Description

Marathon Petroleum Corporation is the fourth largest refiner in the United States with approximately 1.6mm barrels per day of refining capacity.  The company was created through a tax free spin-off from Marathon Oil on June 30, 2011.  It is listed under the ticker MPC and trades at $55.00 per share, a market cap of $18.5B and an Enterprise Value of $21B including underfunded pension obligations.  The newly created company was driven by Marathon Oil’s decision that investors of oil production and exploration companies did not want to invest in refining assets.  Through the creation of Marathon Petroleum Corporation, investors were presented with an opportunity to directly invest in Marathon’s refining assets.  Marathon Petroleum also owns an estimated 8,300 miles of crude pipelines, 1,500 Speedway company owned retail outlets, 5,100 branded third party retail outlets in the US, and one of the largest inland barge & terminal assets in the US.

Valuation:

MPC trades at 3.7x EBITDA, 4.6x EBIT, and 6.2x P/E on 2012 estimates.  The company operates an unlevered balance sheet (1.5B of net debt v $5.6B of EBITDA), and owns assets that carry a significant valuation premium in the public markets.  These assets, which include the logistics/pipeline assets as well as the retail gas stations are far more stable businesses and present an opportunity to realize additional value in the form of IPOs or spin-offs.  As a result, I believe the investment merits are as follows:

1. Cheap Valuation with greater earnings power than the market expects
2. SOTP valuation discount with opportunity for monetization via IPOs & spin-offs
3. Shareholder friendly management team returning capital to shareholders in the form of buybacks and dividends
4. Inefficient balance sheet provides opportunity to further accelerate capital return
5. Asset trades at severe discount to replacement cost
6. Recently announced acquisition is significantly accretive and should drive a step change in normalized earnings
7. Recent listing of variable rate refining MLP provides another significant opportunity to revalue based on tax free status

Cheap Valuation & Earnings Power:

I spend a fair amount of my time evaluating how cost curves change as a result of movements in the commodity markets. Just like the oversupply of natural gas has created attractive investment opportunities in the ethylene market or nitrogen fertilizer market, the expansion in US and Canadian oil production has created a unique investment opportunity for US refiners with access to certain regional types of crude.  I believe Marathon Petroleum Corporation makes for an attractive investment given its unique position on the refining cost curve.  If one believes the industry prices off of marginal cost economics an investment in MPC can generate an attractive return without relying on economic cyclicality/improvement.  That said, any improvement in the macro environment creates optionality for significantly greater returns if demand exceeds supply.   

To better illustrate why MPC’s refining assets are severely cost advantaged I want to highlight a few key points.  In the refining business, you buy a barrel of oil and convert that into gasoline, diesel, heating oil, jet fuel, etc.  Generally speaking, profits for this industry have historically been anemic, amounting to only a couple dollars per barrel (i.e. when you buy a barrel for $100 you generally only make $2-3 dollars in margin).  In an effort to improve margins, the industry has shifted its capital expenditures over the past decade to upgrade refiners so that it can process discounted crudes.  The emergence of Canadian oil sands increased supply of heavy crude barrels into the market creating a discount product, thereby allowing a refiner that could process that type of crude the ability to make substantially more per barrel.  In the past several years there has been an enormous growth in production of US and Canadian oil coupled with a severe infrastructure bottleneck.  Today, there are numerous regional crudes that have disconnected from global oil prices:  WTI ($20 discount), LLS ($3 discount), WCS ($36 discount), Permian ($19 discount), Bakken ($19 discount), etc.  Any refiner with access to these types of crudes & the ability to process them can generate an enormous margin.  It is for this reason the value of a refinery all about location, location, location.

Crude Supply/Demand:

I think it is worth looking at Enbridge’s last investor day as it provides some interesting perspectives on the changing landscape for oil for North America.  The company suggests North America can become energy independent from oil production (not solar, wind etc.) by 2025.  Anyways, this is the main factor driving disocunted crudes in the US.

http://www.enbridge.com/InvestorRelations/~/media/www/Site%20Documents/Investor%20Relations/2012/ENBDays/2012_ENB_Day_Liquids_Pipelines_Steve_Wuori.ashx

