- 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.
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!
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.
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.
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.
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.
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.
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.
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.
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.
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.
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!
This article was written by
Leo Nelissen is an analyst focusing on major economic developments related to supply chains, infrastructure, and commodities. He is a contributing author for iREIT on Alpha.
As a member of the iREIT on Alpha team, Leo aims to provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities. Learn More.
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.
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