Diamondback Energy Rises Fast Drilling Permian Basin

In its first move to tap public capital, Texas driller Diamondback Energy raised more than $230 million in an October 2012 IPO. Since then, it has done a $450 million bond offering and raised over $300 million in follow-on equity offerings.

Secondary offerings expand ownership and dilute the value of pre-offering shares. As such, they often pressure share prices. But that hasn't happened withDiamondback ( FANG ), whose stock has roughly tripled in value since its IPO.

And with the expansion of share count through secondary offerings, Diamondback's market cap -- roughly $250 million in October of 2012 -- has swollen by a factor of 10 to more than $2.5 billion.

All this because Diamondback seems well-positioned to benefit from one of the biggest domestic oil stories of recent decades: the revival of the Permian Basin.

Oil production from the hydrocarbon-rich Permian, whose underground reservoirs stretch into New Mexico from west Texas, had peaked in 1973 and was in steady decline for decades. But new drilling technologies have helped goose production and some believe the best is yet to come.

"The Permian Basin is one of the few onshore basins where we've seen a tremendous amount of exploration success. But we're still in the early innings of understanding what the value of that resource should be," noted Eli Kantor, analyst with Iberia Capital, a New Orleans-based investment bank that specializes in energy (Iberia was a co-manager on Diamondback secondary offerings).

1 Million Barrels A Day

Oil production out of the Permian has been rising for several years. In 2011, output exceeded 1 million barrels a day for the first time since 1998.

The U.S. Energy Information Administration expects the Permian Basin -- whose output grew to 1.32 million barrels per day in 2013 -- to be the fastest-growing U.S. oil-producing region through 2015.

Diamondback is not one of the biggest players in the Permian. It holds just over 66,000 net acres there, a far cry from acreage-rich outfits likeOccidental Petroleum ( OXY ) andPioneer Natural Resources ( PXD ). But Diamondback has been a leader in making the transition from vertical drilling to more productive and financially rewarding horizontal drilling.

The company said Thursday that it increased its total proved reserves by 58% in 2013 to the equivalent of 63.6 million barrels of oil, and boosted production in the fourth quarter by 41% from the third quarter.

Some analysts are keen on the potential in Diamondback's acreage.

"It looks like their acreage lies in the deepest part of the Midland Basin (within the Permian)," Kantor said. "The deepest reservoir has the most pressure. The higher the pressure, the better the production."

Diamondback is already a leader in efficiency. The company claims to have lowered operating costs by more than 50% since the third quarter of 2012.

"They're one of the lowest-cost operators," said Jason Wangler, analyst with Wunderlich Securities, which has also been a co-manager on Diamondback equity offerings.

As a result, Diamondback drilling operations are big cash earners. CEO Travis Stice told analysts in November that Diamondback has a margin of nearly $70 on every barrel of oil.

With production rapidly growing through acquisitions and increased drilling success, Diamondback has brought its drilling success down to the bottom line.

In its third quarter of 2013, reported in November, Diamondback earned 35 cents per share, a penny ahead of the consensus of analysts polled by Thomson Reuters. Oil and natural gas revenue of $57.8 million topped estimates and more than tripled the $16.8 million of the third quarter of 2012.

Perhaps most important, Diamondback reported results from one successfully drilled horizontal well that some analysts see as a sure sign of further gains.

Diamondback drills in the Midland Basin, one of three sub-basins within the Permian. The Midland contains a half-dozen or more oil reservoirs at various depths. Until recently, horizontal drillers had primarily focused on what's called the Wolfcamp level.

But Diamondback CEO Travis Stice was enthusiastic in reporting horizontal drilling results from the Spraberry, which until recently had been mostly tapped through vertical drilling.

"I'm very excited about the early performance from a 5,000-foot lateral Middle Spraberry Shale test in Midland County that we participated in as nonoperator partner," Stice said on a Q3 conference call.

"The Spraberry Interval not only is one of the more continuously deposited shales in the Midland Basin, but also contains among the highest measured original oil in place compared to other shale members," he added.

Jeff Grampp, analyst with Northland Capital Markets, was excited enough about the find to raise his target price for Diamondback shares from $58 to $68.

Diamondback has a net interest in another 137 Spraberry locations, Grampp explains. With the initial horizontal drilling success, these 137 sites have been "de-risked." Grampp figures Diamondback, which reported just $97 million in revenue as recently as 2012, can post $415 million in 2014.

All this again raises the question of Diamondback's steep ascension since its 2012 IPO. Is the tenfold expansion in market cap warranted?

Grampp contends that it is, given the unexpected success Diamondback has had with horizontal drilling. Horizontal drilling is more capital-efficient, yielding "more barrels per capital applied," he said. "When they IPO'd I don't think people ascribed full value to the significant upside potential from horizontal drilling."

Of course, horizontal drilling, typically done in combination with the rock-shattering process of hydraulic fracturing, is very controversial. It has been banned outright in New York state and in many communities scattered around the country.

'Direct Beneficiaries'

Texas has always been exceptionally friendly to drillers. In recent months, though, critics have cited fracking as the cause of unusual earthquake activity in the northern part of the state.

But such anti-fracking sentiment has not penetrated to the Permian. And Grampp doubts it will. In the Permian, he says, "a lot of people who live there are direct beneficiaries of the drilling."

A more immediate concern is oil pricing. With horizontal drilling so successful and offering such lavish margins, some wonder if shale oil could duplicate the recent history of natural gas. Fracking unleashed so much natural gas supply that prices collapsed. Could the same happen with oil?

"It's been a looming fear among investors in 2014," acknowledged analyst Kantor, citing expanding oil output from Colorado and North Dakota as well as from Texas.

Any drop in prices would eat away at Diamondback's rich margins. But it would take a very sharp drop to totally erode profit. Analyst Wangler estimates break-even at around $60 a barrel.

For now, cracking subterranean rock remains a very lucrative business.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.