Diversified Energy Co. Plots Growth Through Culling, Harvesting Mature Gas Wells

Friday, 08/02/2024  Published by: Tom Biracree  rbnenergy.com

Link to full blog with graphs:  https://rbnenergy.com/big-city-stripper-diversified-energy-co-plots...

The term “exploration and production company” has been widely used for only four or five decades, but the activities it represents have a history that dates back to the first oil well drilled by Edwin Drake in Titusville, PA, in 1859. Ever since that world-changing event, discovering and developing new sources of oil and gas has remained the industry’s passion, exemplified by wildcatters and, more recently, by the technological wizards of the Shale Revolution. To this day, every major public upstream company still invests in finding and developing reserves — except one. In today’s RBN blog, we examine the unique approach taken by Diversified Energy Co., which has grown substantially by ignoring the “E” part of E&P. 

As we’ve frequently pointed out in the RBN blogosphere, the long-term sustainability of an E&P depends on the level and effectiveness of its investment in replacing the oil and gas reserves produced each year. Generally speaking, the most impactful are reserves unlocked through the development of existing fields and the successful exploration of new properties, which are both funded by the “finding and development” (F&D) part of the company’s capital spending budget. In 2023, the 42 major U.S. E&Ps we monitor allocated a combined $84 billion — or nearly three-quarters of their total $114 billion investment — to F&D activities. However, as we noted in our most recent blog on reserve replacement, Replace Me, organic replacement costs — that is, the costs of actually finding and developing new reserves — have increased dramatically and the volumes replaced via that approach have been declining. This trend has been a key driver of the recent wave of massive industry consolidation as many producers compete to deepen their portfolios of Tier 1 reserves by acquiring them from others.

We’ve also highlighted strategic alternatives to pursuing large corporate mergers. In Homegrown, for example, we outlined EOG Resources’ long-term laser focus on organic growth through the stealthy exploration and development of new unconventional resource plays. Let’s Dance described the rise of public companies that solely pursue non-operated interests, which allows them to high-grade their F&D investment by giving them the option to participate — or not participate — in individual wells. Non-op entities such as Northern Oil & Gas have played key roles in partially funding major M&A deals, most recently SM Energy’s purchase of Uinta Basin producer XCL Energy (see I Want Your Wax). Today, we’re analyzing a company taking a very different path, namely by entirely eschewing organic development by budgeting virtually no F&D spending.

Diversified Energy (formerly Diversified Gas & Oil), founded in 2001 by banker Robert “Rusty” Hutson Jr., has a specialized focus: to acquire mature, conventional gas and oil assets in Appalachia and hold them until the end of their productive lives. The wells purchased have an average age of 8-9 years and a productive life of an average 20+ years. Because these wells — many of them “stripper wells” with average production of 15 boe/d or less — are past the steepest portion of their decline curves, the company has had virtually no drilling and completion (D&C) costs. Over the last three years (2021-23), Diversified has drilled no exploration wells and developed only six net wells, primarily by completing development that was already underway at the time of purchase. The cumulative F&D reserve additions were just 14 Bcfe (billion cubic feet equivalent), or only 0.03% of the company’s 3.9 Tcf (trillion cubic feet) of proved reserves. 

A second major consequence of purchasing mature wells is predictable low decline rates. Diversified’s corporate decline rate was 10% as of Q1 2024, far below the 25%-35% decline rates of the major Gas-Weighted U.S. producers we track. This means the company has to spend less to replace production. Its 2023 capital intensity, which is calculated by dividing 2023 capex by 2023 production, was just $0.25/Mcfe, compared with $0.75-$1.40/Mcfe for its peers.

Diversified Energy started slowly but began to pursue an aggressive growth strategy after successfully listing on AIM, the London Stock Exchange’s international market for smaller growing companies, in February 2017. The company subsequently moved from AIM to the main London Stock Exchange and in September 2020 its market cap reached $1.3 billion, allowing it to join the FTSE 250, a list of the largest London-traded companies.

