Has Warren Buffett Found The Best Investment In Oil?

Joseph Hogue's picture

Monday, February 8, 2016 - 11:30am

by Joseph Hogue

Shares of oil stocks plunged again as the price of West Texas Intermediate wiped out nearly half of its late-January rebound. Sluggish demand growth and stubbornly high supply has had investors whipsawed for months. 

In all the confusion, it is difficult not to look at the long-term picture and be positive on oil and shares of energy companies. The dramatic cut in the North American rig count has to eventually curtail supply. Even on more uncertain forecasts, China and India are both expected to grow their economies by nearly 7% this year with higher energy demand in tow.
 

So far, Mr. Market has made a fool of the long-term perspective. Oil prices have fallen consistently since mid-2014 and more investors throw in the towel every day. The argument is to buy when there's blood in the streets -- but that's not so easy to do when you're already bleeding.

How can you take advantage of the long-term upside for oil without the short-term pain? It turns out, Warren Buffett may have found the perfect balance.

What's The Future For Oil?
Right now, no one knows what exactly to expect from the price of oil. No sooner did the price of oil rebound from 12-year lows in late January than major institutional firms started downgrading their forecasts, calling for a lower-for-longer scenario. Morgan Stanley is now expecting the price of Brent crude to stay below $30 a barrel for the rest of the year and analysts there think it could even hit $20 a barrel. 

Volatility in the United States Oil Fund (NYSE: USO), which tracks futures prices for petroleum, has shot up to nearly 80% on an annualized basis as investors jump in and out trying to time the market perfectly.

Even as he slashed his previous oil forecast, Credit Suisse energy economist Jan Stuart told Bloomberg last Friday that the market is becoming overly pessimistic on prices and the fourth quarter looks much more positive. 

While the price of crude has fallen back to $30 per barrel, 17 analysts surveyed by Bloomberg expect the price at a median of $48 by the end of the year. That's on a forecast by the Energy Information Administration for a production decline of 620,000 barrels a day in 2016 in the United States. Domestic production has already started coming down and may average 9.11 million barrels a day in the first quarter, down 5% from June's record production of 9.61 million barrels per day.

But how should you position for the eventual rebound without getting burned along the way?

The Oracle Doubles Down On This Oil Giant
Warren Buffett resumed his large-block buying of Phillips 66 (NYSE: PSX) in the last week of January as oil prices plumbed new depths. Berkshire Hathaway bought another 2.5 million shares over three days for nearly $200 million at an average price of $78 per share. The purchases were on top of the $630 million added to the firm's position just in the first half of the month and brings Berkshire's stake to $5.7 billion. Buffett now controls 13.5% of the company, more than any other shareholder.

Buffett isn't just throwing money at any energy company, waiting for an eventual rebound. He's found one of the smartest plays in the sector, one that has withstood the worst that plunging prices have offered. Phillips 66 is down just 5.9% since June 2014 against a 70% plunge in the price of WTI crude and a loss of 44% on the Energy Select Sector SPDR ETF (NYSE: XLE).

Phillips 66 is largely a refinery with 14 facilities and a throughput capacity of 2.2 million barrels per day. Refinery operations accounted for 60% of 2015 adjusted earnings, with a 60% surge in earnings to $2.5 billion from the prior year. Lower crude prices and strong demand for gasoline helped the refinery segment cover earnings losses in the midstream and chemicals segments. The refinery segment posts a 19% return on capital employed, an important measure for management efficiency.

But Buffett told CNBC last September that he wasn't buying the $42 billion giant, "as a refiner, and we're certainly not buying it as an integrated oil company." The refinery operations have helped to smooth earnings as other energy stocks crumbled -- but the real story may lie in the company's other segments. 

The chemicals division accounted for 23% of adjusted earnings and a return on capital employed (ROCE) of 19% in 2015. The marketing and specialties division is another 23% of earnings and posts an amazing 35% return on capital. This gas stations segment fits well with Buffett's preference for consumer products and a national average of just $1.80 per gallon may mean Americans will drive more in 2016. 

The company also has a 50/50 interest in DCP Midstream (NYSE: DPM), which owns 61 natural gas processing facilities, 12 NGL fractionation plants and 62,000 miles of natural gas pipeline. Phillips contributed an additional $1.5 billion to the partnership last year to strengthen DCP's balance sheet, which has struggled under weak natural gas prices. Despite the recent weakness, DCP operates the nation's third largest system of NGL pipelines and is the largest producer of natural gas liquids. The capital injection by the partners means DCP will be able to lower its leverage and could become a valuable asset in the future.

Management has committed to expanding the midstream and chemicals segments, so refining is expected to represent just 30% of earnings by 2017. This could be hugely beneficial as oil prices increase and profitability improves in other segments while refineries margins weaken. Refinery operations will add to earnings this year but should not slow growth down when energy prices increase if the company can strengthen the other segments.

Buffett may also be attracted to the company's strong cash flow and cash return to shareholders. Phillips 66 generated $676 million in free cash flow over the last year after spending $4.4 billion in capital expenditures. It also returned $2.8 billion to shareholders through the dividend and buyback program. Strength in the refinery segment means Phillips 66 may be one of the few in the energy space where investors don't have to worry about the dividend. 

Shares trade for 10.2 times trailing earnings, below the three-year average of 11.4 times earnings, and pay a 2.8% dividend yield. I like the shares back up to $90 over the one-year outlook but the real upside may be over the next several years as Buffett's vision plays out.

Risks to Consider: As a more diversified company, Phillips 66 may not rebound as strongly as pure-play oil explorers when the price of oil rebounds. 

Action to Take: Benefit from stronger earnings in refining now and stronger growth in other segments when crude rebounds by following Warren Buffett into shares of Phillips 66. 

P.S. A new technology that allows you to live completely off the grid is about to hit the market. Business Insider calls it the "next trillion dollar industry"... and Citibank says utilities could see their market share "shrink by more than 50%." Full details here.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.