There may be more disruption taking place in the oil and gas industry today than at any time in the past 100 years. COVID-19 caused such a disruption in oil markets that oil futures prices went negative for a few days this spring as storage around the U.S. filled to the brim. Petroleum products supplied in the U.S. dropped a whopping 23% in April and might be down for the remainder of 2020 as office workers stay home and reduce their commutes.
The impact on a company like Phillips 66 (NYSE:PSX) could be profound over the next decade. Economic shutdowns and working from home may not last for most workers, but I think oil consumption patterns are changing permanently and even small changes may not be good for the business long-term.
Phillips 66 at the core
The three main businesses for Phillips 66 are midstream operations, refining, and marketing of oil products. These businesses generated 84% of the company's adjusted pre-tax income in 2019, with the remainder coming from chemical operations.
If oil consumption falls, Phillips 66's business will be squeezed in a variety of ways. Midstream volumes and revenue will fall, and marketing operations like gas stations will have fewer customers. Refining operations could be more volatile, depending on oil and gasoline prices, but declining volumes overall aren't good news long-term.
Revenue and earnings will likely be volatile depending on how oil prices fluctuate, but long-term investors should look at where consumption is going to guide their view of the industry. And I think it's clear that for the foreseeable future consumption of oil will fall. The new dynamics in energy are taking place at a time when Phillips 66's operations aren't looking very strong.
Borrowing from the future
Despite a strong economy and steadily growing oil demand, Phillips 66 has been spending more money than it takes in to grow dividends and fund share buybacks over the past year and that's before low oil prices hit the market. You can see below that Phillips 66 spent $1.4 billion more paying dividends and buying back stock than it generated in free cash flow over the past year. Over the past five years, the company has returned more to shareholders than it has earned each year.
When a company doesn't generate as much cash as it returns to shareholders, it needs to borrow money to make ends meet. You can see below that Phillips 66 has been adding debt, despite the fact that the business has seen gross profit fall over the past five years.
The debt load isn't problematic from a leverage standpoint yet, but these aren't good trends for any business, especially an energy stock. And when markets become volatile, the return of cash to shareholders can stop quickly. Phillips 66 has already suspended share buybacks and reduced capital expenditure plans for 2020, and the dividend could be next if operations don't start generating more cash flow.
Where is Phillips 66 going?
I think the broad trends are what investors need to think about when looking at a stock like Phillips 66. First, the company wasn't on a strong financial trajectory coming into 2020, with spending on dividends and buybacks exceeding free cash flow over the past decade and debt rising to fill the gap. The sharp drop in gasoline demand due to COVID-19 has sent a negative shock into the business, but it may be a canary in the coal mine for oil companies.
Second and maybe more troubling, we're seeing electric vehicles increase their share of the market, working from home is going to increase and that will reduce commuting, and urbanization and ride-sharing (which is being electrified) are reducing the need for gasoline consumption long-term. These are all trends working against Phillips 66 over the next decade, and that's why I don't like the stock for long-term investors.