Think Twice Before Following Warren Buffett Into Phillips 66

Phillips 66's earnings predictability is difficult to determine

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Aug 30, 2015
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Berkshire Hathaway has disclosed a $4.5 billion stake in Phillips 66 (PSX, Financial). Phillips 66 is organized into four operating segments: Midstream, Chemicals, Refining, and Marketing & Specialities. It might turn out to be a great investment, but before you piggyback off Buffett, I urge readers to research and make independent judgements. Earlier in the year, I looked at Phillips 66 when it was selling in the mid 60’s. I passed. Obviously now that it’s $77 per share, I wish I owned some. However, any profit that I would have enjoyed would have been from dumb luck. I passed on Phillips 66 because there was no way for me to predict the crack spread or to have confidence in its future earnings.

What is a crack spread? The technical definition of crack spread is the difference between market prices for refined petroleum products and crude oil. The most common crack spread term is the 3-2-1 crack spread which is three barrels of crude oil producing two barrels of gasoline and one barrel of diesel. For Phillips 66, their profitability is influenced by the price differential between Brent crude prices and West Texas Intermediate (WTI) prices. Phillips 66 takes crude oil and refines it into a finished product. The Energy Policy and Conservation Act of 1975 prevents U.S. oil companies from exporting most crude oils. That means U.S. refiners have access to WTI oil and international refiners don’t. As a result, when WTI is lower than Brent Crude which comes from the North Sea, U.S. refiners like Phillips 66 enjoy a cost advantage. While U.S. oil producers are restricted from exporting crude oil, refiners are allowed to export their product.

From Phillips 66 investor presentation, the chart below shows the Brent / WTI trend.

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You can see how Phillip 66's refining EBITDA correlates to the Brent / WTI spread. There are large and small spreads in 2013. The company's refining EBITDA was extremely high in 1Q2013 and extremely low in 3Q2013.

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You’ll also notice that the refining segment averages out to about 50% of Phillip 66's EBITDA. If you want to invest, then you’re hoping for favorable WTI / Brent spreads. Phillips 66 is forecasting that its other segments will account for a larger portion of adjusted EBITDA by 2018. I don’t believe that the other segments have earnings predictability either. The Midstream segment is dependent on natural gas liquid prices and the Chemicals segment is dependent on propylene, benzene, ethylene and polyethylene prices.

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Final Thoughts

In 2012, Phillips 66 was spun off from ConocoPhillips (COP) which was another Warren Buffett (Trades, Portfolio) holding. In his 2008 letter to shareholders, Buffett wrote:

“Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

It gives me no pleasure to point out Warren Buffett (Trades, Portfolio)’s errors as I own shares in Berkshire Hathaway. However, he is human as witnessed by his purchases of ConocoPhillips, IBM (so far), and Tesco. There was another time I regretted following his trades.Blindly following another investor is speculation even if that other investor happens to be Warren Buffett.