Should You Follow Warren Buffett Into Phillips 66 Stock?

• Warren Buffett has bought shares of Phillips 66, a major US based refiner.
• Some investors may not like this, considering Buffett’s track record in energy investing and Phillips 66’s recent woes.
• But Phillips 66 could turn out to be a promising pick since it’s much more than just a refiner.

Warren Buffett’s Omaha, Nebraska-based Berkshire Hathaway Inc (NYSE:BRK.A) (NYSE:BRK.B) has recently released its quarterly results along with the details of the company’s $130 billion U.S. stock portfolio. If you have been following Berkshire Hathaway closely, then you may already know that the company has increased its stake in Apple (NSDQ:AAPL) by 55%, as the development has made headlines recently. But what’s even more interesting is that the Oracle of Omaha has built up a sizeable position in Phillips 66 (NYSE:PSX), one of the world’s leading refiners, and this may worry some investors.

At the end of 2014, Berkshire Hathaway owned just 6.5 million shares of Phillips 66, which made it less than 1% of the company’s portfolio. But at the end of June, the conglomerate owned 78.8 million Phillips 66 shares. That’s equivalent to 15% of the oil refiner. In fact, Phillips 66 is the sixth-largest holding in Berkshire Hathaway’s portfolio with a value of more than $6.1 billion, making it significantly bigger than Apple, which is the conglomerate’s fourteenth- largest holding valued at $1.67 billion.

Investor concerns

Some Berkshire Hathaway investors may not like this.  That’s because firstly, while Buffett is arguably one of the world’s greatest investors, he has a poor track record when it comes to investing in the energy space. He did make a killing when he bought $488 million worth of PetroChina shares in 2003 which he sold four years later for around $4 billion. He followed that up by buying one of the world’s leading oil producers ConocoPhillips (NYSE:COP) and the debt of Dallas – based power company Energy Future Holdings. But Buffett failed to foresee the collapse in energy prices in 2008-09 which sank both of these investments.

In 2009, Buffett sold a large chunk of ConocoPhillips stock, which led to one of the biggest quarterly losses in Berkshire Hathaway’s history. He later disposed Energy Future Holdings’ bonds as well for a loss of more than $1.7 billion. Buffett also almost made a poorly timed bet on Exxon Mobil (NYSE:XOM) when he bought the oil giant’s stock for $91 per share in 2013, but quickly exited his position when the current downturn began at roughly $93, reaping just a modest profit in the process and barely avoiding the slump that followed. Exxon Mobil is currently changing hands at less than $88.

Secondly, Phillips 66 is primarily a refiner which spun-off from ConocoPhillips in 2012. In terms of capacity, Phillips 66 ranks second only to Valero Energy (NYSE:VLO), the leading US refiner, and is bigger than other stand-alone refiners such as Marathon Petroleum (NYSE:MPC) and Tesoro (NYSE:TSO). Phillips 66 also has non-refining businesses, such as midstream and chemical, but historically, refining has made the largest contribution to the company’s bottom-line.

This could be a problem. Note that refiners use oil as a raw material. These companies posted strong results last year due to weak oil prices which lowered their production cost and strong demand of refined products, such as gasoline and diesel. However, this year, the business environment has turned. Oil isn’t in free fall anymore. Moreover, we have near record levels of refined product inventories which will hurt refiner’s gasoline and diesel margins.

The challenging backdrop has already hit Phillips 66 which has recently posted a 50% drop in adjusted quarterly profits for the second quarter as refining income plunged 75%. So far, in the first six months of this year, Phillips 66 has generated just $238 million of earnings from the refining business, a far cry from the comparable period last year when it earned more than $1 billion.

Phillips 66 Is A Promising pick

Despite its woes, I believe Phillips 66 could turn out to be a promising pick. As highlighted earlier, Phillips 66, with 2.2 million barrels per day of refining capacity, is one of the world’s biggest refiners, but it also has significant non-refining operations. In the tough business environment, the non-refining segments have fared better. In the first six months of this year, the company posted a 13% decline in earnings from non-refining businesses, which compares against 78.3% drop witnessed by the refining segment. If it weren’t for the non-refining businesses, Phillips 66 would have reported a considerably bigger decline in earnings.

This is what sets Phillips 66 apart from other refiners. Companies like Valero and Marathon Petroleum do not have a large portfolio of midstream, chemical and marketing and specialties businesses, and have greater direct exposure to refining operations. Therefore, most independent refiners have greater exposure to changes in oil prices than Phillips 66.

But what’s really interesting is that Phillips 66 aims to further reduce its exposure to refining in the coming years. The company has been using the cash flows from the refining business to expand in the more lucrative aspects of the midstream segment. In fact, the company plans to spend $3.88 billion as capital expenditure this year, of which $2.34 billion, or 60% of the total, will be spent on aspects of the midstream segment other than refining. In midstream, the company has been spending heavily to build a number of assets, ranging from pipelines to export terminals to fractionators which are projected to come online through 2017.

Phillips 66 also plans to spend more than $1.2 billion on its refining business this year, but that’s aimed at enhancing returns rather than growth. In fact, Phillips 66 has no plans to further expand its refining base.

Due to this focused expansion strategy, Phillips 66 will likely emerge as a unique company in the US energy space over the next few years. It will have one of the largest refining capacities in the industry as well as a vast portfolio of midstream and logistics assets.  This mix of assets will strengthen Phillips 66’s ability to withstand various oil cycles. Its refining unit will perform better in an environment of weak oil prices, but once the oil cycle turns, the non-refining businesses, especially the newer midstream segments, will shine.

Conclusion

Warren Buffett’s Berkshire Hathaway has bought Phillips 66 stock, making it one of the biggest holdings in the conglomerate’s stock portfolio. This may worry some investors, but Phillips 66 could turn out to be a promising pick in the future since the refiner, unlike its peers, maintains a large portfolio of midstream, chemicals and marketing businesses.

Moreover, Phillips 66 is eyeing significant growth in the non-refining midstream space and does not intend to significantly expand its refining operations. As a result, it will emerge as a one-of-a-kind company in the US energy sector with a unique mix of refining, non-refining midstream and chemical assets. Unlike independent refiners like Valero and Tesoro, Phillips 66 will have a lower risk profile since it will have minimum exposure to oil cycles. I believe this is the number one reason why Warren Buffett has been buying Phillips 66 stock, and you should too.