Diversified Gas and Oil — Roadmap to Main Market

DGO announced the successful completion of its securitised financing arrangement. The company closed its Fitch- and Morningstar-rated inaugural BBB- investment grade securitised financing arrangement with a coupon of 5%, 10-year scheduled maturity and 17-year final legal maturity. DGO issued $200m in notes through its wholly owned, fully consolidated SPV, Diversified ABS, secured by c 22% working interest of certain upstream producing assets whose cash flows remain 100% owned and controlled by the company. DGO agreed to hedge 85% of the production of the collateralised assets for 10 years to secure the cash flows; however, this is not new to DGO, which has a record of strategically hedging company revenue streams. According to management, the notes create approximately $60m of additional liquidity and provide for flexible and limited financial covenants tied only to the securitised assets performance.

DGO started formally pursuing a move to the Premium segment of the Main Market of the London Stock Exchange in September 2019. It expects to complete the move after the publication of its FY19 results, expected in Q120, subject to the approval of the UK’s Financial Conduct Authority. As part of this process, it has also identified and appointed a preferred Big Four audit firm, PwC, and is undertaking a full review of its corporate governance with external advisers.

In April 2019, DGO’s board of directors approved the terms of a share buyback programme with an aggregate market value of up to $68.2m and a maximum number of shares of 54,265,394 over a 12-month period. Since the beginning of the programme, DGO has acquired 36,184,100 (c 5% of pre-buyback outstanding shares) and spent c £39.3m (c $48m) at an average price of 109p/share, a c 30% discount to our valuation of 157.2p/share. All repurchased shares were cancelled.

On 25 July 2019, DGO announced it had entered into a ‘stalking-horse’ asset purchase agreement with EdgeMarc Energy to acquire 12 gross producing unconventional natural gas wells and related facilities within the State of Ohio, as well as certain undeveloped lands containing deep Utica rights for a gross cash consideration of $50m. Production is c 99% natural gas with direct access to multiple interstate pipelines with the potential for higher realised pricing. The acquired wells are located near DGO’s existing wells in Ohio and will benefit from economies of scale within the Appalachian Basin, and as such, no incremental administration costs are expected to be attributable to these assets. Since the acquired wells’ lease operating expenses (LOE) are lower than DGO’s consolidated LOE, the acquisition is expected to reduce DGO’s consolidated LOE per boe and enhance DGO’s cash margins.

In line with its acquisition valuation methodology, DGO has attributed value only to EdgeMarc’s PDP reserves, and no value to proved-undeveloped (PUD) reserves or undeveloped acreage. The acquisition included three drilled and uncompleted (DUC) wells, classified as PUD. DGO sold the DUC wells and undeveloped acreage for $10m on 7 November 2019, improving the acquisition metrics. Prior to the disposal EV/EBITDA was 1.6x, decreasing to 1.3x while EV/flowing barrel and EV/1P PDP decreased from $6.5k/boed and $3.7/boe to $5.2k/boed and $3.0/boe respectively.

Compared to DGO’s previous acquisitions, the EdgeMarc assets were at lower cost per flowing barrel, but slightly higher per 1P reserves relative to DGO’s 2018 acquisitions, as can be seen in Exhibit 2. This is line with the fact that these wells are unconventional, with a higher current depletion rate than DGO’s conventional mature acquisitions from the previous year.

Natural gas gathering systems

Following the announcement on EdgeMarc Energy assets, on 27 August 2019, DGO announced its second acquisition so far in H219. The company entered into binding agreements to acquire two separate packages of margin enhancing natural gas gathering systems in Pennsylvania and West Virginia for a net cash consideration of $7.7m. The assets comprise c 1,700 miles of low-pressure wet and dry gas pipelines, compressors, measurement stations and related facilities and equipment of which DGO currently produces c 60% of the transported capacity, with the remaining being utilised by third-party suppliers. DGO expects these assets to increase the company’s margins by increasing third-party revenues by over $3m per year in tariffs and will also allow DGO to control the flow of production, increasing optionality to re-route gas to sales points with higher realised prices. The acquisitions were completed on 27 September 2019.

H119 was an eventful half-year for DGO with the acquisition of HG Energy and consolidation of 2018 acquisitions. Following the close of H119, DGO acquired EdgeMarc Energy assets through a ‘stalking-horse’ bid and natural gas gathering systems from Dominion Gathering and Processing and Equitrans.

