Houthi Attack Has No Impact on Crude Supply, but Geopolitical Tensions Remain
Houthi Attack Has No Impact on Crude Supply, but Geopolitical Tensions Remain
Analyst Note| by Dave MeatsUpdated Mar 08, 2021
Brent crude retreated after initially jumping above $70 per barrel on March 8 following the news that Saudi Arabian oil facilities were attacked in a drone strike organized by Houthi militants. This parallels an earlier attack on Saudi oil infrastructure at Abqaiq in September 2019. The Houthi movement in Yemen claimed responsibility for that event as well, which knocked out approximately 1 million barrels per day for the month (roughly 1% of global supply).
The latest attack is not expected to affect supply at all. The short duration of the spike in prices reflects the apparent lack of damage, consistent with comments from the Saudi Arabia Ministry of Energy. Nevertheless, the event is a useful reminder that political instability in the Middle East can significantly affect crude supply. As the ongoing conflict in Yemen is widely seen as a proxy war between Iran and Saudi Arabia, the attack on Saudi Arabia could affect the prospects of thawing U.S.-Iran relations. The Trump administration withdrew from the Iranian nuclear deal and levied sanctions that have effectively choked off about 2 million barrels per day of Iranian exports since late 2018. The Biden administration has maintained the sanctions but appears more open to negotiation. About a month ago, the president formally stopped designating the Houthis as a global terrorist organization, so the movement's involvement in this attack could stall negotiations further.
Business Strategy and Outlook| by Dave MeatsUpdated Mar 05, 2021
Marathon has comprehensively reshuffled its portfolio in the past five to 10 years, discarding most the conventional projects it historically focused on and doubling down on U.S. shale. The international assets it has retained, in Equatorial Guinea, will be harvested for cash flows that can be redeployed in the U.S.
The firm has a dominant position in the Bakken and Eagle Ford plays, which together comprise over half of its current production. In both plays it has substantial acreage in the "sweet spots," which are characterized by exceptionally strong initial production rates. Marathon's Karnes County Eagle Ford wells typically yield far more resources than the basin average in the first year of production, and in the Myrmidon area in North Dakota the firm has drilled some of the best Bakken wells ever drilled. These eye-popping initial rates are offset by very high initial decline rates, but the overall economics are impressive nonetheless. But not all of the firm's acreage is located in these stand-out areas, and the rest isn't expected to perform at the same level.
Elsewhere, the firm is just getting started. It entered the Permian Basin in 2017, and is ramping quickly from a very low base of production. The position is fairly fragmented, limiting the scope for long-lateral development (though management is attempting to address this with acreage trades, bolt-on acquisitions, and acreage swaps). Well results thus far have been reasonably impressive, and are consistent with a West Texas Intermediate break-even level under $40 per barrel (comparable to, but not significantly better than, what other Permian producers typically achieve). The Oklahoma portion of the portfolio could have similar potential, but this is more speculative--the firm's drilling results to date have been middling, and the natural gas weighting and high cost of development have been weighing on its potential returns there. Activity in both of these areas has been dialed back to a minimum since the 2020 downturn in crude prices.
Economic Moat| by Dave MeatsUpdated Mar 05, 2021
To justify a moat rating we look for strong returns on invested capital, which are likely to elude Marathon in the next few years. Although the company is now targeting low-cost unconventional resources, it has historically concentrated on resources much higher on the global cost curve. The capital sunk on these ventures still weighs on returns at the corporate level. Additionally, the firm was a relatively late entrant to the shale arena and paid handsomely for its assets as a result (most notably in the Permian, where it has only been active since 2017).
By itself, the unconventional side of the portfolio is capable of generating strong returns and could justify a moat if prior spending on nonshale assets were to be ignored. It has locked up some of the juiciest acreage in the Bakken and Eagle Ford Shale plays and enjoys exceptional average initial rates from its wells in both regions. However, these wells also decline more quickly than the norm, diluting the advantage slightly. And not all of its acreage is located in these so-called sweet spots. The rest yields more pedestrian flow rates, which translates to weaker margins and higher break-evens. Meanwhile, the firm's other acreage—in the Permian and Oklahoma SCOOP/STACK areas—shows some promise but well results thus far do not suggest the firm can consistently outperform competitors.
