2020 was supposed to be a great year for Phillips 66 (PSX). With large coking capacity, PSX was in a great position to profit from the new IMO-2020 regulations to significant reduce maritime emissions. Indeed, as I reported in November of last year, diesel crack margins futures for 2020 were then trading ~$4/bbl higher than the historical average. Combined with a strong economy, the future looked bright.
Then COVID-19 started in China and quickly spread around the globe. Now, 2020 is likely to see the first year of falling crude oil demand since the great recession of 2008-2009. As a result, jet-fuel and gasoline demand have cratered, refining utilization has dropped dramatically, and so too have refining margins.
Compounding the problem is significant contraction of the Brent/WTI spread, which averaged ~$7/bbl last year. On Friday, WTI closed at $40.27 and Brent closed at $43.52, for a spread for only $3.25/bbl, half of last year’s average. This is a strong headwind for domestic refiners who depend on the spread being wide enough to keep exported gasoline margins robust. And note that the spread has shrunk despite about a 2 million bpd reduction in US oil production:
Yet despite the big drop in domestic production, the EIA reported in its weekly petroleum report for the week ending July 24, 2020 that US oil inventories were 526 million bbls – 17% above the 5-year average. Gasoline inventories were 8% above the 5-year average, and distillate fuel inventory was a whopping 26% above the 5-year average. The bearish news on distillates were due to a massive drop in jet-fuel demand since March:
The bottom line is this: the macro impact of COVID-19 has swamped any positive impacts from IMO 2020, refinery capacity utilization in the most recent week was only 79.5%, and refining margins collapsed.
PSX’s Q2 Earnings
The impact was obvious in PSX’s Q2 EPS report:
Source: Phillips 66 Q2 EPS Report
Not surprisingly, and as can be seen from the chart above, PSX’s Refining Segment lost $878 million in Q2 versus a profit of close to $1 billion in last year’s Q2.
Luckily for PSX, over the past few years, it has developed robust midstream and chemicals operations to help offset its cyclical Refining Segment. But chemical margins also collapsed in the quarter. However, a bright spot is the company’s Marketing & Specialties Segment (“M&S”). The M&S Segment purchases refined products (gasoline, jet-fuel, distillates), for resale and marketing and manufactures and markets specialty products such as lubricants. The segment is a strong and stable source of cash-flow and – all things considered – delivered solid results in the quarter.
Looking ahead to fall, on the Q2 conference call, EVP & CFO Kevin Mitchell said:
I might add that we’re coming up on the fall season and there’s some seasonal impacts driving to and from schools is in rough numbers about 5% of demand, and there’s probably a carryover impact on commuting as well. So, I think that will have an influence. We’re expecting a strong planting season — or excuse me harvest season this fall, as well to support distillate demand.
However, I don’t share his enthusiasm about schools considering roughly 60% of the biggest 100 school districts in the country have announced 100% virtual online classes.
The only good news I can see is that we have likely seen the (dramatic) low in the cycle during Q2. Crack spreads and RBOB futures bounced nicely higher from the April lows:
PSX has some clear advantages as opposed to the pure refiners in that its midstream, chemicals, M&S segments – as well as what I would argue are the best logistics in the business – give the company multiple cash-flow avenues to help mitigate the worst impacts of the current economic crisis.
That said, going forward it is clear there is simply too much domestic refining capacity in the U.S. given the current economic environment. Refiners cannot thrive running at 80% capacity utilization – that destroys margins. As a result, some refineries are likely going close. Indeed, Reuters reports that Marathon Petroleum (MPC) has already decided to close two refineries:
- Martinez, California (161,000 bpd)
- Gallup, New Mexico (27,000 bpd)
However, consider that last week the EIA reported total refinery throughput in the US 14.6 million bpd in July, and that was running at 79.5% capacity utilization. That implies 100% utilization equates to 18.4 million bpd. The point is, MPC’s closures – in aggregate – amount to only ~190,000 bpd, or only 1% of total US refining capacity. While I don’t believe demand destruction of 20% of total utilization will last over the long-term, I’d be surprised if perhaps 10% doesn’t come back for years. Obviously, more refining capacity is going to have to shut-down, or the recovery in the refining sector could take years instead of months.
Valero (VLO) recently reported Q2 earnings which were an adjusted loss of $1.25/share. Refinery throughput was only 74%, crimping margins. VLO’s dividend of $3.92/share is a stretch because the company likely won’t come close to covering it this year. Recent EPS estimates show it likely won’t cover it in 2021 either.
