What it means
In the oil and gas industry the value chain is divided into three parts. Upstream covers the search for oil and gas and the drilling and operation of wells.
Midstream covers transport and storage through pipelines and tankers, and downstream covers refining and selling products such as fuel and plastics. Upstream businesses carry the most geological and price risk.
A well may find nothing, and even a successful one is exposed to the market price of oil or gas, which can swing widely. Projects need large sums of money years before any revenue arrives, so financing and cost control are central.
Finance teams in this sector use specific measures. Finding and development cost shows how much is spent to add a unit of reserves, and lifting cost shows the cost to bring a barrel to the surface.
Accounting for exploration spending is also special, with companies choosing between the successful efforts and full cost methods, which treat dry wells differently. The word has a wider use outside energy.
In any supply chain, upstream means the suppliers who provide inputs, and downstream means the customers who receive the output. A manufacturer might say it has upstream risk if a key supplier fails, and a farmer is upstream of a food processor.
A third use appears in corporate finance. Upstream describes the movement of cash or support from a subsidiary to its parent company, such as an upstream loan or an upstream dividend.
These flows can raise legal and tax questions, because the subsidiary's own creditors and shareholders have interests to protect. Because the word has several meanings, context is vital.
When an analyst says upstream in a report, it usually refers to oil and gas exploration and production, unless the surrounding text discusses supply chains or intra-group transfers.
In practice
Real-world examples.
Example
An independent oil producer drills ten wells in a new field and raises $500,000,000 from investors to pay for them. Its finance director forecasts cash flow under three oil prices. The bank lends against proven reserves, and the figures are updated each year by an independent engineer.
Example
A chemicals manufacturer buys an interest in a gas field so that it controls the supply of a key raw material. This is a move upstream in its supply chain. The finance team assesses the extra risk from commodity prices.
Example
A subsidiary lends $5,000,000 to its parent company to cover a short-term cash gap. This is an upstream loan, so the group's lawyers check that the subsidiary stays solvent and that the loan complies with local law. The loan is documented with an interest rate and repayment date, and the group treasurer records it in the intra-group loan register.
Formula
Calculation
Finding and development cost per barrel = (exploration costs + development costs) / reserves added
Suppose an exploration company spends $100,000,000 on exploration and $200,000,000 on development in a year. It adds 20,000,000 barrels of oil equivalent to its reserves. Total spending = 100,000,000 + 200,000,000 = $300,000,000. Finding and development cost = 300,000,000 / 20,000,000 = $15 per barrel. If oil sells for $60 a barrel and lifting costs are $12, the margin before other costs is 60 - 15 - 12 = $33 a barrel.Case study
Seen in the real world.
Kestrel Petroleum is an illustrative, fictional company with upstream operations in a mature field. Its finance team found that the cost to find and develop new reserves had risen to $22 per barrel, while the oil price had fallen to $40.
With lifting costs of $15, the margin on new barrels had shrunk to 40 - 22 - 15 = $3. The board decided to pause new drilling and focus on cutting lifting costs at existing wells, which the engineers estimated could save $2 a barrel.
When the price recovered to $65, the margin rose to 65 - 22 - 15 = $28, and drilling restarted. The illustrative lesson is that upstream decisions depend on the gap between price and cost, and a patient approach can protect cash during weak markets.
Watch out
Common mistakes.
- Assuming that upstream always refers to oil and gas, when it can also mean suppliers in a supply chain or flows from a subsidiary to its parent.
- Ignoring commodity price risk, when upstream profit depends heavily on the market price of the resource.
- Treating exploration spending as certain to create value, when many wells find nothing.
Questions
People also ask.
What is the difference between upstream and downstream?
Upstream is the early stage that finds and produces the resource, while downstream is the later stage that refines and sells products to customers.
What is midstream?
It is the transport and storage stage between them, including pipelines, tankers and storage facilities.
Why do upstream companies need so much capital?
Exploration and development require large payments for years before production starts and revenue arrives.
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