In addition, the firm’s exposure to potential environmental, social, and governance issues could further weaken its ability to earn economic profits. For E&P firms, the most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills).
Greenhouse gas emissions are unavoidable for oil producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes being released into the atmosphere during the extraction process. Marathon has reported significant progress in recent years and is targeting further improvement (with the goal of reducing emissions by 50% by 2025, relative to 2019 levels). However, downstream emissions—at the refinery and beyond—are beyond producers' control. Yet these account for the vast majority of total emissions. So, there's really no such thing as a green oil producer. As consumers get more averse to fossil fuels, the reputational risk grows for producers and the probability of widespread substitution away from fossil fuels increases. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base forecasts, but as the impact would be material, it does further erode the firm’s moat potential.
On the other hand, spills are not a major concern for firms primarily operating onshore, like Marathon. There is very little chance of a devastating accident like the BP Macondo disaster in 2010. Nor would the firm be on the hook for adverse events during long-haul transit, like the Kalamazoo River (Michigan) spill, which also occurred in 2010. This activity is typically outsourced to midstream firms that operate regional pipelines. Instead, Marathon is more vulnerable to spills at or around the wellsite. These tend to be frequent, but relatively minor. Significant legal challenges are unlikely for this kind of event, and we see little chance of significant value destruction. However, Marathon reported 800 events in 2019 alone in its sustainability report, which is above average for the industry.
Fair Value and Profit Drivers| by Dave MeatsUpdated Mar 05, 2021
Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single-well basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with a hyperbolic decline rate assumption. Our valuation also includes the mark-to-market present value of the company’s hedging program. We assume oil (WTI) prices in 2021 and 2022 will average $57/bbl and $54/bbl, respectively. In the same periods natural gas (Henry Hub) prices are expected to average $3.10/mcf and $2.80/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $2.80/mcf natural gas).
Based on this methodology our fair value estimate is $12 per share. This corresponds to enterprise value/EBITDA multiples of 5.6 times and 5.7 times for 2021 and 2022, respectively. Our production forecast for 2021 is 338 mboe/d, which is consistent with recent guidance. That drives 2021 EBITDA to $2.6 billion, and we expect cash flow per share to reach $2.93 in the same period. Our 2022 estimates for production, EBITDA and cash flow per share are 339 mboe/d, $2.5 billion, and $2.87, respectively.
Risk and Uncertainty| by Dave MeatsUpdated Mar 05, 2021
As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure this firm’s profitability, reduce cash flows, and drive up financial leverage. An increase to federal taxes, or a revocation of the intangible drilling deduction that U.S. firms enjoy, could also affect profitability and reduce our fair value estimates.
Material ESG exposures create additional risk for E&P investors. In this industry, the most significant exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills). In additional to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, drilling permit suspensions, and perhaps even direct taxes on carbon emissions.
Stewardship| by Dave MeatsUpdated Mar 05, 2021
CEO Lee Tillman’s track record at Marathon is fairly solid, despite several downturns in global crude prices that have occurred on his watch. So far he has largely followed his predecessor’s strategy of focusing on U.S. unconventionals. Noncore assets, including properties in Libya and the Canadian oil sands, were divested to fund this transition without further stressing the balance sheet.
Our Standard capital allocation rating reflects Marathon's lofty but improving financial leverage and fair investment strategy, which is unlikely to drive excess returns on invested capital but should enable the firm to keep generating substantial free cash flows. The firm only intends to reinvest a portion of its operating cash flows (50% at $50/bbl, in management's five-year benchmark scenario). We think distributions are about right. The base dividend was cut during the COVID-related downturn in 2020, but was reinstated in the fourth quarter when there was better line of sight to higher demand.