2023-09-22 12:23:36 ET
Summary
- Marathon Oil's unique capital return policy and the recent rally in crude oil prices are expected to drive value for long-term shareholders.
- The company's focus on share buybacks, rather than supplemental dividends, has resulted in a decline in share count and per share accretion.
- Marathon Oil's stake in Equatorial Guinea's LNG export hub and its lean operations have further contributed to its resilience and potential for upside.
Shares of Marathon Oil ( MRO ) have been a mixed performer over the past year, trading marginally higher. As a company with significant cash flow sensitivity to the price of crude oil, the recent rally should be supportive of its results. Additionally, while seemingly out of favor with the market, its unique capital return policy is driving meaningful per share accretion that should result in value for long-term shareholders. Shares are roughly flat since I rated the stock a buy last October , as recession fears pushed down oil prices earlier this year, which weighed on energy stocks. However, with operating results strong, oil prices moving higher, and a large buyback program, I would take this opportunity to be a buyer at current levels.
In the company's second quarter , it earned $0.48 in adjusted EPS, slightly ahead of consensus with revenue of about $1.51 billion. In the quarter, the company generated $531 million of free cash flow, net of working capital movements. This cash flow enabled $372 million in share repurchases. While many oil and gas companies are paying a supplemental variable dividend to return strong free cash flow to shareholders, MRO is focusing its capital return policy on buybacks. It pays a $0.10 quarterly dividend (for a 1.5% yield), and the remainder of the return is via repurchases.
When oil is above $60, it targets a return of at least 40% of operating cash flow to shareholders, and from $40-60, it targets a return of 30%. The company's capex spending is capped by its maximum 5% annual production growth, so as oil gets past ~$80 its share buybacks can eclipse the 40% floor. Over the past twelve months, its share count has declined by 13% to 615 million, and in the seven quarters since initiating this program, its share count has fallen by 24%. Another $1.8 billion remains on its buyback authorization, enough to repurchase about 12% of the company.
Targeting production growth of 0-5% may seem slow, but when the share count is falling by 10+%/year, the production per share is actually rising in the low teens. This can drive meaningful EPS growth over time, holding oil prices constant. Ultimately, it is per share growth, not company-wide growth, that we as investors should be focusing on. Additionally, given the large size of its buybacks, there is a benefit to the stock price being relatively low - it can buy back more of the company, increasing the accretive power of the repurchases. Because this capital return strategy appeals more to those seeking capital appreciation than those seeking income, MRO trades at a discount valuation to peers with a free cash flow yield of about 13%. While this valuation gap may not close immediately, over time, long-term investors will benefit from the compounding impact of share count declines.
Now, while it has been able to repurchase shares aggressively in the past, investors will want to be sure it can sustain that going forward. First, we will look at its own operating results, which have been solid and within management's control, and then consider commodity prices, which are outside of its control.
Marathon is on track to spend $2 billion on capex this year, with 60% of that spending happening in the first half. Oil production was 189,000 barrels per day, up 13% from last year and 1.5% sequentially. Its total production was 399,000 barrels of oil equivalents per day, up 16% from last year and 1% sequentially. In Q3, oil production should rise sequentially to 195,000 barrels/day. Oil production has been coming in above expectations, thanks to solid well productivity, and should come towards the high-end of guidance, though growth will decelerate in Q4 as comps to last year become more challenging. Its two biggest plays are the Eagle Ford (about 40% of production) and the Bakken (about 27% of production), both well-performing US shale formations.
Outside of US shale, Marathon has a unique and attractive asset: its stake in Equatorial Guinea's LNG export hub. Seaborne LNG has become a valuable commodity, with Europe becoming a significant buyer as it moves away from Russian gas. Importantly, Marathon will benefit from the expiration of fixed-price contracts for this asset's production next year, taking advantage of higher WTI and LNG pricing. With Dutch natural gas futures trading toward $40 and WTI above $80, Equatorial Guinea's EBITDA could triple from 2023 to 2024 to about $1.5 billion. This stake led to a $249 million cash distribution in Q2, and we could begin to see further upside next year as higher prices flow through to results.
