Gleam of Downstream? (Drip Port) January 21, 1999

<THE DRIP PORTFOLIO>
Gleam of Downstream?
Refining, Transporting, and Marketing

by Jeff Fischer ([email protected])

Paris, France (Jan. 21, 1999) -- Our oil saga continues today. Our study will soon be approaching three months in length. The goal is to make it last longer than a season of Dallas. Readers probably don't know this, but Brian looks exactly like J.R., so we have that going for us.

Last week, J.R. reviewed our oil and gas study with skill; if you need to catch up, click here. Now the only thing between us and our exploration of companies on an individual basis is the "Downstream" aspect of the industry. Downstream includes Refining, Transporting, and Marketing. (However, you usually only hear about refining and marketing, because transporting doesn't involve many financial implications for integrated giants: it's an expense, not a "sale.") For review of the official definition of downstream, we consulted Shell Oil:

"Downstream: Those activities which take place between the loading of crude oil at the export terminal and the use of the oil by the end-user. This encompasses the ocean transportation of crude oil, supply and trading, refining and the distribution and marketing of the oil products."

In three words: Refining, Transporting, and Marketing. We recently covered Refining, so Transporting and Marketing: Step right up!

Both are straightforward concepts, but it's important that we understand the entire spectrum of the downstream business (including our old friend, Refining) in relation to downstream operations, which is a highly profitable business by comparison.

Profit margins in the oil industry are measured per barrel of oil sold. In late 1998, Chevron (NYSE: CHV) had profit margins in its worldwide exploration and production (upstream) business that averaged $1.73 per barrel of oil when oil was selling at $11.50 per barrel. Meanwhile, margins on a barrel of oil sold in its refining and marketing (downstream) business were only $1.58 per barrel when sold in the United States, and a mere $0.34 per barrel when sold internationally. When you're producing 870,000 barrels a day, those quarter-dollars add up.

In 1999, poster child Exxon (NYSE: XON) is expected to achieve earnings of $4.7 billion from worldwide exploration and production of oil (again, upstream activities), and just $2.5 billion from worldwide refining and marketing (downstream activities), even though sales volume in downstream activities at times eclipses upstream revenue. Exxon is very gifted at achieving high margins with upstream oil. This year, the company is expected to earn a profit margin of about $4.00 per barrel on upstream oil, while only earning $1.25 per barrel in downstream sales. It isn't surprising that this historical trend should continue.

Upstream means pulling the stuff from the ground. That takes work, but the resulting oil is valuable even when it's crude. To prepare oil for downstream sales, a company needs to be a chemical magician; it also needs endless pipes, incredibly large oil tankers, very large trucks, countless train cars, and extremely large refineries. Then the company needs to package and label its product. Finally, it needs a place to meet the actual consumer: a retail location; several thousand of them, actually. These costs add tremendous overhead to what is -- in the end -- a mere retail business: the selling of a commodity to mass consumers.

If we were to focus on only one side of the industry in which to invest, it would certainly be upstream. We're hoping to find an integrated leader, however -- a company involved in all aspects of the industry -- in order to lower risks across the board. That decided, "Transportation" is the necessary "part two" of three in our downstream operations study.

Transportation. Oil is conveniently moved through pipelines because pipeline networks cross all vital continents. Crude oil pipelines are typically as large in diameter as Michael Jordan's hand, and pumping stations are built at regular intervals along the line to guarantee that oil continues to move at over 3 miles per hour. The construction of such a pipeline and its stations is usually undertaken by several companies, all of them sharing the massive capital investment; and it is done with an agreement or even help from the country (or countries) hosting the pipeline.

Once a pipeline is built (under the ground: don't assume above-ground pipelines anymore), the ground is carefully restored to its former state. That's what the oil companies say, anyway. In Europe there are more than 200 oil pipelines stretching 10,500 miles. You don't see the pipelines winding down the Champs Elysees in Paris, however, or snaking up the Spanish Steps in Rome. The only place that you'll likely see oil pipelines jutting precariously from the ground is Spain. (I've been thrown off trains and nearly robbed in Spain: allow me one criticism. I love the country anyway.)

Once laid, a pipeline is regularly inspected for corrosion or leaks using an "intelligent pig." Perhaps resembling your most recent ex-significant other, an intelligent pig is a device fitted with sensors and recorders that can discover any signs of fault (corrosion or other defects, in this case) as it passes through the pipeline.

As Brian shared, offshore production is growing rapidly, and with it more underwater pipelines are being constructed. These are laid from special made-to-purpose pipe-laying barges. To accomplish this method, steel pipe is welded together before being strewn across the ocean. With lines of small diameter, the pipe can be unwound from an immense spool directly onto the seabed. Lines transporting heavy oil are insulated so the oil flows freely, while smaller pipelines are usually laid in a trench to protect them from fishing apparatus. (How many of us have hooked an oil line during our deep-sea fishing escapades? I pulled one all the way up to the surface, actually. Honest.)

Transporting that isn't accomplished by pipelines is done by oil tankers, trains, and trucks. Every year oil washes up on shores around the world, spills alongside train tracks, or explodes along the highway as unfortunate consequences. The largest disaster by scale was when the Exxon Valdez dumped 11 million gallons of oil in Alaska's Prince William Sound ten years ago. However, even that disaster didn't put a dent in Exxon's ability to sell 65 million gallons of gas per day to 8 million zealous drivers.

On that note, we'll move from Transporting to Marketing next week. Before that, tomorrow Brian will provide the full and final list of individual companies that we'll study, offering information on new Drip plans following mergers. The main point today: In this business, upstream is usually significantly more profitable than downstream per barrel sold.

Fool on!

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