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Investing in Midstream Oil and Gas

Written By Briton Ryle

Posted February 14, 2015

The recent plunge in the prices of crude oil and natural gas have really hammered the upstream oil and gas producers more than the midstream pipeline companies.

With the oil price still down some 52% from its recent high in late June of 2014, the performances of the three largest U.S.-based upstream oil and gas producers (Concho Resources, Inc. NYSE: CXO, Antero Resources Corporation NYSE: AR, and Helmerich & Payne, Inc. NYSE: HP) pale in comparison to the performances of the three largest U.S.-based midstream pipeline and storage companies (Kinder Morgan, Inc. NYSE: KMI, Energy Transfer Equity, L.P. NYSE: ETE, and Energy Transfer Partners, L.P. NYSE: ETP) – with the producers falling from 20% to 40%, where the midstreamers range from 0% to +15% over the past 7.5 months, as graphed below.

midstream oil and gas chart 1


Imagine that – the midstreamers have actually risen in value! It really shouldn’t surprise us, though, since the reason for the oil and gas price declines is not a fall in demand but a rise in supply. And oversupply means there is much more oil and gas being delivered and stored around the country, which means more business for the midstreamers.

Now this doesn’t mean we should count the upstream producers completely out of the picture. At some point the oversupply of oil and gas will be reduced as the U.S. and other economies slowly increase their consumption as they recover. As they do, you can bet the oil producers will once again be producing at full blast, and their stocks will climb once again as a result – making their recent pullbacks a fantastic buying opportunity.

But how do we determine which producer would make the better bet? After all, we don’t know how much longer energy prices will be suppressed. Energy producer stocks could be loosing value for quite a considerable time longer.

Indeed they can and they will. This is why we need to look at more than just a company’s earnings forecasts when picking the right one to add to our holdings. One very important set of metrics we should ascribe considerable importance to is a company’s margins. For it is from margins that we can determine how profitable a business really is. And the more profit it generates, the more its stock value “should” increase.

What Are Company Margins, Anyway?

There are two main categories of margins used to determine a company’s profitability, they being “profit margin” and “operating margin”. Their differences are quite revealing.

Profit margin, as defined by Investopedia, is “a ratio of profitability calculated as net income divided by revenues… It measures how much out of every dollar of sales a company actually keeps in earnings.” For example: a company that derives $1 million of net income from $5 million of total sales has a profit margin of 20%.

Profit margin is much more useful at determining a company’s viability than even revenue growth or earnings growth. For instance, investors would be pretty happy with a company that increases its revenues by 10% over the prior year. But not if its expenses increase by more than 10%. In this case, the company’s profit margin would shrink.

Hence, profit margin is a great means of accurately determining whether a company is really improving its profitability or not. When comparing two companies, the one with the higher profit margin is adding more value to its books.

The other profitability metric, operating margin, is related to profit margin, but encompasses fewer expenses. As defined by Investopedia, “Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc.” It includes only those expenses that are directly incurred in the company’s operation, and excludes other expenses such as interest on debt, taxes, and certain one-time items such as lawsuit settlements and fines.

Thus, a company’s operating margin will be higher than its profit margin – with operating margin providing a way of measuring the profitability of a company’s operations in producing its products or services, where profit margin provides a way of measuring the profitability of the entire company’s business.

Using Margins to Locate Potential Value

Now comes the fun part… using company margins to isolate which companies provide the better value potential.

The idea here is that once oil and gas prices start to rise, revenues will as well. But remember that rising revenues do not result in an overall financial improvement if costs are rising as well. If one company’s revenues rise more than another’s, but its costs rise more too, the company with the lesser revenue gain can still be a better deal since it has a larger profit margin.

So let’s have at it. How do the six companies listed above compare on margins?

midstream oil and gas chart 2

As tabled above, all three of the upstream producers have better operating margins than the three midstream pipers. But notice how AR’s profit margin is negative despite having the highest operating margin of them all? Having such a high profitability of operations is all fine and well. But it doesn’t really do us any good if so much of that profit is lost through other expenses to the point of generating negative profit in the end (in a word, “loss”).

Hence, the top pick from this list would be Concho Resources (CXO), followed close behind by Helmerich & Payne (HP). Seeing as these two are already down some 20% and 40% respectively, they stand the best chance of soaring upward once energy prices rebound (whenever that will be).

If you really wanted a midstream pipeline, which is still a good idea given that we do not know how long oil and gas prices will remain suppressed, then the best pick from this group would be Kinder Morgan (KMI), which has so far been the best performer of the six, with gains of 15% since the energy correction began.

When looking for companies that stand to benefit most from an energy rebound, remember that a company’s profit margin is by far the best indicator of how well a company is poised to take advantage of any upcoming increase in business activity. The higher its margin, the more the company keeps after expenses – and the more its stock price “should” gain in value.

Joseph Cafariello