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This Oil Stock Has a Formula That Should Keep Rewarding Shareholders Over the Long Term

Matthew DiLallo, The Motley Fool

Phillips 66 (NYSE: PSX) has been a very shareholder-friendly company since it separated from oil giant ConocoPhillips (NYSE: COP) in 2012. For starters, it has increased its dividend seven times and by a 30% compound annual growth rate over that time frame, which is why it pays an above-average current yield of 2.8%. On top of that, the refining and logistics giant has repurchased roughly $9 billion in stock, which has reduced shares outstanding by more than 20%. Those cash returns have helped drive a more than 250% total return for shareholders since its separation from ConocoPhillips, which is more than double the total return of the S&P 500.

That outperformance appears poised to continue given Phillips 66's future plans, where it expects to return a significant portion of its cash flow to investors each year.

Oil refinery at twilight with oil storage tanks in front.

Image source: Getty Images.

Drilling down into Phillip 66's plans for 2018 and beyond

In early December, Phillips 66 announced its capital spending budget for 2018, setting it at $2.3 billion. That's about $400 million less than last year's initial budget, with about $900 million of the spending geared toward sustaining its existing assets and $1.4 billion earmarked for growth projects. The company expects to spend about $1 billion of that capital to expand its midstream business, with roughly half of it funded through its MLPPhillips 66 Partners (NYSE: PSXP). That money will enable Phillips 66 Partners to expand two pipelines and build a unit at one of Phillips 66's refineries so it can increase production of higher-octane gasoline. In the meantime, the rest of Phillip 66's growth spending will be on small projects to boost returns at its refineries.

However, that budget represents roughly 60% of the cash flow Phillips 66 expects to pull in next year. The company has targeted to send the remaining 40% back to shareholders. That split aligns with its long-term formula of "re-investing 60% of [its] cash flow back into the business and returning 40% to our shareholders," according to CEO Greg Garland. A portion of those cash returns will continue being the dividend, which currently costs $1.4 billion per year. The rate will likely increase, though, given that Garland noted earlier this year that it is "committed to maintaining a growing, secure and competitive dividend as part of our disciplined approach to capital allocation." Phillips 66 will also spend the rest of its excess cash on share repurchases. It currently has the authorization to buy back $3 billion of its stock, though it could boost that number if cash flow surges in the coming year.

A burst of sunlight shining on a pipeline.

Image source: Getty Images.

A balanced blend should help fuel a more stable return

Phillips 66 is one of a growing number of energy companies that set a clear allocation target for cash flow that balances growth spending with cash returns to investors. One of the most detailed and shareholder-friendly strategies is at its former parent company, ConocoPhillips. The U.S. oil giant estimates that it can produce enough cash flow if oil averages $40 a barrel to pay its current dividend and invest the capital needed to sustain its production rate. If oil averages $50 a barrel, it can achieve those two aims while generating enough excess cash to invest $2 billion in high-return production growth projects and repurchase $1.5 billion in stock per year. If oil rises above that level, the company would aim to return 20% to 30% of its cash flow to investors and allocate the rest toward either high-return growth projects or further strengthening its balance sheet.

One of the benefits of setting a percentage target on cash returns is that it helps ensure that these energy companies don't waste money by investing in lower-return projects during the good times just because they have the cash. That was a big problem for oil companies when crude was in the triple digits since many poured everything that came in and then some into expanding. However, by committing to return a certain percentage of cash flow to investors, it means that shareholders will reap a greater reward during good times since cash returns would follow cash flow higher. In Phillips 66's case, if 2018 turns out to be a big year for its refining business, investors would directly benefit since the company would likely repurchase more stock so that it hits the 40% target. That's a better course of action than potentially wasting that money on a growth project that would only pay off if the good times continued to roll. 

The right formula for success in the sector

Earnings in the energy industry tend to ebb and flow with oil prices. However, by targeting to send 40% of its cash flow to investors each year, Phillips 66 makes it abundantly clear that they will earn a tangible return during tough times while sharing in its success during boom years since cash returns will rise with cash flow. That formula has the potential to keep fueling market-beating returns for investors in the years to come.

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Matthew DiLallo owns shares of ConocoPhillips and Phillips 66. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.