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, ConocoPhillips, Royal 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.

The 2000 film Boiler Room depicts the seedy world of the “pump-and-dump” scam.  In it, a broker purchases a large block of public stock in a shell (i.e. empty) company.  The firm then calls potential clients to pitch them the same stock.  This drives up (“pumps”) the price, making it appear to be a runaway stock, thus attracting more buyers and driving the price higher.

When the price is high enough, the broker “dumps” their own shares at a huge profit and walks away.  The result is that the buyers are left holding stock in a worthless, basically non-existent company, which promptly falls back to zero, wiping out the investors.

Which brings us to Silicon Valley.  Over the past decade or so, Silicon Valley has morphed from a region that was the builder of great companies (Apple, HP, Intuit, Cisco, Oracle, etc), into perhaps the greatest generator of “pump and dump” stocks.

Many people who live in Silicon Valley have complained about the changes that have taken place over the past decade.  Venture Capitalists still like to claim that their primary interest is building great companies. Many of  Silicon Valley’s founding VCs (Art Rock, Tom Perkins, etc) used to believe that if they built great companies, the money would follow.  So they focused on building great companies.

But now it s

eems the VC community is more interested in pumping up their companies, getting “an exit” (i.e. dumping), and moving on.  Today, if they happen to buil

d a great company along the way, that’s terrific.  But it is far from the primary motivation.

Any entrepreneur can tell you about the emphasis VCs place on having a solid “exit strategy.”  But while VCs will sometimes ask about a “business model” how many ask about the company’s “business strategy?”  (Answer: None.)  And no, a business model is not a business strategy, any more than an exit model is an exit strategy.  The model is just the form it will take, such as “selling tickets”, while the strategy is how you are going to go about doing it successfully (e.g. “door-to-door with a fleet of hourly workers familiar with the people who live in the neighborhood, hired from local churches.”)

And the entrepreneurs aren’t much better.  Although many entrepreneurs are still driven by a desire to see their products come to market, the reality is that, faced with a potential multi-million dollar lottery win, most entrepreneurs will abandon the dream in a heartbeat.

I have a little more sympathy for the entrepreneurs as they often don’t have much money, so the temptation has got to be big.  By contrast, a successful VC typically has a much larger personal net worth, and has made a decision to pursue this business model.  Of course, their decision must recognize the difficulty of raising follow-on funds if their prior fund shows sub-standard results.  So the focus on financial results is understandable.

But the net result is an emphasis in Silicon Valley that has moved from building great companies, to pumping up new companies or technologies just long enough to gather a large user base, show a potential for greatness (but not actual greatness), then dumping the technology or company on the highest paying buyers they can find, regardless of long-term value.

And that’s a shame.  Because it makes a few people very wealthy, but at the expense of the system that allowed them to get there.  And in the end, is there any moral difference between them and the seedy brokers in Boiler Room?

]]> http://www.economicsforone.com/blog/2009/04/21/high-tech-boiler-room/feed/ 0 http://www.economicsforone.com/blog/2009/03/21/the-well-of-infinite-depth/ http://www.economicsforone.com/blog/2009/03/21/the-well-of-infinite-depth/#comments Sat, 21 Mar 2009 17:29:02 +0000 rick http://www.economicsforone.com/blog/?p=104 In high school calculus I remember learning about an equation for a 3-dimensional shape whose walls stretch to infinite, but whose volume is limited. Imagine that! It’s like a flower vase that stretches from the earth to the moon, and off to the stars, but which only holds a cup of water.

It’s really neat in theory.  But it doesn’t hold up in the real world.

A lot of economic theories are like that.  They assume that the financial world is infinitely deep, and that their actions are just a tiny part of that. And they may even work—so long as most people don’t use them.

One example is index funds.  Index funds attempt to mirror the market by holding a set of securities in the same proportions as the market.  The theory is that the market incorporates all known information, and represents the best understanding of relative values, and so you cannot own any better portfolio than the overall market.  (The counter-argument is that the market really represents a voting system, and often includes a great deal of emotion.  And there are plenty of examples of stocks rising or falling for reasons that have nothing to do with the underlying value of the stock.)

But if everyone owned index funds, who would be left to set the relative prices?  As more and more people subscribe to index funds, the number of people who are setting the prices goes down, until eventually (in the absurd) a single person is setting relative prices while the rest of the world just follows that person’s allocation.

There are many more examples of financial theories that break down as their adoption rate goes up.  And it’s worse for the better theories.  When people realize they can get an edge, their method, theory, or whatever, quickly spreads through the financial community, thus violating the premise that most of the market is not using it.

So what is the solution?  Two parts:

1. Don’t rely on theories that require you to be a small part of the market.  Instead use approaches that are independent of how much of the stock or how much of the market you own.
2. If you do find a trading edge that requires you to own a small part of the market — keep it to yourself!

And finally, if you find that the market is following a theory like this, be prepared for a breakdown, and position to take advantage of it.

It reminds me of the early 1990′s.  A lot of uncertainty.  A lot of opportunity.  Prices fluctuating.  Irrationality in some areas, but not across the board, much like during the peak of the bubble from 1999 to 2000.

There are some great opportunities in equities right now.  Some long — some short.

I’ve been heavily weighted in energy stocks for the past 3 years, and it’s been a great ride.  But oil won’t go up forever.  The upstream oil producers have benefited from the high price of oil, and they will suffer when it goes down.  And down it will go; despite the claims of increasing demand in China and India, there really is no fundamental justification for the current high price of oil.  It’s a bubble, and it’s clear the large oil producers understand that.

Likewise the ongoing, slow-motion real estate collapse has created some impressive possibilities.  Who is going to buy up all that foreclosed real estate?  And what about the houses that are not in foreclosure?  They may be perfectly good homes, but they won’t be able to command their previous prices.  When prices get irrational–and they will!–gobble them up while you can!  Rent them out and hold onto them.

And watch out for the financial sector.  A lot of companies got caught up in the chase for a quick buck, and are over-dependent on the real estate market.  As that bubble collapses, it’s likely to have a devastating effect on some banks.  The only financials I’m holding onto are Goldman Sachs, Bank of America, and a small position in Schwab.  I also think Wells Fargo remains pretty good.  But these stocks need to be monitored closely, as they are decent issues sitting in the middle of a minefield.

I don’t tend to do a lot of short selling–but there may be some great short opportunities in the financial sector now.