Marathon Oil Stock: It Just Keeps Getting Better

Summary

• Marathon Oil is finally showing upside momentum again as investors recognize the company's benefits in a world desperately in need of affordable energy.
• The company is on pace to generate $2.0 billion in free cash flow this year, which will do wonders to balance sheet health, and dividend growth.
• Even after doubling this year, the stock is attractively valued and well-positioned for strong, long-term gains.

mysticenergy/E+ via Getty Images

Introduction

We're living in truly remarkable times. Right now, we're witnessing some of the worst global supply chain issues in modern times and rapidly rising inflation. One way to protect a portfolio against inflation is by buying high-quality oil assets. I have 17% exposure in my long-term dividend account consisting of Exxon Mobil (XOM), Chevron (CVX), and Valero Energy (VLO). I also own some smaller oil stocks on the side, which are Marathon Oil (NYSE:MRO) and Devon Energy (DVN). This article is about Marathon Oil as the stock just made new highs with support from a ton of macro fundamentals. As I haven't discussed the stock since May, it's time to once again reflect on one of America's finest oil stocks. So, bear with me!

Must-Own Oil

I have started a lot of oil-related articles this way, but I am a huge believer in owning high-quality oil assets. In this case, I define high-quality oil as a company with a solid footprint in the oil industry, a solid balance sheet, and the ability to pay a high dividend. After all, being long energy isn't always fun as everyone who held energy assets for more than a year will agree with.

For example, the Energy ETF (XLE) - which is basically 50% XOM and CVX - is still down 46% from its 2014 highs. Including dividends, the decline is -29%. The situation at Marathon is different as the stock is down 62% from its 2014 highs. This includes dividends.

Data by YCharts

Before I continue to discuss why this will continue to change (dividend growth is picking up), let's take a quick look at the macro environment because oil is back!

For the first time since 2018, it looks like oil will make a successful attempt at breaking above the massive resistance area close to $75.

Source: TradingView

If that happens, oil could easily continue its uptrend and force people into inflation trades. Using the ratio between the S&P Oil & Gas Exploration & Production ETF (XOP) and the S&P 500, we see that energy assets are still extremely poorly performing compared to the stock market. I don't disagree that the post-2014 downtrend was justified because we were in a rather deflationary environment. Now, that's changing and investors are seriously underweight energy.

Data by YCharts

According to the State Street website, the S&P 500 has just 2.75% energy exposure. For example, industrials are at 8% and utilities are 2.5%. Information technology exposure is 27.6%.

All of this sounds good, but we need a reason to make the case for this rotation. In May, when I wrote my most recent Marathon Oil article, I discussed an expected supply/demand imbalance.

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 supply/demand imbalance is now materializing in a huge way. And not just in oil.

All over the world, we're seeing the need for affordable energy. Here are some examples.

Newcastle Coal futures are going through the roof as China and India desperately need coal to maintain growth and because natural gas prices are exploding as well - coal is a cheap alternative.

Source: TradingView

Here's a graph of European TTF natural gas futures. It's a perfect benchmark of the problems Europeans are facing given that energy prices are putting millions at risk of energy poverty.

Source: TradingView

As Reuters writes, there's a huge need for affordable fuel, and that's where oil benefits from.

"If OPEC+ sticks to the script and only delivers the planned 400,000 bpd increase in November, energy markets will shortly be seeing $90 oil prices," said Edward Moya, senior market analyst at OANDA, adding that any increase smaller than 600,000 barrels should boost prices.

Oil is also finding support as a surge in natural gas prices globally prompts power producers to move away from gas. Generators in Pakistan, Bangladesh and the Middle East have started switching fuels.

In this case, it looks very reasonable to expect $90 oil if OPEC+ doesn't aggressively hike - and why would they? On a side note, we're talking Brent oil $90. Right now, Brent is at $79, so please do not confuse it with WTI oil, which is at $75.7. Nonetheless, $90 Brent still means incredible upside for oil companies.

