Marathon Investors Gain as Share Price Falls

Marathon Oil (NYSE: MRO) shares got cheaper but more valuable when the markets closed last Thursday. The Houston-based energy company completed a long awaited spinoff of its lower-margin refining business, creating a second investment for shareholders of record. Investors received one share of Marathon Petroleum Corp. (NYSE: MPC) for every two shares of Marathon Oil they held.

Marathon Petroleum, based in Findlay, Ohio, will handle refining, marketing, and distribution. Marathon Oil was reborn a smaller oil and gas exploration company with a focus on unconventional plays in shale basins including the Eagle Ford field in Texas, the Niobrara field in Colorado and Wyoming, and the Bakken field in North Dakota and Montana.

What's it all mean for investors? Marathon Oil share prices closed Friday about 60% lower than the day before, needlessly alarming investors who forgot to factor in their holdings in the new entity. But yesterday, two key credit raters downgraded Marathon Oil. Fitch Ratings and Standard & Poor's Ratings Services each lowered the oil company's credit ratings to BBB, two notches above junk, citing the company's loss of earnings diversification because of the split.

So let's take a closer look. By separating the upstream (exploration and production) from the downstream (marketing and refining) operations, Marathon Oil wants to streamline operations, improve its flexibility, maximize efficiencies, and, ultimately, create more shareholder value. And based on the details of the spin-off and market price action since Thursday, despite the credit downgrades, I think the move is accomplishing its objectives.

Let's start by examining the price drop in Marathon Oil -- the big issue on investors' minds. Before the spin-off, MRO closed at $52.68. MRO shareholders received a "dividend" of one share in the newly-formed Marathon Petroleum for every two shares of Marathon Oil they held. At the time of assignment/IPO (June 30 close), this equated to a $20.70/share dividend for MRO investors.

Adjusting for the dividend, MRO closed up $0.97 (3%) on Friday, and continued climbing on Tuesday. MPC initiated trading at $41.40 on Friday. It hasn't traded lower, stabilizing around $42/share. That means Marathon Oil shares that were worth $52.68 last week have climbed 4.6% in market value.

Marathon Oil is one of the companies in the IU25 index. So the price drop seemed to have a negative impact on the nominal value of the index. But it didn't. The "dividend" shareholders received in the form of Marathon Petroleum stock has lowered the cost basis and, therefore, increased the real return of the IU25 index.

What will the spin-off do for investors? Primarily, it allows both businesses to focus on creating value in a more focused niche. By reducing the scope of operations, the two management teams are able to concentrate fully on maximizing the value in their individual segments. The concern with this division is the loss of contributing talent on both sides. However, both companies now have capable teams that can take on "tunnel vision" to become even better in their roles.

Along with this niche focus is the expectation of a reduced cost of capital for both companies. Lenders and investors in the exploration and drilling segment are not exposed to risks and fluctuations in the refining and distribution segment and vice versa. This is a material benefit to both companies in the wake of the Gulf Oil Spill and uncertainties in industry regulation.

To MRO's benefit, proceeds from the spinoff were used to cover a third of its outstanding long-term debt, which will lower financing costs and increase the rate of return for MRO shareholders. MPC has taken on new debt, at a lower rate, to fill out the balance sheet and provide initial operating cash.

Investors, meanwhile, have an opportunity to take another look at their portfolios and better allocate their holdings to the two resulting businesses.