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Not ALL Oil Stocks are Plunging...

Balancing your Oil Investments

Written by Briton Ryle
Posted November 5, 2014

There’s a rumbling rolling through the shale oil fields in the U.S. midwest. No, it’s not the imminent gushing of a new oil strike. Rather, it may very well be the imminent implosion of the entire region’s oil production.

The price of West Texas Intermediate crude oil fell yet again yesterday to close at $77.19 per barrel, its lowest close since October 2011. Since reaching its one-year peak of $102.90 on June 25th, oil has fallen 24.99% in just 4.5 months, more than $5.50 per month.

During this time, investors have been dumping shares of almost every type of oil company out there, especially the hydraulic fracking operations working in the shale oil deposits of North Dakota and Montana, sites of one biggest oil booms in U.S. history.

But the falling prices of oil just might sound the death knell for all those fracking ventures, turning the boom into a bust if prices persist at these levels. While the break-even price varies from company to company, on average oil producers in the fracking segment require oil to be between $80 and $84 for operations to continue to be profitable. With oil already some $3 to $7 below their break-even prices, many if not all frackers will have no choice but to close down.

Yet not all companies in the oil and gas sector are in such dire straits. Some, in fact, are up even as oil has been falling. Let’s take a look at how the oil and gas sector’s main segments and industries are faring to get an idea of which ones make the sounder investment choices.

Identifying the Three Streams

As in any resource sector, companies engaged in the oil and gas sector can generally be slotted into one of three main segments: upstream, midstream and downstream. Just like a river, the torrential flow of oil and gas starts upstream.

• Upstream: “Operations stages in the oil and gas industry that involve exploration and production,” Investopedia defines. “Upstream operations deal primarily with the exploration stages of the oil and gas industry, with upstream firms taking the first steps to first locate, test and drill for oil and gas. Later, once reserves are proven, upstream firms will extract any oil and gas from the reserve.”
Simply put, then, upstream companies explore and drill for oil.

• Midstream: “Midstream activities include the processing, storing, transporting and marketing of oil, natural gas and natural gas liquids,” Investopedia walks us through the second segment.
Simply put, midstreamers take the oil and gas from the upstreamers and move it along. Where? Downstream.

• Downstream: “The oil and gas operations that take place after the production phase, through to the point of sale. Downstream operations can include refining crude oil and distributing the by-products down to the retail level. By-products can include gasoline, natural gas liquids, diesel and a variety of other energy sources,” Investopedia completes the cycle.

In a nutshell, downstreamers take the oil and gas that the midstreamers deliver, and then process it into finished products for selling to the consumer.

Of all three oil and gas streams, the one that is most susceptible to a falling oil price is the upstream – the explorers and extractors – while the midstreamers and downstreamers are not affected as much.

Why? Because midstreamers and downstreamers do not depend on a minimum price for crude oil. In fact, a falling oil price is good for them, since they are getting oil at a cheaper price. If oil rises, they simply increase the prices they sell their finished products for. No matter what the price of oil does, midstreamers and downstreams can adjust their other prices accordingly.

Upstreamers, on the other hand, are stuck with costs that are not flexible. It takes a certain amount of money to drill for oil and extract it, and each company has its own break-even price below which crude must not fall if they want to remain profitable. If the price of crude falls, producers can cut wages and other operating costs only so far before they just can’t cut any more. And if crude continues to fall below that, they have no choice but to shut down until prices rise back up again.

In the current cycle of falling oil prices, investors will want to avoid the upstreamers – especially the frackers whose operating costs are even higher. But that does not mean abandoning the entire oil and gas sector all together. We still have a number of very good selections among the midstreamers and downstreamers to choose from.

Six Industries To Choose From

To get a clearer idea of how each type of oil and gas segment has been performing, let’s take a look at the largest U.S. company in each of the six main oil and gas industries. Since fracking is not its own industry, I’ll also select a seventh company from among the frackers.

Since June 25th, as the price of crude oil has fallen some 25%, notice how each of the main oil and gas industries performed, including the frackers. The oil and gas industry is listed first, then the largest U.S. company within it, then its price change since June 25th:

• Oil & Gas Pipelines: Kinder Morgan Energy Partners, L.P. (NYSE: KMP) = rose 12%
• Major Integrated Oil & Gas: Exxon Mobil Corporation (NYSE: XOM) = fell 7.5%
• Oil & Gas Refining & Marketing: Phillips 66 (NYSE: PSX) = fell 8%
• Oil & Gas Equipment & Services: Schlumberger Limited (NYSE: SLB) = fell 17.5%
• Independent Oil & Gas: ConocoPhillips (NYSE: COP) = fell 20%
• Oil & Gas Drilling & Exploration: Antero Resources Corporation (NYSE: AR) = fell 20%
• From the frackers group: Continental Resources, Inc. (NYSE: CLR) = fell 34%.

Notice where the three segments of the oil and gas sector are positioned? The upstreamers (producers) are at the bottom, having suffered the most stock depreciation, with the frackers having suffered the most of all due to the expensive cost of the fracking process.

Close to the bottom is the oil & gas equipment and services giant Schlumberger. This industry is not among the three segments of the stream; it simply produces equipment and offers support services to the upstream producers. But because it is so closely dependent on the producers, Schlumberger’s stock has been badly hit as well.

Now look at the top of the list for something really surprising. The top three performing industries come from all three segments of the stream. In top spot we have the oil and gas pipelines industry which belongs to the midstream, while in third spot we have the oil and gas refining and marketing industry which belongs to the downstream. These two industries we would expect to be at the top of the list, since as we covered earlier, midstream transporters and downstream refiners are not so constrained by the price of oil as upstream producers are.

Yet in the number two spot we have a surprise: the major integrated oil and gas industry which belongs to the upstream producer segment. Why has this upstream industry not been hit as hard as the other upstream industries at the bottom of the list have been? One simple reason: size. The companies belonging to the major integrated oil and gas industry are huge – including Exxon, Chevron (NYSE: CVX), and many other international companies such as Shell, BP and others.

These mega caps of the upstream segment have several times more wells and properties than the smaller producing and exploring companies of the upstream segment have. As such, the larger companies can simply shut down the more expensive wells and keep running the less expensive ones. And since their revenues have been so vast for so long, they have fewer debts and leases to pay for, owning most of their wells outright.

Always a Good Play Somewhere

What this brief exercise reveals for investors is that even in a falling market we can still find some viable investment choices. In the case of oil, we can see how the upstream producers – the smaller ones, that is – would be a place to avoid for now, especially the frackers, at least until the oil price shows signs that it is in recovery.

The place to be, then, would be in the midstream and downstream segments. Which makes logical sense, really, since cheaper oil prices mean they pay less for the oil they handle.

Naturally, we don’t know what the price of oil will do going forward, whether it will continue to fall, or stagnate at these levels for a while, or even gush right back up again. But this we do know: consumers will keep on consuming it, refiners will keep on refining it, and transporters will keep on transporting it… even if many producers have to stop producing it. So until the oil price recovers, stick with the transporters and refiners, and leave the producers for another time.

Joseph Cafariello

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