During the month of April, Seeking Alpha will be featuring interviews with four of the oil and gas industry’s most dynamic CEOs.
Kicking off our series is our interview with Marathon Oil Corporation (MRO) CEO Clarence Cazalot (more on Mr. Cazalot following the article). Joining Seeking Alpha’s Leland Montgomery for the interview is contributor Michael Filloon, who has carved out a role as an expert on the Bakken and Eagle Ford shale plays, among others. Michael’s accompanying article can be found here.
Seeking Alpha (SA) - Marathon has neatly sidestepped what Richard Kinder describes as the industry’s tsunami - the flood of unconventional gas hitting the market and changing the economics for many companies. Can you tell us what led you to shed your gas assets several years ago?
CEO Clarence Cazalot (CC) - I wish I could tell you that we were clairvoyant enough to see this tsunami of natural gas coming. We, like most, certainly saw the potential, but didn't recognize the incredible impact it's had, both the promise it yields for our energy security in the United States, but also the much lower prices that we see for natural gas here in the U.S.
But for quite some time now, we've had a view that crude oil trades on a global basis and has historically, with few exceptions, always traded at a premium on a energy equivalent basis to natural gas. So just a few years ago when we had $75 per-barrel oil and $6 per-mcf natural gas, converting that to a BTU equivalent, crude oil was still priced at a large premium to natural gas. [Editor’s note: One barrel of crude oil has the heating capacity of approximately 5.64 mcf of natural gas to equal a barrel of crude oil, which most analysts round up to 6 mcf, so an a BTU-equivalent basis $75 crude oil should be compared with an effective price of 6 x $6, or $36 per mcf, for natural gas]. Obviously that premium has increased even more dramatically now with $100-plus oil and $2 to $3 gas.
So we've always seen that crude oil, being a global commodity, was leveraged to growth, particularly in the developing regions of the world, and we felt that it would be a more sustainable price perhaps than domestic natural gas that was going to be subject to supply/demand and other competing fuels.
So while we didn’t make the call that natural gas prices were going to fall as they have, we simply held a view that in our mind, global liquids, global crude markets offered more upside for the longer term.
SA - Did your spin-off of the downstream business, creating an upstream focused company, free your hand to pursue a more focused or aggressive strategy? And would you encourage the other integrated oil companies to do the same thing?
CC - I think it has. We said, as we announced that we were going do the spin-off, that there was not a great deal of physical integration between the two businesses. And the spin-off would allow these two strong businesses to operate independently, with each management team focusing on their businesses, on their respective competition, to allocate capital and capture opportunities that were in their best interest and not try to do that across a broader, more complex integrated set of businesses.
As we look back at the performance of MRO and MPC, it certainly has achieved that. For example, we followed the spin-off very quickly with our acquisitions in the Eagle Ford, and we have now begun to ramp-up our drilling there. Historically we’ve probably had less than 10 rigs operating onshore in the United States, and today we’re up to around 30, a significantly higher level of activity.
In terms of other companies, you've seen ConocoPhillips (COP) follow our example, but this is not a one-size-fits-all solution. I think every company has to look at its own unique set of circumstances and determine if it’s best to remain integrated or is it best to split into two separate businesses.
For us, it was a clear-cut answer, because our downstream [refining and marketing] was a larger component of our total business relative to our peers whose upstream businesses [exploration and production] are much larger. Obviously, ConocoPhillips believes it will work for them but everyone else will have to make those decisions based on their own unique circumstances.
SA - Forecasting oil prices can be tricky, but in terms of your capital spending plans, and exploration plans, what kind of prices do you base your plans on?
CC - We have our economic teams do their own projections of what we believe supply and demand is going to be, and take into account the published estimates of other research organizations and data sources. We forecast future prices and - importantly these days - the price differentials between the various types of crude [i.e., West Texas Intermediate vs. Brent vs. Bakken, etc.].
