Diversified Energy puts faith in US listing to relight its fire

When Diversified Energy joined London’s junior market seven years ago, it positioned itself as a rare and different prospect from the other oil and gas minnows. The American producer pledged to hand back bumper cash returns to investors, backed by a steady stream of cash from the unloved gas wells of the energy majors.
The assurance was met with scepticism by some analysts even then, but for a time the company defied its critics, helping to propel its market value from just under £70 million at its admission to Aim to £1.1 billion in 2022.
That was until March this year when the company, which had since moved to London’s main market, cut its dividend in an apparent admission that balancing generous shareholder returns, considerable debt repayments and feeding its acquisition pipeline was too tall an order.
The reset came just three months after it emerged that the company was facing scrutiny from the US Congress over its environmental liabilities, namely concerns that it may be “vastly underestimating well clean-up costs” once the gas production is spent.
Investors have since shunned the company and over the past two years its share price has fallen by about 70 per cent, causing it to be ejected from the FTSE 250 at the latest reshuffle of the index last month. On Tuesday it slipped a further 25½p, or 2.8 per cent, to 894½p.
Despite the decision to cut the dividend to alleviate pressure on the balance sheet, the stock is the most shorted in London, with investors betting it has further to fall.
The company was founded in 2001 by Rusty Hutson Jr, then working in finance, who bought an old gas well in his native state of West Virginia. He is the fourth generation of his family to make his money in oil and gas. “I got the bug to go back and start the company and did, from scratch … I’ve always had an entrepreneurial spirit,” Hutson said.
It is now the largest owner of gas wells in America and has amassed more than 70,000, predominantly in the southern and Appalachian regions, having spent about $2.6 billion since 2017. The group has been helped by what Hutson has described as the “dash for shale” among US producers, acquiring older wells from the energy majors aiming to release cash to invest in drilling for new discoveries.
The case set out by the company is that by investing in extending the life of existing wells, it can improve the profit margins at a lower cost than the previous owners. In the process it can generate sufficient cashflows to pay shareholders a generous dividend, make debt payments and cover the cost of decommissioning old wells, with enough left over to reinvest in expanding its portfolio.
Diversified’s ability to manage the heavy burden of these demands is being questioned by the market. Hutson attributes the sell-off in the shares — whose high dividend yield had attracted income investors — to the heavy outflows that have afflicted UK funds, who have subsequently been forced to sell the shares.
“We got caught up in a very difficult market over almost a two-year period,” Hutson, 55, said.
By the time the decision was taken in March to reduce what was a progressive quarterly dividend of 87.5 cents a share to a flat of 29 cents a share, the yield was approaching an alarm bell ringing 30 per cent. Issuing new shares to raise $1.3 billion between 2017 and last year had also increased the overall cash being paid out.
Hutson’s hand was forced by the company gaining a New York listing at the end of last year. “We knew that was going to screen and we were going to have a lot of trouble finding US investors, who would look at us and say, ‘25-30 per cent, something’s wrong here’,” Hutson said.
Yet the perception that all is not well has clung to the company. One analyst said: “I always thought that there was going to be a reckoning, and I think that is essentially approaching now.”
After day-to-day operating costs and making interest payments of $117 million, the company generated $219 million in free cashflow last year. But that excludes debt repayments, dividends and buying more wells.
Some analysts believe Diversified must still perform a delicate balancing act, even after saving $110 million a year by cutting the dividend. Analysts at Peel Hunt forecast that it will have just $29 million in cash left over this year. That figure rises to just $41 million next year and $58 million in 2026. Those estimates exclude any cash for investing in acquisitions.
The company has said its current focus is on reducing leverage and “driving shareholder value” after three large deals this year.
Tapping equity markets, issuing shares to the seller and debt financing, principally through securitising its assets, are alternatives that the company has turned to. After the $410 million spent on buying out Oaktree Capital Management, the American asset management firm, from several gas assets in June, net debt stood at $1.6 billion, or 2.8 times adjusted earnings before interest and taxes and other items, above its own target range of between 2 and 2.5, although within its covenants.
Hutson hopes to return leverage back within target by the end of next year. He is “very comfortable with [the dividend] for the foreseeable future”, pointing towards debt that is 80 per cent at a fixed rate. Diversified repays debt steadily over a period of ten years or so, rather than being subject to lumpy debt maturities, although a constant drip-feed of cash is needed. For shareholders, the dividend yield on offer is still about 10 per cent, at the top of the industry.
However, the business faces more fundamental questions. In January, a report by Snowcap Research, a London-based short seller, accused the company of underestimating the cost of decommissioning wells.
The report disputed the rate at which the production from Diversified’s wells is declining, putting it at an annualised 18 per cent, higher than the “stable rate” of 10 per cent the company has reported. It also said the lifespan of the company’s wells, which Diversified puts at an average of 50 years but 2095 at the latest, is too optimistic. The undiscounted cost of plugging the wells was $1.96 billion at the end of June, but discounted over the decades, the present value of that liability falls to $507 million.
Diversified said the Snowcap report “contains numerous inaccuracies and is designed for the sole purpose of negatively impacting the company’s share price for the benefit of their short position”.
It said that owning an asset retirement company means it can better control costs, which are reviewed by the company’s auditor, as is the overall asset retirement liability. “The company has a track record of successfully retiring wells in a safe, cost effective and environmentally sound manner,” it said.
Snowcap believes it has been vindicated by Diversified’s decision to cut its dividend and maintains its short position.
Concerns that the company was underestimating well clean-up costs were also aired by four members of the House of Representatives in a letter to Hutson a month earlier, saying that Diversified has more American wells under its direct control than any other company and that if it were unable to cover its environmental liabilities, it “could create thousands of orphaned, methane-leaking wells and undermine efforts to respond to the worsening climate crisis”.
Hutson said: “Let’s be very clear this was a small plurality number of Democrat-only Congressional members. It was just a question and answer. There was no inquiry. There was no investigation.”
The company has clear processes for tracking any methane leakages, he said, and had answered the questions addressed in the letter.
As the shares languish, Hutson believes that the New York listing could provide the key to helping regain momentum.
“The markets in the UK are really, really tough as it relates to our sector. Let’s just call it what it is,” he said, adding: “The education of what we do, how we do it and why we’re a good investment will eventually come through and the US will rewrite the shares accordingly.”