Phillips 66's Diversified Operations and Balance Sheet Have Potential to Support the Dividend

Phillips 66 (PSX) is a diversified petrochemical company that refines crude oil and natural gas into fuels and petrochemicals, operates gas stations in the U.S. and Europe, and owns stakes in two midstream MLPs that transport fuels.

Phillips 66's earnings are very hard to forecast as they depend largely on unpredictable swings in commodity prices (crude oil, natural gas, gasoline, ethylene, etc), which are in turn based on ever-shifting trends in supply and demand.

Moreover, the diversified nature of Phillips 66's operations means that fluctuations in commodity prices can have both favorable and unfavorable impacts on the business. For instance, refining can be more profitable when oil prices are low, whereas midstream firms benefit from high oil prices.

Nevertheless, it's hard to imagine any energy company performing well in the current environment. The coronavirus pandemic has resulted in an unprecedented situation where demand for fuel and consumer goods (which are often manufactured with petrochemicals) is quickly evaporating worldwide.

In fact, fuel prices have fallen even faster than the plunge in oil prices. On March 17, Reuters reported that "margins for producing transportation fuels turned negative in Europe and Asia, and briefly did the same in the United States."

With that said, we believe a dividend cut by Phillips 66 would be surprising at this stage, and we are maintaining Phillips 66's Safe Dividend Safety Score for now.

Refiners like Phillips 66 plan for volatile cycles — it's the nature of their business. As a result, we believe it would be premature to downgrade Phillips 66 until more is known about how the firm's diversified operations are performing or until it becomes more clear how severe this downturn will be. (Phillips 66 next reports earnings in early May.)

For context, Phillips 66's annual cash flow from operations (CFO) has varied anywhere between $3 and $7 billion since 2011 (when the firm spun off from ConocoPhillips), so wild swings in profit are nothing new to management.

Let's suppose Phillips 66's CFO declined this year to $3 billion, the trough of Phillips 66's CFO over the last nine years. The firm's dividend costs $1.6 billion annually, and management had budgeted about $1 billion in "sustaining" capital expenditure (i.e. necessary investments to maintain infrastructure).

In this scenario, Phillips 66's CFO would still be able to cover all capital requirements this year ($2.6 billion), including the dividend.

However, little would be left over to spend on growth projects, which managed had previously budgeted between $1.5 to $2.5 billion to spend on. Management could face pressure to decide between the dividend and growth investments.

Alternatively, Phillips 66 could choose to borrow to meet any deficit in capital needs, which is what the firm did in 2016 when CFO came in at slightly less than $3 billion, an approximately 50% drop from the previous year.

Fortunately, Phillips 66's balance sheet is strong coming into this crisis. The firm's debt levels appear reasonable, and the company holds an investment grade BBB+ credit rating from S&P. The firm also holds $1.6 billion in cash and marketable securities and has access to $5.7 billion from revolving credit facilities.

In other words, Phillips 66 appears to have the flexibility to plug short-term holes in financing, just as the company did in 2016.

However, much depends on management's near-term outlook on the business as well as how eager they are to take on more debt, which would reduce the firm's financial flexibility during this period of heightened uncertainty.

Management has said in past earnings calls that they are "dedicated to a secure, competitive, and growing dividend," but the next several quarters could be a major test of this commitment.

A lot will be learned in the coming weeks and months as the pandemic progresses, the responses of governments become more clear, and energy firms begin providing updates to investors. We'll be monitoring the situation.