Moreover, U.S. crude oil stocks are hovering close to their 5-year lows. I am not making the case for lows below 400 million barrels, but I do not expect oil to make it back to the average unless new lockdown measures are implemented.

Source: EIA

So, why Marathon?

Marathon Is The Place To Be

So, why Marathon? First of all, Marathon has a 50% crude oil, 50% NGL/gas revenue breakdown. Most of it is located in high-margin areas as the company sold its underperforming assets in recent years.

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. - Article

Think about that for a second, Marathon Oil is breakeven at $35 WTI. This means that something truly terrible needs to happen in order for Marathon to enter a situation where it has to deal with a longer-term funding deficit. Even better, with rising oil prices, this means tons of free cash flow. On a side note, while I don't care for long-term capital gains in energy (I only want yield), we're in a truly remarkable situation as most energy companies can repair their balance sheet for the first time since 2014.

For example, Marathon oil is able to generate$8 billion in free cash flow at $60 WTI on a five-year basis. Right now, we're close to $80. This is based on a 40% reinvestment rate (capital expenditures). In 2021, analysts expect MRO to generate $2.0 billion in free cash flow, followed by another $2.0 billion in 2022. That's wild as the company did $460 million in 2018. In my prior article, expectations were below $1.4 billion. Please be aware that this is one of the reasons why oil is high in the first place. Upstream (companies who drill for oil) has found that ever-increasing production only hurts themselves. Why not focus on free cash flow generation instead? It also helps as it doesn't mess with OPEC members who were never happy to cut their own production to indirectly bail out their competitors in the U.S.

Source: TIKR.com (Includes 2021/2022 expectations)

Right now, Marathon Oil has an $11.2 billion market cap. This means that the company's expected free cash flow yield is 17.8%. In other words, unless the company pays a 17.8% dividend, we'll see both a high dividend and a massive improvement in balance sheet health.

For example, the company is expected to lower net debt from $4.7 billion at the end of 2020 to less than $1.5 billion in 2022. That would imply a less than 0.5x net leverage ratio. In such a scenario, even EBITDA comparable to the 2016 lows ($2.0 billion) would result in a net leverage ratio of less than 1.0x. If (and that's a big if) we were to encounter a long-term uptrend in oil, the company could easily turn net debt into net cash.

Almost needless to say, but the valuation is still very attractive.

Valuation

Two indicators related to valuation were already covered in this article. Energy stocks are still extremely poorly performing compared to the market and free cash flow yield is very high. So, if you buy now, you get access to very high free cash flow.

That said, we're dealing with roughly $3.0 billion in expected net debt in 2021. When adding this to the company's $11.2 billion market cap, we get an enterprise value of $14.2 billion. It's $14.3 billion when including all of the company's pension (and related) liabilities. That's just 4.5x 2021 EBITDA.

This is extremely cheap despite a 113% stock price performance this year.

Source: TIKR.com

Takeaway

Between May and the end of September of this year, energy investments caused by portfolio to underperform. 15% (now it's close to 17%) energy exposure is a lot because energy stocks are very volatile. Also, the aforementioned XLE ETF hasn't gone anywhere since 2005, which is why mainly buy energy for its yield - I'm buying long-term and we'll certainly encounter severe weakness again.

That's why MRO makes sense. The company is repairing its balance sheet and hiking its payout thanks to a huge boost in free cash flow. The company has access to high-quality assets and is able to benefit from rising oil and natural gas prices like never before thanks to its low breakeven point.

Given the macro environment relying on affordable energy, I have little doubt that energy will continue its uptrend. While we could see some short-term turbulences because I doubt that this will be an easy rise to new highs, I think MRO has the potential to reach $20 within a year. Maybe $24 if things really get hot. However, given the pressure this is already causing on consumers through higher inflation, I believe that accelerating oil prices will be met with measures to increase production.

Data by YCharts

One last thing, if you decide to buy MRO or any other oil stock. Please be aware of how cyclical and volatile these stocks are. Take this into account when deciding how much energy exposure you're willing to take on.

Other than that, we're in a very good spot where oil companies can lower leverage and prepare for long-term dividend growth. Especially Marathon Oil.

