Facing upstream - Is the crisis for oil & gas the new normal? Marathon Petroleum Corporation

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Goran Đukić's picture

Introduction

Oil prices continue to drop in 2015 as Brent crude fell from last year's July $116 per barrel to around $56 in July 2015. One of the key factors is oversupply of oil market as OPEC continue to push daily productions to record levels at 32 million bpd and US is producing near the fastest rate in last decades at 9.4 million bpd. Iran sanctions might be lifted so Iranian crude exports will return at 4 million bpd, what could further impact over-supply of market. Demand for crude isn't picking up, due to slowing growth of Emerging countries and global economy.

China is shifting its Economy to be more service oriented to lower pollution and also Chinese demand for oil is shrinking due to lower YoY GDP growth from 12% in 2010 to 7% in 2015.

U.S. Energy Information Administration (EIA) data published in June 2015 shows that global petroleum oversupply, has more than doubled to 2.6 million bpd since the end of the second quarter last year and in same report EIA expects oil oversupply to last to year 2017. Also other analysts expect this oversupply of oil market to hold for several years as major oil consumers are becoming less reliable to oil and switching to other alternatives.          

On chart white line presents OPEC daily crude output while yellow one presents price of generic Brent crude futures. We can analyze OPEC behavior and conclude that they used to drop their daily production when Brent crude oil prices drop and vice versa. But as last green arrow is showing in year 2014 is first time in recent history that OPEC increased their daily production even though oil prices fell, and Saudis announced recently, they are willing to increase output further.

Before I decide to pick current undervalued company in Oil industry it is important to check what is current consensus for future oil price.

In Bloomberg screen are reflected current analyst forecasts and number in first row presents current forward price and numbers in row below present median forecasts of analysts. Analysts expect oil futures contracts to increase in following years, for example WTI at 71$/bbl in 2017 and BRENT at $75/bbl, what is higher than $10/bbl compared to current forward rates.

I find most promising sector US oil refining & marketing, as crack spread between crude oil, which is cost input and gasoline price which is source of revenue is high and it will remain so.

In this chart, spread was highest in period of 2012-2013 and it was lowest 2014 but picked up again in 2015 as gasoline demand widens crack spreads together with lower WTI price and this trend should continue. Consequence of higher crack spreads are also higher refinery utilization rates, as there is enough demand for gasoline and inventories are getting low.

Among US oil refining companies I would pick Marathon Petroleum and it is ranked number 1 among largest US energy companies on HOLT Lens platform.              

 

Marathon Petroleum

Marathon Petroleum Corporation (MPC) is involved in Refining & Marketing, which refines crude oil; Speedway, which sells transportation fuels in the retail market and Pipeline Transportation, which transports crude oil to its refineries. Let’s now analyze MPC historical performance with relative wealth chart together with sales, margins & turns chart.

From 2009-2010 company was struggling and CFROI level has been below discount rate, but over the last four years, MPC has been able to improve CFROI levels above the discount rate due to higher sales growth, EBITDA margins and asset turns.

In 2012 MPC showcased strongest performance with 13.06% CFROI level compared to 5.21% discount level, what was also highest spread based on available data. Strong CFROI rate was met with highest HOLT adjusted operating margin at 8.19% and also strong asset growth at 11%, but the problem occurred with lower sales growth at that period only 4.09% that is why company couldn’t continue with strong performance next year.    

2013 CFROI fell to 9.57% while discount rate was 4.22% what makes almost 3% lower spread than previous year, and CFROI declined as HOLT operating margin (5.13%) declined to offset improving asset turns (2.81) and also negative asset growth (-0.97%) had impact on company. This trend quickly reversed in 2014 as CFROI increased to 10.33% with discount rate at 4.57% what makes spread slightly better than previous year but far from peak in 2012. 2014 performance was due to improved HOLT operating margin (5.93%) even though sales growth (5.63%) was weak that year, but the assets grew at 7.55% for company and asset turns slightly declined to 2.72.

