Marathon Oil: Risk Factors In Gas Valuation And Limited Returns (Rating Downgrade)

Marathon Oil Corporation (NYSE:MRO) produces oil, natural gas liquids and natural gas in the US and the African country of Equatorial Guinea. Last year it acquired private natural-gas focused Eagle Ford company Ensign Natural Resources.

In the US, Marathon Oil is primarily active in the Bakken (North Dakota) and Eagle Ford (south Texas) with smaller operations in the New Mexico side of the Permian and Oklahoma.

As before, I do not recommend Marathon Oil to dividend hunters due to its very slender 1.5% dividend. However, I am also changing my recommendation for growth hunters from “buy” to “hold.

The primary reasons for this change are a) unlike some of its competitors, more than half of the company’s production is lower-valued natural gas and natural gas liquids, b) it has leaned further into natural gas with the Ensign purchase, c) given the acquisition of Ensign at a time of higher natural gas prices, it is possible the reserves were over-valued—certainly investors should expect lower year-end SEC PV-10 gas reserve values for Marathon Oil, as for other companies, d) gas fundamentals are decent but gas prices are a third or less of those a year ago and despite LNG export growth appear unlikely to return to average 2022 levels, e) larger competitors offer richer returns to shareholders and smaller competitors offer the prospect of better capital appreciation.

The company has committed to return at least 40% of annual operating cash flow to investors when WTI oil prices are $60/bbl or above, which it does primarily through share repurchases.

Despite similar names, Marathon Oil is an upstream oil and gas company distinct from Marathon Petroleum Corporation (MPC), a downstream refiner.

Macro

US refinery operable capacity is 17.7 million BPD. The US produces 12.7 million BPD of oil domestically. Canada supplies the largest percentage of US oil imports.

The Biden administration has drawn the Strategic Petroleum Reserve down to its lowest level (348.4 million barrels or about 49% of capacity) in years. Due to sanctions, Russia has redirected its oil supplies from the EU to India and China. Both factors, along with supply cuts from OPEC, may continue to press oil prices upward.

Second Quarter 2023 Results

In the second quarter of 2023, Marathon Oil reported net income of $287 million, or $0.47/diluted share. However, despite added Ensign production volumes, 2Q23 net income of $287 million was much lower than 2Q22 net income of $966 million. For reference, MRO's 2Q23 gas price averaged $1.89/mcf while its 2Q22 gas price averaged $6.84/MCF, more than 3x as much.

Net operating cash flow for 2Q23 was $1.1 billion and free cash flow was $442 million.

The company returned $434 million to shareholders in 2Q23, most ($372 million) in the form of share repurchases.

Marathon produced 399,000 net barrels of oil equivalent per day (BOE/D); of that, oil was 189,000 net barrels per day (BPD), or 47%.

The graphs show total hydrocarbon and oil/condensate production by region. (A portion of Eagle Ford oil is lighter condensate.)

US Oil and Gas Prices, and Differentials

The August 18, 2023, oil futures price was $81.26/barrel for West Texas Intermediate (WTI) crude oil delivered in September 2023.

Forward WTI prices are flat, declining slightly by mid-2024.

On August 17, 2023, when WTI was $80.39/barrel, the price for Louisiana Light Sweet—a proxy for the Eagle Ford price--was $79.60/barrel.

The North Dakota Light Sweet oil price (Bakken) is typically less than the WTI price due to differences in transportation and markets. The price for Bakken crude a day earlier—August 16, 2023--was $72.23/barrel.

For the week ending August 11, 2023, US oil production was 12.7 MMBPD. This is only 0.4 million BPD less than the highest-ever level of US oil production of 13.1 MMBPD in February-March 2020.

For September 2023, Bakken oil is predicted to be 1.2 MMBPD or 9.4% of total US oil production. Eagle Ford oil is predicted to be 1.1 MMBPD or 8.7% of total US production. By contrast, Permian oil is predicted to be 5.8 MMBPD, or 46% of the total.

Of this, Marathon’s oil/condensate volumes represent 1.4% of total US oil production.

August 18, 2023, Henry Hub, Louisiana, natural gas futures price for September 2023 delivery was $2.57/MMBTU.

While the “free” or “waste” gas from the Permian is not ramping up at the same breakneck pace as earlier (except as the Permian matures and gets gassier), it is worth noting right now US gas supply of 108 BCF/D outweighs demand of 100 BCF/D. Yes, increased demand for electrical generation—both baseload and renewables back-up—helps, as does the prospect of increased LNG export demand. However, expect market-starved Appalachian gas to compete more heavily once Mountain Valley Pipeline is complete. Appalachian gas is 35.7 BCF/D; Permian is 23.7 BCF/D; by contrast, Eagle Ford is 7.5 BCF/D.

Marathon’s gas production represents 0.46% of total US gas supply.

In its August 8, 2023, Short Term Energy Outlook the Energy Information Administration (EIA) provided 5-95 confidence intervals for US oil and gas futures prices through the end of 2024, shown below.

Ensign Natural Resources Acquisition

On November 2, 2022, Marathon announced it was acquiring private Eagle Ford company Ensign Natural Resources for $3.0 billion. The transaction closed at the end of 2022 with an effective date of October 1, 2022.

Ensign’s production at that time was about 67,000 BOE/D total, including 22,000 BPD of oil. Marathon also acquired 130,000 net acres (99% operated, 97% working interest, 700 wells, 600 undrilled locations) adjacent to its own acreage in the condensate, wet gas, and dry gas phase windows of the Eagle Ford. This acquisition gives Marathon a total of 290,000 Eagle Ford acres.

