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Summary

  • Analysts at Barclays recently lifted their price target on shares of Phillips 66 (PSX) from $90.00 to $95.00 indicating a handsome upside potential for the investors.
  • The spread between Brent and WTI will be reduced in the coming periods as WTI prices are likely to increase and adversely affect the bottom line of U.S. refiners.
  • Phillips 66 has diversified to capitalize on the prospects from emerging trends in the industry and is expanding in more profitable operations in oil and gas midstream and chemical industries.

Analysts at Barclays recently lifted their price target on shares of Phillips 66 (NYSE:PSX), the largest U.S. refining company, from $90.00 to $95.00 as reported by Analyst Ratings Network. The company's shares are currently trading at $76.75 and Barclays' price target on Phillips 66's stock indicates a handsome upside potential for investors.

On the other hand, Phillips 66 was downgraded to hold by Zacks Investment Research at the start of April 2014. The major reason behind the downgrade by the firm was the expectations of decline in the company's profitability due to the increase in oil prices as the company is a buyer of crude. The price of crude oil is soaring to around $100 per barrel indicating the fact that Phillips 66's margins will be adversely affected due to a rise in the cost of crude.

Additionally, due to these factors the company experienced a negative drift in earnings estimate revision during the past month.

Therefore in this article I will analyze a few factors that will impact the company's bottom-line beginning with a discussion on forecasts for crude oil prices and the costs for the company.

Cost of Crude Oil and Forecasts

The more expensive Brent is compared to WTI the better it is for U.S. refiners. Phillips 66 has majority of its operations in the U.S. followed by its operations in Europe and Asia. The following chart shows that 11 out of a total of 15 refineries operated by the company are located in the U.S.

Source: PSX 2014 BofA Refining Conference

As a result the company has easy access to the West Texas Intermediate (WTI) crude that is light and of great quality. Consequently, the foremost portion of the company's refining capacity uses light/sweet crude oil as feedstock. Historically WTI traded at a premium compared to Brent but the situation altered since 2011 as shown in the following chart. At the beginning of 2011 a rise in the U.S. light sweet crude oil production despite limited pipeline capacity to transport the crude from production fields and storage locations to refining centers put descending pressure on the price of WTI crude oil. These field locations include Cushing, Oklahoma the delivery point for the Nymex light sweet crude oil contract.

Source: EIA

Going forward, a decline in infrastructure limitations, previously the reason behind lowered WTI prices, are projected to increase the prices of WTI in the coming periods. Since the middle of 2012 considerable enhancements of the oil and gas infrastructure at Cushing will facilitate crude oil flowing to and from the trading hub. The completion of the pipeline and rail projects will also make it possible to transfer barrels from production areas such as Texas and North Dakota to refinery centers without passing through the hub. In addition to improvements in the U.S. crude oil infrastructure to ease the downward pressure on the price of WTI, a reduction in demand for Brent-quality crude, due to the rise in U.S. light sweet crude production, has also been forecasted. This is because the U.S. East Coast refiners that previously relied on Brent and Brent-like crude oil can now access U.S. light sweet oil due to infrastructure enhancements. This will lower the prices of Brent and also reduce the spread between Brent and WTI. Combined, these factors are likely to reduce the spread between Brent and WTI creating a slightly unfavorable situation for U.S. refineries but Brent is still expected to trade at a premium to WTI during 2014 and 2015.

However, Phillips 66 is no longer solely a refining company. Other than the refining, marketing and transportation businesses, the company has become an integrated downstream company investing and expanding in the midstream and chemicals segments. This diversification and expansion towards the midstream and chemicals industry reflects the strength of the company particularly in standing against the adverse effects on its bottom line that the Brent-WTI spread will create. The following heading will discuss this aspect of the company along with impending future prospects due to diversification.

Diversification to Midstream and Chemical Businesses

According to a recent research report the analysts at UBS asserted their optimistic 12-month view for U.S. refining equities. As a result the firm raised its price target for Phillips 66 to $92 from $90 upholding a "buy" rating for the company. The analysts anticipate the company's chemicals and refining businesses to profit from persistent multi-year feedstock cost discounts due to growing North American exceptional crude, natural gas, and NGL production. Additionally, the analysts are also expecting the shares to benefit from the company's growth initiatives. There initiatives are targeting expansion in the company's commodity chemicals and midstream operations that have conventionally reaped higher multiples from investors than refining.

(click to enlarge)

Source: PSX 2013 10K Filing

The following chart shows that the company plans to invest more in its CPChem (chemical business) and midstream operations.

Source: PSX 2014 Analyst Meeting

Phillips 66's expansion of its higher margin operations is anticipated to increase the company's profits. Investors seem optimistic about the initiatives enacted by the company as the company's share price has increased by 28.56% since the previous year as shown in the following chart.

(click to enlarge)

Source: YCharts

Phillips 66's midstream segment consists of a 50% interest in DCP Midstream (NYSE:DPM) and its oil transportation-oriented master limited partnership Phillips 66 Partners (NYSE:PSXP). The company's chemical segment is almost wholly represented by the Chevron Phillips Chemical Co. also known as CPChem.

According to Deloitte, during 2014 investments in the energy revitalization will move from the upstream sector to midstream infrastructure, refinery operations, and petrochemical facilities. An indication of this movement in spending can already be perceived in the capital expenditure budgets of oil and gas companies. This indicates that market players are seeing more opportunities to capitalize on midstream and chemical facilities and Phillips 66's move to invest more in midstream and chemical operations is timely and in line with the industry trends.

UBS Raised Price Target and Concluding Remarks

Phillips 66 is one of three top refining picks by UBS for 2014. In the coming years analysts presume Phillips 66′s total earnings will depend more on midstream and chemicals operations. Consequently, UBS raised its price target on Phillips 66's shares from $86 to $91.

EIA is projecting a reduction in Brent-WTI spread for the coming years as the decline in WTI's price will ease due to improvements in oil and gas infrastructure in North America. Consequently, refiners will have easy access to U.S. light/sweet crude oil and the demand and price of Brent crude oil will drop. This also indicates that investment in oil and gas infrastructure in North America is an emerging trend and Phillips 66's spending to expand its midstream operations means it is capitalizing on positive growth prospects. In addition to this the company is also increasing its capital spending on its chemical operations that also has a strong bottom line. As a result the company's diversification and interest in oil and gas midstream and chemical industries will offset the negative impacts of the decline in Brent-WTI spread and rise in WTI price on the company's bottom line. On average, analysts expect the company to post EPS of $7.18 for the current fiscal year up from $6.02 recorded in FY 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.

Source: Phillips 66: A Stock Worth Investing In