Diamondback Energy Inc (FANG) — Q2 2021 Earnings Call Transcript

Thank you, Chelsea. Good morning and welcome to Diamondback Energy's Second Quarter 2021 Conference Call. During our call today, we will reference an updated investor presentation, which can be found on Diamondback's website. Representing Diamondback today are Travis Stice, CEO; Kaes Van't Hof, CFO; and Daniel Wesson, EVP of Operations. During this conference call, the participants may make certain forward-looking statements relating to the company's financial condition, results of operations, plans, objectives, future performance, and businesses. We caution you that actual results could differ materially from those that are indicated in these forward-looking statements due to a variety of factors. Information concerning these factors can be found in the company's filings with the SEC. In addition, we will make reference to certain non-GAAP measures. The reconciliations with the appropriate GAAP measures can be found in our earnings release issued yesterday afternoon. I'll now turn the call over to Travis Stice.

Thank you, Adam, and welcome to Diamondback's second quarter earnings call. Diamondback had an outstanding second quarter, extending its track record of operational excellence. I am proud of everything our teams have been able to accomplish this year by pushing the boundaries of our current thought processes and embracing new technologies and playbooks, many of which have come from the personnel we've added through our acquisitions. Nowhere is that more evident than on the drilling and completion side of the business, where we continue to lower costs and improve cycle times. We've decreased our drill times for the spud to total depth of over 30% and are averaging just over 10 days to drill two-mile wells in the Midland Basin. On the completion side, we're now running three simul-frac crews, which lowers our downtime and improves our pad efficiencies. We are currently completing approximately 2,800 lateral feet per day in the Midland Basin, an improvement of nearly 70% as compared to our early zipper-frac designs. All of these operational advances translate to our ability to do more with less. We are seeing some inflation on diesel, steel, and other materials; however, our ability to continually improve operationally and become more efficient has more than offset these cost increases. Our leading-edge D, C&E costs continue to be at the low end of our guidance range. As a result, we're decreasing the number of rigs and crews needed to execute this year's capital plan, and we are reducing our full-year capital guidance by $100 million, or down 6% from prior expectations. On the production side, our wells have outperformed expectations this year. As a result, we are slightly increasing our Permian oil production guidance, which should not be taken as a conscious decision to grow. As we look at supply and demand fundamentals, oil supply is still purposefully being withheld from the market, and we continue to believe there's not a call on U.S. shale production growth. We will therefore continue to target flat oil production for the foreseeable future and plan to do that by completing fewer wells than originally planned this year. These operational highlights coupled with a supportive macro backdrop led to record free cash flow generation for Diamondback. During the second quarter, we generated $578 million in free cash flow or $3.18 per diluted share. To put this into perspective, we entered 2021 anticipating roughly this amount of free cash flow for the full year. We've already put this cash to work by calling and paying down over $600 million of callable debt so far this year, with over $600 million more expected later this year when our 2023 notes become callable. In total, this debt reduction will reduce cash interest expense by almost $40 million annually. We continue to emphasize that reducing debt and increasing shareholder returns are not mutually exclusive. We proved this point again by increasing our quarterly dividend by 12.5% from $0.40 a share to $0.45 a share, or $1.80 annualized. This puts our year-to-date dividend growth at 20% above 2020 levels. At Diamondback, we prefer to talk about our current performance rather than future promises. However, our performance has allowed us to accelerate our debt pay down and increase our base dividend. We now feel it's appropriate to set some goals regarding additional capital return in 2022, given the current free cash flow outlook at strip pricing. Our plan is to distribute 50% of our free cash flow to our shareholders in 2022. The form of additional capital return will be decided by the board at the appropriate time, but we intend to be flexible based on which opportunities we believe present the best return to our stockholders, the owners of our company. Remember, our strategy has been unchanged since 2018 when we initiated our base dividend. This additional clarity is simply an evolution of our guidance and also reflects the maturation of our business. A lot can happen between now and the end of the year, but we feel we are well positioned to take advantage of the current commodity price environment and deliver differential free cash flow in 2022. Our capital efficiency improvement allows us to maintain an elevated base level of Permian oil production through 2022 by spending approximately $1.7 billion to $1.8 billion total capital. The continued improvement in realized pricing and our low cash cost structure combine to form a best-in-class cash margin, which we plan to protect as we layer on hedges focused on protecting extreme downside, allowing our shareholders to participate in commodity price upside. Turning to ESG, we continue to make progress on our initiatives. Flaring continues to be one of the biggest drivers of our CO2 emissions, and while we've made significant progress since 2019, we still have work to do. Our target in 2021 is to flare less than 1% of gross gas produced, and in the first half of the year, we were above that number. This is primarily due to the integration of the QEP assets, and we expect this metric to improve as we build out additional infrastructure in the Midland Basin and close the Williston divestiture later this quarter. We have also begun two pilot projects utilizing tankless and limited tank facility designs. While the first tankless facility is expected to be installed in the fourth quarter, we've already had two successful limited tank design pilots. On average, this design has reduced our CO2 emissions from our storage tanks by more than 90%. Because of this success, we've elected to extend this pilot to another five facilities in the back half of this year and expand to an additional 15 facilities in 2022. Lastly, we are continuing to build out our electrical substations, which will help minimize emissions from combustion equipment, primarily generators and gas engine-driven compressors. We are working to remove or replace over 200 of these units by 2023. The combination of these efforts positions us well to meet our commitment of reducing our Scope 1 GHG intensity by at least 50% and reduce our methane intensity by at least 70% as compared to 2019 figures by 2024. The second quarter exceeded our expectations and exemplified why Diamondback is a leader in the industry. Our people continue to innovate, making us more environmentally responsible and efficient, uniquely positioning us for the future. Our record free cash flow generation allowed us to accelerate our debt pay down and increase our dividend, all the while positioning us for robust shareholder returns next year. We are delivering on our exploit and return strategy, continuing to focus on maintaining Permian oil volumes, reducing debt, and returning cash to shareholders. With these comments now complete, operator, please open the line for questions.

