Market Bites Diamondback
But we think the latest acquisition is moat-enhancing and fairly priced.
Diamondback Energy’s (FANG) shares plunged after the announcement that the oil and gas producer will acquire Energen in all-stock deal valued at $9 billion, a 16% premium to the latter company’s previous closing price. We think this creates an attractive buying opportunity for investors, as Diamondback was already trading at a substantial discount to our fair value estimate and the price paid for Energen appears to be fair.
The combined entity will be one of the largest oil and gas producers in the Permian Basin, with about 390,000 net acres of unconventional leasehold and current volumes of 215 thousand barrels of oil equivalent per day (of which Energen is contributing 179,000 net acres and 90 mboe/d). This footprint is split fairly evenly between the Midland and Delaware basins and encompasses most of the counties in the play. The Tier 1 component by itself could support 15 years of further drilling at the current run rate. Much of the remainder is likely to be sold to bring the value forward, generating cash that can be used to accelerate the development of the core portion--all of which is in accordance with the company’s “grow and prune” strategy. As a bonus, the assets include substantial mineral interests that are ideal for dropping into Diamondback’s Viper Energy Partners (VNOM) subsidiary.
Unusually, the deal appears to enhance rather than detract from Diamondback’s narrow economic moat. In part, that’s because the scale and relatively strong balance sheet of the pro forma entity warrants a slightly lower cost of capital, lowering the hurdle to excess returns on invested capital (we model 8.6%, down from 8.7%). But it also lowers overhead costs and provides a longer runway of Tier 1 drilling opportunities, with more scope for long-lateral development. Further value is generated by bringing Energen’s costs in line with Diamondback’s per guidance, as the latter is the industry cost leader.
Moreover, we emphasize that our bearish views on crude prices are fully incorporated. We believe current U.S. activity is well above the “goldilocks” level that keeps global markets well supplied in the next few years and can shortly reverse the current tightness caused by geopolitical supply disruptions. The resulting correction could put pressure on oil producers, including Diamondback. But this company enjoys a strong enough cost advantage that it can still thrive at our $55/barrel midcycle forecast for West Texas Intermediate with about 20 active rigs. That justifies our current valuation. Investors with a more bullish outlook should note that at $60/bbl, with a rig count in the high 20s per management’s base case, our fair value estimate would rise to $200, putting the stock in 5-star territory.
We See More Double-Digit Growth Ahead
Diamondback was a modest-size oil and gas producer when it went public in 2012, but it has rapidly become one of the largest Permian Basin operators. This was supported by a series of corporate acquisitions, most notably Energen in 2018. The company’s organic volume growth has been impressive, too, and we believe there are several more years of double-digit growth yet to come.
Keeping costs low is baked into the culture at Diamondback, and we expect operations to remain lean and efficient despite the recent expansion. From the outset, the company has enjoyed a considerable competitive advantage that enables it to systematically undercut its upstream peers. This was initially based on the ideal location of its acreage in the core of the play and by the early adoption of innovations like high-intensity completions, resulting in more production for each dollar spent. More recently, the company has started seeing economies of scale as well.
Management has fiercely protected the balance sheet over the years and has been willing to tap equity markets when necessary, as it did several times during the 2015-16 downturn in global crude prices. But such issuances should be less frequent going forward. Though substantial, the acquisitions announced during 2018 will require only $900 million in cash. The company intends to fund this with debt, which will result in a modest and very short-lived uptick in leverage ratios. Meanwhile, spending is unlikely to exceed cash flows unless oil prices collapse well below our midcycle estimate of $55/bbl--and in that scenario, Diamondback would still be better off than most of its peers thanks to its highly competitive cost structure.
Finally, we highlight the company’s 64% stake in its mineral rights subsidiary, Viper. This vehicle owns the mineral rights relating to some of Diamondback’s most attractive acreage, further juicing returns on drilling for the parent. This investment is publicly traded with a current value of roughly $2 billion.
Because of its enviable Permian Basin acreage, Diamondback is the lowest-cost producer in the upstream oil and gas segment. In 2017, it reported finding and development costs of $7.24 per barrel of oil equivalent and operating expenses of $9.25/boe, which translates to a West Texas Intermediate break-even of less than $30/bbl, one of the lowest in our coverage. As such, the company is better positioned to cope with very weak oil prices than most peers, and at our midcycle forecast of $55/bbl WTI, it can really thrive. Accordingly, we award it a narrow economic moat rating.
The company’s cost advantage is underpinned by a long runway of drilling opportunities in low-cost areas. It operates exclusively in the Permian Basin, which is the cheapest source of crude oil in the United States, sitting below other shale plays, deep-water projects, and all other unconventional sources on the global cost curve. It’s no coincidence that in 2017, the top three companies we cover, ranked by operating margin, were all Permian Basin pure plays. And Diamondback, which ranked number one, has a huge footprint in some of the most prolific areas. That’s important because the precise surface location of a horizontal shale well plays a huge role in determining its eventual productivity and influences the oil content of its production stream. By focusing on areas that typically yield very impressive initial flow rates, Diamondback’s fixed costs, such as drilling and completions, are spread more thinly, delivering more bang for the buck.
Management is making the most of this premium acreage by keeping operations lean and efficient and staying ahead of the curve with technical advances such as high-intensity completions. But neither efficiency nor technical savvy constitutes a sustainable competitive advantage, as both are theoretically replicable. It is the assets themselves that drive Diamondback’s moat. The company’s inventory still contains almost 10,000 potential drilling opportunities, which translates to several decades of runway. Of these, we believe a significant majority are in so-called sweet spots.
Diamondback’s impressive returns are also supported by below-average acquisition costs. The technologies that brought about the shale revolution, such as horizontal drilling and fracking, were not widely used in the Permian until 2010; these techniques were only considered effective in natural gas reservoirs initially, which explains why activity in gas plays like the Barnett Shale took off several years earlier. As Diamondback has been active in the play since 2007, it had a head start when the industry finally started recognizing the Permian’s full potential. This enabled the company to lock up a large part of its leasehold before the ensuing land grab pushed up prices. More recently, management has demonstrated that it isn’t averse to making large acquisitions, but so far it has avoided overpaying--even for Energen, which is its largest purchase to date and was announced during a period of what we consider to be unsustainably high commodity prices. As Diamondback is now holding more than 40 years of inventory, we believe it is more likely to be a seller than a buyer going forward.
Financial Health Still Excellent
As with most exploration and production companies, a deteriorating outlook for oil and natural gas prices would pressure Diamondback’s profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy.
Diamondback has historically maintained excellent financial health, with one of the strongest balance sheets in our upstream coverage. The recent acquisitions of Ajax Resources and Energen will push leverage up slightly, but not to an unsustainable level. And the uptick will be very short-lived, given how quickly the company is increasing production and earnings. On a pro forma basis, debt/capital is around 21%, and net debt/EBITDA is about 2.4 times. Both metrics should be back at the low end of the peer group range by mid-2019, as the company can generate cash-flow-neutral production growth under a wide range of commodity price scenarios. The entire management team is returns-focused and has proved itself to be an exemplary steward of capital.
Dave Meats does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.