As such, since the Titan acquisition in late 2017, DGO has completed seven oil and gas asset and natural gas gathering system acquisitions, investing c $1.5bn. DGO has proven to be a resilient, dividend-paying oil and gas stock, outperforming the market, as shown in Exhibit 3. It has maintained its share price stability despite the decrease in natural gas prices in the US, and overall global negative sentiment towards oil and gas companies, which have seen a drop in value even though oil prices have remained relatively stable since the beginning of 2019. Contributing to this share price stability is the delivery of results in line with market expectations and the ability to generate strong cash flows and return cash to shareholders through dividends and share buybacks, while reducing debt. Post the EQT acquisition, DGO shares have been relatively stable compared to its oil and gas peers, outperforming the S&P oil and gas index. We note that DGO is sensitive to Henry Hub gas prices and fluctuations in its share price tend to follow the benchmark, even though DGO has a highly hedged portfolio to protect its cash flow.

Exhibit 4 provides our updated forecasts for FY19, FY20 and FY21. The integration of EdgeMarc and the natural gas gathering systems acquisitions into our model leads to an increase in our production estimates to 83.9kboed for FY19 (+5%), 88.3kboed in FY20 (+8%) and 83.3kboed in FY21 (+7%). Our forecast increase in FY19 production includes uncontrollable negative Q119 effects due to weather, subsequently more than offset by Q319 production of c 91kboed, representing an increase of 10% from Q219. Legacy assets production was c 71kboed and shows the success of DGO's Smarter Well Management Programme, which has offset natural declines since Q218. The increase in yearly production has not translated into an increase in earnings, in part due to our lower oil and gas price assumptions based on the latest EIA estimates, which fell by 9% for HH and 6% for WTI for FY20 compared to our previous note from April 2019. We have also updated our now outdated cost estimates from our previous note based on DGO’s latest acquisition metrics with total cash costs (base LOE, production taxes, gathering and compression, gathering and transportation and administration costs).

We value DGO using a conventional NAV approach based on the NPV10 of the company’s producing assets minus overheads and net financial liabilities. The NAV table below, in Exhibit 5, provides a breakdown of our valuation by asset, using data available in the company’s last published prospectus and CPR as well as state public sources.

We break down the assets into DGO Legacy assets (conventional, late-life, low-decline rate), and the 2019 acquired assets (early life assets) instead of a state breakdown as presented in our previous notes. We note that DGO has now over 12,000 miles of pipeline with related compressor stations, following the August 2019 acquisitions, which provides for optionality and represents a competitive advantage when it comes to assessing future deals in the region. This is reflected in our discounted value for payments DGO receives for third-party use of services and midstream assets and respective operating costs in our valuation – currently estimated at a NAV of $49.1m. We also include the hedging impact based on DGO’s available information on hedging volumes, and the impact of the 2019 equity raise, acquisitions costs and disposals revenues, and the share buyback programme.

Exhibit 6 breaks down our valuation by asset class showing where our base case core NAV sits relative to the current share price. Our valuation suggests that the market is not fully valuing DGO’s 1P PDP reserves (579mmboe = 474mmboe DGO Legacy + 92mmboe HG Energy + 14mmboe EdgeMarc), nor its third-party revenues from midstream assets, and may be overestimating the NPV of decommissioning liabilities.

Key drivers of DGO’s valuation are the gas price and LOE. Our base assumes a long-term (2022) gas price of $3.10/mcf and short-term gas assumptions based on the EIA short-term energy outlook of $2.67/mcf for FY19 and $2.61/mcf for FY20. Our LOE assumptions are specific for DGO Legacy assets, HG Energy and EdgeMarc until all assets are fully consolidated. Our LOE assumptions are based on acquisition metrics for HG Energy of $0.63/boe and EdgeMarc of $1.56/boe and we estimate DGO base LOE at $3.6/boe. Our LOE assumption excludes gathering and transport, SG&A and production taxes. The table below provides a base case valuation sensitivity to these key drivers.

As mentioned above, DGO’s key drivers of free cash flow (FCF) and dividends will be gas realisations and LOE. Below we provide our net debt, net debt/EBITDA and FCF forecasts based on our underlying commodity price assumptions. We forecast a quarterly dividend payment resulting in an annualised 13.6c/share dividend in 2019, and 16.0c/share going forward, equating to an FY19e yield of 12.4% at the current share price. We also assume FCF is used to reduce net debt and gearing with net debt/EBITDA falling from 2.4x in FY19 (management targets a 2.0–2.5x net debt/adjusted EBITDA leverage ratio) in the absence of further acquisitions. The proposed asset securitisation will generate proceeds to reduce DGO’s borrowings on its existing credit facilities.