The past year has been challenging for refining companies, and Phillips 66 (PSX -2.51%) hasn't been immune to those issues. Rising costs and lower volumes due to turnaround activities have caused the company's refining segment to dip into the red for the past couple of quarters. That recent weakness has had a noticeable impact on Phillips 66 because refining remains its biggest moneymaker.
However, despite the importance of refining to the company's bottom line, CEO Greg Garland made it clear that he just doesn't see the segment growing due to industry trends that will likely keep a lid on demand for refined products. Because of that view, the company has invested heavily in expanding its midstream and chemicals segments in recent years. Those investments are about to start paying off since many of its largest projects should enter service by the end of this year. The company therefore should start generating significantly more free cash flow, suggesting that the best days for Phillips 66's investors still lie ahead.
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Getting ready for a big chemical reaction
The largest single investment is in the company's chemicals joint venture CPChem, which it co-owns with Chevron (CVX 0.75%). The companies are pouring $6 billion into building a world-scale ethane cracker and two polyethylene plastics units. Construction of the complex started in April 2014 and should be complete later this year. Once finished, these facilities will increase CPChem's global ethylene and polyethylene capacity by one-third.
The increase in the chemical production capacity of the Chevron-Phillips 66 joint venture will provide a similar boost to the earnings capacity of Phillips 66's chemicals segment. Meanwhile, with investment spending winding down, free cash flow should rise significantly in the coming year. As a result, CPChem could hand out meaningfully higher cash distributions to Phillips 66 in future years, which would give it more money to allocate toward value creation initiatives for investors.
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The midstream building boom is drawing to a close
Another major investment focus of Phillips 66 in recent years has been on expanding its midstream segment. Many of these investments also started taking shape in 2014. For example, in February of that year, the company approved a $3 billion investment to build the Sweeny Fractionator One and Freeport LPG Export Terminal in Texas. The company followed up that decision a few months later by acquiring the Beaumont oil and refined product terminal from Chevron. Finally, it capped the year off by joining Energy Transfer Partners (ETP) as a 25% joint venture partner in building two oil pipelines that would move crude from the Bakken shale to the Gulf Coast.
Phillips 66 has since completed the construction of the Sweeny Fractionator One, which it subsequently dropped down to its master limited partnership, Phillips 66 Partners (PSXP). It also finished construction on the Freeport LPG export terminal late last year, and this past June, Energy Transfer Partners started crude oil service on the Bakken Pipeline system. Meanwhile, Phillips 66 has steadily expanded the Beaumont Terminal since its acquisition and is in the process of wrapping up its latest effort to boost storage and export capacity at the terminal.
Given that Phillips 66 has completed or will shortly finish the bulk of its midstream growth projects, the company will start generating significantly more free cash flow from this segment. At the same time, it will continue to benefit from the growth of its MLPs, Phillips 66 Partners and DCP Midstream (DCP), which have several expansion projects underway. Those projects should enable both entities to increase their cash distributions to Philips 66 in the coming years, adding to its windfall.
Investor takeaway
While Phillips 66 has no plans to expand its core refining business, that doesn't mean its best days are in the rearview mirror. That's because it has chosen to invest billions in expanding its chemicals and midstream business units, which should drive significant earnings and cash flow growth over the coming year since most of its major projects are nearing completion. That gives the company more money to create value for investors, including the likelihood that it will continue buying back stock and growing its dividend at a rapid pace.
