Looking Downstream For Opportunity

The dramatic fall in oil prices that we have witnessed over the last four months has dragged almost all energy related stocks with it. This is hardly surprising as the price of crude is still the benchmark by which energy prices are set. In the case of many exploration and production (E&P) companies the drop in prices has an obvious effect on revenues and profitability, but in some cases stock in companies not directly affected has been hit just as hard and this results in opportunities for investors.

The oil and gas industry is usually split into three sectors, upstream, midstream and downstream. As the names would imply, upstream refers to companies that build and operate wells that extract the commodities, midstream refers mainly to the transportation of that oil and gas to terminals and refineries, and downstream operations are what happens when it gets there; the refining and processing of crude oil and natural gas as well as the marketing and distribution of the related products. In general terms the further you get from production, the less the impact of falling oil prices. They can still hurt for sure, but not as much.

Taking this one step further, if you look at suppliers to the downstream sector they are even less damaged by low crude prices. In fact, in certain cases where fuel is a cost as well as a product, the effects of lower commodity prices are partly offset by lower fuel costs. It would be logical then if a supplier to downstream companies, such as Flowserve (FLS) had seen much lower declines in their stock than the producers; logical maybe, but not the case.

When the price of oil first started to fall, FLS held up pretty well, but as the pace of decline picked up FLS caught up. Oil has dropped from around $110 per barrel at its peak to nudge $80, a drop of around 27 percent. FLS dropped an almost identical 28 percent from its high in May before beginning to retrace as stocks bottomed out a couple of weeks ago. Despite that bounce, the stock still looks hugely undervalued.

Flowserve make pumps, valves and seals for industrial use. The oil and gas industry is certainly a major part of their business, but it accounts for less than half, with the remainder coming from chemical, power, water and general industrial companies. Even within that oil & gas exposure, the upstream operations most directly impacted account for less than 10 percent of Flowserve’s revenue, according to estimates in a Stifel research report.

It seems crazy then that FLS has fallen virtually in lockstep with oil over the last couple of months. It would make sense if the company had other problems, but they have continued to consistently grow EPS each quarter. The fact that the company is 93 percent owned by institutional investors gives some idea of the level of stability.

Of course, the falling oil price will put the brakes on the shale boom in the U.S. that has fueled some of that growth, but the increased flow of oil and natural gas still demands that downstream capacity be increased. Most estimates expect downstream capital expenditure to meet that need will reach around $75 Billion over the next five years and Flowserve, as a market leader, is positioned to benefit from that.

It is understandable that FLS has declined somewhat as oil prices have dropped, but there is every indication that in this case the selloff has been overdone. If that drop turns out to be an indication of a massive global slowdown in industrial production then Flowserve will no doubt be impacted, as will almost everything else. For now, though, the big drop in the stock looks more like an opportunity than a reason to worry.