Diamondback Energy (FANG 2.51%) is one of the few independent oil producers with the cost advantages to thrive -- no matter what OPEC does.
One of the most important metrics used in evaluating an oil and gas producer is its production costs per barrel of oil equivalent (BOE). Diamondback Energy, as one of the most efficient shale producers in the industry, has driven this metric down by 36.4% since fiscal year 2014.
Data source: Diamondback Energy 2016 annual report. Chart by author.
All the better, in its third-quarter earnings report, we learned that its costs per BOE have continued to fall, coming in at just $7.67 for the three months ended Sept. 30.
Image source: Getty Images.
Oil is a commodity. And like all commodities, it can't be differentiated from the competition -- the only industry advantage is in production costs, and the lowest-cost producers are the only ones to win in the long term.
The oil industry has been in a depression ever since OPEC refused to cut production (and thus balance the oil market) in November 2014. This decision was eventually reversed, as OPEC's member nations and its partner state Russia desperately needed the price of crude oil higher to balance their government budgets.
Many oil companies went bankrupt during the rout, but a few have been using it as an opportunity -- a chance to get even better at what they do and even add to their reserve base, while weaker competitors sell valuable leases. These few companies include Diamondback Energy.
Will cost advantages be enough?
Bulls on Diamondback's shares have largely been so because of its rock-bottom production costs -- the very metric we are discussing here. Other than geographic location (which Diamondback also happens to have in spades), there are few other assets an oil company can use to stay ahead of the pack.
Unfortunately, that may not be enough. Being the low-cost producer in a defunct industry doesn't mean much for shareholders.
The shale boom was what led to the eventual bust as global oil supplies swelled. In the face of surging U.S. production, from companies like Diamondback, OPEC chose not to blink. And while they have since reversed course to save their own bank accounts, who's to say it won't happen again?
Those in the bear camp are not wrong to point out these facts.
Worse, an investment in Diamondback very well could prove fruitless for reasons completely unrelated to OPEC and global inventories: Oil could be completely replaced as a fuel for transportation when electric vehicles become the norm -- the stated mission of Elon Musk's Tesla.
Success through prudence
Oil could, at least theoretically, be on its way out as a fuel source, but the smartest minds in the world don't think so. In its "Annual Energy Outlook 2017," the U.S. Energy Information Administration projects oil consumption to level off somewhere in the 2030s -- but continue on as a fuel source well into the 2050s.
While this is no guarantee, it is worth noting that in many of the EIA's future projections, there are multiple scenarios where oil and renewables live in harmony thanks to broad global demand for energy.
To combat the shadow of OPEC production increases and the shift away from fossil-fuel usage, Diamondback is seeking to turn a weakness into a strength. Throughout the downturn, it purchased new oil leases in an effort to expand its portfolio. Just this fall, the company put forth a $725 million bid for the Permian Basin assets of defunct Breitburn Energy.
Coupled with its laudable efficiency gains, the results have been as dynamic as rocket fuel. Diamondback leads its peers in both cash margins and cash operating costs:
Image source: Diamondback Energy investor presentation.
To combat future uncertainty, Diamondback continues to live within its means. Management has specifically stated in its Q3 earnings release that it won't "grow for growth's sake." It is also currently hedging approximately one-third of its production through the end of next year.
Diamondback is focused on what it can control, and not the whims of the markets. For investors looking for an oil stock with an edge as oil prices rally, Diamondback Energy should be at the top of the list.