Yes. Good morning, Travis and team. Travis, I want to start a little bit maybe away from the print. But to get a little bit of your thoughts on the A&D market. We sensed a bit of a fear factor regarding your stock and the potential for Diamondback to engage in larger scale M&A with some of the larger packages apparently on the block. So, I just wanted to hear maybe you could start and remind investors of your approach to A&D and how you balance the general scarcity of Tier 1 opportunities in the A&D market versus just economics and returns?

Sure. A lot of questions contained in there. But just generally, it feels like a seller's market out there. Our M&A focus is really intense around selling non-core assets. One of the most important jobs we have as management is allocating capital. When you look at kind of a mid-cycle oil price, we kind of use $50 for oil, $15 for NGLs, and $2 for gas. The NAV of our stock price is much higher than where we are today. So, if that backdrop persists, the best use of our capital is not in the M&A market; it's rather in buying back our own stock. But we've been very clear about what forms our decision framework and our acquisition frameworks look like. We've articulated that in every earnings call. But today, it doesn't feel like that's the right thing to do. So our focus is simply around monetizing non-core assets and really looking hard at our business. I really like the way our forward plan looks with our existing inventories.

Great. Thanks for that. And just my follow-up. You did raise your production guidance for the back half of the year relative to consensus and our model. I was wondering, Travis and team, could you comment on what drove that? And just your general expectations around 2022? It sounds like it's a $1.8 billion to hold, call it, 220 flat next year, but I just want to get your sense around your second half outlook and thoughts around 2022?

Yes. I'll take this year first. We are going to close the Bakken a little bit later than we expected due to external approvals. Therefore, we kind of raised our full-year guide by about 2,500 barrels a day, which is two months of the Bakken contribution. Above that, we raised our overall guide for the year up 2%, and that's really on an apples-to-apples basis versus our Q1 guide. The impetus for that is some Permian outperformance early in the year. Therefore, I think we're comfortable raising our Permian guidance on oil to 218 to 222 from 216 to 220. As I said, we're not in growth mode, but the wells this year have outperformed, and we've cut more capital on the CapEx side than we've raised on the production side. Generally, we are completing 10 fewer wells this year than originally planned, but with production up a couple percent. More importantly, capital is down 6% or 7% from where we were before. That translates to the 2022 plan which is in dark pencil right now. Flat is the case we're modeling. Generally, maintaining that 218,000 to 222,000 barrels a day in the Permian flat with as little capital as possible is how we see it today. The number we posted yesterday incorporates a little bit of service cost inflation since we know our business partners on that side will be able to push prices a little bit. But generally, we're really excited about a high Midland Basin percentage of wells completed next year that keeps production flat in a very capital-efficient manner.