1. Canadian Oil has grown significantly faster than expected and now stands at ~3mm barrels/day of which 1.7mm bpd is imported into the US by pipeline.  These imports are growing each year at a rate 200-300k barrels per day.
2. Bakken – The oil region in North Dakota is now producing 600k bpd from virtually zero back in 2008.  In the last couple years, oil majors have been buying their way into this market, increasing cap ex and accelerating production growth.  Statoil acquired Brigham Exploration last year for $4.5B and more recently XOM purchased Denbury’s acreage for $1.6B.  The growth from the Bakken appears to be accelerating with current production approximately 255k barrels per day higher YoY.
3. Permian – This basin, once the largest producing oil basin in the US had been in decline for forty straight years until 2007.  Since then, growing cap ex and new oil technology has been applied to the region, leading to a renewed surge in production.  Oil growth is currently 170k bpd above 2011 levels and is actually experiencing the greatest opportunity for new production growth in the US
4. There are other regions that could further drive US oil growth such as the Utica, Niobrara, Brown Dense, SCOOP, etc.  While unproved at this juncture, one large find can drive years of additional regional dislocations of crude.

Growing oil basins in the US have contributed such increases in oil supply that our country’s infrastructure is unable to handle it.  This has resulted in crude oil (WTI) in the Mid-Con selling at a discount to global crude. While that discount stands at approximately $20 barrel today, I believe over time the spread will reflect the marginal cost to bring crude from the Cushing, OK (WTI trading base) to the US Gulf Coast.  I believe the cost to move oil from Cushing, OK to the US Gulf Coast to be approximately $5/barrel (based off estimated tariffs for pipeline capacity).  Additionally, I believe the US Gulf Coast crude (LLS) will also disconnect from global crude (Brent) because of a similar oversupply situation.  This dynamic is not well understood by investors and could lead to another step change higher in earnings power for refiners in the Gulf Coast.  Overall, I believe 1) LLS will trade at a $5 discount to Brent and 2) WTI will sell at a $5 discount to LLS or $10 to the global market.  I am of the view that refiners with exposure to these crudes will generate a profit per barrel equal to the crude advantage + industry margins over the marginal cost to produce. 

Marathon Refining Assets Portfolio consists of 1.2mm barrels per day of capacity of which 623 barrels are in PADD2 (Mid-Con/Midwest) and 570k bpd are in PADD3 (US Gulf Coast).  MPC has stated that 30% of the company’s crude slate is directly exposed to WTI linked pricing.  If one believes WTI will permanently price at a $10 discount to the global market, this cost advantage is worth ~$4.50/share in normalized earnings.  In addition to PADD2’s crude cost advantage, refiners in the region also realize higher product margins (gasoline, diesel, etc.) than the rest of the US.  This is largely because there isn’t enough refining capacity in the Mid-con thereby requiring imports of gasoline from other regions at a price that reflects transportation costs.  I view this structural advantage to be worth an additional $.60 per share in EPS. 

The company also has a large growth project coming online in Detroit that I believe will drive an additional $1.00 in earnings per share.  Over the past several years, the company has spent $2.2B enabling its Detroit refiner to process Canadian Heavy crude.  Once this comes online in early 2013, the company will have capacity to consume 80k bpd of additional heavy crude, a product that sells at a $25-$30 discount to the global market.

Sum of the Parts Value:

I view normalized earnings of the core refining & retail business to be ~$7.20/share.  My estimate is based on marginal economics for the gulf coast assets (i.e. a $6 gulf coast 321 crack spread),a $10 WTI discount, Detroit heavy conversion, and the integration of the BP purchase.  I have also stripped out earnings from what I view to be MLP pipeline and logistics assets.  By applying an 8.0x-10.0x P/E and adding in the MLP qualified assets in the business , net debt, and FCF  generated over the next twelve months, I derive a valuation ranging from $67-$82/share.  To provide some detail as to how large the earnings power can be when S/D environment is tight, it is worth looking at some of the recently updated sell side estimates for the quarter, which run as high as $3.70/share.  Clearly annualizing this number is not sustainable, but it does suggest what earnings can look like if the environment were to remain robust.

Shareholder Friendly Management Team:

Since becoming a public company, management has taken significant steps to return cash to shareholders.  The company was spun out with $2.5B of net debt and an $.80/share dividend.  Management has increased the dividend twice in the last year and now pays out $1.40/share, some 75% above levels at the time of the spin.  Management also announced a $2 billion dollar buyback in February of which $850mm was executed through an accelerated repurchase.  By years’ end, the company will have $1.5B of net debt v a TMT EBITDA of >$6B.  If you read through the recent conference calls, management has reiterated numerous times the company’s continued interest in returning capital to shareholders.  I have attached a couple of statements from the public conference call on 10/08/12 (See below).  If one believes the company over time brings leverage to 1.5x net debt/EBITDA, the accretion on normalized EPS is substantial.  Based on my numbers, I believe normalized earnings would move from $7.20 to greater than $10/share in EPS.

