This Oil Company Is Quietly Building Hidden Value in the Permian Basin
Oil and gas companies have been growing production so fast that third-party midstream providers haven't been able to keep up. So many drillers have started investing in building out their own midstream networks to avoid these speed bumps. These investments have proven to be valuable assets for producers, who can not only save money but also eventually sell these systems for a sizable profit.
One company quietly building out what could prove to be a valuable midstream business is Diamondback Energy (NASDAQ: FANG). The Permian Basin-focused driller has been doing so through its Rattler Midstream subsidiary, which it recently bolstered through two notable transactions.
Building out a meaningful business
Diamondback Energy has been steadily building out its Rattler Midstream unit to support its growth in the Permian. The company has constructed pipelines and other assets that gather oil, natural gas, and water produced from wells it has drilled in the region. The oil- and gas-gathering lines enable the company to funnel these hydrocarbons to longer-haul pipelines that move them out of the area, where Diamondback can sell them for a higher value, while the water assets enable it to reduce costs. Diamondback invested about $205 million in infrastructure last year, with about 60% of that in building midstream assets, and it anticipates spending another $350 million to $400 million on infrastructure projects this year.
In addition to those organic investments, Diamondback Energy recently made a couple of deals that further boosted its midstream business. Last year, the company spent $9.2 billion to acquire Permian peer Energen. That acquisition not only boosted Diamondback's inventory of future drilling locations in the region, but it came with an extensive set of midstream assets that Energen developed to support its growth, which is now part of Rattler.
Meanwhile, as part of Diamondback's strategy to lock up pipeline capacity to move its oil out of the Permian and toward higher-valued markets along the Gulf Coast, it secured an option to acquire a 10% interest in the EPIC Crude Oil Pipeline that is under development. The company recently exercised that option, which will give it a stake in the pipeline that should start flowing oil early next year.
Following a formula that works
Diamondback Energy's investment in the EPIC Crude Oil Pipeline is worth noting because it follows a blueprint laid out by Apache (NYSE: APA) for creating midstream value. Apache spent the last couple of years investing in the build-out of midstream infrastructure to support the growth of its Alpine High discovery in the Permian. Initially, the company invested capital in constructing natural gas-gathering pipelines and other related infrastructure to move its production to regional hubs. However, as Apache signed up to be a major shipper on longer-haul pipeline developments, it also secured options to participate in these projects, making five such agreements.
This strategy enabled Apache to quietly build out a valuable midstream company. That proved to be the case when it launched Altus Midstream (NASDAQ: ALTM) last year, which valued Apache's midstream business at $3.5 billion. The creation of Altus Midstream has subsequently enabled Apache to hand over the development of future midstream assets to that entity, which freed up its cash flow to drill more wells. Altus Midstream has done just that, as it has been expanding the gathering and processing business as well as steadily exercising its options to acquire stakes in the long-haul pipeline developments, including joining Diamondback in buying an interest in the EPIC Crude Oil Pipeline.
Altus believes that these identified expansion opportunities alone can fuel a 105% compound annual growth rate in its EBITDA through 2021. That forecast has the company on track to produce $500 million to $600 million in earnings by 2021. If the midstream company trades at around the industry average of more than 10 times that number, Altus would nearly double in value in the coming years. Because Apache still owns 79% of that entity, it has retained significant upside that it could continue monetizing in the future to either accelerate its drilling program or return more cash to investors.
Apache's success in creating Altus gives Diamondback a good blueprint to follow as it builds out Rattler Midstream. At some point, the company could take a similar path to start monetizing Rattler so that it can unlock the value it has created by developing its midstream business.
A catalyst to keep an eye on
Diamondback Energy has been building out midstream assets to support its growth so that it's not waiting on third-party developers as well as to reduce costs. However, given that investors highly value the steady cash flows these assets produce, this business is becoming a valuable asset, which Diamondback could eventually unlock by following Apache's model. It's a catalyst to monitor, especially as the company moves to return more cash to shareholders in the coming years, which it could accelerate by starting to monetize this asset.
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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.