Marathon Oil Stock: A Top-Tier Oil Play And Potential M&A Target (NYSE:MRO)

Introduction

One of the things I discuss in almost every single oil and gas-focused article is the declining growth rates of U.S. shale production. After the Great Financial Crisis, the shale revolution in the U.S. caused the global oil supply to rise.

In 2007, the U.S. produced less than 1 million barrels of oil per day using unconventional drilling methods (horizontal drilling/shale). When the pandemic hit in 2020, that number was slightly above 8 million barrels per day!

Since then, that number has been unchanged.

This has a number of reasons. Among others:

• Oil companies are focusing on free cash flow instead of production to protect their balance sheets and prevent another oil price crash. After all, the pandemic and the 2015/2016 oil price crash were caused by lower demand hitting a wave of supply. So many smaller players went bankrupt. Especially in an environment where progressive politicians, corporations, and activists want to see oil and gas gone, producers want to be extra careful.
• Producers are running out of Tier One inventories, meaning producers are slowly but steadily dealing with oil and gas reserves that are more expensive to recover.

Even the only major oil basin in the United States that is still capable of growth, the Permian, is closing in on peak production.

This is what Goehring & Rozencwajg wrote earlier this year:

However, we know that geological depletion is clearly taking place and will likely get worse. Year-on year growth in the Permian appears to have peaked at 656,000 b/d in February and is already down to 480,000 b/d year-on-year in May. While the data may be lumpy, we expect this slowdown to continue and believe we may not see any year-on-year growth by the end of next year.

As a result, we’re seeing accelerating M&A activity.

• Exxon Mobil (XOM) is buying Pioneer Natural Resources (PXD) in an all-stock deal, becoming the largest shale player in the Permian.
• Chevron (CVX) is buying Hess (HES) in an all-stock deal.

Because of the XOM/PXD deal, I sold PXD and moved my money into Devon Energy (DVN), in a move that I explained in this article.

Now, rumors are heating up that DVN is about to expand its business through M&A.

In other words, it’s going from being an M&A target to becoming an M&A initiator: its potential goal is Marathon Oil (NYSE:MRO), a company that I have often called a buyback-focused version of DVN.

In this article, I’ll discuss the info we have so far and the reasons that make MRO such a fantastic stock, regardless of M&A chatter.

So, let’s get to it!

More M&A?

Roughly ten years ago, we had a massive trend of healthcare/biotech takeovers. Low rates and innovation demand caused companies to engage in multi-billion dollar deals.

Now, it’s energy that’s making headlines.

A few days ago, Bloomberg reported that Devon Energy is working on a major M&A deal, including Marathon and CrownRock, which is a private driller.

According to Bloomberg, Devon has engaged in initial discussions in recent months regarding a potential merger with Marathon Oil, insiders revealed, preferring to remain anonymous due to the confidential nature of the discussions.

This move is strategically sound, as both companies operate within a similar geographical footprint, focusing on several basins in the Midwestern U.S., particularly in Oklahoma, Texas, and New Mexico.

As we can see in the map above and the overview below, Marathon Oil’s portfolio primarily centers on its core operations in U.S. resource plays and Equatorial Guinea. In the U.S., their primary focus includes the following:

• Eagle Ford: The company has operated in the South Texas Eagle Ford play since 2011, with significant acreage in various Texas counties. They operate numerous gathering facilities and pipelines, supporting a substantial number of producing wells.
• Bakken: Marathon Oil has been involved in the Williston Basin since 2006, with a primary focus on McKenzie, Mountrail, and Dunn Counties in North Dakota.
• Oklahoma: The company’s history in Oklahoma dates back over a century, focusing on the STACK Meramec and SCOOP Woodford plays, with additional rights to various other prospects.
• Permian: Marathon Oil operates in the Northern Delaware Basin, primarily in Eddy and Lea counties in New Mexico, with a focus on the Wolfcamp and Bone Spring New Mexico plays.

This is what the production map of Devon Energy looks like:

In its international arena, Marathon Oil conducts oil and gas exploration, development, and production operations in Equatorial Guinea. Their activities include owning and operating a liquefied petroleum gas (“LPG”) processing plant and facilities for liquefied natural gas (“LNG”) and methanol production.

With that in mind, the company’s production doesn’t just align with Devon’s production, but the company also holds substantial reserves.

• Going into this year, the company had 1.3 billion barrels of oil equivalent in total proved reserves. 48% of this consists of crude oil and condensate. 23% consisted of natural gas liquids.
• This year, the company is expected to produce roughly 333 thousand barrels of oil equivalent per day. Roughly half of this is crude oil.
• This translates to a reserve life of roughly 11 years, excluding any new discoveries and current production rates.

Having said that, there’s more to it than overlapping assets and deep inventories.

What Makes MRO So Special

As I briefly mentioned, this article isn’t just aimed at explaining why DVN might buy MRO. In general, MRO is a fantastic oil play. So, even if M&A chatter doesn’t lead to anything, it won’t hurt the value MRO brings to the table.

