Marathon Oil: A Strong Balance Might Not Be Enough

by

Summary

Marathon Oil (MRO) will likely report bigger losses in the coming quarters as compared to Q1-2020 due to weak oil prices and declining production. The company might face a cash flow deficit this year but it has ample liquidity and an under-levered balance sheet that can help fund the shortfall. The Houston, Texas-based oil producer can stand firm in the downturn. But Marathon Oil's peers might deliver a better performance in this period.

https://static.seekingalpha.com/uploads/2020/5/6100251_15906095667909_rId4_thumb.jpg

Image courtesy of Pixabay

The ongoing weak and volatile oil price environment has darkened the outlook for oil producers, including Marathon Oil. In early-2020, when WTI was still hovering close to $50 per barrel, I wrote that Marathon Oil could deliver profits and strong levels of free cash flows this year while growing oil production. Since then, however, the US oil futures fell to below $30 per barrel in March and into the negative territory in April. It has since recovered to $32 at the time of this writing but the price is still a long way off from more than $60 at the start of the year. The US Energy Information Administration now expects WTI to average just around $30 per barrel in 2020, down from $57.02 in 2019. This weakness in oil prices has pretty much thrown all of the future growth, profits, and free cash flow predictions out the window. The company has already started to feel the pinch from the sharp drop in oil prices, as evident from its latest quarterly results, and it is going to get worse in the future.

Note that some oil producers ended the first quarter on a strong note and are now entering the downturn from a position of strength. Pioneer Natural Resources (PXD), for instance, reported better-than-expected profits and $100 million of free cash flows for the first quarter. Marathon Oil, on the other hand, is entering this challenging period after reporting a greater-than-expected loss.

Earlier this month, Marathon Oil released its financial results for the first quarter in which the company posted an adjusted loss of $0.16 per share, down from a profit of $0.31 per share a year earlier. The loss was higher than the analysts' consensus estimate of $0.14 per share and was driven by large drops in realized prices of crude oil, natural gas, and NGL which fell by 18%, 45%, and 36% respectively on a year-over-year basis. The company produced a total of 340,000 boe per day in the first quarter, including oil production of 207,000 bpd, depicting growth rates of 15% and 17% respectively. The company posted an across the board increase in oil output from all US onshore plays. Its production, however, will decline in the coming quarters.

Previously, I wrote that Marathon Oil's production could decline in 2020 as it cuts CapEx and curtails drilling activity, including suspension of all drilling work in some key areas. The company has now confirmed its total production on an oil-equivalent basis as well as its crude oil output from the US will decline by roughly 8% this year. The company suspended all well completion activity for the second quarter due to the plunge in oil prices. Nearly all of the company's capital activity has been earmarked for the Eagle Ford and Bakken areas. The company has halted the Resource Play Exploration program and nearly all drilling, completion, and exploration work in Oklahoma and Northern Delaware regions.

Marathon Oil's production, therefore, will fall meaningfully in the coming quarters as compared to FY-2019 and Q1-2020 as the impact of the reduction in drilling activity starts to kick in. At the same time, Marathon Oil will also realize much lower levels of oil prices as compared to $44.23 per barrel for Q1-2020 and $55.80 for FY-2019. The drop in production and weak levels of realized oil prices is going to push the company's earnings lower in the coming quarters. This means Marathon Oil will likely report higher levels of losses in the future as compared to Q1-2020.

Marathon Oil also burned cash flows in the first quarter. The company generated $550 million of cash flows, ahead of changes in working capital, which weren't enough to fund all of the capital expenditures of $579 million. From this, we can see the company faced a cash flow shortfall of $29 million ($550M-$579M). Marathon Oil could report a cash flow deficit for the full year as well, although I don't expect the shortfall to be significant (just as long as oil prices don't drop drastically in H2-2020).

That's because firstly, Marathon Oil has cut its capital budget for this year which will help reduce the cash outflows as capital expenditures in the coming quarters. The company now expects to spend $1.3 billion in 2020 as capital expenditures, down from its original forecast of $2.4 billion. Since the company has already spent around 45% (or $579M) of this budgeted amount in the first quarter, I expect the CapEx to drop significantly in the remaining quarters of 2020.

