MPC - Marathon Petroleum: Investing In The Fossil Fuel 'Supernova'

2023-08-09 15:41:46 ET

Summary

• Marathon Petroleum has outperformed energy ETFs and its upstream-centric peers due to its more robust refining profit outlook.
• Refining margins and profits in the downstream sector are expected to increase, driven by falling production levels and steady demand for gasoline and diesel.
• MPC's long-term value opportunity lies in the possibility of a longer-than-expected energy transition, which could result in high cash flows before the eventual decline of its fossil fuel segment.
• In the short term, Marathon faces some recession risks, but low gas and diesel inventories make the probability of a sharp rise in crack spreads much higher.

The US oil and gas sector has faced significant volatility, with little-to-no correlation to the S&P 500 over most of the past three years. The sharp rise in oil and gas prices in 2021, led by production cuts the year prior, caused most in the sector to see sky-high margins in 2022. However, the significant withdrawal of the Strategic Petroleum Reserve last year pushed prices back down, causing most oil and gas commodities to return near their pre-shortage levels. That said, volatility has been most extreme in the upstream oil sector, with the downstream industry seeing relatively strong performance throughout the past year. One notable example is the refining giant Marathon Petroleum ( MPC ), which has continued to rise in value despite headwinds amongst its peers. See below:

Marathon Petroleum has significantly outperformed the general energy ETF ( XLE ) and the upstream-centric ETF ( XOP ). As a downstream company, Marathon has less direct exposure to oil and gas prices (such as XOP) but more exposure to the spread between gasoline (refined products) and crude oil prices, also known as the " crack spread . " This relationship stems from the fact that, as a refiner, Marathon purchases crude oil and sells refined gasoline, so it benefits when gasoline is far more expensive than oil.

The crack spread has been abnormally high in recent years for various reasons. It also rose rapidly over recent weeks due to refinery outages and a general failure to increase gasoline and diesel stockpiles. Accordingly, those two energy commodities have risen in value compared to crude oil, which has also increased in recent weeks. See below:

The gasoline spread has been generally elevated since the initial refinery issues in 2020, but has never returned to its pre-COVID levels due to ongoing refinery capacity shortfalls. The diesel spread was high last year due to the acute shortage of diesel fuel. Although that spread declined considerably after, it has begun to rise again due to signs that the deficit will likely return.

In my view, the situation facing refining margins and profits on other downstream energy segments makes companies like Marathon particularly interesting today. MPC is hovering around its peak value but trades at a lower forward "P/E" of 6.9X, indicating it could be discounted today. Of course, the downstream sector also faces economic, technological, and regulatory risks, which could offset its significant pricing power and tremendous moat. The company faces numerous complex factors; however, I believe its short-term outlook is solid, with decent potential over the coming years. Of course, the company will likely need to make more significant green energy transition investments in the long run. Still, those may never drive substantial profits for well over a decade. Accordingly, I expect MPC will benefit tremendously from the lack of investment in "legacy" oil and gas until then.

Gasoline May Soon Get Much More Expensive

Marathon's earnings were slightly weak in Q2 due to lower refining margins that quarter, primarily driven by the low diesel crack spread. In Q3, its earnings outlook is much stronger due to the recent spread improvement, with both showing a strong upward trend. However, one of the company's major refinery plants will be shut down for most of this quarter due to a recent fire, pushing its capacity utilization down to 93% from 100%. Of course, this issue is a double-edged sword because it contributes to the lack of available refining capacity pushing the crack spread higher. Across the industry, refinery capacity utilization is around 93% today (a standard level), but total capacity is still significantly depressed. See below:

The decline in total refinery capacity is the primary reason for the increase in refining profits, creating a chronic shortage of refined products due to a lack of production and high demand. This was triggered by a large wave of refinery shutdowns in 2020 and 2021 . Refinery shutdowns or production issues will likely continue to grow as no new refineries have been built in the US for nearly 50 years . As the country looks to shift toward electric vehicles, companies like Marathon avoid investing in physical capital due to the immense costs, low projected lifespan of refining projects, and increased regulatory burden outlook.

One company is looking to build a new plant in Oklahoma , which will be completed in 2027; however, it will not add much to total production (129 refineries). I expect that project may struggle with increased labor and material costs (and shortages). The labor and materials shortage is a significant secondary issue limiting capacity expansion and utilization. After that, the sharp increase in interest rates limits these companies' willingness to borrow money to expand and strongly encourages a return of invested capital. This trend is evident in Marathon Petroleum, which has slashed the CapEx budget (despite high profits), and substantially increased its cash-flow returns. See below:

"Cash from financing" are net cash-flows from dividends, stock buybacks, debt repayments (being negative), and stock and debt sales (being positive). When compared to Enterprise Value ($79B for MPC), it gives us a "true" dividend yield for the company as a whole (not just its equity). That figure is currently a staggering 19% for MPC, meaning at its current pace, it could buy back all of its debt and equity in about five years. Of course, MPC's ability to return cash highly depends on its refining margins, as that is the most variable part of its segment income . More importantly, the sharp change in Marathon's focus from capital investing to return on capital shows the company is not looking to expand and is instead paying back its investors - a great sign for investors. The same trend is seen across the oil and gas sector, with virtually all larger companies halting most CapEx instead of capital returns, indicating a widespread unwillingness to expand into the (theoretically) limited lifespan environment (given the rise of electric vehicles).

