Diversified Energy (NYSE: DEC, LSE: DEC) Is 'Too Big To Fail' And Deserves Regulatory Scrutiny, Capital Requirements
The company should reduce dividend payments and expend more on ARO's in the near term given its large number of non-producing, marginal wells
Diversified Energy has accumulated over 70,000 wells in the U.S., many of which are marginal, making it 'Too Big To Fail'.
If the company fails, taxpayers will bear the burden of Asset Retirement Obligations (ARO's) or well plugging, amounting to a taxpayer bailout.
The company should reduce dividend payments and expend more on ARO's in the near term given its large number of non-producing, marginal wells.
Growing regulatory scrutiny should be logically expected due to the company's unique position.
Diversified Energy PLC (DEC) (DECPF) has accumulated over 70,000 largely decrepit wells in the U.S. (by far the largest well owner) and so has earned its status as 'Too Big To Fail' thanks to its massive Asset Retirement Obligations (ARO's). Management has being taken aback by a recent Congressional inquiry in light of its massive environmental liabilities. The company, which does not drill new wells, is only retiring a tiny fraction of its aged wells while paying out massive cash dividends. There is good reason that this business requires regulatory oversight. If Diversified fails, it will amount to a massive taxpayer bailout by shifting the burden of ARO's onto taxpayers.
DEC: Too Big To Fail
It's puzzling that there has been a visceral reaction from management and shareholders to recent Congressional inquiry into Diversified Energy (DEC). When one looks at corporations whose failures can leave a massive scar on the broader citizenry, one should consider the big banks. Lessons learned from 2008 have imparted that the biggest 'Too Big to Fail' banks should come under close regulatory scrutiny and be expected to maintain more prudent capital and lending standards (Annual Fed Stress tests, Basel III are examples).
This is the situation that Diversified now finds itself in which, admittedly, is peculiar for an energy company. But we should note that Diversified is not a typical energy company--something that its own management often touts. Unlike other energy companies with large amounts of proven undeveloped oil and gas reserves in the ground, Diversified largely only has decades old, depleting gas wells and does not actively drill new wells. Hence, the company's cash flows will decline year after year while it has a large obligation to plug its old wells.
Unlike the big banks whose rules have been created from crises like the Great Depression and Great Recession, there are no set of rules for the likes of Diversified. Hence, the company can get away with retiring a tiny number of wells while paying out large sums to shareholders:
It is strange for the CEO to appear naive to this fact. It is also strange that the company has fought states to slow down well retirement while actively paying out large dividends:
In Appalachia the rust accumulates. State records show that more than 1 in 10 of (Diversified CEO) Hutson’s wells there aren’t producing anything at all. Among them is one known as Fee A 36, almost hidden by weeds in a forest in central Pennsylvania...Even Diversified acknowledges this well can’t be resurrected. But its deal with Pennsylvania requires it to plug only 20 wells a year, and there are hundreds of wells to retire. Fee A 36 will have to wait its turn.
-- Bloomberg
At current rates of about 300 wells per year, it will take centuries for Diversified to retire its wells. The company in its own projections plans to only begin retire a majority of its wells over 25 years from now, maintaining a snail's pace for the coming decades.
Of course, present management and shareholder base might not even stick around for 25 years, having cashed their paychecks and dividends over the years, ultimately leaving someone else holding the bag of ARO's.
If Bloomberg's estimate that over 10% of Diversified's wells in Pennsylvania are non-producing is even in the right ballpark, the company's current anemic rate of retirement while paying large dividends is reprehensible. Furthermore, it's likely that many of Diversified's decades old producing wells are making such little gas that they might as well be considered non-producing. Given this, further action from the involved states and the U.S. Congress does not appear farfetched at all.
Diversified's Hubris
Given Diversified's position, investors and management who express shock and outrage at Congress' inquiries into Diversified are naive. A business with this level of potential liabilities ultimately backstopped by taxpayers will not (and should not) be allowed to operate unfettered. If Diversified fails, the massive cost of its ARO liabilities will be socialized to the taxpayers.
