The Phillips 66 (NYSE:PSX) of today is one of the largest midstream and petrochemical companies in the world, with a collection of assets -- both wholly owned and in joint ventures -- that position it for consistent profits and moderate growth for many years to come. Factor in its strength in North America, where oil and gas production are growing faster than the distribution network can handle it, and there's a lot to like about Phillips 66's prospects.
But as with any investment, it's just as important to look for potential weak spots as it is to identify a company's strengths. Here are three reasons Phillips 66's stock could fall, despite what look to be great prospects.
1. Weakening domestic demand for refined products
The table above tells us two things: Demand for refined oil products declines in recessions; but it usually bounces back strongly. The thing is, demand hasn't recovered as strongly this time around, and there are some indications that it may not return to previous levels anytime soon. There are several reasons behind this.
First, as a recent research paper by a University of Michigan researcher shows, there's some compelling data to support permanent changes in American auto habits, including fewer vehicles per driver and per household -- numbers which have continued to decline since peaking in 2006.There's more: The latest data also shows that Americans are driving fewer miles, too. Total miles driven in 2013 in real terms increased less than 1%, while miles per capita actually declined to the lowest level since 1996.
That's not the only challenge for refiners: There is a lot of momentum in reducing the use of oil for transportation, including more stringent fuel economy standards, the increased adoption of hybrid and electric vehicles, and some serious momentum to shift the 25 billion gallon heavy trucking market from diesel to natural gas.
In fairness, none of these are happening overnight, but it's important to remember that refineries are incredibly expensive to operate, with very high fixed costs. A small hit to utilization could take a big bite out of profits.
2. Environmental regulations
The White House has already announced plans to take a hard look at methane emissions from all parts of the oil and gas value chain. Twenty-eight percent of methane emissions in the U.S. came from the oil and gas industry in 2012, with nearly two-thirds of the industry's emissions coming from distribution, processing, transportation and storage, nearly all of which Phillips 66 has exposure to.
While the company's midstream business only generated about 12% of 2013 profits, the potential expense of updating pipelines and processing systems in order to meet new emissions standards could cost billions of dollars. A lot of its exposure is through its 50% ownership of DCP Midstream and DCP Midstream Partners (NYSE:DPM), and MLP Phillips 66 Partners (NYSE:PSXP), all three of which are heavily exposed to gas processing and pipelines, which adds another level of complexity to addressing capital expense, and also our third big concern for Phillips 66:
3. Heavy exposure to joint ventures could increase risk
DCP Midstream is jointly owned with Spectra Energy, and makes up a substantial part of Phillips 66's midstream business. Furthermore, the company's entire petrochemical business, CPChem, is jointly owned with Chevron, which is also a competitor in refining and marketing activities. In 2013, this joint venture contributed nearly $1 billion to the company's bottom line, so it's a substantial -- and growing -- part of the business.
As Phillips 66 puts it in its SEC filings, its involvement in jointly owned ventures decreases the company's ability to manage risk. It may sound overstated, but 36% of the company's net income last year came from midstream and chemicals, which are almost entirely joint venture operations. Sharing half of the ownership interest in ventures that control one-third of your profits is not something to ignore out of hand.
Risk versus reward
Let me be clear: I'm not saying Phillips 66 stock will fall. I actually think it's a well-run company with a number of reasons why its stock could rise in coming years, which I will cover in another article. Yet even with the opportunities, the risks shouldn't be ignored. I'm not making any predictions that any of them will come to pass, but you should factor risk in when deciding how much -- if any -- to invest in the company.
Jason Hall has no position in any stocks mentioned. The Motley Fool recommends DCP Midstream Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.