Diamondback Riding on Permian Focus Amid Pipeline Constraint

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Diamondback Energy Inc. 's FANG strong foothold in the prolific Permian Basin has been quite a boon to the company's performance for a while. Notably, the shares of this Texas-based upstream player have increased 30% over a year, outperforming the industry's growth of 13.5%.

On the flip side, infrastructural bottlenecks in the shale play still remain a concern. That said, let's do a close introspection of the company's performance and see if it can add more laurels to its growth story.

The Permian Advantage

Diamondback's strategic acreage position in the low-cost Permian Basin bodes well. The low operating cost stems from the region's extensive pipeline infrastructure, plentiful labor and supplies, and relatively warm winters that make year-round work possible. The Permian pure-play company holds around 207,000 net acres in the region, including 188,000 net acres in the Midland and Delaware Basins. Its activities are concentrated in the Wolfcamp, Spraberry, Clearfork, Bone Spring and Cline formations.

Diamondback recently delivered its 12th consecutive earnings outperformance, driven by its phenomenal production growth. Owing to its significant resource potential and prime acreage holdings, the company's first-quarter output recorded a year-over-year and sequential increase of 66.5% and 10.5%, respectively.

Driven by the robust results, the company raised the lower end of its 2018 production guidance from 108-116 Mboe/d to 110-116 Mboe/d. For 2018, it is now targeting an annual output growth of 40% within cash flow.

Effective Growth Strategies

A deep inventory of horizontal development opportunities in both the Midland and Delaware sides of the Permian Basin bodes well. The company's strategy of horizontal drilling and increased well density maximizes its productivity. Notably, the lateral length of its wells that was less than 4,000 feet in 2012 is likely to jump to around 9,300 feet by this year, owing to the technological advancements. Diamondback targets around 170-190 horizontal completions in 2018, which will boost its production prospects as the wells become operational. The company also plans to add two more rigs in 2018, increasing its operational rigs by 20% from the last year.

Diamondback is also making continual efforts to convert its undeveloped reserves to developed ones, which is aiding its cash flows further. In 2017, the company's proved reserves increased around 63% to stand at 335,352 thousand barrels of oil-equivalent (MBoe). In fact, it achieved a remarkable 52% CAGR in its total reserves since 2013.

The energy explorer also has an impressive record in purchasing leasehold position, which further spurs its organic growth and bolsters Permian foothold.

The low-cost development strategy is another positive for the company. It has been gaining from the economies of scale and operational efficiencies, thereby maximizing its earnings growth. In the last reported quarter, its cash operating costs were down 10% on a year-over-year basis to stand at $8.42 per barrels of oil equivalent. Diamondback also improved its cost outlook by lowering the lease operating expenses guidance for 2018 by 13% to reflect increased efficiencies.

Cash Flow Generation Bodes Well

Diamondback Energy's cost efficiencies, disciplined capital management and employing more equity financing than debt boosted the financials of the company. Notably, the company generated free cash flow of $21 million in the last reported quarter, while generating 13% annualized return on the capital employed. As a show of confidence in its cash flow generating ability, it also initiated its dividend payout program in the first quarter.

Its return on equity for the trailing 12 months is 10.53%, higher than the industry's figure of 6.07%. Finally, Diamondback's manageable debt-to-capital ratio of 22.9% is lower than most of its peers, providing it with enough financial flexibility to tap the strategic growth opportunities.

Signs of Concern

While production in the Permian is soaring, the takeaway capacity is not increasing in proportion. Due to pipeline capacity constraints, Diamondback Energy and other producers have to sell their products at a discounted rate. Though the company is entering into agreements to improve pricing exposure, the impact of the same is unlikely to be immediate. While Diamondback inked a deal to secure 50 thousand barrels per day of capacity for the Gray Oak pipeline, the project is not expected to become operational till late 2019, providing no immediate respite from the concerns.

Also, while the company's financials are otherwise strong, there is one area of concern in the balance sheet with respect to its cash position. Notably, cash and cash equivalents of the company decreased 35.5% in the last reported quarter. As it is, Diamondback's current ratio of 0.53 compares with 1.06 for its broader industry, which is low both in absolute and relative terms. This may lead to difficulties in meeting its current obligations.

Bottom Line

Despite the above-mentioned hurdles, we believe that the company's top-tier acreage in the Permian, cost-containment and growth initiatives, healthy cash flow generation, along with a rebounding energy landscape will enable Diamondback to counter the limitations.

Zacks Rank and Key Picks

Diamondback currently carries a Zacks Rank #3 (Hold)

Some better-ranked stocks in the oil and energy sector are Cheniere Energy, Inc. LNG , Occidental Petroleum Corporation OXY and Oasis Petroleum Inc., OAS each sporting a Zacks Rank #1 (Strong Buy). You can see the complete list of today's Zacks #1 Rank stocks here.

Cheniere Energy's 2018 earnings are anticipated to grow 224.03% year over year.

Occidental's earnings for 2018 are expected to grow 360.67% year over year.

Oasis Petroleum delivered an average positive earnings surprise of 74.88% in the trailing four quarters.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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