(Public) Diamondback Energy

Editor’s Note: This article was first published to HFI Research main subscribers on Jan 6, 2024. Please note that this write-up occurred before the acquisition of Endeavor and the difference in market data.

Diamondback Energy (FANG) is a leading Permian E&P. It is the largest pure-play Permian operator after Pioneer Natural Resources (PXD), which is being acquired by ExxonMobil (XOM) Diamondback holds some of the highest-quality acreage in the basin. In 2023, it produced approximately 450,000 barrels per day (bpd) comprised of 58% crude oil, 21% NGLs, and 20% natural gas. Its acreage is weighted toward the Midland Bain, but it also has significant holdings in the Delaware Basin, as shown below.

Source: Diamondback Energy website.

As of its 2022 reserve report, the company possessed 14 years of proved and probable reserves.

Diamondback holds a 57% equity interest in Viper Energy Inc. (VNOM), its sponsored mineral and royalty interest holder. Dividends from Viper accounted for 6% of Diamondback’s free cash flow in 2023 through November 30.

Due to its low-cost operating model and conservative financial position, Diamondback is a sort of jack-of-all-trades for E&P investors. The company is able to emphasize returning capital to shareholders while also growing production in the mid-single-digit range.

At the same time, it is able to be an effective consolidator. In 2023, it acquired privately-held E&Ps Lario Permian and FireBird Energy for a combined $3 billion. The acquisitions brought an additional 500 drilling locations across 83,000 acres and increased Diamondback’s production by 37,000 bpd. They provided the company with additional scale in the Midland Basin, and we suspect they extended its reserve life, as well.

In the third quarter, Diamondback established Deep Blue Midland Basin, LLC, a joint venture to manage water in the Permian, in which it owns a 30% equity interest. Deep Blue is now the largest water business in the basin. While it will marginally increase Diamondback’s operating costs per barrel, the cost increase will be more than offset by reduced midstream capex requirements.

Diamondback has been actively disposing of non-core acreage. In the seven quarters ending November 30, 2023, it generated $1.7 billion of proceeds from asset sales. It has allocated the proceeds to fund acquisitions and pay down debt.

At the end of the third quarter, net debt stood at $5.5 billion, a conservative 0.8-times trailing cash flow. The company maintains a conservative debt maturity profile, as shown below.

Source: Diamondback Energy Q3 2023 November 2023 Investor Presentation.

One of the Best E&P Capital Allocators

Diamondback excels in capital allocation. It is committed to paying out 75% of free cash flow to shareholders as dividends and share repurchases. At the moment, it pays a $0.84 per share base dividend supplemented by a large variable dividend.

In 2023, total dividends amounted to $3.37 per share, representing a 2.2% yield on its current $155 share price. The company aims to hedge approximately 60% of its production from quarter to quarter to protect the dividend in the event of a sudden oil price decline.

We particularly like management’s discipline when it comes to share repurchases. Many E&Ps adopt a programmatic approach to repurchases that run the risk of buying shares at too high a price. By contrast, Diamondback only steps up repurchases when its shares trade at a steep discount to its estimate of intrinsic value. It prefers to repurchase when the shares offer a mid-teens annual return at $60 per barrel WTI, $20 per barrel NGLs, and $3.00 natural gas. As the share price increased in the third quarter, it pulled back, repurchasing 406,000 shares for $56 million at an average price of $136.59.

Management has pledged to be bold with capital allocation if circumstances permit. The company is willing to devote all its free cash flow to share repurchases if the share price were to fall low enough. Given the company’s high quality, large repurchases at very low share prices would be an outstanding use of shareholder capital.

Diamondback is likely to continue pursuing acquisitions amid the ongoing consolidation among E&Ps. We wouldn’t be surprised to see it diversify outside the Midland Basin, though it’s likely to maintain its focus within the Permian.

Valuation and Oil Price Sensitivity

Diamondback’s low operating costs and 58% crude oil weighting reduce its cash flow torque to higher oil prices. Free cash flow per share only doubles as WTI moves from $70 per barrel to $95, a far cry from the typical independent Canadian E&P.

Another relative drawback is the premium valuation the market places on Permian-based E&P shares, though Diamondback trades at a discount to PXD and EOG (EOG). The combination of low cash flow torque and a premium valuation means that the shares only offer 17.3% upside at $90 per barrel WTI to trade at a 12% free cash flow yield.

Our discounted cash flow valuation implies the shares trade at a slight premium based on our $82.50 per barrel WTI. They offer 4% downside based on discounted free cash flow at that oil price.

Risks to Shareholders

Macro considerations are the main risk to Diamondback shareholders. On a micro level, shareholders can rest assured that the company will be very well managed. They don’t have to worry about all the bad decisions that so many E&Ps routinely make. For instance, we don’t consider a dumb acquisition to be a material risk. However, due to the company’s high-quality acreage, its high bar to future acquisitions that extend its reserve life while maintaining inventory quality could pose a challenge as it depletes its best acreage.

Aside from the usual macro risks like a sustained bout of low oil prices, shareholders are at risk from a lowball takeover offer, as Diamondback is a prime acquisition candidate for an oil major looking to expand in the Permian. However, the company is as committed to shareholders as it comes in the E&P world. We suspect it would fight tooth and nail to secure an attractive purchase price.

We should add that with Diamondback’s shares trading at all-time highs, any premium offered in a buyout could be underwhelming. We therefore wouldn’t buy Diamondback shares in the hope of a buyout offer.

Conclusion

Diamondback would be an excellent stock to buy during an oil market selloff that takes prices into the $60s per barrel. At those prices, its stock would probably discount WTI in the low-$70s per barrel, and its shares would trade below $125. Since we believe WTI will average more than $80 per barrel over the long term, investors would be able to purchase the shares at a discount and hold until oil prices recover. At that point, they would benefit from management’s superior capital allocation. Capital appreciation, as well as dividends and share repurchases made over a multi-year holding period, would generate an attractive total investment return.

For the moment, however, we rate Diamondback as a Hold simply because the shares aren’t cheap enough for our liking. Our price target is $165, with the 6.5% upside from the current share price coming from annual production growth. We would consider buying Diamondback shares at less than $125 per barrel. Above that level, we recommend that investors look elsewhere to secure a bargain purchase.

Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.