Diversified Gas & Oil — Strong balance sheet allows for dividend increase

Despite the challenging environment oil and gas companies are facing globally, DGO remained essentially unaffected by the COVID-19 pandemic. It completed two acquisitions and achieved record production levels, with an H120 exit rate of 109kboed. The company observed steady production levels from its legacy assets, maintained at c 70kboed for the eighth consecutive quarter. The recent acquisitions provided strong deliverability after the first full month of production, and management acknowledged that additional opportunities for Smarter Well Management, DGO’s bespoke well management approach, have been identified. For financially healthy companies like DGO, the current situation provides rare opportunities for growth.

Historically low commodity prices led to a 23% decline in revenues. However, these were offset by net cash settlements from commodity derivative contracts of c $84m, demonstrating the strength of DGO’s hedging programme. This led to adjusted EBITDA for the period of $146m, 11% higher than the H119 results. Revenues and free cash flow for the near term are offset by the hedging portfolio, where c 80% of natural gas production is protected at a floor of $2.69/mmBtu ($2.79/mcf) for 2020 and c 70% at c $2.62/mmBtu ($2.72/mcf) for 2021.

Since its 2017 IPO, as per its dividend policy, DGO has been distributing c 40% of its free cash flow (FCF) to shareholders via dividends. Strong FCF generation, protected by a robust hedged portfolio allowed DGO to increase its quarterly dividend at a time when most companies are cutting, suspending or eliminating their dividends as economic uncertainty has increased due to COVID-19. The company’s resilience in the face of the pandemic allowed for a quarterly dividend increase of 7% from 3.50c/share in Q120 to 3.75c/share in Q220, generating a 2020 dividend yield of 10.6% at the current share price, and a 2021 yield of 10.9%, assuming the dividend remains constant, at 3.75c per quarter, over the period.

DGO is well-positioned for the second half of 2020 as the management team continues its business strategy of focusing on maximising production, minimising operating costs and keeping an eye on the market for additional FCF-generating assets to acquire and expand its footprint in the Appalachian region. Near-term priorities include the continued integration of the EQT and Carbon assets, and identifying Smarter Well Management improvement activities for existing and newly acquired upstream and midstream assets.

Exhibit 2 provides our updated forecasts for FY20 and FY21. Our FY20 production estimate remains in line with our previous note at 100.0kboed. We update our operating metrics in line with H120 results. This affects base lease operating costs (LOE), production taxes, gathering & transportation (G&T), gathering & compression (G&C) and general & administrative (G&A) per boe. Higher production resulted in lower operating metrics per boe. Our G&A estimate increases to reflect DGO’s realised G&A in the first half of the year. The increase reflects costs associated with the acquisitions and listing on the Main Market of the London Stock Exchange in May 2020. However, the company expects the majority of these costs to be non-recurring. Our FY20 oil and gas price assumptions, based on the 11 August EIA Short-Term Energy Outlook (STEO) estimates, remain virtually the same for Henry Hub (HH) and increased by 10% for WTI. For FY21, the EIA forecasts a 2% increase versus our previous note in HH and a 4% increase in WTI.

We value DGO using a conventional NAV approach based on the NPV10 of its producing assets minus overheads and net financial liabilities. The NAV table below, Exhibit 3, provides a breakdown of our valuation by asset, using the latest data published by the company as well as state public sources.

We break down the assets into DGO legacy assets (conventional, late-life, low decline rate), the 2019 acquired assets (early-life assets) and the recent acquisitions of Carbon Energy and EQT assets. DGO pipelines with related compressor stations are also reflected in our discounted value for payments DGO receives for third-party use of services and midstream assets and respective operating costs – currently estimated at a NAV of $49.0m. We also include the hedging impact based on DGO’s latest available information on hedging volumes from 31 July 2020, as well as the impact of the 2020 share buyback programme and the recent equity raise for the acquisition of the Carbon Energy and EQT assets.

