Warren Buffett is the kind of guy who can spot a good deal from a mile away. And in this case, the good deals are located in the energy sector.
However, America’s favorite bespectacled value investor isn’t snagging up shares of major energy firms like Exxon Mobil Corporation (XOM) or Chevron Corporation (CVX). He’s buying shares of a firm that technically was spun-off because it was a “problem child,” a drag on earnings for its energy-producing parent.
We’re talking about refiner Phillips 66 (PSX).
PSX isn’t a problem child by any means. In fact, it’s quickly become of the biggest downstream and now midstream players in the entire industry — feasting on the lower and lower price for crude oil and natural gas.
And Buffett can’t get his hands enough shares of PSX.
But this isn’t just a case of blindly following Buffett into a stock. PSX has some serious chops and all the makings of a great long-term investment — assuming that the Oracle of Omaha doesn’t buy it outright first.
Buffett’s Continued Buying of PSX
To say that Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B) is a fan of Phillips 66 would be an understatement. Over the last or so, Buffett has made several major buys of the stock. Back in August and September of last year, Buffett added nearly 61.5 million shares of PSX into Berkshire’s portfolio. That gave him roughly 11.5% of all the shares outstanding.
However, in recent days, Buffett has unloaded even more capital into PSX. Throughout January, BRK has continued to buy shares of the refiner and invested more than an additional $825 million into PSX stock. Berkshire’s total haul in Phillips 66 now sits at a whopping 72.3 million shares or around 13.6% of the company. That huge stake is worth around $5.8 billion and puts in the top six in terms of size among Berkshire’s holdings.
Plunking down that sort of cash for PSX seems absurd since Phillips 66 recently reported a 43% drop in earnings. However, there is plenty of method to Buffett’s madness.
Plenty of Bullish Reasons for PSX
For starters, lower oil prices have been a boon to PSX’s bottom line. Downstream players like PSX have been able to feast on cheap crude oil prices thanks to the oversupply of West Texas Intermediate (WTI) and Western Canadian Select (WCS) benchmarked oil.
The refiners earn profits based on the difference between that input price and the price for refined products such as gasoline, jet fuel and heating oil. Last year, those crack spreads/margins were at insanely high levels. Today, that level is still pretty juicy and more sustainable at around $9.40/barrel.
This difference in crack spreads explains the drop in earnings versus a year ago. However, Phillips 66’s earnings were still pretty darn decent and help underscore Buffett’s desire for shares. And that would be PSX’s cash flows and dividends.
The refiner continues to be a free cash flow machine, and the recent drop in crude oil has only helped on that front. Even though margins weren’t what they were a year ago, PSX still managed to produce over $1.4 billion in free cash flows for the year. Over the entire year, Phillips 66 generated $5.7 billion. And it has used those cash flows wisely, both increasing the dividend and plowing them back into the underlying business and growth opportunities.
As for those growth opportunities, that’s meant adding chemicals and natural gas faction capacity as well as pipelines and other midstream assets. These chemical cracking businesses tend to have higher margins than bread-n-butter oil refining and have also benefited from the recent drops in energy prices — especially natural gas.
Owning traditional pipelines and gathering systems equals a steady diet of cash flows that are only enhanced when placed inside PSX’s master limited partnership, Phillip 66 Partners (PSXP).
Even better is that the lion’s share of midstream projects still can be dropped down in PSXP and that Phillips still has plenty of new projects in its backlog to add.
All of this will only go to enhance PSX’s cash flows even further down the road. And those cash flows mean big dividends. Since being spun out back in mid-2012, PSX has increased its dividend by 180%.
Last year alone, Phillips 66 raised its payout by 12%.
If margins still remain robust — and they should, considering how deep the glut of crude oil really is — then PSX should have no problems keeping the cash flow and dividend spigot going. The new projects will only continue to enhance those cash flows further.
And that’s what Buffett is buying with his huge stake in Phillips 66.
You Should Buy PSX Too
Perhaps what’s even better about buying PSX’s cash flows and growth is its current price. The recent drop in shares has it trading for a dirt cheap price-to-earnings ratio of less than 10. That’s less than the broader S&P 500 and the energy sector as represented by the broad Energy Select Sector SPDR ETF (XLE). Adding to its appeal is that Phillip 66’s dividend yield is nearly 3%.
PSX stock was already a great investment on its own thanks to its robust cash flows, dividends and growth potential. Warren Buffett’s continued buy of shares just reaffirms the energy stocks appeal.
As of this writing, Aaron Levitt was long PSX.