Why You Must Not Dismiss Phillips 66

In this episode of Industry Focus: Energy, Nick Sciple chats with Fool.com contributor Jason Hall about the latest news from the market. They discuss the recent oil price fluctuations, Warren Buffett, and challenges within the oil industry.

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This video was recorded on May 21, 2020.

Nick Sciple: Welcome to Industry Focus. It's Thursday, May 21^st, and I'm your host Nick Sciple, joining me once again is Motley Fool contributor, Jason Hall.

Jason, it's been about a month since you came on the podcast, and the last time you were on, we were talking about oil hitting -$37/barrel on the May contract. Today I looked at the June WTI contract for oil prices this morning and was trading around $34/barrel. Jason, that is a massive change, a $70 swing in oil prices in the course of a month. What has happened?

Jason Hall: Running it live right now, buddy; I'm looking at Bloomberg Energy right now. Yeah, it's just under $34. For those that don't remember, almost exactly -- I mean, within one day, a month ago, is when oil hit -$38 U.S. West Texas crude, because of, frankly, retail investors throwing tons and tons of money at WTI or USO, [United States Oil Fund LP] right, is that the ticker USO?

Sciple: Yeah, the index fund oil ETF.

Hall: Yeah, and basically the people had no clue what they were throwing money at futures, for, you know, [laughs] the front month contract that was going to come due the next day and you were going to be a bag-holder on a futures deal requiring you to take possession, physical possession, of crude oil at Cushing, Oklahoma hub there. So, prices went crazy negative that one day. And the next day they bounced back but they were still single digits, low-$10 for some time. So, even adjusting for that anomaly, that weird one day, oil has been on a bull run for a month. I mean, it really, really has.

But I think this is kind of the key thing, right? So, you go back to a month ago and the issues were a bunch of people not really knowing what they were doing that kind of flipped the market upside-down. But there were real storage concerns a month ago that have lessened a little bit, they've lessened some because production has come down. But I think we still have a lot of oil and honestly, yeah, it's hard to get optimistic about $33 oil, I mean that's the greater context, right? Oil is still in the $30s, the low-$30s, that's not a good thing.

Sciple: Right. So, fundamentally we got over some of those issues underlying the oil market that led prices to head so negative, but that doesn't mean we're out of the woods yet by any stretch of the imagination. You sent me over a report this morning, you look about across the board just everywhere in the oil products market, U.S. crude oil inventory is 10% above five-year averages, gasoline inventory is 10% above five-year averages, distillate inventories -- when you hear distillate think diesel fuel -- that's about 20% over five-year averages. So, still massive oversupply.

Obviously, oil prices have recovered, we're seeing some wells actually begin production once again, but these oil companies are not out of the woods by any stretch of imagination.

Hall: No, not at all. I mean, there's a couple things, most of them have some sort of hedges, so even the spot prices that we're seeing and that we've seen over the past month-and-a-half, those were not the prices that a lot of producers are realizing for most of their oil production, they were selling it for higher prices. But the oil that they didn't have hedged, yeah, they've been getting hammered on, and those hedges aren't going to last forever.

But I think a lot of what we're starting to see is a lot of these producers are trying to find any way they can to monetize anything they can, and there's a lot of sunk costs that are already in the oilfield. You got drilled uncompleted wells, you have wells that have been shut in that they've already made most of the investments on, that if they can invest a very small amount of capital the incremental cash, the incremental margin that they'll get from that oil is better than nothing. So, I think we're starting to see some of that, but the key point is that the ones that are trying to just eke out any dollars that they can, it just pushes the full recovery that much farther into the future.

Sciple: Absolutely. Any of that incremental supply is more that we have to burn off before we get back to equilibrium.

Okay. So, moving onto our main topic of the show today. Last Friday, May 15^th, we got our quarterly look into Warren Buffett and Berkshire Hathaway's portfolio with the following of his 13-F. We want to get into some of those transactions, but first, for folks who maybe haven't heard of a 13-F or don't know where to go find one, what can you tell them about that, Jason?

Hall: Yeah. So, the 13-F is the document the SEC requires large investors file once a quarter, 45 days after the end of the quarter that discloses their holdings at quarter end. So, it gives us a very limited window of a very limited period of time. So, first of all, it's 45 days after the quarter ends, it doesn't necessarily disclose specific transactions, it just says, here's what the portfolio was on the last day of the quarter.

