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Phillips 66 (NYSE: PSX) is an undervalued company that is going to take the oil and gas industry by storm. In 2002, Conoco and Phillips 66 merged to form ConocoPhillips (NYSE: COP), making the second largest refiner and marketer of petroleum products, behind Exxon Mobil. Phillips 66 was spun off from ConocoPhillips, the integrated energy giant, just two months ago. To learn more about the best way to profit from this spin-off, here is a good place to start. Each shareholder received one PSX share for every two COP shares, and PSX had a solid rally of about 3% on the first day of trading. Since the first day Phillips became an independent company again, the stock has been depressed almost 500 basis points. In the same period, the S&P 500 benchmark has fallen less and did not experience such a roller coaster ride.
So what does Phillips do? When ConocoPhillips was one giant company, it handled everything from the first step of searching for suitable areas for oil exploration to the last step of selling gas under the “Conoco,” “Phillips 66,” and “76” names in the Mid and Southwest US and under the name “Jet” in Europe. The separation divided the company into upstream and downstream businesses. The so called “upstream” business holds the ConocoPhillips name and operates in the exploration and production sector, where it searches for potential oil and gas fields, drills, and operates wells to recover crude oil.
Phillips 66 handles the rest of the process through three major segments grouped under “downstream” operations: refining and marketing (R&M), midstream, and chemical. Phillips is strategically positioned worldwide to obtain cheap crude oil and natural gas and to sell refined petroleum products at competitive prices.
Refining and Marketing
R&M refines crude oil and other feedstock in petroleum products, such as gas for our cars or fuel for planes, and then transports and sells them primarily in the US, Europe, and Asia. Phillips is a leader in R&M with 15 refineries, 80,000 miles of pipeline, and a crude oil capacity of 2.8 million barrels per day. With 11 refineries in the US, three in Europe, and one in Asia, Phillips’s R&M is one of the top in the industry. Refiners and marketers have been facing tough times, though, as crack spreads (the price differential between crude oil and the petroleum products extracted from it) have not been favorable.
In the first quarter of 2012, the R&M segment reported earnings in the US down $16 million due to lower refining margins and higher operating expenses. It was hit hard by international losses of $7 million because of $42 million in after-tax property impairment from cancelled projects, higher taxation, and lower margins. Margins for upcoming quarters will be substantially more attractive, however, as Phillips 66 is improving crack spreads and working towards lower operating expenses. Phillips also partially offset their losses with high refining volumes.
Midstream
Though called midstream, this segment is often grouped under downstream operations. Midstream buys raw natural gas from producers and gathers natural gas from pipelines. Natural gas is then processed to extract NGLs (Natural Gas Liquids), which are fractionated into individual components including ethane, butane, and propane. The segment is mainly operated through a 50% interest in DCP Midstream (NYSE: DPM), a joint venture between Phillips 66 and Spectra Energy (NYSE: SE). DCP is one of the biggest natural gas gatherers and processors in the US with 61 natural gas processing sites and $4 billion in growth projects through 2014. First quarter earnings were up significantly year-on-year as higher gathering and processing volumes offset weaker demand for NGLs. These figures are expected to grow even more impressively next quarter from higher NGL demand.
Most importantly, Phillips is positioning itself strategically for the shale gas boom. Shale gas is natural gas trapped in shale formations and extracted using horizontal drilling and hydraulic fracturing. Many analysts believe that shale gas will lead to full US energy independence in only 15 years. Phillips is increasing shale oil processed in its refineries from 100,000 barrels a day to over 450,000 and is expending $6 billion in new pipelines. It is also extending rail lines to haul crude oil, which is four times cheaper than traditional trucking. Lower operating costs, improving margins from summer demand for NGLs, and increasing volume from shale gas will boost the bottom line for Phillips 66.
Chemicals
Phillips’ chemical operation manufactures and markets petrochemicals and plastics worldwide. Business is mostly carried out through a 50% stake in Chevron Phillips Chemical Company, a joint venture with Chevron (NYSE: CVX). CPChem is a leading producer of olefins and polyolefins, which are used in consumer goods, plastics, food packaging, and more. CPChem uses NGLs and other feedstock, which is fed from midstream operations to produce petrochemicals. The chemical segment has benefited from low natural gas prices, as it is an input for its operations. Superior margins and substantial volume have allowed Phillips to add more than $30 million to its bottom line last quarter, year-on-year. Phillips’ rising exposure to shale gas will be a huge advantage to the chemicals segment as well. Phillips is building the world’s largest 1-hexane plant in Texas and is also considering a $5 billion ethane crack and ethylene complex in the Gulf coast. This project, if executed, would increase CPChem’s US ethylene capacity by over 40% and allow further leverage of shale gas developments.
Economic Forecasts and Estimates
The chemical and midstream segments will drive earnings growth in the second half of 2012. The two segments currently make up 40% of earnings, but Phillips is shifting operations heavily to benefit the two. Rising natural gas demand will benefit the midstream operations substantially, with the chemical segment still able to obtain feedstock at competitive prices. Chemical earnings are expected to exceed $900 million in 2012 from high demand and cheap feedstock, and Midstream is expected to raise the bottom line by $37 million in 2012; the R&M segment is likely to experience better growth as well. WTI crude oil prices averaged more than $100 per barrel over the first quarter of 2012 and should drop by more than $5 per barrel on average for the 2nd half of 2012, which will boost margins. The EIA (Energy Information Administration) expects gas prices to rise not only this summer, but for all of 2012 compared to a year earlier. The EIA also predicts that the demand for distillates, including diesel and heating oil, will rise by 0.7% in 2012 and 2.4% next year. In 2013, the EIA expects a whopping 30% rise in natural gas prices.
The Stock
PSX has tons of room for growth. A discounted cash flow analysis using a weighted average cost of capital of 10% and a terminal growth of 3% yields a $40 intrinsic price for PSX, an 18% upside. Moreover, in the third quarter this year, PSX is expected to issue a $0.80 dividend and announce a share repurchase program. Return on capital for PSX has improved from 1% in 2009 to 4% in 2010 to 13% in 2011. At this pace, PSX will become an efficiency and profitability machine. Its main competitors are Valero Energy (NYSE: VLO) and Marathon Petroleum (NYSE: MPC), which specialize in downstream operations as well. Phillips 66 competes with Valero for the largest downstream company and is twice the size of Marathon. Meanwhile, it trades at just 4.6X earnings while Valero is at 8.5X and Marathon is trading at 6X. PSX is clearly a cheap stock right now that, as a growing spin-off, is perfectly positioned to dominate the downstream oil and gas industry.
This article is written by Simon Osipov and edited by Jake Mann. They don't own shares in any of the companies mentioned above. The Motley Fool owns shares of ExxonMobil. Motley Fool newsletter services recommend Chevron and Spectra Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