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

Analyst’s Disclosure: I/we have a beneficial long position in the shares of XOM, CVX, VLO, MRO either through stock ownership, options, or other derivatives. 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.

Comments

[allen drewe]

MRO is one of the safest, easiest investments of 2021 if you can stand the volatility. Easily a $20 stock if not much higher.

[Florida_Dreaming]

You want to see some angry investors? Wait until energy earnings come out in a few weeks and watch the hedging losses. MRO is hedged but they are hedged better than 95% energy companies out there. This is a main reason I don't see US energy increasing cap ex any time soon. Hedging losses. Angry investors. If oil is anywhere near this price next year energy companies will be multiples of where they are because their hedges won't be lousy.

Caution though. Once you start seeing companies hedging a bunch of production up in the $70's and above relatively long term its time to start looking for the exit because that's when heavy drilling will begin. Probably be a good time to rotate into midstream once that occurs.

[huskers123]

@Florida_Dreaming Actually they are not hedge. They have a few hedges , but not significant.

[Florida_Dreaming]

@huskers123 Check out their investor presentation and then come back and tell us they don't have hedges. They have well priced hedges but it's no where near $80. I own 5 shares of this thing so I have a lot riding on it.

[OverTheHorizon]

@Florida_Dreaming Agree on heavy drilling ahead. Buy PTEN

[Shamanski]

Nice article.
Any comment on their level of hedging, it is my understanding that they are relatively unhedged??

[huskers123]

@Shamanski that is correct. Barron’s had an article last week stating the same.

[AndreP]

I plan to keep my MRO to $20.

[Hockeyguy4unow]

Just in the last week I’ve talked to 3 friends—all amateur investors— who’ve said that oil company stocks are now pretty much a guaranteed winner. “Buy oil” seems like the easy bet now. Due to this I expect a fairly significant drop soon to “shake-out” some retail investors before MRO’s eventual rise into the $20’s.

[kdplace]

@Hockeyguy4unow Lucy always pulls the football out from Charley Brown. Why should this time be any different?
I’m all in with dividend payers like XOM so I can wait for the time it is different

[kdplace]

@kdplace plowed under my cornfield in March & April 2020 and went all in in multiple issues. Doubled down on MRO, drilled a real thick payzone with OKE at 23 per share yielding 20% which never cut div (That’ll do Pig). Now the question is do you listen to the voice in the cornfield that says “Go the distance” or do you listen to the bankers that want you to “sell the farm”?

[Larry Ev]

@kdplace Go with the cornfield. There might be some pigs loose and they are a better class of animal than bankers!

[jcolbyclark]

MRO is the stock to be in for equity price appreciation in the next six months.

Last time (before this year) that oil was over $70, MRO stock price was well over $20. Right now it is $14, and more profitable now.

Also, at las earnings call MRO stated “at $60 oil and $3 gas, MRO can buy back 90% of its market cap in 4 years.” Oil is $75 and gas is over $5, FCF is going to be record setting.

One last thing, with debt repayments this quarter, MRO is already under 1.0x leverage.

And Barron’s just picked MRO too as they are relatively unhedged — with “Marathon Oil (NYSE:MRO), where natural gas and natural gas liquids account for nearly half of production and has reported relatively few hedges for this year and next.”

Long MRO, DVN, SD (completely unhedged), WTI and MTDR (both with high insider ownership and buying activity), and RRC, CRK and XLE

[abcde1]

Good investment advice, Leo, always good to see what you have to say. One thing that could derail the great investment opportunity in oil stocks is the democrats. When these massive profits start rolling in, you can set your watch by the shrill democrat propaganda in the democrat media about "windfall profits". i lived through the carter nightmare as a young employee at a big oil company, and well remember the hatred of big oil that the democrats cranked up in their media day and night so that they could steal all that money from shareholders like me via carter's "windfall profits tax". i'm hoping that oil company managements remember that, or if they are too young have some old codgers on their boards that remember that, and are more politically astute this time around about fighting back to protect their shareholders. interesting how democrat darlings like microsoft, google, amazon, et al have made obscene amounts of money for decades and never been accused by the democrats of making too much. surely big oil can figure out how to play this too.

