Marathon Oil (MRO) struggled in the second quarter, but the company now looks all set to grow earnings and deliver free cash flows, thanks to the improvement in oil prices to more than $40 a barrel. Its production, which fell in the second quarter, will likely decline further in the third quarter but will start to recover in the subsequent months. The company will, therefore, end the year on a strong note and enter 2021 with momentum on its side. As oil hovers close to mid-$40s in 2021, the Houston, Texas-based company will likely continue generating free cash flows. In short, Marathon Oil’s outlook is now looking good.
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Marathon Oil, like other E&P companies, has reported a large drop in earnings and cash flows for the second quarter. Its total production (after adjusting for asset sales) fell by 7.6% from Q1-2020 to 390,000 boe per day in Q2-2020, led by a 10.9% drop in oil production to 197,000 bpd. Its oil price realization dropped by more than 50% in this period to $21.65 per barrel. Back in April, I explained how Marathon Oil’s crude oil hedges offered little downside protection and its cash flows will come under pressure in a weak oil price environment. Subsequently, the company reported an 84% drop in cash flow from operations to just $86 million. Its adjusted losses expanded from $125 million in Q1-2020 to $477 million in Q2-2020.
Marathon Oil’s outlook, however, is looking better. Oil prices have improved considerably since the second quarter in which WTI spot price averaged a little less than $28 per barrel and the futures dropped into the negative territory for the first time. But since early-June, the US benchmark has been hovering near low-$40s. In this environment, Marathon Oil will realize substantially higher oil prices which will push its earnings higher.
The earnings growth will be driven primarily by higher oil prices, as opposed to production growth. Several shale oil drillers, ranging from the industry giant EOG Resources (EOG) to the small-cap operator Laredo Petroleum (LPI), have slightly increased drilling activity in response to the improvement in oil prices. Marathon Oil will also slowly ramp up activity at the Eagle Ford and Bakken shale oil plays. I expect its output to decline further in the third quarter and recover in the fourth quarter, although its H2-2020 production will still likely be lower than the strong volume reported for the first half of the year.
Marathon Oil paused activity in the second quarter, but due to the timing of the completion work that flowed from the first into the second quarter, it still placed 32 wells to sales in April on a gross basis. In July, however, as oil stabilized near $40 a barrel, it resumed activity in the Eagle Ford and Bakken plays and kept its operations largely suspended in other regions (Northern Delaware, Oklahoma, and our Resource Play Exploration program). This is a sensible decision since Marathon Oil holds its highest-return and lowest-cost wells at Eagle Ford and Bakken.
The company will likely work with three rigs and two frac crews in H2-2020 and will place 25 wells to sales in this period. Marathon Oil has said that this activity will be tilted towards the fourth quarter in which a vast majority of the H2-2020 wells will be placed to sales. Marathon Oil hasn’t given any quarterly guidance, but for the full year, it expects to produce 370,000-384,000 boepd, including oil production of 186,000-194,000 bpd. I expect the company’s oil production to drop in the third quarter to around 169,000 bpd before recovering to 173,000 bpd in the fourth quarter as more wells are brought online.
I also expect Marathon Oil to generate free cash flows in the coming quarters while operating in the low-$40s a barrel oil price environment. The increase in oil prices will also push the company’s cash flow from operations higher. The company has also done a commendable job of cutting its costs which have helped it in reducing its cash flow break-even point. The company is targeting $260 million of cash cost savings on an annualized basis. It has pushed its average completed well costs down by 10% so far as compared to 2019 and is expecting further cuts in H2-2020.
Marathon Oil has been successful in consistently cutting well costs in its two primary shale oil plays since 2019. The company is on track to bring its completed well costs at Eagle Ford down to $700 per lateral foot in H2-2020. At Bakken, Marathon Oil brought the completed well costs down to as low as $500 per lateral foot for some wells in Q2-2020.
What’s great is that these cost reductions are primarily associated with the company’s self-help measures, such as improvements in well design, and therefore I believe they will be sustainable in the long run. That’s helped improve Marathon Oil’s cost structure to a point where it can balance cash flows at low-$30s a barrel oil price environment in H2-2020. This means that in the current low-$40s a barrel oil price environment, the company will likely generate strong levels of free cash flows. This will mark a turnaround for Marathon Oil which burned cash flows in the previous quarter. As indicated earlier, the company generated $86 million of cash flow from operations in the second quarter which couldn’t cover capital expenditures of $137 million. From this, we can estimate that the company faced a cash flow deficit of $51 million in Q2-2020 ($86Mn-$137Mn).
In my opinion, Marathon Oil’s cash flow outlook for 2021 is also looking good. That’s because the company has said that it needs $35 per barrel oil price to balance cash flows next year with a maintenance capital budget that will keep the company’s production flat at Q4-2020 levels. The oil prices, on the other hand, could end up averaging in the mid-$40s a barrel range in 2021, as indicated by the current futures. That’s also in line with the US Energy Information Administration’s forecast of an average 2021 price of $45.53 per barrel. This oil price scenario will enable Marathon Oil to post free cash flows in 2021 as well.
For the above-mentioned reasons, I think Marathon Oil is looking good. In the current $40s a barrel oil price environment, the company will likely grow earnings, improve production, and generate free cash flows. That should help push Marathon Oil stock higher, which has fallen by 13% in the last three months. The company’s shares are trading at 5.8x in terms of EV/EBITDA multiple, below the sector median of 7.7x and large-cap peer average of around 8x, as per data from Seeking Alpha Essential. I think for long-term-oriented investors who can tolerate oil price-related swings, this may be a buying opportunity.
Marathon Oil, however, comes with its fair share of risks. If oil prices come under pressure again and fall to $30s a barrel or lower due to, for instance, a second wave of the coronavirus pandemic that hurts oil demand or an increase in oil supplies from OPEC+, then the company’s earnings might slip deeper into the red.
Also, note that Marathon Oil’s cash flows have limited downside protection with crude oil hedges. The company’s hedge coverage consists mostly of three-way collars with a sold put price of $48 per barrel. The more index price falls below the sold put price, the less effective these hedges become. In an oil price environment of under $30 per barrel, the company will likely burn cash flows, which is also implied by the company’s cash flow break-even guidance. By comparison, other oil producers like Pioneer Natural Resources (PXD) that maintain a robust hedge book are better prepared to handle weak oil prices than Marathon Oil.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.