So, for a lot of large investors, especially firms that focus on trading, it's nearly useless, right? But I think it's really interesting for -- you think about Buffett. Buffett has created billions and billions of dollars in investor value and returns by focusing on fundamentally sound companies and being an owner of those companies for as long as possible. So, that means that there tends to be less turnover in the portfolio, and also, it's a good snapshot of, kind of, what Buffett's thinking is; that's the way a lot of us think about it. So, when there are big changes, it seems to be something that maybe is a little more noteworthy and something to factor into how you think about investing. So, that's what the 13-F is and that's why it's a little more informing for Berkshire, even within the fact that it has a lot of limitations.

Sciple: Absolutely. I think that's a really good point to call out that it's important to know the investing style and strategy of the super-investor, you might want to go look into through the 13-F. Somebody like Jim Simons, very quantitative, his portfolio might be turning over the course of a quarter a large number of times, but for Warren Buffett, a long-term investor, maybe that's someone you want to go follow. And obviously, everyone's very excited to see what Warren Buffett's portfolio is, everyone looks forward to his 13-F to see, "Hey, maybe we can go follow this great investor."

When we look at his 13-F for this quarter, however, really not a lot of activities, some very small marginal buying on airlines which he has since said he has sold his entire stake. And there was a little bit of buying in PNC, [PNC Financial Services] but very, very marginal.

Jason, when you saw this report, any high-level takeaways on the buys?

Hall: You know, there really weren't. And I think you nailed it on the selling, the airlines we already, kind of, knew about that. So, I mean, there was nothing new there. But I think, maybe if there's one takeaway on the buying, PNC is a commercial back, that's their main business, and you can, kind of, tie that in. If you look at the rest of the bank investments in the portfolio, JPMorgan, Bank of America, etc., these are large commercial banks, yeah, they have investment banks as well, but commercial banks are, kind of, a big part of their business. And he added to PNC and he did not sell massive gobs of any of these commercial banks. So, that to me, I think kind of counters, a little bit, the idea, "Well, hey, Buffett didn't go big, he's got to be bearish on stocks." I think if Buffett was really bearish, it would be because of concerns about the underlying economy. And I think a bellwether, maybe an indicator would have been if Buffett had started lightening some of his bank positions, because banks are so directly exposed to the consumer economy. And he didn't. He trimmed a little bit of JPMorgan I think, but it was just a small amount. And I think he sold off 3% of the holdings, but he kept 97% of it. So, I think that's a big indicator of really where Buffett --

And again, I think it's crazy to try to read the tea leaves too much on what Buffett is thinking. Buffett's thinking what Buffett has always thought; that American businesses are some of the best in the world, U.S. stocks or one of the great sources of wealth creation, and that obviously hasn't necessarily changed in [laughs] any fundamental way.

Sciple: Yeah, if you look at his portfolio in aggregate, it changed by 1%, the biggest move -- and on the buy side, obviously, he juiced PNC by 6%, but that's only 0.03% change in his portfolio, so obviously not moving mountains here with these buys.

The sells are a little bit more significant, but again, in aggregate between all the activity in his portfolio, there was only a 1% change in his holdings. The big sell was Goldman Sachs, sold 84% of that holding, which he's held since 2012. Also sold all of Travelers and all of Phillips 66. One of those, Jason, you don't necessarily agree with; which one of those would that be?

Hall: Yeah, it's Phillips 66. Anybody that's followed my writing knows that I've been pretty bullish on Phillips 66 during the crisis. Two months ago I called it, you know, I thought it could be the biggest winner coming out of the coronavirus world crash, because of the structure of its business, the fact that it's not as exposed to the downside because of that business structure, and because, I think, it's got an incredible management team that have demonstrated that they are really, really good at allocating capital, managing the balance sheet and taking the company through market cycles. So, yeah, I think, you know, wrong is maybe kind of a -- we'll talk about that in a minute, but yeah, I think this is a company to be buying despite Berkshire selling.

Sciple: Yeah. You talked earlier about Berkshire's long-term investing horizon; everybody talks about this. And this is true for Phillips 66 as well. This is a holding they've had since 2012.

