I had always admired the “old” Conoco Phillips that included what is now ConocoPhillips (COP) and the new Phillips 66 (PSX). It owned immense oil, natural gas, and refining assets, and due to some historical mismanagement and the fact that it was an oil explorer without pockets as deep as rivals Chevron and what is now ExxonMobil, it always traded at a substantial discount to its peers.
For most of the 1990s and early 2000s, Conoco could be purchased with a 4% or 5% starting yield, which would get reinvested at low prices, and it created the type of situation where someone could make look back on several years of financial statements and see the compounding of dividends getting reinvested build wealth right before their eyes, even in as short of a time frame as 3-5 years.
In 2012, as we all know, Conoco decided to spin off Phillips 66, with the ConocoPhillips shareholder base receiving one share of the new Phillips 66 for every 2 shares of Conco held. As in, if you held 1,000 shares of Conoco on April 29, 2012, you would find yourself owning 1,000 shares of Conoco on April 30, 2012 with 500 shares of Phillips 66.
Phillips 66 is a downstream energy company comprised of four units. The Refining division owns or has a stake in 13 refineries with a net crude oil capacity of 2.1 million barrels per day. The Marketing and Specialties segment includes wholesale and retail fuel marketing and power generation businesses. The Midstream unit holds a 50% interest in DCP Midstream, one of the biggest natural gas gatherers and processors in the U.S. Lastly, the Chemicals division consists of a 50% stake in Chevron Phillips Chemical, a top producer of olefins and polyolefins. The company had an IPO for Phillips 66 Partners in 2013 (Phillips 66 owns 57.0% of the partnership units).
“Downstreaming” is just a fancy word for taking a product and turning it into finished product. In the case of Phillips 66, downstream production means refining crude oil and distributing its byproducts — specifically including gasoline, natural gas liquids, and diesel — down to the retail level that it can be sold to a gas station or what have you.
Historically speaking, refiners have been “ok” investments. The refining arms of Marathon oil, as well as other subsidiaries that are now part of Occidental and Halliburton, returned 8.5% returns from 1962 through 2012. The total returns were slightly less than the U.S. stock market as a whole, and due to the cyclical nature of the oil industry, the price volatility was extreme.
The original Marathon Petroleum subsidiary fell 75% in stock price at one point in the 1980s, whereas the S&P 500 had never delivered losses of greater than 40% over the same time frame. It would be approximately accurate to say that the refinery investing can take you to a low twice as low as a market-tracking index fund, but the returns that investors receive do not typically match the S&P 500. It’s a classic case of uncompensated volatility.
For that reason, I have not regarded the Phillips 66 as a particularly wise move, as I find they can perform best when part of an energy conglomerate like Chevron, ExxonMobil, Royal Dutch Shell, or even the old Conoco. My basis for this preference is that well-capitalized parent companies can inject capital into the refiners and buy out poorly-capitalized competitors during market droughts, and can remove the excess profits during the boom years to bolster their chemical and other less cyclical operations. In short, the Big Daddies can give you money when you need it, and take it from you when you don’t and redirect it to something that does.
But Phillips 66 wasn’t just any old refiner. It was spun off at a time when it was earning over $4 billion in profits and the initial dividend was started in the $800 million. Unlike most refiners where the dividend payout is poorly managed due to cultural expectations, Phillips 66 was starting from a position of an incredibly low payout ratio with very high retained profits.
The best strategy would be for a refiner to say “We can’t be one of those companies that raise the dividend every year for half-a-century, we’ll pay you big cash dividends during good times and we will need to retain our cash during poor times because we’re barely profitable.” Dividend growth is great when the economics of the business support it, but can undermine the business when borrowing becomes necessary to maintain shareholder’s previous expectations.
Due to Phillips 66’s low dividend payout ratio, it has been able to repurchase almost 30% of its outstanding shares since being spun off, reducing the share count from 623 million to 440 million. That is why, despite the fact that profits have fallen from over $4 billion to over $2 billion in the past seven years, earnings per share are only down from $6.48 to around $5 per share.
The stock, which currently yield 4.34%, only has to pay out about 60% of its profits as dividends despite the falling profits because the company started its dividend payouts at such a low initial pace.
So far, Phillips 66 has been a great investment. It’s up 183% in seven years, plus dividends which takes the total return up to 238% over the same time frame. The hard part, as always, is figuring out the future from here. I fully expect that, between 2019 and 2030, there will come a point when shareholders encounter a price south of $50 and north of $200 per share, adjusted for any future splits that may occur.
What I like about the company is that, for a refiner, it is conservatively financed with only $11 billion in debt, with only $3.5 billion due within the next five years and most of it at a rate below 5% financing. For a capital-intensive business, that is not bad. It will survive the next bear market for refiners, based upon its current assets and balance sheet strength.
This is not the kind of company that I would put 10% or more of my net worth in. At most, I would cap it at 5%, and if the position grew above that, I would take the dividends and deploy them elsewhere.
For those who own it as a small portion of their portfolio and reinvest, I expect that no other refiner will deliver more competitive returns with the S&P 500 than Phillips 66, I expect that high cash dividends over a multigenerational period will come the way of shareholders, but I also expect that extreme price volatility and maybe even a dividend-cut-and-rebuild could occur at some point in the next two decades.
On a total return basis, I think there are some oil supermajors that will dramatically outperform it. Phillips 66 is in the area of the investment universe where it is better than the typical S&P 500 component but it’s no Johnson & Johnson. The inherent economics are difficult to beat the market over a long time, and it’s incredibly volatile, but what it does have, is managed optimally.
Originally posted 2019-05-25 11:47:47.