Phillips 66 Swims With the Tide

Up, down, mid -- it's important which stream in the energy sector you choose if you want to find some interesting investing opportunities. Despite oil sitting at $92 a barrel, upstream exploration and production companies like Chesapeake Energy (CHKA.Q) and McMoRan Exploration (NYSE: MMR) have been the hardest hit of the lot. While those two trade about 30% below their 52-week highs, much of the E&P space is littered with losers.

In the midstream, those who gatherer, transport, and store the liquids the E&P's produce have been benefiting from their position as toll collectors. Two prime examples: Energy Transfer Partners (ETP) pulled back from recent highs, it still sits more than 11% above where it was a year ago, and Williams Companies (WMB 1.21%) has done even better than that, rising 68% over the last 12 months.

Not cracking under pressure
Yet it's in downstream refiners, distributors, and sellers of petroleum products that I think investors will score some impressive gains, even though they probably have outshone their peers higher up in the chain. Phillips 66 (PSX -0.66%) and Valero (VLO -0.32%) don't rely upon the price of oil per se, but rather the "crack spread," the difference between what they pay for crude oil and how much they can sell the products they refine. Add together the price of two barrels of gasoline and one barrel of heating oil, divide by three, subtract this average from the price of a barrel of crude, and there's your crack spread, an estimate of the profit margin that refiners earn by turning crude oil into end-use products.

It can be a volatile mix that sometimes leaves the industry depressed, but it still holds lots of potential. Because natural gas remains ridiculously cheap and the fuel source is a key component of the refining process, the input costs are low. On the other end, gas prices are at record levels in some areas -- in California they recently soared above $5 a gallon! -- so the refiners are receiving premiums on their output. Put the two together and you have a confluence of trends that should push refiners higher.

Still hanging onto the apron strings
Phillips is the country's largest independent refinery. Having been spun off from ConocoPhillips (COP -0.43%) earlier this year it operates as the refining and marketing portion of its former parent. Despite the soaring valuation of its stock since being sent off on its own (it's up 30%), Phillips still trades at less than six times trailing earnings and slightly more than that on forward estimates.

Last quarter's profits were almost $1.2 billion, or $1.86 per share, even though revenues fell 10% to $47.8 billion. Adjusted profits that exclude one-time costs such as the sales of assets and debt retirement came in at $2.23 per share, well ahead of analyst expectations.

Phillips 66 snapshot

Source: FinViz.com. N/A = not available; PSX went public 4/12/12

Last time out Phillips was able to earn $12.56 on average for each barrel of gasoline and other petroleum products produced, compared with $9.49 per barrel last year. As mentioned, that was predicated on low crude and natural gas prices and relatively high prices at the pump, which at the time averaged $3.09 per gallon.

Pump up the volume
According to the Department of Labor, wholesale prices rose 1.1% in September, following a 1.7% jump in August, which had been the largest one-month increase in more than three years. According to AAA, the average per gallon nationally is $3.81. With natural gas prices still hovering at the low end between $3 and $4 per million British thermal units, Phillips input costs don't seem to have risen all that much, if at all. The downstream specialist is due to report earnings on Oct. 31, but I'm not anticipating any scary surprises.

I previously rated Phillips 66 to outperform the broad market indexes on Motley Fool CAPS, the 180,000-member driven investor community where informed opinion is translated into stock ratings of one to five stars. By making a CAPScalls on the stock I hold myself accountable for the opinions I express here that you can then track in real time. But let me know in the comments section below whether you agree Phillips remains a refined opportunity for investors.