PSX - Phillips 66: Crack Spread Decline Lowers EPS Estimate By Over Two-Thirds (Rating Downgrade)

2023-10-04 13:12:47 ET

Summary

• Refinery stocks, including Phillips 66, outperformed the energy sector during Q1 and Q2 due to the rise in gasoline prices compared to crude oil.
• The recent sharp decline in the crack spread, a measure of refinery profit margins, suggests much lower Q4 profits for Phillips 66.
• The increase in electric vehicle sales and potential decline in gasoline demand pose long-term risks for Phillips 66's refining business.
• While I believe PSX may still have decent long-term potential, I must sharply revise my previous outlook based on the recent crack spread crash.

Over the past year, I have held a bullish view of refinery stocks, specifically Phillips 66 ( PSX ). Refineries have outperformed the energy sector due to the rise in the price of gasoline and other refined products compared to crude oil. The spread between refined products and crude oil is called the " crack spread ," giving us a live indicator of refinery profit margins. This spread has recently declined, pointing toward lower Q4 profits for Phillips 66 and its peers. Accordingly, PSX's strong bullish trend is now waning compared to the broader energy sector ETF ( XLE ). See below:

My longstanding view is that the "crack spread" will be permanently elevated compared to pre-2020 levels until gasoline is phased out of most vehicles, potentially giving Phillips 66 over a decade of significant returns. This long-term outlook is based on weak capacity growth in the refinery sector and the substantial decline in refinery capital investments, leading to a general shortage of gasoline and diesel products.

Of course, potential profit margins on oil refining have declined dramatically since August. Philips 66 and its peers have hardly declined in value. Thus, refinery stocks may be significantly overvalued on a short-term basis. To better determine that, we must look more closely at the core causes of the crack spread's volatility and how it may impact Phillips 66 on a short-term basis.

The "Hot and Cold" Oil Product Market

Since 2020, oil production and refinery capacity utilization volatility have led to immense crack spread changes. The crack spread is often measured as the difference between a barrel of two-thirds RBOB gasoline plus one-third Heating Oil minus one barrel of crude oil. There are 42 gallons per barrel. To simplify, I will show both on a 1:1 basis; however, the spread between RBOB and oil is generally more critical for Phillips 66's profits than the heating oil spread. See below:

The gasoline spread is back in its 10-year average range, falling by over 50% over the past three months. Conversely, the heating oil spread, which, as a distillate, is more telling of diesel fuel, is back at its high range. Overall, the "3:2:1" crack spread, which measures both together, is down by over one-third over recent months, the lowest level since the initial 2022 spike. Accordingly, aside from hedging and other sources of income, this data implies Phillip 66's EPS will soon be back near its 2021 levels.

There are multiple causes for the boom and bust in the crack spread. For one, refinery capacity utilization was generally low earlier this year but strengthened dramatically over the summer, improving the gasoline supply. The manufacturing PMI has slipped over the past two years, indicating a slowdown and contraction in industrial activity. Further, refinery capacity utilization has also fallen, pointing toward a potential decline in gasoline demand. See below:

Notably, the US 12-month total vehicle miles traveled is still around 2.5% below the pre-COVID peak, similar to 2018. Vehicle usage has increased throughout 2023 but remains just below pre-COVID levels, while gasoline production and products supplied are generally at 2019 levels. These data indicate a small glut may have developed in the gasoline market over the past two months.

That said, total stocks of both gasoline and distillate fuels remain below average today. Total petroleum product exports are also very high, though they have declined marginally over the past two months. See below:

With fuel exports high and inventories low, there remains the significant possibility that gasoline will fall back into a shortage. The price of crude oil has also risen dramatically over the past two months due to shortages developing in that market, creating higher costs for Phillips 66. The short-term outlook for the company's refining margins is bearish due to the low crack spread today. However, there have been no evident fundamental supply changes, such as (dramatically) improved refining infrastructure investments or a sharp increase in inventories that would point toward a prolonged glut. Most likely, the current small surplus is caused by a decline in gasoline demand associated with the economic trend.

Electric Vehicle Demand Accelerates

From a longer-term standpoint, we're also seeing a massive increase in sales of electric and hybrid vehicles. Interestingly, there is a relatively strong correlation between the sales of these types of cars and the price of gasoline. As gasoline becomes more expensive, more people buy these more efficient vehicles to save costs. See below:

Strong EV sales are also promoted by a marked ~19%- 30% decline in electric vehicle prices over the past year, partly due to overproduction and growing competition. Of course, as more companies build EV infrastructure, they're becoming more competitive with conventional vehicles (which are still becoming more expensive). Additionally, battery prices are falling due to the overproduction of lithium, which may continue over the coming years.

