An Investor’s Guide to Upstream Oil and Gas

The oil and gas industry pumps, transports, and processes more than 100 million barrels of crude oil and over 355 billion cubic feet of natural gas per day worldwide. The upstream part of the oil and gas sector does the initial heavy lifting; it's engaged in the exploration and production of hydrocarbons -- oil, natural gas, and natural gas liquids (NGLs). It then transfers this output to the midstream sector, which focuses on the transportation, processing, and storage of hydrocarbons. From there, oil and gas flow downstream, where the oil is refined into finished petroleum products such as gasoline and diesel, and distributed to end users. 

This guide will walk investors through how the upstream oil and gas sector operates. We'll explore the types of companies needed to find and produce oil, how they make money, and the role oil prices play in this particular segment of the industry. That should help investors make better-informed decisions when buying upstream oil stocks.

Upstream oil and gas companies either pull hydrocarbons out of the ground, or directly assist those companies that do with goods and services. Image source: Getty Images.

What is the upstream oil and gas sector?

The upstream oil and gas sector contains two main components:

Exploration and production (E&P): The E&P segment encompasses companies that explore for new sources of oil and gas and then drill wells to extract these resources. E&P companies range in size from private family-run businesses that operate a handful of wells, to multinational corporations with globe-spanning assets. E&Ps can also have a narrow focus -- such as conventionally drilled vertical wells -- or operate several different types of oil fields, including offshore, oil sands, and unconventional shale wells that are drilled horizontally and hydraulically fractured (fracked).

E&P companies typically lease land from individuals or the government, then drill exploration wells to test whether the rocks beneath contain commercially viable hydrocarbons. If they make a discovery, then they'll invest more money to drill additional wells and build the necessary infrastructure to develop the resources. The E&P business demands lots of capital -- oil companies need to continually invest money to find and develop new oil and gas resources to replace the production of legacy wells, which steadily decline and eventually are depleted.

Oil-field services and equipment: This segment supports E&P companies by providing a range of services, equipment, and products so they can find and produce oil. Oil-field services provide support along the three main stages of the drilling process: 

1. Exploration services such as seismic and geophysical testing that help E&P companies discover prospects worth exploring. They also conduct reservoir testing to determine a discovery's commercial viability as well as how to develop the resources.
2. Drilling services, including operating onshore and offshore drilling rigs.
3. Well completion services such as cementing and fracking newly drilled wells so that they can produce oil and gas. 

The oil-field services segment also provides both E&Ps and other service-focused companies with a wide array of specialized products and equipment. 

What are the different types of upstream oil and gas companies?

The upstream oil and gas industry consists of four types of companies:

1. Integrated oil companies 

These are "wellhead to end user" operations that span the upstream, midstream, and downstream segments of the oil market.

ExxonMobil (XOM -2.28%) is the biggest publicly traded integrated oil company in the world. It operates one of the largest E&P businesses, with assets spanning the globe, a growing midstream segment, and a meaningful downstream portfolio that includes oil refineries, petrochemical plants, and distribution and marketing operations such as retail gas stations. That diversification across the sector enables integrated oil and gas companies like Exxon to maximize the value of each barrel they produce. It also helps mute some of the impacts of oil price volatility, since their downstream assets benefit from lower prices.

2. Independent E&P companies

These companies focus primarily on the upstream segment. While some independent E&Ps will operate midstream assets that support their production, they make most of their money by producing oil and gas. Because of that, they're much more susceptible to changes in oil prices since their earnings tend to rise and fall with commodity prices.

3. Diversified oil-field service companies

These companies provide a range of services, equipment, and products to support their E&P customers. They're akin to a one-stop shop for developing oil and gas resources. In addition to providing a variety of much-needed services, they often manufacture mission-critical equipment such as: 

• Drilling rigs.
• Oil production systems and pump jacks.
• Remotely operated vehicles used in developing deepwater resources.
• Specialized drilling pipe, valves and fittings, and separations systems.
• Storage tanks.
• Raw materials like sand used in fracking wells.

