Debunking Warren Buffett’s Phillips 66 Investment

If Warren Buffett did not recently agree to buy Precision Castparts for $32 billion, I think he would have considered finding a way to buy Phillips 66 outright. The problem is that the company’s market cap is around $42 billion, and when you factor in the necessary premium to purchase a business outright, it would have likely consumed all $60+ billion of Berkshire’s resources and put the company’s cash hoard below the $20 billion desired level. So he had to settle for a $4.5 billion, 10.8% stake instead.

Much of the conventional reaction to Buffett’s purchase can be found in the Wall Street Journal or in the litany of analyses offered by Seeking Alpha writers, and I just want to address two of the specific conventional wisdom claims that you have read about Buffett’s Phillips 66 purchase.

Conventional Wisdom #1: Buffett’s purchase of Phillips 66 is “proof” that he thinks the price per barrel of oil is going to stay low for awhile, and this prediction indicates that investors should be in no rush to scoop up the deals among the other oil majors.

My Argument: Buying Phillips 66 is not, as many people claim, proof that Buffett thinks low oil prices are here to stay. I understand why people think that. Phillips 66 is widely known as a refiner, and refiners benefit from lower prices of oil because they have to pay less for each barrel of crude oil to perfect (and can thus capture higher margins by doing so).

But you need to read the annual report. CEO Greg Garland has been stressing for two years now that Phillips 66 is not interested in using retained earnings to buy new refineries. It is using retained earnings to buy chemical divisions, buy out franchises that operate Phillips 66 gas stations, increase its chemical joint venture with Chevron, and begin investing heavily into midstream projects. Midstream refers to the actual pipelines and anything else that helps transport oil to its final locations.

Garland has even put specific numbers on his intentions. He mentions that, by 2018, he wants the refinery to make up 35% of Phillips 66’s overall business. It is 60% of the overall business now, and was 85% of the business at the time Conoco spun it off in April 2012. Phillips 66 is positioning itself to be equal parts refinery, chemical divisions, and midstream assets. This is a strategy that will benefit moderately from higher oil prices, and will see refinery profits shoot through the roof when oil gets cheap. Most see this as a Buffett bet that oil will stay cheap; I see it as an act of oil price agnosticism that seeks to make money from energy regardless of economic conditions.

Conventional Wisdom #2: Buffett’s purchase of Phillips 66 is also accompanied by a “Buffett premium” because peers Marathon Petroleum and Valero Energy only trade at 8x earnings while Phillips 66 trades at 12x earnings.

My argument: The word premium is used way too lazily in the investor community, often used as a synonym for “This stock has a P/E ratio that is higher than another company in the same industry.” I think the word premium should be used to describe a stock price that is trading higher than you’d fairly expect.

In the case of Phillips 66, it has much more attractive operations than Valero and Marathon. It has more cash than those two. It has less debt relative to annual profits. It has a larger credit line available, if possible. It has a profitable chemical joint venture with Chevron, and there is nothing quite analogous going on at Marathon or Valero. It has geographically desirable locations that involve less costs to refine, and Phillips 66 has long-term contracts giving it a $20 per barrel discount over its peers. And, it is entering the highly lucrative oil transportation space, which is the main reason why Kinder Morgan shareholders have reaped 20% annual returns since 1997.

I don’t think Phillips 66 should be stated as having a premium compared to Valero or Marathon. It has a superior balance sheet, current business characteristics, and better future plans than those two other refiners. It is entirely justified based on the fundamentals of the company. I would not use the word premium to describe something that is deserved. Phillips 66 sells at 12x earnings, and probably represents a better bargain than its two peers trading at 8x earnings, and will almost certainly deliver outsized risk-adjusted returns.

The only downside to Phillips 66? If the price of oil balloons to $110+ in a short period of time, it will lag all of the oil majors. It will especially lag Conoco Phillips, which focuses solely on the exploration and production side of the equation. Phillips 66 is positioning itself to be an industry leader in bad times and hold up competitive in normal energy environments, but it will be a laggard during a period when commodities rise quickly. That may not be the end of the world either, as Phillips 66 keeps a lot of cash available to buy back stock and may do so aggressively if the price is stagnant during the next energy market boom.