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PHILLIPS 66 - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Management's Discussion and Analysis is the company's analysis of its financial performance, financial condition, and significant trends that may affect future performance. It should be read in conjunction with the consolidated financial statements and notes included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the company's plans, strategies, objectives, expectations and intentions that are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The words "anticipate," "estimate," "believe," "budget," "continue," "could," "intend," "may," "plan," "potential," "predict," "seek," "should," "will," "would," "expect," "objective," "projection," "forecast," "goal," "guidance," "outlook," "effort," "target" and similar expressions identify forward-looking statements. The company does not undertake to update, revise or correct any of the forward-looking information unless required to do so under the federal securities laws. Readers are cautioned that such forward-looking statements should be read in conjunction with the company's disclosures under the heading: "CAUTIONARY STATEMENT FOR THE PURPOSES OF THE 'SAFE HARBOR' PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995," beginning on page 53. The terms "earnings" and "loss" as used in Management's Discussion and Analysis refer to net income (loss) attributable to Phillips 66. BUSINESS ENVIRONMENT AND EXECUTIVE OVERVIEW Phillips 66 is an energy manufacturing and logistics company with midstream, chemicals, refining, and marketing and specialties businesses. At September 30, 2014, we had total assets of $50 billion. Our common stock trades on the New York Stock Exchange under the symbol "PSX." Executive Overview We reported earnings of $1,180 million in the third quarter of 2014 and generated $429 million in cash from operating activities. We used available cash to fund capital expenditures and investments of $1,514 million, pay dividends of $277 million, and repurchase $494 million of our common stock. We ended the third quarter of 2014 with $3.1 billion of cash and cash equivalents and approximately $4.7 billion of total capacity available under our liquidity facilities. Basis of Presentation Effective January 1, 2014, we changed the organizational structure of the internal financial information reviewed by our chief executive officer, and determined this resulted in a change in the composition of our operating segments. The primary effects of this reporting reorganization were as follows: • We moved two of our equity investments, Excel Paralubes and Jupiter Sulphur, LLC, as well as the commission revenues related to needle and anode coke, polypropylene and solvents, from the Refining segment to the Marketing and Specialties (M&S) segment. • We moved several refining logistics projects from the Refining segment to the Midstream segment. The new segment alignment is presented for the three- and nine-month periods ended September 30, 2014, with the prior periods recast for comparability. 36-------------------------------------------------------------------------------- Table of Contents Business Environment The Midstream segment includes our 50 percent equity investment in DCP Midstream, LLC (DCP Midstream). Earnings of DCP Midstream are closely linked to natural gas liquids (NGL) prices, natural gas prices and crude oil prices. Industry NGL prices decreased in the third quarter of 2014, compared with the second quarter of 2014 and the third quarter of 2013. Ethane prices decreased in the third quarter of 2014, compared with the second quarter of 2014 and the third quarter of 2013, primarily due to increased supply in the market. Propane prices continued to decrease from the second quarter of 2014 to the third quarter of 2014, due to a lack of seasonal demand. Natural gas prices decreased in the third quarter of 2014, compared with the second quarter of 2014, but increased from the third quarter of 2013. The decline in natural gas prices in the third quarter of 2014 was a result of a seasonal inventory restocking. The increase from the third quarter of 2013 reflects concerns over low industry inventory levels heading into the winter season. The Chemicals segment consists of our 50 percent equity investment in Chevron Phillips Chemical Company LLC (CPChem). The chemicals and plastics industry is mainly a commodity-based industry where the margins for key products are based on market factors. The chemicals industry continues to experience higher ethylene margins in regions of the world where production is based upon NGL versus crude-derived feedstocks. In particular, companies with North American ethane-based crackers benefited from lower-priced feedstocks and improved ethylene margins, as well as improved margins for polyethylene, an ethylene derivative. Results for our Refining segment depend largely on refining margins, cost control, refinery throughput, and product yields. The crack spread is a measure of the difference between market prices for refined petroleum products and crude oil, and it is used within our industry as an indicator for refining margins. The U.S. 3:2:1 crack spread (three barrels of crude oil producing two barrels of gasoline and one barrel of diesel) decreased in the third quarter of 2014, compared with the second quarter of 2014, but increased compared with the third quarter of 2013. The third-quarter 2014 domestic industry crack spread decreased compared with the second quarter of 2014, largely as the result of higher supply due to higher than anticipated refinery output, and a decrease in gasoline prices in part driven by the transition to winter gasoline specifications. The increase in the third-quarter 2014 domestic industry crack spread compared with the third quarter of 2013 was due to the average market crude oil price declining more than the average market gasoline and distillate prices. The Northwest Europe benchmark crack spread in the third quarter of 2014 increased compared with the second quarter of 2014 and the third quarter of 2013. The increase from the second quarter of 2014 was a result of crude prices declining faster than gasoline and distillate prices, as well as lower supply due to lower refinery output. Results for our M&S segment depend largely on marketing fuel margins, base oil margins, lubricant margins and other specialty product margins. These margins are primarily based on market factors, largely determined by the relationship between demand and supply. Marketing fuel margins are influenced by crude oil pricing trends, which drive spot prices for refined products. Generally, in a period of rising crude oil prices, refined product spot prices will increase at a faster pace than the corresponding wholesale "rack" price of products sold to retailers, thereby tightening marketing margins. In a period of falling crude oil prices, the inverse occurs, and marketing margins generally benefit. Crude oil prices declined significantly during the third quarter of 2014, which resulted in the expected benefit to marketing margins. 