Diamondback Energy

We've re-evaluated our Morningstar Uncertainty Rating for Diamondback as the dispersion of potential outcomes in our forecast narrows.

Why it matters: Our uncertainty rating forms the basis of the margin of safety we demand before a stock trips 4- or 5-star territory. The oil and gas cycle inherently introduces uncertainty across the value chain, particularly for E&Ps, whose returns on capital are highly correlated to the price of oil. Still, Diamondback has executed well in integrating its large deals in recent years, and we're more confident that global oil inventories will need to be replenished following the Iran war. While demand destruction is a risk, we think Diamondback will have runway for selective growth from here.

The bottom line: We raise our fair value estimate for narrow-moat-rated Diamondback to $220 from $219, as the stock price decline marginally boosted valuation due to better implied share repurchases. But we lower our Uncertainty Rating from High to Medium. At current prices and with the uncertainty rating changes, the stock now trades in 4-star territory with roughly 18% upside. Our narrow-moat and Exemplary Capital Allocation ratings remain unchanged. Diamondback's position on the cost curve, given its attractive Midland inventory, gives us confidence that the firm can balance both net present value and return-on-capital considerations.

Long view: Diamondback remains our favorite US shale stock from a quality lens given its strong balance sheet, inventory depth, position on the cost curve, and proven management team.

We raise our fair value estimate for narrow-moat-rated Diamondback by $1 to $220, as the stock price decline following our most recent model review marginally increased the valuation due to better implied share repurchases. Despite management flagging that geology is starting to outweigh the benefits of technology, Diamondback still managed to eke out more efficiencies. While Diamondback remains our favorite US shale E&P from a quality standpoint, we don't see much upside at these prices.

We continue to see near-term oil price uncertainty with the Iran war. But we think long-term global oil demand should remain resilient over the next decade and beyond, and continued investment will be required, including from low-cost producers like Diamondback.

We assume oil (West Texas Intermediate) prices in 2026 and 2027 will average $81 and $72 per barrel, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $3.10 and $3.49 per thousand cubic feet. Terminal prices are defined by our long-term midcycle price estimates (currently $65/bbl Brent, $60/bbl WTI, and $3.70/mcf natural gas), which we inflation-adjust at a rate of 2.25% to derive nominal pricing. We derive our midcycle pricing estimates from a 10-year price average from our in-house supply/demand forecast.

Diamondback earns a narrow economic moat from cost advantage. Moats are relatively rare within the exploration and production industry. Hydrocarbons like oil, natural gas liquids, and natural gas are commodities, so they don’t exhibit pricing power, switching costs, or other moat sources that depend on differentiation or cornering a market niche. While Diamondback extracts all three hydrocarbons, over half of its production and earnings are tied to oil, which is usually more valuable than gas on a barrel-of-oil-equivalent basis.

Despite the commoditized nature of oil, the industry’s low-cost producers can command a moat over other E&Ps higher on the cost curve. Diamondback’s average half-cycle breakeven price of $39 per barrel of Brent Crude remains well below our estimated marginal cost of production at $65/bbl of Brent and provides a larger buffer than other US independent producers we cover.

Nearly all Diamondback’s operations are in the Permian Basin of West Texas, specifically in the attractive Midland and Delaware sub-basins. The company’s competitive edge is rooted in the superior geological quality of its core Midland acreage, where high production rates and robust recoverable reserves translate into lower per-barrel production costs compared with other regions.

Diamondback operates mostly in the Midland sub-basin, which represents over 80% of its well quantity, developed and undeveloped acreage, and oil and total production. Within the Midland, Diamondback operates acreage with tremendous stacked-pay potential through the Wolfcamp (WC) and Spraberry formations. This is the heart of the Permian advantage; these overlapping resources allow producers to drill multiple wells from the same surface pad, which speeds up well completion times and leads to lower capital expenditure per well.

Well production is efficient in the Midland relative to other plays, allowing Diamondback to spread its fixed costs, like drilling and completion, to elicit higher margins as production rises. We glean evidence of Diamondback’s status as a low-cost producer from both its industry-leading unit costs and cash margins. Diamondback also has a strong portfolio of remaining proved inventory, which we estimate totals roughly 14 years and 34% of tier one acreage remaining.

Diamondback also has a successful acquisition history. While there’s noise in these figures, an analysis by Rystad Energy reveals that Diamondback paid roughly $85,000 per barrel of oil equivalent per day to grow production by 20% (both organically and inorganically), while narrow-moat rated EOG paid around $96,000 per boe/d to grow its production by that same change (EOG is well-known in the oil and gas industry to heavily favor organic investments).

Major acquisitions following the 2009-16 US Shale Revolution include the purchases of Double Eagle ($4 billion), Endeavor (at $26 billion, its largest ever), QEP ($3 billion), and Energen ($9 billion), all helped solidify Diamondback’s position as the largest independent pure-play in the Permian Basin.

Focus in this basin has helped its integration execution, even in times when it’s materially increased production, like with its Endeavor acquisition. Owning contiguous acreage enables Diamondback to drill longer horizontal wells, resulting in significant cost savings on infrastructure and equipment. While simultaneous fracking and similar techniques are imitable by competitors and don't offer a permanent competitive edge, the ability to develop with longer laterals is a structural advantage that can only come from large, uninterrupted land positions.

Diamondback also benefits from one of the lowest cost reinvestment ratios, which it cites at 36% assuming WTI oil prices in the mid-60s. The typical oil producer we cover’s reinvestment rate sits at 46%, assuming similar pricing levels. We think there’s a heightened likelihood that Diamondback improves its historically narrow excess returns spread as it consolidates the Midland Basin’s most attractive remaining acreage. Management’s already flagged that it’s going to be more selective than it has in the past, as there’s not a lot of inventory left to acquire that could compete for capital relative to Diamondback’s current inventory.

Furthermore, unlike other peers who’ve steadily started developing non-US basins, Diamondback has publicly committed to reinvesting within its moat and developing the Permian asset it knows best; according to Diamondback’s proxy statement, much of its executive officers’ compensation is tied to variable compensation, which is itself significantly tied to return on capital employed, cash operating costs, and capital expenditures.

Even through two significant OPEC+ price wars, exacerbated in 2020 by the covid-19 pandemic, Diamondback managed to generate economic profit over the prior decade, and its cost position in the Permian gives us greater confidence it can do so over the next decade, particularly given the long-term drivers for oil demand.

Diamondback has pioneered returns-enhancing technology in the field, such as horizontal drilling, and is expected to remain at the leading edge.

Diamondback owns prime acreage in Midland County, which boasts the lowest cost stacked pay opportunities in the US.

Diamondback has over a decade of proved reserves at current production levels, so it stands to benefit from an undersupplied global market.

Well productivity could decline when the best acreage is exhausted, pushing up break-evens over time.

Greater associated gas in the production mix could adversely affect Diamondback’s profitability, as gas is abundant and cheap in the Permian Basin.

Diamondback periodically expands its acreage holding through potentially expensive and dilutive corporate M&A.