Description

Overview

Diversified Energy is one of the largest natural gas well owners in the United States and is among the only publicly listed PDP acquirers. While most operators in the oil and gas space are focused on creating value (insert laugh here) at the drill bit, Diversified Energy is focused almost exclusively on rolling up mature, long-life, low decline assets. These assets are often non-core and neglected by the former owners, leaving Diversified simple and predictable targets for operational improvement. The team has a demonstrated track record of slowing decline rates on acquired properties and consistently driving down unit operating cost through scale. Over the last five years Diversified Energy has completed over $2.5 billion in acquisitions, resulting in more than a 50x increase in production and a 70% CAGR in dividends per share. The founder and CEO Rusty Hutson owns more than $30 million in stock (>40x annual salary), and I believe is among the best capital allocators in the energy space. 

Set-Up

On October 12, 2021, Bloomberg Green released a hit piece on Diversified Energy highlighting methane leaks at some well sites representing less than 0.5% of the company portfolio. Despite extensive engagement with the company over the last several months, the authors naturally elected for sensationalism over a dispassionate account of the facts. Many of the leaks cited in the report were related to pneumatic valves that were operating as designed and are a current priority of the entire industry to redesign. In addition, all cited leaks have since been fixed, requiring less than 2 weeks of work and a total cost of $2K. The shares fell ~20% with the release of the article and pro forma for recent acquisitions trades at 4.4x EV/EBITDA and a 21% FCF yield. Even still, prior to the release of the article shares of Diversified Energy largely went unnoticed due to its stranded listing (100% US operations and LSE listing). 

History

Rusty Hutson is a fourth generation oil and gas operator with deep family roots in the Appalachian basin. He was the first in his family to earn a college degree and pursued a successful career in banking before buying his first package of wells in 2001. The deal was brought to Rusty by his father, and he used a combination of seller financing and second mortgage on his house to purchase the wells. For the next several years, Rusty focused on small deals that fell below the radar of other private acquirers and brought his co-founder and capital partner Robert Post onboard in 2005. Neither Rusty or Robert have ever sold a share of the company. Beginning in the early-2010s, operators became extremely eager to divest their legacy conventional assets in favor of horizontal development. And as a local proven and competent operator, Diversified soon became an acquirer of choice. In 2015 Diversified listed a bond in London to take advantage of the opportunity set and went public on the AIM stock exchange 2 years later. Up until 2021, Diversified Energy focused exclusively on the Appalachian basin but has recently added the Central Region to its target universe which brings into play hundreds of thousands of conventional and unconventional wells across Texas, Louisiana, Arkansas, and Oklahoma. Today, Diversified owns nearly 70,000 wells which on an EBITDA basis are split 60% Appalachia and 40% Central region. In October 2020, Diversified Energy inked a $1 billion partnership with Oaktree to pursue large well packages over $250 million. Under the arrangement both parties fund the acquisition 50/50 and Diversified gets a 2.5% upfront promote with an ultimate ownership reversion of interest of 60% once Oaktree achieves a 10% IRR. There is $630 million of Oaktree capital left for further deals. 

Acquisition Environment

Scott Sheffield noted at the Barclay’s energy conference in September that there are probably 10x as many oil and gas assets for sale today as there is capital interested to buy them. And this is certainly what rings true for Diversified Energy, as CEO Rusty Hutson has said several times over the last 12-18 months that this is the most attractive acquisition environment he has ever seen. Diversified generally will pay 2-3.5x EBITDA for an asset with 30+ remaining years of economic production which is declining between 7-12% per year. The Diversified team then has a detailed operational playbook where they target low hanging projects across the often neglected assets. This involves things like returning select idle wells to production, adjusting well additives, optimizing compression, reconfiguring wellhead setup, eliminating leaks, and swabbing wells. Diversified Energy calls this program SAM, or Smarter Asset Management. Notably, Diversified has held its legacy conventional portfolio at a 0% decline for the last 10 quarters, creating immense additional value above its modeled acquisition price. In addition, through building significant regional scale Diversified Energy has a strong track record of driving down operating unit costs. When a new well package is acquired, it is often within close proximity of Diversified’s existing footprint which allows them to service the well with the same well tender at little to no additional cost. Recently, well packages have been available from private equity owners with a limited holding period, or E&Ps looking to offload non-core assets to drill core acreage at higher commodity prices. Historically, divestments came from sellers in distress or E&Ps looking to pivot to horizontal development. Now with the energy Majors looking to unload assets due to ESG pressures, it is an ideal time to be seated at the other side of the table with available capital. 

