More than a century ago, John D. Rockefeller shaped the oil
and gas industry into what we know it as today. His vision was
the concept of the integrated oil and gas company. Instead of
focusing on just one aspect of the business, such as production
or refining, he built an empire that did all of these things, and
made a fortune along the way. By having operational control of
every step in the oil and gas process -- production,
transportation, refining, and retail -- Standard Oil provided an
incredible amount of pricing and cost control. The original
Standard Oil was divided up into several smaller parts, but it
laid the groundwork for how the biggest names in oil and gas
The household name oil companies that we all know like
were all built on John Rockefeller's model: vertical integration.
The problem is, though, that these companies are not vertically
integrated anymore, and that drastically changes the way we need
to think about them as investments. Let's take a look at why we
should stop calling these companies integrated and how that
impacts your investment thesis.
Not integrated, just co-existing
The reason that oil and gas companies got the label
"integrated" and not "diversified" is because, at one time, their
operations across the entire value chain were built to take one
barrel of oil from the source all the way to the end consumer by
filling their gas tank at the pump or selling you chemicals
derived from oil and gas. In theory, this business model gives
the company greater control. Since it doesn't need to farm out
transportation costs to a pipeline company, or sell it to a
refiner only to buy it back to use in retail locations, it could
lower its costs and maximize the value of that barrel of oil by
selling it as its refined products.
If we look at the assets held by Big Oil companies today, on
the surface, it looks as though they are still integrated oil and
gas companies. They all generate revenue from the production,
transportation, refining, and retail sales of oil and gas.
However, calling them integrated businesses is like saying you
have an apple pie when all you have is a bushel of apples and a
couple cups of flour and sugar. These companies are more like a
random collection of assets in different facets of the oil and
gas industry, and for the most part, they rarely complement each
other to add value to the company.
BP's newly revamped Whiting refinery, running everything but
oil produced by BP. Source: BP.
Quite possibly the most egregious example of this is
's Whiting refinery in Indiana. It recently completed a $4
billion upgrade at the facility to modernize it as well as add a
102,000 barrel per day hydrocracker unit. These upgrades not only
increased capacity, but they also completely changed the type of
oil the facility processes. Now, Whiting is geared to run 80%
heavy/sour crudes, which is the type of oil produced from
Canadian oil sands. These crudes are generally less expensive,
and refineries that can run this type of crude in the U.S. can
reduce their feedstock costs.
As a stand-alone investment, it makes a lot of sense for BP.
It should lower feedstock costs and increase margins and cash
flow for the business. If we look through the lens of a
vertically integrated company, though, it doesn't make as much
sense. Why? Because BP doesn't produce any oil from Canadian oil
sands. In fact, it only produced 1,000 barrels of oil per day
total from Canada in 2013. Granted, the company does have a
non-operating interest in a few oil sands projects, but the
projected output from these projects isn't even enough to provide
this new refinery with half of its heavy oil capacity, and they
aren't likely to all come online until beyond 2020.
This isn't the only example, either. Take a look at Chevron's
American operations. In the fiscal year 2013, Chevron produced
657,000 barrels per day of crude oil in the U.S. At the same
time, its U.S. refineries processed an average of 774,000 barrels
per day. Thinking of the company as an integrated company, then,
a majority of the oil supplying its refineries would be sourced
from the U.S. and supplemented with oil from elsewhere. The
reality of the situation is very different.
Source: Chevron 2013 Annual Report Supplement.
In fact, total U.S.-sourced crude for Chevron refineries was
just barely more than 20% of total throughput -- around 150,000
barrels per day. A majority of the oil for these facilities came
from Mexico -- where Chevron has no operations -- and the Middle
East -- where Chevron only generates 87,000 barrels per day. What
this means is that the company is routinely selling its American
produced oil to other refineries in the region, while sourcing
crudes for its own refineries from elsewhere.
The integrated oil and gas space is littered with examples
like this. They all have assets in every facet of the value
chain, but very rarely work in ways that complement each other.
To be fair, part of the reason these assets have become detached
is because the geography of oil production has shifted immensely
since when these refineries were first built, and you can't
exactly close up shop and move these multibillion-dollar
investments every 5-10 years to follow production.
Invest like it's diversification, not integration
With a conglomerate of not necessarily correlated business
segments, some investors might ask why integrated majors don't
separate themselves into completely business altogether? There
are two arguments that support this idea. The first one is that
all Big Oil companies generate a disproportionate amount of their
earnings from oil and gas production, and the results from other
sectors are pretty much ancillary.
% of Earnings Generated From Oil and Gas
|Royal Dutch Shell
Source: Quarterly earnings reports.
The second reason this seems attractive is that it has been
done before with some success; both
spun off their refining and retail segments into separate
entities a few years ago. By liberating the downstream
businesses, it allowed them to make investments more strategic
for the downstream side of the business, provide a decent
dividend for its shareholders, and buy back loads of shares with
MPC Total Return Price
Does this mean you should stay away from Big Oil? Not
necessarily. One argument against divesting these assets is that
it provides some diversity within a single investment.
Basically, you have separate entities operating under one
roof that act in opposition to each other. For example, the
production side will benefit immensely when
are high, but those same high oil prices will likely cut into the
profitability of refining and chemicals operations because
feedstock costs are increasing. And the opposite happens when oil
prices are low.
The overall impact of this dynamic means that as oil prices
slump, Big Oil companies will not be as drastically affected as
companies that deal exclusively with the production side of the
business. However, during times of rising oil prices, Big Oil
players will not reap the benefits as much.
What a Fool Believes
As the years have passed, the benefits of vertical integration
have slowly eroded at these companies to the point that they
really can't be called integrated anymore. Instead of fighting
this change, some companies are actually embracing. BP recently
announced that it is spinning off its Lower 48 exploration and
production business into its own entity that will be wholly owned
by BP. This move, as well as its 19.75% interest in Russian
, are turning BP into more of a holding company.
It's hard to say that this is what integrated oil and gas
companies will become in the future, but it's not a bad idea.
After all, John Rockefeller made way more money after Standard
Oil was broken up into multiple parts than when it was a single
entity. Based on the current portfolios for Big Oil, though, they
certainly don't pass the "integrated" test anymore.
Integrated Oil & Gas Isn't Really That
originally appeared on Fool.com.
has no position in any stocks mentioned.
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