Berkshire Hathaway (NYSE:BRK-B) CEO Warren Buffett called his $6 billion 2008 investment in ConocoPhillips (NYSE:COP) a "mistake of commission," that would cost the company billions in losses. Since then, he's been whittling Berkshire's holdings in ConocoPhillips down, while also starting positions in integrated major ExxonMobil (NYSE:XOM) and oil services giant National Oilwell Varco, adding to a portfolio that also features a 27+ million share stake in Phillips 66 (NYSE:PSX), awarded when it was spun off from ConocoPhillips in 2012.
The recent announcement that Berkshire would acquire Phillips Specialty Products from Phillips 66 for 19 million of its 27 million shares comes at the end of a year that saw Berkshire selling off almost half of its remaining stake in ConocoPhillips while taking a nearly $3.5 billion stake in ExxonMobil. There's a really good chance that by the time the calendar moves to 2015, ConocoPhillips won't be in the Berkshire portfolio at all. Why is that, and should you follow suit? Let's take a closer look.
Buffett's "mistake of commission" with ConocoPhillips in 2008 was largely a result of the relatively unpredictable nature of market crashes and oil prices, tied to taking a significant stake very close to the peak in both oil prices and ConocoPhillips' share price:
ConocoPhillips only recently recovered its share price from Buffett's "erroneous" buy, while the market has roared to new highs, meaning Berkshire has likely lost money on the 61 million shares it's sold since. Based on how Buffett has chosen to invest in energy and related companies since then, it looks like the lesson he's learned is about reducing exposure to the unpredictable and volatile prices of oil and gas.
Hence the large investment in ExxonMobil, commonly considered one of the best -- if not the best -- of the major oil companies. The ConocoPhillips that Berkshire bought was a diversified energy company; after its spinoff of Phillips 66, the refining, chemical, and marketing parts of the former business, the ConocoPhillips of today is a massive exploration and production (E&P) company. E&P companies are much more exposed to the downside of falling energy prices than integrated majors like ExxonMobil, or to midstream companies like Phillips 66.
Frankly, ExxonMobil's business is just a higher quality operation, with a higher return on capital employed (ROCE) of 23% for ExxonMobil, versus 16% for both Phillips 66 and ConocoPhillips over the past year. Since 2010, ConocoPhillips' (before and after the spinoff of Phillips 66) ROCE has ranged between 10% and 20%, while ExxonMobil's has consistently been between 20% and 30%.
Further protection from oil prices
National Oilwell Varco and the purchase of Phillips Speciality Products (PSPI) play an important role for Berkshire. Both offer direct exposure to oil and gas production and distribution, without the same level of downside risk that an E&P like ConocoPhillips has become since the spinoff of the midstream and downstream business in Phillips 66. PSPI, which will be led by Berkshire Subsidiary Lubrizol's CEO James L. Hambrick, is primarily in the business of producing flow improvers which aid in moving oil through pipelines, and in extraction of oil from shale. This is a critical component of the oil distribution and refining business, and is largely shielded from the gyrations of the oil market.
While there isn't a lot of data available, the Q3 earnings release does tell us that through the first nine months of the year, Phillips 66's chemicals business generated $725 million in earnings. And if we step back into the 2012 annual report, there's this little nugget:
For example, our flow improve business has grown in volume by 70% over the last five years. A significant portion of the growth is coming form North American shale plays. As the inventor of the technology with 50 years of market leadership, we believe this business has significant growth potential.
Sounds like Buffett got another steal of a deal, and paid with shares of a company one gets the impression maybe he doesn't want to own any longer. Over time, PSPI will likely generate significantly more than the roughly $1.4 billion it's costing.
Final thoughts: What makes sense for Berkshire might make sense for you
ConocoPhillips' exposure to falling oil prices put it at a higher level of risk. Global production of crude is moving ever higher, while political unrest, and many other uncontrollable factors could see oil prices fall sharply in 2014. You can bet that this has crossed Buffett's mind, and is part of why ConocoPhillips probably won't see 2015 in the Berkshire portfolio. Phillips 66's largest business -- refining -- is close to maximum capacity as is, meaning the upside is limited, and it's another possibility to get moved on.
The large stake in ExxonMobil and the trade of Phillips 66 shares for PSPI are great for Berkshire investors, and should generate lots of cash for Buffett's "elephant gun." When it comes to your portfolio, owning companies like Berkshire and ExxonMobil offers both reasonable upside and long-term safety, with top-notch management that doesn't make risky bets that can be devastating when times are lean. Sounds like investors should follow suit.