Energy company stocks have been battered since staging their recent May/June highs after the surge in buying momentum following the Russia-Ukraine conflict. The market turned its focus from the geopolitical uncertainties toward worsening macro headwinds, as fears of demand destruction sent several energy stocks tumbling to their pre-conflict lows.
Marathon Oil Corporation (NYSE:MRO) stock also gave up all its post-conflict gains at its recent July lows, as it fell more than 40% from its May/June highs. The extent of the steep selldown has also formed an oversold bottom (technically speaking) on MRO's short- and medium-term charts.
Furthermore, it also created a bear trap (a price structure where the buyers decisively rejected further selling pressure, helping stanch further selling downside). As a result, we believe that MRO is at a pretty robust near-term bottom, supported by its near-term support ($19.40).
The price action has also recovered remarkably from its bottom, driven by solid buying upside from dip-buyers. Therefore, we believe the critical question facing investors looking to add MRO exposure is whether the rally is sustainable?
Depending on who you choose to believe in, reading the news isn't going to help much, we think. We have parsed commentary that suggests demand destruction could cause oil prices to continue moderating. In contrast, Street analysts remain steadfast that the supply/demand imbalance would continue to help support robust oil prices that should overcome any near-term weakness.
Notwithstanding, our valuation model (which incorporated these bullish estimates) suggests that MRO could underperform the market, despite its seemingly "cheap" valuations. Our price action analysis indicates that the market could use a short-term rally to attract more dip buyers before forcing its next selldown.
Therefore, we urge investors looking to add more exposure to be patient. As such, we rate MRO as a Hold for now and watch its price action unfold.
The market is forward-looking, as it anticipates potential demand destruction resulting from the worsening macro headwinds coupled with a hawkish Fed. As a result, WTI crude formed a bull trap (indicating the selling pressure decisively rejected further buying upside) in early June, even as the media was filled with bullish commentary.
Recent data from the Energy Information Administration indicated that "U.S. gasoline inventories unexpectedly rose by 3.5M barrels [in mid-July] compared to the consensus forecast for a rise of 400K barrels, even as refinery runs fell to 93.7%, from 94.9% a week ago."
Furthermore, Morgan Stanley also cut its oil price projections through 2023 "due to reduced demand projections following a slowdown, although the investment bank signaled that the crude market remains tight."
Therefore, we believe the market has gotten the sell-off on point in early June, as it set up the bull trap. The market had anticipated further weakness in forward oil price projections, even though the supply/demand dynamics remain tight.
Hence, we urge investors to focus on the market and not wait for the news. By the time the news arrived, it would have been too late to cut exposure at fantastic price levels. We also cautioned investors in Occidental (OXY) and Exxon (XOM) to take their profits quickly in June (See here and here).
Given Marathon's sizeable exposure to crude oil products, investors must watch the oil market closely. As seen above, crude oil and condensate accounted for 78% of its FQ1 revenue. Also, crude oil revenue has driven the upswings/downswings in MRO's revenue over the last three years.
Marathon Oil also cautioned in its filings (edited):
Our revenues and operating results are highly dependent on the prices we receive for our crude oil and condensate, NGLs, and natural gas. Historical declines in commodity prices have adversely affected our business by reducing the amount of crude oil and condensate, NGLs, and natural gas that we can produce economically; reducing our revenues, operating income, and cash flows. (Marathon Oil 10-Q)
The consensus estimates (bullish) suggest that Marathon Oil's revenue growth for FY22 could peak in FQ2 (earnings release on August 3), reaching 84%. It's also expected to fall markedly through FY23.
Notwithstanding, MRO's adjusted EBIT margins are still expected to remain robust. We believe it reflected the Street's optimism on Marathon Oil's operating model, as it leverages the current supply imbalance coupled with limited hedging.
As opportunistic investors, we were also keen to assess whether MRO's July bottom represented an attractive opportunity to add exposure. However, our valuation model suggests that MRO could underperform the market, even though we applied the bullish consensus estimates in our model.
|Current market cap||$16.4B|
|Hurdle rate [CAGR]||11%|
|Projection through|| |
|Required FCF yield in CQ4'26||18%|
|Assumed TTM FCF margin in CQ4'26||45%|
|Implied TTM revenue by CQ4'26||$10.42B|
MRO reverse cash flow valuation model. Data source: S&P Cap IQ, author
We applied a market-perform hurdle rate of 11% to assess whether MRO's future performance could stay in line with the market.
The critical question is what is an appropriate level of yield that should model the current market risk dynamics. We noted that the market rejected further buying upside in early June at an NTM FCF yield of about 18%. But note that the consensus estimates suggest that Marathon Oil's adjusted net margins and free cash flow (FCF) margins could fall through FY24. Therefore, MRO traded at an FY24 FCF yield of 13.17% if we consider the falling profitability estimates.
Also, we noted that the market formed a bear trap in July, as it rejected further selling downside at an FY24 FCF yield of 22.54%. Hence, we believe using an FCF yield of 18% in our model is appropriate.
Consequently, we require Marathon Oil to post a TTM revenue of $10.42B by CQ4'26 to meet the market-perform hurdle rate implied in our model. Therefore, it's clear to us that the market expects MRO to underperform over the next four years, which could explain why it demanded such high FCF yields.
If investors are assessing price levels that could help them obtain a market-perform hurdle rate, we suggest price levels below $14 (40% downside) as appropriate.
We rate MRO as a Hold for now.
We noted that MRO formed a bear trap in July, even as it gave up all its post-conflict gains. Therefore, the rally that followed the near-term bottom did not surprise us.
However, we don't encourage investors to join the recovery yet. Instead, investors should watch where the current rally could fail (meet sustained selling pressure). Then, watch for the following bottoming process to assess whether it would re-test its July lows before determining whether to add exposure.
Our valuation model indicates that MRO could likely underperform over the next four years at the current levels. Therefore, investors looking to add should wait for a deeper sell-off to improve their chances of outperforming the market.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.