The Chemical Equation of Phillips 66
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
About a month ago I pondered whether the ConocoPhillips (NYSE: COP) spin-off of their Phillips 66 business made sense for shareholders. I really was not sure if two separate businesses would be better than one when in my opinion the refining component of Phillips 66 was best left integrated in a multi-national oil company than trying to make it a go alone. As a long-term holder of Conoco, I’ve been debating whether or not to dump my soon to be issued Phillips 66 shares as soon as I get them. What I don’t want to do is leave money on the table so I want to get to know the new company before I bail on the shares.
After having a chance to take a look at their recent analyst event I am leaning toward holding my shares and collecting the dividend until I decide how best to allocate this capital dedicated to the energy portion of my portfolio. With oil prices still over $100 a barrel and gas over $4 a gallon I’d be earning nothing on the cash while I can pick up the dividend payments which will act as an increased yield on my current ConocoPhillips shares that I plan to continue to hold. I want to run through the three divisions of the Phillips 66 business as I continue to work though my rationale.
When I first heard they wanted to spin off this business I thought shareholders would just be getting the refining and marketing assets and figured I’d be marketing my shares for sale the second I got them. There really isn’t much to like in the R&M industry, the margins are historically low, and the returns on capital are not that high so there isn’t much of a return left over for shareholders. This is by far the biggest asset base of Phillips 66 and the only set of assets that they own outright (though some of their midstream assets are wholly owned). A look at the assets finds 15 refineries, 11 of which are in the US for a total of 2.2 MMBPD of refining capacity. They also have about 10,000 marketing outlets, 15,000 miles of pipelines, 56 terminals and a lubes and specialties business. However, they operate on the lower end of their peers and have stated numerous times that investors will see less R&M going forward. Still they generated adjusted earnings of $2.7 billion dollars last year, which isn’t bad at all, and they are still working to right size this business by shutting down or selling off the less profitable capacity.
When it comes to their midstream business I am of two minds. I love the midstream sector but think that a pure play MLP such as Enterprise Products Partners (NYSE: EPD) is a better way to invest in this asset class thanks to the exceptional tax efficient cash distributions to unit holders. In the case of Phillips 66, their midstream business is a unique collection of assets. The bulk of this business is in a 50/50 joint venture with Spectra (NYSE: SE) called DCP and within DCP is a growing MLP called DPM. The remaining parts of their midstream business consist of some wholly owned fractionators and a 25% ownership of the Rockies Express Pipeline, which is a venture with Kinder Morgan (NYSE: KMI) and Sempra (NYSE: SRE). Conoco had been rumored to want to unload their stake in the pipeline but that’s currently on hold. To me, it’s a bit of a confusing mixture that I could see all being off loaded over time if they can get enough value for the assets. In the mean time though it does produce excellent returns and they have a lot of growth opportunities ahead thanks to the resurgence of the US onshore oil and gas industry.
The business I like the most is their CPChem business, which is a 50/50 joint venture with Chevron (NYSE: CVX). I really like the high returns of this business combined with their strong Middle East position. There is a lot of future growth embedded in this business in both their Middle East positions as well as in the US thanks again to the growth in shale gas. They are the best operator in their industry with leading returns on capital employed. There is a lot to like but it’s a small business providing about 20% of the adjusted earnings of Phillips 66. I must admit however that I am a novice when it comes to chemicals and one of the reasons I want to hold Phillips 66 for a while is to learn more about this industry.
When I look at the assets being spun off to shareholders the chemicals business is the one that interests me the most at the moment. However, I don’t want to unload my shares when they arrive because I do think there is value here that the markets wont realize for a while. R&M plus midsteam plus chemicals is a much better formula for success than R&M alone. I think that Phillips 66 can add to this equation by being able to use their excess cash to buy back shares at a discount while providing shareholders with a nice dividend. They do have several marketable assets that they could realize additional value for shareholders, their interest in the REX pipeline being at the top of the list. I plan to hold my Phillips 66 shares and reevaluate the company in about six months time to see if they are heading in the right direction to turn their asset base into an equation for enhanced shareholder returns.
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