[Leo Nelissen]

@abcde1 Yup. The left-wing agenda wants oil gone. For now, it's what drives energy prices - isn't that ironic? That's why I mainly consider them yield trades on a long-term basis.

[abcde1]

@Leo Nelissen i agree somewhat, and for that reason, i sell covered calls on about half of my oil positions to juice that dividend yield and happily miss out on big gains when their stock prices spike. i say "somewhat" because the present anti-oil hysteria in DC will instantly fade when voters are queued up for their monthly quota of 10 gallons of gasoline at $10 per gallon and the biden puppet show leaves the stage. XOM in particular will benefit when this happens. until the start of the scamdemic, the price of a share of XOM had for several decades always been greater than the price of a barrel of WTI. no physical reason, it just was. i believe that this price relationship will revert to the mean, and that XOM will be selling at $90 or more after the democrats lose their grip on DC a year from now.

[Leo Nelissen]

@abcde1 Excellent comment and good strategy!

[cenc]

Bought it last year Sold it last week, along with ESTE and MUR . Had to take my profits and run. Nothing against MRO, other than it was a relatively small position in my oil portfolio that went too far, too fast. If the price pulls back, would consider buying it again.

LONG FANG, COP, OIH, etc.

[allen drewe]

@cenc says Mro went too far too fast and holds FANG lol

[rj4103]

I agree MRO is an outstanding opportunity in the E& P sector. Free cash flow should be at least $1 billion from July 1, 2021 through Dec 31, and more than $2 billion in 2022. I also expect hedging activity to reach out to 2023 ( beginning prior to Dec 31) at these attractive levels to also support very good cashflow in 2023.

Your net debt estimations appear to assume the cash all goes to future debt repayments. In the near term, now through 2023, based on company comments, I think the majority of free cash flow will be used for additional variable dividends (in addition to the base, which I see going up slightly) AND equity buybacks. In fact, I think equity buybacks may have already begun since they paid down the $900 million of debt in September.

For 2022, I see the vast majority of $2+ billion going to equity buybacks and variable dividends. Debt (or net debt) could decline slightly, but, MRO has no major maturities until 2027. I don't see them using cash for debt retirement until at least 2025.

Using FCF for a return to shareholders should cause the equity price to increase substantially. I look forward to hearing more about these plans on the 3rd qtr earnings call.

Many E&P and Midstream firms have used FCF these past two years to improve their balance sheets. Capex has been prudent. Now. shareholders are poised to reap the rewards. It should be a good run, even in a hated industry. Returns will be too good to ignore.

[Florida_Dreaming]

@rj4103 They aren't paying any more LT debt. We both know this. And they better be making over $3B in 2022 in cash flow. I think it's going to be mostly buybacks instead of variable dividends. Take a page out of tech playbook. I want to see them buy back half their shares in two years. That would make me happy.

[huskers123]

Great Company! Oil companies drilling in 2021 were from approved budgets from 2020. Oil CO’s are too scared, frozen on how much to spend on drilling, so there is significant decreases in drilling from about here on for awhile. “It’s The Green New Deal”. Hey libs , how do you like filling up the tank today…lol. I’ve been adding MRO, will continue!

[Bikerron1]

The bargain is BP. It would be interesting to see what you have to say about BP?

[Leo Nelissen]

@Bikerron1 I haven't researched BP. I like CVX and XOM as oil majors. CVX does a lot of research in new areas like hydrogen and renewables. XOM has a high yield and is rapidly improving its balance sheet. If I have time, I will look into BP.

[abcde1]

@Bikerron1 bp sold its soul to the green european socialists. since it is divesting itself of oil and can't even supply the gas stations in england with the evil stuff, i can't understand why investors believe it will make money as oil prices climb

[allen drewe]

@Bikerron1 bP is no bargain. Company has horrible management.

[Jamjack]

Do you think MRO is a possible merger of equals or take over bid target?

