Economics for One

Upstream, Downstream

Energy companies can often make a great investment. So it’s worth taking a moment to understand how these companies operate.

The energy business (more specifically the oil industry) can be split into two main areas: Upstream and Downstream. The Upstream business acquires “crude” oil (the raw material removed from the ground), while the Downstream business takes the crude oil and “refines” it, turning it into a finished product that end users want to purchase, and sells it to them.

Upstream

The Upstream business deals with finding and acquiring oil from the earth.  These are the “wildcatters” who use geological sciences, predictive modeling, and other means to find underground locations where there is likely to be a lot of oil.  Often, that oil is in an area of the world that is difficult to get to, either for political or engineering reasons, or both. It may be in an area that has a lot of political unrest, or a corrupt government, or simply a government that is hostile to the energy industry. Or it may be very difficult to access, such as deep underneath an ocean plate.

The Upstream business unit must make financial arrangements to get legal access to the underground oil, then must acquire the necessary equipment to access the oil, and finally must actually drill for and extract that oil. These are huge capital-intensive operations that can often cost many tens of billions of dollars.  And unfortunately, the lead time is so long to get the rights to drill, as well as to line up the equipment, that by the time they are able to drill, the market price of the oil they intend to extract may be too low to justify actually removing the oil.

Then there is the uncertainty they face about the type and quality of the oil they will extract.  Since some oil is easier to process than other (depending upon contaminant, for example), and some oil produces more of the more desirable and expensive final products,

However, once they have extracted the oil, the Upstream business can sell it on the open market for the going rate, which fluctuates daily.

These can often be highly profitable businesses, but they are subject to a lot of market risk, since the global market price of oil is often unknown when the businesses need to make key expenditure decisions.  The key to this business is the ability to find the best sources of oil, manage risk, and time your operations so that the market price of crude oil is as high as possible when you are ready to sell it on the market (typically right after you’ve extracted it).

Downstream

The Downstream business acquires oil on the open market from someone who has already extracted it. They know what quality oil they are getting, and what they can make from it (different grades of gasoline, jet fuel, diesel, kerosene, etc). Their job is to refine the oil into a variety of finished products, package it up, ship it to its destination, and market and sell it.

These businesses are highly competitive, and require extremely careful operational efficiency.  They are typically not as profitable as the Upstream businesses, but the business is often more steady and predictable than the Upstream businesses are.

Companies

There are a handful of “supermajors” or “big oil” companies who have both significant Upstream and Downstream operations. These include ExxonMobil, Chevron, BP, ConocoPhillipsRoyal Dutch Shell, and Total, SA.

There are also many Upstream-only companies, such as Occidental, XTO, Anadarko, and so on.

There are also a handful of regional Downstream-only companies. However, the downstream market has largely consolidated, with most of the well-known brands belonging to one of the major integrated energy companies.

Posted in Article | No comments

No comments yet. Be the first.

Leave a reply