Better Buy: Phillips 66 vs. Chevron Corporation

While Chevron (NYSE: CVX) and Phillips 66 (NYSE: PSX) both operate in the oil industry, they have entirely different focuses. Chevron, for example, makes most of its money exploring for and producing oil. As an integrated oil company, though, it also operates refineries and chemical plants, with the latter part of a joint venture with Phillips 66. Meanwhile, Phillips 66 makes most of its money on refining, though it also operates a midstream business and that chemicals joint venture with Chevron.

This difference is important for investors to understand because the decision to buy one of these stocks over the other boils down to two factors: risk tolerance and the outlook for oil prices. For those who are bullish on oil and have a higher risk tolerance, Chevron is the better buy because it has far more upside. Phillips 66, on the other hand, offers investors a lower-risk way to invest in the oil market since it should do well even if crude falls, which for some is enough to put it over the top.

The bull case for Chevron

Chevron spent the bulk of the recent oil market downturn repositioning its portfolio and cost structure so it can thrive at lower oil prices. That transformation has been noticeable this year because the company finally started generating free cash flow after paying its dividend. As a result, the oil behemoth is in the position to deliver sustainable growth in production and cash flow at $50 oil.

That said, where Chevron shines is in a higher oil price environment due to its leverage to crude. Under the company's current assumptions, free cash flow would rise from about $1 billion this year to nearly $4 billion by 2020 if oil stays around $50 a barrel. However, free cash flow would surge to more than $7 billion if oil hits $60 and could rise above $12 billion should it reach $70. That potential gusher of free cash flow in an oil recovery could send its stock soaring, though another steep slide in crude would likely take Chevron down with it.

The bull case for Phillips 66

By contrast, Phillips 66 hasn't had any issues producing free cash flow during the oil market downturn since it benefits from lower prices because its business consumes crude. Last year, for example, the company generated $3 billion of operating cash flow even though it was a challenging year for refiners. That money, when combined with its top-notch balance sheet, enabled Phillips 66 to return $2.3 billion in cash to investors via share repurchases and a rapidly rising dividend.

The company expects its cash flow to head higher this year even if market conditions don't improve because it's putting the finishing touches on several major growth projects. These include an oil pipeline in the Bakken shale, the expansion of its Beaumont Terminal, a petrochemicals project at its chemicals joint venture with Chevron, and several high-return upgrades across its refineries. That's in addition to expansions at its master limited partnerships.

One thing that's worth noting is that the largest portion of Phillips 66's investments has been on building midstream assets supported by long-term, fee-based contracts that will generate steady cash flow no matter what oil prices do. Consequently, the company has greater certainty on future cash flow growth, which makes it more likely that it can continue to boost cash returns to investors.

This option doesn't need any outside help

Oil bulls could do very well in Chevron because its stock should flourish if crude rallies over the coming years. That's because it's built to generate a gusher of cash flow in that environment, which the oil giant could then use to hike its dividend or repurchase shares.

Phillips 66, however, doesn't need higher oil prices to thrive. Instead, the refiner's cash flow should steadily rise over the coming years as it completes its current slate of major projects, which would give it more money to continue buying back stock and increase the dividend. That more visible upside, in my opinion, makes it the better buy since there's no guarantee that crude will run up any further.

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Matthew DiLallo owns shares of Phillips 66. The Motley Fool recommends Chevron. The Motley Fool has a disclosure policy.