Hall: Yeah. So, it started -- technically, they've owned the Phillips 66 business since before the global financial crisis, I think, '06 or '07 when Buffett first bought ConocoPhillips. I think he invested $4 billion into ConocoPhillips at the time. It wasn't just an independent oil producer that it is today, it was a fully integrated super-major, you know, kind of close to the scale of ExxonMobil, it wasn't that big but it was the second-largest U.S.-based oil and gas integrated super-major behind ExxonMobil. And he chose to invest in it.

And the Phillips 66 shares that first popped up in the Berkshire portfolio weren't an active buy by Buffett, they were awarded from the spinoff when Phillips 66 in 2012 was spun out of ConocoPhillips and you had two separate companies: ConocoPhillips, the independent oil and gas producer; and Phillips 66 was the refiner, the petrochemicals business and the oil and gas midstream company with the pipelines and the storage facilities. And then the marketing business, so the 76 stations and the other retail gas stations that it operates, that was the Phillips 66. So, that's how Buffett ended up owning Phillips 66 to begin with, when the businesses were separated.

Sciple: Right. And then he has since held that since 2012, started selling some down in 2018, and obviously, finally sold out the last of his stake in this first quarter of 2020.

We were talking before we hopped on the show, Jason, when you look back at Buffett's track record in the oil and gas industry, this is the one industry that seems to have given Buffett some problems over time. Obviously, airlines are another one he's noted.

Hall: Yeah, but airlines, that happened pretty quick, right? And the world changed in fundamental [laughs] ways there that were a little bit different. So, like I said before, I think calling Buffett wrong on Phillips 66 might be a bit subjective. He's never outright said he doesn't like the business, to the contrary, he's always spoken very highly of Phillips 66, spoken very highly of the management. And the management team does exactly what Buffett likes. Managers that run the companies that he invests in do, he likes for them to pay a good dividend, grow the dividend when they can and buyback gobs and gobs of shares of stock. Buffett has regularly talked about those things. And they do that really, really well.

So, if you think about why Buffett might have been steadily selling Phillips 66 over the years; I think, in 2015 it actually peaked, not long after the 2012 and the ConocoPhillips split, I think in '08 Buffett actually admitted that it was a mistake to have bought the company. He called it an error of commission, he didn't talk with Munger about it, he just bought it. He just threw several billion dollars at it, and he did it when oil was over $100/barrel and [laughs] before the world, you know, caught on fire after the last economic crisis.

But anyway, so they split it off and he started buying more and more and at one point ended up owning, like, 15% of Phillips 66. At some point they reached a deal to actually trade some of those shares for a subsidiary, like, a specialty chemicals business that they rolled into Lubrizol, which is a wholly owned subsidiary of Berkshire. So, he went through all of these things and he's done really well. And then at some point just started steadily selling, steadily selling, steadily selling off bits of business. And then this last quarter, I think it was kind of like washing the dregs out of your teacup, I mean, it was, you know, went from owning tens of millions of shares to a couple hundred thousand, and sold the little bit off.

But if you go back over the past dozen years, Buffett, he's been terrible at picking winning oil stocks. He bought -- at about the same time the whole ConocoPhillips thing was going on, he went pretty big in ExxonMobil. And at some point, ExxonMobil became one of its four or five biggest investments in the Berkshire portfolio, which is pretty concentrated in the top-five holdings, those typically make up a big bulk of the portfolio. Lost money, ended up selling all of that.

At some point, he owned a little bit of National Oilwell Varco. I don't think it ever broke $1 billion, so in the Berkshire scale it was never really big. But that didn't do very well, the offshore market crashed in 2015-2016 during the last little oil crisis. Lost money there. May have owned some Core Lab [Core Laboratories] or something. So, he just hasn't done well over the past dozen years. I mean, even if you look at the sweetheart, Occidental Petroleum deal that everybody said, well, you know, this is uncle Warren making a ton of money. I think it was 9% on the deal when OXY bought Anadarko. And what happened this past quarter, OXY doesn't have enough cash to pay the interest, so they send Berkshire shares, right, for the interest payment.