But after taking all that into account we still tend to look at pricing on a bit more conservative basis in terms of planning our capital projects. Our average capital spend for the next five years is around $5 billion a year, and investing that money for projects that are many years in life dictates that we can’t be aggressive on pricing: it’s important to plan conservatively. If prices are lower, at least you retain some flexibility to adjust. If prices are higher, then you will have stronger cash flows that you can return to your shareholders or re-invest in a profitable growth. So, we tend to price at what we believe to be long-term realizable prices on a fairly conservative basis and hope that prices end up much higher than we budget for.
Moreover, price volatility not only affects our price realizations, it affects our cost of doing business. As prices are rising and activity picks up, costs rise with that as well. That kind of volatility in both price realizations and cost is really one of the challenges we face because we do invest such large sums of money over a long period of time.
Contributor Michael Filloon (MF) - You recently announced that you had increased your 2012 capex spending for the Eagle Ford. Why did you chose to ramp up that spending there as opposed to the Bakken, Niobrara or Anadarko or Woodford?
CC - We have said pretty consistently that the Eagle Ford is the best unconventional resource play, not only in the U.S., but also in North America, and maybe in the world, for that matter. If you look at the Howard Weil Energy Conference presentation that I gave March 26, on slide 17 we show the economics for the three major trends in the Eagle Ford. There is an oil trend, which really falls into two categories: What we call the high-gas-to-oil, or GOR ratio trend, which produces more than 500 standard cubic feet of additional gas per barrel, and the low-GOR oil [less than 500 scf/bbl]. The third type is the gas condensate trend. And what you’ll see are very different economic returns for the investment there.
All these wells cost about $8 million, but the gas condensate wells have much higher recoveries and much higher rates of production. So therefore, the economics are best for the gas condensate, because its higher energy component permits better recoveries. Second-best is the high-GOR oil, because it has more gas in it. The lowest return is the low-GOR oil, whose economics look a lot like the Bakken. Similar kinds of recoveries, similar kinds of well cost and good economics, but not as strong as what you see in the other parts of the Eagle Ford. So I think if you look at those slides, comparing the Eagle Ford to the Bakken, you’ll see why we would allocate more of our capital to the Eagle Ford.
MF - Marathon’s first real big purchase in the Eagle Ford was met with criticism that you had spent too much for it. Looking at what you have found now, especially in Gonzales and Lavaca Counties, how would you rate your investments in that area now?
CC - I think at the time of the acquisition, there was a tendency for people to take a very simplistic analysis: 'Here’s how much money you spent, here’s how much acreage you got, here’s the dollar per acre, and therefore compared to other transactions in the Eagle Ford, this is at the high end.' What we and other operators have now shown, and is illustrated in that presentation, is that not every acre in the Eagle Ford is created equal. So if you've got acreage over in the low-GOR oil window where the economics simply are not there today, that acreage is much less valuable than the condensate or high-GOR oil window.
We bought into the core of the Eagle Ford, the prime zip code. And our results thus far have absolutely proven that out, and the real upside has yet to be demonstrated. In the Howard Weil presentation on slide 19, we’ll be doing five pilot projects to test down-spacing this year. And those down-spacing pilots will demonstrate to us, how much we can down-space from 160-acre drill-sites down to 80-, 60- and 40-acre spacing. We plan to drill 500 wells, based on 160-acre spacing, in the high-GOR oil zone. But if we’re able to down-space those wells to 80 acres, with fairly minimal diminution of the ultimate recoveries per well, that's another 500 wells with an average recovery of around 700,000 BOE per well, that's another 350 million barrels of oil equivalent reserves we'll recover beyond what we anticipated at the time of the acquisition.
So while we're doing a lot today in terms of reducing our drilling times to get our costs down, optimizing our completions, optimizing our landing zone in the Eagle Ford to make sure we're putting our horizontals into the optimum part of the reservoir and all of that’s going to improve our returns, the real upside will be in our ability to down-space in the Eagle Ford.
