Marathon Petroleum (MPC) is a high-beta stock. This means that the stock tends to move at a faster pace than the broad market. The refiner has plunged 30% since early October and is thus now trading at a 52-week low level. In this article, we will analyze why the recent plunge of Marathon Petroleum has presented a great investing opportunity, with the stock being capable of offering double-digit annual returns going forward.

The Reasons Behind The Plunge

The plunge of all the U.S. refiners began in early October and coincided with the peak of the oil price. Since then, the price of oil has plunged from $75 to $48 and domestic refiners have all been under great pressure. The market is afraid that a low oil price signals an economic slowdown in the upcoming quarters, which will adversely affect the demand for refined products and hence the refining margins.

We view these concerns as overblown. A recession has not shown up for nine consecutive years so it can show up at any time. However, it is impossible to time the next recession and numerous investors have missed the longest bull market in history waiting for the next recession to occur. Even if a recession shows up within the next two years, it is not likely to be as severe as the last one.

Moreover, the recent collapse of the oil price is actually a gift for domestic refiners. When the oil price is so low, it significantly increases the demand for refined products and thus provides a strong boost to the refining margins. We have not witnessed this effect yet due to adverse seasonality, as the demand for gasoline is much lower in the winter than in the summer. However, when the winter approaches its end, the refining margins will begin to expand and the market will realize that the prospects for refiners are excellent at the prevailing oil prices.

Another reason behind the plunge of the stocks of U.S. refiners was a WSJ report, which was issued two months ago. According to that report, the U.S. government was trying to postpone the implementation of the new international marine rules in the U.S. According to the new rules, which will come into force in January-2020, all the vessels that sail in international waters will be forced to burn low-sulfur diesel instead of heavy fuel oil. As the former is much more expensive than the latter, the new rules will greatly enhance the refining margins. Therefore, if the government succeeds in its efforts, it will adversely affect the domestic refiners.

However, it is doubtful whether the U.S. government has the power to postpone the implementation of the new international marine standard in the U.S. Even if it has such a power, it will only be able to postpone the new rules by one or two years. Consequently, domestic refiners will eventually enjoy the strong tailwind from the new marine standard.

Finally, domestic refiners have also been adversely affected by the ongoing correction of the broad market. During the last three months, S&P has shed 13%. As the market has entered a high-volatility period, it is likely to continue to weigh on the domestic refiners, at least in the short term.

The Tailwinds for Marathon Petroleum

So far we have analyzed the reasons behind the plunge of U.S. refiners and why we view these concerns are overblown. Moreover, Marathon Petroleum is facing some tailwinds.

First of all, the U.S. oil production has climbed to record levels this year and is expected by EIA to post new all-time highs next year, around 12.0 M barrels per day. Thanks to the booming oil production, WTI is trading at a wide discount to Brent. The spread between the two types of crude oil has widened from $6 in the beginning of the year to $10 right now. As a result, domestic refiners enjoy much higher margins than their international counterparts. As the U.S. oil production is expected to remain strong in the upcoming years, this strong competitive advantage of domestic refiners is likely to remain in place for the foreseeable future.

Moreover, Marathon Petroleum recently completed its acquisition of Andeavor. As the company has now become the largest U.S. refiner, this acquisition is likely to prove a game changer for the stock. Management expects to achieve at least $1 B of annual synergies while the company will also benefit from the inland location of the refineries of Andeavor thanks to the wide discount of the oil price relative to WTI in these locations.

Valuation

Thanks to the aforementioned tailwinds, Marathon Petroleum is expected to greatly increase its earnings per share, from $5.20 this year to $7.64 next year. This means that the stock is now trading at a forward price-to-earnings ratio of 7.7. This is a remarkably cheap valuation given the tailwinds facing the company and the rich valuation of the broad market. The historical average price-to-earnings ratio of the stock is 10.6, though we believe that the stock deserves an earnings multiple of at least 12.0. If Marathon Petroleum reverts to its average valuation level over the next five years, it will enjoy a 6.6% annualized boost in its returns thanks to the expansion of its valuation level.

Final Thoughts

Refining is a cyclical business and hence the valuation of refiners is justified to be somewhat cheaper than the valuation of the broad market. However, the recent plunge of Marathon Petroleum has led the stock to overvalued territory. The stock is offering a 3.1% dividend yield and is likely to enjoy at least a 6.6% annualized boost from the expansion of its price-to-earnings ratio in the upcoming years. Moreover, the company is expected to continue to grow its earnings per share thanks to the above tailwinds and its consistent share repurchases. Thanks to all these factors, Marathon Petroleum is poised to offer a double-digit average annual return in the upcoming years. While the momentum of the stock and the broad market is negative right now, those who maintain a long-term horizon are likely to be highly rewarded if they purchase the stock around its current level.