Midstream Assets

In addition to owning 70,000 wells, Diversified Energy also owns ~17,000 miles of midstream infrastructure which provides flow assurance and pricing optimization. More than half of Diversified’s Appalachia gas volumes move through its own infrastructure, which lowers transportation costs materially in addition to providing ~$30 million of third party revenue. Finally, Diversified’s midstream footprint provides for occasional attractive capital deployment opportunities. For example, the company recently re-routed its pipeline that flowed northbound into Dominion South to East Tennessee Natural Gas which is expected to result in a 25%+ increase in realized pricing and a 20 month payback. 

Upside Optionality via Undeveloped 

When Diversified acquires a package of wells, they regularly obtain undeveloped acreage as part of the deal. Given the extreme buyers’ market that has existed over the last several years, Diversified has effectively obtained this undeveloped footprint at zero additional cost. Today, the company has a land bank of 8.2 million net acres of leasehold which is largely undeveloped and held by production. The vast majority of undeveloped locations are conventional Appalachian basin locations which are highly delineated and predictable. Present development sits at ~100 acre spacing, while a fully developed program could be as low as 20 acre spacing – implying four additional wells per producing well. Drilling costs would range from $200k-$300k per well and Diversified expects it could earn a 30% well level IRR at $3.5mcf gas. Importantly, the company has drilled over 150 wells prior to 2018 with decent success. Today, Diversified still believes that acquisitions provide the most compelling opportunity for capital deployment, however if prices remain elevated or increase further, this provides an additional potential lever for value creation. 

Asset Retirement Obligations

While Diversified Energy is conservatively leveraged, they have significant asset retirement obligations as a large owner of mature wells. In addition, because there is very little in the way of public transparent data on well plugging cost, and because retirement cost varies so much depending on the nature of the asset, this can be a source of confusion. Complex offshore deep-water platforms can cost tens of millions to retire while shallow conventional wells that constitute the vast majority of Diversified’s well count cost between $20K-$30K per well. Unconventional wells that make up an increasingly large portion of Diversified Energy’s portfolio cost between $60k-$90K to retire but can produce 40x as much as a conventional well in its terminal decline years. As of June 30th, on an undiscounted basis the group has a $1.7 billion asset retirement obligation which it carries on its financial statements at $513 million. This assumes a 2.5% rate of inflation and a 5.4% discount rate. However, costs of well retirement for Diversified on a per well basis are going down not up (and this is perhaps unsurprising given the history of innovation and efficiencies gained on the drilling and completion side). Diversified has completed an increasing number of its retirements through its internal plugging team where they have seen a 25% cost savings over third party contractors. In addition, they have seen the time to retire a well site decrease by nearly 50%. More than 80% of well plugging cost is tied to time, not materials, and as such I would expect significant efficiencies to be gained as Diversified moves from plugging ~100 wells per year to 1,000 wells per year. Finally, something worth noting is that the recent infrastructure bill currently has more than $2 billion earmarked for the retirement of orphan oil and gas wells, or those that have become a responsibility of the state due to a bankrupt or defunct operator. Diversified Energy has plugged more wells than any operator, and many of the orphan wells that plague the state (and truly are emitting harmful methane into the atmosphere), are near Diversified’s wells. The company has mentioned providing P&A services externally, and this would allow them to build even more density and drive efficiencies in their plugging program. In contrast to today’s Bloomberg article, ironically, I expect Diversified Energy will be much more a part of the solution rather than the problem, 

Valuation

On effectively any metric, Diversified is exceptionally cheap. Pro forma for recent acquisitions the company expects to have ~150Mboepd in net production which could yield as much as $515 million in adjusted EBITDA and $250 million in FCF. The company expects to have a slightly increased ~9% decline following recent acquisitions which moderates back to 7% in 5 years. At a 9% decline, they have to replace $46 million in EBITDA which at an average 3x acquisition multiple leads to ~$125 million in maintenance CAPEX. In addition, because they acquire new packages at 3x with 50% cash and 50% debt at a 5% interest cost, they are able to grow production at a low double digit rate, while paying out 40% of FCF as a dividend, while also deleveraging. Additional cost efficiencies from added scale are just a bonus at this point. Finally, the company provides an illustrative wind down model which points to $7.7 billion in field level cash flow over the next 75 years which, with highly conservative assumptions, would lead to $2.6 billion in dividends on a $1.1 billion market cap (mid-single digit IRR in liquidation assuming a caped gas price of 3.15/mcf). The company currently has 2/3 of production hedged in 2022 at ~$2.90/mcf (before basis diff), and is largely unhedged thereafter. If the strip remains high, the company expects its EBITDA margin to move into the 60s. 

Catalyst

- continued FCF

- further acquisitions

- share repurchases

- US dula listing