To sum it up, company stock price has outperformed S&P 500 index in period of 2011-2015 for almost 102%, but to continue with such strong performance, future downside risks for company should be neutralized and current company operation improved. In last several years biggest problem has been high volatility of sales growth from 2011 high of 40% to 2013 low of 4% but improved margins offset that problem with increased asset turns which are steady around 2.7 last few years. Because of the complexity of oil market and increased competition in oil refining industry, company CFROI levels and margins will be even pressured more in future, that is why market expects pattern of maturing company to occur with steady decline in CFROI level, margins and asset growth in following years and that present t+5 market implied green dot on charts of CFROI (4.62%)  and asset growth (1.27%).  

Comparison with peers

According to HOLT scorecard percentiles which are reflects in table above and top 6 companies in peer group are presented, MPC has highest overall Percentile of 100 what makes it best in class investment on 2nd place is Valero Energy with 99. MPC also scores well in Momentum Percentile 99 and Valuation Percentile 95, where is Valero slightly better with 96. Marathon is slightly weaker in operational quality percentile with 76, but still better than top 6 competitors.  

In charts below are presented CFROI, Adj. Operating Margins, Asset Turns and Sales growth in last Fiscal year.

MPC is at top place compared to peers at CFROI LFY with 1.83% higher than closest competitor Valero and more than 5% higher than median. MPC is also leading at asset turns, but has slight advantage over Valero and Phillips 66, on the other hand it is higher for 2 points over median what is high competitive advantage over other peers. MPC is weakest in Adj. operating margins almost 35% below median, but closest competitor Valero is at similar level, but nevertheless company should increase margins if it wants to keep high CFROI level and maintain competitive advantage over peers. Sales growth are 5% below median, while some of peers had negative sales growth like Valero energy, anyway MPC should increase sales above median level.

Flex valuation

To support my initial claim that MPC is undervalued company, I will use FLEX valuation               3 driver model and output is shown below.

For sales growth, EBITDA % and Asset Turns are used 3 Year median numbers and numbers are reflected in output above as company, should be able to maintain CFROI around 10.3% in future what makes warranted price at $86.62 and 54% upside potential what is above analysts' consensus range of $65- $75.  

Company is selling petroleum especially in mid-coast US, which market is different than west coast or east coast, so MPC will be able to maintain operating refining margin of $5.5/ barrel. Very important thing is also Utilization rate, which should increase from 95% in 2014 to at least 97% in following years. Revenues might fall down in future, due to less car mileage of Americans or whether consumers decide to use alternatives like electric cars, nevertheless MPC COGS also lowers what makes EBIT similar to high revenue period.   

Upside/Downside risks

Upside/Downside primary risks to warranted price could be increased clarity that the US crude export ban will (not be/be) lifted, what is currently ongoing issue in US congress as oil producers are lobbying to lift the ban so they can sell oil international and on oil consumers are lobbying against lift.

Gulf Coast crude spreads or so called crack spreads (widen/ narrow) versus international markets and also Mid-Continent crude spreads (widen/tighten) versus other markets.

MPC recently acquired MarkWest for $20 billion to get involved in natural gas industry.  Cash flows and earnings from MarkWest transaction (outperform/underperform) expectations.

Summary  

My investment advice would be to invest in MPC as currently one of the most undervalued companies in the oil industry. MPC will be able to maintain a high CFROI level in the future, due to increased crack spreads if WTI oil price continues to remain in the $45- $55 range, and this makes it a better stock pick than for example investing in crude oil producers or some small cap oil exploration companies. MPC has also a strong balance sheet and operating performance, but investors should consider all downside risks and the high complexity of oil industry.   

References: 

HOLT Lens, Bloomberg Terminal and MPC Annual report

Comments

Great overview of the oil industry and the macro headwinds facing it. I am wondering what assumptions you are using in keeping the revenue growth numbers at the 3-year average, is that sustainable over the next five years?