Diamondback Energy: Updating Valuation Methodology for U.S. E&Ps

We have adjusted our valuation methodology for U.S. exploration and production companies. Our multistage DCF valuation incorporates explicit projections for a fixed period, typically 5 years. Terminal values are derived by assuming firms eventually earn their cost of capital in perpetuity. This contrasts with our previous methodology, which modeled the harvesting of all company assets over a 30-year timeframe The change brings our E&P valuations in line with Morningstar’s standard equity research methodology.

For an industry facing secular decline, it might seem counterintuitive to switch to a perpetuity method. However, we maintain our long-held view that oil and gas demand will keep growing in the short run before slowly declining over a multidecade horizon. We agree that electric vehicles and renewables are effective substitutes for oil and gas respectively, but light duty vehicles account for less than half of crude consumption and there are no viable alternatives for the remainder (aviation, shipping, and petrochemicals). And natural gas will remain a core part of the energy mix for many years yet, initially taking share from coal that is still widely used for electric power generation. As production from existing wells declines quickly, the industry will have to keep developing oil and gas reserves to meet this persistent demand, and firms should receive credit for the ability to continue generating returns as a result, even when their current inventories are exhausted. Because our multistage DCF now implicitly incorporates this, the impact on fair values is typically positive (with an average increase of 5%-10%).

In Diamondback’s FANG case, the impact is much higher because its high-quality Permian acreage and deeply cost-focused management team support very strong EBI margins in the final year of our explicit forecast, thus boosting the terminal value. Our updated fair value is $167 per share, compared with the last close at $151.