[Leo Nelissen]

@Jamjack Yes, I think so. However, I cannot give you names of companies that I think would be willing to buy MRO. I don't know exactly what XOM, CVX, etc. are looking for. CVX bought Noble at distressed prices. Others are divesting shale assets.

[Nathan5]

I think MRO is a good choice; but even better is the new COG/XEC combo with the new name: Coterra/ ticker starting Monday- CTRA. They are focused in 3 basins- Permian, Marcellus and Anadarko. Marcellus ng production is totally unhedged for 2022. They also are amongst the lowest cost producers; with a fortress balance sheet, with little debt and leverage below 1x. Returning FCF in the form of dividends is their focus, with a soon-to-be-announced $0.50 special divi on the merger closing. Minimum FCF payouts will be at 50%, with supplemental divis along the way. Take a look. I speculate that perhaps they will try an all-share merger with MRO(with it's good balance sheet) in the future, but the ceo said he would focus on increasing Permian accerage.

[Leo Nelissen]

@Nathan5 Interesting comment, thanks for sharing!

[Nathan5]

@Leo Nelissen Since August 20, COG is up 53%, compared to MRO up 33%.

[Freedom Seeker]

@Nathan5 since Oct 2020 (pre-pandemic) they are virtually equal: up 23% (MRO) vs 21% (COG), although MRO had much more volatility. Nat gas names held up better in the March 2020 washout but MRO was punished due to perception as an "oil" company (even tho it's close to 50/50). COG took a hit for the same reason when the merger w/ Cim was announced (and that's when/why I picked up some COG shares). Interestingly both MRO and the new Coterra are well balanced between O/G

[BooBooGao]

Too many stories on MRO, oil at the top, time to get rid of it

[Jamjack]

High interest in a sector on individual sector name should not be a reason to dump it. The reasons for the high interest are far more important.

[allen drewe]

@BooBooGao it’s just getting started is what’s happening

[Kevin Paszli]

How does marathon keep getting better it was at the same price 6 months ago it's barely broken out of its Channel

[Leo Nelissen]

@Kevin Paszli I just used close to 1,500 words answering that question.

[Kevin Paszli]

@Leo Nelissen now that it's finally broken out of the channel pullback eminent you can be the smart guy some other time

[Kevin Paszli]

@Kevin Paszli it's going to pull back and on that pull back that's when you should buy it

[David777]

The past 30 days Exxon has only risen 10% compared to 20% for mur & mro and 24% for dvn. Oil has risen 10%. Plus xom dividend crushes them all at 5.7%. Why do investors love mur, mro & dvn so much with 2%, 1.35% & 1.2% dividend? It seems like the lower the dividend the more investors love it & drive up the price. The 17.4% mro earnings you mention will only last until supply chain issues are resolved and like you say will mostly go to pay down debt incurred from lower priced oil from the pandemic. And can someone explain why such supply chain issues caused by delta variant? Seems the transport of oil shouldn't involve a high level of in person contact and vaccines have been available for quite awhile. Thanks.

[Leo Nelissen]

@David777 Delta didn't cause supply chain issues. It's mainly how politicians reacted to the first wave of COVID in 2020. Most modern supply chains are based on 'just-in-time'. That's awesome on paper but doesn't work when some parts of the supply chain get messed up. It's a truly terrible situation we're in. It could last until 2023. Also, MRO's yield is low, but they will hike it aggressively. Companies like MRO and DVN will apply a variable dividend approach.

[David777]

@Leo Nelissen yes I just noticed xom has huge $60B debt, 20x cash far higher than others. Yet it continues to crank out high dividend so doesn't seem concerned. It also seems to have a high natural gas output. I don't see supply chain issues lasting nearly as long as through 2023 as they've corrected quickly in the past and seem to be due mostly to pent up demand from virus recovery. I'll stay short dvn & mur and on oil dips cover some to buy xom as a counter balance.

[Leo Nelissen]

@David777 XOM's debt accelerated as they didn't cut their dividend. They're fine now. Current prices allow for fast debt reduction.