This year was supposed to be a big one for oil producer Diamondback Energy (NASDAQ: FANG). The company was right on the cusp of an inflection point that would have enabled it to generate a gusher of free cash flow if oil averaged $55 a barrel, slightly below where crude entered this year. Unfortunately, oil prices would go on to crater, which upended Diamondback Energy's 2020 game plan, causing its shares to plummet 55% so far this year.
While shares are down sharply this year, several catalysts could fuel a rebound in the coming months. Here's a look at that bull case for buying the stock now as well as what could go wrong.
The bull case for buying Diamondback Energy
Diamondback Energy initially estimated that it would invest between $2.45 billion and $2.6 billion to drill and complete roughly 300 new wells to grow its oil production by 10% to 15%. It only needed oil to average $45 a barrel to support that plan and its dividend. However, with crude oil crashing, it cut its spending plan by roughly half, which will cause its production to decline. That reset spending level will also enable it to generate enough money at the current oil price of around $40 a barrel to maintain its dividend and retain some free cash to bolster its balance sheet.
It's therefore set up to generate an increasing amount of free cash flow if oil prices continue recovering. That seems likely given the historic amount of support provided by OPEC and the bounce back in gasoline demand as the economy has started reopening. Several analysts believe that Diamondback Energy could produce a prodigious amount of free cash flow next year in an improving oil market. That surging free cash could give Diamondback Energy the funds to repurchase some of its beaten-down stock, which could push its price higher.
Meanwhile, another potential upside catalyst is consolidation in the oil patch. Chevron (NYSE: CVX) recently agreed to buy Noble Energy (NASDAQ: NBL) for $5 billion in stock, a double-digit premium to its prior trading price. That deal might spark an M&A wave and drive valuations in the sector higher. Diamondback could be a target of a larger oil company or go on the offensive and make a needle-moving acquisition.
The bear case for Diamondback Energy
Because it is an oil producer, changes in crude prices have a significant effect on Diamondback Energy. At oil's current price in the low-$40s, Diamondback generates just enough cash to maintain its operations and dividend. However, if oil tumbled again and remained lower for an extended period, Diamondback's cash flow would decline, forcing it to start borrowing money to bridge the gap. That would put some pressure on its balance sheet, which would likely weigh on Diamondback Energy's stock price.
On a positive note, the company did enter this downturn in better financial shape than many other drillers because it had a low leverage ratio and lots of liquidity. However, it does have a $400 million debt maturity in September of 2021 that it will need to address eventually. While it currently has access to the debt market -- it issued $500 million of 2025 notes in May at an attractive rate -- it might not be able to refinance this debt if the oil market crashes again.
Another concern is that even if oil prices improve in the near term, the long-term outlook for oil demand growth has dimmed considerably. Most analysts don't expect consumption to return to pre-pandemic levels until 2022. This outlook suggests that Diamondback Energy might not be able to return to growth mode for a few years. Further, even when oil demand starts growing again from its recent peak, it might reach a permanent plateau a few years later. While many analysts initially thought oil demand would continue growing until 2040, several now see consumption hitting a peak by 2030. Thus, oil companies like Diamondback Energy might not have much more room to grow in the coming years.
A potential gusher of near-term upside
Diamondback Energy is a compelling option for investors looking for a bounce-back candidate in the oil market. Shares are down more than 50% even though it has lots of upside if oil prices continue bouncing back, which seems likely given OPEC's support. That would enable it to generate lots of cash over the next year, giving it the funds to buy back a big chunk of its beaten-down stock, which could boost the price. Add in the potential catalyst from M&A, and Diamondback Energy is one of the more intriguing oil stock opportunities these days.
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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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