Phillips 66 Looks to Pipes to Blunt Refining Volatility

04 09, 2012 by Bloomberg

Phillips 66 (0006104D) will debut next month as the world’s largest independent refiner by market value. In the future, it may look more like a pipeline and chemical business.

The new Houston-based company, set to begin trading May 1 after its spinoff from ConocoPhillips (COP), plans to boost profit by emphasizing growth in its higher return businesses while shrinking its more volatile fuel processing. Greg Garland, slated to become chief executive officer, updated investors in a webcast today on its outlook as a standalone company.

Phillips 66 is trying to sell its Trainer refinery in Pennsylvania and Alliance plant in Louisiana that provide about a sixth of its capacity. At the same time, it plans to boost the proportion of capital it invests in chemicals and pipelines to 50 percent in the long term, compared with 16 percent last year.

“The strongest growth story is in those two businesses,” Brian Youngberg, an analyst with Edward Jones, said in an interview. “There are a lot of opportunities in chemicals and in pipelines.”

ConocoPhillips has seen wide swings in profit from refining and marketing in the past five years. Earnings, excluding one- time gains and losses, fell to as low as $115 million in 2009 from $5.33 billion in 2007. Profit recovered to $2.62 billion last year, still half of the 2007 level.

Earnings from chemicals surged to $745 million last year from $498 million in 2010. Pipeline profit rose to $458 million from $306 million in the same period.

ConocoPhillips has gained 3 percent this year, the only positive performance on the six-member Standard and Poor’s 500 Integrated Oil & Gas Index, which fell 1.2 percent. Exxon Mobil Corp. (XOM), with half the index’s weighting, fell 1 percent.

Higher-Value Pipelines

Pipeline companies are valued at an average of eight times earnings before interest, tax, depreciation and amortization -- more than triple that of refiners such as Valero Energy Corp. (VLO), which trades at about 2.7 times trailing Ebitda, according to data compiled by Bloomberg.

Pipeline projects are not risk-free. ConocoPhillips last week said it suspended funding for a proposed C$16.2 billion ($16.3 billion) project that would bring natural gas from northern Canada to U.S. markets, citing low prices for the fuel. ConocoPhillips will have a one-time charge of about $525 million in its first-quarter results because of the project. Its partners didn’t immediately announce any expected charges.

Chemical Makers Benefit

Global demand for chemicals will more than double the industry’s profits by 2016, according to IHS Inc. (IHS), a consultant. Earnings for companies with primarily U.S.-based operations have surged as gas prices have fallen to the lowest in a decade, according to data compiled by Bloomberg.

Chemical makers get a double benefit from cheap gas, using it to power their factories and as a feedstock to make products such as ethylene and polyethylene plastic.

Rising crude prices and declining U.S. demand for gasoline have squeezed refining margins in U.S. coastal areas. Refining profitability on the U.S. East Coast fell in 2011 to the lowest point in nine years, according to data compiled by Bloomberg.

Refinery owners including Exxon and BP Plc (BP/) are closing or selling plants to refocus spending on more profitable operations such as crude production.

Sunoco Inc. (SUN) and Marathon Petroleum Corp. (MPC) have sought to increase shareholder value by capitalizing on the networks of pipelines they own that carry crude and fuel to their plants. Refiners are able to lock in long-term shipping contracts on the pipelines that provide stable earnings and growth independent of the peaks and valleys of crude prices.

Sunoco’s Refineries

While losing money on refining in 10 of the last 11 quarters, Sunoco shares almost doubled during that time, according to data compiled by Bloomberg, as Sunoco sold or closed five of its refineries and invested more heavily in pipelines and storage. Marathon is considering an initial public offering for its pipeline assets that may be worth as much as $6.2 billion.

Refiners that have spun off or issued shares for their pipeline assets have been outperformed by the newly created partnerships. Tesoro Logistics LP, an affiliated pipeline partnership of Tesoro Corp., rose 69 percent since its separation in April. Tesoro fell 7 percent in that time. Sunoco Logistics Partners LP rose 41 percent in 2011 compared to 1.8 percent for Sunoco, according to data compiled by Bloomberg.
Chemicals Experience

Garland, the CEO-designate of Phillips 66 (PSX-W), previously held that job at Conoco’s chemical joint venture with Chevron Corp. (CVX), Chevron Phillips Chemical Co., which operates primarily in the U.S. and is based in The Woodlands, Texas. ConocoPhillips’ portion of the venture will become a part of Phillips 66 after the spinoff. Profit at the chemical company jumped 42 percent in 2011 to $1.97 billion compared with the previous year, according to the company website.

The venture is spending $5 billion to build a new ethylene plant in Baytown, Texas, by 2017 as well as two polyethylene plants and related infrastructure, Executive Vice President Mark Lashier said in an interview March 6. The chemical industry may spend $30 billion to build U.S. factories that can convert gas into plastics as low gas prices have made American production the cheapest outside the Middle East, Lashier said.

ConocoPhillips shareholders will receive one share of the new Phillips 66 refining entity on April 30 for every two ConocoPhillips shares they hold as of the close of business on April 16.

Phillips 66 was the name given to a high-octane gasoline in 1927 that allowed drivers to take a vehicle to a cruising speed of 66 miles per hour on Route 66, according to the company’s website.

Market Value

ConocoPhillips’s current market capitalization is about $96 billion, according to Bloomberg data. Using the spinoff formula, about two-thirds of Houston-based ConocoPhillips’s market value will remain in the business of finding and producing oil and gas, said Philip Weiss, an analyst with Argus Research.

The other third will go to Phillips 66, which will include refining, pipeline and chemical operations. The new refiner’s potential market capitalization of about $32 billion would be more than twice that of current leaders Valero and Marathon Petroleum, each worth about $14 billion to $15 billion.

Based on its refining holdings, which are comparable in scale to Valero, combined with chemicals and pipelines, Phillips 66’s assets will be worth $23 billion, Paul Sankey, an analyst with Deutsche Bank AG in New York, said in a note to clients yesterday.

Investors accustomed to the more stable returns of an oil and gas explorer may want to sell their shares of Phillips 66 if the company is perceived solely as a refiner, said Ted Harper, who helps manage $8 billion for Frost Investment Advisors LLC in Houston.

More Midstream Investment

“Refining generally has lower margins and returns in the energy value chain,” he said. “Conoco was never really known as having the best refining assets.”

Phillips 66 sees possible dividend increases and share repurchases, according to a ConocoPhillips investor slide presentation on March 5. Its “midstream” pipeline operations, which move crude or fuel products to and from refineries, are managed primarily through DCP Midstream LLC, a Denver-based joint venture with Spectra Energy Corp. (SE)

“You’re going to see more investment proportionately towards the midstream and chemicals through those joint ventures,” ConocoPhillips CEO Jim Mulva told investors during the presentation. “We think diversification, a strong balance sheet, is really going to position this company to create value.”
Employing More Capital

About 25 percent of the capital employed to operate the refining spinoff will go toward its chemicals business in the long term, compared with 11 percent last year, according to today’s presentation. Midstream projects also will comprise 25 percent of capital employed in the long term, compared with 5 percent in 2011.

U.S. gasoline demand averaged about 5 percent lower in March than in the previous year, according to the U.S. Energy Department. Phillips 66 has said it plans to cut daily crude refining capacity to about 2 million barrels by the end of this year, compared with 2.7 million at the end of 2010.