An Investor's Guide to Downstream Oil and Gas

The oil and gas industry consists of three main sectors that work together to take raw production from a well and turn it into useable products:

1. Upstream companies produce hydrocarbons -- oil, natural gas, and natural gas liquids (NGLs) -- by drilling wells into underground reservoirs.
2. Midstream entities transport, store, and process hydrocarbons.
3. The downstream sector focuses on the last link in the industry's value chain by turning raw materials like crude oil and natural gas into higher-valued products such as fuels and petrochemicals.

Because downstream companies use oil to make other things, their business model differs significantly from that of upstream oil companies. Since production from existing wells declines and then depletes, oil producers continually need to invest capital to drill more of them. But downstream companies buy oil from producers, and then sell the refined products they manufacture for more money to end users. This difference means they're less sensitive to oil price volatility, which enables them to generate more free cash flow that they tend to return to investors. Those factors can make downstream oil and gas companies more appealing options for investors who don't like all the volatility that often comes with owning an upstream oil producer.

What is the downstream oil and gas sector?

The downstream segment of the petroleum industry focuses on three main activities: refining oil, manufacturing petrochemicals, and marketing and distributing refined products and natural gas.

Oil refineries process crude oil and other raw materials such as ethanol into the following higher-value refined petroleum products:

• Naphtha
• Gasoline
• Kerosene
• Jet fuel
• Diesel
• Fuel oil
• Waxes
• Asphalt
• Lubricants

The oil refining process consists of three main steps:

1. Separation pipes crude oil through hot furnaces that discharge the liquids and vapors into distillation units, where they separate into fractions according to their boiling point.
2. Conversion, often known as cracking, uses heat, pressure, and a catalyst to crack heavy hydrocarbon molecules into lighter ones.
3. In treatment, a refinery will combine different hydrocarbon streams to create a finished refined product (i.e., gasoline, diesel, etc.), which then goes into storage until it's transported to end users.

Petrochemical complexes use heat and pressure to process raw materials such as naphtha produced at an oil refinery, or purified ethane and propane that come from an NGL fractionation plant. They transform them into products used by chemicals companies and plastics manufacturers.

Finally, marketing and distribution companies transport and sell the finished petroleum products to end users. Examples of marketing and distribution companies include retail gas stations, home heating fuel delivery companies, and natural gas distribution utilities.

Types of downstream companies

Some companies operate across nearly the entire oil and gas value chain, meaning they produce oil (upstream), transport it (midstream), and refine it (downstream). The industry refers to these entities as integrated oil and gas companies because they operate a "wellhead-to-end user" business. One example of an integrated oil company is ExxonMobil (NYSE: XOM), which has one of the largest oil and gas production businesses in the world, investments in key oil and gas pipelines, and meaningful refining, chemicals, and marketing and distribution businesses, including Exxon- and Mobil-branded gas stations.

Meanwhile, other companies only operate in the downstream segment, with some focusing on one activity (refining, chemicals, or distribution and marketing). These pure-plays on either the downstream sector or one of its activities give investors the opportunity to make outsized profits when market conditions are strong. However, when the environment weakens, which tends to happen as commodity price volatility increases, it can put pressure on the profits and stock prices of downstream companies.

How downstream companies make money

Like companies that operate in the upstream segment, the volatility of oil and gas prices can have a significant impact on the profitability of downstream companies, because both earn a commodity-based margin. However, while commodity prices directly impact the sector's earnings, companies that operate in the downstream space don't make money in the same way as producers. Whereas oil companies earn a profit on the difference (or margin) between what it costs them to produce a barrel of oil, and the price at which they sell, most downstream companies make money on the spread between what they pay to buy raw materials such as crude oil, and the price at which they sell higher-valued refined products or petrochemicals.

Because of that, most downstream companies make more money when oil and natural gas prices are lower, because they can buy these raw materials or feedstocks at cheaper prices. While the price at which they sell their finished refined products also tends to decline along with crude, there's usually a lag that enables these companies to cash in on the lower prices. Downstream margins, on the other hand, tend to fall as commodity prices rise, because the companies need to absorb those higher feedstock prices, which they aren't always able to pass through to customers.