And just to give you a sense, if we indeed end up really with 2,000 wells in the Eagle Ford instead of the 1,300-1,400 wells we plan today, we’re talking about 10 years of activity, running our current 18 rigs, that would represent nine to 10 years of drilling activity. That’s a very significant business for Marathon.
MF - Back to the Bakken... Bakken oil pricing has been real difficult due to the pipeline bottleneck at the Cushing, Oklahoma, hub. With the reversal of the Seaway pipeline to flow south in June, more oil can move out of Cushing and into those big refineries that can handle heavy Canadian crude. Some analysts believe that only the heavy Canadian crudes will benefit, but do you see that opening will also help the price of Bakken?
CC - Any additional takeaway capacity out of Cushing is going to help the transport and improve the pricing of overall inland U.S. crudes as well as Canadian oil. I think overall it's a net-net benefit, so to your point the Seaway pipeline announcement, which in June will begin to transport 150,000 barrels a day from Cushing to the Coast and then transitioning up to 450,000 barrels a day by 2014, that's a very real positive.
TransCanada (TRP) has said they're going to go forward with the southern portion of the Keystone Excel pipeline that would transport barrels from Cushing to the Gulf coast and that will be 700,000 barrels a day by the end of 2013. That’s a significant positive. You also saw Enbridge’s (ENB) announcement about expanding the Flanagan South line that runs from Illinois down to Cushing.
So, that will also take barrels out of that Midwest market that are either coming out of the Bakken or coming out of Canada. Yet I say - and Enbridge made a statement yesterday - that until they really open up additional markets to the West and get the barrels to the Pacific, that's when Canadian barrels will begin to attract a much higher world-related price because they’ll actually have multiple markets to seek out.
So, I think that whole issue of transportation dynamics, how quickly it gets built out, is going to impact all of these prices. But I think you also have to recognize that inland crudes or Canadian crudes are always going to sell at a discount to Gulf Coast crudes, simply because of the transportation costs, but those differentials are going to narrow over the next several years as these new pipelines are built out.
SA - A lot of the operators are saying that by mid-2013, transport capacity out of the Bakken is going to improve. Do you think the discount that Bakken oil trades as compared to WTI will be narrower by that time.
CC - We’re a bit different than many of the Bakken producers up there in that we sell a majority - about 55% - of our barrels directly to Tesoro’s (TSO) Mandan refinery. We put about 28% in the pipeline and 14% or so on rail and the rest in trucks. That’s very different than others. And we use rail on an as-needed basis. Since we've been in the Bakken, our relationship with that refinery has been a good one: We believe the pricing we've gotten has been very competitive.
There is no question that takeaway capacity is quite tight, and rail is indeed needed today, and additional rail capacity is ramping up significantly this year. But as we look at the pipeline projects that are contemplated, by the end of 2013, early 2014, there will be ample pipeline takeaway capacity, even if the basin is producing up to roughly 1,000,000 barrels a day by that time. We think that will continue to help shrink those differentials to WTI or LLS [Light Louisiana Sweet Crude] pricing.
But rail will always have a place in the Bakken, only because putting barrels on rail gives you destination flexibility. If you put a barrel in a pipeline, it goes from point A to point B all the time. And with rail at least, if let's say Pad 2 margins [refineries in the Midwest] are better than Pad 3 [the Gulf Coast refineries] and you can rail the barrels to Patoka to get into the Pad 2 refining system, that may be a better economic decision to make, and rail would give you that option to do that versus pipelining, let's say, to the Gulf Coast.
SA - Your stock is owned by several deep value investors, including Vanguard Windsor and Washington Mutual Investors. Do you think Wall Street and institutional investors in general find it hard to place fair value on oil and gas assets? (*Reader question)
CC - You can’t really group Wall Street investors into one philosophy. There are different horses for different courses. We recognize that for example, in the new space we are in, the E&P investors, there is a segment of investors for whom success is defined by the highest growth rate possible, and they love to see double-digit, 10%, 12%, 15% production growth.