In light of the aforementioned oil and gas production numbers, going into 2024, the company plans to maintain maintenance-level oil production, maximizing sustainable free cash flow, and prioritizing shareholder distributions and per-share growth (another example of a company prioritizing free cash flow over production growth)

They also expect to lead the peer group on key metrics in 2024, benefiting from potential market deflation and a significant financial uplift from increased exposure to the global LNG market.

One of the metrics that makes MRO look good versus its peers is the breakeven price the company needs to cover its costs. Excluding any dividends, MRO is breakeven close to $40 WTI. Next year, that number is expected to drop well below $40.

Thanks to its efficient business, the company has a rather aggressive capital spending plan. When oil prices are above $60, it aims to return at least 40% of its operating cash flow to shareholders, with room to potentially grow production by 5%.

In the second quarter of this year, the company generated $531 million of adjusted free cash flow and returned $434 million of capital to shareholders, representing a 10% increase in shareholder distributions compared to the first quarter.

They expect further improvement in financial delivery in the second half of the year, driven by higher expected production and lower capital spending.

Returning significant capital to shareholders remains a fundamental part of their value proposition.

In the first two quarters of 2023, they returned over $830 million to shareholders, representing 40% of adjusted CFO and translating to a double-digit shareholder distribution yield on an annualized basis, which is the highest in their peer group.

• The company currently pays a $0.10 per share per quarter dividend. This translates to a yield of 1.4%.

This yield is nothing to write home about, as MRO is a buyback-focused company.

Since the spike in energy prices less than three years ago, MRO has bought back 23% of its shares!

As a result, the per-share value of the company rises, which includes production per share and profit per share.

• Furthermore, every $1 per barrel that WTI rises translates to a $70 million tailwind for operating cash flow.
• Every $0.50 increase in Henry Hub translates to a $100 million CFO increase.
• In a scenario of $95 WTI, $4 Henry Hub, and $25 TTF (Dutch natural gas prices), the company has the potential to generate close to $4 billion in free cash flow, which translates to a 25% FCF yield.

It also helps that the company has an investment-grade BBB- credit rating. This year, the company is expected to lower net debt to $5.0 billion, which is roughly 1x expected EBITDA.

Adding to this, the company is becoming a bigger player in the LNG industry.

Starting from January 1, 2024, the company is set to change its LNG pricing strategy.

Currently, they sell LNG linked to Henry Hub pricing, but they plan to transition to selling it in the global LNG market.

This shift is expected to take advantage of potential pricing arbitrage between Henry Hub and global LNG pricing, possibly resulting in increased financial returns.

To further maximize LNG production and take advantage of these new commercial terms, the company is actively assessing a 2-well infill drilling program at Alba.

This program targets high-confidence, low-execution-risk opportunities to mitigate base decline and maximize equity molecules through the LNG plant under the more attractive global LNG-linked pricing.

The company also has a long-term focus on the gas mega-hub concept in West Africa. They aim to leverage their infrastructure in a gas-rich region to extend the life of EG LNG well into the next decade.

I’m very excited about these developments and would like it if DVN and MRO combined their businesses. I think adding a new layer of LNG capabilities to its business would be a terrific long-term opportunity.

Also, MRO is an outperformer. Fueled by post-pandemic buybacks, MRO has returned close to 50% over the past five years, beating its peers in the oil and gas exploration and production industry.

In light of my outlook on higher oil prices and my belief that we could witness a prolonged period of triple-digit dollar oil prices, I believe that MRO is significantly undervalued, which is mainly based on its free cash flow sensitivity (the hypothetical free cash flow chart I showed).

Given that MRO could generate more than 20% in free cash flow at $95 WTI (and favorable natural gas prices), I believe that the stock is at least 40% to 50% undervalued, with much higher gains over the next five to ten years.

The current consensus price target is $33, which is roughly 18% above the current price.

Takeaway

In a world where the oil and gas industry is undergoing significant changes, one thing is clear: U.S. shale production is facing a new reality.

The days of skyrocketing growth seem to be behind us, and the industry is shifting towards a focus on free cash flow and sustainability.

The latest buzz revolves around potential M&A activity in the sector, particularly with Devon Energy eyeing Marathon Oil.

While the merger talks are intriguing, what makes Marathon Oil truly special extends beyond M&A chatter. Their commitment to maximizing sustainable free cash flow and shareholder value is commendable.

Marathon Oil’s strategic moves in LNG pricing and expansion, along with their consistent buybacks, make them a standout performer in the industry.

With a promising outlook for higher oil prices, MRO’s stock appears significantly undervalued, offering the potential for substantial gains in the coming years.

Having said all of this, in this evolving energy landscape, Marathon Oil is a hidden gem worth keeping an eye on, whether or not the merger with Devon materializes.