Super helpful. Thanks.

Thank you, Arun.

Thank you. Travis, maybe we could start on the 50% 2022 number that you threw out there in terms of the return of cash flow. Do you see the potential for that to grow over time as the balance sheet strengthens? Any early thoughts in terms of what the right mechanism is to return that capital, whether it's through dividends or buybacks, especially with the stock yielding the free cash flow yield that it is right now?

Yes. Certainly, we try to maintain the flexibility to make that decision when that point occurs. Because we want to make that decision on what creates the greatest return for our shareholders. Looking at 2022, if you have a plus 20% free cash flow yield, that would suggest more of a stock buyback. But we're going to maintain flexibility and try to do what we've always done, which is create the framework that generates the greatest shareholder returns. Regarding what that number does over time? I couldn't be more excited about the forward outlook of the company. Even at that mid-cycle oil price and break-even cost of around $32 a barrel, we're making a lot of really good free cash flow daily as we look out into the future. We'll make that decision when that cash flows come through the doors in terms of what we're going to do with it. But we've signaled very clearly an evolution in our guidance by talking about distributing 50% back to shareholders, and that evolution in guidance reflects the maturation of our business.

Travis, can you talk a little bit about the cost structure of the business? How do you see that evolving over time, not only in the back half of the year, but as you get into 2022, and all the different moving pieces as it relates to both cost and capital efficiency?

I have to be honest; our operations organization just continues to surprise me. I feel like we're already the best at what we do out here in drilling and completing these wells. Our team has come up with some clear fluid drilling technology that came over quite honestly from the QEP acquisition, and they've knocked out significant costs. I think it's on slide 10 of our deck. That continues to surprise me. We're able to back out capital in the next six months of the year due to improved capital efficiencies against the backdrop of increasing costs of goods and services. I don't know that it's reasonable, but you can always forecast efficiencies going up and costs going down; certainly, I don't think it's prudent to issue guidance that way. But I'm really impressed with the way our organization continues to lean into doing more with less.

Yes. Generally, the step change that the team has made in drilling times is expected to be permanent and will stay with us through 2022 and beyond. Essentially, we can do what we once had to do with ten rigs with eight now in the Midland Basin, where the majority of our capital will be allocated for the foreseeable future.

Thanks, Kaes.

Morning, guys. My first question is also around your comment about your plan to return 50% of free cash flow next year. I'm wondering if this will be more of a backward-looking formula, or what approach will you use for determining the timing and the type of shareholder return?

Yes, Neal, good question. I think it comes down to a variable dividend or share buyback. If it's a variable dividend, it'll be backward-looking based on the quarter that we announced it, which will pay for the quarter prior. But if it's a buyback, I think we'll do a little math on how much free cash you're generating essentially per day and buy back that amount consistently. The board and Travis are very focused on which option provides the best return to shareholders at the time. It won't be a permanent decision; there's flexibility to move between those options. The only thing that’s sacrosanct is the base dividend, which needs to be protected.

Great. Glad you're staying flexible there. And then my second question pertains to your comment in the release regarding the flat 2022 production expectation versus the fourth quarter with just a slightly higher spin. I understand some of this is driven by a change of ducts and QEP going forward. Could you speak to your expectations for 2022 baseline production decline? And maybe the rig and frac spreads involved in this, along with any other notable drivers you're using to achieve this?