There are others who are looking for more moderate growth, with more capital discipline and funding with internally generated cash and focusing on higher returns. And we really appeal to the latter. I make very clear to people that our growth projections are 5% to 7% compound average growth in our production between 2010 and 2016.
That’s not as high as those who have double-digit growth. We have no aspiration to get to double-digit growth. We don’t believe that kind of growth is sustainable. We think investing at the kinds of levels that it takes to get there means that companies spend beyond their own organic cash flows. Our preference is to have more moderate growth, which is more sustainable, and we can fund that using the cash we generate.
In terms of returning value to our shareholders, our 2% dividend yield is at the top end of our peer group, and it’s our intent to continue to pay at the top end of that range. So, as I say to investors, take the 5% to 7% and add the 2% dividend yield on top of that, and that’s the kind of value that Marathon will look to deliver on a consistent basis. Those who buy into that will buy Marathon stock, and those who are looking for other things will invest somewhere else.
SA - Do you think Wall Street analysts have a hard time giving full value to a company like Marathon that’s willing to operate in politically troubled regions, such as Angola, Africa, Libya or anywhere there is political conflict? (*Reader question)
CC - I don’t think so. I think it’s more a question of the total portfolio the company has. If you had 70% of your assets in politically risky countries, I think there certainly would be some discount applied. But so long as it’s viewed as an acceptable level of the total portfolio, I think investors will look at it and say, this is a viable business. So, while we certainly have assets in Libya and Angola, and elsewhere, anyone looking at our business today, we’re still dominantly OECD.
I’ve seen conflicts in many areas of the world, and typically the conflicts don’t impact production operations, or if they do, the production operations come back fairly quickly when the things are resolved, as we’re seeing in Libya today. We left there in February of 2011 when the conflict broke out. We’re working our way back in today, but the operations are coming up much faster than we expected.
And we have every expectation of getting back to our original production levels, and more importantly, taking that production from what was previously 350,000 barrels a day up to 600,000 barrels a day as part of Libya’s Waha Oil Company consortium along with our partners, the National Oil Company, Conoco, and Hess (HES).
SA - Looking at your portfolio of holdings and your percentage of oil, how fast your business is going to grow - why is your stock trading as cheap as it is? When I look at it, it looks like it should be trading for a higher number than it is today? (*Reader question)
CC - I certainly don't disagree, and I think the biggest issue for us is the recognition we have now built a tremendous set of assets and opportunities. Investors are very pleased with the fact that we are in the two best resource plays in the U.S. today with strong positions in the Eagle Ford and the Bakken. I think there is one thing they’re looking for from us, and that's execution.
I think they want to see us execute on that growth, quarter-after-quarter, year-after-year, driving production up, replacing more than 100% of our reserves at competitive finding and development costs. And I think it's that credibility of delivering upon what we say that I think will begin to reflect in the value of our shares.
SA - Does Marathon have any interest in possibly entering into other plays in the United States like the Permian Basin, the Utica Shale any of those areas have any interest for you?
CC - We are always looking for new opportunities, in a resource business you have to always replace more of the resource than you produce in any given year. So, yes we’re constantly looking for new opportunities, but I won't be specific as which plays we’re looking at. I’d just as soon not alert the competition as to what we’re doing.
SA - Thank you, Mr. Cazalot.
Clarence Cazalot started his career at Texaco, rising to the post of president of Texaco’s worldwide production operations in his 27-year career there. He joined USX Corporation in 2000, and, upon the spin-off of USX’s energy business into Marathon Oil in 2002, was named president, and, in 2011, chairman of the board, as he guided the split-up of Marathon into two companies; the exploration and production company Marathon Oil and the refining and marketing businesses into Marathon Petroleum Corporation (MPC).
Prior to the interview, we asked Seeking Alpha readers to send in questions that we could put to the various oil company CEOs. We’d like to thank them for the excellent response we received! We were unable to use all of the questions submitted, but have indicated the ones we did use. Please note that the interview transcript has been edited for length, grammar, clarity, readability and syntax, and explanatory notes have been added in brackets where necessary.