Here's Why You Should Consider Phillips 66

| About: Phillips 66 (PSX)

Summary

It is not just a refiner, and the overall business mix protects it against commodity price risk.

Midstream capacity expansion will result in this segment becoming an even bigger player.

Diversification reduces the risk of the company and ensures steady growth under the normal market conditions.

When Warren Buffett buys a stock the world takes notice. A number of investors blindly follow the wizard of the investment world as he is correct most of the time. Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has been consistently adding to its position in Phillips 66 (NYSE:PSX). On the face of it, this might look like an odd decision to some investors as refiners offer the best opportunity for quick gains when the oil prices start to go down. At the moment, oil prices have stabilized and the refining margins are in fact taking a hit. However, Phillips 66 is not merely a refiner; it is a diversified business which has the capability to perform well in a number of scenarios. It is not affected by a single factor like crude oil prices. Although refining is its biggest segment, other areas have their own business environments.

The refining segment will surely not perform as well as it has performed over the last few quarters because the oil prices are expected to rise. Furthermore, the spread between WTI and Brent has narrowed due to a number of reasons. This has resulted in eliminating the cost advantage that the US refiners had over their European and Asian rivals. Refining margins are converging and there are strong possibilities that the margin will remain narrow between these two benchmarks. You can read a detailed piece about the convergence of refining margins and the reasons behind it here.

Source: EIA

One of the key reasons mentioned in the article by EIA is that the improved infrastructure for transportation of oil and gas played a role in reducing the spread between WTI and Brent. This element will be further enhanced as the export facilities and other pipelines come on line. This means that the global oil market might see further closing of gap between the WTI and Brent. Refining margins also took a hit due to the excessive production of gasoline. It is natural for any business to target the high-yield area. Gasoline margins were the highest as the prices fell which gave an incentive to the refiners to utilize their capacity to the maximum. However, this resulted in oversupply of diesel and its margins were compressed further. At the moment, the whole gasoline market is also showing oversupply, and the overall margins of the industry are coming under pressure.

Midstream segment of the company has a completely opposite relationship with oil and gas prices. Most of its contracts are dependent on the commodity prices and as the commodity prices go down, the earnings from this segment start to fall. Over the last two years, the impact from a decline in this segment was much smaller than the refining segment, which resulted in a net positive effect. Another thing to keep in mind is that this area of business is much smaller than the refining business. However, impairments in this area can still have a substantial effect on the overall earnings. In case the oil and gas prices rise, this segment will benefit and it will make up for some of the losses from the refining segment. Midstream business is still expanding and the rising terminal capacity along with the increased pipeline coverage should increase its overall share in the business mix. Oil and gas prices outlook is positive as I believe we have seen the bottom. Rising capacity plus higher prices mean the earnings from this segment are going to rise over the next few quarters.

The chemical segment has been the second largest in terms of overall contribution towards the revenues in the past. However, it fell behind the marketing and sales segment during the last year. It is important to understand the cost structure of this segment and how it was able to do well. Producing ethylene from NGL gave an advantage to Phillips 66's joint venture, CPChem. However, as the crude oil prices came down, the manufacturers using oil to produce ethylene were afforded an equal footing in the costs area. As a result, this market became more competitive and the margins fell. Again, rising crude oil prices will reestablish Phillips 66's advantage and the chemical segment will contribute more.

Marketing segment might see a decline in margin if the spot prices for refined products rise as it has a negative relationship with the spot prices. As the spot prices have been coming down, we can see that the margin from this segment has been rising. With the future spot prices expected to rise, this segment will likely see a decline in earnings over the next few quarters.

An analysis of the business mix of the company shows that the diversified nature of the business is what attracts investors such as Warren Buffett. These four segments give protection to each other by how they behave in different market conditions. This results in elimination of risk to some extent from a single market force. The business mix of Phillips 66 makes it an ideal long-term investment as it will continue to grow at a steady pace. There might be some opportunities to have a big gain from the commodity prices in the future. However, the diversified nature of the business means that the business will continue to flourish in the normal market conditions. Phillips 66 has some of the basic qualities that Warrant Buffett looks in an investment and it is no surprise that he continues to grow his stake in the company even when the oil prices are on the verge of a rebound.

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.