Marathon Oil: No Mercy For Costs And Capex

Summary

• MRO's 1Q20 total revenues and other income were buttressed by commodity derivatives and rose by 2.7% vs. 1Q19.
• The company has been radically cutting costs and investments to weather the crisis.
• Profound reduction in the 2020 capex will likely result in around 8% U.S. oil production decline.
• The 1Q20 results did not fully reflect the impact of the oil price meltdown, and the 2Q20 figures will likely be much weaker.

Marathon Oil Corporation (NYSE:MRO) has recently presented the disappointing first-quarter results, announced profound capex cuts and suspension of completion activities, and halted shareholder rewards. Sapping demand for crude oil sent its 1Q20 profit plunging and shattered output growth plans. But, in the first quarter, its hardships only began to mount, and the worst is ahead.

The dividend suspension is disappointing but unavoidable. An upstream, tight oil-focused company in the world upended by the pandemic cannot please shareowners with solid returns ad infinitum. The news the supermajor Royal Dutch Shell (RDS.A) slashed the dividend for the first time since WWII is horrible and perplexing; MRO's decision to suspend shareholder rewards is unpleasant but fully explainable and inevitable.

The previous article was titled "Be careful with Marathon Oil in 2020." Since the piece was published in February, the stock has lost more than 46% in value, even despite the April rebound. Now, the stock is even cheaper than it was in 2016, the year which was overshadowed by the previous oil price slump. So, some investors might point out that there is a value investing opportunity here. Let's assess the 1Q20 results to answer that question.

The top line

Last year, it was the trade war and its ramifications that caused WTI gyrations and affected Marathon's top line, margins, and cash flows. But the trade war-induced uncertainty can be barely compared with the pandemic and the oil market turmoil in 2020. However, as the first quarter figures vividly illustrate, the company emerged from the March meltdown relatively unscathed, and Q2 will likely be much weaker. As of data presented by Seeking Alpha PREMIUM, analysts are predicting the Q2 revenue to plummet by around 60% to $561 million, and their bearishness is entirely justified.

First, the 1Q20 revenues from contracts with customers dipped by 14.7% because of a decline in realized oil and condensate prices. Total revenues and other income, which was supported by a $202 million net gain on commodity derivatives, rose by 2.7%. Please keep in mind that, as of data presented by MRO, the WTI crude oil price averaged $45.78 a barrel in the first quarter. As the March energy survey conducted by the Federal Reserve Bank of Dallas illustrated, that was quite a comfortable level for the U.S. shale industry, adequate to cover new drilling.

MRO sold its crude oil and condensate at a 3.4% discount to the benchmark (little had changed since 1Q19 and 4Q19) mostly because of weaker pricing in the Bakken formation, while light oil produced in the Eagle Ford and Northern Delaware had been sold at a premium.

Crude oil & condensate realized price was the primary culprit of the decline, but lower gas prices dragged down by warmer-than-normal temperatures in March that took a toll on demand for space heating also added to the difficulties. The silver lining is that the U.S. Energy Information Administration expects the Henry Hub spot price to average $2.11/MMBtu in 2020 (or $2.06/Mcf assuming 0.9756 coefficient) because of looming supply reduction. In Q1, MRO received $1.6 per Mcf. So, more expensive natural gas will likely slightly offset the impact of West Texas Intermediate price weakness on Marathon's top line this year.

While revenue edged lower, MRO has been consistently delivering on its promises to slash costs. The company is literally cutting operating expenses to the bone. That, however, did not help to show material operating income. The Q1 operating margin amounted to meager 1.2%. Please keep in mind that one of the most burdensome expenses is depreciation, depletion & amortization, which climbs higher if production increases. The expense is non-cash and has no impact on cash from operations and FCF.

