Phillips 66 Is Cashing In On The Oil Spread

May 21, 2018

• Phillips 66 is a great way to play the rising price of oil.
• The refining company can take advantage of the $8 differential between West Texas Intermediate crude oil and Brent crude.
• The company is a money printing machine. First-quarter earnings surged 86% beating analysts expectations.
• Shareholders are receiving the benefits. It's in the middle of a large share buyback program and the dividend was just hiked 14%.

The price of oil has been rising since it hit a low of $48 last summer. While oil stocks have been rising since, it's not too late to feel like Jed Clampett of the Beverly Hillbillies and get some black gold into your portfolio.

A lot of oil stocks have been doing well lately. My pick is Phillips 66 (PSX), which posted great first-quarter earnings, just raised its dividend and is a favorite of Warren Buffett. Even as the broader market fell Thursday, Phillips 66 rose $3.71, or 3%, to $121.87.

The price of both oil benchmarks are up about 4% this month. This is because concerns about oil supply disruptions are increasing with turmoil in the Middle East and the prospect of trade sanctions against Iran in the wake of President Trump pulling out of the Iran Nuclear Deal.

On Thursday, July Brent crude oil, the European and global benchmark, closed at $79.39 a barrel, after hitting $80 earlier in the day, its highest finish since November 2014. Meanwhile, the U.S. benchmark, June West Texas Intermediate (NYSE:WTI) crude closed at $71.49 a barrel, a 3 1/2 year high. This means the spread between the two is almost $8.

"The spread between the two contracts is basically Europe and Asia screaming for more oil from the United States to fill the potential void and feed their ravenous oil demand," Phil Flynn, senior market analyst at Price Futures Group, told MarketWatch on Tuesday.

And it looks like Saudi Arabia wants the price of oil to go up. As the de facto leader of the Organization of the Petroleum Exporting Countries, Saudi Arabia plans to curtail production to boost the price of Brent crude. In its most recent report, OPEC reduced its forecast for global oil production.

"The Saudi's are signaling that they would be relaxed with the scenario in which they temporarily over tighten the market," Paul Horsnell, the head of commodity research at Standard Chartered told MarketWatch on Tuesday. "Coupled with no signs of new supply coming on, demand remaining strong as well as the geopolitical turmoil in Iran and you have the conditions for this push up towards $80" a barrel. This means the price differential between Brent and West Texas Intermediate will probably stay wide or widen for the foreseeable future.

The majority of Phillips' refineries are located in the U.S. and they're able to purchase crude oil at a discount to WTI, such as Western Canadian Select (WCS). Phillips is able to buy this crude and turn it into jet fuel, diesel and gasoline and sell at world market prices.

For the first quarter, Phillips 66 posted adjusted earnings of $512 million, or $1.04 a share, compared with $294 million, or 56 cents a share in the year-ago quarter. Earnings per share surged 86%, beating analysts' consensus estimate of 91 cents. Revenues jumped 23% to $29.2 billion, according to Zacks Investment Research.

The company is utilizing this cash to pay dividends and buyback stock. In the first quarter of 2018, the Houston oil and gas refiner returned $3.8 billion to shareholders through dividends and repurchasing 37 million shares, representing a 7% reduction in the float. Of that share repurchase, 35 million were bought from Berkshire Hathaway (NYSE:BRK.A)(BRK.B) at $93.725 per share for a total of $3.3 billion on Feb. 14.

"Phillips 66 is a great company with a diversified downstream portfolio and a strong management team," said Warren Buffett, Berkshire Hathaway's chairman and chief executive in a written statement. "This transaction was solely motivated by our desire to eliminate the regulatory requirements that come with ownership levels above 10 percent. We remain one of Phillips 66's largest shareholders and plan to continue to hold the stock for the long term."

After the transaction, Phillips 66 had 466.5 million shares outstanding, down from 501 million at the end of 2017. Berkshire owned 45.7 million shares.

The company continues to buyback shares. They have an authorized program to purchase as much as $12 billion of outstanding common stock, including the authorization in October 2017 to repurchase $3 billion of additional shares. The authorizations don't have an expiration date and the share repurchases are expected to be funded primarily through available cash.

If Phillips bought back $12 billion a year for each of the next five years, it would in essence buy back all the stock in the company. But, in the meantime, it's shrinking the float and boosting the earnings per share.

On May 9, the board lifted the dividend 14% to 80 cents per share from 70 cents. The $3.20 payout gives the dividend a current yield of 2.7%. The dividend is payable on June 1, to shareholders of record as of the close of business on May 21. The company has increased the dividend eight times since its inception in 2012.

Spun off from ConocoPhillips (NYSE:COP) downstream business in 2012, Phillips 66 is in the midst of streamlining its portfolio of assets. It has an 73% ownership stake in Philips 66 Partners (NYSE:PSXP), where it can raise cash by selling lower margin businesses to the limited partnership such as midstream assets of pipelines and storage facilities

For 2017, Phillips earned $9.85 a share. I think if Phillips earns $12 a share in 2020 and put a 14 price-to-earnings multiple on it, that gets you to $168. The company is buying back so much stock and raising the dividend that it's like a money printing machine. The risk to the situation is that if the U.S. goes to a higher level of production and the Saudis and the Russians flood the market then the spread between Brent and WTI narrows or reverses, or even WTI becomes higher than Brent. But the likelihood of that happening is very low.

Looking at the stock, it built a first stage base on Feb. 2, 2018, and that base was 11 weeks long. It had a depth of 17% and broke out of the base at a pivot of $107.47 on April 17. If the company were to sustain the current trajectory that it's on, several more bases could be built in the next two years and the stock could trade at a significantly higher price.

The stock could rise 20% to 25% from the pivot. It could then correct, build a new base and break out and run again. I'm looking to get a 25% gain and depending on what happens with the buyback and the spread between WTI and Brent, I'll keep the majority of the position on. If it falls below the 50-day moving average, I'll probably sell it.

Disclosure: I am/we are long PSX.