Diamondback Energy Stock Riding High On Back Of Permian, As Long As Prime Acreage Will Last

About: Diamondback Energy, Inc. (FANG)
by: Zoltan Ban

Diamondback is blessed with above industry average acreage quality, as well as larger than average drilling inventory measured in years.

It is also producing impressive net earnings/revenues on a regular basis.

High debt may be a hindrance to profitability if it is not paid down by the time Diamondback will have to increasingly rely on second tier acreage.

In the early years of the fracking boom it was claimed that all shale drillers were hitting the jackpot. They were all increasing production at a fantastic pace, and all of them were claiming to be profitable. 2015 was the year of reckoning for most of the industry, as average yearly oil prices declined from the $80-$100/barrel plateau that they were on in the 2010-2014 period, to something closer in the $50-$60/barrel range. We should keep in mind that most drillers, as well as outside analysts were claiming that frackers were profitable in such a price range, it was just that ramp-up costs were getting in the way of achieving actual profits. As drilling activity cratered, followed by a decline in production, so did the ramp-up argument, which was dispelled as a true reason why shale drillers failed to produce profits for so long. As it turned out very few companies were able to make money with oil prices in the $50-$60/barrel range, while anything bellow these levels seemed to be catastrophic. Diamondback Energy (FANG) however turned out to be an exception. It emerged as a rising star in the shale industry, with the right acreage in the right field. The Permian acreage was the magic ingredient and Diamondback continued to grow together with the field. Now question remains how long the magic of superior prime acreage will last.

Diamondback Resources acreage map Source: Diamondback Energy.

As we can see from the map, Diamondback has its acreage scattered across a large swathe of the Permian field. On this land, which amounts to 342,000 net acres, Diamondback claims the opportunity to drill 7,600 net wells. This all sounds very good, given that it is currently drilling about 275 net wells per year, based on 2019 plans, which gives it a 27 year inventory of potential wells that can still be drilled. This is of course in no way an indication of just how many profitable wells Diamondback can drill at any given price. In other words, how many of those wells would be profitably drilled if the price of oil were $30/barrel or $40, $50, $60 and so on. I am sure that the overwhelming majority of those wells might be profitable if oil prices were to average $80-$100/barrel. But that is not likely to be the most likely scenario in regards to the global oil market. Especially now that we are seeing more and more signs of a global economic slowdown, which might linger around for years, leading to dampened global oil demand growth.

It is impossible to tell where the total of 7,600 drilling opportunities would fit within the profitability/oil price relationship. Looking at the map, it seems that it has plenty of acreage within the more active parts of the Permian, such as in Midland. Martin and Reeve counties, which are currently leading the Permian production growth story. Then there is also quite a bit of acreage in less popular areas, such as in Ector and Crane counties, where overall oil and gas production is actually in decline and has been for a few years now.

Overall, it does seem that Diamondback is sitting on superior acreage compared with the industry peer average, but we should not by any means assume that the quality of the acreage it will be drilling five or ten years from now will be as good as what it is drilling through right now. But it does mean that it might still be drilling through prime acreage, even as more and more of its peers will run out and move on to second tier acreage, which would be a tremendous competitive advantage.

One of the main negative aspects of Diamondback's process of amassing all this acreage, which is arguably superior to the industry average is that it came at the price of amassing quite a bit of debt. To date, it has amassed almost $4.5 billion in debt.

Diamondback Energy debt Source: Diamondback.

If it is to go into some of the tougher phases of shale production, in other words the phase when less and less prime acreage and more and more secondary acreage will have to be drilled, the debt situation will have to be improved over the next few years in order to better cope with declining profitability.

In this regard, Diamondback's potential ability to pay down its debts, given the positive financial results is there. It most certainly can make inroads in this regard, for as long as the higher quality acreage lasts. In the latest quarter, it produced a net profit of $349 million, on revenues of just over one billion dollars. It is an impressive rate of profitability of almost 35% of revenue. It is especially impressive given that Diamondback production increased by 7% compared with the previous quarter. Capex spending between $2.7-$2.9 billion seems rather high, given that it represents about two thirds of total revenues for the year. It is a testament to the capital-intensive nature of the business, and it is a reminder of the fact that there is not much room for further declines in oil prices, which shale drillers, including Diamondback can afford to see going forward. Part of the reason why Capex spending is so high has to do with the fact that this company is still increasing production aggressively. It is still a very high number nevertheless and it means that paying down debt will be potentially difficult. For the first half of this year, Diamondback actually increased its long-term debt load, just slightly.

What this all means to longer term Diamondback stock investors is that in the absence of significantly higher oil and gas prices in coming years, there is a prospect of declining profitability as top tier drilling opportunities will dwindle. The current debt load would be a hindrance to profitability in the face of declining acreage quality, therefore investors would be better served by debt reduction than they are by the continued robust growth in production. The good news is that Diamondback will reach the point of significant acreage quality decline far later than many of its industry peers, which does potentially mean that it may outlast the current period of relatively weak oil & gas prices.

In the shorter term, investors can expect continuing profits, but with a market cap of $15.5 billion, it seems somewhat overvalued. It is roughly 3.8 times revenues per year, based on recent revenue trends. In terms of market cap versus reserves and cash, minus debt, Diamondback claims reserves of just under a billion barrels of oil equivalent, about two thirds of which is oil. Based on current oil and gas prices, those reserves are worth about $44 billion. Adding cash of $326 million, and subtracting debt of $4.48 billion, we have $39.8 billion worth of net reserve value. In other words, its reserves are worth 2.57 times the company's market cap. When it comes to mining companies, I personally like to see reserves surpass the company's market cap by about five times. But one should keep in mind that there is also the profitability issue, so this ratio on its own is not necessarily the ultimate indicator of where a company should be valued.

We should keep in mind that most shale reserves have been calculated in ways that should leave us cautious in regards to claimed, versus actual numbers. Ultimate production per well has been inflated industry-wide, which was proven by the fact that shale was never as profitable as it has been claimed. What this means is that ultimate recovery per well will be lower, as well as that claims in regards to how many viable drilling locations a shale company is sitting on, tends to be inflated as well. We have no way of knowing for sure to what extent Diamondback continues to participate in presenting overly optimistic recovery forecasts, but given that it seems to be an industry-wide trend, investors should remain skeptical in regards to reserves.

The fact that Diamondback's market cap is far higher compared with its peers who might otherwise match it in terms of revenues and reserves, stems from its continued growth potential, as well as its proven track record in terms of profitability. Thing is however that it became one of the last magnets for investors to pile into within the shale space, which pushed its market cap perhaps a little bit higher than its financial results and reserves can justify. The downside in the shorter term is that any slight hint of deteriorating profits, lack of ability to pay down debt or some other surprises can send this stock into a tailspin, while upside is more limited. In other words, there is potentially more downside risk than potential for upside surprises in terms of this company's future stock price. In effect, it is a good company, but perhaps too many investors have already recognized it and acted on it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.