What's more is that there is strong evidence that Diversified is operating with a level of extreme hubris. Diversified claims that it can retire wells at less than $25,000 per well in its 2022 asset retirement report which appears to be highly optimistic and unrealistic:
For instance, when Diversified Energy acquired wells from CNX Resources Corp. (CNX Resources) in 2018, CNX Resources estimated remediation would cost $197 million. Diversified Energy determined remediating the same wells would only cost $14 million. However, when examining approximately $12.6 million in plugging agreements between Next LVL Energy—a Diversified Energy subsidiary—and the West Virginia Department of Environmental Protection funded by federal grants and covering 100 orphan wells, researchers determined that Next LVL Energy’s average plugging cost could be as high as $126,000 per well. While orphaned wells can be more expensive to plug and clean up, this is a major cost discrepancy that casts doubt on Diversified Energy’s claims that it can remediate its wells at a lower cost than previous well owners had estimated.
Next LVL is Diversified's well retiring subsidiary and the fact that it has a $12.6M contract to retire 100 wells ($126,000 per well) while Diversified claims its retirement obligations at less than $25,000 per well speaks volumes. In short, it appears that Diversified has accumulated marginal wells from others by touting extremely rosy and unrealistic projections of low well retirement costs that are likely to be multiples of what they project. Other energy companies like CNX (CNX) are likely only happy to rid themselves of large ARO liabilities and leave Diversified holding the bag.
Many of these wells are decades old and sit in rural, remote, and isolated forests across Appalachia. To project that they will cost less than a mere $25,000 per well to retire is unheard of in the industry and it is extremely irresponsible to delay well retirement decades into the future with such lofty expectations while paying out large cash dividends today.
Other analysts have concluded the same:
“Diversified claims it can plug wells at a cost less than half the industry average. They claim their dying wells will continue producing at an economic rate for decades.” said report author and ORVI Research Fellow Kathy Hipple. “These unusual assumptions—as well as accounting practices that function to punt cleanup costs down the line—are not used by any other company in the industry.”
Indeed, journalists, politicians, and even think tanks like the Ohio River Valley Institute have grown alarmed at Diversified's unusual estimates and projections that are not used by anyone else in the industry. Congress has the right concerns here and has only begun to investigate Diversified:
Researchers examining Diversified Energy’s accounting practices found that agreements with states would allow the company to defer environmental liabilities that they estimated at more than $2 billion. Deferring and underestimating environmental liabilities would provide Diversified Energy the appearance of profitability on paper, which would allow your company to payout hundreds of millions of dollars to creditors and shareholders over the next decade without ensuring adequate funds to cover those liabilities. If this analysis is accurate, it is highly unlikely that Diversified Energy will have adequate funds to clean up all of its marginal wells when they should be retired.
U.S. Natural Gas is Likely in a Multi-Decade Glut
Not only is Diversified likely overoptimistic on well retirement costs, but its cash flow projections are also suspect. Diversified is largely a natural gas producer and, as it is well known, the commodity has been in a multi-decade glut in the United States. Natural gas is produced as a byproduct of shale drillers looking for oil in places like the Permian and it is likely it will continue to be produced in excess in the United States for the decades to come, only adding to the glut.
For Diversified to project its cash flows from selling gas decades into the future and to defer most of its well retirement far into the future is the pinnacle of hubris. As any commodity investor knows, energy cycles are impossible to predict far into the future and any prolonged downturn in strip prices can cause a business to go under, even one that is hedged (as the downturn can persist much longer than expected).
For a company to rely on such projections while sitting on a large pile of ARO's (as well as $1.5B in debt) is extreme overconfidence while being in a precarious state of leverage. The victim of this overconfidence will ultimately be the taxpayer as shareholders will collect dividends in excess of their investment over the years.
Conclusion
Diversified is not necessarily a business guaranteed to fail; however, the business operates with extreme hubris. It has large environmental liabilities that it has fought to defer far into the future while paying out large amounts of cash to shareholders today. Its assets are largely aged, depleted gas wells and it does not drill new wells nor does it have meaningful undeveloped reserves. Given this, its practices have rightfully come under scrutiny. We think the right thing for the company to do is to meaningfully accelerate well retirement, at the very least retiring its non-producing wells within the next 5 years. This is very different from what the company is proposing. For this to happen, the dividend would likely need to be cut. This represents a material issue that current and prospective investors must consider.
Disclosure
I have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
Hm, why didn't you mention or attempt to pick apart DEC's response letter to the Congress inquiry - management hasn't been taken aback but responded in a detailed way.
The way you frame the situation is that management received a letter and all items in it are neither responded nor disputed - which I find misleading. You should have at least tried to discuss their responses.