Marathon Oil (U/A): E&P outlook improving, but relative valuation still not compelling _ Goldman Sachs - January 26, 2006
We maintain an Underperform rating on Marathon Oil shares in the context of an Attractive coverage view as we continue to see better relative risk/reward in other domestic oil/E&P stocks. On an absolute basis, we see meaningful upside in MRO shares given our bullish commodity macro outlook. In our view, although MRO has made significant progress in its E&P turnaround, we see its relative reserve life, returns, and capital intensity as still lagging its peers. If MRO can continue to deliver on its E&P targets while maintaining capital discipline, or if it trades toward a more meaningful discount to its peers, our view would turn more favorable. We expect 2006 to be largely a transition year for MRO, with high-impact E&P projects not on-line until 2007 and investment decisions in potentially large projects (Garyville refinery, Angola, Libya) unlikely until late 2006/early 2007.
WITH SHARES AT SLIGHTLY ABOVE OUR $70 "TRADITIONAL" PEAK VALUE, WE SEE BETTER RISK/REWARD IN OTHER DOMESTIC OIL/E&Ps We see Marathon shares trading at slightly above our $70 "traditional" peak value versus its peer group showing 15% upside to traditional peak valuations on average. In our view, 2006 could be a year where the sector overall trades through the 1990s cycle valuations that underpin our view of "traditional" mid-cycle and peak values. Should this occur, we believe Marathon shares have considerable upside on an absolute basis. We estimate 39% upside to a $99 super-spike-adjusted peak value. By way of comparison, however, Marathon's domestic oil/E&P peer group shows 48% upside on average to super-spike-adjusted peak valuations. In terms of downside risk for Marathon, we believe it is likely limited to 22% to a $55 traditional mid-cycle value. Note, our traditional mid-cycle valuations are based on a $35 long-term WTI oil and commensurate other commodity price assumptions.
We note that Marathon shares appear inexpensive on the basis of EV/DACF (enterprise value to debt-adjusted cash flow), trading at 4.7X 2006E and 4.2X 2007E EV/DACF relative to the peer group average, excluding oil sands-leveraged companies, of 5.1X and 4.6X, respectively. In our view, given Marathon's relatively short reserve life, average returns on capital employed (ROCE), and rising capital intensity, we believe the valuation discount is justified. In fact, many of the companies Marathon trades at a discount to are growthy E&P companies with a significant resource base such as Murphy Oil (MUR; OP/A), EnCana (ECA; OP/A), and EOG Resources (EOG; IL/A). Meanwhile, Marathon trades at a premium to several companies in which we have greater confidence in the E&P portfolio, namely Amerada Hess (AHC; IL/A), Apache (APA; IL/A), Occidental Petroleum (OXY; NR), and Anadarko Petroleum (APC; IL/A). See Exhibit 1 for comparative risk/reward and valuation.
KEY COMPANY-SPECIFIC CATALYSTS
(1) DELIVERING THE UPPER-END OF THE 365,000-390,000 BOE/d 2006 PRODUCTION GUIDANCE. Marathon's 2006 production guidance was in-line with its previous guidance of 325,000-350,000 BOE/d which excluded production from Libya. Volumes from Libya are expected to average 40,000-45,000 BOE/d net to Marathon. In our view, although the revised guidance confirms the intended progress management has made with respect to the turnaround of its E&P production profile, we believe the lower-end of the guidance would suggest a relatively steep decline rate in its core asset base. That is, a 375,000 BOE/d production rate (assuming no significant hurricane or other exogenous impact) for 2006 would imply a 10% annual decline in the US and Europe, which collectively are expected to account for over 60% of total production. A 385,000 BOE/d rate, which is our current base-case assumption, would imply a 6% decline rate for the same regions, consistent with what management claimed to be during its earnings conference call. Note, through 2004 and 2005, we estimate production in the US and Europe has declined at an annual rate of 11%. If management can deliver the upper-end of its guidance without meaningful incremental CAPEX, we believe investor confidence in Marathon's ability to deliver the high production growth consistently and profitably will improve meaningfully.
