Diamondback Energy Is Prepared To Perform In A Flat-To-Down Market (NASDAQ:FANG)

Diamondback (NASDAQ:FANG) is in a position of strength in the current market, with uncertain macroeconomic conditions going through CY24. I believe that the oil market will remain flat-to-down during the duration of the year, contingent upon no tail-end exogenous event. Given their operational efficiencies, a focus on bringing current DUC inventories into production, and lighter capital investments for eFY24, I provide FANG shares a BUY recommendation with a price target of $209.46/share at 6x eFY24 aEBITDA.

Operations

Diamondback has been steadily increasing production throughout the last year, with daily oil production volumes of 263.5Mbbl/d and total production of 447Mboe/d for FY23. These volumes have significantly offset weaker oil prices throughout the year, with total revenue growing by 2% in Q4’23 on a TTM basis. This has also led Diamondback to maintain their 73% aEBITDA margin for the year, despite experiencing some decline in free cash flow generation as a result of higher capital investments made in FY23. Proved reserves increased by 7% in FY23 to 2,178MMboe with crude oil accounting for 53% of the total proved reserves. 356MMboe of this increase was the result of discoveries and extensions, with the remaining resulting from net purchases. Management anticipates converting 38% of its PUD reserves to proved developed reserves by the end of eFY24.

Much of the spending in FY23 was in relation to development costs, with a modest drop-off in exploration. Considering their combination with Endeavor, I anticipate this trend to continue through eFY25-eFY26 with the additional asset base.

Management remained adamant about focusing efforts in the Midland Basin and keeping the Delaware Basin on the backburner throughout eFY24. In Q4’23, Diamondback drilled and completed 84 and 59 wells, respectively, with only four and nine of these wells residing in the Delaware Basin. Total wells drilled and completed in FY23 were 315 and 263, respectively. Looking to guidance, management will be pivoting to completing inventory wells in eFY24 with expected drilled to be 244-263 net with completed in the range of 273-291 net. This will coincide with their lower capital investment guidance as the firm flows through inventories. Management also alluded to lower total volumes in eFY25 once the Endeavor merger is completed towards the end of eFY24. Though this goes counter to the recent Exxon (XOM) and Pioneer Natural Resources (PXD) direction of increasing production in the Permian Basin, I believe reducing total volumes will support higher oil prices going forward.

Management guided production volumes to remain flat for eFY24 when compared to Q4’23 at 270-275Mbbl/d, or 458-466Mboe/d when considering natural gas and NGLs volumes. Management also guided a $150-$400mm reduction to capital investments for eFY24, suggesting that the firm will be depending more heavily on their current inventories as well as acquired inventories through the Endeavor merger.

Looking to eFY24, management guided over $3b in free cash flow based on the current commodity prices with capital investments in the range of $2,300-$2,550mm. I believe Diamondback is well-positioned to utilize their current inventory of DUC wells throughout eFY24 in anticipation of the added inventory coming in through Endeavor.

Forecasting production volumes, I’m modeling at the lower end of guidance, with WTI and natural gas priced to the futures curve for eFY24. The market is pricing modest stability in WTI with the price tapering off to $73/bbl in December.

Natural gas futures anticipate strong tailwinds to natural gas prices going forward into the end of the year. I believe that the recent news of Chesapeake Energy (CHK) cutting production has positively impacted prices; however, the cohort of dry gas producers that I cover have been tapering production since FY23, which can be found in my report covering Kinder Morgan (KMI) or the charts below.

Endeavor Acquisition

Diamondback announced their intent to acquire Endeavor, with an expected close date in the latter part of eFY24. The acquisition cost Diamondback $26b, 69% of which was funded by equity and the remainder with cash. The acquisition includes approximately 838,000 net acres with 816Mboe/d of net production across the Permian Basin, with acreage relatively close to Diamondback’s assets. Management estimates $550mm in synergies, with a strong free cash flow accretion in the range of 10% beginning in 2025. I believe that the combined firm makes for an appealing investment as the newco will have a broader asset outlay in the core Permian region with breakevens remaining at ~$40/bbl. In terms of operations, I believe that with more control over larger production volumes allows the firm to taper production during down markets, providing the flexibility to preserve higher-tier wells.

Value & Shareholder Value

FANG provides significant shareholder value through its ability to generate free cash flow. In Q4’23, Diamondback raised the annualized base dividend by 7% to $3.60/share, or $0.90/share quarterly, and will pay out $2.18/share through their variable dividend rate in the coming period on March 12, 2024. The firm also repurchased 872,667 shares in the quarter for $129mm and has so far repurchased 279,266 shares in Q1’24. Returns to shareholders totaled $2.3b from the combined dividend and buybacks for FY23, resulting in a return of capital reaching 75% of free cash flow in Q4’23. As of Q4’23, Diamondback has $1.6b remaining under the current buyback authorization. Management mentioned in their Q4’23 earnings presentation that they will be reducing their return of capital ratio to 50% starting in Q1’24 to improve financial flexibility and to reduce debt. This is primarily driven by the Endeavor merger and may only be temporary until the balance sheet is corrected. Aside from the base dividend increase, I believe that Diamondback will be reducing their variable dividend in favor of buybacks on top of the debt reduction. This will follow suit to competitor Devon Energy (DVN) as the firm will be reducing their variable dividend rate in favor of buybacks. Shareholders appear to be welcoming to the decision, as FANG shares haven’t experienced much of a pullback since the announcement.

Considering my free cash flow forecast for eFY24 at $3.5b, we can expect $1,755mm to be allocated to debt reduction and the same amount to buybacks and the variable dividend. This comes out to ~$9.81/share of additional value on top of the base dividend of $3.60/share. In terms of dividend safety, FANG has the financial flexibility to maintain the base dividend at a breakeven price of $40/bbl and currently has downside hedge protection at $55/bbl, suggesting a certain degree of dividend safety. With no debt maturities through 2026, I believe Diamondback has significant flexibility to manage operations appropriately as the firm merges Endeavor and pays down the new debt load.

In terms of an investment, I believe FANG poses as a strong investment candidate as the firm hedges a significant portion of production to potential downside risks. As the market is pricing in flat-to-slightly down oil prices for CY24, FANG may be in an opportune position if global economic activity were to continue to slow, resulting in a potential fall in the oil market. Using DVN as a comparison, DVN shares would be the appropriate equity holding in an oil upswing whereas FANG would be more ideal in a flat-to-down market.

Considering the firm’s appealing 11% eFY24 FCF yield, I believe FANG makes for a strong investment candidate. Considering the firm’s capital discipline and focus on generating free cash flow on DUC inventories in eFY24 as well as their downside risk protection, I provide FANG a BUY recommendation with a price target of $209.46/share. For a pairs trade, I believe DVN shares can provide for a short position to allocate cash to FANG shares during a flat-to-down market, and an opposite position when oil prices strengthen.