What Does Warren Buffett's Phillips 66 Trade Mean for Pipelines?

Is the Oracle of Omaha giving pipeline companies his seal of approval?

Jay Yao
Jay Yao
Jan 11, 2014 at 11:27AM
Energy, Materials, and Utilities

Warren Buffett, known as one of the best investors in history and CEO of Berkshire Hathaway, recently traded 19 million shares of his Phillips 66 (NYSE:PSX) stock for Phillips Specialty Products, a Phillips 66 subsidiary that makes flow improver chemicals. Flow improvers maximize flow potential for oil and natural gas pipelines. Mr Buffett's buy is a big vote of confidence for pipelines since the revenues and profits of the flow improver business should grow as pipeline companies grow.

Big vote of confidence for pipeline operators
The pipeline business is currently benefiting from a confluence of positive trends that are likely to continue. One underlying trend is the favorable tax treatment of MLPs. Because they are partnerships, MLPs do not pay taxes. Because they do not pay taxes, MLPs have a lower cost of capital. The lower cost of capital in turn makes more projects economically feasible and leads to higher growth and better margins.

Another major positive trend is the continuance of America's shale revolution. Because of advances in horizontal drilling and fracking, America now produces more oil than it imports. 

According to the Energy Information Administration's Annual Energy Outlook for 2014, U.S. oil production will grow by 800,000 bpd a year until 2016. Natural gas production will grow by 56% to 37.6 trillion cubic feet by 2040. 

As more oil and natural gas are drilled, more pipelines are needed to transport oil and natural gas to refineries. Since pipeline companies make money from the volume of oil or natural gas that pass through their pipes, those companies are almost guaranteed to see larger revenues as production increases.

Despite significant opposition to developing Canadian oil sands because of environmental concerns, I believe the gigantic spread between Canadian heavy oil and WTI oil will outweigh these concerns. At one point last year, Canadian heavy oil traded at a whopping $42 per barrel discount to WTI. 

The lower price of Canada's heavy oil is due to the fact that there are not enough pipelines to transport oil to refiners or end markets. The giant spread provides strong incentive for private interests to argue for pipelines or railroads to be built to connect oil sands to refiners so that those investors can realize profits when the spread narrows. If those pipelines are built, pipeline companies will benefit greatly.

The bottom line
Because Warren Buffett put his weight behind a company that will only grow when pipeline companies grow, the investment can be taken as a bullish sign for other midstream companies such as Kinder Morgan (NYSE:KMI) and TransCanada (NYSE:TRP) for the long term. TransCanada will benefit as more oil from Canadian oil sands is delivered to refiners on the Gulf Coast or export terminals that ship to China. Kinder Morgan will benefit as more oil and natural gas produced from the Bakken and other shale plays flow through its pipes.

By trading in his Phillips 66 shares rather than buying the flow improver business outright, Warren Buffett seems to be taking profits on his Phillips 66 investment.

While Phillips 66 stock did not change much after the news was announced, selling the unit may not have been a wise choice in the long term. As his investments in Bank of America, Goldman Sachs, and General Electric show, Mr. Buffett almost always wins in these type of custom deals.