Diversified Energy (DEC LN) - Hedged income
Diversified Energy is an independent energy company focused on acquiring natural gas producing assets and related midstream infrastructure in the US onshore space. The company has operations in the Appalachia Basin and the central states of Louisiana, Oklahoma, and Texas. The company was listed on AIM in February 2017 but was uplisted to the main board of the London Stock Exchange in 2020 and currently has a market cap of around £1 billion.
Diversified Energy focuses on low-risk, low-cost, long-life producing assets. The company predominantly acquires mature producing conventional and non-conventional gas assets from industry players who are seeking to refocus their financial resources. These assets are characterised by predictable production rates, long lifespans (40-50 years) and low decline rates.
The graph below illustrates the production decline of natural gas wells. Production falls quickly in the early years but then declines at a much slower and more predictable rate in later years. Not only are more mature fields proven, but their performance is predictable with lower risk and uncertainty.
Production profile
Diversified Energy currently has a net daily production of 144Mboepd or 862MMcfepd. Natural gas makes up 90% of the mix, nongas liquid (NGL) is around 8% and oil is 1% and the consolidated production decline is estimated to be around 8.5% per annum - well below the industry average of 27%. Diversified Energy attempts to optimise its assets even further by applying the company's internally developed Smarter Asset Management programme, which aids in offsetting natural production declines. The company's current PDP (proved developed producing) reserves are 823MMBoe.
As a result of continuous acquisitions since its IPO in 2017, Diversified Energy's asset base has grown significantly over the years.
Hedging Strategy
Diversified Energy uses a hedging strategy which is designed to secure healthy cash margins (50%+) to protect cash flow reliability and sustain shareholder returns.
As of 1 May 2023, the group maintained a favourable natural gas hedge position with the 2023 average “floor” pricing 35% above strip pricing and 55% higher than the active contract price. The group has hedged over 85% of its natural gas production in 2023, ~80% in 2024 and ~70% in 2025 and continues to opportunistically add to its hedge portfolio where the price curve is higher.
Vertically integrated to reduce expenses
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Midstream pipeline: Diversified Energy is partly vertically integrated as it owns 17 000 miles of pipeline into which the company is a large producer. This reduces transport cost and enhances margins.
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Asset retirement: Diversified Energy has committed to retire 200 wells annually (66 000 in total). In 2020, the cost to retire a well was $25 000, however, Diversified Energy has made strategic investments in retirement capacity to offset these cash costs with third party revenues. It is expected that plugging costs will average under $20 000 per well in 2023. Diversified energy has bought three plugging companies with 12 crews and 15 rigs, with a target to reach 15 crews. The company's aim is to fully offset well retirement costs from third party revenues.
Investment case summary
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Diversified Energy operates a differentiated business model which focuses on optimising long-life, low decline producing assets. Its annual decline rate is 8.5%, which compares favourably to the peer average of ~27%.
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It hedges most of its production to protect its cash flow, along with vertically integrating certain functions such as well plugging and transportation to reduce costs and increase cash margin.
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Predictable cash flows through hedging enables Diversified Energy to pay a healthy dividend, even through the difficult years of the Covid-19 pandemic. Oil and Gas E&Ps often cut or suspend their dividend in down cycles; however, Diversified Energy aims to consistently pay a dividend. Diversified Energy's current dividend yield is well above its peer average at 14.8%.
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When Diversified Energy acquires assets the company uses asset-backed debt securitised by certain natural gas and oil assets, which are long-term, fixed-rate, fully-amortsising debt structures that better match the long-life nature of its assets. These structures offer low borrowing rates and provide a visible path for reducing leverage as the company makes scheduled principle payments.
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We believe the assets of the company are currently undervalued, with a possible catalyst being a possible listing on the New York Stock exchange.
Risks
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Oil and gas prices can be volatile - although this risk is reduced by hedging to a certain extent.
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Demand for its product may be impacted by economic pressures.
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As the company is highly acquisitive, there is an element of execution risk attached to its strategy.
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Production shortfalls will negatively impact revenue.
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Political and regulatory risk is apparent in the industry.
Consensus and Valuation
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Consensus is positive on Diversified Energy's stock, with 89% of sell-side analysts maintaining a “Buy” on the stock and 11% having a “Hold” rating.
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Consensus is looking for the company to break even on a net profit basis in FY23 after recording a loss in FY22 - the business is expected to remain profitable over our forecast horizon.
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The company currently trades below its five-year historical average PE and EV/EBITDA. While it is difficult to find direct competitors, Diversified Energy's dividend yield stands out from peers and its valuation is attractive.
