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Marathon Petroleum Completes Speedway Sale, Begins Repurchase ProgramMarathon Petroleum Completes Speedway Sale, Begins Repurchase Program Allen Good Sector Strategist Business Strategy and Outlook | by Allen Good Updated Aug 19, 2021 The combination of Marathon and Andeavor created the U.S.' largest refiner with facilities in the Midcontinent, Gulf Coast, and West Coast. Through the combination, Marathon planned to leverage this geographically diverse footprint to optimize its crude supply from North America to reduce feedstock cost, while also improving its operating cost structure. It delivered $1.1 billion of a planned $1.4 billion in synergies by year-end 2019, but its focus shifted to capital and cost reductions in 2020 when the pandemic hit. These efforts proved successful with the company delivering over $1 billion in operating expense reductions. In the near term, its focus remains on delivering more cost and capital improvements. It also reassessed its portfolio, resulting in the closure of its poorly positioned Gallup, NM and Martinez, CA, petroleum refineries, both acquired with Andeavor. Martinez will likely be converted to a renewable diesel production facility, as it did with its small Dickinson, ND, facility. In May 2021, it completed the sale of its Speedway segment for $17.2 billion after tax, a valuation, which represented a good deal for shareholders and premium to publicly traded peers. The sale also released value for shareholders as the embedded value of Speedway was well below that level. Proceeds are set for strengthening the balance sheet and returning capital to shareholders. With the sale, Marathon will no longer be a fully integrated refiner, but it is not a pure play refiner either as midstream operations, held largely through its MLP MPLX, comprise a greater share of earnings than refining. Although the segment delivers steadier earnings that are less susceptible to commodity price volatility, it is not immune from the impact of the pandemic. Growth has slowed in the near term as MPLX looks to reduce spending to protect its balance sheet. Long term, investment and growth will be focused on gathering and processing assets with plans to create an integrated Permian network ranging from gathering and processing assets to export terminals. However, the viability of these investments remain reliant on a commodity price recovery to drive an increase in drilling activity. Economic Moat | by Allen Good Updated Aug 19, 2021 We have downgraded our economic moat rating for Marathon Petroleum to none from narrow. The revision to our moat rating is due in part to the company’s inability to consistently deliver returns on capital in excess of its cost of capital during the last five years. Also, while we forecast it to deliver excess returns in the later years of our forecast when refining market conditions normalize, the magnitude of excess returns is relatively small, leaving us with insufficient confidence to award a narrow moat given the volatility of the refining business. We also believe the addition of Andeavor’s portfolio has diluted Marathon Petroleum’s competitive position somewhat, evident in part by recent impairment charges. After the Andeavor acquisition, Marathon Petroleum holds a larger, more geographically diverse portfolio with high-complexity facilities in the midcontinent, West Coast, and Gulf Coast. However, we view Andeavor’s collection of refineries as lower quality than Marathon’s and as such is slightly dilutive to portfolio quality. As an example, Marathon recently decided to shutter its Gallup, New Mexico, and Martinez, California, refineries, both acquired through Andeavor. That said, Marathon still possess a relatively high-quality portfolio of refineries with an overall complexity rating of 10.8, including Andeavor's assets, on par with peers. With the addition of Andeavor’s West Coast refineries, particularly California, however, Marathon no longer has a midcontinent and Gulf Coast-focused portfolio where crude flexibility and availability of discounts are greater, costs lower and exports possible. High-complexity refineries like Galveston Bay and Garyville on the Gulf Coast (38% of capacity) possess flexibility to run domestic or imported, light or heavy crudes, based on which offers the greatest discount. The addition of new pipeline capacity to the Gulf Coast should give Marathon greater access to discount light domestic and Canadian heavy crude. Meanwhile, smaller inland refineries (38% of capacity) scattered throughout the midcontinent can capture transportation discounts associated with domestic light tight oil production due to their proximity to producing basins in Texas and North Dakota. We expect Marathon to extend its crude advantage, as a key element of its strategy is to integrate its refineries and invest in assets to increase throughput of advantaged feedstocks from Canada, the Permian, and the Bakken while investing in upgrading capability and conversion capacity. We see