And then, you know, and I think this is one of those things that it's a side note worth mentioning, I've seen on Twitter people decided to go long on Occidental Petroleum citing Berkshire Hathaway's ownership of common stock in OXY. I promise you, Warren Buffett has no interest in owning common stock of Occidental Petroleum. OXY was the one that had the choice, cash or shares, right? So, Buffett couldn't overrule that.

So, the point is, I think, you know OXY is a mess, and if OXY has to go through bankruptcy, which is not out of the realm of possibilities at all, I mean, it's definitely a reasonable potential outcome, Buffett might lose money on what everybody was convinced was a sweetheart deal.

So, you know, I don't want to throw Buffett under the bus here. I wrote an article, The Single Most Important Oil Stock Chart You May Ever See, about a week or so ago. And the thing that it points out is that this has been a really, really tough, ugly industry for more than a decade. With the exception of some of the oil majors, very, very few companies have been able to consistently make money for more than a decade. And billions of dollars of investor capital has been destroyed, and I think instead of saying, "Hey, Buffett has been bad at oil," I think the bigger point is, even somebody like Buffett, who has proven for 60 years to be one of the best investors in history, has struggled to make money in oil. And I think in a big way, maybe this is just Buffett acknowledging that this is, kind of, in the "too hard" pile even for him and he's just, kind of, moved on.

The only [laughs] other, besides Phillips 66, which I think he kind of walked backwards into before finding it as a good business, I think the only other business that Berkshire has done really well by way of oil is BNSF Railway's shipping crew, that's been a big source of profits for BNSF for the past five or six years, yeah, so, that's that.

Sciple: Yeah. BNSF probably has made a decent amount of money shipping all that frac sand down from Wisconsin to all the different basins as well. I mean, so yeah, supplying picks-and-shovels, you know, selling the jeans and the pickaxes to the gold miners, I think, it's true in the case of fracking as well. And to your point, oil has just been a very difficult industry ...

Hall: ... I'll take it a step further. It's being the company that ships the picks-and-shovels, because even the picks-and-shovels companies have had their hats handed to them for the past five years. So, [laughs] yeah; so shipping them, moving them around, that's been where the money has been.

Sciple: Sure. And so, we telegraph, this is a difficult industry. It's been a lot of challenges with the rise of fracking, oil goes up to above $100/barrel, it's been down in the $20s; we just had it go negative earlier.

In this environment that we're in, in short-term with coronavirus as well as you look back over the past decade how difficult it's been to make money, even if you're Warren Buffett, why do you like Phillips 66 today? What do they bring to the table that's different from those challenges the rest of the industry seems to face?

Hall: So, something I've highlighted a lot recently is that the companies that are most at-risk right now, and always the riskiest part of the oil and gas industry is the closer to the well you are, the more you're exposed to the downside. And in this place the obvious downside is the crash in prices.

Again, oil prices have been rising sharply the past couple of months, but we're still at prices that are going to put a lot of companies out of business, because these are the companies that are most directly exposed to prices. The producers, obviously, if they can't realize a price above what it cost them to produce, they lose money, right? And you start factoring in the debt loads and all those sorts of things and it's really ugly right now.

But it's not just the producers, you also have, you mentioned the frac sand suppliers, the companies that do the drilling, the companies that provide drill tips and pipes and all of those other stuff, they're the ones that are getting killed, because as producers have slashed costs, the first thing they've done is stopped buying new stuff and find every way out of every contract that they're under with any service provider that they possibly can; and then really tighten the screws to drive those services costs down as much as they can. So, that's why it's been so very tough.

Phillips 66 doesn't do any of those things, they completely avoid that business, so. I mean, they miss the downside when oil, or the upside, when oil prices can go up. But this is an industry, because of the cyclical nature, avoiding the downside is the safest and the best play. So, they are a consumer of oil, they buy oil that they use in their refineries. They have some of the best refineries in the world and that puts them in a position of strength to be able to buy lower cost crude. So, we talk about Brent crude, we talk about West Texas crude. Those are just two of the major benchmarks, there's lots of crude that comes from various places that gets traded at very, very different prices and often much, much lower.

When you have really advanced refineries, you can buy cheaper crude and you can make more money when you turn it into a refined product, because the prices for refined products are set by the bigger benchmarks. So, that's a big part of it right there. So, they have the ability to profit from lower oil costs in a big way.

