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Energy prices have fallen after rising dramatically in the first half of 2022. Crude oil is currently below $100 a barrel, down 17% from its June peak of $122. US retail gasoline prices also fell to an average of $4.44, down 15% from a peak of $5.10. The moderate correction of energy prices has caused many oil and gas-producing stocks to fall, with the Oil Exploration and Production ETF (WELL) declining about 30% from its June peak to its recent low. Popular E&P stocks such as Diamondback Energy (NASDAQ: MUD), have experienced similar losses.
I think the recent drop in energy prices can be a substantial buying opportunity for energy producers like Diamondback. High energy prices, driven by long-lasting production deficits, are the main direct driver of inflation in the United States. The US economy is now technically in recession, mainly due to the negative impact of rising inflation on real wages and personal savings. Many investors and analysts believe that high energy prices are leading to an increasing destruction of demand for energy products. this factor has had the most important impact on energy prices over the past six weeks.
Recessions are historically low for energy prices because demand for crude oil typically declines with the economy. However, the US economy is entering recession with a significant shortfall in oil production. Second, the current recession has significantly affected the services sector (such as technology) more than the goods sector. Despite fears of demand destruction, refinery capacity utilization remains extremely high, while total crude storage levels continue to decline rapidly. In my view, as the US government slows the release of SPR reserves, energy markets will quickly return to a scarcity dynamic due to a lack of supply growth. Even with some demand destruction, crude oil may be poised to hit new all-time highs as storage levels reach critical lows.
Energy producers with low valuations, strong balance sheets and steady cash flows, such as Diamondback, can offer investors a means to earn significant returns from higher energy prices. While I think the macroeconomic backdrop behind crude oil is quite strong, Diamondback’s value potential can boost returns. Of course, as with its peers, Diamondback is not without risk, and crude oil prices may continue to decline. However, until the fundamental issues of energy scarcity are resolved, Diamondback’s cash flows should remain strong or grow further.
Crude oil could rise much higher
The price of FANG is closely related to the price of crude oil, as the company generates slightly more than half of its sales from oil. FANG, crude oil and other E&Ps have been steadily rising since the 2020 crash with numerous moderate corrections. While FANG has experienced high volatility over the past two months, it has rebounded from multiple corrections since 2020. See below:
FANG total return level data for YCharts
The current correction in the energy market looks more important because energy prices hit roughly 14-year highs in June. Crude oil at $100/bbl and natural gas at $8.30/MMBTU are expensive compared to recent history, but oil topped $145/bbl in 2008, while natural gas reached $13 dollars/MMBTU. Crude oil was closer to $200 per barrel in 2008 using 2022 inflation-adjusted dollars (giving ~40% inflation since 2008). Oil is not necessarily expensive today from this perspective.
Commercial energy inventory levels most directly influence the retail price of crude oil and gasoline. Prices fall when inventories rise and rise when storage levels fall. Today, commercial storage levels are low, but have increased dramatically over the past two months. driving up oil prices (and FANG) lower. Watch below:
US crude oil and petroleum products stocks, without SPR data for YCharts
On the surface, this inventory data, tracked by many energy market watchers, may imply that the oil shortage is over. Commercial inventories are rising, allowing more gasoline to flow to the pumps and supporting prices. In fact, in the short term, this factor may cause July’s inflation figures to be lower than June’s. However, if we consider the impact of the massive drawdown of strategic oil reserves, it is clear that the crude oil shortage is getting worse, not better. See total oil inventories, including SPR reserves, below:
US crude oil stocks data for YCharts
Commercial oil storage levels would be significantly lower were it not for the rapid decline in the US government’s SPR reserves. Total oil stockpiles have declined more rapidly in recent months and are now the lowest they have been in nearly two decades. There are few signs that this trend will slow down any time soon. Total U.S. crude oil production has increased slowly, but is still moderately below its pre-Covid-19 levels. Global oil production remains well below pre-Covid levels as the global oil rig count has stagnated (signaling a growth plateau). At the same time, US refinery capacity utilization (an indicator of demand) remains near moderately high levels. Watch below:
US utilization of refinery capacity data for YCharts
US crude oil exports have been on the rise, rising 40-60% this year. The increase in exports has achieved growth in domestic oil production due to the lack of growth in production abroad. Even much of the strategic issuance of oil reserves has been directly exported abroad. Crude oil is a global commodity, so higher US exports and a lack of overseas production growth benefit domestic prices. While there is minimal useful global data on refinery utilization, US oil demand remains strong despite fears of demand destruction.
