2023-04-11 11:29:33 ET
Summary
- Diamondback Energy trades with oil prices but as an independent oil producer is still highly exposed to prices in natural gas.
- Solid price collars are sufficient to prevent loss of revenue in Q1 vs Q4.
- I believe the hedging strategy employed by FANG is far more robust and protective than its peers. This gives FANG a decided advantage for shareholder returns.
Thesis
In February, I published an article on Devon Energy ( DVN ) that identified the potential risk that was developing from falling natural gas prices . In that article, I showed how much of an impact even $3.00/MCF natural gas could have on the earnings of DVN. Since then, gas prices have continued to fall, touching $2.00 or lower on several occasions. This may present a serious challenge to independent producers who are not hedged or under hedged. Diamondback Energy ( FANG ) is positioned with excellent hedges, in what I think will allow it to stand out from the crowd when Q1 earnings are released.
Most oil and gas producer stock prices have shot up in the last two weeks thanks to a surprise 1.1 million barrel per day cut announcement from Saudi Arabia. This price action is only looking at the price of oil, which unfortunately does not paint the whole picture. Most producers generate roughly 50% of their total volumes from natural gas and natural gas liquids and FANG is no exception.
I believe we will see FANG's stock price remain stable following Q1 earnings while peers like Devon and Pioneer ( PXD ) may face pressure from disappointed shareholders.
Price challenges
In Q1, per EIA data, the average price per barrel of crude dropped to $76.08. This is roughly an 8% drop from Q4, which by itself, is not earth shattering. There have been moments of panic this quarter when Crude dropped below $70/barrel or on scares of a banking collapse, but now we are onto the next shiny object. The market got the taste of increased WTI and Brent prices due to the actions of Saudi Arabia . Now, investors are buying up shares of all oil producers, regardless of fundamentals. After all, rising tides lift all boats, right? Unfortunately, oil prices seem to be the only thing the average investor pays attention too.
The following graph shows where the real trouble lies.
Q4 averaged roughly $5 per MCF for natural gas and since that time, the price has been in absolute free fall. This is mostly due to the unseasonably warm winter, but also compacted by reduced exports from a fire at the Freeport LNG facility. The cumulative effect is that these prices are now hovering are $2/MCF and could sap as much 52% of the income associated with natural gas.
For a company like Devon for example, they produced $381.5 million via natural gas in Q4 at $4.01/MCF. The average spot price per the EIA was $2.65/MCF during Q1. This would result in a $130 million loss quarter over quarter for DVN. As a side note, that is almost exactly the amount DVN will be paying out for their base dividend this quarter to give some perspective on how that could impact the variable dividend for these companies.
Hedging Strategy
FANG has a tremendously robust hedging strategy for natural gas. In Q4, the average sale price per MCF for FANG was $3.20. In the figure below you will see the hedged price for Q1 at $3.14/MMBTU which converts to $3.03/MCF.
The key ingredient is the volume hedged. The total contracted volume accounts for approximately 70% of the forecasted volume in Q1. I have modeled a realized price of $2.92/MCF for FANG in Q1, due to this collar. This will result in a less than a 10% drop from Q4.
The table below compares this to the contracts employed by DVN and PXD. PXD has almost non-existent hedges, coming in at 1/10 the volume of FANG. Also, while DVN's collar is higher in value, it only covers roughly 20% of its volumes.
This very plainly shows that FANG has the best protection of the group in the current natural gas price environment. One weakness that can be seen is that the contracted volumes drop to 30% starting in Q3 and Q4 of 2023. This may be partially mitigated if natural gas prices rebound entering the winter season.
FANG | DVN | PXD | |
Volume (MMBTU/d) | 370,000 | 199,490 | 30,000 |
Price ($) | $3.14 | $3.78 | $7.80 |
So how does this translate to the bottom line? In Q4, revenues generated from natural gas stood at $144 million . Thanks to recent acquisitions, total production is slated to increase from 386 MBOE/day to 418 MBOE/day. I have modeled natural gas revenue coming in at $134 million, only a $10 million drop. Since FANG's Q4 revenue was slightly over $2 billion, this is almost a trivial loss.
The difference between a $130 million loss and a $10 million loss is $0.65 per share that could not be paid out to the FANG shareholders.
The Oilier the Better
Right now, the producers who have the highest oil content will be less susceptible to natural gas price fluctuations. FANG has a slight edge on competitors in this arena, ringing the register at 58% oil and 21% NGL/natural gas production. For comparison, Devon Energy is 49.7% and Pioneer Natural Resources is 53% oil. The lower exposure to NGLs and natural gas will limit the potential damage caused by lowering natural gas prices for FANG compared to peers.
Natural Gas Recovery
How long should investors expect natural gas prices to remain depressed? Unfortunately, since a significant portion of the demand for natural gas relates to space heating, I do not believe there will be any material market movers until cold weather returns.
