How Low Oil Prices Affect Downstream And Upstream Oil Companies In Different Ways

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Includes: SNP
by: MarketGyrations

Summary

Cheap crude hurts upstream oil companies, but can also benefit downstream companies under certain circumstances.

The bottom line of certain companies has been distorted by price controls, which can be lifted with the drop in oil prices.

Opportunities exist due to overreaction caused by the sudden and drastic drop in oil prices.

As the price of crude oil has fallen, so too has everyone associated with it. Every company that's directly or indirectly connected with oil has seen its share price decline by a significant margin. That's not surprising considering the price of oil has fallen by more than half over the course of several months.

Oil is going down

The natural inclination for people is understandably to dump everything that's even remotely connected to oil. That includes every company that's involved in the oil business. The general assumption is that low oil prices will hurt oil companies.

However, a decline in the price of oil does not have to be a bad thing for every company involved in the oil industry. To understand why, it's important to differentiate between upstream and downstream players when it comes to oil.

Cheap crude oil can be a major headwind, especially in exploration and production

Basically, the difference between upstream and downstream companies is that the latter are further removed from the actual extraction of crude oil from the ground than the former. Upstream companies are more directly involved in the actual exploration and production of crude oil.

When the price of oil is relatively low, then this will have an immediate impact on these companies. In order for exploration and production of crude to be commercially viable, the price needs to be high enough to make sense from a financial standpoint.

That's especially hard to do when you have high costs while prices for oil are low. High costs can be caused by various factors. Geographic location and unconventional extraction methods are just some of the examples that come into play. Traditional oil fields using conventional methods are at an advantage in such a situation and something that can separate certain upstream oil companies from their peers.

Cheap oil does not have to be a negative for downstream companies

On the other hand, downstream companies are primarily in the business of refining crude oil into various products and the related marketing and distribution of these products. For these companies, low prices for crude oil does not have to be a bad thing.

It may reduce the margins for refiners, but it can also help increase consumption by the public. Increased consumption can lead to increased sales of refined products, which can offset lower margins.

It's therefore important to know what the real reason is behind the fall in the price of crude oil. As long as the low price of crude oil was not caused by low demand, refiners should not have to worry as much as those in exploration and production.

Cheap oil can also be a tailwind for refiners under certain circumstances

A reduction in the price of crude oil can also directly benefit the bottom line of certain downstream companies. That's because high oil prices often leads to high inflation and increased cost of living. This in turn can lead to public discontent, especially in developing countries where disposable income is lower.

Many developing countries will for that reason exercise strict control over the price of fuel, which affects everything in an economy. That includes setting a maximum price for which fuel and other oil products may be sold, even if that price is too low to allow companies to profit or even to recoup their costs.

The government in these countries can get away with this because they are usually the majority owner of the oil company. It is not unusual to see the refining segment operate at a loss because of government policies. This changes when the price of crude oil is relatively low.

Governments are in a better position to allow companies to set their own prices without any backlash from the public. A formerly unprofitable but necessary business can now all of a sudden become highly profitable in the absence of price controls.

Sinopec is primarily a downstream company held back by government control

Large oil companies tend to be vertically integrated in that they operate both upstream and downstream (including midstream) businesses. However, some companies tend to lean towards one or the other. They can primarily be a downstream company or an upstream company even though they operate in both segments.

China is one example of a country where you can find all of the above. In China, the oil industry is dominated by three oil companies. They are Sinopec (NYSE:SNP), PetroChina (NYSE:PTR) and CNOOC (NYSE:CEO). PetroChina and CNOOC are tasked primarily with the exploration and production of crude oil with the latter responsible for offshore deposits.

Sinopec turnover

On the other hand, Sinopec is more of a downstream oil company. Exploration and production only makes up a small part of its revenue. It's much more important in terms of profits and those will take a hit due to the collapse in oil prices.

Refining, marketing and distribution is where Sinopec gets most of its revenue. However, due to price controls exercised by the Chinese government, downstream segments are not as profitable as they could be if retail prices were set free.

Like many of its peers, Sinopec has dropped in market value as the price of oil has fallen. While Sinopec has recovered somewhat recently, its share price is still down substantially. It may now be looking to break out.

Oil has hurt Sinopec

Sinopec's future looks bright

The Chinese government levied windfall taxes on profits of oil companies when the price of crude oil kept increasing. Fortunately, the Chinese government has responded to the drop in oil prices and has recently adjusted these taxes to help ease the tax burden. This should help Sinopec.

While price controls have hurt Sinopec's earnings, the drop in oil prices has reduced the need for them. Freeing retail prices of fuel is crucial to Sinopec due to the impact it would have on earnings. Sinopec is after all China's biggest refiner and the one who stands to gain the most from such a move.

Demand for oil is still increasing in China and Sinopec is well-positioned to take advantage of that fact as long as price controls are lifted. For instance, vehicle sales are projected to rise to 25.1 million in 2015 from 23.5 million the previous year. These vehicles will need oil and crude imports by China averaged 7.17 million barrels per day in 2014, a 9.5 percent increase over the previous year.

Lower taxes combined with much more profitable refining and distribution segments should more than offset reduced profits from the much smaller exploration and production segment. Overall, low oil prices can actually help Sinopec's bottom line and therefore be a net benefit as long as price controls are relaxed.

Conclusion

The tidal wave caused by the drop in oil prices has swept aside every company involved in the oil business. While in many cases the drop in share prices is justified, there are a number of oil companies out there where one can make a legitimate argument that the reduction in share price is excessive and not warranted considering the nature of their operations.

While a lot of attention has been paid to the negative effects of low oil prices, it seems that the positive effects are being overlooked in a number of companies. The bottom line is that the sudden and dramatic drop in oil prices has caused the market to overreact in some cases and in the process created a number of opportunities that one could take advantage of.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.