37-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS Unless otherwise indicated, discussion of results for the three- and nine-month periods ended September 30, 2014, is based on a comparison with the corresponding periods of 2013. Consolidated Results A summary of net income (loss) attributable to Phillips 66 by business segment follows: Millions of Dollars Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Midstream $ 115 147 411 348 Chemicals 230 262 870 725 Refining 558 (30 ) 1,254 1,329 Marketing and Specialties 368 255 667 789 Corporate and Other (91 ) (113 ) (293 ) (334 ) Discontinued Operations - 14 706 43Net income attributable to Phillips 66 $ 1,180 535 3,615 2,900 Earnings for Phillips 66 increased $645 million, or 121 percent, in the third quarter of 2014. The increase was due to higher realized refining margins primarily driven by lower crude prices. In addition, third-quarter 2014 results included the recognition of $109 million of the previously deferred gain related to the sale of Immingham Combined Heat and Power Plant (ICHP). See Note 6-Assets Held for Sale or Sold, in the Notes to Consolidated Financial Statements, for additional information on this transaction. Earnings for the nine months ended September 30, 2014, increased $715 million, or 25 percent, largely due to the recognition of a noncash $696 million gain related to the Phillips Specialty Products, Inc. (PSPI) share exchange, as well as improved realized margins in our Chemicals segment, resulting from increased ethylene and polyethylene margins. See the "Segment Results" section, for additional information on our segment results. Statement of Income Analysis Sales and other operating revenues for the third quarter and nine-month period of 2014 decreased 8 percent and 2 percent, respectively, and purchased crude oil and products decreased 13 percent and 4 percent, respectively. The decreases for the third quarter of 2014 were primarily due to lower prices for petroleum products, crude oil and NGL. Equity in earnings of affiliates decreased 21 percent in the third quarter of 2014, primarily resulting from decreased earnings from DCP Midstream and CPChem. Equity in earnings for the nine-month period of 2014 decreased 11 percent, primarily due to decreased earnings from WRB Refining LP (WRB), partially offset by increased earnings from CPChem. Equity in earnings of WRB decreased 54 percent during the nine-month period of 2014, mainly due to lower refining margins. See the "Segment Results" section, for additional information on CPChem and DCP Midstream earnings. Gain on dispositions for the third quarter of 2014 was $109 million, compared with $8 million for the third quarter of 2013. During the nine-month period of 2014, there was a $125 million gain on dispositions, compared with $50 million for the nine-month period of 2013. The increase for the third quarter and nine-month period of 2014 is due to the recognition of $109 million of the previously deferred gain related to the sale of ICHP. See Note 6-Assets Held for Sale or Sold, in the Notes to Consolidated Financial Statements, for additional information on this transaction. 38-------------------------------------------------------------------------------- Table of Contents Operating expenses for the third quarter and nine-month period of 2014 increased $112 million, or 11 percent, and $269 million, or 9 percent, respectively, primarily related to higher turnaround costs at our refineries, as well as increased utility costs, largely due to higher natural gas prices. Selling, general and administrative expenses increased $52 million, or 15 percent, and $171 million, or 16 percent, in the third quarter and nine-month period of 2014, respectively. These increases were primarily due to additional fees under marketing consignment fuels agreements. In addition, the nine-month period of 2014 was impacted by the costs associated with the acquisition of an additional interest in an entity that operates a power and steam generation plant. See Note 22-Income Taxes, in the Notes to Consolidated Financial Statements, for information regarding our provision for income taxes and effective tax rates. Income from discontinued operations increased $663 million in the nine-month period of 2014, due to the completion of the PSPI share exchange on February 25, 2014. See Note 6-Assets Held for Sale or Sold, in the Notes to Consolidated Financial Statements, for additional information on this transaction. 39-------------------------------------------------------------------------------- Table of Contents Segment Results Midstream Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Millions of Dollars Net Income Attributable to Phillips 66 Transportation $ 58 54 180 149 DCP Midstream 31 87 147 173 NGL 26 6 84 26 Total Midstream $ 115 147 411 348 Dollars Per Unit Weighted Average NGL Price* DCP Midstream (per barrel) $ 37.66 37.84 40.42 36.63 DCP Midstream (per gallon) 0.90 0.90 0.96 0.87 * Based on index prices from the Mont Belvieu and Conway market hubs that are weighted by NGL component and location mix. 2013 weighted average NGL prices have been recast to reflect the impact of ethane rejection. Thousands of Barrels Daily Transportation Volumes Pipelines* 3,142 3,222 3,162 3,142 Terminals 1,763 1,419 1,617 1,219 Refining Logistics 17 - 6 - Operating Statistics NGL extracted** 471 442 456 417 NGL fractionated*** 110 123 113 118 * Pipelines represent the sum of volumes transported through each separately tariffed pipeline segment, including our share of equity volumes from Yellowstone Pipe Line Company and Lake Charles Pipe Line Company. ** Includes 100 percent of DCP Midstream's volumes. *** Excludes DCP Midstream. The Midstream segment purchases raw natural gas from producers and gathers natural gas through an extensive network of pipeline gathering systems. The natural gas is then processed to extract NGL from the raw gas stream. The remaining "residue" gas is marketed to electric utilities, industrial users and gas marketing companies. Most of the NGLs are fractionated-separated into individual components such as ethane, propane and butane-and marketed as chemical feedstock, fuel or blendstock. In addition, the Midstream segment includes U.S. transportation, pipeline, terminaling, and refining logistics services associated with the movement of crude