Overall, I think this situation points to an increase in global crude oil prices in the coming months. Although commercial oil storage levels have improved, this is only due to a dramatic decline in SPR reserves. Demand has not abated this year despite a slowing economy, while global crude output is unlikely to rise due to a plateau in the oil rig count. Finally, even if the U.S. economic downturn results in lower demand for oil, it is likely to be met with stimulus policies from the Federal Reserve (or direct stimulus bills) that artificially boost economic demand. I believe this would further promote an oil shortage, as last seen in 2020.
The situation of natural gas and NGLs is similar to that of crude oil. Diamondback generates almost half of its sales from natural gas and NGLs, and prices for both gas and NGLs have increased significantly. US natural gas production has recovered faster than oil. However, production has recently dropped to environmental factors and, more importantly, a lower potential plateau in the count of natural gas rigs. This segment also benefits from increased demand for exports due to severe shortages in Europe; however, the importance of this factor may be overestimated as LNG production has reached capacity.
Value opportunity in FANG
Like most oil and gas producers, Diamondback was in a difficult period before 2020, as the energy market was stuck in excessive dynamics and prices were often below profitable levels. Diamondback’s valuation is still priced as if the company is struggling with insolvency, given its 5X forward “P/E” ratio and similar cash flow. Prior to 2020, the company expanded operations rapidly, creating an immense build-up of leverage during low profitability. The end of the “shale boom” could not have come at a better time, as it was on the verge of insolvency before 2020.
The company has used some of its current cash flows to reduce its financial debt and has begun paying dividends. Its dividend has grown, giving it a forward yield of 1.7%. As Diamondback continues to clean up its balance sheet and reach maturity with consistent production, I suspect its dividend can rise significantly. The company still has $5.8B in financial debt, which is relatively low compared to its market cap of ~$23B and annual operating cash flow of ~$4.6B . Watch below:
FANG Financial Debt (Quarterly) data for YCharts
I believe the FANG would rise even if oil prices remain stable. The company’s operating cash flow yield is around 20% and as it comes to maturity it is paying much less in CapEx, so most of its cash flow is now “free” . As detailed in his last investor presentation, Diamondback aims to keep production flat and reduce its total debt, making it an excellent target for dividend growth as its FCF expands. Also, if crude oil or natural gas continues to rise, as I suspect, the company could earn significantly higher cash flows.
The bottom line
In my view, crude oil and natural gas are in a long-term bullish supercycle as global producers struggle to increase production, which means high cash flows can be sustained for many years. At its current valuation, FANG looks like a stellar long-term investment as the company reaches a more mature stage and its dividend expands. In the short term, I think it can be a good way to generate leveraged returns from another big wave higher in energy commodity prices, driven by growing storage shortfalls.
The Biden administration is targeting fill the SPR in 2023, meaning releases must end or slow down over the next six months. This factor may catalyze a more significant rally in crude oil, as commercial inventories would likely deteriorate rapidly as global production remains weak. Of course, other nations may rush to increase energy production, or the Russian conflict may end, potentially helping the energy shortage. These are potential risks to my bullish FANG thesis. However, I think its valuation is low enough that its cash flow yield would be high today, even with lower oil prices. Overall, I am bullish on FANG and believe it can reach new highs in the coming months.
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