Over the year, we’ve seen a great deal of debate occurring over the environmental feasibility of the Keystone pipeline project. This project proposes to build a massive new pipeline from Canada, which will transport petroleum products all the way throughout the USA. While environmentally contentious (particularly in Nebraska), the project serves to relieve a massive gap in supply and demand between the two regions, and therefore carries a massive economic implication.
While I don’t see this column as being the place to argue over the benefits and detriments of the project, I do want to take a moment to discuss the investment implications of this project. Specifically, it is important to understand how major pipeline infrastructure has a greater impact on larger production companies than it does smaller.
When valuing a small-cap petroleum company, the three biggest indicators of value are cash flow, reserve and/or production prospects, and the company’s potential as an acquisition target. In looking at these metrics, it is important to understand that, at least in most situations for a smaller company, cash flows will be generated by selling oil off to a mid-streaming or fully-integrated company, meaning that cash-flows are generally in place as a representation of how much product the company is actually producing.
How it is that the product is actually distributed after being sold off doesn’t really matter to the smaller company, because they are sacrificing the integration profits so that they can focus on increasing their volume. This means that the company’s valuation will be based mainly on how much product it is producing now, will be able to produce in the future, and how appealing these metrics would be to an acquiring company.
While the valuation of a larger petroleum company will be very similar to the above framework, it is important to realize how the size of the company can act as a disincentive to acquisition, because it becomes too comparatively expensive. As such, valuation models for mega-cap petroleum companies tend to favour an ability to integrate upstream and downstream aspects of production and distribution, so as to maximize the value that is generated for the shareholder.
This means that many larger oil companies will negotiate their own pipeline agreements, and distribute their own product. One of the main reasons as to why this is seen to create value is because of the way in which the sheer amount of product being produced by these companies needs to be sent across a great geographic region in order to find an appropriate level of demand. Essentially, the companies are producing so much oil that they need to have access to an infrastructure network in place to sell it all across the continent.
Looking at these two valuation models, it suddenly becomes apparent why larger companies are more sensitive to pipeline politics than smaller companies. Is the pipe doesn’t go in, the larger company needs to pay more for trucks to ship all the product to its destination. However, if the pipe does go in, it ensures that the company will have access to a larger breadth of market, and therefore have a strong ability to continue profiting.
Conversely, the small-cap company only needs to focus on getting the product out of the ground, and let someone else worry about the distribution problems. This means that the small-cap company will generally only be impacted by the pipeline’s impact on the price of their product, as opposed to its distribution capabilities.
