While shares of Marathon Petroleum (NYSE:MPC) are up substantially over the past year, they have been a poor performer over the past few months, dropping about 25% from their 52-week high, as concerns have built over the health of the refining cycle. I last covered MPC in March, downgrading shares from a “strong buy” to a “buy.” While shares did briefly rally to my $216 target, in hindsight, I did not downgrade shares strongly enough as they have fallen by 15%. Given this underperformance and with concerns around refiners swirling, now is an opportune time to revisit MPC. I view this pullback as an opportunity.
Much of the pressure on shares in recent weeks has come from the softening crack spread environment. As you can see below, benchmark 321 crack spreads are down to about $25 from $29 three months ago. As a reminder, this measures how much refiners make by turning a barrel of crude oil into gasoline and diesel. This narrowing of the spread will, all else equal, reduce refiner profitability.
Now, taking a step back, I think it is important to remember that $25 is still a solid level for refining margins. Indeed in my prior article, I mentioned my view of crack spreads being around $25 this year and in the long-term being in the upper-end of my $15-25 view, rather than the $10-20 seen before COVID. Crack spreads can be very volatile, and that is why I have tried to anchor my valuation around MPC based on a long-term normalized level, which I view as being in the low $20’s.
As the chart above shows, Russia’s invasion of Ukraine caused a surge in spreads as product markets dislocated and diesel went into a shortage. Refiners like MPC made record profits, enabling massive share repurchases, but this level of profitability was never likely to be sustained. Indeed, it hasn’t been. With shares trading at mid-single-digit multiples back then, the stock was never pricing in that those earnings levels would be sustained, which is why shares have generated strong returns over the past several years.
In other words, the current level of crack spreads is consistent with my expectations, but short-term movement in crack spreads can cause movement in refinery stocks, especially as investors worry that the deterioration can continue. The primary source of concern is that gasoline inventories are higher than a month ago. Gasoline inventories tend to fall from April through September, given the summer driving season.
That has not been the case this year, which has increased worries that product demand is softening, leading to looser inventory conditions and wider spreads. I would note though that while inventories have picked up a bit, they do still remain at the low-end of the five-year range, a five-year period that has been quite good for the refiners.
A reason for this is that the summer driving season got off to a slow start. In May, gasoline demand was running 3-4% below last year’s level. Since then, it has rebounded to within about 1% of last year’s level. Parts of California had 3-4x as much rain as normal earlier this year, which may have reduced driving. The fact it is rebounding suggests that we are not seeing the economy roll over but just saw a period of transitory weakness.
With driving activity having rebounded significantly, I am less concerned about persistently sluggish demand or a spiral higher in inventories, and a resilient demand side should help to limit further pressure on crack spreads. Moreover, we are now entering the time of year when we can see supply-side disruptions, which can help to tighten the market.
While Hurricane Beryl left energy infrastructure largely unscathed, Goldman Sachs (GS) noted that an active hurricane season (as is forecast) could widen refining margins. The Gulf Coast is home to much of the US’s refining infrastructure, as well as much our gasoline export capacity. Insofar as hurricanes cause outages, that could reduce refinery throughput, tightening product market supply and widening spreads.
While there has been a cyclical spook in the refining market, we may be nearing an inflection point. Moreover, this should not be enough to cause long-term investors to look past the favorable secular backdrop I have spoken about before. The developed world is not building new refineries; it has been over 40 years since the US built a new large refinery. Refining capacity is likely to be an increasing bottleneck in the global energy supply chain, which is why I view crack spreads as likely to be persistently wider than pre-COVID.
Moreover, we should see MPC earnings accelerate in Q2, and even Q1 results were not that bad, considering where shares are trading today. In the company’s first quarter, MPC earned $2.58, which was down from $6.09 last year, given the normalization in crack spreads. As always, I believe it best to value MPC on a sum-of-the-parts basis. Aside from its refining operations, MPC also has a ~65% stake in MPLX (MPLX). This stake is worth just over $28 billion or about $77 a share. Additionally, MPLX distributed about $550 million to MPC in Q1.
In its refining unit, Marathon’s EBITDA declined to $1.87 billion from $2.16 billion in Q4, primarily due to a $287 million decline in the West Coast. EBITDA was down by $2 billion from last year’s $3.9 billion level. There are several factors at work here. First, refining throughput was down 6% from a year ago, primarily due to a 15% drop in the West Coast.
