Energy Prospectus

The Sweet 16 declined 5.56% during the week ending Friday, August 17. It is now down 6.59% YTD, which makes no sense considering that oil, gas and NGL prices are much higher today than they were at the beginning of the year.

All of the Sweet 16 reported GOOD to VERY GOOD 2nd quarter results. They are increasing production and increasing cash flow from operations, which are the primary drivers of stock valuations for upstream companies. First Call's price targets for most of the Sweet 16 have moved higher since they released Q2 results, although it does take several weeks before the FC price targets are completely up-to-date. Remember that only the analysts' reports submitted to Reuters after Q2 results are known are valid.

Here are the FEARS that are holding back fund managers from rotating money into this sub-sector:

1. Oil Prices: WTI has pulled back recently because of the increase in the U.S. dollar index. Since April, the increase in the dollar has shaved $7/bbl off the oil price.

2. Permian Basin Takeaway Capacity: This is a real problem, but it is a short-term problem. Actually, it has done more harm to West Texas natural gas prices than to the Permian Basin oil prices. All of the Sweet 16 have worked out the logistics to get their oil to market and most of them are insulated to some extent with hedges against the pricing issue.

3. Trade Wars: IMO this fear is way over-blown. The fear is that Trump's Tariffs will slow oil demand. No sign of that happening yet. Plus, there is a good chance that we work out a "No Tariffs" agreement with Europe. If that happens, there will be increasing pressure on China to make some kind of deal with Trump.

4. End of Summer: It is a common belief that demand for oil dips after the summer driving season is over. There is a smidgen of truth in this fear, but after a brief "turnaround" period for the refiners, they have a lot of work to do this year because distillate inventories (diesel and heating oil) are dangerously low. Go to the IEA website and take a hard look at the chart that pops up here https://www.iea.org/oilmarketreport/omrpublic/ What you'll see is that global demand for oil holds up well from Q3 to Q4.

The near-term outlook for natural gas and NGL prices is very good. After Labor Day, it is a good bet that we seen the NYMEX futures contract for October natural gas move firmly over $3.00. Since it closed on Friday at $2.95, I'm not way out on a limb making this prediction. All three of the gassers (AR, GPOR and RRC) are trading well below book value. That only makes sense if you believe natural gas and NGL prices are going to plunge in the future. I think there is a much better chance that they spike this winter. Go to https://www.weatherbell.com/premium/ and take a look at the winter forecast for the U.S.

We are sending out an updated profile on Earthstone Energy (ESTE) today. Read it carefully and note that, despite a slowdown in their D&C program, Earthstone's production is going to ramp up sharply over the next two quarters.

I am updating the forecast and profile for Diamondback Energy (FANG) today. We will post my weekly podcast late today.

The Sweet 16 spreadsheet has been updated and posted to the EPG website. It shows my valuation and First Call's price target for each company on Tab 2. The individual forecast/valuation models for all 16 companies can be found under the Sweet 16 tab. All of the forecasts assume that WTI will average $65/bbl for all future periods, even though I expect us to see WTI test $75/bbl later this year (Trump is serious about Iran).

This deal creates another "Powerhouse Permian Company". FANG will be right up there with PXD and CXO. I have highlighted in BLUE what I really like about it. - Dan

MIDLAND, Texas, Aug. 14, 2018 (GLOBE NEWSWIRE) -- Diamondback Energy, Inc. (NASDAQ: FANG) (“Diamondback” or the “Company”) and Energen Corporation (NYSE: EGN) or (“Energen”), today announced that they have entered into a definitive agreement under which Diamondback will acquire Energen in an all-stock transaction valued at approximately $9.2 billion, including Energen’s net debt of $830 million as of June 30, 2018. The consideration will consist of 0.6442 shares of Diamondback common stock for each share of Energen common stock, representing an implied value to each Energen shareholder of $84.95 per share based on the closing price of Diamondback common stock on August 13, 2018. The transaction was unanimously approved by the Board of Directors of each company.