less opportunity to capture crude discounts on its West Coast refineries which now constitute nearly 20% of its refining capacity, given little access to domestically produced light crude. Its California refinery is high complexity and can process lower quality, discount crudes, but they also incur higher costs to do so, leaving net margins unaffected. As such, we view Marathon’s greatest competitive advantage, the ability to capitalize on a variety of discount crude streams, as weakened after the Andeavor acquisition. We do not see any change to Marathon’s cost advantage stemming from the benefit of low long-term natural gas prices. While other U.S. refiners realize a similar benefit, refining is a global business and large export markets mean Marathon is in constant competition with foreign refineries for market share. Depending on the spread between domestic and global natural gas prices, U.S. refiners can realize a cost advantage of $1-2/bbl compared with European and Asian refineries. This helps keep U.S. refiners like Marathon near the bottom of the global cost curve. That said, that spread has compressed in the last year as global gas prices fall toward U.S. levels given oversupply, somewhat negating the advantage for U.S. refiners. Our midcycle price assumptions, however, imply a persistent advantage for U.S. refiners. Marathon has improved its cost position in the past year, however, by reducing its operating cost so that's its closer to narrow-moat peers. Part of the progress is due to the low-quality refinery closures, but also in part due to its own cost-reduction efforts. It plans additional progress, which could potentially lift returns and result in a revision to the no moat rating. It is also investing in renewable diesel through conversions of its Dickinson, North Dakota and Martinez, California facilities. If Marathon is able to carve out a cost advantage with this new segment, it could be accretive to its moat. We do not have any evidence it has yet though. Marathon's MLP, MPLX, holds a narrow-moat rating, demonstrating the quality of its midstream assets. The large size relative to other refiners’ MLPs is a key differentiator while the strong returns generated by MPLX lift Marathon’s overall consolidated returns on capital. While we think the midstream segment is a moatworthy businesses, the contribution of each segment’s returns is not enough to push total firm returns to a level where we are comfortable awarding a narrow moat. Over time, if this segment becomes a larger portion of the firm or if Marathon’s profit improvement plans including integrating Andeavor’s refining system pay off, we would reconsider our moat rating. We have incorporated ESG risk into our moat evaluation, but no risk is material or probable enough within the next 10 years to influence our moat rating. A carbon tax is likely to be implemented and will likely impact demand, but not in the near term. Marathon discloses its GHG emissions and carbon intensity and has set a target to reduce its GHG emissions per barrel by 30% below 2014 levels by 2030. Marathon’s investment in renewable diesel addresses potential petroleum product demand destruction while reducing its carbon intensity. It also diversifies its output and protects against RIN purchase obligation costs. The company recently completed conversion of its North Dakota refinery into a 184 million gallon per year renewable diesel facility. It also plans to convert its Martinez, CA, refinery with potential to produce 730 million gallons annually by the end of 2023. Investments in renewable diesel can deliver high rates of return given growing governmental blending mandates and financial support through blending credits. Fair Value and Profit Drivers | by Allen Good Updated Aug 19, 2021 We are increasing our fair value estimate to $65 from $60 per share after updating our near-term margin forecast with the latest market crack spreads and incorporating the retail segment sale, management's guidance, and the latest financial results. Our fair value estimate is derived from a discounted cash flow analysis of the individual segments and incorporation of after-tax proceeds for Speedway. Ownership stakes in MPLX is valued separately. Our fair value estimate reflects our updated refining margin deck, in which we incorporate our long-term outlook for crude differentials. Our long-term outlook for the West Texas Intermediate/Brent differential is $5 and the Light Louisiana Sweet/Brent differential is $1. We assume long-term Gulf Coast refining margins of $14 and adjust capture rates to reflect asset quality and investment. Though the margin strength in the midcontinent has been volatile, our expectations for midcycle differentials are wider than historical averages (prior to 2010). We expect stronger margins in the Gulf Coast region in the later years of our forecast, as we anticipate that the region will see improved crude discounts with greater supply of domestic and Canadian crude. We project per-barrel operating costs to improve slightly as natural