Marathon Oil (MRO) reported second quarter earnings in line with analyst expectations, at $0.56 per share, buoyed by rapidly increasing production. However, the rapid rise will be tapering off in the near future as Marathon attempts to keep its spending within revenues, rather than following the example of firms like Encana (ECA) and Chesapeake Energy (CHK), which are outstripping earnings in a desperate attempt to keep oil production growing. This more level headed approach will help Marathon through the next two years with what I believe will be consistent growth, even if that growth will not be as meteoric as seen in the past.
Marathon CEO Clarence Cazalot Jr. explained the main reason for the anticipated pullback when he indicated that the current oil and gas prices and stable or rising production costs call for "a more disciplined level of domestic spending and activity," though Marathon expects to meet its production targets for the year. While it is cutting its rig count domestically in line with this outlook, particularly in the Anadarko Woodford Basin and the Bakken Shale, Marathon's unconventional shale production is beating the company's expectations, in some cases dramatically. In the Eagle Ford, Marathon increased its second quarter production by 50% over the first quarter, which was a major contributor to its production growth.
Marathon is making moves to shed non-core assets, led by its plans to sell ten of its Cook Inlet fields with net proved reserves totaling 17 mboe to Hilcorp Alaska LLC, a subsidiary of privately owned Hilcorp Energy Company. The deal is subject to approval by the Federal Trade Commission due to Hilcorp's aggressive moves on Alaskan plays.
With its purchase of nearly 165,000 acres in the Cook Inlet from Chevron (CVX) earlier this year, including ten offshore platforms and two onshore fields, Hilcorp became one of the largest Cook Inlet operators virtually overnight. If the Marathon deal is closed, Hilcorp would control between 60 and 80% of the Alaskan natural gas market, which is raising anti-trust concerns with regulatory agencies. Responding to the FTC study, Marathon released a statement indicating "we remain confident that we will close the transaction, subject to completion of the necessary government and regulatory approvals, during the fall of this year."
Price Environment is a Major Reason to Cut Costs
While Marathon is increasing its production, it is not seeing the benefit of lower costs that many producers realize with higher activity. On its second quarter conference call Marathon noted that its exploration and production costs per barrel of oil equivalent were flat in the second quarter compared with the previous four quarters, though if exploration costs are removed from the equation, production costs are down $3.80 per barrel. However, this is somewhat misleading as it includes Marathon's reduced DD&A costs, which are mostly dependent on its planned disposition of the Cook Inlet assets to Hilcorp mentioned above.
There is just one major area where Marathon is proving successful at reducing costs, its oil sands mining segment, where it increased earnings by $10 million quarter over quarter, which it attributes to lower operating costs as sales remained essentially flat. I believe that in order to maximize its U.S. onshore holdings Marathon needs to think outside the box on ways to control its production costs, or face the prospect of holding non-producing wells at a greater cost than forecast.
At present, Marathon can claim the financial strength to explore alternative cost reduction strategies, with $2.3 billion in operating cash flow and $452 million cash on hand. EOG Resources (EOG) is seeing success with its alternative strategies, which include its own frac sand production facilities and its St. James crude by rail transportation system.
Although Marathon may be hesitant to pick up such facilities so soon after its spin off, in today's unconventional environment I think that these moves are becoming increasingly necessary to control costs. Though Marathon can coast with its international operations, it would be a stronger company if it looked into building its domestic production, rather than reducing activity to bare minimums.
Marathon is one of few producers to make the decision to suspend drilling in the Niobrara indefinitely. While others like Anadarko Petroleum (APC) surge ahead with aggressive drilling driven by impressive results, Marathon seems to be hitting less profitable pockets with its Niobrara activities, evidenced by Cazalot's indication that the company will evaluate its Niobrara acreage based on previously collected data and 16 wells in production, without a timeline. To me this is a sign that Marathon's cutback on domestic drilling could be more severe than anticipated, at least outside of the Eagle Ford.
Marathon is currently trading around $28, giving it a price to book of 1.1 and a forward price to earnings of 7.6. For reference, competitor EOG is trading around $110 with a price to book of 2.2 and a forward price to earnings of 17.1, while Chevron is trading around $112 with a price to book of 1.7 and a forward price to earnings of 8.1. Natural gas dependent peers Encana and Chesapeake are holding ground; Encana is trading around $22 with a price to book of 2.4 and a forward price to earnings of 76.2, while recent trades on Chesapeake are around $20, giving it a price to book of 1.0 and a forward price to earnings of 9.7.
Overall, this makes Marathon a cheap buy compared to its peers and competitors. Unlike Chesapeake, Marathon has strong worldwide operations to help it overcome unfavorable pricing, and unlike Encana Marathon is well diversified into oil. Marathon also holds strong positions in its unconventional plays that can be counted as assets even without aggressive drilling, despite its relatively recent entry compared to firms like EOG. I believe that Marathon is trading at a significant discount, and is a buy now opportunity.