Marathon did $648 million of turnaround work at its refineries in Q1, which reduced their operating capacity. In Q2, turnaround activity should diminish to $200 million, as MPC did a disproportionate amount of the work during the seasonally quieter Q1. Because of these turnarounds, crude capacity utilization was 82% in Q1, and it should rise to 94% utilization in Q2. All else equal, more barrels should increase gross margin.
Additionally, refineries have substantial fixed costs. With turnarounds reducing throughput, that fixed cost is spread across fewer barrels, further tightening operating margins. Because throughput will rise in Q2, it expects $4.95 in Q2 refining costs from $6.14 in Q1.
Finally, in Q1, gross refining margins were $18.99 a barrel, down from $26.15 last year. While crack spreads have narrowed from three months ago, they have been higher during the second quarter than they were in the first, which should widen the refining margin. Because of turnarounds, product mix, and hedges, MPC only realized 92% of spreads in Q1, and we should also see some improvement here in Q2. Crack spreads were a $974 million sequential tailwind in Q1, offset by $1.16 billion of product mix headwinds. We should see material improvement here in Q2.
We are likely to see MPC report a meaningful acceleration in Q2 results, given more throughput, wider gross margins, and lower operating costs. Currently, analysts are looking for $4.73 in Q2 EPS. While quarterly results are hard to predict to a penny, I see upside to closer to $5.00, depending on its tax rate and the exact pace of share repurchases, which determine the average quarterly share count used to calculate EPS.
In Q1, MPC did $2.2 billion of share repurchases alongside $299 million of dividends. Additionally, $0.8 billion was repurchased in April. Alongside Q1 results, MPC announced a $5 billion buyback authorization for $8.8 billion total. These repurchases have been very powerful with its share count down 19% over the past year. MPC also carries $7.2 billion of cash and $6.8 billion of debt, excluding MPLX. I would continue to expect more than 100% of free cash flow to be returned to shareholders given its excess cash position.
Now, of course any investment has risks, and as we have seen MPC shares can be volatile. There are several risks I would highlight. First, nearly half of its current value from its $77 stake in MPLX shares. As MPLX shares move, the value of this stake can change. MPLX has been a solid performer with a healthy balance sheet and stable, fee-based cash flows; I have written positively on it previously and am comfortable with its valuation.
I expect sentiment around refining spreads to move shares much more than its MPLX stake, as evidenced by the fact MPLX shares have rallied slightly since March even as MPC has sold off. The biggest risk would be a narrowing of crack spreads. In the near term, if this hurricane season proves to be much calmer than expected, we may not see as many outages, which could make my call for a bottoming in crack spreads premature and leave some pressure on shares.
That said, I am focused less on one quarter’s crack spreads than the longer-term trend. The leading risk is in my view that refining margins are likely to be somewhat higher structurally than pre-COVID. Now, either more refining supply or less demand for refined products could weaken spreads. I am less concerned on supply. Refineries take several years to build, so we know new capacity is set to be limited. Given the cost and regulatory environment, I struggle to see a case for new refineries in the developed world being built. The supply side is likely to stay constrained.
As such, I believe the biggest risk is weaker demand. Now, if global gasoline and diesel demand start to persistently fall, this could reduce spreads. I still view this as a very long-term risk given EM countries continue to grow, and EV adoption has been somewhat slower. The more likely cause over the next two years would be a recession. Recessions typically reduce fuel demand and crack spreads. As such, I would continue to closely monitor economic activity. I view a recession as unlikely, especially with the Fed seemingly inching towards lowering rates. Still, if we were to see one, I would not expect MPC to perform as well. Overall, I view these risks as manageable.
Given where shares trade today and its MPLX stake, its refining unit is being valued at $31 billion. In a $20-25 crack spread environment, MPC has about $7.5-80 billion of free cash flow capacity, so it is trading nearly 4x free cash flow.
Including its MPLX dividends, I believe MPC can sustainably return $10 billion in cash to shareholders, and we will likely see it do more as it spends down some cash. That translates to a 16% capital return yield, which I view as extremely compelling, and with its share price lower, its buyback become even more accretive. Given the cyclicality and long-term push towards renewables, I conservatively have valued MPC’s refining arm at just 6x free cash flow or about $45 billion.
That leads to a sum of the parts valuation of $201, which still leaves shares with a 13% free cash flow yield. Additionally, over the next twelve months, we should see at least 10% share count reduction, which would push fair value past $220. That points to over 35% upside in MPC. This sell-off has created an opportunity for long-term investors, with hurricanes also potentially a near-term catalyst. As such, I am upgrading shares to a “strong buy” again.
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