4. Pure-play oil-field service or equipment companies

These companies focus on one aspect of the service sector. Some, for example, only own and operate offshore drilling rigs. Others provide services specific to completing newly-drilled oil wells, or they produce sand used in fracking wells. This focus on one aspect of the oil-field service sector enables these pure plays to make lots of money during boom times. But they can be much more susceptible to trouble when market conditions deteriorate. That was the case during the oil market downturn of 2014 through 2017, when several pure-play oil service companies declared bankruptcy.

How upstream oil and gas companies make money

E&P companies are known as price takers, which means they sell their oil and gas for the going market rate. That price point can fluctuate significantly, and it's influenced heavily by changes in supply and demand. If oil producers pump more oil than the market needs, it can cause crude prices to plunge, which eats into the profitability of E&Ps.

Oil-field service companies, on the other hand, make money by providing services and equipment to E&P companies. While some service companies sign long-term contracts with E&Ps or other service providers that give them some revenue visibility, most operate under shorter-term contracts or sell products as needed. That can be problematic: Demand -- and rates -- for oil-field services, products, and equipment tends to ebb and flow with oil prices. That's because E&Ps often base their capital spending on their anticipated cash flow, which also rises and falls with oil. As a result, oil-field service companies -- especially pure plays -- tend to be highly sensitive to oil prices.

Because of the upstream oil sector's exposure to price volatility, investors should look for companies with low costs. For E&P's, that means finding those that can sustain their current production rate at oil prices well below $50 a barrel. Meanwhile, low-cost service companies will have peer-leading margins. While it will take some digging -- including sifting through investor-relation presentations on company websites -- that work will be well worth it in the end. That's because low-cost upstream companies can still make money at lower oil prices, which sets them up to generate a gusher of profits when they rebound.

The 10 largest upstream oil and gas stocks by market capitalization

Governments of several major oil-producing countries control many of the world's largest upstream oil producers. However, given the massive size of the worldwide oil industry, investors still have plenty of options from which to choose. The following chart lists the 10 largest publicly traded upstream stocks that aren't controlled by foreign governments: 

Data source: Company investor relations websites.

To give investors a flavor of the different types of upstream stocks, we'll drill down a bit deeper into the largest in each group: ExxonMobil (integrated), ConocoPhillips (independent E&P), and Schlumberger (diversified oil-field services).

ExxonMobil: An investment covering the entire oil value chain

ExxonMobil is one of the largest oil and gas producers in the world. In 2017, it was the world's third biggest natural gas producer as well as the No. 2 oil producer in America. Exxon also has a sizable midstream footprint and a meaningful downstream business consisting of the world's largest refining operation and one of the biggest chemical manufacturing businesses.

This diversification gives the company three notable advantages:

1. It helps generate steadier profits and cash flow. Its downstream businesses tend to produce higher earnings during periods of lower oil prices, which helps mute some of the impacts of price volatility on the upstream operations.
2. It helps the company maximize the value of its production. Instead of selling its output at the wellhead for the going market price, Exxon can transport oil and gas via its midstream assets to its downstream facilities, where it can transform this production into higher-value refined products or petrochemicals.
3. It opens more opportunities to expand, since the company can invest capital not only around the globe but also across the oil and gas value chain.

ExxonMobil plans to invest $50 billion into expanding its integrated operations in the U.S. through 2025. This includes drilling more oil and gas wells in the Permian Basin and building pipelines to move its production to the Gulf Coast, where it's expanding its downstream footprint. These projects are a key aspect of Exxon's ambitious plan to double its earnings and cash flow by 2025 from 2017's baseline, without any assistance from higher oil and gas prices.

Exxon's diversification makes it a lower-risk way to invest in the oil sector. It has the upside to higher oil prices thanks to its upstream business, with less downside risk during periods of lower prices because its midstream and downstream segments partly mitigate that impact. Add in Exxon's top-tier balance sheet and attractive dividend, and it's an ideal way for investors to gain exposure to the oil industry. 

Image source: Getty Images.

ConocoPhillips: A pure-play upstream E&P

ConocoPhillips used to have integrated operations like Exxon, but the company separated from its downstream and midstream businesses by spinning off Phillips 66 to shareholders in 2012. That enabled ConocoPhillips to focus on expanding its global E&P operations while freeing Phillips 66 to grow the refining, chemicals, and midstream businesses.