If the refinery market continues to see low production levels, which I strongly suspect, then there is a significant probability of a sharper increase in gasoline and diesel prices. One major catalyst is the lower inventories of these commodities and the rising fuel export level. Many other countries face similar issues to the US, mainly Europe, which was previously dependent on Russian fuel. As demand for US exports grows amid depressed refinery production, fuel inventories may fall to critically low levels and cause another significant price spike like that seen in diesel last year. See below:

Overall, I believe the current situation points to a potentially large increase in refining profits, led by a sharp rise in diesel and gasoline prices compared to crude oil. Low inventories of those two critical commodities, volatile production after summer, and rising export demand could bring a more considerable shortage than last year's diesel shortage. As hurricane season nears, the potential for a black-swan decline in refinery capacity utilization is very high, possibly creating a larger temporary production decline that pushes the shortage to an extreme.

What is MPC Worth Today?

I believe MPC is an excellent way for investors to bet on increased gasoline prices. Indeed, it is also a means to hedge against a rise in fuel costs, a significant ongoing risk for most companies and the economy today. Marathon offers the speculative potential of a sharp acute rise in refining profits, which I suspect could occur over the coming months. The stock also appears attractive over the 3-7 year horizon, as fuel demand may be substantially higher than supply over that timeframe due to underinvestment across the industry. Eventually, the associated increase in fuel costs should accelerate the transition toward electric vehicles, likely causing MPC to lose much of its sales in the 2030s into the 2040s . After that, the company can still sell chemical products, around 10-15% of total oil consumption today; however, its total profits should be much lower after the transition.

I believe MPC's most significant long-term value opportunity is the possibility that the energy transition will take longer than expected. Marathon, and its major peers, are acting as if it will occur very quickly, rapidly reducing investments and returning capital today. However, should fossil fuel demand remain high until the 2030s , the chronic shortage today could become far more significant. In my view, this situation makes MPC a "Supernova" investment, where it could see extremely high cash flows for years before its eventual demise (of its fossil fuel segment, but not its much smaller chemical segment). Given the US power grid must be expanded significantly before a larger EV transition can occur, combined with utility companies' labor shortages , fossil fuels may dominate for longer than expected, extending the size of this "supernova."

The difference between Marathon and its peers Valero ( VLO ) and Phillips 66 ( PSX ) is insignificant. MPC's valuation is between the two, with a forward "EV/EBITDA" of 4.7X vs. PSX at 5.8X and VLO and 3.9X. However, their three-year out-forward valuations are closer, with VLO being the most expensive at a three-year forward "P/E" of 12.3X compared to MPC at 12X. That indicates Valero's EPS will likely decline faster than MPC and PSX. Marathon is larger and has a higher operating margin of 10.4% compared to both of its peers. Thus, I believe Marathon has the best potential to maintain production over the coming years and reinvest into assets that should have greater value after the energy transition is complete. As such, MPC is my favorite stock in the group, but I am also bullish on PSX and VLO.

The most significant long-term risk for Marathon is a more rapid increase in the utilization of electric vehicles. Currently, the EV market is a bit cold, with sales lower than most had hoped, likely due to economic strains on white-collar workers. For the EV transition to occur more quickly, interest rates on consumer loans would need to be lower, discretionary income higher (or EV prices much lower), and fossil fuel prices would likely need to be higher. All those factors are possible, but today's specific environment does not encourage a rapid EV transition. Indeed, I believe the transition may be slower than most expect.

Marathon also faces short-term risks, particularly with the stock reaching a new record peak. While I am moderately bullish on MPC, a short-term pullback may occur simply due to its recent breakout. A sharp economic slowdown could also harm gasoline consumption, pushing crack spreads and refining profits back down. That is a distinct possibility today; however , fossil fuel consumption has been highly resilient despite economic and price strains since late 2021, so a recession may not harm gasoline consumption as much as it did in the past. A recession would likely further break refinery capacity, probably increasing the sector's total "supernova" potential. While MPC faces distinct short- and long-term risks, it also offers tremendous immediate value and is a strong hedge against today's most considerable inflationary strains.

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