume heavier crude (lower API gravity) and therefore produces higher yields of more valuable refined products. These refineries also are often more flexible and can meet a wider variety of demands from the market. We will ignore the details of complexity of the refineries for now, as this is a very niche topic, but just know that complex refineries have more operational complexity than simpler ones, take heavy grades of crude and can produce higher yields of more valuable products.

The marketing side of the operations sells the refined product, usually in the form of gasoline, diesel or jet fuel at company-branded fuel stations, which act as the outlet to interact directly with customers. This is key in a commodity market where it is difficult to differentiate oneself from its competitors since a commodity is fungible. This word, fungible, is key because it perfectly describes the headache any commodity producer/marketer deals with. Fungible means the product can be replaced or substituted by another identical item. In other words, it is perfectly interchangeable. The marketer’s job in any downstream company is extremely important (sometimes good marketers are paid higher than other members of management) as their primary responsibility is to build the brand name and customer loyalty to ensure a minimum, if not growing, level of demand is sustained and risks of customer substitution are reduced.

How They Make Money

A refinery needs crude oil to make refined products so a refinery’s profitability is dictated by its ability to procure ample supplies of cheap, quality feedstock (crude oil) while producing the refined products required by the market, whether local or international. The key measure of profitability is what’s known as the “3:2:1 crack spread”, which is the approximate difference in sales price of thee sum of 2 barrels of gasoline and 1 barrel of diesel less the purchase price of 3 barrels of crude oil as a typical refinery consumes 3 barrels of crude to produce 2 barrels of gasoline and 1 barrel of diesel. Take that number and divide it by 3 to get a $/bbl crack spread. The wider this spread is (in other words, the lower the crude oil price and the higher the refined products prices), the more profitable the refinery will be. This is why we saw, in the chart above, Valero Energy’s share price move in the opposite direction of the crude price as they are net consumers of crude oil. Below is a monthly chart of U.S. crack spreads using WTI as the crude input price and U.S. Gulf Coast delivered gasoline and diesel prices*.

* Note: In order to make a more accurate representation, we should have used the Louisiana Light Sweet (LLS) crude oil price as it is a Gulf Coast price where as WTI is a mid-continent price, which does not take into account the cost of transportation to the Gulf Coast. However, since we do not have LLS prices available to us, we had to settle for WTI. Regardless, the graph below is simply meant to provide an illustration on what crack spreads have done over the past few years.

US Crack Spreads

The blue line represents the approximate U.S. Gulf Coast crack spread while the red dotted line represents the price of crude oil (WTI). What is important to point out here is that when crude prices came down in the second half of 2014, crack spreads began to marginally increase as a result; however, as we went into winter, gasoline and diesel demand are usually at their seasonal lows (since summer is the driving season in the U.S.) and when compounded by a warmer-than-normal winter, crack spreads suffered in the 4th Quarter of 2014. However, prices of gasoline and diesel started to pick up in the first half of 2015 while crude prices remained low, resulting in an average crack spread of $18.65/bbl vs. $16.32/bbl in the same period in 2014. Refiners were earning approximately another $2/bbl on their margins thanks to low crude oil prices and relatively strong gasoline and diesel demand, which is likely the primary reason we saw VLO in the graph at the top of this blog rally in 2015 and what is typically the primary driver of profitability of refining and marketing companies.

So Who Made the Shortlist?

Ah. Now we are getting closer to the fun part, but not quite there yet – the recommendation. As you can tell already from the past few blogs, arriving at a thesis, screening for quality companies and making a final decision on whom to own is a rigorous process, but worthwhile once that process is clearly defined and refined as there are few greater feelings that making the right call on a stock. In the next blog we will dive further into the details on whom we’d like to own by going through some key areas of the financial statements and company assets while also touching on a few of the more qualitative factors that help boost our confidence in our decision making process.

Summary

To briefly summarize, we utilized our initial screen, the “2-10-10” to filter out companies who have been achieving above average results in this current oil price environment (which we expect to persist). The two main successful sub-sectors our screen revealed were: storage & transportation (or midstream) companies and refining & marketing (or downstream companies). We elaborated on why these companies showed up in our results, how they make their money and what drives profitability of each type of business. The next blog in this series will end with our recommendation on whom we’d like to own in this space and cover some of the more detailed analysis we typically conduct before making any purchases.

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