Marathon Oil (U/A): For R&M exposure among integrateds, we prefer ConocoPhillips - Goldman Sachs - April 27, 2006
With Marathon Oil among the best performing oil and gas equity year-to- date, up 38% versus 19% for the XOI index, we maintain a U/A rating on the shares as we see greater relative upside in a number of its oil-leveraged E&P/domestic oil peers. For investors looking for inexpensive exposure to refining, we would highlight ConocoPhillips (OP/A), whose implied R&M 2007E EV/DACF we estimate to be 2.9X relative to Marathon's implied R&M valuation of 6.1X. If Marathon can negotiate a favorable asset swap/joint venture agreement with Canadian heavy oil producers, our outlook for its E&P business--and hence its shares--could improve. On an absolute basis we see 33% upside for Marathon to a $109 "super-spike"-adjusted peak value, consistent with discounting a $60/bbl long-term WTI oil.
ADDING LONG-LIVED AND A REPEATABLE PROSPECT INVENTORY KEY TO MARATHON'S E&P OUTLOOK
Our concern with Marathon's E&P portfolio has long been its short-lived E&P asset base and below-average profitability. In our view, the potential for Marathon to gain access to large heavy oil resources by way of an asset swap/joint venture/equity interest is encouraging. As we highlighted in our December 5, 2002 report, "Marathon Oil: We would prefer reversal of management strategy; reiterate Underperform", we believe a reverse-integration with upstream heavy oil/bitumen producing assets would be logical and fit nicely with its already well-integrated, top-quartile downstream (refining-transportation-marketing) business. We believe this strategy can help increase Marathon's reserve life, raise long-term returns, and reduce EPS volatility.
In our view, Marathon's recent leasehold acquisition in the Bakken shale gives Marathon the potential for a low-risk, repeatable prospect inventory which, if successful, could also increase Marathon's reserve life and boost its risk-adjusted returns. However, given the company's sub-par track record at the Powder River Basin--also an unconventional (though gas) play--we are taking a wait-and-see approach for now.
Note, we believe Marathon has made significant strides in improving its E&P outlook. Ramp-up in liquids production at Equatorial Guinea, the addition of Libya volumes, the Alvheim/Vilje development in Norway, and Equatorial Guinea LNG are expected to fuel high single-digit per annum growth through 2008 after which we expect annual growth to be closer to 2%. This contrasts to several years of declining production prior to 2005. However, we continue to believe that with a relatively short E&P asset life, there remains the potential for the fast-declining asset base to undermine future production growth, or at least that growth is achieved at meaningfully higher capital spending levels than is currently projected.
CONOCO PREFERRED AMONG THE INTEGRATEDS FOR REFINING EXPOSURE
For investors that prefer Marathon as an inexpensive way to gain leverage to the refining cycle (given that the independent R&Ms have been re-rated up in the current up-cycle and trade at super-major-like valuations), we believe Conoco shares offer superior risk/reward. Assuming the domestic oil/E&P average 2007E EV/DACF (enterprise value to debt adjusted cash flow) of 5.6X on Conoco's E&P business, we estimate that the implied R&M EV/DACF is a mere 2.9X. For Marathon, we estimate that the implied R&M EV/DACF is 6.1X assuming a 4X E&P EV/DACF multiple. Note, we believe Marathon's E&P business deserves a discount to the domestic oil/E&P overall average due to a less attractive returns/growth combination. A more comparable "peer" group, in our view, would include among others Amerada Hess, Anadarko Petroleum, Devon Energy, and Chesapeake Energy (all IL/A), which trade between 4.0X-4.5X 2007E EV/DACF. For comparative purposes, if we assume that Marathon's E&P segment deserves the domestic oil/E&P multiple of 5.6X, we estimate an implied R&M EV/DACF of 3.7X, still meaningfully above the 2.9X for Conoco.
AMONG E&Ps, WE SEE SIGNIFICANT UPSIDE IN OUR FAVORITE GAS-LEVERED E&P PICKS
While we see Marathon trading near our $80 "traditional" peak value (consistent with discounting a $45/bbl long-term WTI oil), we see on average 32% upside to our "traditional" peak values for our top gas-E&P picks XTO Energy (OP/A), Newfield Exploration (OP/A), and Anadarko Petroleum (IL/A). In our view, the near unanimous bearish view of natural gas following warm winter weather and high natural gas inventory levels has created a particularly favorable risk/reward for gas-levered E&Ps. With that said, given our overall bullish outlook for oil, natural gas, and refining, we believe meaningful absolute upside for Marathon shares exists. We estimate 33% upside for Marathon to a $109 "super-spike"-adjusted peak value, which is consistent with discounting a $60/bbl long-term WTI oil. 1Q
2006 RESULTS BELOW EXPECTATIONS
Marathon reported adjusted 1Q 2006 EPS of $2.01, below both the $2.35 First Call consensus and our $2.25 forecast. Including a $45 million after-tax marked-to-market gain on long-term UK natural gas contracts, Marathon reported 1Q 2006 EPS of $2.13. The negative variance between actual results and our expectation was largely driven by higher-than-expected effective tax rates due to Marathon's re-entry into Libya. E&P production volumes in 1Q 2006 were higher-than-expected while realized liquids and natural gas prices were lower than expected. R&M earnings were slightly lower than expected primarily due to gross realized margins that were weaker than our forecast.
UPDATED ESTIMATES
We have updated our 2Q-4Q 2006 and full-year 2006-2007 EPS estimates, which now stand at $2.38 ($2.43 before), $2.74 ($2.63 before), $2.67 ($2.74 before), $9.80 ($10.05 before), and $11.15 ($11.25 before). Our updated EPS estimates reflect higher assumed tax rates, lower assumed share count, updated E&P production profile, and minor other adjustments. We have made no change to our normalized 2008-2010 EPS estimates. See Exhibit 1 for a summary model.
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. |
