Oil refiner Marathon Petroleum (NYSE:MPC) has a few good things going for it. The stock is currently undervalued, oversold, and the company recently initiated a new stock repurchase plan. Marathon operates seven refineries in the U.S. with a capacity of about 1.7 million barrels per day. The company also has interests in 8,300 miles of pipelines that transport crude oil and refined products. I think that the recent sell-off in the stock has created a good buying opportunity for investors.
Marathon operates the following three segments: Refining & Marketing, Speedway, and Pipeline Transportation. Refining & Marketing comprises the majority of the business with 86% of segment revenue. The Speedway segment sells transportation fuels and convenience items in the Midwest and comprises about 13% of segment revenue. The Pipeline Transportation segment comprises the remaining 1% of segment revenue. Marathon depends a lot on the size of the crack spread (the difference between the price of crude oil and the price for the refined products such as gasoline and heating oil). When the crack spread widens, Marathon is more profitable. Therefore, traders buy and sell Marathon and other refiners based on the widening or narrowing of the crack spread. Refining margins have declined in the past few months as a result of a narrowing of the crack spread. The crack spread was wider in the beginning of the year and the refiners performed well as a result. Marathon's stock can be volatile as a result of these fluctuations. However, I think that the stock can hold up over the long-term based on the company's earnings growth. Marathon's earnings are expected to increase 18% next year.
The recent sell-off in Marathon's stock can be attributed to the narrowing of the crack spread in the past few months. The sell-off has created an attractive low valuation for the stock. The stock is currently trading with a forward PE ratio of 8.2, PEG of 0.89, and a price to book ratio of 1.8. The current EV/EBITDA is also attractive at 3.38. This valuation is significantly lower than the S&P 500's forward PE of 15 and price to book of 2.4. Other refiners are trading at similar low valuations, including Phillips 66 (NYSE:PSX) and Valero Energy (NYSE:VLO). These competitors should also be attractive investments for the long term. However, another competitor Tesoro (NYSE:TSO) is valued higher with a PEG of 2.
Although it is difficult to predict the widening or narrowing of the crack spread based on various short-term factors, we'll have to base the investment decision on the likelihood that refiners will experience reasonable average margins over time. Marathon achieved positive year-over-year increases in operating cash flow for the past few years since 2010. As a result, the company has rewarded shareholders with annual dividend increases and stock buybacks. Marathon currently pays a dividend of 2.6% on a 14% payout ratio. The company recently announced that it will add $2 billion to its existing share repurchase program that had $1.3 billion remaining as of June 30, 2013. CEO Gary R. Heminger stated in the recent press release that Marathon is committed to returning capital to shareholders. This share repurchase should provide a boost for the stock as less outstanding shares remain in the market. The buyback should also provide a boost to EPS, which should also drive the stock higher.
Crack Spread Likely to Increase
Getting back to the crack spread, which affects Marathon's refining margins; the price of oil has fluctuated between about $85 and $111 per barrel over the past year. The RBOB gasoline price has fluctuated between $2.47 and $2.98. Barring any extreme situations, I would expect these prices to remain approximately in this range. The situation in Syria has calmed down and the price of oil has dropped to about $101. According to the futures, the price of WTI crude is expected to drop to $93-$94 per barrel by September 2014, while the price of RBOB gasoline is expected to be about $2.66 per gallon and heating oil is expected to be $2.88 per gallon. With the price of oil currently at $102 and the price of RBOB gasoline at $2.63 today, the futures suggest that the crack spread will widen over the next year. Therefore, today's crack spread of $13-$14 should increase to $21-$22 by September 2014. This should provide a nice boost to Marathon's refining margins and increase its EPS. The 18 analysts covering the company expect Marathon's stock price to increase to about $86 in a year. This represents a 30% potential gain for the stock.
What Could Go Wrong?
The primary risk for the company is that the crack spread could potentially narrow, thus reducing the refining margins. If the price of oil were to remain about the same and the price of gasoline and heating oil were to fall, the crack spread would be reduced and so would Marathon's refining margins. If this were to occur, Marathon's stock would likely drop. However, I don't think that this is the likely scenario.
Marathon is attractively undervalued as compared to the fairly valued S&P 500. The recent sell-off represents a good opportunity for investors to begin a position in the stock. With a decent dividend yield, a stock buyback, and with the crack spread likely to increase, Marathon is likely to move higher over the next year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.