2023-06-20 13:04:47 ET
Summary
- I identified Diamondback as having the right quality acreage to survive and even thrive within the shale patch almost a decade ago.
- Diamondback continues to increase production this year, even as the overall industry seems to be pulling back.
- A potentially good entry point for investors could emerge this summer for Diamondback stock, as the market continues to focus on weak demand issues.
- A selling opportunity might arise next year if I am correct and oil prices will rise, despite a weak global economy, on tight supplies.
Investment thesis: I identified Diamondback ( FANG ) almost a decade ago as one of the shale drillers with the potential to have the right acreage in place to survive and even thrive. Its stock price has gone up accordingly since then, roughly doubling in price. It is a lot better than what we saw with many other shale investment opportunities. It is also better arguably going forward compared with other drillers. Many of its peers are pulling back their drilling activities, arguably for fear of running out of prime drilling acreage, while it seems Diamondback is still looking to slightly grow production going forward, and continue to do so profitably. It is, therefore, a decent potential investment opportunity, in the event that its stock would see a significant pull-back, which could happen this summer, while next year we could see a great opportunity to sell if I am correct about the oil market going forward.
Diamondback continues to see decent financial results, while production is forecast to increase
For the first quarter of the year, Diamondback increased its total oil & gas production by 11%, to 425,000 barrels of oil equivalent compared with the same period from a year ago. For the year, Diamondback is expecting to produce an average of about 430,000 to 440,000 barrels of oil equivalent per day, meaning that production should be higher in the coming quarters.
For the same time period, net income declined by 7%, to $712 million for the latest quarter. Even though production increased, oil & gas prices declined significantly, affecting Diamondback's profitability. Debt increased from just under $6 billion in the first quarter of 2022, to almost $7.1 billion for the latest quarter. This is the most worrying trend in its financial performance by far. We should keep in mind that interest rates have gone higher lately, which will make debt-servicing more costly in the longer term as companies retire low-yielding debt for higher-yielding debt. For the latest quarter, net interest was only $46 million, which is by no means very high, but the costs are likely to rise further going forward.
The performance of new wells suggests that Diamondback managed to stabilize average well productivity after an initial decline at the end of the last decade
The key to success or failure for all shale drillers is the acreage quality lottery that played itself out in the last decade. Diamondback did well in the initial acreage lottery, which is something I highlighted already almost a decade ago as being a standout from many of its industry peers. The latest well results suggest that Diamondback's acreage quality continues to hold up, which is not necessarily the case with the broader shale industry as the EIA drilling productivity reports suggest.
As we can see, while well performance is not quite as high as it was half a decade ago, it has improved slightly in 2022 versus the average performance seen in the past three years.
Technological improvements as well as improvements in execution, ranging from a better mapping and understanding of the geology to more accurate drilling may have contributed somewhat to production per well having stabilized in the past few years. The data also suggests that there hasn't been a very significant decline in average acreage quality that is being drilled in the past few years.
It remains to be seen what kind of average well performance we will see from Diamondback this year and beyond. It is entirely possible that another sudden and significant downshift in average well performance will occur, as it did from 2018 to 2019. Such a downshift would have a significant effect on production as well as profits. As of now, however, there seems to be no sign of such an event occurring.
Growing odds of a sustained oil price rally starting this fall
While analyzing company-specific details provide a very good understanding of the investment fitness of any specific company, when it comes to commodities producers in particular, it is in my view imperative for investors to try to gain an understanding of where the market for the related commodity might be headed. At the moment, the market is fixated on low-demand growth prospects this year and perhaps next year, owing to a slowing global economy. The IEA just recently forecast an increase of 6% in global oil demand between 2022 and 2028. We can reasonably assume that the IEA has taken slower global economic growth into account when it modeled demand for the next half-decade.
While the IEA provides a guide to the longer-term outlook, OPEC's latest monthly report provides a more detailed glimpse in regard to the shorter-term situation. It takes into account and bakes slower economic growth into the forecast, based on the latest available data. It currently sees average liquid fuels demand at 103.25 mb/d in the last quarter of this year.
There is a 3 mb/d gap in the global liquid fuels supply/demand balance that needs to be closed in the next few months in order to balance the market as we can see from the chart above, which shows production in May averaging just 100.2 mb/d. I am sure that some extra production will surface around the world. A slowing global economy might help to cut demand somewhat. At the same time, Saudi Arabia is set to cut production by 1 mb/d in July, leading to a further widening of the gap. My current view is that we will see the start of a sustained oil price rally starting this fall, even if the global economy will continue to be sluggish. It should be a market trend that will likely lift all oil-producing boats.
Investment implications:
As I often pointed out lately, I became increasingly reluctant to invest in any stocks that are close to their all-time high, within the current economic, geopolitical, and other relevant contexts. Diamondback stock currently trades about 20% below its all-time price peak, which can arguably be considered to be somewhat comfortably off its all-time peak for the purpose of investors looking for a good entry point. Personally, I would like to find an even deeper discount on this one, for a number of reasons.
With a forward P/E of 7, it trades at a similar valuation to Suncor ( SU ) in this regard, which is currently by far the largest stock holding in my portfolio. There is however a very good reason why I place a premium on Suncor stock, namely its longer proven reserves life. With Diamondback, as is the case with most other shale producers, we never know when we might be blindsided by a revelation that drilling activities will be greatly curtailed going forward, presumably due to dwindling prime acreage inventories available for drilling. Declining production, even if it happens within the context of rising oil & gas prices, as I expect it to be the case this fall and beyond has the potential to put a damper on stock price gains. This is especially the case with companies that are mostly focused on upstream activities.
While I personally do believe that Diamondback is probably going to continue to increase production for the remainder of this year, and perhaps all the way until the middle of this decade, it is by no means a sure thing that it will manage to do so. It is an added risk factor, in addition to being a mostly upstream operator, which leaves it potentially vulnerable to wild oil & gas price swings. The rising debt levels are also an added reason to be cautious, especially within the context of the higher interest rates we are seeing compared with the past decade. Given all these potential risks, I would not consider purchasing Diamondback stock at its current price level.
A potential window of opportunity might arise on the back of a significant decline in oil prices this summer. At the moment, the market is still mostly focused on demand-side worries, as the global economy struggles to get any significant sustained traction. If a significant swing in oil prices to the downside were to shave off another 10% to 20% from Diamondback's current stock price, it would make for a good entry point. My view on oil prices is that despite sluggish global economic growth, we could still see $100/barrel oil in WTI terms by the end of 2024, or even sooner. With Diamondback being an upstream company, with presumably some production growth potential, its stock price gains would most likely outpace that of integrated oil companies, as well as those upstream producers that are facing declining production going forward. Overall, Diamondback is worth keeping an eye on this summer, for a good entry point.
For further details see:
Diamondback: Potential Opportunity To Buy Low Soon And Sell High Next Year