Secondly, although Marathon Oil's cash inflows from operations will likely decline in the future due to the weakness in oil prices, it will get some support from the enhanced crude oil hedges. The company's hedge coverage originally consisted of three-way collars which offered limited downside protection in an oil price environment of less than $48 a barrel. But as oil prices began to crash, Marathon Oil scrambled to expand its hedge coverage using fixed price swaps and two-way collars which offer better downside protection than the three-way collars. For Q2-2020, Marathon Oil has hedged 40,000 bpd of oil production using two-way collars with a ceiling of $40.31 per barrel and a floor of $32.89 and 76,703 bpd of volumes using swaps at a weighted average price of approximately $29 per barrel.

Furthermore, Marathon Oil has also used basis swaps to cover a large portion of its future oil output for the remainder of 2020 to protect its cash flows against the risk of any negative movements in in-basin price differentials.

But what I don't like about Marathon Oil is that it still offers little downside protection for the full year. Marathon Oil's enhanced hedges (swaps and two-way collars) offer little coverage for H2-2020 volumes. The company has hedged just 10,000 bpd of oil production for Q3-2020 using swaps at an average of $32.77 per barrel and hasn't hedged any volumes using swaps or two-way collars for Q4-2020.

Fortunately, the oil price environment has already improved, with WTI rising to the $30s a barrel range. If oil continues to climb, then a lack of hedges will allow the company to participate fully in this rally. Besides, the management has said that for the second half of the year, Marathon Oil can balance cash flows with oil "in the low $30 per barrel range." This implies if oil prices increase to $35 to $40 a barrel in H2-2020, then the company can post modest levels of free cash flows for this period. Although if Marathon Oil posts a cash flow deficit for the second quarter then it might still report negative free cash flows for the full year.

If, however, instead of recovering, the oil prices come under pressure and drop below $30 per barrel in the second half of the year, then Marathon Oil could face a major cash-flow deficit. In this case, the company's cash flow from operations, which will be fully exposed to the oil price weakness, will drop sharply. This can adversely impact Marathon Oil stock.

The good thing, however, is that Marathon Oil is in decent financial health and can use its robust liquidity to fund a cash flow shortfall. The company had $3.8 billion of liquidity at the end of the first quarter, consisting of $817 million of cash reserves and $3 billion available under the revolving credit facility. The company also benefits from having below-average levels of debt with no significant maturities until November 2022. The company had $5.5 billion of long-term debt which translates into a debt-to-equity ratio of 46% which is below the large-cap peer median of 52%, as per my calculation.

In my view, Marathon Oil can withstand the downturn. But some other oil who are in an even better position to do the same. Pioneer Natural Resources, for instance, has a stronger balance sheet marked by lower levels of debt, offers a superior hedge coverage, and is more likely to generate free cash flows in 2020 than Marathon Oil, as I've discussed in my previous article. Companies such as Pioneer and Devon Energy (DVN) have hedged a vast majority of their estimated oil production for Q2-Q4-2020 and can now live within cash flows. Therefore, Marathon Oil will likely generate weaker levels of cash flows than some of its well-hedged peers in the future if oil prices come under pressure.

On top of this, companies like Pioneer Natural Resources expect to hold their oil production flat in 2020 as compared to last year, which is something Marathon Oil is unable to do. As indicated earlier, Marathon Oil might balance cash flows in H2-2020 at low-$30s per barrel oil but it can only do that with its annual output dropping by 8%. Consequently, due to the weak levels of cash flows and production, Marathon Oil's shares might underperform.

Shares of Marathon Oil have fallen by 48% in the last six months, underperforming its exploration and production peers (XOP) whose shares dropped by 33% in the same period. The company's shares are now trading around 6.7x on an EV/EBITDA multiple, below sector median of 7.9x and large-cap peer-median of 8.2x, as per data from Seeking Alpha Essential. Although Marathon Oil looks undervalued, I think investors should play defense during the ongoing weak and volatile oil price environment by focusing on buying those oil producers which not only have a great asset base and a rock-solid balance sheet but their future cash flows are also protected by hedges. In my view, investors should avoid Marathon Oil stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.