- Diversified Gas & Oil finally announced the long-anticipated entry into a new regional focus area - the Gulf Coast.
- In this article, I review the Cotton Valley play, analyze the transaction metrics, review the immediate and long-term impact of the deal, and update the investment thesis.
- I believe Diversified offers a more attractive risk-reward profile at the present time than ever before.
- I do much more than just articles at The Natural Resources Hub: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
The management of Diversified Gas & Oil Plc (DGOC.LSE)(DGOCF) said during the 2020 earnings call in March 2021,
"We will be acquiring assets this year. We're just making sure that the ones that we do fit the profile, are valued properly and give us the ability to give our investors long-term value that we have promised them."
I posited the next acquisition might be outside the Appalachian Basin in a move "to open the second operational center, which will then serve as the cornerstone asset for future synergistic bolt-on deals".
Below, let's examine this strategic transaction, in the hope of updating the investment thesis of this unique natural gas producer.
What was acquired
Diversified acquired ~50 MMBoe (or 305 Bcfe) of proved developed producing (aka, PDP) reserves in the conventional Cotton Valley play (see below) in around 180,000 net acres of land mostly in the Caddo and De Soto parishes, northwestern Louisiana, which are 100% held by production with no other encumbrances (Fig. 1).
- The PV-10 for the PDP reserves comes to $175 million as of March 1, 2021, effective date, based on April 16, 2021, NYMEX strip price.
The acquired properties produce ~16,000 boe/d (or 95 MMcfe/d) from 815 net wells, of which 780 net wells (or 95.7%) are operated by Indigo.
- Indigo has an average net revenue interest of 60% and a working interest of 79% in these wells, which average 17 years in age.
- The year-one decline rate is estimated to be ~14%, and the terminal decline rate 6%.
Fig. 1. The Cotton Valley properties (in yellow) acquired from Indigo, from this source.
What is the Cotton Valley play?
The Upper Jurassic to Lower Cretaceous Cotton Valley Group is a ~1,000-10,000' thick stratigraphic unit that extends from East Texas to the Florida panhandle, although gas production is largely limited to East Texas and northwestern Louisiana (Fig. 2).
Fig. 2. Location of wells producing gas from the Cotton Valley Group exclusive of the Bossier Formation, from this source.
Overlying the famous Haynesville shale, Cotton Valley consists of stacked barrier-island, strand plain, and fluvial-deltaic sandstones that serve as the Cotton Valley reservoir rocks. Hydrocarbon in Cotton Valley sands sources from the underlying Haynesville shale and Bossier shale (Fig. 3). Being 'tight sands', Cotton Valley requires moderate hydraulic fracturing to flow gas and condensate (see here).
- Cotton Valley is known to produce wet gas. Previously reported examples of production mix include 63.7% gas, 14.7% oil, and 21.6% natural gas liquids (or NGLs). In another example, Goodrich Petroleum (GDP) had 62.7% gas, 14.4% oil, and 22.8% NGLs; the company said it produced 57-143 barrels of NGLs for every 1 MMcf of gas (see here).
- Cotton Valley wells usually deliver better economics than Haynesville wells. The shallower (~9,900’) Cotton Valley wells cost less to drill. The higher NGL cut in the Cotton Valley wet gas production helps realize greater revenue than dry Haynesville gas.
Fig. 3. Generalized stratigraphic nomenclature of Cotton Valley Group (patterned units) in northern Louisiana, from this source.
Having been producing since the 1940s, Cotton Valley became hot again in the 2000s and 2010s, thanks to new technologies including horizontal drilling and hydraulic fracking and the advent of cross-unit lateral wells. At one point, there were 180 operators working on Cotton Valley, including Indigo; Memorial Resource Development LLC that was acquired by Range Resources (RRC) in 2016; PetroQuest; Goodrich Petroleum; Sabine Oil & Gas (nee NFR Energy) that merged with Forest Oil in 2014; GMX Resources, which split into two entities after bankruptcy, i.e., Thunderbird Resources Equity Inc. and Thunderbird Resources LP; Exco Resources (OTCPK:EXCE); Bonanza Creek Energy (BCEI) which exited from Cotton Valley in 2018; Breitburn Energy Partners LP (OTCPK:BBEPQ), and etc.