The largest downstream oil and gas companies

Integrated oil companies operate many of the largest downstream businesses, because those assets help them maximize the value of the oil and gas they produce. Furthermore, while the downstream oil and gas sector can include petrochemicals manufacturers and natural gas distribution utilities, most investors classify those companies in the chemicals and utility segments, respectively. Those factors narrow the list of pure-play downstream companies to those mainly focused on refining, as well as distribution and marking.

The 10 largest downstream oil and gas companies that fit these qualifications and trade on U.S. exchanges are the following:

To give investors a flavor of the differences in focuses by these downstream companies, we'll drill down a bit deeper into the three largest ones.

Marathon Petroleum: The new king of U.S. refining

In 2018, Marathon Petroleum became the top independent refiner in the U.S., when it acquired fellow refiner Andeavor, which had formed in 2017 following the merger of Tesoro and Western Refining. Aside from increasing the scale of Marathon's refining business, one of its big drivers of the merger with Andeavor was that the combined company could generate significant cost savings.

Marathon Petroleum's refining segment is its bread-and-butter business; it typically generates more than half of the company's EBITDA. Marathon has invested heavily in expanding its refining business over the years, both through acquisitions like Andeavor as well as organic expansion projects. It has focused on investments that will improve its ability to process cheaper types of oil produced in North America, while increasing its capacity to make higher-valued refined products. This approach has helped drive down costs and improve margins, which expands profitability.

One of Marathon's nonrefining businesses is its midstream operation, which consists of its ownership in master limited partnerships (MLPs) MPLX and Andeavor Logistics,as well as its wholly owned pipeline and logistics assets. Midstream investments have been another area of focus for the company over the years, because these assets help drive down transportation costs while increasing Marathon's access to cheaper crude oil produced in North American. On top of that, midstream assets tend to generate steady cash flow backed by long-term contracts. That helps offset some of the volatility of its refining business.

Its other nonrefining business is its marketing and retail operations that sell fuel directly to end users. The company operates three retail brands: Marathon, Speedway, and Arco, as well as several licensed brands from third parties.

Integration between midstream, refining, and retail enables Marathon to capture value across most of the oil industry's value chain. The link between midstream and refining has been an important one for the company because it has allowed it to participate in oil pipeline projects designed to move cheaper North American crude to its refineries. That has improved its margins since oil produced in the U.S. often sells for a wide discount to imported oil.

Marathon's growth and cost-saving initiatives have enabled it to generate significant cash flow. The company aims to return about half of that money to shareholders through dividends and share buybacks. Combine that with its growth-focused investments, and Marathon should be able to continue rewarding its investors over the long haul.

Phillips 66: Creating value both downstream and midstream

Phillips 66 operates across both the downstream and midstream segments. What sets the company apart is that it's one of the leaders in refining heavy Canadian crude oil, which has traditionally sold at a steep discount to oil produced in the U.S. because of that country's lack of pipeline space. That focus on processing this oil has enabled Phillips 66's refining business to cash in on those lower prices.

The company has been taking a different approach to grow in its refining business. Instead of investing in big-dollar, multiyear large-capacity expansion projects like some peers, Phillips 66 prefers to spend money on low-capital, quick-payout projects that enable it to process higher volumes of cheaper North American oil as well as increase its production of higher-value refined products.

Phillips 66 also has a meaningful chemicals business via its 50% interest in CPChem, a chemicals joint venture with Chevron. CPChem holds an interest in several petrochemical manufacturing facilities around the world. CPChem has steadily expanded over the years, with it focusing on pursuing growth opportunities in the U.S. Gulf Coast region to take advantage of cheap raw materials produced in North America.

The company also operates a downstream marketing and specialties business. This segment markets gasoline, diesel, and aviation fuel through several thousand independently owned sites that license the company's brands, which includes Phillips 66, Conoco, 76, and Jet. The company's specialties business, meanwhile, produces lubricants and is pursuing opportunities to make renewable fuels.

