Global oil and gas prices continue to experience downward pressure. The industry had expected prices to recover by the second half of the year. However, crude oversupply and other factors, still constrain a price recovery. To understand future developments in the industry it is important to assimilate the factors that are impeding prices to rebound.
Prices have been affected by both supply and demand. First of all, the slowdown in China’s economic growth has been a concern as it is the second largest consumer of oil. For the second quarter of this year, China barely beat estimates by reporting economic growth of 7%. According to Reuters, there have been many concerns on the accuracy and transparency of the data. Other estimates such as Citibank’s, calculate slower growth around 5%-6%. Another concern is the effectiveness of government’s recent actions to spur economic activity. In the past months, China has cut interest rates four times, lowered its bank reserve requirements and taken other measures that have not stimulated activity as desired. Not to mention the recent stock market turmoil where unconventional measures were taken to “stabilize” it. Additionally, global growth forecasts cuts both by the IMF and the World Bank, have also negatively influenced prices due to lower future demand. On the other hand, solid economic growth in the United States and expectations an interest rate increase by the Federal Reserve, are also expected to affect future demand with the valuation of the dollar. Crude price is determined in dollars and as the currency strengthens, foreign buyers lose their purchasing power, hence reduce demand for crude.
On the supply side, OPEC continues to pump record amount of crude after it decided not to cut production to stabilize prices. According to the Economist “Sheiks vs Shale”, several OPEC members have shown an inclination to cut output, but Saudi Arabia, the major producer in the cartel, has ruled the option out. The decision is supported by historical experience when the cartel decreased production in the 1970’s. Consequently, prices stabilized which spurred investment in northern Europe and lead OPEC to lose global market share. OPECs strategy now focuses on maintaining market share by driving high-cost shale and sand producers out of business. Such strategy seems to have impacted heavily on capex spending for many shale producers which are also experiencing large lay-offs, other costs cuts and even asset sales. Such actions might slow production growth but production continues to be robust. Production in the United States reached this June its highest output since the 1970’s according to the WSJ, despite a decrease in oil rigs since prices tumbled, rig count is stabilizing. Furthermore, it is also important to take Iran into consideration. A recent nuclear deal could further contribute to the global oversupply of oil. Economic sanctions imposed on Iran might not immediately be lifted. However, the WSJ argued that Iran has around 20 million barrels in storage and could ramp up production by half a million barrels a day if the deal is approved by the US Congress and sanctions are lifted.
Summing all up together, supply does not show any sign of slowdown in the near term. The global oversupply continues to pressure prices as the International Energy Agency pointed out that currently there is a surplus of over two million barrels a day produced. The U.S. Energy Information Administration expects oversupply to last at least until 2017.
An environment of low prices is certainly pressuring the industry to consolidate, cut costs and increase efficiencies. The market has reacted unfavorably towards the energy sector where companies have suffered losses in share values. Such events have raised interest on possible acquisition opportunities of cheap assets. Nonetheless, it is important to consider that prices might remain depressed over the medium term. For this reason, it is prudent to carefully analyze an investment strategy. The exploration and production sector in the industry still face many adversities due to highly leveraged structures and the expiration of price hedges this upcoming fall that locked selling prices at $90. The downstream sector on the other hand, presents some interesting opportunities. A publication by the World Economic Forum focused on opportunities for downstream companies as lower input prices and positive demand for refined products benefited the sector with wider margins. Large oil companies are considering industry consolidation in order to accommodate and endure in a low price oil environment. The publication also mentions that large oil companies with healthy balance sheets are considering acquisitions of refining assets with the purpose of securing outlets for their oil.
For those reasons, Marathon Petroleum Corporation presents a great investment opportunity. The company engages in refining, marketing, retailing and transporting oil products primarily in the US. It operates seven refineries in the Gulf Coast and Midwest regions of the United States. Marathon Petroleum refined products include: gasoline, distillates, propane, feed stocks and special products, heavy fuel oil, and asphalt. Besides its primary Refining and Marketing segment, the company also operates Segway and Pipeline Transportation.
The Relative Wealth Chart shows that, besides 2009 and 2010, Marathon has managed to keep its CFROI above its discount rate. Management has successfully created shareholders value with proper administration of the company and this can be observed in the driving factors of CFROI. Management has successfully maintained operating margins which show a stable improvement over time. Asset turns have also shown constant improvement. On the other hand, sales growth has decreased continually the past couple of years. However, the outlook for Marathon sales growth does not necessarily mean a loss of market share when compared to sales growth performance of competitors. All peers show the same trend which indicates that such tendency might be the result of a cycle in the industry.
Overall economic returns from Marathon are not only higher than those of competitors, but also HOLT’s forecasts of CFROI indicate better performance.
In terms of valuation, Marathon is also an attractive stock among competitors. It trades at a lower PE multiple than the industry.
CFROI over price to book indicate that the stock is underpriced.
Overall, when Marathon Petroleum is compared to its peers, the HOLT valuation methodology assigns it a score percentile of 100 due to momentum, operational quality and positive valuation.
The HOLT valuation methodology assigns Marathon Petroleum Corp a warranted price of $101.64 which is 80% higher than its current market value. The investment thesis in this paper is based on the idea that oversupply in the oil and gas industry maintain prices depressed over the medium term. Nonetheless, prices have experienced high volatility since prices started their decline in 2014. For this reason it is also important to consider possible future price fluctuations. In the event that oil prices recover, I conducted a scenario analysis using HOLT’s Flex Valuation tool. The discount rate was left unchanged given that it is implied that the market already assimilated future rates. To remain conservative, asset growth was also not altered given that the company already has accounts with a fully integrated downstream system according to their investor presentation. In the scenario analysis it is assumed that over T+F oil prices recover to $100 per barrel. The World Economic Forum publication indicated that the price of refined products is not directly tied with refined products. For that reason and the fact that management has been able to return wealth despite price fluctuation even on record high oil prices, a negative impact of 40% on CFORI seems appropriate. As it can be observed, even in a scenario of price recovery, Marathon Petroleum Corp is a great investment opportunity with a warranted price of $74.54 and an upside of 39%.
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