2023-06-12 13:24:27 ET
Summary
- Marathon Oil's cash flow risks are increasing due to dropping petroleum and natural gas prices. Marathon Oil's adjusted CFO dropped 15% Q/Q.
- The company's aggressive stock buybacks may not be sustainable in a lower-price world.
- A continued decline in market prices for petroleum and natural gas poses the biggest commercial risk for Marathon Oil.
- The EPS revision trend is highly negative.
With energy prices dropping off in recent months over fears of a global economic slowdown, downside risks for producers like Marathon Oil ( MRO ) have grown significantly. Although the energy company has said that it wants to return at least 40% of its cash flow from operations to shareholders as dividends and stock buybacks, I believe that the setup remains unfavorable for investors as Marathon Oil's adjusted cash flow from operations has already started to decline. Marathon Oil also faces the very real risk of EPS downside revisions as petroleum and natural gas prices decline. For those reasons, I expect shares of Marathon Oil to go into a new down-leg and believe the risk/reward trade-off remains unattractive!
Marathon Oil is a U.S.-centric E&P play
Marathon Oil is a leading E&P company with multiple assets in the Permian, Bakken, Oklahoma and the Eagle Ford. Additionally, the company owns offshore gas assets in Equatorial Guinea, which gives Marathon Oil international exposure.
Marathon Oil announced that it was acquiring 130 thousand net acreage in the Eagle Ford from Ensign Natural Resources in the fourth-quarter of FY 2022 and the firm has said in its first-quarter earnings release that it has completed Ensign's integration. Because of the acquisition of Ensign’s natural gas assets, Marathon Oil now expects double-digit production per-share growth in FY 2023, on a year-over-year basis. Together with share repurchases, Marathon Oil has guided for 30% production per-share growth this year.
Due to its aggressive production growth and high market prices for petroleum, Marathon Oil has laid out an ambitious target to return at least 40% of its adjusted cash flow from operations to shareholders, the majority of which typically comes as stock buybacks. As a result, Marathon Oil has achieved a leading distribution yield of 12% in the E&P sector, widely outperforming other E&P companies in the last year.
However, with prices for petroleum and natural gas dropping off lately, Marathon Oil’s free cash flow risks have greatly increased.
Cash flow risks are growing
Marathon Oil generated $942M in adjusted operating cash flow in the first-quarter, showing a decline of 15% compared to the fourth-quarter due to lower realized prices for its energy products. Marathon Oil’s average realized price for crude oil and condensate dropped 11% quarter over quarter to $74.69 a barrel, while the average realized price for natural gas declined 40% quarter over quarter to $2.95 per mcf (based off of data published for Marathon Oil's U.S. business).
While the company still returned 42% of its cash flow from operations ($63M as dividends and $334M as stock buybacks), the decline in cash flow is concerning and indicates weaker capital returns going forward, especially if energy prices continue to drop. The price for a barrel of WTI, as an example, has dropped below $70 recently and the trend for prices is negative as economic risks are growing and OPEC continues to push for output cuts in order to support weak market prices.
Marathon Oil’s valuation relative to E&P rivals
With petroleum and natural gas prices falling, and Marathon Oil's cash flow dropping off as well, the company is facing a potentially negative EPS revision trend which, in my opinion, is set to continue as long as economic fundamentals indicate slowing economic growth. According to the International Monetary Fund, advanced economies are headed for a sharp growth slowdown in 2023: the IMF expects advanced economies to grow only 1.3% in 2023, showing a potential deceleration of 1.4 PP year over year. As a result, Marathon Oil has seen a sharp downside correction in its earnings estimates: analysts project $2.73 per-share in earnings for FY 2023, indicating a 39% year-over-year drop.
With deteriorating EPS expectations comes a potentially significant increase in the company's P/E ratio: Marathon Oil is currently valued at a P/E ratio of 6.2X, but the valuation ratio is still based on optimistic expectations about energy companies benefiting from above-average energy prices. A down-turn in the U.S. economy, as an example, could lead to a serious contraction not only in Marathon Oil's cash flow prospects, but also result in lower EPS expectations... and a much higher P/E ratio. In the last 90 days, EPS downside revisions for the current fiscal year outnumbered upside revisions by 10:1.
Risks with Marathon Oil
The biggest commercial risk for Marathon Oil, as I see it, is a continued decline in market prices for petroleum and natural gas. Falling prices imply a potentially material correction in the company’s cash flow… which would also impact Marathon Oil’s potential to keep up its aggressive pace of stock buybacks. What would change my mind about Marathon Oil is if the company saw an improvement in its cash flow prospects on the back of higher market prices for petroleum and natural gas.
Final thoughts
The risk/reward for Marathon Oil remains unfavorable at this point, in my opinion, because declining petroleum and natural gas prices translate to higher free cash flow risks. I also believe that aggressive stock buybacks at a time of booming petroleum prices is not a good allocation of capital, and Marathon Oil's high distribution/buyback yield achieved last year is therefore highly unlikely to be sustainable. I also see significant EPS risks on the horizon and if economic growth forecasts continue to deteriorate, Marathon Oil could all of a sudden trade at a materially higher P/E ratio!
For further details see:
Marathon Oil: More Downside Risk