Finally, Phillips 66 controls a sizable midstream network through both assets it directly owns as well as its stakes in MLPs Phillips 66 Partners and DCP Midstream. Both of those MLPs have focused on organically expanding their capacity to transport, store, and process hydrocarbons produced in the U.S. thanks to the country's fast-growing production. With the industry needing to invest $44 billion per year on energy infrastructure through 2035, Phillips 66 and its MLPs should have no shortage of expansion opportunities.

Phillips 66's integrated midstream and downstream network generate significant cash flow. The company aims to return about 40% of that money to shareholders through dividends and buybacks and reinvest the rest into high-return expansions, with the bulk of the spending focused on midstream projects. That balanced approach should enable the company to continue creating value for its investors in the coming years, which it has done since its formation in 2012. Overall, it had generated a nearly 250% total return through early 2019, which outperformed the S&P 500's roughly 115% total return over that time frame.

Valero Energy: A downstream giant with a clean fuels' component

While Marathon Petroleum is the largest independent refiner in the U.S., Valero Energy held the global title in early 2019, as it operated several refineries not only in the U.S. but also in Canada, and the U.K. Valero Energy's downstream assets also consist of a meaningful marketing and distribution business, that operated thousands of branded outlets in the U.S., Canada, the U.K., and Ireland.

Valero also operates a small logistics business consisting of oil and refined products pipelines as well as storage capacity and export docks, the bulk of which supports its refining operations. The company used to have an MLP -- Valero Energy Partners -- to help grow this segment. Valero took that company private in 2018 because it had become harder for MLPs to issue equity to fund acquisitions because of turmoil in that market. The company routinely has midstream projects under construction and in development, the bulk of which help support its refining operations.

In addition to refining, Valero Energy operates a large-scale ethanol business. These plants help support the company's refining operations by providing it with low-cost access to this gasoline additive. Valero also held a 50% interest in Diamond Green Diesel, which produces renewable diesel.

While Valero doesn't generate as much steady fee-based midstream income as rivals Marathon and Phillips 66, the company's integrated refining and ethanol businesses still produce lots of cash. Like Marathon, it aims to return about 50% of that money to investors via dividends and share repurchases. It reinvests the rest to sustain and grow its business, the bulk of which it has been earmarking toward expanding its refining and green diesel operations. That combination of growth and shareholder returns should enable the company to continue creating value for its investors, which it has done by retiring a significant portion of its outstanding shares since 2011.

Downstream exchange-traded funds

Another option for investors who want exposure to the downstream oil and gas sector is to consider an exchange-traded fund (ETF), which is a stock-like vehicle that tends to invest in a broad basket of companies. While there is one downstream-focused ETF, VanEck Vectors Oil Refiners ETF, it's a tiny fund that likely isn't an ideal option for investors.

A potentially better oil ETF is the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEMKT: XOP), which invests in both upstream and downstream companies. The ETF held more than 65 stocks at the beginning of 2019, including all the major U.S. refiners. Another noteworthy aspect of this ETF is that it's an equal-weight fund, which means it invests roughly the same amount of money in each holding. That differs from a market cap-weighted fund, which puts more money into larger companies. As a result, the performance of larger companies doesn't completely drive the returns of this fund.

Why investing in downstream stocks could make sense for your portfolio

Downstream companies tend to make money on the spread between were they buy crude oil and sell higher-valued refined products. Because of that, these companies typically cash in during periods of lower prices, which makes them a great option to pair with the stock of an oil-producing company since the performance of the downstream company's stock should help smooth out some of the oil price volatility that comes with investing in the upstream sector.

Another benefit of downstream companies is that they tend to generate lots of free cash flow because refineries aren't as capital intensive as oil fields, meaning refiners don't have to invest as much money to maintain their operations. As noted already, most of the large refiners only plan to reinvest 50% to 60% of their cash flow on capital projects whereas many oil companies spend 75% or more of their cash flow on drilling more wells. That leaves downstream companies with more excess cash to return to shareholders via dividends and stock buybacks, which has helped their stocks outperform most oil producers over the years.

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Matthew DiLallo owns shares of Phillips 66. The Motley Fool owns shares of ExxonMobil. The Motley Fool has a disclosure policy.