Yes. I'll start with the number. We expect 10% to 15% more capital, which is an increase versus this year. What's forgotten is that Guidon and QEP closed at the end of Q1, so we didn't have a full quarter of their capital contribution. About half of the increase comes from that. The other half is we had a nice DUC benefit since we are completing 270 wells and drilling 220 this year. That's about another $100 million benefit because, when we were running as many rigs as we were into the downturn, we opted not to pay early termination fees and instead built the DUC backlog, which was the best use of investor dollars at the time. From a crew and rig count perspective, we dropped two rigs this quarter and will probably bring those two rigs back. We’ll likely need around 11 or 12 rigs next year and three simul-frac crews, potentially a fourth spot crew, to execute that plan. This is a testament to how efficient the operations team has become.

Very good. Thanks for the details.

Thanks Neal.

Good morning. You guys have demonstrated a very strong commitment to ESG. On the water recycling front, you're above the 2021 target already. Can you just talk about the future progression of water recycling? And can you remind me of the potential cost savings that exist in that world?

Yes. That's an important question. I think we are above our target so far this year with the shift to the Midland Basin. We need to build out some permanent infrastructure on the recycling side to not only recycle the water but also store produced water so that we're not overusing freshwater. That process is underway, and I expect that we will have a solid connected system across our Sale, Robertson Ranch, and Martin County positions by the middle to the end of next year. This will significantly raise that target percentage in coming years. We've used 100% recycled water in the Delaware Basin, but typically, you're pulling from the existing system. On the Midland side, there's less produced water. So storing and reusing it downhole is the next step in the evolution, which should allow us to improve that number quite dramatically over the next couple of years.

Great. Then on the electrification efforts you're doing, can you talk about thoughts on the utilization of electric frac fleets and drilling rigs? And on the electrical substation work, there is an LOE benefit to that as well, correct?

Yes. The electrical substation work is obvious by inspection; it is beneficial for ESG and run times and costs significantly less than in-field power generation. We've been working on that for the last few years. By the end of this year, I think we will be close to all of our major fields being on infield electrification. The issue we have on the frac and drilling side is that we're testing some drilling rigs on line power. They don't use as much power as a frac crew, but our frac crews are focused on dual fuel and Tier 4 engine capabilities rather than connecting to line power. I'll ask Danny if you want to add anything to that.

I think that's right. On the eFrac side of things, the main issue has been on the power generation side and providing enough power to the fleet to run effectively. Some of our partners are working hard to solve that issue. We are definitely monitoring that closely and hope to make advancements in the next couple of years.

Great. Thank you.

Good morning, everybody. Thanks for taking my question. One of the easiest ways to return value to investors is to pay down debt. Where do you see the right absolute level of debt when considering the free cash flow you're generating right now?

That's a good question. I think in the near term, paying off our 2023s and having enough cash to pay off our 2024s by about a year to two years ahead of schedule feels like a very good place to be. Given the break-even as low as it is, and the delta between that and current oil prices while not stepping on the accelerator to grow, that provides more flexibility on the free cash side to build the cash balance and pay off bullet maturities as they come due. Near term, handling everything prior to 2025 puts us in an excellent position, putting our gross debt position in the low $4 billion range and basically a turn of leverage with a lot of free cash coming to both the shareholders and debt reduction.

Great. Thanks for that. I think slide 10 is terrific. My question, Kaes, is regarding slide 10. If you're not growing production and moving to a sustaining capital model for the time being, one has to imagine that the underlying decline slows down some. So what happens to that $32 break-even if you hold the line on production through the end of 2022?

Yes. That's a good question, Doug. I think it will go down, but probably not as dramatically as it has in past years. Our oil decline rate quarter-end to quarter-end is generally in the mid to lower 30s right now. I think it moves down kind of a percent or two a year if we continue to stay flat. Additionally, there's going to be some investments needed in infrastructure and midstream next year with the Sale and Robertson Ranch development that came with no real infrastructure, so that spend would also be reduced. Generally, we will keep pushing it down by a buck or two a year, which gives us a lot of flexibility to manage debt pay down and return free cash to shareholders.

Terrific. Thanks, Travis.

Thank you, Doug.

Good morning. The base dividend has been a core pathway for Diamondback’s return of cash to shareholders. It’s nice to see another bump today. How do you think about the appropriate level for the base dividend over time? Is there a certain percentage of cash flow that you target at a certain oil price? How do you think about the base dividend?