oil, refined and specialty products, natural gas and NGL, as well as NGL fractionation, trading and marketing businesses in the United States. The Midstream segment includes our 50 percent equity investment in DCP Midstream and the consolidated results of Phillips 66 Partners LP. Earnings from the Midstream segment decreased $32 million, or 22 percent, in the third quarter of 2014 and increased $63 million, or 18 percent, in the nine-month period of 2014. Transportation earnings increased $4 million in the third quarter of 2014 and increased $31 million in the nine-month period of 2014. The increases in both periods of 2014 primarily resulted from increased throughput fees, as well as 40-------------------------------------------------------------------------------- Table of Contents higher earnings associated with railcar activity. These increases were partially offset by higher earnings attributable to noncontrolling interests, reflecting the contribution of previously wholly owned assets to Phillips 66 Partners. Earnings associated with our investment in DCP Midstream decreased $56 million in the third quarter of 2014 and $26 million in the nine-month period. A portion of the decreased earnings in both periods reflects DCP Midstream's contribution of assets to its publicly traded master limited partnership, DCP Midstream Partners, LP (DCP Partners). After contribution to DCP Partners, a percentage of these assets' earnings are attributable to public unitholders, thus decreasing income attributable to DCP Midstream, and, thereby, Phillips 66. Earnings in both periods benefited from higher volumes resulting from growth projects. Lower commodity prices had a negative impact on third-quarter 2014 results, while higher commodity prices benefited the year-to-date 2014 period. Higher interest expense, primarily associated with debt incurred by DCP Partners to finance its growth activities, as well as lower capitalized interest associated with certain projects placed into service in 2013, also reduced earnings in the nine-month period ended September 30, 2014. See the "Business Environment and Executive Overview" section for information on market factors impacting this quarter's results. DCP Partners issues, from time to time, limited partner units to the public. These issuances benefited our equity in earnings from DCP Midstream, on an after-tax basis, by $6 million and $41 million in the three- and nine-month periods ended September 30, 2014, respectively, compared with $24 million and $56 million in the corresponding periods of 2013. Earnings of our NGL business increased $20 million in the third quarter of 2014 and $58 million for the nine-month period of 2014. The third quarter of 2014 benefited from gains related to seasonal storage activities. The increase for the nine-month period of 2014 was primarily due to improved margins driven by strong propane prices, positive asset performance and inventory impacts. In addition, both periods benefited from equity earnings from the DCP Sand Hills and DCP Southern Hills pipeline entities. 41-------------------------------------------------------------------------------- Table of Contents Chemicals Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Millions of Dollars Net Income Attributable to Phillips 66 $ 230 262 870 725 Millions of Pounds CPChem Externally Marketed Sales Volumes* Olefins and Polyolefins 4,067 3,927 12,764 11,825 Specialties, Aromatics and Styrenics 1,571 1,577 4,670 4,558 5,638 5,504 17,434 16,383 * Includes 100 percent of CPChem's outside sales of produced petrochemical products, as well as commission sales from equity affiliates. Olefins and Polyolefins Capacity Utilization (percent) 83 % 87 % 90 % 85 % The Chemicals segment consists of our 50 percent interest in CPChem, which we account for under the equity method. CPChem uses NGL and other feedstocks to produce petrochemicals. These products are then marketed and sold or used as feedstocks to produce plastics and other chemicals. Earnings from the Chemicals segment decreased $32 million, or 12 percent, in the third quarter of 2014 and increased $145 million, or 20 percent, in the nine-month period of 2014. The decrease in the third quarter of 2014 was primarily driven by $45 million of impairments related to two of CPChem's equity affiliate investments, as well as an impairment of $24 million related to the sale of Engineering Polymers. In addition, lower ethylene volumes and increased controllable costs related to the Port Arthur facility fire described below further reduced earnings in the third quarter of 2014. These decreases were partially offset by an improvement in ethylene margins, as well as increased earnings from CPChem's equity affiliates. The increase in earnings in the nine-month period of 2014 was primarily due to improved ethylene and polyethylene realized margins and higher earnings from CPChem's equity affiliates. These increases were partially offset by an increase in utility costs due to higher natural gas prices, as well as the asset impairments discussed above. See the "Business Environment and Executive Overview" section for information on market factors impacting this quarter's results. CPChem's Port Arthur facility experienced a localized fire in a portion of its ethylene unit in early July 2014, shutting down the ethylene and cyclohexane production. Cyclohexane production resumed in mid-July at reduced rates, but ethylene production is not expected to restart until late fourth quarter of 2014. We expect CPChem's results in the fourth quarter of 2014 to continue to be negatively impacted by this shutdown. 42-------------------------------------------------------------------------------- Table of Contents Refining Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Millions of Dollars Net Income (Loss) Attributable to Phillips 66 Atlantic Basin/Europe $ 125 47 131 166 Gulf Coast 43 (79 ) 238 (126 ) Central Corridor 300 119 751 1,102 Western/Pacific (3 ) (94 ) 15 2 Other Refining 93 (23 ) 119 185 Worldwide $ 558 (30 ) 1,254 1,329 Dollars Per Barrel Refining Margins* Atlantic Basin/Europe $ 9.99 6.59 7.82 7.34 Gulf Coast 6.80 3.35 7.81 4.93 Central Corridor 16.87 9.80 15.66 18.65 Western/Pacific 8.71 4.77 8.79 7.75 Worldwide 10.89 5.94 10.15 9.70* Based on total processed inputs and includes proportional share of refining margins contributed by certain equity affiliates. Thousands of Barrels Daily Operating Statistics Refining operations* Atlantic Basin/Europe Crude oil capacity 588 588 588 588 Crude oil processed 538 574 550 567 Capacity utilization (percent) 92 % 98 94 96 Refinery production 593 609 599 609 Gulf Coast Crude oil capacity 733 733 733 733 Crude oil processed 710 671 666 640 Capacity utilization (percent) 97 % 92 91 87 Refinery production 798 774 766 723 Central Corridor Crude oil capacity 485 478 485 476 Crude oil processed 476 480 478 470 Capacity utilization (percent) 98 % 101 99 99 Refinery production 494 497 497 487 Western/Pacific Crude oil capacity 440 440 440 440 Crude oil processed 390 403 403 407 Capacity utilization (percent) 89 % 91 92 92 Refinery production 425 432 436 442 Worldwide Crude oil capacity 2,246 2,239 2,246 2,237 Crude oil processed 2,114 2,128 2,097 2,084 Capacity utilization (percent) 94 % 95 93 93 Refinery production 2,310 2,312 2,298 2,261 * Includes our share of equity affiliates. 