They also have a really strong natural gas driven business in the midstream segment and in the petrochemical segment. Natural gas demand is holding up much, much better than oil because it's used in different applications. We use it for electricity. So, yeah, sure, every factory in America has been closed for six weeks and we're starting to see some of that start to open back up, so power demand has fallen but it hasn't been cut-in-half. So, moving gas, storing gas has still been a pretty good business.

And they also use it in CP Chem [Chevron Phillips Chemical] which is their 50-50 petrochemicals joint venture with Chevron. That's held up pretty well, because the feed stocks out of a petrochemicals business are used for a ton of stuff. You think about plastics, you think about PPE, so that uses a lot of plastics, bleach bottles, you know, most consumer goods packaging, that's plastic. So, that's a pretty important business right now; fertilizers.

So, demand for a lot of those products has been steady, and even in some ways increasing. And yeah, the refining business, that's their cash cow and that's not the best business right now, but the other parts of the business are helping soak up some of those losses and help the company, kind of, ride things out.

Then the next thing you have, is you have a great balance sheet. You know, most of these really large integrated oil and gas companies do have very good balance sheets, and Phillips 66 is no exception. And they have that margin of error that helps protect the business during these times. But I think simply avoiding the massive cash outflows that come from selling a commodity in oil for less than it costs you to produce is a huge competitive advantage in the sector right now.

Then going forward, this is something I really like about the business, you know, we've talked about the downturn and the continued oversupply of oil and that 200 million barrels of oil sitting in tanker ships that's not even counted in that commercial storage numbers that the EIA gave that we were talking about at the open. I think you have to remember that a company like Phillips 66 benefits from an economic recovery much more quickly than most of the oil patch, because as demand for fuels goes back up, the refiners are the ones that are going to more quickly see the benefit of that by selling more product.

Phillips 66 is one of the biggest gas station operators in the world, in the U.S. it sells a ton of gasoline. So, again, that's a scenario where it's set to recover lost revenues much more quickly than Occidental, as an example.

So, those are the things that I absolutely love about this business and think that make it one of the few investable companies in the oil patch right now.

Sciple: Yeah. We talk about the refining part of the business. Obviously, it's been well-documented that gasoline demand is starting to come back on line as folks are more comfortable driving, which is helpful for the business. Another part of the PSX refining business, however, is jet fuel. When you think about the puts-and-takes of people shifting their consumption more toward driving versus flying, are their margin differences between those parts of the business? How does that trickle down to Phillips 66 from a business point-of-view?

Hall: There are. I think the best takeaway to have on the jet fuel part of business is it's a single-digit portion of its refining business. So, yes, it's exposed, yes, it's going to have some impact, but it's a small enough position part of the prior business. You know, because I think we have to accept the fact that jet fuel sales are going to be changed for five years. It's a small enough part of the business that I think they're going to be able to adapt and it's not going to hurt them quickly -- it's not going to hurt them as much as -- I think, they're going to make it out fine, be able to shift to other products in a way that's going to work fine.

Sciple: And then, one of the things that we haven't mentioned is, different from a lot of these oil companies, obviously, their business has been disrupted, cashflows impacted by this oversupply in oil as well as the reduction in demand. You've seen a lot of dividends get cut. Phillips 66 has maintained its dividend, I looked up this morning, about 4.6% yield, so pretty healthy. What can you tell us about the dividend, Jason?

Hall: Yeah. So, I mean, if there's a negative about it it's, technically this is the quarter that historically since they paid the first dividend, this is the quarter, that it has been increased every single year. So, they did break their record of their streak of raising the dividend every single year. But again, I think it points to a management team that's being prudent and not doing arbitrary things just because they tick a box. So, sure, it would be great if they could have kept that dividend growing every year for 25 years and get on the dividend aristocrats or something like that. Yeah, sure, that would be great, but [laughs] I much prefer a management team that says, the prudent decision is just to maintain it, because it's affordable where it is, and focus on maintaining the strength of our balance sheet and the strength of our business.