MRO has also leaned down operations meaningfully to lower break-even costs. Capex spending is about $14 per barrel of oil. Operating costs are about $10, and there is another $10 in interest and G&A costs. As a consequence, the company has brought its free cash flow breakeven (after its dividend but assuming no share repurchases) down to about $40, creating significant resilience during downturns.
Of course, today oil is well above $40, and it has been rising recently, as you can see below with WTI touching $90/barrel. While MRO has a resilient cost structure to last through downturns, I would not recommend shares to those who expect oil prices to fall meaningfully, as that will obviously reduce cash flow. If that is your view, I would not just avoid MRO - I would be inclined to avoid E&P companies as a sector, as no oil company wins from lower prices. However, I expect prices to at least remain around current levels, which leaves MRO shares in an attractive position.
Russia and Saudi Arabia have announced they will be extending their oil production cuts through year-end, which are keeping supply tight. There is still long-term uncertainty about Russian supply, given the war with Ukraine. And for all the focus on alternative energy, I would note the International Energy Agency (IEA) expects global oil demand to be about 5.5% higher in 2028 than it was in 2022. Primarily due to growth in EM, oil demand is still rising, but capital spending has been low in recent years due both to climate objectives in the West as well as companies like MRO having more discipline and choosing to buy back shares rather than grow production more quickly.
Accordingly, while no one can know where commodity prices are going, I view them remaining in the $80-100 as more likely than falling to the $50-70 level. Now, in Q2, MRO realized $72.49/barrel of oil. With its production levels, each $1 move in crude oil is worth about $70 million to annual cash flow. Last quarter, MRO generated an annualized $2.1 billion in free cash flow for a 13% free cash flow yield. At $85, free cash flow will be $2.75-3 billion, with a further potential tailwind next year for incremental income from higher price realizations out of Equatorial Guinea.
In terms of downside risks to my expectations, lower commodity prices are the primary risk. In particular, a global recession would reduce oil demand and lower prices. A resolution to the Russia-Ukraine conflict that enabled Russia to export gas to the EU again would also lower LNG prices and eliminate my expected tailwind from Equatorial Guinea. I do not expect a recession, and the resolution of Russia-Ukraine appears quite unlikely.
There is also a risk that the efficacy of Marathon's capex program worsens, forcing it to invest more to maintain production, thereby reducing free cash flow. However, so far, the capex spending is leading to production toward the high end of guidance, so this does not appear to be a pressing risk. Finally, there is a risk that because of its buyback vs dividend focus, the valuation gap vs peers never closes, and it maintains a 13+% free cash flow yield. This would not cause the stock to drop - indeed it would still rise proportionately to its share count reduction - but it would mean that the upside is more limited, with shares unlikely to eclipse $30. While a macroeconomic downturn could cause shares downside, with its current discounted valuation, I believe investors are being well compensated for this risk.
In the current oil environment, MRO has a free cash flow yield of closer to 18%, meaning we can see an even faster pace of buybacks and per share accretion. Given its oil-intensive production out of its US shale plays, MRO has significant gearing to the price of oil, and the market is looking past this cash flow yield given, in my view, its lower dividend yield.
However over the next several quarters, as we see free cash flow rise considerably, leading to a faster pace of buybacks, due to higher crude oil realization and its LNG exposure, MRO should engender more focus. While it may still trade at a discount to the ~8% free cash yield of peers, a forward 12% free cash flow yield off $2.8 billion in free cash flow results in a share price of $38, offering nearly 40% upside, conservatively using today's share count. Investors should look to buy shares of MRO, a hidden gem with substantial cash flow and buyback capacity.
For further details see:
Accelerating Cash Flow Makes Marathon A Buy