Understanding the Downstream Oil and Gas Business: Why Refiners Generate More Cash Than Producers

The petroleum industry operates as an interconnected ecosystem with three distinct but complementary layers. While upstream entities extract crude oil and natural gas from underground reserves, and midstream operators handle transportation and storage, the downstream segment sits at the end of this value chain—converting raw petroleum into consumer-ready products like gasoline, diesel, and chemicals. This positioning fundamentally shapes how downstream businesses generate profits differently from their upstream counterparts.

The Business Model That Beats Oil Price Volatility

Here’s the critical distinction: upstream oil companies make money on the gap between production costs and selling prices. Since wells naturally deplete, they must continuously drill new ones, demanding relentless capital expenditure. Downstream operators follow an entirely different playbook. They purchase crude oil at market prices, then refine and market it as higher-value products—capturing profits on the spread between input costs and output prices.

This approach creates a remarkable advantage during commodity downturns. When crude oil prices drop, downstream businesses can lock in cheaper feedstock while their refined products don’t fall at the same pace, at least initially. This lag effect generates outsized margins. Conversely, when oil prices surge, margins compress because refiners absorb higher costs they can’t immediately pass to customers.

The result? Downstream operators generate substantially more free cash flow relative to capital requirements. Most refiners reinvest only 50-60% of cash into maintaining operations, leaving ample funds for shareholder distributions. Compare this to upstream producers spending 75%+ just to sustain production.

Inside the Refining and Chemicals Manufacturing Process

Downstream businesses engage in three primary activities: refining crude oil, manufacturing petrochemicals, and distributing finished products.

The refining process unfolds in three stages:

Separation routes crude through heated furnaces that convert liquids and gases into a distillation unit, where molecules separate by boiling point into distinct fractions.

Conversion (also called cracking) employs heat, pressure, and catalysts to break heavy hydrocarbon molecules into lighter, more valuable ones.

Treatment blends different hydrocarbon streams to create finished products—gasoline, diesel, jet fuel, kerosene, and others—stored until distribution.

Petrochemical complexes take naphtha from refineries or purified ethane and propane from NGL fractionators, then use heat and pressure to transform them into inputs for plastics manufacturers and chemical producers. Marketing and distribution businesses—from retail gas stations to heating fuel delivery services to natural gas utilities—complete the chain by delivering products to end users.

How the Industry’s Giants Operate Differently

Integrated Oil Majors like ExxonMobil operate across the entire value chain—exploring and producing hydrocarbons, transiting them through pipelines, and refining into consumer products. This “wellhead-to-end-user” model maximizes value capture but introduces complexity.

Pure-play downstream companies focus exclusively on refining, chemicals, or distribution. During strong commodity environments, these specialists can deliver outsized profits. However, when market conditions weaken, their earnings face pressure since they lack the diversification of integrated peers.

Three Case Studies: Contrasting Downstream Strategies

Marathon Petroleum emerged as the U.S.'s leading independent refiner following its 2018 acquisition of Andeavor. The merger delivered significant cost synergies and scale. Refining generates over half the company’s EBITDA. Marathon strategically invested in equipment that processes cheaper North American crude—particularly U.S. shale output that trades at discounts to imported barrels—while boosting capacity for higher-margin refined products. The company also owns stakes in master limited partnerships like MPLX, providing steady fee-based income that buffers refining volatility. Retail operations under the Marathon, Speedway, and Arco brands connect the company to end consumers. These layers of integration allow Marathon to retain margins across most of the oil industry’s value chain. The company targets returning roughly 50% of cash flow to shareholders via dividends and buybacks.

Phillips 66 takes a differentiated approach. The company specializes in processing heavy Canadian crude oil, which historically sells at steep discounts due to pipeline constraints in Canada. Rather than betting on massive, multi-year capacity expansions like some rivals, Phillips 66 favors lower-capital, faster-payoff projects that squeeze additional volume from cheaper feedstocks while increasing premium product output. The company holds a 50% stake in CPChem, a joint venture with Chevron focused on petrochemical manufacturing, particularly in the U.S. Gulf Coast where raw materials remain abundant and affordable. A downstream marketing segment sells gasoline, diesel, and aviation fuel through thousands of licensed independent retailers operating under Phillips 66, Conoco, 76, and Jet brands. Phillips 66 Partners and DCP Midstream—two master limited partnerships where Phillips 66 holds stakes—have organically expanded pipeline capacity and processing facilities. With the industry requiring $44 billion annually in infrastructure investment through 2035, these growth avenues remain substantial. The company allocates roughly 40% of cash flow to shareholder distributions and reinvests the remainder into high-return expansions, predominantly midstream projects. This balanced strategy has generated approximately 250% total returns since the company’s 2012 formation, outpacing the S&P 500’s ~115% over the same window.

Valero Energy held the global independent refiner title as of early 2019, operating refineries across the U.S., Canada, and the United Kingdom. The company maintains a significant marketing and distribution footprint with branded outlets spanning multiple countries. Its smaller logistics business—consisting of pipelines, storage, and export docks—primarily supports refining operations. Uniquely, Valero operates a large-scale ethanol business providing low-cost gasoline additives to its refineries. The company also owns 50% of Diamond Green Diesel, which produces renewable diesel. While Valero generates less steady midstream fee income than Marathon or Phillips 66, its integrated refining and ethanol operations still generate substantial cash. Like Marathon, Valero targets returning 50% of cash flow to investors through dividends and share repurchases, reinvesting the remainder into refining and renewable fuel expansion. The company has retired significant share counts since 2011, rewarding long-term shareholders.

Why This Segment Deserves Portfolio Consideration

Downstream companies and upstream oil producers exhibit inverse performance patterns during commodity cycles. When crude prices fall, refiners thrive while producers struggle. This natural hedge makes pairing downstream equities with upstream exposure an effective portfolio diversification strategy.

The capital-light nature of refining operations—compared to drilling—means downstream businesses convert revenue into cash more efficiently. Without the drilling treadmill consuming most earnings, these operators retain substantial excess cash for shareholders. Over time, this superior cash generation has translated into better stock performance relative to most oil producers.

For investors seeking petroleum exposure without enduring the acute volatility of exploration and production stocks, downstream businesses in refining, chemicals, and distribution offer a compelling alternative. Their distinct profit mechanics, cash generation potential, and shareholder return orientation provide meaningful portfolio benefits, particularly during periods when crude prices face headwinds.

Exchange-traded funds like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which holds both upstream and downstream operators equally weighted, provide convenient exposure to the downstream segment without requiring individual stock selection.