I Doubled My Position In Marathon Oil

Summary

• I believe that oil prices have the ability to extend their rally well above their prior 2018 peak based on supply/demand and the Federal Reserve's actions.
• Marathon Oil is one of the best ways to play this oil uptrend as the company is extremely efficient and financially stable.
• I believe that Marathon Oil will outperform its peers and generate up to 100% in capital gains from current prices.

Photo by grandriver/E+ via Getty Images

In February of this year, I discussed one of my all-time favorite oil stocks on the market. Now, a few months later, I am updating that call. I will use this opportunity to give you my updated macro thesis and tell you why I doubled my Marathon Oil (NYSE:MRO) position. Even though I consider the stock to be a trade that I will sell once oil peaks, I made the trade size comparable to my high-conviction long-term investments as I am not only a firm believer in my oil bull thesis but also in Marathon's ability to generate significant shareholder value through its fantastic low-cost business model and its streamlined balance sheet. While it remains a volatile and extremely cyclical oil company, I feel very comfortable holding a rather large position. In this article, I will give you the details.

The Fundamentally-Backed Breakout Is Here

In my last article, I mentioned the long-term downtrend in oil, which included a nasty crash in 2014 and 2015, a significant rebound until 2019, and another crash that resulted in oil prices trading at negative values for a short while.

Since the Great Financial Crisis, oil has been stuck in a very wide and volatile downtrend pressured by lower rates, a strong dollar, and underperforming growth in emerging markets (the markets that mainly drive oil demand). - Article

Right now, oil is once again trying to break out from this long-term downtrend, which - I believe - will result in an oil price of $85 - $90 over the next 12 months.

Source: TradingView

A pretty technical picture is one thing. However, when I cannot make a fundamental case I quickly lose interest. In this case, I believe that oil is a great place to be for a number of reasons.

First of all, I am a big believer in a demand/supply imbalance. Unlike in the previous recovery, we are now NOT dealing with a situation where supply is outperforming demand. According to EIA data (graph below), we are about to witness an extended period with negative to flat inventory changes as demand will likely outpace supply. As EIA expectations are often very conservative, I think that this effect will be bigger than some might think. Especially once economies reopen, we will see a rapid increase in energy demand.

This trend includes potential troubles in the United States to accelerate oil production again as I discussed in an article in February.

Low prices have led to a sharp drilling slowdown in the rest of the world as well. Between February and June of 2020, the non-US rig count fell by 40% to 800 - also the lowest on record. We have often written about the depletion problem facing the non-OPEC+ world outside of the US shales. Over the last decade, this group has seen production decline slowly and steadily as a dearth of new large projects has not been enough to offset legacy field depletion. By laying down half their rigs, this group ensured that future production would be materially impacted.

- Goehring & Rozencwajg

Currently, we are seeing a lot of evidence of a slow production return as the U.S. is very (read: extremely) unlikely to see a situation as we saw in 2018/2019 - let alone after the Great Financial Crisis - where unconventional oil production is using every upswing in oil prices to boost output. Right now, we are seeing that the rig count is stuck below 400 despite oil prices being somewhat close to their 2018 peak levels (graph below). It is quite remarkable that the rig count is still at its lows of the prior cycle and I believe that this confirms what I expected going into this year.

Data by YCharts

The other reason I like oil is that the Fed is basically telling us to buy basic materials.

Source: Twitter

Let me explain what I mean by that.

Currently, two things are happening. The first one is a very accommodative Fed with billions in QE and record-low rates to support the economy.

America’s central bank is responsible for fostering maximum employment and stable inflation — making it the first line of defense against fast price gains. Fed officials have been clear for months that they expect prices to pop this spring and summer as the economy reopens but that they think the jump will prove temporary. By and large, they are sticking to that script. - NY Times

Meanwhile, this economy is seeing both high unemployment and a labor shortage. I never expected to write a sentence like this, but comments from the most recent Dallas Fed Manufacturing Index could not have said it any better (look what machinery managers were commenting on in the overview below).