43-------------------------------------------------------------------------------- Table of Contents The Refining segment buys, sells and refines crude oil and other feedstocks into petroleum products (such as gasoline, distillates and aviation fuels) at 15 refineries, mainly in the United States, Europe and Asia. Earnings for the Refining segment increased $588 million in the third quarter of 2014. The increase was primarily due to higher realized refining margins resulting from increased market crack spreads, as well as the improvement of refined petroleum product differentials. See the "Business Environment and Executive Overview" section for information on market factors impacting this quarter's results. Earnings for the nine-month period of 2014 decreased $75 million, or 6 percent, primarily related to higher utility costs due to increased natural gas prices and higher turnaround costs. In addition, earnings were impacted by improved refined petroleum product differentials, partially offset by decreased market crack spreads. See the "Business Environment and Executive Overview" section for information on industry crack spreads and other market factors impacting this quarter's results. Our worldwide refining crude oil capacity utilization rate was 94 percent in the third quarter of 2014, compared with 95 percent in the third quarter of 2013. The current year decrease was primarily due to turnaround activity. Industry refining margins can vary by region of the world, due to differing crude slates and refined product demand fundamentals. In addition to monitoring for interim indicators of impairment, we perform an annual review for impairment indicators of property and equity investments in the fourth quarter, in conjunction with our long-range planning efforts. This review takes into account our outlook on economic factors that influence refinery cash flows, including commodity prices, industry refining margins, capital spending and other operating plan assumptions. As we finalize our plans and conduct our review, it is reasonably possible non-cash impairments of some of our properties and equity investments may be required. 44-------------------------------------------------------------------------------- Table of Contents Marketing and Specialties Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Millions of Dollars Net Income Attributable to Phillips 66 Marketing and Other $ 325 199 537 634 Specialties 43 56 130 155 Total Marketing and Specialties $ 368 255 667 789 Dollars Per Barrel Realized Marketing Fuel Margin* U.S. $ 1.78 1.25 1.38 1.36 International 6.10 5.55 4.79 4.56 * On third-party petroleum products sales. Dollars Per Gallon U.S. Average Wholesale Prices* Gasoline $ 2.90 2.98 2.92 2.97 Distillates 3.02 3.16 3.08 3.12 * Excludes excise taxes. Thousands of Barrels Daily Marketing Petroleum Products Sales Volumes Gasoline 1,188 1,206 1,181 1,181 Distillates 940 951 952 971 Other products 17 18 17 17 Total 2,145 2,175 2,150 2,169 The M&S segment purchases for resale and markets refined petroleum products (such as gasoline, distillates and aviation fuels), mainly in the United States and Europe. In addition, this segment includes the manufacturing and marketing of specialty products (such as base oils and lubricants), as well as power generation operations. The M&S segment earnings increased $113 million, or 44 percent, in the third quarter of 2014, primarily due to the first tranche of the deferred gain related to the ICHP sale that was recognized in the third quarter of 2014. Earnings for the nine-month period of 2014 decreased $122 million, or 15 percent. The decrease was primarily due to lower credits associated with renewable fuels blending activities. In addition, earnings in the nine-month period of 2013 benefited from earnings from our U.K. power generation business, which was sold in July 2013, the sale of our E-GasTM Technology business in May 2013, and the biodiesel tax credit program that was discontinued in 2014. These decreases were partially offset by the deferred gain related to the sale of ICHP that was recognized in the third quarter of 2014. See the "Business Environment and Executive Overview" section for information on marketing fuel margins and other market factors impacting this quarter's results. 45 -------------------------------------------------------------------------------- Table of Contents Corporate and Other Millions of Dollars Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Net Income (Loss) Attributable to Phillips 66 Net interest $ (36 ) (41 ) (116 ) (126 ) Corporate general and administrative expenses (32 ) (32 ) (116 ) (102 ) Technology (14 ) (12 ) (41 ) (36 ) Other (9 ) (28 ) (20 ) (70 ) Total Corporate and Other $ (91 ) (113 ) (293 ) (334 ) Net interest consists of interest and financing expense, net of interest income and capitalized interest. Net interest decreased $5 million and $10 million, respectively, in the three- and nine-month periods ended September 30, 2014, primarily due to increased capitalized interest and a lower average debt principal balance. Corporate general and administrative expenses increased $14 million in the nine-month period ended September 30, 2014, primarily due to increased employee benefit costs and charitable contributions. The category "Other" includes certain income tax expenses, environmental costs associated with sites no longer in operation, foreign currency transaction gains and losses and other costs not directly associated with an operating segment. The decrease in costs for the three- and nine-month periods of 2014 was primarily due to increased utilization of foreign tax credit carry forwards. In addition, the nine-month period of 2013 was negatively impacted by an asset impairment and higher environmental costs. 