Phillips 66

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Phillips 66 is a diversified energy manufacturing and logistics company, operating in refining, midstream, chemicals, and marketing, with a notable presence in both the United States and Europe.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Phillips 66 operates in an industry characterized by volatility and cyclicality, making the assessment of moats particularly challenging. Their competitive advantage primarily stems from their large, complex refining assets and established logistics network, rather than strong brand recognition or technological differentiation, leading to a medium moat rating.

Business Overview:

  • Revenues Distribution: PSX operates across four segments:
    • Refining: This is the largest segment, accounting for the majority of PSX’s revenue. It involves processing crude oil and other feedstocks into gasoline, diesel, jet fuel, and other refined products. Revenues in this segment are closely linked to crack spreads—the difference between the price of crude oil and refined products—which are highly volatile.
    • Midstream: This segment transports, stores, and processes crude oil and natural gas. It provides revenue stability through fee-based operations that are less sensitive to changes in commodity prices compared to the refining business.
    • Chemicals: This segment is operated through their 50% equity investment in Chevron Phillips Chemical Company, which produces a range of petrochemicals used in plastics, packaging, and other applications. Revenue in this segment is a function of demand for various chemical products and related prices.
    • Marketing and Specialties: This segment distributes refined products primarily in the United States and Europe. This segment includes a small but differentiated lubricant business.
  • Industry Trends:
    • Refining: The refining industry has seen increased capacity globally, which creates some price pressure. However, the closure of less efficient refineries in the past have improved the profitability of surviving refineries by creating more capacity tightness. Demand for refined products, though, remains linked to economic growth. Furthermore, the shift towards electric vehicles may eventually decrease the long-term demand for transportation fuels, though this is still a distant threat.
    • Midstream: The midstream sector has been growing due to increased oil and gas production, and also due to the increased exports of energy products. The need for more infrastructure to support the transport of hydrocarbons has made this a lucrative sector.
    • Chemicals: The petrochemical industry is dependent on demand from various downstream products including plastics, packaging, and industrial sectors.
    • Marketing: The marketing segment is primarily impacted by consumer demand and transportation regulations, such as the sale of reformulated gasoline.
  • Margins: * Margins in refining are volatile and highly dependent on crack spreads, which themselves can be impacted by global economic and political events.
    • Midstream margins are more stable due to fee-based contracts.
    • Chemical margins are variable and are dependent on raw materials pricing and product demand.
    • Marketing margins tend to be relatively stable.
  • Competitive Landscape: The refining industry is highly competitive, with many refiners of various sizes vying for share. The midstream sector is more concentrated with companies that have well-developed distribution networks. The chemicals sector, dominated by a few large players, has significant scale advantages. The retail sector also contains well established competitors.
  • What Makes the Company Different: Phillips 66 is not just a refiner, but a diversified energy business that is more integrated than many of its competitors and has a wide operating reach. They are trying to leverage their unique assets to obtain profits, instead of competing on price alone. Specifically, they rely on their midstream assets and unique access to transportation to move refined products more efficiently. In addition, their stake in Chevron Phillips Chemicals offers diversification away from refining towards the growing chemical business.
  • Recent Concerns: Phillips 66 and its competitors have been subject to volatile crack spreads which lead to uneven returns in the short term. Further, the long-term threat of the shift to alternative fuel sources creates some uncertainty about the future. Also, the company is facing greater regulatory pressures to reduce pollution from refining operations.

It is important to note that the economic situation and industry conditions are very fluid, the facts above were pulled using the latest annual report and earnings calls.

Financials:

Phillips 66’s financial performance is closely tied to commodity prices. While this presents volatility, it also means that, in times of strong pricing, PSX can generate a lot of cash.

  • Revenues: Revenues are highly cyclical and largely dependent on global oil prices and demand for refined products. Higher crude oil prices may boost revenue in their refining business, but also increase cost of goods sold which means they need to pass costs on to consumers by increasing prices.
  • Profits: Profits also depend heavily on refining margins and demand, and can be volatile. Net income is dependent on oil prices and refining margins. Strong pricing environments can bring exceptional returns to the business, while a pricing downturn can lead to heavy losses.
  • Cash Flows: In periods of high prices, free cash flow is very high, as a lot of cash is coming from the refining sector. Free cash flow is used for returning capital to shareholders through dividends and share repurchases and to fund acquisitions or growth opportunities.
  • Capital Structure: Phillips 66 has a healthy balance sheet with a low debt-to-capital ratio, however this metric is trending upwards. This gives them financial flexibility and access to debt at lower rates.
  • Capital Allocation: A primary source of capital allocation is share repurchases. PSX also returns capital to shareholders through regular dividends that are usually close to 4-5% of stock prices and which typically increase over the years.