Source: Dallas Fed

That's not all, while we continue to deal with structural problems, commodities like grains, lumber, metals, etc., have all accelerated. However, the Fed believes this is just transitory as they changed their inflation goal from 2% to 2% ON AVERAGE. That means that they know what is going on (of course they do) and are willing to take these risks until structural problems are taken care of. I think that will take a while as we could face another COVID wave in fall and winter. And even if we didn't, achieving full employment will take at least 1-2 years. If the Fed remains accommodative that long, I cannot help but wonder if their main goal is to create inflation to lower the global debt load that resulted from massive COVID stimulus. I cannot prove it as I'm not a Fed insider - and if I were I wouldn't be allowed to comment - but it looks like they will let inflation run hot for a while. I do not subscribe to the idea of hyperinflation and I also do not believe that the Fed will allow the middle class to get crushed. That's why I expect inflation to run hot going into 2022. By then, I think we will see tapering and maybe higher rates.

Time will tell, but for now, the bull case for oil is looking very, very good.

I Doubled My MRO Position

I like to keep things simple. Whenever I find a fundamental bull case, I want a stock that fits right in with the narrative. In this case, an oil stock with a great balance sheet, low production costs (I want to benefit now, not once oil hits $80), and the ability to generate serious shareholder value through dividends/buybacks.

If you're new to Marathon Oil, you can basically think of it as a US-only oil play. The company does have some minor exposure overseas but used the past few years to sell its foreign assets to solely focus on high-margin U.S. projects. Over 90% of the company's Bakken and Eagle Ford operations are established in so-called high-quality areas which makes capital investments more rewarding. This is one of the reasons why the company is free cash flow breakeven (so, AFTER accounting for capital expenses) at less than $35 WTI. This is a huge deal as it means that the company can basically generate strong free cash flow in every scenario where oil prices are not depressed.

Source: MRO 1Q21 Earnings Presentation

Right now, the company expects to generate $1.6 billion in free cash flow based on $60 WTI. This has resulted in accelerated gross debt reduction by $500 million with the target to reduce gross debt by $1.0 billion on a full-year basis. That's a huge deal as the company also raised its base dividend by 33% to $0.04 per quarter.

Longer-term, the company has at least 10 years of high-quality inventory and is expected to generate $5 billion in cumulative FCF over the next 5 years. That's based on $50 WTI.

Using $60 WTI, the company is one of the most efficient producers among its peers (its peers include APA, CLR, DVN, EOG, FANG, MUR, OVV, PXD, XEC) as its reinvestment rate to keep operations going falls to 40%. In other words, this further accelerates FCF.

Source: MRO 1Q21 Earnings Presentation

With that being said, keep in mind that the numbers I am going to show you next are based on conservative oil estimates as analysts are still far from expecting $70-$80 oil. However, even based on these numbers, my case that MRO is a high-quality producer seems to be confirmed. For example, based on roughly $1.2 billion in FCF over the next 2 years, the company is able to reduce net debt to $1.8 billion, which is 0.6x EBITDA. Needless to say, this is extremely healthy and will protect - together with the $35 WTI FCF breakeven price - investors during downturns.

Source: TIKR.com

The numbers above also suggest that MRO is trading at just 3.9x EBITDA, which I believe is a steal given my bull case.

So, let's summarize by game plan.

Takeaway

Marathon Oil is a high conviction trade for me. I doubled my position when the stock fell more than 20% over the past few weeks as I believe that:

• Oil prices will continue to benefit from a supply/demand imbalance
• The Federal Reserve will remain accommodative for at least a few more quarters
• Marathon Oil has the ability to generate high returns and strong free cash flow

Also, whenever oil rises, Marathon Oil outperforms its peers as the graph below shows.

I believe that Marathon Oil has the ability to rise to at least $20 and probably $25 if oil indeed hits $85 or higher.

However, keep in mind that MRO is volatile and that I consider it to be a trade. Unlike my dividend investments, I will sell MRO once I believe that oil will fall again. Needless to say, I will update you once I do that.

(Dis)agree? Let me know in the comments!

Analyst’s Disclosure: I am/we are long MRO. 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.

This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.