46-------------------------------------------------------------------------------- Table of Contents Discontinued Operations Millions of Dollars Three Months Ended Nine Months Ended September 30 September 30 2014 2013 2014 2013 Net Income Attributable to Phillips 66 Discontinued operations $ - 14 706 43 In December 2013, we entered into an agreement to exchange the stock of PSPI, a flow improver business, which was included in our M&S segment, for shares of Phillips 66 common stock owned by the other party to the transaction. On February 25, 2014, we completed the PSPI share exchange, resulting in the receipt of approximately 17.4 million shares of Phillips 66 common stock, which are held as treasury shares, and the recognition of a before-tax noncash gain of $696 million. See Note 6-Assets Held for Sale or Sold, in the Notes to Consolidated Financial Statements, for additional information on this transaction. 47-------------------------------------------------------------------------------- Table of Contents CAPITAL RESOURCES AND LIQUIDITY Financial Indicators Millions of Dollars Except as Indicated September 30 December 31 2014 2013 Short-term debt $ 35 24 Total debt 6,213 6,155 Total equity 22,194 22,392 Percent of total debt to capital* 22 % 22 Percent of floating-rate debt to total debt 1 % 1 * Capital includes total debt and total equity. To meet our short- and long-term liquidity requirements, we look to a variety of funding sources, but rely primarily on cash generated from operating activities. During the first nine months of 2014, we generated $2,657 million in cash from operations and received $663 million from asset dispositions, including return of investments in equity affiliates. Available cash was primarily used for capital expenditures and investments ($2,647 million), repurchases of our common stock ($1,750 million), the PSPI share exchange ($450 million), debt repayments ($30 million) and dividend payments on our common stock ($787 million). During the first nine months of 2014, cash and cash equivalents decreased by $2,292 million to $3,108 million. In addition to cash flows from operating activities, we rely on our credit facility programs, asset sales and our ability to issue securities using our shelf registration statement to support our short- and long-term liquidity requirements. We believe current cash and cash equivalents and cash generated by operations, together with access to external sources of funds as described below in the "Significant Sources of Capital" section, will be sufficient to meet our funding requirements in the near and long term, including our capital spending, dividend payments, defined benefit plan contributions, repayment of debt and share repurchases. Significant Sources of Capital Operating Activities During the first nine months of 2014, cash provided by operating activities was $2,657 million, compared with $5,130 million for the first nine months of 2013. The decrease in the 2014 period primarily reflected negative working capital impacts, driven mainly by higher inventory builds relative to the prior year, compared to positive working capital impacts during the comparable period of 2013. Our short- and long-term operating cash flows are highly dependent upon refining and marketing margins, NGL prices, and chemicals margins. Prices and margins in our industry are typically volatile, and are driven by market conditions over which we have little or no control. Absent other mitigating factors, as these prices and margins fluctuate, we would expect a corresponding change in our operating cash flows. The level and quality of output from our refineries impacts our cash flows. The output at our refineries is impacted by such factors as operating efficiency, maintenance turnarounds, market conditions, feedstock availability and weather conditions. We actively manage the operations of our refineries and, typically, any variability in their operations has not been as significant to cash flows as that caused by margins and prices. During the third quarter of 2014, we increased inventory levels, which reduced cash from operating activities by $772 million. We are currently forecasting inventory reductions in the fourth quarter of 2014 that are estimated to increase cash from operating activities by a similar amount. 48-------------------------------------------------------------------------------- Table of Contents Our operating cash flows are also impacted by dividend decisions made by our equity affiliates, including DCP Midstream, CPChem and WRB. During the first nine months of 2014, cash from operations included dividends of $2,413 million from our equity affiliates, compared with $2,228 million during the same period of 2013. We cannot control the amount of future dividends from equity affiliates; therefore, future dividend payments by these companies are not assured. WRB WRB is a 50-percent-owned business venture with Cenovus Energy Inc. (Cenovus). Cenovus was obligated to contribute $7.5 billion, plus accrued interest, to WRB over a 10-year period that began in 2007. In the first quarter of 2014, Cenovus prepaid its remaining balance under this obligation. As a result, WRB declared a special dividend, which was distributed to the co-venturers in March 2014. Of the $1,232 million that we received, $760 million was considered a return on our investment in WRB (an operating cash inflow), and $472 million was considered a return of our investment in WRB (an investing cash inflow). The return of investment portion of the dividend was included in the "Proceeds from assets dispositions" line in our consolidated statement of cash flows. A further $129 million of distributions from WRB during the first nine months of 2014 was considered a return of investment. Contribution to Phillips 66 Partners LP Effective March 1, 2014, we contributed to Phillips 66 Partners certain transportation, terminaling and storage assets for total consideration of $700 million. These assets consisted of the Gold Line products system and the Medford spheres, which are two newly constructed refinery-grade propylene storage spheres. Phillips 66 Partners financed the acquisition with cash on hand of $400 million, the issuance to us of 3,530,595 and 72,053 additional common and general partner units, respectively, valued at $140 million, and a five-year, $160 million note payable to a subsidiary of Phillips 66. See Note 23-Phillips 66 Partners LP, in the Notes to Consolidated Financial Statements, for additional information. Credit Facilities As of September 30, 2014, no amount had been drawn under our $4.5 billion credit facility; however, $51 million in letters of credit had been issued that were supported by this facility. As of September 30, 2014, no amount had been drawn under Phillips 66 Partners' $250 million revolving credit facility. Trade Receivables Securitization Facility Effective September 30, 2014, we terminated our $696 million trade receivables securitization facility. No amounts were drawn on this facility throughout its duration, and at the time of