The following month (October 2020), the company signed a $1 billion strategic participation agreement with funds related to Oaktree Capital Management to pursue acquisitions with a value greater than $250 million. Diversified initially received a 51.25% working interest (WI) in acquired properties for funding 50% of the acquisition price, with Oaktree receiving a 48.75% WI. Diversified’s interest eventually increased to 60% when Oaktree achieved a 10% unlevered internal rate of return (IRR) on the assets. Through subsequent acquisitions that totaled nearly $2.3 billion, Diversified’s production grew to 135 Mboe/d in 2022 as the company expanded beyond Appalachia to the Haynesville/Cotton Valley play in Louisiana, the Barnett Shale, and the western Anadarko Basin. Annual revenue that year topped $1 billion and Adjusted EBITDA exceeded $500 million.

Despite the growth, Diversified encountered challenges in the investment environment. The first hurdle was an October 2021 report by Bloomberg that revealed the company owned 61,000 wells as of December 2020 — the highest total for any U.S. producer and 65% more than second-place ExxonMobil’s 36,900 wells. Bloomberg’s investigation raised serious concerns about potential methane leaks from what it claimed were slow and flawed efforts by Diversified to plug and retire decaying, unproductive wells. The report resulted in a 20%+ decline in Diversified’s stock price in Q4 2021. The company responded by initiating a process to acquire existing-well plugging firms and a program to increase the pace of inspection of decommissioned wells. (We wrote about the role low-producing wells play in methane emissions in Cover Me.)

Diversified’s stock price slowly recovered and peaked at 2,800 pence (28 British pounds, or $35.67) per share in mid-2022 as higher natural gas prices boosted profits and cash flows. However, the subsequent steady decline in gas prices and rising debt — along with lingering environmental concerns — led to a steady erosion of the stock price to less than half that level by late 2023. One consequence was that Diversified’s quarterly dividend of 0.6844 British pounds ($0.875) per share resulted in an extraordinary yield of 30%. While the company had always protected its cash flows through hedging, including a peer-group high 85% of volumes at an average floor of $3.09/MMBtu in 2024, the percentage of volumes protected at that level eroded in future years, potentially reducing cash flows.

One immediate company response was listing the company on the New York Stock Exchange (NYSE; stock symbol DEC) in December 2023 to make shares more accessible to U.S. investors. The second substantive step was Diversified’s March 2024 announcement of an updated capital-allocation framework. The company said that after weighing the intrinsic value of its current share price against its historical dividend policy, it decided to reduce the quarterly dividend to 0.2283 British pounds ($0.29) per share for a three-year period. This freed capital for systematic debt reduction of approximately $200 million per year to enable the company to remain within its target leverage range of 2x to 2.5x. The new plan also allowed for strategic share repurchases and funding accretive strategic acquisitions.

Diversified concurrently announced a major transaction: the $410 million purchase of Oaktree Capital’s proportionate interests in assets acquired since the participation agreement signed in 2020, bringing Diversified’s interest to 100%. The purchase included production of 122 MMcfe/d, a 15% increase to the company’s 2023 average output. The price included the assumption of approximately $120 million in debt and about $90 million in deferred cash payments to Oaktree. Benefits included an average floor price for the acquired volumes at a 25% premium to Diversified’s current hedge portfolio, which boosted the company’s pro forma 2024 average price by $0.10/MMBtu. The deal also brought $15 million in cost efficiencies.

To partially fund the Oaktree transaction and lower debt, Diversified management highlighted efforts to unlock hidden asset value in its portfolio, which included sales of non-core assets such as undeveloped acreage and proved undeveloped reserves. (The blue-shaded areas in Figure 1 above show the company’s current production assets and the gold-shaded areas show its midstream assets — mostly gas-gathering lines.) A more important innovation was the transfer of producing Appalachia properties to a Special Purpose Vehicle (SPV), in which the company retained a 20% minority interest. The deal generated proceeds to Diversified of approximately $200 million, comprised of debt issuance backed by the assets (known as Asset Backed Securitization, or ABS) and a sale of an 80% interest in the SPV to investors for $30 million. The deal provided proceeds for debt reduction and triggered an increase in the company’s borrowing base. The company’s total divestiture proceeds, including non-operated well interests and acreage sales, reached $240 million.

