You Gotta Know the Lingo, Vol. 3: Upstream, Midstream, and Downstream

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Fans of The Motley Fool can't help but be aware that it's practically impossible for Wall Street pundits and writers to communicate without some obscure patois slipping into the mix. It's not their fault, of course. The purpose of specialized argot in any arena is to provide folks with shorthand so they don't have to keep repeating long phrases to describe things like "employer-sponsored, tax-advantaged investment accounts whose funds are intended only to be withdrawn in retirement." So much easier just to say "401(k)."

But if you want to play the game, you have to comprehend the conversation, so in this week's Rule Breaker Investing podcast, Motley Fool co-founder David Gardner is bringing in a trio of special Foolish guests to explain six terms that investors might not know as well as they think they do or as well as they'd like to. In this segment, Industry Focus host Sarah Priestley -- who spends a fair amount of time covering the energy sector -- defines and differentiates a trio of terms that get used constantly by folks talking about oil and natural gas companies: upstream, midstream, and downstream.

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A full transcript follows the video.

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This video was recorded on Feb. 21, 2018.

David Gardner: Sarah, a delight to have you join with me. And what is term No. 3?

Sarah Priestley: I'm going to squeeze three terms into one...

Gardner: This is definitely innovative.

Priestley: ... and do "upstream, midstream, and downstream" in the oil industry, because I see a lot of people using it all the time, and often people within the industry don't actually know what falls into these definitions.

Gardner: Now, I might already be one of those that's not going to be able to award myself the two points for being smart about this, because I feel like if even people in the industry don't get this right, Sarah, I don't even want to take a guess at it other than we're talking about how energy reaches us. At what stage it's channeling where it's coming from. Let's start with upstream.

Priestley: Absolutely. Upstream is sometimes called the exploration and production sector, or a factor of E&P. The segment in the industry finds and extracts crude oil and natural gas. They do the geological surveys, they apply for the permits and leases. They search for underground and underwater reserves. They drill the exploratory wells. But they also are responsible for -- once they've found those -- managing and operating the wells so will then bring the crude oil from the ground.

Gardner: Now what is it about the phrase upstream that denotes that?

Priestley: Essentially, the closer you are to the end consumer, the further downstream that you are. Essentially, you're furthest away. You're at the upstream.

Gardner: Thank you very much. I have had some very bad upstream stock picks in the last few years, Sarah...

Priestley: A lot of people have.

Gardner: ... as the oil price -- especially my underwater explorers and others. It hasn't been a great time, although the last six months, it seems like energy and the oil price has been picking up. Around $70 a barrel...

Priestley: Absolutely.

Gardner: ... for a little while, there, so that's been interesting.

Priestley: And there's a lot of opportunity, there, because as you said, people have been fleeing the area, the sector. It's definitely a high-risk, high-reward element of the oil industry. I think if you want a more medium, low-risk, then the midstream, which we're going to talk about next, is definitely where you'd want to allocate your dollars.

Gardner: Midstream.

Priestley: Midstream is essentially the segment that includes all the infrastructure that's needed to move unrefined oil and gas over long distances. This is pipeline, pumping stations, terminals, rail tank cars, tanks, ships, and trucks. It covers a huge amount, and it also bleeds into upstream and downstream, depending on the kind of company you're talking about and things like that.

And given the commercial success of U.S. shale, which we saw boom 2012, 2014, and we've seen the whole result of that with the collapse of oil prices, midstream has become more important. You've got the Eagle Ford and Permian Basin. They're in Texas, so they're close to refineries, but a lot of the deposits -- Marcellus and the Appalachian Basin, South Dakota, Colorado, and Nebraska -- we're aiming very, very far. You're talking thousands of miles.

Gardner: Did I not read that thanks to shale, the U.S. is poised to become the world's No. 1 oil producer.

Priestley: Absolutely, yes.

Gardner: I couldn't have expected that 10 or 20 years ago when I first started The Motley Fool. Sarah, how long have you been at The Motley Fool?

Priestley: Almost two years. Not very long. I'm still a baby.

Gardner: It's a delight to have you. Let's go to downstream.

Priestley: Downstream refers to companies that refine crude oil and transform that into raw materials which we use for a myriad of useful substances. The one that comes, obviously, straight to mind is petroleum for our cars. Not your car -- much more green -- but they own oil refineries and petrochemical plants. Distributed and retail outlets.

This part of the chain is crucial to a lot of different industries. Petrochemicals are used to make rubber, asphalt, fertilizers -- a lot of things that people don't consider -- and downstream is a margin business, so you're essentially hedging on the difference between what you can sell the refined products for, for what you bought the crude oil for, which means it tends to do well, actually, in a low crude oil environment.

Gardner: Sarah, what's an example... I didn't speak to midstream. I should briefly say I've also made at least one pretty bad stock pick midstream, because Kinder Morgan has been a real underperformer despite an attractive-looking dividend a few years ago when I first picked it. But what is a downstream company or two that is of note?

Priestley: So, Phillips 66 and Valero are two that spring to mind. I can definitely empathize in the midstream sector, but I would say that TransCanada looks great right now with the boom of liquid natural gas. So, if you're bullish on that, then.

Gardner: Awesome. Sarah, are you prepared to use one or more of your three terms that you somehow made one term in a single sentence or three?

Priestley: Yes, I'm actually going to call myself out. I'm completely guilty of not being very accessible, so on last week's Energy show, I said, "Rising profits upstream from crude oil sales but narrowing downstream margins." And what I meant by that was that the extractors are experiencing booming profits because obviously they're getting more per barrel of crude oil.

And downstream they're being pressured because, as I said, downstream tends to do well in a low crude oil environment. As these prices come up, you can't necessarily recover all those costs from the marketplace so quickly. You have to be kind of a slow increase, so, yes, it's pressuring margins of the refineries.

Gardner: Sarah Priestley, that was awesome! Thank you very much!

David Gardner has no position in any of the stocks mentioned. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has a disclosure policy.