Summary
- Diamondback Energy's competitive advantage comes from being one of the industry's lowest-cost producers, with a vast footprint in some of the most productive areas in the Permian Basin.
- FANG's Q4 production met guidance, financial results exceeded consensus estimates and reinvested 32% of generated free cash was into drilling.
- FANG stock has conservative 2023 guidance, with a 14% increase in capital spending driven by service cost inflation, but management targets a 2% year-over-year volume growth.
- FANG fulfilled its commitment to return 75% of free cash flow to shareholders for the second consecutive quarter, with $861 million returned across several channels.
- The shares are trading higher than my NAV of $120 per share, so I recommend staying away unless your oil outlook is more optimistic than mine.
Diamondback Energy Inc. ( FANG ) is a U.S.-based independent oil and gas producer that operates exclusively in the Permian Basin. At the close of 2021, FANG reported net proven reserves of 1.8 billion barrels of oil equivalent. Their 2021 average daily production was 375,000 barrels, comprising 60% oil, 20% natural gas liquids, and 20% natural gas.
On February 21, FANG released Q4 2022 earnings results . Based on the guidance, I have updated my NAV, and the shares seem slightly overpriced. However, the NAV value is sensitive to the long-term assumption of oil and gas prices, so if you are more bullish than me, you may consider buying the shares.
Good Q4 results and conservative 2023 guidance
FANG's fourth-quarter production met previous guidance, and its financial results exceeded consensus estimates from the street. FANG reinvested only 32% of the generated free cash into drilling during the period. In 2023, FANG will invest cautiously, with a 14% increase in capital spending driven mostly by service cost inflation. Despite the rise, FANG's management targets a 2% year-over-year volume growth on an acquisition-adjusted basis. This growth was offset by the sale of non-core assets that will generate over $600 million and have a negligible impact on net asset value estimates.
FANG's management fulfilled its commitment to return 75% of free cash flow to shareholders for the second consecutive quarter, returning a total of $861 million across several channels, representing approximately 76% of Q4 2022 free cash flow. FANG plans to maintain this payout in 2023, utilizing a variable dividend and repurchases to supplement the fixed dividend, which was increased by 6.7% to 80 cents per share and is up 33% over the last year.
In Q4 2022, FANG reported an average daily production of 226.1 MBO/d (391.4 MBOE/d) and net cash from operating activities of $1.44 billion. Besides the base cash dividend of $0.80 per share, FANG declared a variable cash dividend of $2.15 on the same date. In addition, they repurchased 2,344,850 shares of common stock for $316 million and closed two acquisitions.
As per the highlights for the full year 2022, FANG had an average production of 223.6 MBO/d (386.0 MBOE/d), generating net cash from operating activities of $6.33 billion. They declared total base-plus-variable dividends of $11.31 per share and repurchased 8,693,384 shares of common stock for $1.10 billion. FANG had proved reserves of 2,033 MMBOE (1,070 MBO, 53% oil), which is up 14% year over year. The total full-year return of capital was $3.11 billion from stock repurchases and declared base-plus-variable dividends, representing approximately 68% of the year's free cash flow.
Also, FANG has provided its production and capital expenditure guidance for the year 2023. It expects to produce an average of 256 - 262 thousand barrels of oil per day (430 - 440 thousand barrels of oil equivalent per day) and spend $2.5 - $2.7 billion in cash capital expenditures for the year. FANG plans to drill between 325 and 345 gross wells in the year and complete between 330 and 350 gross wells. The average lateral length of these wells would be approximately 10,500 feet. For Q1 2023, FANG expects to produce an average of 248 - 252 thousand barrels of oil per day (415 - 422 thousand barrels of oil equivalent per day) and spend $625 - $675 million in cash capital expenditures.
In Q1 2023, FANG completed the divestiture of a 10% equity ownership in the Gray Oak crude oil pipeline, receiving $180 million in gross proceeds. Additionally, definitive agreements were signed for the divestiture of approximately 19,000 net acres in Glasscock County and approximately 4,900 net acres in Ward and Winkler counties for $439 million, resulting in an estimated loss of 2 MBO/d (7 MBOE/d) of production in 2023. FANG has completed pending asset sales of over $750 million and has increased its non-core asset sale target to at least $1 billion by the end of 2023.
A Low-Cost Producer with a Competitive Advantage in the Permian Basin
FANG started as a small oil and gas producer but has since become one of the largest firms focused on the Permian region, thanks to organic growth and acquisitions of Firebird Energy and Lario Permian in 2022. FANG has a reputation for being one of the industry's lowest-cost independent producers, emphasizing keeping costs low. FANG has a competitive advantage in the core of the Permian basin and by adopting innovations like high-intensity completions, which result in more production for each dollar spent. FANG has also realized significant economies of scale.
FANG has a competitive advantage in the upstream oil and gas industry due to its desirable acreage in the Permian Basin, the US's most cost-effective source of crude oil. With vast drilling opportunities, FANG is better positioned to handle weak oil prices than its competitors. FANG's long-term cost advantage comes from FANG's focus on drilling in areas that yield impressive initial flow rates.
FANG has a vast footprint in some of the most productive areas in the Permian Basin, which enables it to spread its fixed costs, such as drilling and completions, more thinly, delivering more efficient results. FANG's impressive returns are supported by its below-average acquisition costs and head start in the Permian Basin. It locked up a significant portion of the leasehold before prices surged, enabling it to avoid overpaying for larger acquisitions.
Finally, FANG's stake in its mineral rights subsidiary, Viper Energy Partners, further enhances returns on drilling for the parent, owning mineral rights to some of the most attractive acreages.
Great Capital Allocator
I consider FANG an excellent capital allocator. FANG is one of the first US E&P companies to practice effective capital allocation consistently. Over the past few years, FANG has made several acquisitions. They have successfully added high-quality assets within a relatively narrow and well-understood footprint. Its efforts around returning capital to shareholders have been well-planned, including a fixed dividend, which has increased over time. However, FANG still plans to return 75% of its future free cash flows to shareholders. By not committing to a specific payout, FANG can control the mechanism for returning that cash through buybacks or dividends, as circumstances dictate over time.
Valuation
I valued FANG using the net asset value (NAV) approach. This approach heavily depends on the assumption of oil and gas prices. For the near term, I assumed oil price to be in the mid $70 per barrel and natural gas around $3.50 per thousand cubic feet. The long-term prices are lower at $60 per barrel and $3.20 per mcf. As per volume, I expect growth to be in the low single digits as management focuses more on returning cash to shareholders and only investing in high-return opportunities. With these assumptions, the NAV is $120 per share, suggesting the shares are slightly overpriced.
Conclusion
FANG is one of the lowest-cost oil producers operating in the United States. FANG has maintained a strong balance sheet and can generate substantial free cash flows under various commodity scenarios. FANG has been cautious with its capital allocation, meaning production will likely stay flat or grow at low-single-digit rates in the near future. The excess cash will mostly be returned to shareholders.
However, if oil and natural gas prices continue to decline, FANG's profitability will suffer, leading to lower cash flows and increased financial leverage. Well productivity could decline when the best acreage is exhausted, pushing up break-evens over time. Production growth could outpace takeaway capacity additions in the Permian Basin, creating periodic bottlenecks and volatile basis differentials. FANG periodically expands its acreage holding through potentially expensive and dilutive corporate M&A.
The shares are trading slightly about my NAV of $120 per share. However, that value is sensitive to the oil price assumptions used.
For further details see:
Diamondback Energy: Lowest-Cost Producer But Trading Above NAV