“A point that I want to emphasize is, this or any other transaction will not be mutually exclusive with returning capital to our shareholders. We remain committed to a balanced approach of making value adding investments in the business, and returning capital to our shareholders."

"And to wrap up my comments, I want to again highlight all this transaction fits with our strategy including our priorities of increasing earnings and cash flow by making selective acquisitions. What I also want to reemphasize our commitment to balance returning capital to shareholders while making value enhancing investments in our business." 

"Well – and that's why I mentioned it twice in my remarks, is we want our shareholders to understand that this does not take us away from our commitment of returning capital, repatriating capital to the shareholders. We remain committed to this and the way we've structured this transaction, if the earn out is triggered overtime."

"So I agree with your question Arjun that is to provide significant cash to us but at the same time we are very committed to the direction we've been going with our repatriation of capital to the shareholder."

"I'd just thank everyone for tuning in today. This is an exciting day for MPC, and I'll just close again to reiterate that repatriation of capital is still top of mind to us, but we saw this as a great opportunity in an acquisition that really fits our model, fits our system that we believe can provide tremendous value to the shareholders going forward.”

Replacement Cost Analysis:

Given the company trades well below replacement costs, it is unlikely we see new investment from a greenfield standpoint in the refining sector.  Of note is that the robust refining margins only represent a portion of the US market and an immaterial portion of the global market.  Additionally, I believe the replacement cost analysis below is understated as it only values refining and does not take into account the pipelines, barges, retail stations, etc. 

BP Texas City:

On 08/12/2012, MPC announced the acquisition of BP’s Texas City refiner for $598mm in cash, a $700mm earn out, and $1.2B in working capital.  BP has been trying to raise cash to pay for the Macondo liabilities and has divested numerous assets across its portfolio at very attractive prices.  MPC was strategically positioned to purchase this asset as the company already operates a refiner adjacent to this site.   When assuming the earn-out is fully paid at the fastest rate possible (maximum amount allowable per year), I calculate a purchase valuation of 1.5-2.5x EBITDA.  This is one of the largest refiners in the US with a Nelson complexity of 15.3 and synergies that are expected to be $130mm per year.  Given the low valuation, I believe this purchase to be significantly accretive.  Management has guided accretion of approximately $1-$2/share range, something I believe to be conservative (http://www.marathonpetroleum.com/content/documents/investor_center/presentations/TexasCityAcquistion.pdf ).  Based on crack spreads YTD, I believe this asset would add in excess of $3.00 in EPS. 

MLP Arbitrage:

With pipeline assets trading at multiples that often go well above 12x EBITDA, management is taking strategic action to IPO its pipeline business.  The company has filed its S-1 under the name MPLX.  According to the filing, MPLX earned $168mm of EBITDA in 2011 and is expected to come public within the next several months.  In my opinion, this will likely set the stage for future MLP drop downs and should close the significant multiple gap between refining valuations (3.5x EBITDA) and stable pipeline MLPs (10.0x-12.0x). When you dig through the financials of MPC, you will only see $250mm of EBITDA in the pipeline segment which is clearly MLP qualified. What you will not see is the many additional MLP qualified assets that are grouped within the refining segment, which I view to represent $350mm.  This additional EBITDA can be estimated using details from the MPLX S-1 filing/other publicly traded MLPs and applying them to value MPC’s logistics assets.  I believe the recent success of EQT’s MLP IPO (EQM) provides a good roadmap for value creation and shareholder appreciation for the parent C-corp.

There has also been a new development in the MLP market in the form of variable rate MLPs.  Over the summer, Northern Tier Energy (NTI) was listed in the public markets as a first of its kind variable rate MLP.  This stock has done considerably well and presents the opportunity for C-corp refiners to convert into MLPs.  Northern Tier Energy, due to its tax free nature and yield oriented structure, trades at $25k per bpd of capacity, well above MPC at $15k and the rest of the refining group in the $8-$17k range.  To the extent this begins to gain broad appeal, it does present another arbitrage opportunity for Marathon Petroleum Corporation. 

 (The above commentary is solely the authors' opinion)

Catalyst