termination no letters of credit were outstanding thereunder. Shelf Registration We have a universal shelf registration statement on file with the U.S. Securities and Exchange Commission (SEC) under which we, as a well-known seasoned issuer, have the ability to issue and sell an indeterminate amount of various types of debt and equity securities. Off-Balance Sheet Arrangements In April 2012, in connection with our separation from ConocoPhillips (the Separation), we entered into an agreement to guarantee 100 percent of certain outstanding debt obligations of Merey Sweeny, L.P. (MSLP). At September 30, 2014, the aggregate principal amount of MSLP debt guaranteed by us was $203 million. For additional information about guarantees, see Note 13-Guarantees, in the Notes to Consolidated Financial Statements. Capital Requirements For information about our capital expenditures and investments, see the "Capital Spending" section. Our debt balance at both September 30, 2014, and December 31, 2013, was $6.2 billion. Our debt-to-capital ratio was 22 percent at both September 30, 2014, and December 31, 2013, within our target range of 20-to-30 percent. On July 9, 2014, our Board of Directors declared a quarterly cash dividend of $0.50 per common share. The dividend was paid on September 2, 2014, to holders of record at the close of business on August 15, 2014. On October 1, 2014, our Board of Directors declared a quarterly cash dividend of $0.50 per common share. The dividend is payable on 49-------------------------------------------------------------------------------- Table of Contents December 1, 2014, to holders of record at the close of business on November 14, 2014. We are forecasting annual double-digit dividend rate increases in 2015 and 2016. During 2012 and 2013, our Board of Directors authorized repurchases totaling up to $5 billion of our outstanding common stock. The share repurchases are expected to be funded primarily through available cash. In July 2014, our Board of Directors authorized additional share repurchases totaling up to $2 billion. During the third quarter of 2014, we repurchased 5,970,667 shares at a cost of $494 million. Since the inception of our share repurchases in 2012, through September 30, 2014, we have repurchased a total of 66,004,675 shares at a cost of $4,352 million. Shares of stock repurchased are held as treasury shares. On October 15, 2014, we signed agreements to form two joint ventures to develop the Dakota Access Pipeline (DAPL) and Energy Transfer Crude Oil Pipeline (ETCOP) projects. We own a 25 percent interest in each joint venture, with our co-venturer holding the remaining 75 percent interest and acting as operator of both the DAPL and ETCOP systems. Our share of construction cost is estimated to be approximately $1.2 billion, which will be reflected as investments in equity-method affiliates. We expect the majority of this capital spending commitment to be incurred in 2015 and 2016, and anticipate it to be funded as part of our overall capital program. In December 2013, we announced that we had entered into an agreement to exchange the stock of PSPI for shares of our common stock held by the other party to the transaction. On February 25, 2014, we completed the PSPI share exchange, resulting in the receipt of approximately 17.4 million shares of Phillips 66 common stock, which are held as treasury shares, and the recognition of a before-tax, noncash gain of $696 million. Capital Spending Millions of Dollars Nine Months Ended September 30 2014 2013 Capital Expenditures and Investments Midstream $ 1,532 377 Chemicals - - Refining 679 511 Marketing and Specialties 358 180 Corporate and Other 78 88 Total consolidated from continuing operations $ 2,647 1,156 Discontinued operations $ - 14 Selected Equity Affiliates* DCP Midstream $ 561 760 CPChem** 623 420 WRB 96 78 $ 1,280 1,258 * Our share of capital spending, which is self-funded by the equity affiliate. ** 2013 has been recast to reflect a change in CPChem's basis of presentation. In July 2014, our Board of Directors authorized an increase of $1.2 billion to the 2014 planned capital budget previously reported in our 2013 Annual Report on Form 10-K. The increased capital budget is designed to support planned or completed acquisitions, including a U.S. Gulf Coast crude oil and refined products terminal and a specialty lubricants company, as well as the construction of Midstream organic growth projects. The Midstream segment budget was increased by approximately $0.8 billion, while the M&S segment budget was increased by approximately $0.4 billion. 50-------------------------------------------------------------------------------- Table of Contents Midstream During the first nine months of 2014, DCP Midstream had a self-funded capital program, and thus required no new capital infusions from us or our co-venturer. During this period, on a 100 percent basis, DCP Midstream's capital expenditures and investments were approximately $1,122 million. During the first nine months of 2014, other capital spending in our Midstream segment not related to DCP Midstream included construction activities related to our Sweeny Fractionator One and Freeport Liquid Petroleum Gas Export Terminal projects, our acquisition of a 7.1 million-barrel-storage-capacity crude oil and petroleum products terminal located near Beaumont, Texas, the purchase of an additional 5.7 percent interest in the refined products Explorer Pipeline, and spending associated with return, reliability and maintenance projects. In addition to our Sweeny Fractionator One and Freeport Liquid Petroleum Gas Export Terminal projects, our major construction activities in progress include the installation of rail racks to accept advantaged crude deliveries at our Ferndale refinery. Chemicals During the first nine months of 2014, CPChem had a self-funded capital program, and thus required no new capital infusions from us or our co-venturer. During this period, on a 100 percent basis, CPChem's capital expenditures and investments were $1,245 million, primarily for its U.S. Gulf Coast Petrochemicals Project. We are currently forecasting CPChem to remain self-funding through 2014. Refining Capital spending for the Refining segment during the first nine months of 2014 was primarily for air emission reduction projects to meet new environmental standards, refinery upgrade projects to increase accessibility of advantaged crudes and improve product yields, improvements to the operating integrity of key processing units and safety-related projects. Major construction activities in progress include: • Installation of facilities to reduce nitrous oxide emissions from the fluid catalytic cracker at the Alliance Refinery. • Installation of a