So, again it shows their priorities as a management team. And that it's an industry where really having a pristine balance sheet is, you know, that's the most important thing in the world to do, is to have a pristine balance sheet and then focus on capital. And refining is a capital-intensive business and you have to spend money to maintain your facilities, it's incredibly important, because if you don't, you're stepping over dollars to pick up pennies. So, No. 1, maintain the balance sheet; No. 2, spend that money to keep your facilities performing at the max. And then, like, 2.A is that dividend. So, I think that it just shows that their priorities are in the right place.

Sciple: Absolutely. We got a quote from management from their most recent conference call, it says, "In the current crisis, liquidity is king; you've seen us take tough steps to defend liquidity, but the real purpose of that is to protect our investment grade credit rating and protect the dividend as they go through that," and that's really what they've done. But they also raised, I believe, $3 billion in debt capital to, kind of, shore up their balance sheet. Already had a strong balance sheet coming in.

So, I think for a lot of the points you mentioned, lack of direct exposure to the commodity prices, strong balance sheet, management that takes care of the downside for shareholders has really put this company in a position to withstand a disruption like coronavirus whereas a lot of folks in the industry really have not been.

Hall: Yeah, it goes back to being in the right parts of the oil and gas business, No. 1, that's where it starts; and then the things you mentioned.

Sciple: Okay, Jason, so closing out. Moving high-level, looking at the industry, we heard Warren Buffett when he talked about his airline sale, talking about the reason he sold that stock is because the future for airlines has changed given the way coronavirus has shifted the way people are living their lives, I think that applies across industries, whether it's energy, industrials, tech, anywhere.

So, as you're incorporating this change in what we can expect from a growth perspective into your investment thesis, how are you doing that, how are you thinking through that process?

Hall: Yes. So, first of all, it hasn't fundamentally changed how I think about energy and how I think about investing in energy stocks as a category. So, I think it gets back to, you know, the fundamentals, No. 1. So, you think about finding the best companies that are going to be the best companies at what they do for a long time, and that what they do is going to be in demand for a long time. And that to me continues to point back toward renewables.

And some of the companies that have done the best for me, like, Brookfield Renewable Partners, some more recent investments that I followed for a while but have only started to buy this year, you look at Atlantica Yield. So, what are those tickers; BEP is Brookfield Renewable. Atlantica Yield, the ticker is AY. Clearway Energy, CWEN. These are companies that are in a way, they are kind of like the midstream companies in the renewable business. They produce renewable energy, solar and wind. They sell it on long-term fixed contracts to utility companies and industrial users. And from a cost perspective, renewables are competitive with just about any fossil fuel. So, I continue to look there when I think about the world in a decade, when I think about the world in twenty years ago.

And when I look at oil and gas, yeah, you know, oil prices have started to surge and there's going to be money to be made, there is. And I think maybe in a couple of months, we're going to be closer to having a better view forward for even some of the more at-risk parts of -- as we see the chaff start to separate from the wheat, so to speak.

But I still, I think about it from that long-term perspective, you know, would I rather own an independent oil producer that's still exposed to all of the same things, and the same risks are still there. You know, technology has made production cost much less and has made shale viable, but there are still low-cost producers out there that still will continue to swing and dominate the market. And that fundamental understanding of that competitive risk continues to guide me when I think about oil and gas.

Sciple: I agree with you completely, Jason. Even when I was thinking about renewables, as we were talking, I was thinking about the oil sector, we don't really want to touch the companies that are directly pulling the oil out of the ground. I think even renewables, you could argue they're not really directly touching the energy, they're taking the energy that already exists from the sun and then turning into something that's useful. And when we're talking about the things that we want to invest in, in oil, it's really the things that are taking that energy and putting it into a form that's useful, like Phillips 66 refining, like the midstream companies that transport it to market.

Just don't -- if you're touching the energy directly, it's probably going to be less attractive from an investment point-of-view, would you agree with that?

Hall: When there's a cost to the feedstock, yes. That's the thing, when you have renewables, you have free feedstock, right? It's just figuring out the cheapest way to tap it, and that's a massive, massive competitive advantage, the technology is just going to make it stronger.

Sciple: Absolutely. Jason, thanks for coming on the show, as always.

Hall: Absolutely.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for making us sound so good. For Jason Hall, I'm Nick Sciple, thanks for listening and Fool on!