Diamondback Energy, Inc. (NASDAQ:FANG) has long grown reserves at a brisk pace. Management shows every intention of continuing that brisk pace. Generally, management does this through a combination of organic growth and acquisitions. As the company grows larger the “bolt-on” acquisition strategy is likely to prove a material growth engine because organic growth often has considerable logistical challenges. Therefore, it is usually easier for large companies to grow using acquisitions that are material.
Management is still taking advantage of a buyer’s market to grow the company through acquisitions. The oil and gas industry is generally fragmented enough to allow such a strategy to continue for a long time.
The wells are profitable enough to allow the company to replace reserves comfortably. Therefore, the presentation shown above will likely be shown in future presentations for a long time into the future.
Admittedly, it will be hard to grow reserves at the pace shown above using any strategy as the company gets larger. However, there are a lot of numbers less than the 52% average shown above that would be satisfactory or excellent growth rates for the next decade.
Companies that grow this fast usually have far higher valuations when they are not in the oil and gas industry. The best part is that this company keeps the cash flow growing along with the reserves to validate the reserve growth shown above.
I have followed a lot of companies with tremendous reserves and little to no cash flow into reorganization. It usually then was demonstrated that the costs to produce those fantastic reserve numbers were far too high for the current environment. The result was a drastically reduced valuation in bankruptcy court.
The other thing the reserve report really does not cover really well is risk. Diamondback, through its participation in the unconventional industry, has lower risk of unsuccessful exploration than is the case with (for example) offshore. But that is rarely mentioned in a reserve report. Instead, they often read like success is assumed.
The latest acquisitions show the emphasis on cash flow.
(Note that the Larios acquisition was completed on January 31, 2023.)
Investors should notice the emphasis on cash flow. Specifically, a very low relationship of the purchase price to free cash flow. The Larios acquisition is atypically expensive on a per acre basis. But it most likely has to do with the lower maintenance capital and free cash flow generated. Notice also that the Larios acquisition has another interval as a target zone. In some ways that increases the number of possible drilling locations unless wells are completed in multiple zones. Even then, the location with more intervals is a clue that there is more oil in place. Hence Larios is more valuable on a per acre basis.
In both cases management proposes to decrease the number of rigs drilling to maintain production while increasing free cash flow. The selling owners obviously increased production (and likely supporting infrastructure as well) to maximize the selling price.
However, Diamondback management is catering to a market that demands return of capital. Therefore, the combination of stock and debt keeps the debt ratio low while assuring an acquisition that is accretive to current shareholders. This is a clever way to grow production per share while catering to the market demands of dividends.
This strategy also caters to the fact that the Permian takeaway capacity often fills up during the boom times. A company that wants to grow rapidly either needs to participate in midstream projects that will come online “just in time” or incur some very expensive transportation costs and commodity price discounts to get the product to market. That says little about the challenges of labor shortages that also pose a challenge to fast growth in the Permian. The strategy chosen by management is minimizing a lot of challenges that face the industry in this basin currently.
This company has found a way to increase investor returns at various pricing points while officially maintaining the market-loved policy of returning capital to investors instead of rapidly growing production.
Management is increasing cash flow per share at a decent pace. Therefore, there will be more cash to distribute to shareholders at various commodity prices than there was in the past. Since the industry is fairly fragmented, there are lots of operators that management could potentially acquire in the future to keep this per share growth going.
Hopefully at some point the market will come to its senses to allow some decent organic production growth. But until that happens, this appears to be an excellent way to navigate the current situation. The market always loves a growth story. This management is providing that growth story so that future valuations of the company stock remain above average.
Diamondback Energy, Inc. management has focused upon good acreage because good acreage provides a lot of free cash flow even though unconventional wells are known for fast production declines initially. This company has long had the ability to grow organically while repaying debt as well as distributing money to shareholders.
Right now, the organic growth is frowned upon by the market. Management is catering to that by acquiring good acreage and then increasing free cash flow by doing maintenance drilling (whereas the selling owners grew production to get a better selling price).
Investors can expect a steady stream of increasing dividends from this management one way or another because there is a determination to grow production per share that is not often seen in this industry. So many companies I follow are maintaining production and returning a lot of free cash flow to shareholders. But that leads to a maintenance dividend (whereas with Diamondback the dividend will clearly grow).
The industry is still cyclical. However, a consolidation strategy like the one with Diamondback Energy, Inc. should lead to capital appreciation over time. An investor considering an investment in this industry needs to find companies like Diamondback Energy, Inc. that do that extra bit for investors. That kind of ambition often adds protection to the downside potential that is not seen with companies simply maintaining production and dividends well into the future.