Marathon Pete Is Running Full Throttle

When Marathon Oil (NYSE: MRO) spun off its refining operations to shareholders as Marathon Petroleum (NYSE: MPC) in the summer of 2011, the downstream business must have held all the long-term appeal of a drum filled with used motor oil.

Marathon’s refining and marketing segment income slid from $2.8 billion in its 2006 heyday to a mere $464 million in 2009 as the global downturn crushed margins. And even though refining income bounced back to $682 million in 2010, and even as margins continued to recover in the first half of 2011, Marathon must have felt it was selling high.

The Great Recession ushered in a secular decline in the US consumption of gasoline: the 8 million barrels per day registered in the first week of 2013 was down from more than 9 million from six years ago and no higher than in January of 1999.

And the refining industry remains extremely vulnerable to the vagaries of the business cycle. When growth wilts, the crack spreads that drive refinery profits tend to follow, depressing the bottom line. This historic volatility accounts for the traditionally low valuations of refining stocks relative to steadier businesses.

For a while, it looked as if Marathon did indeed sell high. A little more than three months after the spinoff MPC shares were down 30 percent to $27 as the European financial crisis and the US debt ceiling fiasco fueled fears of a recession.

And that was when fortune smiled on Marathon Pete and indeed on its entire ugly-duckling industry.  The recession never materialized, but a growing surplus of cheap crude from the North American shale drilling boom did, in locations advantageous to Marathon.

The discount on all this crude without an affordable route to Gulf Coast refineries boosted MPC’s profit fourfold in 2011. And in the 2012 fiscal year just reported by the company, refining income from operations was up another 42 percent, thanks to the widening spread between the cost of making gasoline and its wholesale price as well as the persistent discount on domestic crude.

Shares now trade at all-time highs above $72, having gained 75 percent since the spinoff while progenitor Marathon Oil eked out a 2 percent bump.

Other refiners came along for the ride, with rivals Valero (NYSE: VLO), Tesoro (NYSE: TSO) and ConocoPhillips (NYSE: COP) spinoff Phillips 66 (NYSE: PSX) consistently leading the S&P 500 pack throughout the year.

But Marathon Pete has been just a bit nimbler than most, ranking tops among the largest eight refiners in profit per barrel of crude in 2011, and second last year.

At 7 times this year’s forecast earnings and 5 times trailing cash flow, the stock remains inexpensive, in line with the rest of the refining industry. It’s likely to trade much higher before the business cycle takes its toll, as Marathon continues to exploit favorable long-term trends.

In November, Marathon completed a $2.2 billion retrofit of its Detroit refinery to process heavy and therefore discounted crudes from the Canadian tar sands.

Marathon is also about to close its purchase of BP’s (NYSE: BP) massive Texas City, Texas, refinery at a bargain-basement price. By the Wall Street Journal’s math, Marathon could recoup the entire purchase price in a single year if it hits its synergy targets. The BP refinery is across the street from a smaller Marathon plant.

Texas City and Marathon’s other big Gulf refinery at Garyville, Louisiana, are key to the company’s plans to convert heavy crudes from the continental interior into lucrative fuels for sale across the eastern half of the United States as well as in Europe and Latin America.

Those prospects have been boosted by the closure of unprofitable refineries in Europe, the Caribbean and the US East Coast, which lacked access to the cheap crude from the interior. Diesel exports from Garyville have tripled over the last two years, for example.

Across Latin America, refinery capacity has not kept up with demand, turning the region into an ever-thirstier importer of refined fuels. Mexico, a leading destination for US gasoline, has a refinery monopoly controlled by the state-owned oil giant Pemex, which is building its first new plant in 30 years with a completion date in 2015. In Brazil, which has also become a customer, state-controlled giant Petrobras (NYSE: PBR) has ambitious plans to expand its own inadequate refining capacity. But national price controls on gasoline will be a hindrance. And Venezuela’s refineries remain a mess, forcing their former customers in Central America to look northward.

Latin America’s fuel demand grew right through the recent global recession, and will in the near future surpass that of the US, according to industry forecaster IHS. The opportunity for US refiners with access to cheap sour crude is large. IHS expects the coking margin on domestic sour crude to rise over the next decade, more than doubling on average from the average in 2009-2011.

And Marathon’s Gulf Coast refineries have the coking capacity to profitably bid on Canadian oil sands crude should the Keystone XL pipeline bring it to the Gulf in volume.

MPC infrastructure map

Marathon’s own crude and refined fuel pipelines span 8,300 miles, permitting wide product distribution across the Midwest, the Southeast and into the Northeast. Marathon spun off some of its pipeline and transport infrastructure into the master limited partnership
MPLX (NYSE: MPLX) last fall, garnering tax advantages as well as inexpensive financing. Marathon has retained a 49 percent stake in the vehicle, which has rallied out of the gate.

The gasoline Marathon makes and distributes is also sold by the company’s nearly 1,400 Speedway stations and convenience stores, whose steady if modest profit somewhat dampens the refining operations’ volatility.  

With major capital projects out of the way, Marathon has focused on returning money to shareholders, boosting the quarterly dividend by 75 percent in less than two years to a quarterly 35 cents a share, for a 2.1 percent annual yield at the current price. It’s also ramped up the pace of share repurchases, and has now added a new $2 billion authorization to the $650 million remaining under the old one.

MPC growth map

In all, MPC returned $1.6 billion last year via dividends and share repurchases, a big number for a company with a market cap of less than $23 billion. That also helps explain why the stock nearly doubled in 2012.

Marathon’s infrastructure and geographic positioning promise more of the same in the coming years barring another severe economic downturn or an oil supply shock—definite risks that have nevertheless appeared to recede in recent months. Its stock is in a strong, sector-wide uptrend and yet remains among the market’s cheapest overachievers.

The stock has been red-hot of late. A possible pullback to $65 would present a more attractive entry point. But the stock remains a value at any price below $85. Barring a black swan, this ugly duckling should keep flying.


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