Finally, Diversified combined its acquired well plugging and abandonment assets into a new entity, Next LVL Energy, that targeted innovative, full-scope retirement services for both Diversified and third-party operators. The company increased its retired wells from 136 in 2021 to 222 in 2023. Next LVL also retired 182 third-party wells, which generated revenue that significantly lowered Diversified’s net cash retirement costs.

Despite these initiatives, Diversified’s share price continued to decline to a low of 895 pence (8.95 pounds) per share in late March 2024, then slowly climbed to about 1,200 pence (12 pounds) per share. Similarly, the NYSE stock price declined from $15/share at listing to $12/share in March 2024 before returning to just above $15/share in late June. We reviewed the company’s reserve replacement, financial performance and leverage metrics to compare them to the 12 companies in our Gas-Weighted E&P peer group. As shown by the bars to the left in Figure 2 above, Diversified’s three-year reserve replacement cost of $3.28/boe (blue bar to left) is 47% lower than the peer group average of $6.24/boe (orange bar to left), while its three-year replacement rate of 233% (blue bar to right) is about one-quarter higher than the peer group’s 189%. Most significantly, in 2023 the peer group’s replacement costs rose significantly and the replacement rate fell.

As shown in Figure 3 below, Diversified’s financial performance over the last three years (blue bars in chart) is right on par with the average for the Gas-Weighted peer group (orange bars). Slightly higher revenues and cash flows for the peer group likely reflect the higher liquids contribution to the production of some peers, while Diversified’s lower DD&A (depreciation, depletion and amortization) costs result from lower reserve replacement costs. Operating costs line up too, indicating a comparable level of operating efficiency. From cash flows, Diversified funded $180 million in dividend and share repurchases in 2023 and set a 2024 quarterly dividend that is currently yielding about 7%.

The most significant difference between Diversified and the peer group is debt. As shown in Figure 4 below, the company’s year-end 2023 net debt was $1.28 billion, or $1.99/boe of proved reserves (red dot and Y-axis), compared with the peer-group average of $1.26/boe. DEC’s debt exceeds the liabilities of the major Appalachian producers but is well below the $2.70/boe debt of SilverBow Resources (SBOW), which is being acquired by Crescent Energy after a series of major acquisitions, and the $3.20/boe of closely held Haynesville producer Comstock Resources (CRK). Diversified’s debt-to-capital ratio of about 45% (red dot and X-axis) is also among the highest in the group. A structural difference in Diversified’s liabilities is that 90% are from notes secured by packages of assets (ABS) rather than by the overall credit of the corporation. (Note: Crescent Energy is not on the chart because it is in our Diversified peer group — that is, E&Ps with a balance of oil- and gas-focused production.)

Going forward, Diversified Energy’s management considers the recent wave of massive industry consolidation an especially fertile environment to implement its acquisition strategy. The major consolidators have all indicated they plan to make non-core assets sales after their deals close. For example, Occidental Petroleum has mentioned a target of $6 billion in divestitures after completing its planned purchase of CrownRock. Currently, Diversified is the sole public E&P with the funding in place to acquire significant packages of maturing gas-focused properties. It will be interesting to see if new start-ups emulate Diversified’s strategy to compete for inevitably increasing volumes of maturing assets.

Like other gas producers, Diversified is optimistic about rising future gas demand from the increase in LNG export facilities, Mexican exports and rising domestic demand. The risk for the company would be a longer-than-expected period of low gas realizations that erode returns from its hedging program, which would challenge its debt-reduction plan. While waiting for stronger demand, Diversified is seeking to improve operational efficiency through an automated Smarter Asset Management program to monitor well performance and targeted purchases of midstream assets to lower gathering, processing and transportation costs. After Diversified’s listing on the NYSE, we have added the company to the universe we follow and will be closely monitoring its future performance.