How crude oil dynamics influence the upstream and downstream sectors

Summary

  • Crude oil prices have witnessed a dramatic journey, rising from a negative territory in 2020 to the pre-pandemic levels in 2021.
  • The dynamics in crude oil prices have a significant impact on all the sectors of the oil & gas industry.
  • Amid declining crude oil prices, upstream is the hardest-hit sector, whereas the downstream sector can increase its earnings based on certain regional scenarios.

Crude oil prices have been on a roller-coaster ride since last year. The commodity saw some of the darkest days in its entire history when WTI crude oil prices touched negative territory in April last year due to coronavirus pandemic-induced challenges.

There was nearly no demand for crude oil, as COVID-19-led lockdowns impacted the to-and-fro movement across national and international borders.

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However, the situation has changed now. As of May end, the crude oil prices have rallied more than 35% in the last one year.

The production cut decision by OPEC and its allies to clear oil gluts and a stable market have lifted the prices to their pre-pandemic levels. Additionally, Saudi Arabia’s unilateral decision to cut its production by 1Mbpd has positively influenced the oil market.

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The crude oil price has direct impacts on the sectors such as aviation, transport, lubricants, plastic, fast-moving consumer goods, rubber, and paint. As soon as crude oil prices go down, the transportation cost also declines, thus lowering the expense of a company.

While on the flip side, lower crude oil prices could negatively impact an oil & gas firm. The maximum impact is seen on the upstream industry in the entire value chain of the oil & gas industry, as the latter involves most of the industry's expense to extract crude oil and gas. However, with lower crude oil prices, the downstream sector can earn higher margins.

Impact of cost dynamics on oil & gas industry

Oil breakdown has obvious effects on the finances of an organisation, which is also responsible for the asset impairment. Lower crude oil prices mean lower profits from oil & gas business units. This in turn, reduces the net present value (NPV) of an asset.

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Rising crude oil prices can drive the prospects for upstream companies as well as downstream companies. Players operating in both sectors can improve their earnings outlook. With rising oil prices, the liability of upstream companies to share the subsidy with downstream or oil marketing companies gets reduced.

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A rapid fluctuation in the crude oil price dynamics makes it difficult to estimate the NPV of an asset for investment decisions and capital allocations.

An oil & gas business is divided based on various facets including drilling, exploration, refining, and distribution of petroleum products. The impact of crude oil price movement on a company is directly linked with the segment that it is operating within the industry.

On a major scale, the industry is divided into the upstream and downstream sectors. The upstream segment includes players that are directly involved in the exploration and production of crude oil from the subsurface deposits. Downstream companies are engaged in the refining of raw crude and gas for conversion into the finished product, which is then transported to end users.

Let us have a glance at the impacts of oil cost dynamics on both sectors.

Impacts on Upstream Sector:

Upstream is the hardest-hit sector during the breakdown of crude oil prices as the selling price of crude oil is determined by market sentiments, whereas the production cost is fixed and requires a fixed sum of investment.

If the cost of production of a barrel of oil is more compared to its market selling price, the company will eventually face losses.

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The extraction of crude oil requires a huge investment in drilling rigs, crew, storage, and transportation, etc., and a slight change in crude oil prices can significantly affect the entire supply chain.  

With declining oil prices, it is reasonable to expect that more expensive production operations would be reduced to maintain the profits of a company. The prospects of continuation of investments in new projects come to a temporary halt until the prices go up as these projects require substantial investment.

Cost-cutting is another very common consequence of oil breakdown. Companies announce significant spending cuts to reduce their expenses to sustain in the market.

Delay in final investment decisions (FID) of new projects is another ill effect of decline in crude oil prices.

Additionally, reduction in service contracts as a measure to reduce company expenses is regularly witnessed in the oil industry.

Good Read: Why were the oil prices volatile in May?

On the flip side, a rise in crude oil prices provides leverage to oil & gas firms for higher investment and increases the risk-taking capacity of that organisation.

Impacts on Downstream Sector:

While upstream is the hardest-hit sector with oil downturns, downstream has the reverse effect with a fall in crude oil prices. The downturn condition offers an exciting opportunity to the downstream sector for good revenues and profits.

However, the scenario is not uniform in all the regions. The companies need to understand the market dynamics and choose their strategies carefully if they intend to capitalise on oil downturns.

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The lower-price environment can be a blessing for various oil & gas companies. With a fall in crude oil prices, feedstock costs fall substantially. At the same time, the demand for the company's product rises, fuelled by a pick-up in economic growth due to relatively lower crude oil prices. The downstream companies increase their profit margins during crude oil breakdowns.

With higher margins, the downstream companies are well positioned to go ahead with transactions that were not feasible earlier. Rather than building new infrastructure, some companies consider the acquisition of new refining assets.  

Must Read: Demand-supply game balancing the crude oil markets


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