Westlake and Phillips 66, 9th May 2012

Today, 9th May 2012, a Credit Suisse analyst, Edward Westlake, initiated an analysts’ report for Phillips 66 and gave the company an “outperform” rating. The analyst urged that the 12-month target price would be $42.00 per share. As a result, the share price of Phillips 66 jumped about 7.9% in late afternoon trading to about $32.49 per share. It is not possible that the value of Phillips 66, as a company, is 7.9% higher today than its value yesterday. The justification offered by Westlake was as follows: (1) the spot and futures price for natural gas has declined to the lowest level in a decade and, therefore, raw materials costs for Phillips 66 chemical plants have declined markedly, which should increase the profit margin; and, (2) crude oil production has increased in the upper midwest which is driving down the raw materials costs for the Phillips 66 refineries.

Neither of these assertions provide any basis for either the marked increase in the share price seen today or in the short-term prospect that the shares deserve a price of $42.00. As to the natural gas issue, if the 2012-2013 winter is hard the price of natural gas will increase dramatically reversing any benefit that Mr. Westlake might see for Phillips 66. Also, the price for natural gas has been quite low for a substantial amount of time and has already been priced into the price of chemicals made from that raw material. That it will remain low until some point in the future will not increase the profit margin of Phillips 66. Further, the profit margin for the chemicals business of Phillips 66 will increase only when a substantial uplift in demand exists. With the troubled economies in Europe and, to some extent, in the United States, I cannot see anywhere near a 29% increase in the chemicals business (that is, from 32.49 to 42.00).

As to the cost of petroleum at Cushing, Oklahoma, this will not improve the situation at any of the downstream refineries, including Phillips 66. The analyst failed to recognize that the split between the price of Brent Sweet Light and West Texas Intermediate is, in significant part, attributable to the lack of pipelines to transport the oil from Cushing to the refineries and the lack of storage capacity at Cushing. Even when the increase in storage capacity at Cushing is completed, the problem be alleviated only on a short term basis. With the current depressed price for West Texas Intermediate, the profit margin for refineries is slim, at best, and this is also true for Phillips 66. A substantial reason for this narrow, or negative, margin arises from the decline in demand for the refined products, including gasoline. A further problem plagues the refinery business: a substantial portion of the refineries are located at an unreasonable distance from the largest markets, which are the east and west coasts. Again with demand stagnated, at best, or declining, in reality, it is not likely that the profit margin from the refineries for the next year will justify a 29% increase in the price of the shares.

In addition the aforementioned few points, Mr. Westlake failed to recognize the following paramount piece of information. The costs of raw materials today are almost identical to the costs of raw materials during the weeks and months before Phillips 66 was spun off from ConocoPhillips. It may reasonably be expected that the profit from the downstream operations, including refineries, will remain approximately the same as before Phillips 66 became an independent refinery. In his missive, Mr. Westlake has failed to recognize that Phillips 66 plans to shut down and sell unprofitable assets, meaning refineries. Thus, the price of West Texas Intermediate at Cushing, Oklahoma, including oil from the upper midwest, will have nothing to do with improving the profit margin of the refineries held by Phillips 66.

The important point to remember as time passes, is that the large institutional investors are keenly aware that the refinery business, and chemicals business, will struggle for some time to come. Thus, for them, shedding shares of Phillips 66 to reinvest the cash in companies with greater long-term returns is the sensible move.

Nathan A. Busch

2 Responses to “Westlake and Phillips 66, 9th May 2012”

  1. El Chavo Says:

    This blog entry uses the most convoluted logic I’ve ever encountered. BTW, Phillips 66 stock is now $66 per share as a direct result of the elements that you mentioned were going to hinder their performance.

    • El Chavo and my audience:

      Thank you for your response.

      Your comment is apparently based upon the assumption that the market has somehow changed since Phillips 66 was spun off. In fact, the price of natural gas, the price of West Texas Intermediate Crude, the price of Brent Sweet light, the issues surrounding Cushing, and the price of the products produced by Phillips 66 are not dramatically different than during the weeks before the spinoff or the weeks immediately after the spinoff. Also, the price of refining a gallon of petroleum product and the profit margin in such products are not significantly different. True, whilst we have recently had a spike in the price of gasoline, that certainly has not made a significant impact on the price of the shares of Phillips 66. In fact, the spike has seen a significant drop in the price of the shares of Phillips and some considerable volatility since: this is, of course, not meant to imply a correlation rather simply an observation. The price of the shares saw their most dramatic rise before the price of gasoline spiked late this spring.

      The price of Phillips 66 shares did not move to any considerable extent until Warren Buffet had announced that he had obtained a considerable holding. Then, the price went through the roof and has recently somewhat stagnated with considerable volatility. Also, a cursory examination of the major holders of the shares of Phillips 66 indicates that money had been pouring into this stock because it was paying a modest dividend, which is now in the neighbourhood of 1.9%.

      Whilst I hold Phillips 66, the fundamentals of this company do not justify purchase of shares of this company at the current price in view of alternatives. Also, at the time that I wrote the original post, of which you wrote so harshly, the fundamentals justified purchase in the range of $35 per share but not higher.

      It is easy to consider the ideas of others in retrospect and conclude that their ideas were wrong in view of current events. The best that one can do is to use an investment strategy that works and to stick to that strategy no matter what the market does. Warren Buffet has famously stated that if he had only a million dollars he could obtain returns of 50% per year. He also freely admits that he finds it extremely difficult to obtain long-term returns that either match the market or beat the market. That is because he is so big that he is able to move the market simply by stating that he has purchased shares in a company. To confirm the idea, articulated by Warren Buffet, that his size restricts his returns, I have developed a moderately sophisticated set of of rules that have provided annualized returns in excess of 62.5% for the years of 2011, 2012, and 2013 when applied to a real money portfolio. To purchase shares in a company just because Warren Buffet announced that he did so is foolish: by the time of the announcement, the consequences of the reasons upon which he based his decisions have already been priced into the market for the shares. By then it is too late.

      Through this blog and through the development of my hedge fund, I am desirous of informing others of my way of thinking, my strategies and techniques, and to obtain constructive comments and criticisms in return. It is neither useful to my audience nor to the general discussion to simply retrospectively dismiss a concept or articulation of a thought without suggesting how that concept could be modified to benefit the other readers.

      Through my investment strategies and the hedging operation, I am able to increase the efficiency of a portfolio by three fold, using a relatively primitive hedging strategy, to nine fold, using a quite sophisticated hedging strategy. These numbers are not based upon some nonsensical hyperbole; rather these numbers are based upon the sound theory of stochastic processes and backtesting of the theory against actual fundamental data of companies dating back to 1996. Whilst the theory and application are not complete to my satisfaction, I am more than willing to share my ideas, concepts, and the mathematics with anyone interested in growing their portfolio. All that I ask in return is that my readers, if they wish to do so, provide improvements to the techniques that will be beneficial to both them and my readers.

      I hope that this helps.

      Nathan A. Busch

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