Moat Rating: 3/5

  • Scale Advantage: PSX benefits from economies of scale in refining and midstream. Its large, complex refineries allow it to process a wider variety of feedstocks more efficiently than smaller refiners, especially as there is considerable economies of scale in refinery construction and operations. Its distribution networks are also expansive and difficult to duplicate, creating some competitive advantage.
  • Unique assets: Their high grade and high density refining capacity and their access to midstream networks provide an advantage. In particular, their access to the Permian Basin provides an opportunity for higher margins.
  • Barriers to Entry: The high capital requirements and regulatory hurdles in the refining, midstream, and chemical sectors create some barriers to new entrants, benefiting existing players. Also, the regulations in refining tend to favor larger incumbents. The long and arduous process of permitting and building pipelines and storage facilities also keeps competition at bay.
  • Brand: The company has some brand recognition among its B2B customers for high quality and reliability.

However, most of their operations are in commoditized industries, where pricing power is limited, which limits their moat. Also, the industry is susceptible to changes in technology and regulation, such as new and more efficient sources of energy or new rules that disfavor the usage of certain chemicals, which can weaken or even destroy their competitive advantages. For example, the looming impact of electric vehicles and shifts away from petroleum fuels represent long-term risks that cannot be ignored. Their dependence on refining also is a risk.

Legitimate Risks that Could Hurt the Moat and Business Resilience:

Phillips 66, being involved in the petroleum and chemicals businesses, is highly sensitive to changes in regulations, new inventions in the energy market, and the price of oil. It is also susceptible to the cyclicality of those markets.

  • Technological Disruption: As mentioned above, the rise of electric vehicles and alternative energy sources will hurt sales of refined products. Additionally, improvements in energy efficiency and new chemical processes could render some products obsolete. Also, changes in regulation could hurt existing facilities. These threats are significant and may diminish existing returns on capital in the long-term.
  • Commodity Price Volatility: PSX is sensitive to fluctuations in oil and natural gas prices, which impact refining margins, and the price of chemicals. A drop in prices will hurt profitability, while a prolonged low price regime may cause the company to make losses. They may mitigate this risk by operating a highly diversified business, but they cannot eliminate the risk entirely.
    • Regulatory Changes: Regulatory policies affecting pollution control and climate change may impact the profitability of refineries and chemical plants. Further regulatory rules on interstate or international commerce may have significant consequences.
  • Competition: The presence of multiple large players in the energy industry could lead to price wars and margin pressures. Although they have certain cost advantages that help them against weaker incumbents, if a low-cost producer emerges, it could hurt returns.
  • Acquisition Risk: As a potential acquirer in the oil and gas space, PSX faces the risk of overpaying for acquisitions that would not deliver enough profit to justify their cost. This risk is especially high since most acquisitions are made in a competitive environment and require the premium over the intrinsic value of the target.
  • Reliance on a Small Number of Business Segments: A significant portion of their revenues comes from their refining segment, creating vulnerabilities if they cannot reduce costs or sell their products for adequate prices.

Understandability: 2/5

While the business model itself can be easily described, the intricacies of the industry and its operations, such as understanding chemical manufacturing or midstream logistics, makes this a difficult company to value. It can be difficult to see the differences between the business and its competitors, and also to keep up with evolving regulation and technologies, making this a complex business to keep up with.

  • Business Complexity: While the core idea of converting raw materials to products and selling them is easy to grasp, understanding the competitive landscape for each of the segments and the economic drivers behind them is challenging. For example, the interplay of regulations, commodity prices and global events on refining margins is tough to keep track of.
  • Accounting Issues: The non-recurring, one-time items and complexities in tax laws creates additional issues and can be hard to account for. Also, goodwill and intangible assets need to be carefully examined, as different accounting methods can alter valuations.
  • Cyclicality: The inherent cyclicality of the petroleum business leads to volatility in revenues and makes the company’s financial performance difficult to predict and understand.

Balance Sheet Health: 4/5

  • Debt Levels: Overall, debt levels are modest and manageable for the scale of the business. However, their current debt to enterprise value is trending upwards, which is important to keep in mind.
  • Cash Position: PSX’s cash position and liquidity levels is high enough to weather short-term economic downturns.
  • Pension liabilities: The pension plan is overfunded, which also helps to improve the health of their balance sheet. However, any negative change in returns can diminish this advantage.
  • Working Capital: They are not a capital intensive business and the requirement for working capital is not significant, meaning large increases in short term debts are unlikely.

While their business is vulnerable to high debt burdens, their current balance sheet indicates they have a good amount of flexibility when it comes to financial structure. This implies they have sufficient room to take on more debt as well, and suggests they have a healthy business structure.