ConocoPhillips has further streamlined since then by selling off many noncore operations so that it could focus on its lowest-cost assets, using the cash proceeds to pay off debt and buy back its stock. As a result, the company controls a slimmed-down portfolio of low-cost oil and gas assets that include unconventional shale properties in North America, traditional conventional oil fields such as those in Alaska, liquified natural gas export facilities in Australia, and interests in oil sands in Canada. This balanced portfolio enables the company to generate lots of cash flow at oil prices above $40 a barrel.

E&P companies have traditionally plowed all their available cash flow into drilling more wells. But ConocoPhillips has spearheaded a new approach within the sector by investing its capital to earn high returns on investment. Because of that, it only invests in its best opportunities, which frees it up to generate excess cash. That allows it to pay a growing dividend and buy back stock, which has the potential to create more value for shareholders.

ConocoPhillips has worked hard to reduce the impact of oil price volatility by focusing on operating low-cost oil and gas assets. That allows the company to sustain its production rate on the cash flows it can produce at $40 oil. Because of that, the company is well positioned to cash in on higher prices, with it aiming to return a significant portion of its excess cash flow to investors via share buybacks. That should help the company generate healthy total returns for its shareholders throughout the ups and downs of the oil market.

Schlumberger: The other side of the upstream oil and gas segment

Schlumberger is the largest oil-field service company in the world. It provides E&P companies with a comprehensive suite of services to find, drill, and produce oil and gas. The company also manufactures a broad array of products and equipment, especially for supporting offshore operations.

Schlumberger operates four businesses segments:

• Reservoir characterization, which provides tools and services that help E&P companies understand reservoir rocks and fluids.
• Drilling services, which offers a range of services, equipment, and tools to drill exploration and development wells.
• Production services, which provides producers with the services, tools, products, and equipment needed to maximize and extend the life of an oil and gas reservoir.
• Cameron, which manufactures pressure control systems, rig equipment, drilling tools, and valves.

Schlumberger's diversification has several competitive advantages. For starters, it helps mute some of the impacts of weaker market conditions in one subsector of the upstream industry. That has been evident in the fact that international and offshore markets had been slower in bouncing back from the oil downturn that started in 2014, which hurt companies focused on those areas. Schlumberger has been able to offset some of this weakness because North American onshore shale drilling bounced back much quicker. Meanwhile, another advantage of its large scale is that it enables Schlumberger to offer comprehensive service contracts at competitive prices. That puts it in a better position to win the business of major oil companies, which prefer to have one service partner since it's easier to coordinate activities.

Because of its diversification and scale, Schlumberger isn't as susceptible to market downturns as smaller pure-play peers. While the company's revenue, margins, and cash flow all declined alongside oil prices during the market downturn, it significantly outperformed its rivals since its financial performance held up much better.

That ability to continue making money when market conditions deteriorated allowed Schlumberger to take advantage of the situation by making acquisitions, including buying Cameron, which improves its ability to prosper during the next up cycle. While pure-play service and equipment companies can make more money during the boom times, Schlumberger's diversified approach, when combined with its top-notch balance sheet, ensures that it can survive oil market downturns so that it's still around to thrive when conditions improve. 

A word on upstream exchange-traded funds (ETFs)

Picking the right upstream oil stock can be challenging. Unanticipated company-specific issues, such as poor drilling results, mismanagement, or other problems, can cause an oil stock to significantly underperform its peers even if oil prices are rising. That's why investors might want to consider buying an oil-focused exchange-traded fund, which is a stock-like vehicle that invests in several oil companies.

One oil ETF worth considering is the SPDR S&P Oil & Gas Exploration & Production ETF. This fund owns an equal amount of roughly 70 companies spread across both the upstream E&P segment and the downstream refining and marketing sector. This broad-based approach sets investors up to profit from higher prices due to the exposure to the E&Ps. Meanwhile, it partly cushions the blow of oil price volatility thanks to the inclusion of some downstream operations.

Why investing in upstream stocks could make sense for your portfolio

While oil prices ebb and flow, demand for crude has continued to trudge higher and isn't expected to plateau for several more years. So the upstream oil and gas sector has the potential to enrich investors. But they do need to be mindful of which upstream stocks they buy because oil price volatility enhances risk. One of the better ways to reduce this risk is by focusing on larger, more diversified companies. Their scale and diversification should help mute some of the impacts of the inevitable ups and downs of the oil market.