The immediate impact of the acquisition
The Indigo acquisition will be accretive to Diversified, effective March 1, 2021 (expected closing in late May 2021):
- The transaction adds ~50 MMboe (~305 Bcfe) of PDP reserves to DGOC's yar-end 2020 PDP reserves of 607 MMboe, representing an 8.2% expansion. The PV-10 of these newly acquired reserves is ~$175 million as of March 1, 2021, a 9.2% increase from that as of December 31, 2020.
- The acquisition adds ~16,000 boe/d (or 95 MMcfe/d) to DGOC's 102,000 boe/d (612 MMcfe/d) existing production in the Appalachian Basin, a 15.7% growth;
- The deal adds approximately $40 million of adjusted EBITDA, hedged and before anticipated synergies. Relative to the runtime 1Q2021 hedged, adjusted EBITDA of ~$78 million, it represents a 12.8% increase.
Diversified will likely expand its hedging portfolio in view of the 15.7% increase in production (Fig. 4).
Fig. 4. The hedging portfolio of DGOC, from this source.
The hedged adjusted EBITDA margin for the Cotton Valley properties is ~50%, only 2% below the cash margin achieved by Diversified in the 1Q2021 in the Appalachian Basin. The ~50% margin is an excellent starting point for DGOC to drive for further improvements using its Smarter Asset Management (or SAM) program. To that end, DGOC will retain ~25 field personnel currently servicing the wells to ensure operational continuity and smooth integration into the SAM program. I expect Cotton Valley to match or even surmount the Appalachian assets in terms of margins within a couple of years.
- The high NGL cut in the Cotton Valley production mix helps with price realization, where the net gas basis differential is -$0.10-0.20/MMbtu, as compared with -$0.50-0.60/MMbtu in the Appalachian Basin.
- The cash operating cost is estimated at $8.13/boe (or $1.36/Mcfe) for the Cotton Valley production, including the lease operating expense ($5.34/boe), owned and third-party gathering and compression ($2.13/boe), and production taxes ($0.66/boe).
- A high percentage of net wells in Catton Valley is operated by Indigo (95.7%).
The acquired Cotton Valley wells, with an average age of 17 years, are already in terminal decline at ~6%, similar to Diversified's Appalachian assets. The Cotton Valley properties are also 100% held by production. Therefore, the acquisition should exert little capital spending pressure, except for possible SAM-related spendings.
The strategic significance of the acquisition
Strategically, the Indigo acquisition opens a new regional focus area for DGOC in addition to its Appalachian operations (Fig. 5). The significance of this transaction to the long-term growth outlook of the company cannot be over-emphasized.
The central regional focus area encompasses Louisiana, Texas, Oklahoma, and Arkansas. These states provide a supportive regulatory environment and mature infrastructure.
- The gas-prone Cotton Valley offers excellent economics thanks to its high NGL cut in the production mix, and low differential, offsetting greater well depths. Cotton Valley is geographically compact, suitable for driving efficiencies through its SAM program.
- Cotton Valley is similar to the Appalachian assets with regard to basin maturity, decline rate, reservoir drive mechanism, well life, and well retirement costs, such that Diversified may parlay its skillset accumulated in the Northeast to the new area.
- The central regional focus area is right next door to the Gulf Coast natural gas market, with extensive takeaway capacity and booming LNG facilities (Fig. 6).
- The opening of the central regional focus area may even enable future arbitrage opportunities between the Appalachian Basin and Gulf Coast, as envisioned by Range Resources when it acquired Memorial Resource Development (see here).
Development has slowed substantially from historic levels in the region (Fig. 7), a clear sign that local operators are ready to exit from the mature properties in terminal decline, which are perfect for DGOC's taste. Now that a foothold has been established in the new regional focus area, I expect Diversified to aggressively enlarge its footprint and roll up for economies of scale. The central regional focus area, especially Cotton Valley, is known to have a fragmented competitive landscape, which is ideal for complementary bolt-on and/or larger opportunities, including those costing >$250 million using capital provided by Oaktree.