Adjusted EBITDAX, the metric that eliminates the impact of DD&A, dropped by 22% in the first quarter. That is quite puzzling, as total revenues and other income rose by 2.7%, as I mentioned above. At the same time, unadjusted EBITDAX changed only slightly (was down $2 million vs. 1Q19). That happened because, last year, special items (primarily unrealized loss on derivatives) amounted to $89 million and were added back, while in 1Q20, an unrealized gain of $171 million was subtracted from EBITDAX.

Capex reduction to hamstrung production growth

My dear long-term readers surely remember that I prioritize free cash flow and not accounting profit in my research. I am also not a proponent of overstretched capex budgets, monstrous leverages, deeply negative cash flows, and dividends covered by debt. However, an oil company must explore for hydrocarbons and develop resources to support and increase future output and cash flows, which are behind its intrinsic value. And a company's essential and the most complicated task is to balance future growth and current cash returns. Unfortunately, at some point, a firm may face a perfect storm when commodity prices do not allow it to deliver even a meager cash surplus despite massive capex reduction (which, in turn, will take a toll on hydrocarbon output). This is precisely the case of MRO.

Marathon expects to spend $1.3 billion or less on total capex, $1.1 billion below the initial 2020 capex plans. Behind such a deep reduction is "a pause in virtually all completion activity during second quarter." As investments were slashed, MRO anticipates the 2020 U.S. crude oil production (divestiture-adjusted) to go down by approximately 8%.

The output decline is an industry-wide issue. As it was said in the EIA April Short-Term Energy Outlook,

the United States will return to being a net importer of crude oil and petroleum products in the third quarter of 2020 and remain a net importer in most months through the end of the forecast period.

It is worth mentioning here that the OFS companies focused on light oil bear the brunt of the capex reduction across the unconventional plays. More layoffs recently announced by Halliburton Company (HAL) are a bitter sign of the times.

Free cash flow

As I said in my previous article, MRO was FCF positive in 2019, and the dividend was fully covered. The charts below illustrate how much net income was converted into free cash flow in the first quarter of 2019 and Q1 2020.

The Q1 2019 FCF. Author's creation, data from Marathon Oil. Pro forma FCFE was computed by the author.

The Q1 2020 FCF. Author's creation, data from Marathon Oil.

The difference is somewhat perplexing as in 1Q20, MRO had much higher net CFFO and positive FCF, while in 1Q19, FCF was negative. One of the reasons is that $407 million in receivables was collected and provided a massive inflow that buttressed FCF despite sub-zero net income.

A 40% 2020 revenue decline anticipated by analysts will likely result in a proportionate decline in net cash from operations. Assuming that MRO may generate around $1.6 billion in net CFFO and will invest $1.3 billion or less, its FCF may remain positive.

Final thoughts

Q1 results of MRO were weak but not abysmal. Investors should brace for a much deeper revenue and EPS drop in Q2.

With a 46% Debt/Equity, Marathon Oil is not overleveraged, but there is room for improvement. Interestingly, MRO has not followed the suit of a few other energy companies and did not issue debt in Q1, as financing activities on the cash flow statement illustrate.

While the economies across the globe are slowly reopening, I am still not optimistic about the oil price recovery. Surely, we see two principal trends: output decline and slow recovery in demand. But the scars are deep. There is a long-lasting (I would not say permanent) damage to the airlines and, hence, a deep reduction in the jet fuel demand. In my article on Valero Energy Corporation (VLO) in 2018, I mentioned kerosene would be one of the key drivers of the company's value in the long term, while gasoline demand in the second half of the 2020s is questionable. Now, jet fuel consumption trends are highly uncertain.

In sum, MRO is a speculative stock that may generate impressive returns if WTI price goes up spurred by the V-shaped economic recovery and a steep decline in oil supply. However, a bearish argument here is that the recovery may be U-shaped or even W-shaped (considering the possibility of the second wave of the pandemic). There are too many risks worth paying attention to.

So, it is up to an investor to decide if it is worth owning shares in the company that will likely deliver high-single-digit production drop and double-digit sales decline this year.

Analyst’s 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.