If 2015 was a poor year for energy companies, 2016 will likely be a year of consolidation for the heavily indebted weak links. However, not the entire sector has been hit hard by the sharp downturn in oil and gas prices. In particular, downstream refinery production has benefited from lower restocking costs and near record oil production globally. This has kept companies like Phillips 66 (NYSE:PSX) in positive performance territory year-to-date while many other integrated peers in the sector are busy dealing with the fallout from the softness in prices. At a time when investors are looking for increasingly defensive positioning owing to elevated market volatility and more downside risks, Phillips 66 stands out as a promising channel to dodge much of the existing energy industry hazards.
When The Best Offense is a Strong Defense
One area of the oil and gas industry that has remained mostly insulated from the dramatic drop in commodity prices has been the midstream and downstream operations. Even though the industry is going through a day of reckoning after prices tumbled with futures curves showing no recovery above $50.00 per barrel before 2021, Phillips 66 was able to avoid many of the pitfalls thanks in large part to its diversified operations that also count chemical production amongst its three core businesses. Even though margins in the refining business have been shrinking modestly over the past few months as evidenced by the fourth quarter earnings report, this is not an overwhelming problem for the company which is benefiting from more robust margins in the chemical division.
While it is easy to make the case to sell many integrated oil and gas companies because of upstream exposure, downstream operators have shown standout performance with Phillips 66 proving one of the few success stories of the last year. However, while the upside potential in beleaguered integrated oil and gas companies is evident based on the tumultuous price action of the last year, it ultimately depends on oil and gas prices rebounding. Refiners on the other hand are benefiting from lower restocking costs thanks to the ongoing supply-demand imbalance which has created price competition amongst producers. This will help Phillips maintain or even expand refining margins over the coming years, especially if the oversupply conditions are not alleviated and distillate and fuel demand growth remains positive.
Compelling Performance and Financials
Compared to major benchmarks, Phillips has stood out as an industry stalwart thanks to its effective downstream operations integration with midstream and chemicals divisions which increases efficiencies. One a one-year basis, Phillips 66 has returned 13.51% compared to -2.81% for S&P 500 futures over the same period. Standing at $2.48 billion for the fourth quarter, capital expenditures are by no means small, but these allocations mean greater productivity in certain key divisions and expanded production in the petrochemicals arena. Even with the uptick in expenditures, net operating cash flows continue to grow, currently trending above $1.50 billion as of the latest earnings report.
From a balance sheet perspective, Phillips 66 goes from strength to strength. With $3.07 billion in cash and equivalents alongside only $8.89 billion in total debt, the company has a very manageable position financially. Aside from robust financials, Phillips has shown strong performance during earnings season, routinely beating the consensus estimate. Should oil prices begin to rebound further helping to alleviate existing pressure on the refinery business margins, it could also be a boon for share prices and help bolster the bottom line for a business that has remained relatively stable despite some sensitivity to oil and gas prices.
Delivering Strong Shareholder Value
Since splitting from ConocoPhillips (NYSE:COP), Phillips 66 has grown the dividend in each subsequent year, making it extremely attractive from an income investor's perspective because unlike many companies in the sector, it has been able to maintain payouts thanks in large part to strong refining output. At present, the dividend yield sits at 2.54%, adding to the attractiveness, especially as a defensive position. ConocoPhillips investors have not been as fortunate, with the dividend slashed in the first quarter from $0.74 to $0.25. However, this follows the pattern of massive divergence between upstream and downstream entities witnessed over the last year and a half.
While Phillips 66 shares have pulled back from 52-week highs, it does not mean that the ongoing bull market in shares has come to a screeching halt. At a time when performance is easily outstripping peers, a great way to avoid the uncertainty is by investing in the utility-like returns of downstream and midstream operations that make money in spite of the phase of the commodity cycle. The dividend may not be as stunning as other companies in the space like Valero which sports a 3.70% yield, but it is the future capabilities that make Phillips 66 standout. The emphasis on reinvesting cash flows at a time when the industry is slightly depressed makes for smart strategic planning that will benefit longer-term shareholders looking for solid growth and price appreciation.
Forward Looking Thoughts
Share prices are likely to continue the upward march following a brief respite, retesting $94.12 before making a run at $100.00 per share. With a price-to-earnings ratio of 11.40, the company is fairly valued or even potentially modestly undervalued, meaning that should earnings match or exceed 2015 results, the company is poised to see shares appreciate further over the medium-to-long term. Although maybe not a value investor's ideal pick considering the appreciation over the last year, the shares still do provide tremendous upside for investors with a longer horizon. Strong management, balance sheet discipline, consistently growing shareholder returns via dividends and buybacks alongside integrated operations make Phillips 66 the perfect defensive play in the oil and gas sector. Should oil and gas prices eventually rebound, loyal shareholders will undoubtedly ride the wave of a longstanding emphasis on building operational efficiencies and additional petrochemical capacity intended to fill growing demand.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.