Two important general trends in oil exploration, production, and refining are particularly worth noting. First, over the past two years, many integrated oil companies have either restructured or spun off their downstream operations. Second, energy companies have become more liquids-focused. In July 2011, Marathon Petroleum Corp (NYSE:MPC) spun off from Marathon Oil Corporation (NYSE:MRO); the former took the downstream business (refining, chemicals, and distribution), while the latter took the upstream business (exploration for and production of crude fossil fuels). ConocoPhillips (NYSE:COP) spun off its downstream operation as Phillips 66 (NYSE:PSX) in April. Looking at these two pairs, what are the virtues and vices of going long upstream or downstream?
Commodity Prices and Crack Spreads
Oil exploration and production (E&P) companies—including the “big oil” supermajors—have continued to focus their capital expenditures on liquids over natural gas, and for good reason.
Since their June 28 lows, oil futures have increased 27 percent to $99, while the S&P has only increased 10 percent in the same time. Political unrest between Israel and Iran was the initial impetus for exploration and production firms to focus on liquids, but broader instability in the Middle East might well propel prices even higher. About 17 million barrels of oil a day pass through the Strait of Hormuz, nearly 20 percent of all oil transported in the world, and Iran would likely attempt to close this chokepoint in the event of extreme sanctions or military action.
Crack spreads, on the other hand, are king for downstream businesses. The crack spread is the price difference between what downstream companies sell refined products for and what they purchased crude oil for. Thus, lower commodity prices benefit downstream producers. This fact makes downstream companies interesting because they can benefit in economic situations in which E&Ps do not.
Here are some background statistics on the spun off companies above, with the two upstream E&Ps listed first (data from Yahoo Finance):
|Company||Price (9/17 )||Price (6/28)||Forward P/E (2013 earnings)||EV/EBITDA|
|S&P BMI Energy||--||--||11.2||~ 4|
The first thing to notice is that analysts see ConocoPhillips and Phillips 66 trading at a richer forward earnings multiple. One reason for this is that spin-offs (as Joel Greenblatt notes) tend to outperform the market two years post-split, so this is likely to encourage a richer valuation projection on the part of analysts. Additionally, there is some enthusiasm surrounding Phillips 66, which is trading at a higher forward P/E than another major refining competitor, Valero Energy Corporation (NYSE:VLO), whose shares are trading at 6.9 times forward earnings. As we noted in a previously article, Warren Buffett's Berkshire Hathaway disclosed a position in Phillips 66 in August.
A second observation is that, though oil futures have risen since their bottom on June 28 from $77 to $99 (weakening the crack spread), refinery stocks like Marathon Petroleum and Phillips 66 have risen significantly since June 28, more so than have Marathon Oil and ConocoPhillips. And they are not alone. Valero Energy shares are up 36 percent since June 28, while Exxon Mobil Corporation (NYSE:XOM), Chevron Corporation (NYSE:CVX), and Apache Corporation (NYSE:APA) are all up less than 15 percent each. So the supermajors and the independent oil and gas companies alike have yet to see a serious upswing from this increase in oil futures.
Is it really “opposite day” for energy equities? From an economic point of view, not really; there is plenty of anxiety brewing over the “Fiscal Cliff” in the United States, which, if implemented, would greatly decrease aggregate demand. Specific to the energy sector, however, upstream producers are, as I noted, restructuring operations that lie further downstream and altering their capex to go full-speed-ahead toward oil. To orient itself towards liquids, Chevron, for instance, has an estimated 2012 capex of $32.7 billion, 87 percent of which is destined for long-term E&P. In 2011, as part of its downstream restructuring, Chevron sold its stake in the Pembroke refinery to Valero. When will the dynamism of the downstream refiners be eclipsed by the promise of recharged upstream E&Ps?
Long-term oil projections lie in the favor of liquids producers. Demand for oil in 2013 is expected to hit 89.7 million barrels per day, up from 88.8 million barrels per day in 2012, according to the U.S. Energy Information Administration (EIA). Brent crude could reach above $120 if QE3 goes well.
There are caveats, though. According to Deutsche Bank analysts, China will represent 35 percent and 50 percent of total demand growth for oil in 2012 and 2013, respectively. Some hedge fund managers like Jim Chanos and Ray Dalio, however, are very cautious in their outlook on China, so simply going long on the supermajors is implicitly a bullish call on China. Playing the supermajors is also a delicate situation given Iran's political instability. "We've got a $10 to $15 premium [for oil prices] just on Iran, so the market is susceptible to just come off," says Dorado Energy Services analyst Tony Rosado.
The worst possible scenario for E&Ps would be a boat-load of oil on supply with no demand to drink it. With more E&Ps investing specifically in oil production, thereby increasing supply, this is a distinct possibility. Perhaps this is one of the reasons why investors are attracted to downstream businesses, where certain businesses such as chemical production are wider margin businesses that are less sensitive to commodity fluctuations. That said, with the upward secular trends in liquids, anxiety in China, problems in the Middle East, a Fiscal Cliff, and monetary stimulus, it is hard to play the part of the oracle in the energy sector.
Disclosure: Brian is long Phillips 66.