In retrospect, while companies were eager to get gas for LNG export, the timing given the high gas prices of 2022 could have led to an overvaluation problem similar to (but smaller) than the one ExxonMobil faced when it acquired XTO.

Reserves

On December 31, 2022, Marathon's total proved reserves were 1.34 billion BOE. This divides as 91% US and 9% Equatorial Guinea. Of the total, 48% was crude oil and condensate.

The SEC PV-10 value of the reserves was $22.2 billion (compared to $12.4 billion for year-end 2021) using the following reference prices:

*WTI oil price of $93.67/bbl

*Mont Belvieu NGL price of $36.59/bbl

*Henry Hub natural gas price of $6.36/MCF

Only 2.5% of this reserve value ($551 million) is attributable to the company’s Equatorial Guinea holdings.

Competitors

Marathon Oil Corporation is headquartered in Houston, Texas.

Some of Marathon Oil’s Eagle Ford competitors include BP (BP), ConocoPhillips (COP), Devon Energy (DVN), EOG Resources (EOG), SilverBow Resources (SBOW), and Exxon Mobil (XOM).

Public companies competing with Marathon in the Bakken/Williston Basin are Chord Energy (CHRD), private Continental Resources, ConocoPhillips, Devon, EOG Resources, Hess (HES), and ExxonMobil.

Marathon Oil also competes with companies in Oklahoma, in the Permian, and with private companies.

Marathon Oil’s largest competitor in Equatorial Guinea is Exxon Mobil.

Governance

On August 1, 2023, Institutional Shareholder Services ranked Marathon Oil’s overall governance as a 4, with sub-scores of audit (4), board (5), shareholder rights (5), and compensation (4). In this ranking a 1 indicates lower governance risk and a 10 indicates higher governance risk.

Short shares are 2.1% of floated shares on July 31, 2023. Insiders own a small 0.4% of outstanding stock.

Marathon Oil’s beta of 2.38 represents considerably more volatility than the overall market but is in line with cyclic oil and gas prices.

On June 29, 2023, much of Marathon Oil’s stock was held by institutions, some of which represents index fund investments that match the overall market. The three largest institutional holders of Marathon’s stock were Vanguard (12.0%), BlackRock (8.2%), and State Street (6.85%).

BlackRock and State Street are signatories to the Net Zero Asset Managers Initiative, a group that, as of June 30, 2023, manages $59 trillion in assets worldwide and which (despite disrupted energy supply due to rerouting of Russian energy exports from Europe to Asia) limits hydrocarbon investment via its commitment to achieve net zero alignment by 2050 or sooner.

Financial and Stock Highlights

The company’s 52-week price range is $20.57-$33.42 per share, so its August 18, 2023, closing price of $26.39/share is 79% of the 52-week high and 82% of the one-year target of $32.18. Market capitalization is $16.3 billion.

Marathon Oil’s trailing twelve months’ earnings per share (EPS) is $4.14 for a bargain price/earnings ratio of 6.4. The averages of analysts’ 2023 and 2024 EPS estimates are $2.41 and $3.39, respectively, for a forward price-earnings ratio range of 7.8-11.0.

Twelve-month returns on assets and equity, while both good at 8.3% and 18.0% respectively, are not as strong as some competitors.

Trailing twelve-months operating cash flow is excellent at $4.6 billion and levered free cash flow is good at $1.6 billion.

Marathon Oil’s annual dividend is $0.40/share for a yield of 1.5%.

MRO has a share repurchase authorization that helps meet its commitment to return a minimum of 40% of cash flow from operations to equity investors when WTI oil prices are $60/bbl or more.

At June 30, 2023, the company had $8.7 billion in liabilities including $5.7 billion of long-term debt. Marathon Oil had $19.9 billion in assets giving it a liability-to-asset ratio of 44%. The debt-to-EBITDA ratio was 1.3.

The company’s mean analyst rating is 2.5: between “buy” and “hold”. At least one analyst considers the stock very undervalued.

Notes on Valuation

With an enterprise value (EV) of $21.4 billion, the EV/EBITDA ratio is a small 4.7, well below the maximum preferred ratio of 10 or less, suggesting the stock is a bargain.

The company’s book value per share of $18.55 is below the current market price, indicating positive investor sentiment.

Market capitalization per flowing BOE is $40,900 while the market cap per flowing barrel of oil is $89,200. This more-than-doubling reflects the inclusion of lower-valued natural gas and natural gas liquids in the BOE calculation.

Current enterprise value is $21.4 billion and market capitalization is $16.3 billion. On June 30, 2023, the company had assets of $19.9 billion and liabilities of $8.7 billion including $5.7 billion of long-term debt. The company’s December 31, 2022, SEC PV-10 asset value was $22.2 billion.

Positive and Negative Risks

Potential investors should consider their oil and natural gas price expectations as the factors most likely to affect Marathon Oil. While the Eagle Ford is prolific and sizable, its reserves are also smaller (and more gas-prone) than those in the Permian. It is possible Marathon will not realize synergies from its Ensign acquisition or may have overpaid for it.

The Bakken Tier 1 oil core is smaller than the Permian.

There is US political risk as the Biden administration continues anti-US-hydrocarbon policies.

Equatorial Guinea depends on oil and gas production for its GDP and fiscal revenues: it and Marathon Oil are incentivized to keep volumes flowing.

Recommendations for Marathon Oil

I am changing my recommendation for Marathon Oil from buy to hold. Its shareholder return program is not competitive, and its capital appreciation prospects don't make up for that lack. While all companies with natural gas are likely to see lower reserve values at year-end 2023 compared to year-end 2022, Marathon specifically may have overpaid for its $3 billion gas-focused Ensign acquisition, made during a period of abnormally high gas prices.