Over the past week, I have discussed investing in the midstream versus oil and gas sector and the best way to invest in hydrocarbons in the face of the changing climate.
In both cases, I concluded the midstream sector could be the best way to invest with its fixed cash flows and diversification across different oil products.
The midstream sector benefits from several competitive advantages that are not available in the upstream sector.
First, the sector does not have to worry about volatile commodity prices. While there might be some exposure to prices in contracts, they are generally laid out in advance, providing a stable income stream for the midstream operators and a stable cost for producers.
At the same time, pipelines are a unique asset. It is getting harder and harder to build the infrastructure to transport oil and gas products around the U.S. Companies that already have the facilities are uniquely positioned to benefit from growing demand but constrained by the supply of new infrastructure.
And if the demand for oil and gas starts to drop, these facilities can be repurposed to transfer other liquids and gases.
While there will be a cost involved in this transformation, it does mean they will not become stranded assets and, as a result, have a much longer life than some oil fields do if the world does manage to move to a future without oil.
The best sector pick
Phillips 66 (PSX, Financial) could be one of the best ways to play these themes. The company describes itself as a manufacturing and logistics company with midstream, chemicals, refining and marketing and specialties businesses.
Put simply, it is a midstream company that is also active in many of the downstream businesses big oil also owns and operates. It has all of the good points of a big oil stock without any of the downside (exposure to volatile oil prices and the risk of stranded assets if demand declines).
I think it is notable that this stock once featured in the portfolio of Warren Buffett (Trades, Portfolio). The Oracle of Omaha gained a position after Phillips 66 split from ConocoPhillips (COP, Financial) in 2012.
He liked the company so much that he added to the initial position, eventually buying a $6.4 billion stake.
While this position no longer features in his equity portfolio, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has acquired one of the company's businesses.
In 2013, it agreed to acquire a specialty chemicals unit, Phillips Specialty Products, from Phillips 66 for around $1.4 billion worth of stock.
Buffett regularly touted Phillips 66's management team as being one of the best in the business, lauding its wonderful job managing capital. It continues to pursue this strategy today.
At the time of writing, the company offers a dividend yield of 4.6%. It has reduced the total number of shares outstanding by more than 10% since 2017.
Thanks to volatility in the oil markets and wide crack spreads in the petrochemical industry, Wall Street reckons the company will report one of its highest profits in years for 2022.
Analysts have penciled in a net income of $7.9 billion. If the company hits this target, the stock is trading at just five times forward earnings today. That seems dirt cheap for a highly profitable company with a strong competitive advantage.
The big risk is that crack spreads will decline in the years ahead and earnings will return to normalized levels. It seems likely that crack spreads will decline, but no one is building any large refineries or petrochemical facilities anymore.
Regulatory constraints are holding back the development of new facilities. That suggests, in the long term, profit margins may only expand as demand exceeds supply.