Yes, Scott. When you look back at how the board has previously communicated this commitment, we talked about having a base dividend somewhat approximating the S&P yields. Anything above that reflects additional forms of shareholder returns. So, a base yield around 2.5% is what we target for that base dividend.

On top of that, we also consider our break-even. As our break-even comes down over time, that allows for greater flexibility to pay the dividend. The 2022 break-even is at $35 a barrel WTI. If the break-even decreases a bit, it offers even more flexibility on the base,since, as we stated earlier in the call, the base dividend is sacrosanct and must be protected.

Got it. Transitioning back to the 2022 maintenance plan, I may have missed this earlier; is there a TIL count in the maintenance program given the acquisitions and productivity gains you've seen?

Yes. Generally, it's flat to where we are now and where our pace will be in the second half of the year. Typically, we aim for around 65 to 75 TILs a quarter, with 75 to 80 of those in the Midland Basin.

Got it. Appreciate the color. Thank you.

Thank you, Scott.

Hey, good morning all, and congrats on your strong quarter and update.

Thank you, Derrick.

Perhaps for Travis or Kaes, regarding your volume outperformance during Q2, are there one to two factors you would attribute to that production outperformance?

Derrick, generally, the new wells we brought on in the legacy Diamondback position are seeing the benefits from reallocating capital to the Midland Basin, which are our best-returning assets in the portfolio. So, we are seeing early-time outperformance. Overall, it was a good quarter. Even base production did not suffer from many weather events or unforeseen incidents. So, on the positive side, capital efficiency—not just on the cost side but on performance—is improving, and we're optimistic about what the rest of the year and 2022 hold, given the developments from QEP and Guidon.

Great. As my follow-up, perhaps for Travis. How concerned are you with the recent ramp in private activity in the Permian regarding inflationary pressures or a potential breakdown in industry capital discipline?

That's an interesting question, Derrick. There's no doubt that the privates are really pushing into this higher commodity price. Notwithstanding the fact that the forward curve is $20 disconnected from today's price. A couple of factors should be considered. While some privates have Tier 1 assets, many are more in the Tier 1.5 or Tier 2 range, and they're not as productive. However, the effect on both Permian production and cost increases isn't negligible. It's still too early to see what the overall impact will be, but I believe as more quarters pass with public companies exercising flat production discipline, that's what our industry needs. The privates will have an effect on the overall equation, but the macro element won't change significantly.

Hopefully, the longevity of that impact will be considered, given the depth of inventory on the private side.

Right.

That's a great update. Thanks again for your time.

Thank you, Derrick.

Hey guys, wanted to jump into the expense side of the equation here. I know you closed QEP and Guidon later in Q1, but I noted that some of your expense items in the second quarter on a per BOE basis picked up compared to Q1—most notably cash G&A, LOE, and even transport cost. Could you help clarify if there were one-time items as you're flushing through the integration that could have affected those numbers, and should we expect per barrel costs to start to decline in the second half? Any help would be appreciated.

Yes, certainly. Good question. With the addition of the Bakken assets, those assets come with a different cost structure than our traditional Permian operations. So, on the LOE and GP&T side, there was a slight pickup from the Bakken contribution. Permian LOE still remains around the $4 range, giving you an idea of the Bakken impact. In this quarter, I expect that trend to continue into Q3. The G&A side did see a transition period for many of the QEP employees, which will begin to wane in the latter part of the year, allowing G&A to slightly decrease in the second half.

Okay. That's helpful for sure. To take a harder look at your production guidance, comparing your third-quarter oil guide to the actual second-quarter oil number shows a slight drop. I know you discussed maintaining flat production. Is that due to seasonality or random variance? But generally speaking, are you trying your best to keep it flat?

Yes. Q2 was a fantastic quarter. We've been vocal that we don't need production growth from the U.S. We're just resetting that baseline back to where we were originally in Q2. There's been a bit of outperformance. As we mentioned throughout the year, we'd rather sacrifice capital than grow production. If you keep beating production estimates and raising your baseline for staying flat, that's effectively growth. We really don't desire that. We see our 218 to 222 oil baseline for the Permian for Q3 and Q4 rolling into 2022. Hopefully, our ops teams will continue to outperform expectations, under promise, and over deliver.

