Why Marathon Oil's Bull Run Will Continue In 2017

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About: Marathon Oil Corporation (MRO)
by: Alpha Investor
Summary

MRO is increasing production from assets where it can generate higher returns, such as the STACK play, where an IRR of 60%-80% can be expected at a price of $50/barrel.

MRO forecasts that its cash flow will grow at a CAGR of 15%-20% at a WTI price of $55/barrel due to increased production from low-cost assets.

Due to improving oil prices and stronger returns from assets such as the STACK, MRO will witness a constant improvement in its bottom line and achieve profitability in 2018.

Based on MRO’s price to sales ratio, it is likely that the company will be able to deliver gains of 40% in 2017, therefore replicating its 2016 performance.

Marathon Oil (NYSE:MRO) is moving aggressively toward achieving profitability. The company's bottom line has been very weak over the last couple of years due to low oil prices, but all that is set to change. Marathon Oil has been focusing on improving its internal rates of returns. It has been doing so by enhancing production from wells with a low cost base, which should allow Marathon to benefit from higher crude oil pricing going forward.

In my opinion, a combination of low costs and high oil pricing will help Marathon improve its bottom line performance, which will eventually lead to growth in its stock price. Let's see how.

Marathon is accelerating production from efficient assets

In order to remain free cash flow positive, Marathon Oil is accelerating its production in the STACK area. The reason why Marathon has been enhancing its position in the STACK play is because its Meramec oil wells can generate IRR in the range of 60% to 80% at a crude oil price of $50 per barrel. Given that oil prices are already above $55 per barrel, Marathon should generate stronger returns from these assets.

For instance, Marathon's production in the STACK play has averaged roughly 41 million barrels of oil equivalent per day in the third quarter of 2016, up nearly 50% from the second quarter of 2016. Marathon has done the right thing by enhancing production in the STACK area as the majority of oil wells drilled and completed during the third quarter had an initial production rate of 2,845 barrels of oil equivalent during the first thirty days. This means that the production from the STACK will be higher in the fourth quarter of 2016 as more productive wells come online.

What's more, given the encouraging production results, Marathon is planning to expand its position in the high-return and liquid-rich areas. As such, Marathon acquired approximately 61,000 net acres at STACK by spending $888 million earlier this year. Now, to make use of this acquisition, the company is increasing delineation work and drilling activities. In fact, Marathon has added another rig at STACK that should improve its production.

Another important thing to note is that while Marathon is increasing production from low-cost assets, it is divesting its non-core assets at the same time. In fact, Marathon Oil has divested approximately $1.5 billion of non-core assets since August 2015, exceeding the high end of its asset sales target by $500 million. This has helped the company invest more in the U.S. resources play, with its capital expenditure in this segment increasing to $1.3 billion this year as compared to the earlier budget of $847 million stated earlier.

In my view, increasing the capital expenditure in the high-return and liquid-rich areas is a smart move as Marathon will be able to generate higher cash flow due to its ability to remain profitable in the current commodity price environment. One such example is that due to the higher production at STACK, Bakken, and the Eagle Ford, Marathon generated $618 million in cash flow in the third quarter. This is an increase of 145% as compared to the operating cash flow of $252 million in the second quarter of 2016. In fact, its operating cash flow covered both its capital expenditure and dividend at an average WTI price of approximately $45 per barrel.

Looking ahead, Marathon Oil expects its cash flow to grow at a compounded average growth rate in the range of 15% to 20% at a WTI crude oil price of $55 per barrel for the next five years, especially as it continues to reduce costs. More importantly, the reduction in costs will help Marathon improve its bottom line performance, which will lead to upside in the stock price. Let's see how.

A stronger earnings performance will lead to stock price upside

In 2015, Marathon Oil had posted a huge loss of $1.28 per share due to the weakness in oil prices. But, this year, the company is expected to reduce its net loss to $0.93 per share. Additionally, next year, analysts expect that Marathon will be close to profitability with a loss of $0.11 per share. Thus, a positive trend can be clearly seen in Marathon's bottom line performance going forward.

Eventually, Marathon is expected to post a profit of $0.17 per share in 2018. But, since Marathon is currently a loss-making company, it will be difficult to judge its potential stock price upside based on earnings growth since it has negative price to earnings ratios. However, we can use the price to sales ratio to calculate the potential upside in the coming year.

For instance, due to its production ramp up from efficient assets and potentially higher oil pricing next year, Marathon's revenue is expected to grow to $5.77 billion as compared to $4.44 billion this year, indicating a rise of close to 30%. Now Marathon has a price to sales ratio of 3.76, which means that at a revenue level of $5.77 billion, its market capitalization will grow to $21.7 billion next year as compared to the current market cap of $15.3 billion.

This means that Marathon Oil's market cap is set to grow 41% in 2017, indicating strong upside even after gains of more than 40% this year.

Conclusion

Marathon Oil has done impressively in 2016 and it is likely that the company will be able to replicate the performance next year as well. So, investors should continue to hold the stock going into the New Year and enjoy more gains.

Disclosure: I/we 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.