At the bottom of the downturn back in April, the Houston Chronicle reported that Fitch Ratings downgraded the holding company of refining giant PBF Energy (PBF), and warned it was considering doing the same to Sugar Land-based CVR Energy (CVR) and Dallas-based Holly Frontier (HFC). Indeed, in June Moody’s downgraded Holly Frontier’s outlook to “negative” from “stable” and both CVR and Holly have recently announced cut jobs. Unfortunately, I expect more job cuts in the refining sector, but would prefer to see executive pay cuts before that happens.
Fitch said that although refiners have historically shown an ability to adjust quickly to drops in demand, a key consideration is the unknown duration and severity of the current downturn. The advantage goes to PSX, which will prove to be a tough competitor to pure refiners due to its big midstream and chemicals operations.
In addition to the demand destruction caused by COVID-19, there are two other primary risks associated with PSX:
- The current court order for the Dakota Access pipeline to shut-down
- Additional chemical plant expansions at CPChem
Phillips 66 Partners (PSXP) owns a 25% working interest the DAPL pipeline. As ludicrous as it seems to shut-down a pipeline that received all permits and which took billions of dollars to build and is operating safely could be shut-down, I suppose in the courts anything could happen. It’s the last thing we need in a severe economic contraction because more jobs will be lost (not just with the pipeline, but all the economic activity generated from transporting 570,000 bpd). This is a financial risk to PSX because of its majority ownership in its MLP’s units and the possibility that distributions up to the general partner could be cut.
Meantime, CPChem – the 50/50 chemicals JV with Chevron (CVX), is said to be considering yet more new large-scale chemical plants. While I have written in prior articles that I consider PSX management to be the best in the business, I was very dismayed to here the company is considering yet more chemicals expansions. An announcement of yet another multi-billion spend on new chemical capacity would be completely tone-deaf to the market and would likely cause shares to drop further. I say this because PSX has not even paused to get a decent return on its recent large scale Gulf Coast chemical plants – profits in the chemical segment nowhere near justify the massive multi-billion capital required to build them. In fact, CPChem’s recent returns are below what they were before the new plants were built (!). That is because PSX is competing head-on with companies like Exxon Mobil (XOM) that also built massive new chemical capacity on the Gulf Coast. The rationale used by both companies was low feedstock costs (i.e. NGLs and natural gas), which was spot-on. But apparently the bean-counters at both companies failed to take into consideration what the massive capacity addition would due to margins, which have simply cratered.
EV sales are, in my view, a longer-term threat as the domestic EV fleet is currently a drop in the bucket compared to the overall car and truck fleet and I don’t expect that to change over the next few years. That is, the short- and medium-term will be dominated by the COVID-19 crisis, not EV sales. That said, COVID-19 demand destruction could force a reduction in domestic refining capacity that will, in the future, better prepare the domestic refining industry for a future that includes significantly more EVs on the road.
Summary & Conclusion
COVID-19, and the US’s response to it, has created a macro environment that is – and will continue to be – especially hard on refiners over the next 1-2 years. Luckily for PSX shareholders, the company has diversified into midstream and chemicals and will likely fare much better than pure refiners for the duration of the crisis. The current large-scale community spread in the US does not bode well for schools opening nor for the travel industry – both of which significantly affect refined product demand. As long as Americans are not welcome to visit the EU, China, Canada, the Bahamas, and many other countries, Americans will be practically de-coupled from the global economic recovery. That is bad news for energy companies in general, and specifically the refining industry.
Meantime, current EPS estimates for full-year 2020 are for $1.39/share – not enough to cover the $3.60/share dividend. But estimates for next year are for $5.71/share in earnings, which more than covers the dividend. For now, PSX offers a very tempting 5.7% yield, which is inline with the risks because the dividend is relatively safe in my opinion. However, a prolonged economic downturn (more than 18 months), an adverse decision on DAPL, or a big cap-ex announcement by CPChem could put the dividend at risk one year from now. I rate the shares a hold, and expect there could be a COVID-19 induced market sell-off later this Fall due to deteriorating economic conditions in the general economy.
Lastly, PSX may be primarily an income oriented investment until the US gets a handle on COVID-10 and demand for jet-fuel returns. Once jet-fuel and gasoline demand return, PSX’s capital appreciation potential will begin to shine. But that won’t happen in the short-term … and perhaps not even the mid-term (18-24 months).
Source: Yahoo Finance
Disclosure: I am/we are long cvx, PSX, PSXP, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am an engineer, not a CFA. The information and data presented in this article were obtained from company documents and/or sources believed to be reliable, but have not been independently verified. Therefore, the author cannot guarantee their accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for the investment decisions you make.
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