On the export side, the Freeport facility is approaching 100% capacity again, which can export up to 2 BCF/day. Beyond that, there are no large scale demand pulls on the near term horizon to indicate we should expect a large rebound.
The dynamics start to change as we enter 2024. The EIA projects three significant LNG export projects coming online, all with very comparable capacities to the Freeport LNG facilities. For the rest of 2023, the EIA is projecting an average $3.02/MBTU. Ultimately, there may be some relief later this year but the upside is likely limited, at least compared to 2022 standards.
Crude Outlook
The outlook for crude for the medium term looks to be stable with a slight trend in the upward direction. This is mostly attributed to Saudi Arabia's desire to maintain a price floor in the market and the increase in demand that is projected to result from China's reopening following the COVID pandemic.
The average forecast in the figure below projects 2023 averaging to be similar to Q4. I have modeled Q1 to Q4 as relatively flat due a 10% increase in production with an 8% price drop. After this downward blip in Q1 passes, if 2023 averages $80/barrel in the remaining quarters, FANG should be able to generate an addition $150 million per quarter at its projected run rates.
The Dividend
Let's take a look at what all this means for how investors get paid. For Q1, I have modeled a net increase in revenue of $50 million, thanks to volume increases in crude. I have also assumed a flat NGL price environment and I have already discussed at length how I see a minor $10 million decrease in revenues associated with natural gas volumes.
The big challenge for FANG will be the capital expenses. In 2022, excluding the Fire Bird acquisition, the company spent $1.9 billion on CAPEX. The 2023 forecast is for $2.6 billion at the midpoint or $175 million extra each quarter.
Since revenue is nearly flat Q4 to Q1, I have also held taxes, interest, and other expenses flat as well. The additional CAPEX spend will reduce FCF from $1.13 billion to $1.0 billion. The target distributable cash flow to shareholders should be approximately $750 million.
The base dividend consumes $147 million of that cash. This will leave just north of $600 million to spend on share repurchases and the variable dividend. Q4 saw 63% of the distribution directed toward the dividend. My model will predict a 60/40 split between buybacks and cash returns due to the generally reduced prices in Q1. This calculates out to be $300 million spent on buybacks and $2.44/share in base plus variable dividends.
The combined return to shareholders would be 12% under this scenario at $135/share (7.2% cash and 4.8% equity). Given the subdued energy prices of since the end of 2022, I would consider this solid performance.
Risks
Since Q1 is now officially in the books, there is a fair amount of predictability in revenues and profitability for oil producers. One assumption that could change the model I have presented is if NGL prices decline. The EIA has not released data for February or March to date. As a result, I have projected those to flat line (January was actually in an upward trend). Should this not prove to be accurate, profits and thus shareholder returns will be negatively impacted as the NGL business is not hedged.
Capital expenses will also be a long-term headwind as producers fight to keep inflation at bay. This is not unique to FANG but is driving up well costs and the general cost of doing business. $175 million in additional capital expenses every quarter is a significant pill to swallow. Putting this in simple terms, this amounts to almost $0.75/share worth in variable dividend that shareholders will not receive EVERY quarter at this spend rate.
Another long-term challenge will be to muster price growth on the natural gas side of the business. I do not believe there is anything near term that will cause prices to rise meaningfully over the summer months. The longer the depression in natural gas prices last, the more vulnerable FANG will be. As mentioned earlier, the size of their hedging program decreases in the second half of 2023. This could evolve as the year progresses, however.
Summary
I believe the natural gas and NGLs aspects of the business have the potential to catch investors off guard for unhedged producers. FANG has been disciplined and has high volume hedges that provide meaningful protection from the sub $2.00 natural gas prices the market is experiencing. Peers such as Devon Energy and Pioneer Natural Resources have minimal hedging contracts in place, and thus, could experience meaningful revenue, earnings, and distribution misses during Q1 earnings.
I have shown a scenario where double-digit returns can be achieved with some degree of margin even if NGL prices decline. NGL prices should be somewhat less volatile than natural gas as they are less sensitive to seasonal usage (space heating during the winter months). Future forecasts for higher crude prices also have the potential to carry earnings and the stock price higher.
Ultimately investing in oil/energy should be done with the long term in mind. This article is to remind investors not to just watch WTI and Brent prices. There is the other half of the business that sells NGLs and natural gas that must also be taken into account prior to initiating/expanding a position.
Don't be the average investor. Be prepared when a price decline occurs to capture this quality producer at a discount for a long position. I recommend FANG as a buy for a long-term position at prices under $135/share. This is based on $80 WTI and $3.00/MCF. At these levels, the company is capable of producing double digit shareholder returns in my view.
For further details see:
Diamondback Energy: Hedging May Save Q1