TRANSACTION HIGHLIGHTS:
•Creates the premier large cap Permian independent with peer-leading production growth, cost structure and capital efficiency
•Over 266,000 net Tier One acres in the Permian Basin, an increase of 57% from Diamondback’s current Tier One acreage of approximately 170,000 net acres (pro forma for previously announced Ajax acquisition)
•Over 7,000 estimated total net horizontal Permian locations, an increase of over 120% from Diamondback’s current estimated net locations (pro forma for previously announced Ajax acquisition)
•Combined pro forma Q2 2018 production of over 222 Mboe/d (67% oil), third largest production for a pure play company in the Permian Basin, an increase of 79% from Diamondback’s Q2 2018 production of 124.7 Mboe/d (includes production from the previously announced Ajax acquisition)
•390,000 net acres across the Midland and Delaware basins, an increase of 85% from 211,000 net acres as of June 30, 2018 (pro forma for previously announced Ajax acquisition)
•Immediately accretive in 2019 on key per-share metrics including: earnings per share, cash flow per share, net asset value, production growth per debt-adjusted share and acreage
•Free cash flow enhancement expected to support increases in return of capital; Diamondback dividend to be maintained and growth in return of capital program to be assessed in 2019
•Held by production nature of assets allows for development optimization with multi-zone, multi-well pads in both Midland and Delaware Basins

Primary deliverable synergies with net present value of $2.0 billion or more include:
•Capital Productivity: Drilling, completion and equip (“D,C&E”) well cost savings of up to $200 per lateral foot across over 2,000 net operated locations in the Midland Basin
•Estimated annual general and administrative (“G&A”) savings of $30 - $40 million
•Lower cost of capital and accelerated path to investment grade profile
•Primary deliverable synergies expected to be realized beginning in 2019

Secondary synergies with net present value of $1.0 billion or more include:
•Capital Productivity: D,C&E well cost savings of up to $50 per lateral foot across over 1,500 net operated locations in the Delaware Basin
•Benefits of economies of scale
•Benefit of overlapping and adjacent acreage in Howard, Martin and Ward counties
•Lease operating expense reduction
•High grading of inventory allows for cash flow acceleration and reinvestment
•“Grow and prune” strategy for non-core assets with cash reinvested into higher return projects
•Substantial mineral ownership and acreage with net revenue interest greater than 75%, providing compelling drop down opportunities for Viper Energy Partners LP
•Combination of significant midstream assets across both Midland and Delaware basins
•Secondary synergies expected to be realized post integration

Energen is an oil-focused exploration and production company with operations in the Permian Basin of west Texas and New Mexico. As of July 1, 2017, the company has identified 4,116 net engineered, unrisked, potential drilling locations in the Delaware and Midland basins with an estimated 2.5 billion barrels of oil-equivalent, net, undeveloped resource potential. Energen’s proved reserves at year-end 2016 totaled 316 million BOE.

Since Diamondback announced the merger with Energen, six analysts have submitted new forecasts/valuations to Reuters.
> Dan McSpirit at BMO Capital rates FANG a HOLD with a valuation of $135/share
> Gabriele Sorbara at Williams Capital rates FANG a HOLD with a valuation of $165/share
> The other four analysts rate FANG a BUY with valuations that range from $166 to $175 per share.

Based on Energen's production guidance, the merger should add the following production to FANG at closing:
> 69,000 bbls per day of oil
> 21,000 bbls per day of NGLs
> 132,000 mcf per day of natural gas

For modeling purposes I am assuming that those rates increase by 20% on average for full-year 2019, which compares to Diamondback's pre-merger growth forecast of 31% YOY growth in 2019.

So, here is what Diamondback's production looks like assuming the acquisition of AJAX and the merger with Energen close in December, 2018.
Production:
2017A = 79,122 Boepd (74.1% crude oil)
2018E = 118,550 Boepd (74.0% crude oil)
2019E = 287,700 Boepd (68.1% crude oil)

What is your updated value?

For now I am leaving my valuation of FANG at $170/share. Once the acquisition of AJAX and the merger of Energen close, the company should issued production guidance for 2019. If it matches what I am assuming post-merger, my valuation will go over $180/share.

What I've done is add two forecasts for 2019: One is proforma for the AJAX acquisition, which is 99.9% sure to close in December. The second one is proforma for both the AJAX acquisition and Energen merger closing in late December, 2019, which is ~95% chance of happening. Sometimes deals the size of the Energen merger have problems closing, but if both boards have approved it and major shareholders like Carl Ichan are onboard it should close on schedule.

Post-merger, FANG should have "stunning" growth. Plus, based on my model, it will have over $3.5 Billion of cash flow from operations in 2019 to fund a very aggressive drilling program.

FANG closed on Friday at $120.18/share.

PS: Post-closing FANG will only have ~166 million shares of common stock outstanding and a very strong balance sheet. That is not a lot of stock of a company of this size.