Why Phillips 66 Is the Best Buy in the Refining Sector

On the surface, Phillips 66 (PSX -0.43%) doesn't look like compelling buy when compared with its refining-sector peers, at least on a value basis.

At more than 13 times its enterprise value-to-EBITDA, the stock trades at a much more expensive valuation than other refiners:

Data source: YCharts. 

But there's a reason investors are willing to pay up to own Phillips 66's stock. Unlike most of its peers, it has an abundance of growth projects coming down the pipeline because of its strategic decision to invest billions in recent years to grow its chemicals and midstream businesses. Not only are its most recent investments about to pay off, but those two segments will also provide the company with more growth opportunities in the future, which is what makes Phillips 66 the best stock to buy in the refining sector.

Image source: Getty Images.

Peak gas demand is just around the corner

One reason most refiners trade for dirt-cheap valuations is that the sector doesn't have any growth prospects on the horizon. Earlier this year, Phillips 66 CEO Greg Garland summed up his company's lukewarm view on the refining industry:

I think refining is a good business. It's just, long-term, I just don't see it growing. I think that we've seen some decent gasoline demand growth over the last two years in the U.S., but ultimately, I think there's just too many factors that are going to hit you in terms of efficiencies of vehicles.

Recent forecasts back up that statement. For example, leading energy research firm Wood Mackenzie recently released an updated forecast for gasoline demand. While its analysts see gasoline demand in the U.S. growing from 9.3 million barrels per day last year up to 9.45 million this year because of lower oil prices, that level looks to be the peak for U.S. gas demand. WoodMac anticipates that demand will level out in 2018 before slipping back to 9.3 million barrels a day by 2019, driven by an expected increase in fuel efficiency and the growing adoption of hybrid and electric cars. Meanwhile, WoodMac sees worldwide gas demand peaking as early as 2021, even as the global vehicle fleet is expected to grow by more than 10% and hit 1 billion by 2025.

Because gas demand is at its peak, Garland said that "to invest in refining to add capacity still doesn't make sense to us." Therefore, the only money the company is investing in refining is to maintain its current position and complete high-return projects that reduce costs or increase production of higher-value refined products. Most of its competitors are doing the same thing, as well as consolidating. That has been the course of action at Tesoro, which recently acquired Western Refining (a company that had previously bought Northern Tier Energy), and PBF Energy, which bought two refineries last year. These deals should help increase profitability, but the fact is that the refining industry isn't expected to grow earnings capacity in the future.

Image source: Getty Images.

Investing in what's growing

Since it doesn't make sense to add any refining capacity, Phillips 66 has been reinvesting the cash flow it pulls in from refining to expand its chemicals and midstream segments, which have much more compelling growth prospects thanks to the surge in oil and gas production from U.S. shale plays. One of the largest projects is in its chemicals joint venture CP Chem, where the company and its partner are investing $6 billion in building a world-class petrochemical complex along the Gulf Coast, which will turn cheap natural gas into high-value feedstocks for making plastics. The company recently completed construction of two of the units and should finish the final one later this year, which will expand CPChem's global capacity by a third.

Meanwhile, Phillips 66 has also been pouring money into expanding its midstream business, including investing $3 billion in building a liquefied petroleum gas export facility and a natural gas fractionation unit. In addition, the company holds a 25% stake in the recently completed $4.78 billion Bakken Pipeline that will move oil out of North Dakota. The company is also expanding the storage and export capacity of its Beaumont Terminal, and its two master limited partnerships (MLPs), Phillips 66 Partners (PSXP) and DCP Midstream (DCP), are building a slew of pipelines, processing plants, and other midstream assets around the country.

Not to be outdone, rival refiners Tesoro, PBF Energy, Marathon Petroleum, and Valero Energy are also expanding their midstream businesses. However, only Marathon has grown its midstream unit past simply being a support for its refining operations. It did so after its MLP, MPLX (MPLX 0.23%), bought a natural gas-focused MLP that provided the company with a new growth platform. Because of that deal, MPLX has an abundance of growth options thanks to its prime position in the fast-growing Marcellus and Utica shale gas plays. That's one reason Marathon trades for a higher value than most of its rivals. 

That said, Phillips 66 gets its well-deserved premium valuation because it possesses not only a fast-growing midstream business but also a growing chemicals business. Those dual growth engines are the reason the company's best days appear to be ahead of it at a time when the refining sector is already past its prime. 

Investor takeaway

There doesn't seem to be any growth left in the tank in the refining industry, given that peak gas demand appears to be just around the corner. That's why Phillips 66 decided several years ago that it was going to invest in growing its other businesses, which are moves that will start paying big dividends in the coming year as these projects enter service. Meanwhile, with those two growth platforms in its portfolio, the company will have more opportunities to expand in the coming years, which makes it the best stock to buy for investors considering the refining sector.