When investing for the long term, one of the most popular types of holdings in most investors' portfolios is oil and gas stocks. Common choices include sector giants like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX), which are very diverse companies but derive the bulk of their profits from exploration & production (E&P) activities. The other major way that oil companies make money is through refining and marketing, which is the aspect of oil companies that more people see, such as service stations that sell gasoline. Today let's look at Phillips 66 (NYSE: PSX), which I feel is a great choice for investors who may want to focus their exposure on this area of the business, and especially a growing trend toward energy production in the U.S.
What is Phillips 66?
Phillips 66 owns and operates 15 refineries with a total of 2.2 million barrels per day of production capacity in addition to about 10,000 branded service stations and 15,000 miles of pipeline systems. The company's refining and marketing businesses account for about 82% of earnings.
The rest of Phillips 66's earnings mainly come from the chemicals segment, which owns 50% of ChevronPhillips Chemicals, a joint venture with Chevron that produces over 33 billion pounds of various chemical products each year. Additionally, the company also has a relatively small midstream segment that processes natural gas in 62 processing facilities.
Downstream energy as a play on America's energy independence
The downstream aspects of the oil and gas business are generally less lucrative than the upstream activities, so why would we want to invest in what is essentially a pure refining and marketing play? One of the main reasons is that Phillips 66's refining and marketing efforts are concentrated in the United States. In fact, about 1.8 billion barrels per day of the company's refining capacity (82% of the total) is within the U.S. Why do we care?
With the growing trend toward energy independence, North American crude oil production stands to rise tremendously in the coming decades. As one of the largest American refiners, this creates a distinct cost advantage for companies such as Phillips 66. The growth in North American production is beginning to depress prices of local crude oil when compared to imported, which is excellent for the profitability of refiners that are close to the source of the cheaper oil.
Since refiners charge the same amount of money for their finished product, regardless of where the crude oil originated from, this will cause Phillips 66's profit margins to grow as domestic production increases. Currently, only about 200,000 barrels per day of the company's refined product is a result of North American crude oil, so it is easy to see the long-term potential as production increases locally.
The downside to investing exclusively in downstream operations
The biggest issue created when choosing a downstream company to invest in is the lack of diversity in that company's income stream. For instance, there is some benefit to the amount of diversity in ExxonMobil's revenue stream. Exxon derives about 64% of its earnings from its upstream operations, 28% from downstream, and 8% from chemicals. Upstream business also tends to be more consistent and has some built in safety, such as a large amount of reserves. Exxon has about 25.2 billion barrels worth of proven reserves, which is more than the company will produce in the next 16 years, at the current rate.
Another downside, although it doesn't really matter unless you are very dependent on your portfolio for current income, is the lower dividend yield offered by Phillips 66. Although Exxon isn't an extremely high-yielder, its 2.87% yield easily tops Phillips 66's 2.18%. Chevron is the real dividend champion here, and is an excellent investment in the sector, just not the best way to play America's growing energy independence efforts. Not only is its 3.2% yield among the best in the sector, but it has an excellent record of raising the payout and adding value for its shareholders in the form of buybacks and cash stockpiling.
While it is not the only good way to play oil and gas, nor is it the least risky, Phillips 66 has the potential to produce excellent returns over the next several decades as North America ramps up its efforts to produce the bulk of its crude oil here at home.
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