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Marathon Rounds Out Stellar 2021--Expect 2022 to Be More of the SameMorningstar's AnalysisMarathon Rounds Out Stellar 2021--Expect 2022 to Be More of the Same Dave Meats Director Analyst Note | by Dave Meats Updated Mar 16, 2022 After a second look at Marathon's fourth-quarter operating and financial results we have increased our fair value estimate to $22 per share (from $20). This incorporates a higher cost of capital for the firm, which is appropriate given the capital structure is now heavily weighted to equity after a period of intense deleveraging (net debt/EBITDA has fallen from over 3 times to under 1 times in the past five quarters). However, the higher discount rate was more than offset by the surging outlook for near-term commodity prices, related to the crisis in Ukraine. As a reminder, the firm comfortably met financial and production targets in the fourth quarter and anticipates more of the same in the new year. The firm announced a 2022 capital budget of $1.2 billion (compared with $1.05 billion spent in 2021). We estimate that includes well cost inflation of about 15%, reflecting the frothy environment for labor, steel, and fuel. That should keep production roughly flat through the year. The company is taking a passive approach and sitting tight in the backdrop of high prices, rather than deploying excess capital in a bid to take advantage of near-term pricing. This is consistent with the trend across the upstream space. And shareholders have reacted well to the strategy--Marathon's stock has more than doubled year over year and was the second-best performer in the S&P 500 (behind shale peer Devon). The firm's capital return framework, unveiled previously, has much in common with those of peers, but is different in one respect: the firm aims to return a minimum percentage (40%) of operating cash to shareholders (as opposed to free cash). Theoretically, this prioritizes shareholder returns ahead of capital spending. Leaning on buybacks for these distributions raises the risk that the firm will disproportionately buy stock during upcycles, when it has more surplus cash. But as the stock is currently fairly valued we do not anticipate substantial dilution right now. Business Strategy and Outlook | by Dave Meats Updated Mar 16, 2022 Marathon has comprehensively reshuffled its portfolio in the past five to 10 years, discarding most of 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. or returned to shareholders. 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. Management will need to continue improving the firm's capital efficiency to preserve its margins when it starts running out of top-tier drilling opportunities. Fortunately, the firm isn't in a hurry to burn through its best inventory. Like many shale firms, it has been prioritizing shareholder distributions rather than production growth. But what's unusual about Marathon's capital return framework is the emphasis on distributing a portion of its operating cash, rather than free cash (which theoretically prioritizes shareholder returns ahead of capital spending). However, to deliver these returns the firm supplements its modest base dividend with buybacks, rather than variable dividends. As it will have cash to distribute during upcycles, this strategy risks disproportionate share repurchases during upcycles, when the price is probably least favorable. Economic Moat | by Dave Meats Updated Mar 16, 2022 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 been active only 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 Meats Updated Mar 16, 2022 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 2022 and 2023 will average $104/bbl and $89/bbl, respectively. In the same periods natural gas (Henry Hub) prices are expected to average $4.90/mcf and $4.10/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas). Based on this methodology our fair value estimate is $22 per share. This corresponds to enterprise value/EBITDA multiples of 4.8 times and 5.4 times for 2022 and 2023, respectively. Our production forecast for 2022 is 350 mboe/d, which is consistent with recent guidance. That drives 2022 EBITDA to $5.8 billion, and we expect cash flow per share to reach $6.50 in the same period. Our 2023 estimates for production, EBITDA and cash flow per share are 358 mboe/d, $3.7 billion, and $5.72, respectively. Risk and Uncertainty | by Dave Meats Updated Mar 16, 2022 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. Capital Allocation | by Dave Meats Updated Mar 16, 2022 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 impressive 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 (no more than 70% at $50-$60/bbl, and even less in upcycles). We think distributions are about right. The base dividend was cut during the COVID-19-related downturn in 2020, but was reinstated in the fourth quarter when there was better line of sight to higher demand. It was subsequently lifted several times, and the firm now supplements it with buybacks to deliver competitive overall returns. We applaud the firm for committing to these distributions instead of ploughing more cash into new drilling. However, we caution that systematically repurchasing shares during upcycles, when the firm has more cash to distribute, risks disproportionally buying back stock at elevated prices. |
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