Can shale companies pay back investors?
Frontispiece: Roll up, roll up! Diamondback’s share price performance. (Source: Share price data from Yahoo Finance).
I bought stock in Diamondback Energy (FANG) because I fancied them as one of the best shale companies. Their stock has outperformed their peers until the middle of 2018, but 3 earnings misses in 4 quarters and the general funk that the sector has sunk into over the last few years has dragged Diamondback into to the collective mire. In a 4Q update last December, their CEO gave an upbeat forecast for the new year including a reassertion of the promise of free cash flow, substantial return ($1.8 billion in 2020) of capital to shareholders and a continued 10-15% production growth, despite the fact that the company has not yet managed anything close to that combination. In this piece I take on a deeper dive in the company and by proxy the industry. As one of the better shale companies can Diamondback turn itself round from a EBITDA (= value?) growth strategy to a free cash returns model? In the rising concern of climate change and emissions intensity of upstream oil and gas operations can Diamondback distinguish itself from the competition?
Figure 1: Diamondback’s phenomenal growth story. (Source: Data - DrillingInfo, Diamondback Investor Presentation and Yahoo France; Graphics - Capriole Energy).
Diamondback’s rise to being one of the larger Permian Permian shale producers is indeed phenomenal, particularly as it was accomplished in the post 2014 era of lower for longer oil prices. I have been impressed by their access of better acreage, apparent improving efficiency of drilling and completions, and the acquisition and assimilation of Energen. For Diamondback, like many peers over the period up to 2018, the investing pitch was based on growing EBITDA as a proxy for asset value.
The reality, like most if not all shale companies, this has been achieved on credit, with new stock issues complementing increasing long term debt which now stands at nearly $5 billion dollars (Figure 1). Because of that, absent continued growth in share value, there is no real opportunity for returns to investor. Investors began to get wise to this problem in late 2018 and companies began to change their pitch to one of capital discipline, free cash flow and return of capital to investors. EOG were the first firm I noticed in this mode. Diamondback also focused on this investment thesis during 2019 and I used them as an example of how shale might make good in an otherwise very gloomy outlook. During 2019, Diamondback have still not turned the corner to positive free cash and now providing guidance they will do so in 2020 to the tune of $675 million of free cash flow at $55/Bbl WTI oil price. As shown in Figure 1, I can’t make the math work using the Diamondback guidance on Capex and Production and assuming a similar cash generation multiple to production as 2019, coming with a number approximately 1/3 of their guidance, let alone the promised $1.8 billion of cash back to shareholders. Let’s take a look at underlying cost performance to explore for opportunities.
Figure 2. Capital efficiency of gross operated oil production added per quarter. Each quarter’s new production in bod is divided by the gross company capital expenditure for the prior quarter. (Source: Data - DrillingInfo, Yahoo Finance; Graphic - Capriole Energy)
Cost per barrel performance
Diamondback claim to be the low cost leader for per unit operating and capital costs per completed lateral foot. I have no reason to dispute that, but what I am rmore concerned about is the underlying performance of new deployed capital in bringing new production (cash) on, particularly a settings where early year declines are so precipitous. Figure 2 illustrates my analysis of underlying capital efficiency. It demonstrates that Diamondback’s performance in adding production per $ capital deployed as been more or less flat through the last five years. This lack of improvement tells me that management are tracking (and presenting) the wrong efficiency measurements. I think it’s reasonable to expect an organization focused on performance improvement could deliver at least 10% per year or 35% in the five year period.
Figure 3: Production per completion performance for Diamondback wells. (Source: ShalePro)
Drilling down into production per completion performance shows radical improvement from 2010 to 2017 (Figure 3). However, for the last three years oil production performance appears to have stagnated at 2017 levels.
Figure 4: Growth and Performance Trends in Lease Operating Expenses. (Source: Data - SEC Filings, DrillingInfo; Graphic - Capriole Energy)
Similarly for Lease Operating Costs, it appears that there is much opportunity in reversing flat to increasing unit costs (Figure 4). Given my experience of production companies in a hurry to grow, I am not surprised that there is so much opportunity in cost efficiency. Furthermore I expect that there will be enormous opportunities in performance improvement in re-tooling the company it how it approaches its business, for example adopting the principles, culture and processes of lean manufacturing.
In a similar vein of operational excellence, there is also an opportunity for shale companies to manage risks associated with climate change, such as development and operational emissions intensity or depletion rates and hence exposure to lower price or higher cost due to carbon pricing. Diamondback remain distinctive as one of a smaller sub-set of shale companies that are taking action to reduce as GHG intensity and consider various price scenarios to test the resilience of their reserve base to future regulatory, cost (e.g. carbon pricing) and oil price changes.
Figure 5: Sources and uses of cash in 2019. Sources: SEC filings, company guidance, some extrapolation by Capriole Energy)
Becoming a cash cow
In the final part of this piece, I want to take a look at the ability of Diamondback to deliver free cash back to shareholders. As I indicated at the beginning, their 2019 performance doesn’t fill me with huge confidence that they can deliver the $1.8 billion odd cash promised in 2020 without further borrowing. Diamondback’s management presentation indicates that close to $1 billion free cash can be deliver if the price stays at $60/bo or above. A price in the mid-50s only delivers $675 million.
Figure 6: 2020 guidance for a $55/bo price regime. (Source: Data - Diamondback presentation, graphic- Capriole Energy)
Figure 6 illustrates my interpretation of the Diamondback guidance on sources and uses of cash in 2020. $675 million returned to shareholders, $180 million as dividends, would represent $4.21/share return in total (as long as share buy backs are realized in share price) or a 4.4% yield. That would be a good start, but I suspect that the company can do much better if the actions on bottom line cash efficiency outlined above are taken now.
Figure 7: Sources & Uses of Cash in 2020 in Alternative Strategy A
In Figure 7 I have outlined a model wherein 20% efficiency improvements from 2019 in both capital efficiency and operating cash efficiency yield nearly $1.5 billion of free cash. This would mean a more confident pivot to the cash strategy, representing a 10% yield (dividend and share buy back). I do see the attractiveness of this model because as confidence builds in cash delivery dividends can be raised to deliver more certain yield.
Figure 8: Sources & Uses of Cash in 2020 in Alternative Strategy bB
Finally, in Figure 8 I offer a different strategy, which has the company lay down about 8 rigs to concentrate effort on 15 rigs to sustain production at 2019 levels. I suggest that this focus would allow even better optimization of operations and hence performance through quality through choice and operations excellence. So I’ve included the 20% performance improvement that is in option A but with the reduced activity set the result in free cash is better than the growth model, more than $1.7 billion of free cash.
Conclusion
There’s no denying Diamondback’s past achievements and their distinctive attitudes to ESG performance. For that reason, I believe that the current management team, probably with some help, can pull off this pivot to cash generation. But it’s quite a challenge and they need to get to work. The board needs to do their part as well, agreeing the right strategy and consequent plan, monitoring performance, and structuring executive pay that only gets paid if shareholders are rewarded and the agreed strategic actions were accomplished.