Diamondback Energy ( FANG -3.50% ) is starting a new chapter. The energy company has spent the past five years building out a large-scale drilling operation in the oil-rich Permian Basin. As a result, the company has rapidly grown its oil production in recent years through a combination of acquisitions and organic drilling.
However, it plans to shift gears in 2020 by slowing its investment pace. That will enable it to turn its focus toward generating free cash flow, which was one of the key themes on its third-quarter conference call. Here's why that could make it a big winner next year.
Responding to the challenge
Diamondback Energy's CEO, Travis Stice, started the call by discussing the current environment in the oil market:
Investor sentiment toward energy remains decidedly negative even in the face of commodity prices performing fairly well this year. The U.S. rig count is now down over 25% year over year, and we expect that downward trajectory to continue with frozen capital markets, tighter lending conditions, and the search for free cash flow sectorwide. As a result of these conditions, we expect continued pressure on U.S. production growth numbers, and expectations for 2020 U.S. production growth need to recalibrate lower, all of which may potentially support oil prices, pending demand growth.
This year has been an odd one for the oil market. The price of crude oil has rallied almost 25% this year. However, oil stocks are mostly down because the sector has fallen out of favor with investors. That's causing oil companies to struggle with obtaining outside funding, which is forcing them to cut spending on new wells so that they can live well within their cash flow.
Diamondback is responding to these market conditions by offering a "2020 investment framework that's focused on flat to down capital spending," according to Stice.
Set up for success in 2020
He later drilled down into the company's plan for the coming year:
Looking ahead to 2020, our goal in putting together our capital plan was to maximize oil-weighted production growth within a similar budget framework as 2019, getting more with less. As a result, we expect to grow oil production 10% to 15% year over year and complete over 10% more net lateral footage than 2019. Most importantly, our budget assumes we cover our budget and base dividend above $45 oil and have over $675 million of pre-dividend free cash flow at $55 oil.
As Stice notes, Diamondback Energy plans to keep its 2020 capital spending level roughly flat with this year's budget. However, that's still enough money to grow its oil output by 10% to 15%, in large part because of its ability to drill more for less money. The company can thus fund its spending plan, as well as its dividend at just $45 oil, which is well below the current market price of around $58 per barrel. That sets it up to produce more than $675 million in free cash next year if oil remains around that level.
The company intends to use that money to repurchase its shares. That ability to buy back a meaningful amount of stock comes at a good time, since shares have declined by about 30% over the past year, even though oil prices have rallied sharply during that time frame. At the current stock price, Diamondback could retire 5% of its outstanding shares next year with its free cash flow.
Meanwhile, given that the entire industry is keeping a lid on spending next year, that could cause oil production in the U.S. to grow at a slower-than-expected pace. That could help boost oil prices above their current level if demand growth improves, which would enable Diamondback to produce even more free cash next year. If that happens, Stice stated that "we plan to use excess free cash flow to accelerate our capital return program and reduce debt." In other words, it would be able to repurchase even more of its stock while further bolstering its already strong balance sheet.
Plenty of fuel for a big-time bounce-back in 2020
Diamondback Energy is transitioning from an oil growth company to one that can generate an increasing gusher of free cash flow. That will give it the funds to buy back a big chunk of its beaten-down shares next year. The oil stock could rebound sharply in the coming months if so, especially if oil prices keep improving amid the U.S. drilling slowdown. That makes it a compelling bounce-back candidate to put on your radar for 2020.