Last week, I blogged about My Upstream Oil & Gas (O&G) Rescue Operations. This week, the focus is on my downstream O&G stocks. Upstream O&G refers to the exploration and production of crude oil, while downstream O&G refers to the processing of crude oil into refined oil products such as gasoline. If you refer to the profit contributions at oil majors such as Exxon Mobil, BP, Shell, etc., downstream operations have been the segment that is making up for depressed profits at upstream operations. The figure below shows the breakdown of profits from upstream and downstream operations for BP (source: Bloomberg).
|Fig. 1: Profits from Upstream & Downstream Operations for BP|
The fact that downstream operations are making more money than before the oil crash is not surprising. Refineries buy crude oil and sell refined oil products. Given the prolonged crash in crude oil price since mid 2014, their input price has dropped and refining margins have increased. However, the increased refining margins are only temporary, eventually, the glut in crude oil volume will find its way to the refined oil product market and depress the selling price of refined oil products, thereby diminishing the refining margins. Fig. 2 below shows the diminishing refining margins (source: Bloomberg).
|Fig. 2: Refining Margins|
Still, downstream O&G is comparatively more stable than upstream O&G. In Singapore, we do not have any listed companies that operate refineries. However, we have a couple of companies that build and maintain petrochemical plants, storage tanks, oil terminals, etc. Some of these Engineering, Procurement and Construction (EPC) companies include Rotary, PEC, Hiap Seng, Hai Leck and Mun Siong.
Generally, compared to upstream companies, the business of these EPC companies are much more stable, because the more OPEC countries pump oil to increase market share, the more oil that needs to be transported, processed and stored. However, some of the customers in this segment are the oil majors which are cutting costs wherever possible. There is also increased competition for less new EPC projects, thereby depressing margins for these companies. Nevertheless, downstream companies have performed better than upstream companies at withstanding unexpected shocks. When Swiber announced winding-up in Jul, Pacific Radiance announced that it had to provide for about $13.5M (USD10.1M) in doubtful receivables, which led to a sustained sell-off in its shares (together with other upstream O&G stocks). In contrast, in Oct last year, PEC had to write-off trade receivables of about $19M when Jurong Aromatics went into receivership. Its share price held steady after the news.
Among the listed companies mentioned above, PEC has ventured into Middle East and increased its revenue. It essentially points the way to what companies can do to survive the long and harsh O&G winter: go into Middle East where oil production is increasing at the expense of everywhere else and have a large portion of revenue from maintenance projects. Even if companies stop buying/ building new facilities, they still have to maintain their existing ones. In FY2015, Middle East contributed 18% of total revenue by geography while maintenance contributed 31% of total revenue by segment. Action-wise, at the middle of last year, my original cost price in PEC was $0.59. After its announcement of Jurong Aromatics going into receivership in Oct 2015, I averaged down at $0.375.
Rotary operates in a similar size and geography as PEC. However, it relies predominantly on projects rather than maintenance. The proportion of revenue from maintenance is only 17% in FY2015. Due to a lack of new projects, its revenue in FY2015 fell by 52%. Middle East contributed 30% of total revenue. As the business prospects are uncertain, I have not averaged down. My cost price remains at $0.62.
Hiap Seng is smaller than both Rotary and PEC and operates predominantly in South East Asia. In FY2016, it swung from a loss of $12.7M to a profit of $5.6M. When oil was trading at below USD30 in Jan, I initiated a small position at $0.10 as a turnaround play.
Hai Leck is even smaller and operates in Singapore only. It derives 67% of its revenue from maintenance in FY2015. What attracted me to it initially was its high dividend. It paid interim dividend of $0.05 in Jun. I initiated my position in Jun/Jul at an average price of $0.38, hoping for more dividends to come.
Mun Siong is the smallest of all the companies mentioned above and operates in Singapore only. I decided to give it a miss, although it also pays fairly good dividends.
Finally, there is an oil trader in China Aviation Oil (CAO). Like all other upstream O&G companies, its revenue and share price crashed in 2015. I was concerned initially, but eventually accepted the explanation that Noble gave, which is that it is a commodity trader and is not affected by the commodity price. CAO was identified as 1 of the 2 O&G stocks in my portfolio that could save itself and others. However, there was a problem: I had maxed out the position limit on this stock. Thus, when the share price recovered to my cost price of $0.86 in Apr, I sold about half my position, hoping to create some space to buy should it decline subsequently. It went up instead and there went a part of my O&G rescue plans. (Note: Given the significant run-up in price, CAO is now considered as available-for-sale.)
Although all are in the O&G industry, the prospects of upstream and downstream O&G companies could not have been more different. Upstream companies are facing the most significant challenges seen in decades, with no signs of letting up yet. In contrast, downstream companies are comparatively more stable, although profits are nothing to shout about.
Some investors, like myself, like the excitement of finding multi-baggers, and the O&G industry presents opportunities as well as significant risks. However, as explained in Different Types of Bears, upstream companies are facing a ferocious bear. When faced with such a bear, it is not good enough just to have sufficient endurance, i.e. buy and hold for as long as it takes to outlast the bear. Not all companies will survive and we have already seen a couple of companies falling by the sideways. More are expected to come. Make one mistake and it would be difficult to recover.
On the other hand, downstream companies are facing the long-winded bear which is milder. Given sufficient endurance, it is usually possible to outlast it. This is why the plans for the downstream O&G stocks are considered as recovery operations (i.e. average down and hold) but that for the upstream O&G stocks are rescue operations (i.e. average down and sell)!
Finally, O&G is highly risky. I would not recommend it to anybody. Like what BullyTheBear said, it is not as if there is only this sector to focus on!
Just a disclaimer, this post is not a recommendation for anyone to buy or sell any O&G stocks. It is a recollection of my actions to rescue the downstream O&G stocks in my portfolio.
- The Demand and Supply for Oil
- Understanding Saudi Arabia's Game Plan on Oil Price
- The Missing Link Between Oil Price & O&G Profitability
- The Economics of An Oil Exploration & Production Company
- Lessons for Investing in OSV Companies from Shipping Trusts
- Understanding Shipbuilders' Balance Sheets
- Is Keppel Corp's Provision for Sete Brasil's Orders Adequate?
- How Will Keppel Corp Navigate the Oil Crash?
- Keppel Corp – A Good Captain Sailing Through Rough Waters
- The Type of Debts O&G Companies Have Matters
- My Upstream Oil & Gas Rescue Operations