Diamondback: Permian Pick

10/15/2013 7:00 am EST

Focus: STOCKS

Tyler Laundon

Editor, Cabot Small-Cap Confidential

The top dog for oil exploration and production in the US at the moment just might be the Permian Basin in the western part of Texas, suggests Tyler Laundon in the 100% Letter.

The Permian lies just northwest of the Eagle Ford and is home to a number of shale intervals, including the Cline, Spraberry, and Wolfcamp. These stacked formations are gaining notoriety as they appear to hold far more oil than any previous estimate.

Diamondback Energy (FANG) is a relatively new small-cap pure play on the Permian Basin, given that the company just went public in October of 2012.

The company is smallish with a market cap of $1.8 billion. It has a nice acreage position approaching 65,000 acres (including recent acquisitions, which I'll soon discuss), almost all of which it operates.

It's a pure play Permian oil stock. It's also a fairly pure oil investment. The company's production split is 75% oil, 14% natural gas liquids (NGLs) and 11% natural gas. On a revenue basis, 90% of revenues come from oil, while 6% and 4% come from NGLs and natural gas, respectively.

FANG is aggressively transitioning away from vertical drilling and toward horizontal drilling, a move which is paying off in spades. In fact, based on management comments, it sounds like it will only drill vertical wells if it has to, to keep current with exploration commitments. Horizontal is the way to go, no ifs, ands, or buts.

Why horizontal? It's simple really—horizontal wells are far more profitable. While they cost several times more than a vertical wells (~$7.5 million versus ~$2.1 million), a horizontal well generates a much higher return, around 40% versus just 25% for a vertical well, according to FANG's reports.

Because of horizontal drilling, cost per barrel is going down, drilling time is going down, and returns are going up. Seems like a pretty sweet deal that's likely to get sweeter when FANG gets more rigs going.

The pace of drilling is ramping up; FANG has averaged around 16 wells per quarter over the last six months.

Meanwhile, acquisitions are fueling growth in reserves, drilling inventory, production and cash flow. FANG is on target to more than double its well count in 2013, it's moving more rigs in for 2014, and it has acquired a lot of very attractive acreage to drill out in the coming years.

In 2012, revenues were $75 million. It's on pace to hit ~$210 million in 2013—that represents a 180% increase. And I see 2014 revenues growing by another 120% to 140% considering the catalysts discussed above.

Given this revenue growth, earnings per share should be in the neighborhood of $1.30 in 2013 and $3.10 in 2014. That implies a forward-PE ratio on shares of about 14 times 2014 earnings, which is insanely cheap for this kind of growth.

The bottom line, in my view, is that Diamondback is an exciting small exploration and production company; operations are great, rig and well count is rising, production is growing, and the company has shown an ability to complete really attractive deals.

The Permian is one of the best places to be for US oil, and FANG is 100% levered to it. The stock has been a strong performer, but I don't see that as a reason to stay away. I'm looking for a steady grind higher from FANG.

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