Admittedly, the core reason for my bullish perspective on Phillips 66 has been that I do not believe EV adoption will be as quick as many investors expect. I think barriers include higher prices, technological constraints, utility infrastructure needs, and greater exposure to economic shifts (due to higher prices). That said, the fundamental trend does not support my previous outlook as improved battery prices and immense infrastructure investments are making electric vehicles more competitive, which has dramatically accelerated in 2023.

The recent sharp decline in EV prices has caused some analysts to expect that two-thirds of cars will be electric by 2030. Such an outlook appeared to be extreme in the past, but given the increase in fuel prices and the decline in EV production costs, it is becoming far more reasonable. In my view, the primary remaining barrier is inadequate electric grid infrastructure and poor investment patterns by significant utilities. Still, if that barrier is overcome, electric vehicles may be adopted accelerated, potentially limiting gasoline demand significantly. Roughly two-thirds of crude oil is used for transportation, while over 90% is used for some fuel products. Given that, Phillips 66 does far relatively significant long-term risk associated with a potentially complete decline in transportation gasoline demand.

What is PSX Worth Today?

Around one-half to two-thirds of Phillip's usual operating income is derived from its refining segment. Other vital segments include downstream marketing and midstream transportation, which should be stable due to the current volatility in crack spreads. The overall crack spread is now back at similar levels to its 2021 and 2019 range but above its 2020 range. Between 2021 and 2019, Phillips 66 had an average annual operating refining segment income of -$282M. Its refining income was over $5B annually during the first half of 2023, indicating immense exposure to changes in crack spreads.

Since the company does not hedge crack spreads, I will estimate its future income using the -$282M average for 2019 and 2021, given the crack spread is now back in that range. However, I will extrapolate its income for its other segments based on their six-month profits during Q1 and Q2 of this year. Total segment profits from non-refining segments were ~$2.15B during the first half of 2023, giving us a $4.3B non-refining annualized profit outlook. Combined with expected losses on refining, its annual profit outlook is ~$4.03B. Those figures account for each segment's interest, depreciation, and other operating and non-operating costs, excluding taxes. At a 25% tax rate, my income target for PSX is ~$3.02B, or ~$2.87B, after accounting for noncontrolling interests.

With a twelve-month profit outlook of $2.87B, I expect PSX to deliver an EPS of around $6.45. This figure is well below the consensus EPS estimate from other analysts of over $16 . However, most of those estimates were likely made before the very recent crack spread crash, erasing the most significant portion of Phillips 66's usual income. Of course, my method for estimating its segment income may differ from others, so there is a wide range in potential variation to its income, with +/- $1B not being unreasonable. Further, based on low gasoline stocks, the crack spread could certainly rebound over the coming months should the minor glut reverse. That said, I prefer to make estimates based on current commodity prices.

PSX has traded at an unreasonable low "P/E" over recent years due to immense profits in its refining segment. Since the data has shifted against refining profits, its EPS will likely decline, potentially back to around $6.45. Before 2020, PSX traded at a "P/E" of around 12.5X during most of the 2010s decade, which were more stable years for crack spreads (but not oil prices). Using my EPS target at a 12.5X valuation, I value PSX at $80 per share today, just over 25% below its current share price.

As such, I am slightly bearish on the stock today but would not bet against it because the crack spread could rebound and dramatically improve its outlook. Obviously, my new target for PSX is quite bearish compared to my bullish outlook seven months ago. I continue to believe that PSX could have ample long-term upside due to a lack of total refining capacity, as previously discussed. However, as investors, we must also remember the immediate reality, which is bearish for Phillips 66 due mainly to the sharp increase in oil prices and stagnate gas prices.

Further, my long-term view is based on the rate of adoption of electric vehicles. If adoption is slow, then Phillips 66 could benefit from abnormally high crack spreads as it has over recent years. However, if adoption is faster, as I've been surprised to see this year, then marginally lower gasoline demand could easily cause crack spreads to become lower than usual. At this point, I will not admit that EV demand is so high that the bulk of the refining business model will soon be antiquated. However, it is admittedly more elevated than I previously assumed, mainly due to improvements in battery costs and greater EV price competition. If that pattern continues through 2024, Phillips 66 could face more significant issues as gasoline demand falters. Even then, I believe the company should have enough time to alter its investments to cater to a post-gasoline future, which could be anywhere from one to three decades away.

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