What it means
The industry is usually divided into three segments. Upstream covers exploration and production, midstream covers transport and storage through pipelines, tankers and terminals, and downstream covers refining crude oil into products and selling them through retail outlets and to industry.
An integrated company has major operations in all three. The attraction is a natural hedge, which is a built-in offset against risk.
When the oil price is high, the upstream business earns large profits, but the downstream business pays more for its crude oil and may earn less. When the oil price is low, upstream profits shrink, while refining and marketing margins often improve.
This tends to make an integrated company's earnings steadier than those of a pure producer, and its dividend is often seen as more dependable. The trade-off is complexity and heavy capital needs, since every segment needs large investment in wells, pipelines and refineries.
Returns on capital in the downstream business are typically lower than in a successful upstream business. Analysts examine each segment separately.
They study production volumes and costs per barrel upstream, throughput and fees in the midstream, and refining margins downstream. The group also reports capital spending by segment, which shows where management is placing its bets.
Some of the largest integrated companies have sold off or separated parts of their operations over the years. The reason is often that investors prefer to own a pure upstream or pure downstream business and to decide their own mix, which can make the combined group trade at a discount.
Climate policy and the energy transition add a further layer. Many integrated companies are now investing in lower-carbon fuels and power, and analysts watch the size of that spending and the returns it earns.
In practice
Real-world examples.
Example
An investor who wants energy exposure but cannot tolerate big swings in earnings buys shares in an integrated company. She accepts a lower upside in a boom in exchange for steadier results and a dividend.
Example
A pure refiner's finance director studies an integrated rival. He notices that the rival is protected when crude prices rise, because its own wells provide the crude at cost, while his company must buy crude on the market.
Example
An analyst values an integrated company by adding together the value of each segment. If the combined market value is below the sum of the parts, she flags that the group may be worth more if separated. She also compares capital spending per segment, because high spending on a low-return refinery can offset gains elsewhere.
Formula
Calculation
Total operating profit = Upstream profit + Midstream profit + Downstream profit
An integrated company earns operating profit of $3,000 million upstream, $400 million midstream and $200 million downstream in a year of high oil prices. Total profit is 3,000 + 400 + 200 = $3,600 million. In a low-price year the figures are $800 million, $400 million and $900 million, giving a total of 800 + 400 + 900 = $2,100 million.
The upstream segment alone fell by (3,000 - 800) / 3,000 = 73.3%. Total profit fell by (3,600 - 2,100) / 3,600 = 41.7%, a much smaller drop because downstream profit rose as crude became cheaper.Case study
Seen in the real world.
Redcliff Energy Group is an illustrative, fictional integrated company with wells, a pipeline network and two refineries. After a long period of low oil prices, activist shareholders argued that the company should be broken up.
The finance team prepared a segment analysis. In the low-price year, upstream earned only $500 million, but downstream earned $700 million and midstream $300 million, giving 500 + 700 + 300 = $1,500 million in total, compared with only $500 million for a pure upstream producer in the same year.
The board concluded that integration had protected earnings through the cycle and rejected the break-up. In this illustrative story, it also promised to publish more detailed segment returns so investors could judge each part on its merits. The chairman noted that the segment figures would be audited and published each quarter, so that shareholders could challenge any part of the business that earned less than its cost of capital.
Watch out
Common mistakes.
- Assuming integration removes all exposure to oil prices, when it only softens the impact.
- Treating the three segments as equally profitable, when upstream usually earns higher but more volatile returns than refining.
- Valuing the group with a single multiple, when a sum-of-the-parts approach often reveals more.
Questions
People also ask.
What are upstream, midstream and downstream?
Upstream is finding and producing oil and gas, midstream is moving and storing it, and downstream is refining and selling the finished products.
Why do integrated companies have steadier earnings?
Falling crude prices hurt the upstream segment but help refining and marketing, so the segments offset each other to some extent.
Is an integrated company always a better investment than a pure producer?
No, it gives steadier results but may lag in a boom, and the choice depends on the investor's goals.
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