- Diversified Gas & Oil is deeply undervalued at this point in time, as shown by my risk-reward analysis.
- Going forward, I anticipate a number of catalysts to drive a re-rating, on top of production and EBITDA growth.
- Enormous upside and largely mitigated risks make this stock attractive for both income and capital appreciation investors.
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“Some companies are built to drill, and some to operate. Diversified is built to operate very efficiently." - An investor
In a previous article, I stated Diversified Gas & Oil Plc (DGOC.LSE)(DGOCF) - DGOC henceforth - actually performed extremely well in terms of operational and financial numbers, in spite of the noise caused by the hedging-related mark-to-market non-cash charge as in the 2020 annual results. As production expanded and unit cash costs decreased, the company maintained high margins, which enabled the company to pay well-covered, high-yield, and growing dividends. Therefore, DGOC is a great investment vehicle for high-yield investors.
I subsequently stated DGOC grew annual average production by 18% from 85,000 boe/d in 2019 to 100,000 boe/d in 2020; however, the growth momentum may substantially accelerate in 2021, driven by potential major acquisitions fueled by $1 billion of Oaktree capital in a conducive industry environment. That makes DGOC an especially attractive stock for capital appreciation-oriented investors.
Below, let's examine DGOC from a risk-reward analytical point of view, to revisit the investment thesis that was first laid out here.
As of end-2020, DGOC had 607 MMboe of proven (1P) reserves, up 7.8% from end-2019, as audited by Netherland Sewell & Associates, a top-ranking oil and gas consultancy.
From the NPV-10 value for the PDP reserves ($1.9 billion), the net debt ($725 million), and the fully-diluted market cap ($1,252 million), the EV/NAV multiple comes to 1.07X. It is important to remember that more than 95% of the proven reserves are classified as proved developed producing (or PDP), which will continue to pull in revenue without material capital outlays until reserve depletion.
As a comparison, Appalachian peer Cabot Oil & Gas (COG) trades at 2.5X of NAV for proven reserves, even though its proven reserves only include 37.2% of proven undeveloped (or PUD) reserves (see here); EQT Corp. (EQT) trades at 1.0X of NAV for proven reserves, despite its proven reserves only include 32.4% of PUD reserves (see here). Please note, the development of PUD reserves require hundreds of millions of dollar in capital expenditures. Therefore, DGOC is clearly undervalued relative to Cabot and EQT in terms of EV/NAV.
In terms of the EV/EBITDA multiple, DGOC is undervalued at least by 1/3 relative to an average natural gas producer in the Appalachian Basin (Table 1). Such an undervaluation is probably due to misunderstandings about DGOC's unique business model in relation to its peers in the Appalachian Basin (Fig. 1).
Table 1. The EV/EBITDA multiples for major Appalachian natural gas producers and for select midstream companies, including Range Resources (RRC), Antero Resources (AR), Gulfport Energy (GPOR), Southwestern Energy (SWN), Equitrans Midstream (ETRN), Tallgrass Energy (TGE), TC Energy (TRP), and ONEOK (OKE), compiled by Laurentian Research.
Fig. 1. A list of market perception and corresponding reality with regard to DGOC, from this source.
I believe DGOC deserves a higher multiple than a regular gas producer because by leveraging its unique business model (less volatile cash flow due to hedging, debt amortization) and superior assets (low decline, low costs, and high margins), DGOC was able to establish an envious track record of high margins, reliable free cash flow, and profitable growth at either high or low commodity prices. Specifically, I believe DGOC should be valued at an EV/EBITDA multiple close to those of the natural gas midstream companies. The mid-point between the EV/EBITDA multiples of the Appalachian gas producers and the midstream companies is at 11.0X.
Let's consider three scenarios, namely, the conservative case where DGOC maintains the 2020 exit level of production going forward, the base case where it grows production by 18%, and the aggressive case where it grows production by 50%.
In these cases, in 2021, DGOC is estimated to generate an EBITDA of $390 million, $460 million, and $590 million, respectively, under the current hedge program (as of March 4, 2021, the 2021 production is ~90% hedged with an average floor gas price of $2.94/Mcf, see here for details).
Firstly, let's assume the EV/EBITDA multiple of DGOC expands to the level captured by the Appalachian gas producers. In that case, the stock would reach $2.36, $2.97, and $4.05, respectively, in the conservative, base, and aggressive cases, implying an upside of 53%, 93%, and 163% from the current share price of $1.54.
Then, assume the EV/EBITDA multiple of DGOC is re-rated to 11.0X, the mid-point between the EV/EBITDA multiples of the Appalachian gas producers and the midstream companies (Table 1). The stock would reach $5.05, $6.14, and $8.09, respectively, in the conservative, base, and aggressive cases, implying an upside of 228%, 299%, and 425% from the current share price of $1.54 (Table 2).
The pace of re-rating of DGOC is uncertain, depending on a number of foreseeable and unforeseeable factors:
- A major acquisition, using the up to $1 billion dry powder supplied by Oaktree Capital Management, L.P. would generate enormous media publicity.
- A potential up-listing in the U.S. from the illiquid OTCXB would help bring the company to the radar screen of Wall Street.
