Marathon Oil (NYSE:MRO) is one energy stock that has corrected sharply in the recent past. At the end of fiscal year 2019, MRO stock was trading at $13.58, and that’s not as bad as things can get for the company.
The fact that U.S. factories have suffered the worst slump since 1946 certainly isn’t helping. Considering the demand slump, it’s not surprising that oil has failed to trend higher even after the production cut agreement. A deeper production cut is likely to boost the oil price to some extent. However, it makes sense to be very selective in buying stocks from the energy industry.
Currently, MRO is lower by 71% at $3.96. Even after the deep correction, I believe that the stock can be avoided. This column will focus on the factors for this view.
I had a relatively positive view of the stock when it declined to $3.4 last month, and Marathon Oil did bounce back to $4.39. However, considering the extent of the downturn coupled with expectations of a relatively longer duration of oil price weakness, I am compelled to change my view.
Further, if we look at stocks in the energy industry, there are better investment options. Just as an example, Exxon Mobil (NYSE:XOM) has strong fundamentals and a dividend pay-out of $3.48, which is sustainable. Further, the company has strong production growth visibility from international offshore assets.
Similarly, BP (NYSE:BP) has a strong liquidity buffer, low gearing and a robust dividend pay-out.
Therefore, there are relatively better stocks in the energy industry. Moreover, the likes of Exxon Mobil and BP can be classified as the “too big to fail” in the industry. Of course, these companies have the financial strength to survive a deep downturn.
Cash Flow and MRO Stock
Marathon Oil expects organic free cash flow break-even at $47 per barrel (West Texas Intermediate) for the current year. For the next year, the company expects it to be lower than $47 per barrel. This is attractive in a scenario of robust economic growth and oil trading above $60 per barrel.
However, the U.S. Energy Information Administration expects WTI crude price to average $29.34 for the year and $41.12 for FY2021. Therefore, in all probability, Marathon Oil is likely to report negative free cash flows through the next year. This would imply leveraging and is a negative for MRO considering the economic outlook.
Deep production cuts by OPEC and non-OPEC countries can help in WTI price trending higher than the assumptions by the EIA. Still, its unlikely that WTI will average $47 for the current year.
The positive point is that Marathon Oil reported total liquidity of $3.9 billion as of December 2019. This will help the company survive, but balance sheet debt can potentially increase in the coming quarters.
It’s worth noting that in March 2020, the company announced a $500 million reduction in investments for 2020 to $1.9 billion. In April 2020, the company further reduced investment guidance to $1.3 billion. This is an indication that operating cash flows will be weak even with the company’s having hedged positions for the current year.
I also believe that Marathon Oil could suspend dividends in the coming months to preserve cash. This is another downside trigger for MRO stock.
Another factor that can trigger downside for the stock is credit rating downgrade. Recently, Marathon Oil was downgraded to BBB- by S&P. Considering the weakness in oil prices and the impact on FCF, a long-term poor rating can possibly be a downgrade to junk status.
The Asset Quality Perspective
Marathon Oil has presence in the Eagle Ford, Bakken, Northern Delaware and Oklahoma. It’s worth noting that 70% of the company’s capital allocation for the current year is towards Eagle Ford and Bakken. Since 2018, the company has added 500 inventory locations in these two assets. This can help in production growth once oil trends higher.
Further, Marathon Oil is targeting 18,000 undeveloped net acres that’s adjacent to its leasehold in Eagle Ford. Bolt-on acquisition can help in expanding the Eagle Ford inventory. The key concern, however, is the possibility of sustained weakness in oil prices.
Another concern is as follows: The company had proved reserves of 1,281 MMBOE in FY2018 and it declined to 1,205 MMBOE in FY2019. The reserve replacement ratio has therefore been below 100%.
Adding to the concerns is the fact that the company’s organic finding and development cost per barrel was $12.41 in FY2018. The finding and development cost increased significantly to $26.97 per barrel for the last fiscal year. Therefore, the slow pace of reserve addition and the escalating cost per barrel for new reserves is a worry.
My Concluding Views on MRO Stock
Be it any industry, it’s cash flows that deliver incremental value. Marathon Oil has been FCF positive in the past years, but the next 18-24 months are likely to be challenging. This will keep MRO stock depressed even after a major correction in the recent past.
From a survival perspective, Marathon Oil has an ample liquidity buffer. However, that’s not a factor that will drive MRO stock higher.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock-specific articles with a focus on the technology, energy and commodities sector. As of this writing, he did not hold a position in any of the aforementioned securities.
