Can Phillips 66 Survive with Low Refining Margins?

By Markets Fool.com

IMAGE SOURCE: PHILLIPS 66.

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Phillips 66 (NYSE: PSX) reported adjusted second-quarter earnings of $499 million, a 50% decrease from the $1 billion in earnings from one year ago. The real story, though, is Phillips' brutally low refining margins, which dropped 40% from a year ago. For a company that depended on refining for over 60% of its earnings in the first half of 2015, this should strike any investor as an alarming development.

Despite the sharp decrease in its refining margin, though, here's why the company remains well positioned for future growth.

Impacts from refining

Phillips' weaker earnings were caused almost entirely because of weak refining margins. The company's second-quarter report states that even with higher market crack spreads -- the margin from turning crude oil into petroleum products -- the overall margins were weak because oflower margins on gasoline & diesel and lower margins one other petroleum products due to rising crude prices.

Because of this, the company's refining business dropped nearly 75%. Adjusted earnings from refining in the second quarter were $152 million, an increase over its first-quarter earnings of $86 million, but a huge decrease from the $604 million from the second quarter of 2015. Year over year, refining earnings for the six-month period that ended in June dropped from $1.1 billion to $238 million.

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Phillip 66 now joins several oil refiners, such asValero Energy, to indicate that the low margins will have further impacts this year. Like Valero, the company expects its refinery capacity to drop from 100% utilization in the second quarter to the mid-90% range in the second half of 2016. While this should have minimal impact on earnings, it highlights the continued struggle Phillips will endure as it contends with the difficult operating environment.

Projects coming online

While Phillips' refining utilization might drop, though,the company has several projects coming online within the next two years. In its refining business, yield improvement projects at the Wood River Refinery are scheduled for completion in the third quarter. Additionally, improvements to increase heavy Canadian crude utilization at its Billings Refinery should be complete in the first half of 2017, and modernization projects to increase gasoline yields at its Bayway Refinery will finish up in 2018.

In Phillips 66's midstream business, several additional projects will contribute to returns by the end of this year or next year. Joint ventures to develop the Dakota Access and Energy Transfer Crude Oil pipelines remain on schedule to come online by the end of 2016. And an expansion project at its Beaumont Terminal will add 3.2 million barrels of new storage capacity by mid-2017.

The fact that Phillips has managed to invest in these projects and continues to turn a profit while refining margins are so low is a very encouraging sign.

Looking beyond refining

While low refining margins are hard to overcome, Phillips actually increased its marketing fuel margins and brought in higher adjusted marketing earnings than a year ago. This is vitally important for its long-term profitablity as it shows how the company can work through hard times for a core business.

The company also managed to generate $1.2 billion in cash from operations, which more than covered its capital expenditures of $620 million. Because of its strong cash flows, it had no issues returning $571 million to its investors during the quarter through its dividend and share repurchases. In fact, the company even increased its dividend by 12.5%.

It's hard to look past the low refining margins and it is prudent to monitor the situation. With strong cash flows, though, as well as multiple sources of revenue and continued investment focused on future growth, Phillips 66 remains a very strong pick for long-term investors.

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David Lettis owns shares of Phillips 66. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.