Rusty Hutson, Jr., CEO of DGOC, said:
"Our strategic expansion into a new producing region turns vision to reality and marks a key milestone in our development. The expansion also provides significant runway for us to replicate our success in Appalachia: reducing unit expenses, improving margins and optimising production.
Our new regional focus area covers a multi-state area in a similar size footprint to Appalachia, and meets our expansion criteria in terms of asset quality, infrastructure, market dynamics, opportunity set and supportive regulatory environment. This first strategic acquisition outside of Appalachia also reflects our continued commitment to a consistent asset profile and valuation while affording us expanded value-accretive roll-up opportunities in this new region that will enable us to quickly build scale and drive efficiencies. Our financial and operational strengths continue to uniquely position Diversified to capitalise on current market conditions as the PDP buyer of choice."
How much was paid?
The purchase price is $135 million gross or $115 million net, after customary purchase price adjustments to account for the period between the effective date of March 1, 2021, and the anticipated closing date in late May 2021.
The transaction metrics are as follows:
- Diversified paid $2.3/boe for the PDP reserves, or US$7,188/boepd for the flowing production;
- It paid 0.66X of the PV-10 of the PDP reserves;
- DGOC paid 2.9X of the net adjusted EBITDA.
Compared with the pre-Indigo valuation metrics of $3.2/boe of PDP reserves, $19,400/boepd of flowing production, and 6.22X of adjusted EBITDA, the acquisition is clearly value-accretive.
Diversified expects to initially fully fund the acquisition from the existing liquidity on its revolving credit facility, as it evaluates the options for long-term financing including additional asset-backed securitizations, term loans, or other financing options.
The transaction will result in a pro forma net debt/adjusted EBITDA of 2.3x, in line with its current leverage.
Peter Lynch would have liked Diversified. It sounds dull, and it does something dull - producing natural gas from old wells that nobody wants. Few analysts follow it, and nobody seems to know of it. There is something depressing about running an oil company from Birmingham, Alabama; (the first thing Diamondback Energy (FANG) did after acquiring Energen was to close the Birmingham office.) Nobody views gas production as a growing industry. Nonetheless, DGOC has found a niche and thrives in it. The insiders believe in the story; co-founder and CEO Robert Hutson just spent US$238,000 buying the stock.
As I said here, Diversified faces a slew of risk factors including uncertainties associated with entering a new region, commodity price volatility, and costs for asset retirement. Other than AIM, the stock trades on OTCQB, where liquidity is limited until the stock is potentially up-listed to either Nasdaq or NYSE. A U.S. investor will be levied foreign dividend withholding tax and may be charged an onerous foreign stock transaction fee depending on the brokerage.
On the other hand, DGOC seems to have made an extremely advantageous deal acquiring the Cotton Valley properties. The transaction is immediately accretive to the PDP reserves, production, and adjusted EBITDA, thus de-risking the growth outlook in 2021. More importantly, in the long run, the deal gives DGOC a solid foothold in a well-chosen new regional focus area, where nearly limitless opportunities exist for bolt-on and/or larger acquisitions and where the company can replicate its proven business model on an expanded scale. In that sense, a new chapter of growth is ushered in, for which I commend the management.
Judging from the 1.8% share price advance on the breaking news, Mr. Market appears to be blasé about such a momentous milestone in the corporate history of DGOC. However, I believe this is an opportunity for discerning investors who believe in the long-term prospect of this unique natural gas producer. I believe Diversified offers a more attractive risk-reward profile at the present time than ever before.
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.
Some abridged samples of my writings are published here. However, for a more extensive selection, I recommend accessing TNRH, a sought-after Seeking Alpha Investing Group. By joining TNRH, you gain access to:
(1) A stream of high-alpha actionable investment ideas;
(2) Live portfolios for both capital appreciation and income generation;
(3) A suite of tools to assist you in making informed investment decisions;
(4) Trade alerts and multiple thematic newsletters; and
(5) A vibrant community of investors to exchange ideas and share information as well as direct, private access to me.
Sign up today HERE to immediately benefit from Laurentian Research's comprehensive research and the TNRH platform. Start exploring the wealth of valuable resources available to you!
* * *
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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.