We also present our three scenarios with a low case commodity price scenario of HH in 2022 at $2.73/mcf, calculated from a 2020 HH of $2.60/mcf escalated at 2.5% per year; a mid-case scenario with HH in 2022 of $2.94/mcf, calculated from a 2020 HH of $2.80/mcf escalated at 2.5% per year; and a high-case scenario of HH in 2022 of $3.15/mcf, calculated from a 2020 HH of $3.00/mcf escalated at 2.5% per year.

Exhibit 4 breaks down our valuation by asset class showing where our base case core NAV sits relative to the current share price. Our valuation suggests the market is not fully valuing DGO’s 1P PDP reserves of 684mmboe nor its third-party revenues from midstream assets.

The key drivers of DGO’s valuation are the gas price and LOE. Our mid-case assumes a long-term (2022) gas price of $2.94/mcf based on a 2020 $2.80/mcf and short-term gas assumptions based on the EIA short-term energy outlook of $2.11/mcf for FY20 and $3.25/mcf for FY21. Our base LOE assumption excludes gathering and transport, SG&A and production taxes. The table below provides a base case valuation sensitivity to these key drivers.

DGO recently completed upstream and midstream asset acquisitions from Carbon ($110m) and EQT ($125m) financed through a successful $86m (gross) share placing and a $160m (gross) amortising 10-year term loan underwritten by Munich Re Reserves Risk Financing (MRRF). Further details on the acquisition terms can be found in our outlook note published on 15 June 2020.

Key drivers of FCF and dividends for the company will be natural gas realisations and LOE. Below we provide our net debt and net debt/EBITDA forecasts based on our underlying commodity price assumptions. We forecast a quarterly dividend payment resulting in an annualised 14.25c dividend paid in 2020, equating to an FY20e yield of 10.6% at the current share price. Assuming the dividend remains constant (at 3.75 per quarter) in FY21, this would result in an annualised dividend paid in 2021 of 15.00c and a yield of 11.1%. We also assume FCF is used to reduce net debt and gearing, with our forecast net debt/EBITDA standing at 2.3x in FY20 following the recent acquisitions (management targets less than 2.5x net debt/adjusted EBITDA leverage ratio) and falling to 2.1x in FY21. We believe DGO will continue to mitigate the impact of low gas prices realisations by continuing with its opportunistic hedging strategy, as it did in 2020.

Although the market has been observing lower HH prices, the redetermination of DGO’s senior secured credit facility in June 2020 reaffirms a $425m borrowing base and demonstrates that the lenders have confidence in DGO’s ability to reduce its debt, even at current commodity prices. The current facility has a maturity date of July 2023, an interest rate of 2.5% plus one-month Libor and is subject to a grid that fluctuates from 2.0–3.0% plus Libor based on utilisation.

DGO has distributed regular and increasing dividends to shareholders since 2017. Management targets shareholder returns of c 40% of FCF. In Exhibits 7 and 8 we show that at a 10% discount to our current commodity price assumptions and a constant quarterly dividend of 3.75c from Q220, FY20 and FY21 maintenance capex and cash dividends are covered by cash from operations. We have stress-tested our model for commodity prices and observed that we would have to see an average realised HH price of $1.35/mcf in 2020 and $2.67/mcf 2021 for cash from operations to just about cover current capex and dividend assumptions. However, as already mentioned, DGO’s floor hedge price for 2020 is $2.69/mmBtu ($2.79/mcf) and $2.62/mmBtu ($2.72/mcf) for 2021.

Exhibit 9 provides a test of DGO’s new quarterly dividend sustainability until 2025 under our different modelled scenarios. We highlight that this stress test excludes any future potential share buyback programme or acquisitions. We observe that under our mid-case scenario, assuming dividend payouts remain constant, cash dividends would account for c 46% of generated FCF from 2022, broadly in line with the company’s current dividend policy. In our low-case scenario, this would increase to c 56% of FCF from 2022.