tail gas treating unit at the Humber Refinery to reduce emissions from the sulfur recovery units. Generally, our equity affiliates in the Refining segment are intended to have self-funding capital programs. Marketing and Specialties Capital spending for the M&S segment during the first nine months of 2014 included our acquisition of a private label specialty lubricants business headquartered in Memphis, Tennessee, as well as the remaining interest that we did not already own in an entity that operates a power and steam generation plant. The remaining spend was primarily for projects targeted at growing our international marketing business. Contingencies A number of lawsuits involving a variety of claims that arose in the ordinary course of business have been filed against us or are subject to indemnifications provided by us. We also may be required to remove or mitigate the effects on the environment of the placement, storage, disposal or release of certain chemical, mineral and petroleum substances at various active and inactive sites. We regularly assess the need for accounting recognition or disclosure of these contingencies. In the case of all known contingencies (other than those related to income taxes), we accrue a liability when the loss is probable and the amount is reasonably estimable. If a range of amounts can be reasonably estimated and no amount within the range is a better estimate than any other amount, then the minimum of the range is accrued. We do not reduce these liabilities for potential insurance or third-party recoveries. If applicable, we accrue receivables for probable insurance or other third-party recoveries. In the case of income-tax-related contingencies, we use a cumulative probability-weighted loss accrual in cases where sustaining a tax position is less than certain. Based on currently available information, we believe it is remote that future costs related to known contingent liability exposures will exceed current accruals by an amount that would have a material adverse impact on our consolidated financial statements. As we learn new facts concerning contingencies, we reassess our position both with respect to accrued liabilities and other potential exposures. Estimates particularly sensitive to future changes include contingent 51-------------------------------------------------------------------------------- Table of Contents liabilities recorded for environmental remediation, tax and legal matters. Estimated future environmental remediation costs are subject to change due to such factors as the uncertain magnitude of cleanup costs, the unknown time and extent of such remedial actions that may be required, and the determination of our liability in proportion to that of other potentially responsible parties. Estimated future costs related to tax and legal matters are subject to change as events evolve and as additional information becomes available during the administrative and litigation processes. Legal and Tax Matters Our legal and tax matters are handled by our legal and tax organizations. These organizations apply their knowledge, experience and professional judgment to the specific characteristics of our cases and uncertain tax positions. We employ a litigation management process to manage and monitor the legal proceedings against us. Our process facilitates the early evaluation and quantification of potential exposures in individual cases and enables the tracking of those cases that have been scheduled for trial and/or mediation. Based on professional judgment and experience in using these litigation management tools and available information about current developments in all our cases, our legal organization regularly assesses the adequacy of current accruals and determines if adjustment of existing accruals, or establishment of new accruals, is required. In the case of income-tax-related contingencies, we monitor tax legislation and court decisions, the status of tax audits and the statute of limitations within which a taxing authority can assert a liability. Environmental We are subject to the same numerous international, federal, state and local environmental laws and regulations as other companies in our industry. For a discussion of the most significant of these environmental laws and regulations, including those with associated remediation obligations, see the "Environmental" section in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 50, 51 and 52 of our 2013 Annual Report on Form 10-K. From time to time, we receive requests for information or notices of potential liability from the U.S. Environmental Protection Agency (EPA) and state environmental agencies alleging that we are a potentially responsible party under the Federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) or an equivalent state statute. On occasion, we also have been made a party to cost recovery litigation by those agencies or by private parties. These requests, notices and lawsuits assert potential liability for remediation costs at various sites that typically are not owned by us, but allegedly contain wastes attributable to our past operations. As of December 31, 2013, we reported that we had been notified of potential liability under CERCLA and comparable state laws at 35 sites around the United States. During the first nine months of 2014, there were no new sites for which we received notification of potential liability and one site was deemed resolved and closed, leaving 34 unresolved sites with potential liability at September 30, 2014. At September 30, 2014, our total environmental accrual was $519 million, compared with $492 million at December 31, 2013. We expect to incur a substantial amount of these expenditures within the next 30 years. Notwithstanding any of the foregoing, and as with other companies engaged in similar businesses, environmental costs and liabilities are inherent concerns in our operations and products, and there can be no assurance that material costs and liabilities will not be incurred. However, we currently do not expect any material adverse effect on our results of operations or financial position as a result of compliance with current environmental laws and regulations. Climate Change There has been a broad range of proposed or promulgated state, national and international laws focusing on greenhouse gas (GHG) emissions reduction, including various regulations proposed or issued by the EPA. These proposed or promulgated laws apply or could apply in states and/or countries where we have interests or may have interests in the future. We consider and take into account future GHG emissions in designing and developing major facilities and projects, and implement energy efficiency initiatives to reduce such emissions. Laws in this field continue to evolve, and while it is not possible to accurately estimate either a timetable for implementation or our future compliance costs relating to implementation, such laws, if enacted, potentially could have a material impact on our results of operations and financial condition as a result of increasing costs of compliance, lengthening project implementation and agency review times, or reducing demand for certain hydrocarbon products. We continue to monitor legislative and regulatory actions and legal proceedings globally relating to GHG emissions for potential impacts on our operations. 