Just like the other refiners, Marathon Petroleum (MPC) has outperformed the market by a wide margin in the last two years. During this period, the stock has doubled whereas S&P has advanced only 35%. Nevertheless, the rally of the refiner has stalled in the last six months. Therefore, the big question is whether conditions are ripe for the rally to resume.
Acquisition of Andeavor
Marathon Petroleum recently completed its acquisition of Andeavor. Thanks to this acquisition, Marathon Petroleum has become the largest refiner in North America, with 16 refineries and a total processing capacity slightly above 3.0 M barrels per day. In addition, it has become one of the largest midstream operators in North America. Moreover, the company has greatly enhanced its geographic diversification, as Andeavor operates in the Midwest and the West whereas Marathon Petroleum operates in the East.
Marathon Petroleum expects to achieve at least $1 B synergies from the deal, which will be immediately accretive to its earnings and cash flows per share. The acquisition will also markedly enhance the potential of the company to take advantage of the fluctuations in the spreads among different types of crude oil and the dynamics of export markets. Such a potential will increase the profitability of the company and its resilience during downturns of the sector.
The other tailwinds
Marathon Petroleum benefits from the favorable trends that currently prevail in the refining sector. First of all, the U.S. oil production has reached a record level this year and is expected by EIA to rise to new all-time highs next year. This supply glut has resulted in an excessive discount of WTI to Brent. The discount has widened from $6 in the beginning of the year to $10 now. As WTI has slightly higher quality than Brent, its heavy discount to Brent is merely the result of the supply glut. The U.S. refiners greatly benefit from this discount, as their margins are much higher than those of their international counterparts.
Another possible tailwind in the refining sector is the expected change in EPA regulation about the biofuel blending costs of domestic refiners. These expenses have remarkably increased in recent years, and hence a change in their calculation will greatly alleviate refiners. While a significant cost reduction is expected, its magnitude and timing are unknown, as there have been numerous delays in the process.
Finally, refiners will greatly benefit from the new international marine standard, which will come into effect in January 2020. This standard will force all the vessels that sail in international waters to burn low-sulfur diesel instead of heavy fuel oil. As a result, refiners will experience a steep increase in their diesel sales and an equal decrease in their heavy fuel sales. As diesel is much more expensive than heavy fuel oil, refiners will see their margins jump towards the end of next year.
The production growth is tremendous in Permian. Consequently, the pipeline capacity in the region has proved insufficient to transport all the crude oil that is produced, and hence there are significant bottlenecks in the area. These bottlenecks cause the crude oil in the area to be sold to refiners at a wide discount to WTI. As a result, domestic refiners enjoy extremely high margins in this area, as they purchase crude at a wide discount to WTI, which in turn is trading at a wide discount to Brent. However, additional pipeline capacity is expected to come online in the area in about a year and will thus alleviate the supply glut. This development will reduce the discount of Permian crude oil to WTI, and hence it will cause a decrease in the margins of the refiners who purchase crude from the area.
The other major risk facing refiners is the impressive rally of the price of oil. As the oil market has eliminated its supply glut, the oil price has enjoyed a relentless rally this year and is now trading at a 4-year high. High oil prices increase the input costs of refiners while they also tend to reduce the demand of consumers for refined products and thus cause a negative shift in the supply/demand of the oil market. As a result, high oil prices tend to exert pressure on the refining margins.
During 2012-2014, when oil was trading around $100, U.S. refiners were being protected from the high oil prices thanks to the ban on the oil exports that prevailed back then. However, this sort of protectionism was removed by Obama administration and hence domestic refiners will be in much worse shape whenever oil returns to $100. The shareholders of refiners should closely monitor the trend of the oil price in order to avoid negative surprises in the results of this sector.
Marathon Petroleum is trading at a forward P/E ratio of 10.8. While most investors will consider this ratio extremely low, they should note that refiners are highly cyclical stocks and thus they tend to trade at low P/E ratios near the peak of their cycle. Nevertheless, while refiners have enjoyed record margins in recent years, they have additional tailwinds to benefit from in the near future. Therefore, the valuation of Marathon Petroleum should be viewed as attractive.
Marathon Petroleum will greatly benefit from its acquisition of Andeavor, as its scale will enable the company to achieve great synergies and flexibility. In addition, the upcoming change in the fuel requirements of vessels will provide a strong tailwind to all the refiners. This is a major reason behind the vast outperformance of refiners relative to the broad market. On the other hand, the rally of the oil price is a point of concern. If the oil price remains around its current level, it will not cause any harm to refiners. However, if it continues to rally, up to $100, then it is likely to exert significant pressure on the refining margins. Overall, thanks to the strong tailwinds and its reasonable valuation, Marathon Petroleum is likely to resume its rally. This rally is likely to remain in place as long as oil does not rally up to $100 and the U.S. does not face a recession.
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.