Diamondback Energy: Coiled To Strike Or To Miss?

| About: Diamondback Energy (FANG)

Diamondback Energy (NASDAQ:FANG) (with the evocative stock symbol of FANG) is a pure Permian, or West Texas, oil play company. Its operations are straightforward: drilling for oil in one of the hottest basins in the country. Investors who expect oil prices to fall may want to consider shorting this fully-valued stock. Investors who want to remain long commodities in the face of continued quantitative easing with a clear window into the strongest traditional/unconventional play may want to buy the dips.

Many of Diamondback Energy's stockholders have taken an understandable victory lap: the stock price had more than tripled since its initial public offering price of $17.50/share a year ago to a $52.75/share close on Monday, October 21st. The closing price October 23rd was $49.10/share.

The growth of Texas oil production from one million barrels per day to over two million barrels per day has been an optimistic, powerful story. Buying Diamondback Energy stock a year ago was a way to jump in. Is it still? That depends on several factors meshing together well, especially continued high oil prices. The October 23rd futures price of West Texas Intermediate oil, was just over $97/barrel, down somewhat from prior weeks. Its widening split from Brent, priced near $108/barrel, suggests a slight overhang of US oil supply. However, note that the Permian basin has the lowest break-even oil price, about $55/barrel, of any of the Lower 48 unconventional resource plays.

Potential Diamondback Energy investors need to be expecting some of the following factors: a) a pullback in stock price, b) a takeover, c) continued high oil prices, d) prospective acreage with more downspacing (wells/acre) yielding more proved reserves, e) further declines in Diamondback's operating costs, f) a continued increase in production, or g) continued sufficient takeaway capacity with robust demand at the other end of the pipe.

Diamondback Energy is headquartered in Midland, Texas. It has 52 full-time employees and 51,700 acres of leasehold. The majority of its 10,000 barrels per day of production is oil, over 80%. In the last year it participated in 20 horizontal wells, 19 of those in the Wolfcamp B formation.

With four rigs completing horizontal wells and one rig completing vertical wells, Diamondback is already producing from the Wolfcamp B and Clearfork formations with stacked pay potential locations in Wolfcamp A and C, Spraberry, Cline, Strawn, and Atoka formations. It has 1,114 gross and 867 net potential horizontal targets, with estimated ultimate recovery from each of 400,000-600,000 barrels of oil equivalent. Note that this 867-location total is estimated at 40-acre spacing but 20-acre spacing (downspacing) is a distinct possibility, and the benefit of 20-acre spacing was not included in the company's present-value estimate. A recent Diamondback announcement indicates the company's activities, and that of the wider basin when it said that the Digger 601H Clearfork Shale well in Andrews County reached a maximum rate of 611 barrels of oil equivalent per day (87% oil) from a 7,541 foot lateral. The well was completed for $6.8 million, with 30 frac stages, using a slickwater stimulation technique.

Diamondback Energy's pro forma proved reserves as of September 1, 2013 were 57.9 million barrels of oil equivalent. According to the company's outside reserve engineering firm, 65% of the total is oil (37.4 million barrels), 20% is natural gas liquids and 15% is natural gas. Proved developed reserves-what can be taken to the bank-are 43% of the total, or 24.9 million barrels of oil equivalent, giving a pro-forma present value at 10% (PV-10) of $952 million. The oil portion of the proved developed reserves is 15.5 million barrels.

Diamondback Energy has takeaway contracts with Magellan for oil, Lone Star and other west Texas pipelines for natural gas liquids, and Oneok for natural gas.

The company reported its general and administrative costs of $3-$5/barrel and its third-quarter 2013 lease operating expense was $9/barrel, down from $18/barrel a year earlier-a function of its higher production level.

Diamondback's management team has experience, including some with Permian Basin and specific Wolfberry experience, from ConocoPhillips (NYSE:COP), Apache (NYSE:APA), Laredo (NYSE:LPI), Burlington Resources, and Concho (NYSE:CXO).

The company is followed by 17 analysts. Its largest holder is Gulfport Energy, another oil producer, with 12%. Wexford Capital is the largest institutional stockholder by far, owning 27% of shares outstanding.

As a pure-play Permian oil stock, Diamondback's prospects depend on one's estimate of the price of oil, particularly West Texas Intermediate. This relies in part on continued quantitative easing, which appears likely.

However, simple economics suggest a price decline: high prices bring lower prices as companies jump in to produce more oil. With record-high November production in North Dakota of 961,000 barrels per day and 2,300,000 barrels per day in just the Permian and the Eagle Ford basins of Texas, the US is reliably on this path. There are hundreds of thousands of drilling locations. Operators are completing wells more quickly and producing more hydrocarbons per well. The process resembles manufacturing rather than speculative, high-risk exploration. Travis Stice, chief executive officer of Diamondback, reports a trend in line with these efficiencies, that a year ago horizontal wells were taking more than a month to drill and today they are doing it in less than half that time.

The EIA has just produced a new drilling productivity report showing these increased efficiencies. While they are more apparent in basins outside the Permian, the bottom line is that there is more domestic supply, which will tend to drive down the domestic oil price.

While demand for oil is increasing, the strength or weakness of global economies, including especially the US and China, will remain important to the price of oil. The US consumes 21% of the world's oil, while China uses 11%.

The latest oil inventory numbers show an increase worldwide to 380 million barrels. This includes an increase in China, reported by Xinhua News Agency, to about 238 million barrels and an increase in the US at Cushing to 33 million barrels. The supply increases have pushed down the near-term price of oil.

Insiders took a selling opportunity in September, when Diamondback's price was lower. After the eight executives sold shares, none now owns more than 0.3% of the company, and the chief executive officer owns less than 0.1% of the company.

Similar Permian-focused stocks include Laredo Petroleum, Inc., and Athlon (NYSE:ATHL). With a trailing price-earnings ratio of 94 and a forward price-earnings ratio of 40, for the near term Diamondback Energy appears fully valued and dependent on continued high West Texas Intermediate oil prices to sustain its stock price.

Disclosure: I am long FANG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Primary ticker is FANG