2023-09-22 18:13:27 ET
Summary
- Diamondback's stock is known for its stability and consistent growth, making it difficult to find a favorable buying opportunity, as the market tends to keep it from underperforming.
- Lower oil and gas prices led to a drop in profits for Diamondback in the latest quarter, but production is still growing at a strong pace.
- The availability of prime acreage for drilling is a major risk factor for Diamondback's future growth and profitability, potentially denying investors the luxury of time to wait out unforeseen market turns.
Investment thesis:
Diamondback ( FANG ) stock is perhaps one of the least price-volatile in the oil & gas industry. The constant promise of growth, and more recently a more evident well-established track record of profitability kept this company in the good graces of its investors on a steady basis, making it very hard to find a favorable buy-in point for its stock. A decent dividend that seems sustainable within the context of Diamondback's profitable activities probably adds to investor reluctance to sell, even in the face of the company trading at a higher P/E relative to peers. An increasingly rare production growth story within the shale patch also makes this company a prized holding in the stock portfolio of many investors.
Having said that, as is the case with most shale drillers, there is the overhanging question of prime acreage availability, which is the main risk factor that can make both profits and Diamondback's production growth story dissipate. Thus I continue to be reluctant to invest, in the absence of a better buying opportunity.
Diamondback saw a drop in profits related to lower oil & gas prices, but production is growing at a robust pace
In the second quarter of this year, Diamondback saw a sharp decline in revenues & profits, mostly due to lower oil & gas prices. The average sale price of its oil was almost $109/barrel in the second quarter of 2022, but only $71/barrel in the second quarter of this year. The price it got for its natural gas tumbled by about six-fold in the same period. Revenues dropped to $1.92 billion from $2.77 billion in the corresponding quarter of 2022 as a result, despite higher production volumes. At the same time, operating expenses increased from $790 million in Q2, 2022, to $919 million in the second quarter of this year. Interest expenses also rose from $39 million to $51 million for the same period. As a result of all the converging negative factors, Diamondback saw its net income drop to $556 million, in the latest quarter, from $1.42 billion in Q2, 2022.
Diamondback's production of oil & gas increased for the period from 380,000 b/d on average in Q2, 2022, to 450,000 b/d for the second quarter of this year. It is a very impressive increase of almost 20%, which is far above the US industry average.
As we can see, oil production, which is arguably more important within current market trends compared with natural gas has been increasing at a robust pace in the past year, and it is forecast to continue increasing for the rest of the year.
The fast-paced drilling schedule calls into question how much longer prime acreage drilling sites will continue to last
As we can see, Diamondback intends to drill & complete almost one well per day this year.
Diamondback
On the face of it, at the current pace of drilling, Diamondback should be able to drill prime acreage locations for almost two decades. In reality, when it comes to the shale industry, such data points failed to tell us much over the past decade when it comes to the number of prime acreage drilling locations that companies had or the true economics of the acreage. Most of the countless shale companies that went under in the last decade were claiming to break even on their drilling at $30-$40/barrel for WTI, even as oil prices tended to be higher, at times double their claimed break-even price.
Diamondback
Diamondback's production curve data suggests that there was a significant decline in the average quality of acreage being drilled between 2018 and 2019 and that the downshift has been permanent since every year since then has been significantly lower in terms of average production achieved from wells than the volumes we saw in 2018. However, the yearly production curves also confirm that since 2019 there has been no major degradation. A slight increase has taken place, most likely due to ongoing improvements in execution. It remains to be seen how much longer it will be before a further downshift in average acreage quality will occur. It could happen next year or a decade from now. One never knows with shale producers, but we know that it is to be expected to happen at some point.
Investment implications:
It increasingly looks like despite a slowing global economy, oil prices are set to continue marching higher on tight supplies, in part due to production cuts in Saudi Arabia & Russia, but also due to a lack of new supply growth in much of the rest of the world. In this context, oil & gas producers still have production growth prospects that are especially attractive as investment options.
In the case of Diamondback, however, the growth we have been seeing and are likely to continue seeing at least in the shorter term seems to be constantly priced in. For that reason, while I have been keeping an eye on this company, I have been reluctant to invest. If I am correct and oil & gas prices continue to rise going forward, Diamondback will probably see a bump in its stock price, which makes it an interesting prospective investment opportunity, especially given its strong production growth trajectory. I am not entirely comfortable investing in this company at the moment because I always like to have room for error, in case several intervening factors delay the expected spike in oil prices. With Diamondback, I see a risk of time not being on the side of the investor.
To better illustrate my reasoning, I want to compare it to Suncor ( SU ), which is currently the largest stock position in my portfolio by far, and I recently covered it in a recent article . The main difference is that I have a high degree of confidence that Suncor will be able to produce oil at a similar profitability level, given a certain market price for oil, three years from now, and will also be able to continue to steadily increase production. In other words, I can ride out any unforeseen circumstances. This might not be the case for Diamondback investors. For instance, next year's average well production curve might end up far below this year's average, signaling a further deterioration in the average quality of the acreage it is drilling. If that happens, it will also likely reduce drilling, leading to a reverse in its production growth trajectory. In other words, at any point in time, investors can be faced with lower oil & gas prices due to unforeseen events, contrary to current expectations, which could potentially coincide with Diamondback being faced with having to shift its drilling into more second-tier acreage as the inventory of drilling opportunities at current quality levels could dwindle at any moment.
I last covered Diamondback in early summer, when it was trading at just under $127/share. Back then, the bull thesis for oil prices was far less certain. Now that the outlook for oil prices seems far more entrenched on a rising path, the share price it was trading at a few months back would make sense, given that a more secure oil price forecast makes for a lessened downside risk profile for its stock price. Given my current views on the oil market outlook, if I had a chance to turn back time, I would probably buy some Diamondback stock at $127/share, but given that its share price is up about 20% from those levels, the potential risk/potential reward considerations as I see them, lead me to believe that it is a missed opportunity that probably should have been taken in hindsight, but perhaps it is not that great of an opportunity at current price levels.
For further details see:
Diamondback Energy: I Missed The Train