What Are Downstream Energy Companies?

Upstream and Downstream are terms that refer to a company's location in the energy supply chain. The closer to the end user a service or firm is, the further downstream it is. At Miller/Howard Investments, we include in our Downstream category utilities, refiners, marine shippers, and terminals, though gas and electric utilities figure most prominently.

Downstream companies are among the most direct Beneficiaries of the shale revolution, as the abundance of domestically available natural gas works to hold prices down. Downstream companies‘ performance tends to show little or even inverse correlation to oil and gas prices, thus increasing portfolio diversification and broadening investment opportunities across an array of companies that benefit from ample low-cost domestic oil and gas resources. As an example, low natural gas prices help keep utilities' total cost of service lower, which makes it easier for utilities to obtain regulator permission to invest in larger capital projects—the main source of profit growth for regulated utilities.

Why Focus on Utility Companies?

We believe that the United States' increased production of shale gas, which has grown sixfold from 2008 through 2015, is the dominant theme in the energy industry. Utilities and their customers (the American consumer) are among the foremost Beneficiaries of that trend. The increased gas supply and resulting lower prices for the commodity have caused a surge in natural gas usage as a fuel among electric power generators and industrial companies. In 2016, natural gas will power more electricity generation than coal on an annual average basis for the first time in US history.

Factors that Distinguish Utilities from Other Companies

Essential services and monopoly status. Utilities provide essential services to society. It's hard to envision life without lights, or without the ability to stay cool in the summer and warm in the winter. Imagine the chaos that would result if the local electric or gas company decided to cancel service because a municipality didn't generate sufficient profits. To avoid the problems that free-market forces can create in the delivery of essential services, state and local regulators grant utilities monopoly power in their operating area.
Regulation and allowed rates of return. Another benefit of regulation is that it helps reduce earnings fluctuations. Utilities are capital-intensive, requiring significant expenditures to build, maintain, and update the power grid's infrastructure. The regulators' role is to allow utilities to earn a reasonable return on their capital investments. It's a balancing act between utilities' goal of earning the highest possible returns and satisfying customers' desire for low energy costs.
Visible earnings and dividend growth. This regulatory framework, in our view, usually results in steady and reliable revenues, a reasonable return on invested capital, and moderately growing dividend yields that are often among the highest we've seen in the market. It's a business model that we feel conservative income investors will value, especially in periods of low interest rates or market volatility.
Direct benefit from the shale revolution. The growth of shale gas supply has provided an additional financial benefit to both consumers and utility investors. The price that utilities can charge customers reflects both the allowed return on capital investments and the cost of fuel used in power generation or for delivery. When energy commodity prices are high and customers' bills are increasing, regulators are often hesitant to grant higher rates of return on investment. But when natural gas commodity prices are declining, as they have been in recent years, regulators are more likely to approve rate base increase requests because customers' overall utility bill increases have been muted by the lower fuel expenses.

INVESTMENT PRODUCTS: ARE NOT FDIC INSURED • MAY LOSE VALUE • ARE NOT BANK GUARANTEED

© 2017 Miller/Howard Investments, Inc. All rights reserved.

This material represents Miller/Howard Investments' views. These views may change based on changing circumstance. The information provided should not be considered a recommendation to buy or sell any security, and should not be considered investment, legal, or tax advice. Information is obtained from sources believed to be credible and reliable, but its accuracy, completeness, and interpretation cannot be guaranteed.
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