Phillips 66 (NYSE:PSX) is still a good investment for the next 2-3 years despite a healthy gain in the last few months. Most of the times when we talk about Phillips 66, we only take into account the refining business of the company and ignore the midstream assets. It is true that the midstream assets are the smallest contributors towards the net income but going forward, these assets have the potential to be a significant player for the company. For the first 9 months of 2016, these assets contributed $179 million to the net income, accounting for just less than 13% of the total earnings.
We will see this proportion increase considerably in the next 2/3 years. At the moment, the bulk of the capital spending is on midstream assets. The company is working to increase its midstream business and we can expect the midstream earnings to rise substantially and become a larger contributor towards the total earnings. The breakdown of the 2017 capital budget also clearly shows where Phillips 66 is focusing in order to get more growth. $1.3 billion will be spent on midstream growth projects, out of a total of $2.7 billion earmarked for 2017. That is more than 48% of the total capital budget for the next year. Phillips 66 will also spend $1.1 billion on its chemical joint venture with Chevron (NYSE:CVX). This will take its total capital budget to $3.8 billion, even at these levels, spending on midstream projects accounts for more than 34% of the total budget.
Most of these projects will be operational by 2019, which means that the earnings growth from the midstream assets will remain robust in this period. This segment will probably become as big as the refining and chemicals businesses, in terms of its contribution to the earnings. However, earnings growth might stagnate a little after this period if the company does not initiate new growth projects. New government might be more friendly to the energy industry as the president-elect, Donald Trump, wants to make America energy independent. In order to achieve this, relaxed energy policies will be needed. If the production increases, there will be need for further midstream infrastructure development. So, we can expect the midstream companies to exploit this opportunity and invest more in these assets. Phillips 66 might also want to look at additional capacity and transportation assets once the energy policy of the new president becomes clear.
A rather quick windfall might come from the reorganization of DCP Midstream (DPM). Phillips 66 has a 50% equity share in the business, Spectra Energy (NY:SESE) holds the remaining 50%. Total share of both these parent companies will reach 38% after the reorganization. Before the reorganization transactions, both these companies held 21% share in the business. Remaining share is held by the common unit holders. One of the key reasons behind this transaction was to improve the debt profile of the company and get rid of the revolver debt. This debt had a covenant which did not allow DCP Midstream to pay any distributions to its parent companies. Moody's analysts believe that this transaction will free up around $300 million for both these companies to divide between them evenly. They also believe that the transaction will allow the new entity to have better EBITDA and cash flows, which should result in 20% growth in distributions in 2017. However, they also mentioned that it is still unclear how much of that $300 million both these companies will be able to get.
Phillips 66 has a wide economic moat which makes it an excellent long-term investment. The company is not dependent on any one segment for its earnings growth. While refining and marketing profits can fluctuate with oil prices, midstream earnings are likely to be growing steadily in the next three years. As the oil prices have been weak, the refined products prices have also been low as well. However, we will see a gradual increase in refined product prices in the next few months as the oil prices recover. This will push marketing profits higher. Refining margins might take a small hit, although I believe most of the negativity from the refining margins has already been baked in. More than $900 million from the capital budget will be spent on improving the efficiency of the refining business. This should help the company maintain its refining margins as well. Midstream, however, will be the key growth driver in its earnings over the next few years.
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.