- Sustained high natural gas prices may attract trend-following investors into the natural gas space. A search for bargains in that space would likely lead to the eventual discovery of DGOC.
- However, by the end of the day, if DGOC continues to report amazing results, the gap between the share price and the intrinsic value cannot sustain forever.
Given DGOC owns thousands of mature gas wells, costs for asset retirement are naturally a risk. As a matter of fact, DGOC has had an active well-plugging program underway. The company plugged more wells than required by the Consent Order and Agreement (or COA) that it reached with the four states it operates in - West Virginia, Kentucky, Ohio, and Pennsylvania (Fig. 2). DGOC is gaining efficiency as it climbs the learning curve of retiring wells; it is even piloting an internal plugging team with an initial focus on West Virginia. With each well costing approximately $25,000 to plug, DGOC incurred less than $2.4 million in asset retirement in 2020, which is a minimal portion of the $301 million of hedged adjusted EBITDA it generated in 2020. Operating ~60,000 wells that have an average well life of 40-50 years, DGOC is estimated to cumulatively incur roughly $250 million in 10%-discounted asset retirement costs over the next 40-50 years.
Fig. 2. The number of wells that were required to be and actually were plugged by DGOC, from this source.
DGOC may face a staffing crunch and could temporarily lose the extraordinary operational efficiency it is known for, if it makes an acquisition in an entirely different region away from the Appalachian home base. In that case, investors will need to stay patient as the hard-driving management pull the staff up a learning curve in that new region.
None of the above worries me more than a surging natural gas price. A key component of DGOC's growth strategy is to buy mature producing assets on the cheap so that future costs associated with well workover and asset retirement are recovered on the front end. Aided by the capital supplied by Oaktree, DGOC is on the eve of acquiring on a massive scale. The least the management wants at such a crucial time is that dry gas properties, including mature producing gas assets, suddenly become too pricey due to skyrocketing natural gas prices. I think DGOC management may get lucky since a lot of dry gas assets are coming to the market, as I discussed elsewhere.
Lastly, impatience on the part of investors may expose them to unforced errors. Other than AIM, DGOC also trades on OTCQB, where liquidity is limited until the stock is potentially up-listed to either Nasdaq or NYSE; some brokerages charge an onerous foreign stock transaction fee on buying and selling DGOC; British non-residents have to pay foreign dividend withholding tax. In my opinion, anyone who doesn't plan to hold for more than three years should not own the stock.
DGOC is one of those companies that do things differently from the crowd that they are misunderstood. In summary, I see four defining features that attract me to this quirky stock:
- High-quality assets of full-cycle low costs. DGOC owns a portfolio of mature dry gas wells in the Appalachian Basin. The company is doubly blessed, first by the cheap valuation assessed by the property sellers, then by the shallow decline curve that comes with the mature assets. DGOC has a corporate decline rate of ~7%, which is substantially lower than the U.S. natural gas base decline rate of 26%. The shallow decline curve lowers maintenance capital expenditures, which leads to abundant free cash flow, which is deployed to inorganic acquisitions (in addition to distributed dividends), thus forming a flywheel.
- A management team that not only is extraordinarily talented but also has skin in the game. To amortize debt repayment is refreshingly odd in today's Corporate America. To give up the so-called commodity price torque in favor of safe cash flow gives the company antifragility. To be disciplined in acquisitions and proactive in asset retirement proves this is a team of far-seeing adults. The 7% insider shareholding suggests the alignment of their interest with that of the outside shareholders.
- Blue-sky growth potential. The chosen niche of DGOC - managing mature dry gas wells - is expanding in the aftermath of the shale revolution. The business model of some shale gas developers has not been unsustainable, to begin with. A slew of shale producers become forced sellers of dry gas assets, scrambling to contain 'sinful' fossil fuel production while attempting to grow cash flow. Perfectly in time, Oaktree showed up with $1 billion to set up a JV, to which DGOC contributes 50% of the acquisition capital for a 52.5-59.625% working interest.
- An adequate margin of safety. DGOC is undervalued in terms of the P/NAV metric, relative to the top-performing Appalachian shale gas developers. If its EV/EBITDA multiple expands to the same level captured by its Appalachian peers, DGOC will deliver 53% to 163% in a series of scenarios ranging from flat production to 50% production growth; if the market comes to recognize DGOC as a high-margin, reliably free-cash-flowing, and growth-potent compounder, the stock may even deliver from 228% to 425%, on top of the high-yield and growing dividends.
That is why I made DGOC a core position in both the income and capital appreciation strategies of my portfolio.
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This article was written by
As a natural resources industry expert with years of successful investing experience, I conduct in-depth research to generate alpha-rich, low-risk ideas for members of The Natural Resources Hub (TNRH). I focus on identifying high-quality deep values in the natural resources sector and undervalued wide-moat businesses. This investment approach has proven to be extremely rewarding over the years.
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Disclosure: Besides myself, TNRH is fortunate enough to have multiple other contributing authors who post articles for and share their views with our thriving community. These authors include Silver Coast Research, among others. I'd like to emphasize that the articles contributed by these authors are the product of their respective independent research and analysis.
Analyst’s Disclosure: I am/we are long DGOCF. 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.
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