Sounds like there's some element of you folks who had very strong performance in recent quarters, which isn't something you can necessarily credit every quarter.

That's right. We anticipate continued success and increased capital efficiency, especially with developments planned for the Midland Basin. But this industry operates on the principle of under-promising and over-delivering.

Lastly, concerning asset sales, you talked about it being a seller's market. I know you're busy closing the Bakken divestiture, but is there anything else you might look to prune this year or into next year?

Yes, we have received inquiries about some non-core assets that don't compete for our capital in the next ten years of our development plan. Surprisingly, there's a lot of private capital looking to do things in E&P, which is a real shift from six or nine months ago. If someone wants to pay a fair price for something that has no relevance to our shareholders based on present value, we'll consider it. There are a couple of areas where that could come into play, but no guarantees—we're not desperate to sell. We will do what's right for our shareholders regarding the sale of non-core assets.

Okay. Thanks, guys.

Thanks, Leo.

Good morning. Thanks for taking my questions. My first one is on hedging. Could you remind us of your overall philosophy there? There's obviously a lot of capacity to add as we look to the back half of next year, which may speak to the strategy already as well as how the curve sits. I want to get the latest since you're continuing to improve the balance sheet, which naturally helps mitigate volatility as that gets better.

Yes, Jeff, great question. We see the back relation in the curve. It's tough for us to hedge further out than about the next nine to twelve months. We'd like to be close to 50% to 60% hedged going into a quarter and build that consistently over the three or four quarters prior. We've been keeping wide two-way callers to retain upside for our investors. As we get closer to quarters and the time value of money declines, it makes sense to layer on deferred premium puts on top of the wide two-way callers. Overall, we feel excellent about the state of our balance sheet at the end of the year and the free cash flow generation expected next year.

Got it. Thanks. I also wanted to see if you could provide more details on the cost inflation dynamics that you mentioned. What specific movements are you observing currently on the services side?

It's been very visible on the steel, diesel, and raw material sides. Steel inflation, in our opinion, needs to decelerate at some point. The cost inflation will flip to more service-oriented lines on the labor side and other segments that will increase with rig counts. We've withheld long enough on that front to allow the service industry to push prices here, but importantly, the efficiency improvements we've made in the Midland Basin have counteracted any increases thus far.

Okay. I appreciate the color. Thanks.

Thanks, Jeff.

Good morning, Travis and Kaes, and the rest of the team there. I'd like to ask one more question from a different direction regarding the 50% of cash flow return to shareholders in 2022. I recognize that you will keep your options open and observe the conditions before making a decision, but can you share any preferences or frameworks regarding how you could approach that decision? Share buybacks are more tax efficient, but they’ve been criticized as pro-cyclical. How do you plan to approach this?

That's a great question, Charles, and a topic we discuss internally. What's changed is that we're no longer growing as fast as we can while spending capital to return cash to shareholders. Now, with capital constrained to maintenance, there's more flexibility above that. Ultimately, we must look at our NAV based on a mid-cycle oil price and commodity price landscape. If we're trading below that, even with oil as it is now, buybacks may make sense, as it offers a better return to shareholders. Right now, given the situation, it seems like a buyback may be the way to go, but it’s only early August so we have time to evaluate.

I can't emphasize enough from the board's perspective. That decision will be made based on what drives the greatest shareholder value. There are technical questions that need addressing, but generating differential shareholder value remains our core mission.

That’s helpful. Thank you. On ESG, specifically regarding the tankless design, can you share insights on its incremental cost in comparison to spending on carbon offset credits?

Yes. It's part of the calculation, but it's not an either-or scenario. The decision to invest in carbon credits was made on the basis of recognizing operational shifts that will achieve our goals over time. This initiative is strategic, with meaningful CO2 and flaring reductions. We share statistics showing our success, aiming for significant CO2 reduction by over 90% on atmospheric tanks. The goal is to make sure we're reluctant to keep it a Diamondback secret; instead, we should be transparent about successful innovative strategies that can benefit the entire industry.

Great. Thanks for the commentary.

You bet. Thanks, Charles.

Thank you again for everyone participating in today's call. If you have any questions, please contact us using the contact information provided.