(2) 2006 CAPITAL PROGRAM AND 2005 RESERVE DATA. In its 4Q earnings conference call, Marathon management noted that within the next couple of weeks it will release details of its 2006 capital program followed by 2005 reserve data. Excluding the impact from Marathon's re-entry into Libya, we estimate Marathon's budget could be $3.2 billion, or roughly a 13% increase from 2005 levels. Including the $732 million in payment to the Libyan National Oil Corporation--which includes re-entry, extension of the concesssions, and unamortized investments--we estimate Marathon's capital program could be roughly $4 billion, or a 38% increase from 2005.
In terms of reserves, we estimate Marathon to have added over 190 million BOE in 2005 at a finding and development cost (F&D) of $8.40 per BOE. This implies a reserve replacement ratio of over 150%. Our estimates assume that Marathon does not book any reserves in Libya until 2006. Should Marathon achieve such results, it would mark the fourth consecutive year of 100%+ reserve replacement at a single digit F&D. Given our view that a low-double digit F&D among the domestic oil/E&Ps is robust especially in a rising service cost and resource-constrained environment, Marathon undoubtedly has achieved much improved results in recent years. However, although improving, we still see Marathon's reserve life lagging its peers with a proved developed reserves to production (PD R/P) ratio of 7 years versus the peer group average of 9 years. Overall R/P is expected to be 10 years versus the peer group average of 12+ years.
(3) USE OF FREE CASH. With Marathon's net debt-to-tangible capital estimated to be 11% at year-end 2005 and close to 0% by the end of this year, we believe investors will be keen to know how Marathon intends to use excess free cash. Based on 4Q earnings conference call, management appears unlikely to engage in a large acquisition though it left itself open to potential strategic investments or perhaps joint ventures that can expand or leverage off of integration between its upstream and downstream businesses. In our view, until these strategic initiatives have been thoroughly examined and until Marathon and its Oasis partners firm up a development plan in Libya, we believe Marathon may be less likely to engage in meaningful share buybacks or special dividends until later in the year. We would, however, expect continued strong growth in regular dividends as was the case in 2005.
(4) DRILLBIT AND DEVELOPMENT NEWS IN ANGOLA. We believe Marathon is on-track to deliver robust near- to medium-term E&P production growth through 2008. Recent discoveries in both Angola Block 31 (10% Marathon working interest) and Block 32 (10% interest), in our view, is raising the likelihood that Marathon could extend its growth rate beyond 2008. We would have a more favorable view on Marathon shares if management can raise confidence that the discoveries could be developed profitably and timely.
4Q 2005 RESULTS AHEAD OF EXPECTATIONS Marathon reported adjusted 4Q 2005 EPS of $3.61, which was well ahead of the $3.02 First Call consensus estimate and our $2.90 forecast. Both E&P and R&M results were much better than expected. In E&P, better-than-expected realized prices and lower-than-expected unit costs drove the bulk of the favorable variance. E&P volumes were largely in-line at 392,000 BOE/d versus management's 385,000 to 390,000 guidance. In R&M, higher-than-expected realized refining as well as marketing margins accounted for the positive variance.
UPDATING ESTIMATES We are updating our full-year 2006-2010 EPS estimates for Marathon, which now stand at $10.60 ($10.75 previously), $11.40 ($11.85 previously), $4.30 ($4.15 previously), $4.40 ($4.23 previously), and $4.65 ($4.39 previously), respectively. Our updated EPS estimates reflect higher assumed corporate tax rates due to production from Libya, offset by higher estimated realized prices, lower assumed interest and corporate expenses, updated E&P production profile, and minor other adjustments.
We are also introducing our quarterly 2006 EPS estimates, which stand at $2.33, $2.73, $2.77, and $2.77 for 1Q, 2Q, 3Q, and 4Q, respectively. Note, we have updated our 2006 Henry Hub spot natural gas price assumption to $9.50 per MMBtu ($10 before), our 2006 and 2007 California refining margin to $24 per barrel ($28 before), and our 2006 New York, Chicago, and Mid-continent refining margins to $10.75 ($11 before), $11.50 ($13 before), and $11 ($13 before) per barrel, respectively. See Exhibit 2 for a summary model of Marathon Oil.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