gas prices remain low and management cost reduction efforts take hold. Given the amount of operating leverage in a refiner, our valuation is highly dependent on our refining margin assumptions. A significant improvement or deterioration in crack spreads could result in significant upside or downside to our valuation. Crack spreads have improved in recent months, , but they remain volatile given the uncertain outlook for product demand in light of the coronavirus pandemic and potential for higher supply from increased utilization and greater imports. Risk and Uncertainty | by Allen Good Updated Aug 19, 2021 Based on our scenario analysis, we assign Marathon Petroleum a very high uncertainty rating. Success in refining is primarily a function of the difference in the amount the refiner pays for oil and the amount at which it sells the refined product. As such, the short- and long-term risks depend on movements in the prices of crude oil and gasoline or diesel which can be volatile. Most notable is the fluctuation during the last five years in the domestic crude discounts that benefit Marathon. Supply interruptions or increased demand that drive up oil prices as well as demand destruction or economic slowdowns that depress refined product prices are the primary risks. Any extended turnaround or shutdown because of an accident or weather could also damage financial performance. With greater reliance on the export market, construction of overseas refiners could pose a threat. In the long term, electric vehicle adoption, autonomous vehicles, and ride-sharing present challenges to demand for Marathon's primary products. We have also incorporated ESG risks into our uncertainty rating, but they are not material or probable enough to alter the scenario analysis derived very high rating. Marathon’s primary ESG risk is the implantation of a carbon tax on the emissions associated with its operations and products. A carbon tax would likely increase the final price of refined products as emission costs would likely be borne by consumers. While we expect a carbon tax to eventually be implemented, the negative impact on product demand would likely take time. Meanwhile, Marathon is aiming to reduce its operated emissions, which should lower its costs over time. Marathon also holds the risk of an oil or product spills or emissions from its refineries. While this is likely to occur, we expect the amounts to be small and any financial penalties to be manageable. Capital Allocation | by Allen Good Updated Jan 18, 2021 Based on our capital allocation framework which evaluates the soundness of the balance sheet, investment strategy and appropriateness of shareholder distributions, Marathon Petroleum earns a Standard rating. Although Marathon’s business has a high amount of operating leverage as well as revenue cyclicality, management operates with manageable levels of debt that retains flexibility in times of market weakness. Furthermore, management’s priority remains maintaining a healthy balance sheet evident in its decision to apply proceeds from the Speedway sale toward debt reduction. Given this likely reduction in leverage levels, Marathons rates as having a sound balance sheet in our framework. Marathon also scores a fair rating for its investment strategy. It recently focused on integrating its operations with Andeavor’s, but has begun to turn toward reducing operating and capital costs given the weak market environment. Combined with refinery closures and conversions to renewable fuels, this should leave it in a better competitive position. However, both the recently closed refineries were part of Andeavor, which along with impairment charges, indicate the acquisition is not fulfilling management’s expectations at the time of the deal. Future investments in refining are likely to focus on increasing discount crude processing, improving yields and lowering costs as its peers are doing. Growth will likely continue to focus on midstream investment in the Permian through MPLX, but that depends in a large part on a recovery of crude oil prices. Finally, we see Marathon’s shareholder distribution policy as appropriate given the volatility of the refining business. Previously it committed to returning 50% of operating cash flow through dividends and share repurchases. Given the decline in refining margins and the Speedway transaction, actual returns will deviate from this policy. However, we expect management to return to its long-term plans. Although without Speedway, this will likely result in lower absolute levels of returns as is warranted given the new business structure and cash flow potential. A set payout ratio means higher absolute payouts when market conditions are favorable and stock prices likely high, implying value-destructive repurchases. However, historically, repurchases have occurred below or near our fair value at the time with about 90% of total share repurchases over the last 10 years occurring at a price/fair value of 1.0 or less. |
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