52-------------------------------------------------------------------------------- Table of Contents For examples of legislation or precursors for possible regulation that do or could affect our operations, see the "Climate Change" section in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 53 and 54 of our 2013 Annual Report on Form 10-K. NEW ACCOUNTING STANDARDS In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2014-09, "Revenue from Contracts with Customers (Topic 606)." The new standard converged guidance on recognizing revenues in contracts with customers under accounting principles generally accepted in the United States and International Financial Reporting Standards. This ASU is intended to improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets. ASU 2014-09 is effective for annual and quarterly reporting periods of public entities beginning after December 15, 2016. Early application for public entities is not permitted. We are currently evaluating the provisions of ASU 2014-09 and assessing the impact, if any, it may have on our financial position and results of operations. OUTLOOK On October 22, 2014, we entered into an agreement to contribute to Phillips 66 Partners certain logistics assets for total consideration of $340 million. These assets consist of two new crude oil rail-unloading facilities located at or adjacent to our Bayway and Ferndale refineries, and the Cross-Channel Connector pipeline assets located near the partnership's Pasadena terminal. Phillips 66 Partners expects to finance the acquisition with the borrowing of $28 million under its revolving credit facility, the assumption of a 5-year, $244 million note payable to a subsidiary of Phillips 66, and the issuance to Phillips 66 of 1,066,412 common and 21,764 general partner units valued at $68 million. The transaction is anticipated to close in December 2014. Since we consolidate Phillips 66 Partners for financial reporting purposes, the note payable and unit issuances will eliminate in consolidation, while consolidated cash and debt will both increase by $28 million. CAUTIONARY STATEMENT FOR THE PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify our forward-looking statements by the words "anticipate," "estimate," "believe," "budget," "continue," "could," "intend," "may," "plan," "potential," "predict," "seek," "should," "will," "would," "expect," "objective," "projection," "forecast," "goal," "guidance," "outlook," "effort," "target" and similar expressions. We based the forward-looking statements on our current expectations, estimates and projections about us and the industries in which we operate in general. We caution you these statements are not guarantees of future performance as they involve assumptions that, while made in good faith, may prove to be incorrect, and involve risks and uncertainties we cannot predict. In addition, we based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Accordingly, our actual outcomes and results may differ materially from what we have expressed or forecast in the forward-looking statements. Any differences could result from a variety of factors, including the following: • Fluctuations in NGL, crude oil and natural gas prices and petrochemical and refining margins. • Failure of new products and services to achieve market acceptance. • Unexpected changes in costs or technical requirements for constructing, modifying or operating our facilities or transporting our products. • Unexpected technological or commercial difficulties in manufacturing, refining or transporting our products, including chemicals products. • Lack of, or disruptions in, adequate and reliable transportation for our NGL, crude oil, natural gas and refined products. 53-------------------------------------------------------------------------------- Table of Contents • The level and success of natural gas drilling around DCP Midstream's assets, the level and quality of gas production volumes around its assets and its ability to connect supplies to its gathering and processing systems in light of competition. • Inability to timely obtain or maintain permits, including those necessary for capital projects; comply with government regulations; or make capital expenditures required to maintain compliance. • Failure to complete definitive agreements and feasibility studies for, and to timely complete construction of, announced and future capital projects. • Potential disruption or interruption of our operations due to accidents, weather events, civil unrest, political events, terrorism or cyber attacks. • International monetary conditions and exchange controls. • Substantial investment or reduced demand for products as a result of existing or future environmental rules and regulations. • Liability resulting from litigation or for remedial actions, including removal and reclamation obligations under environmental regulations. • General domestic and international economic and political developments including: armed hostilities; expropriation of assets; changes in governmental policies relating to NGL, crude oil, natural gas or refined product pricing, regulation or taxation; and other political, economic or diplomatic developments. • Changes in tax, environmental and other laws and regulations (including alternative energy mandates) applicable to our business. • Limited access to capital or significantly higher cost of capital related to changes to our credit profile or illiquidity or uncertainty in the domestic or international financial markets. • The operation, financing and distribution decisions of our joint ventures. • Domestic and foreign supplies of crude oil and other feedstocks. • Domestic and foreign supplies of petrochemicals and refined products, such as gasoline, diesel, jet fuel and home heating oil. • Governmental policies relating to exports of crude oil and natural gas. • Overcapacity or undercapacity in the midstream, chemicals and refining industries. • Fluctuations in consumer demand for refined products. • The factors generally described in Item 1A.-Risk Factors in our 2013 Annual Report on Form 10-K. |