Oil and gas firm Diversified Gas & Oil’s (DGOC:AIM) buy-and-build strategy in the US Appalachian basin is gathering pace following a big fundraise and two sizeable acquisitions which are set to make it the biggest producer on AIM.

Crucially this is a story with strong returns on capital and generous dividends at its heart, making the company something of an outlier in the oil and gas sector.

The company has a policy of returning 40% of its operating cash flow to shareholders. It is set to yield between 5.5% and 6% once the latest deals complete, based on forecasts from banking group Mirabaud.

The enlarged company will have $70m to $75m annualised earnings (+150% on previous run-rate), adds Mirabaud.

WHAT HAS IT BOUGHT?

Its strategy is to buy conventional assets, typically from larger operators which are not set up to run them as efficiently and are often chasing the higher volumes associated with unconventional assets.

Diversified’s wells often have long lives and low rates of decline with minimal maintenance costs. Its output is heavily weighted towards natural gas.

The most recent acquisitions – and the accompanying $189m placing at 80p to fund them – received shareholder approval on 19 February. The transactions are expected to complete in March.

Production is set to increase from 10,000 barrels of oil equivalent per day (boepd) to 28,000 boepd and proven, developed and producing reserves will more than double to 173m barrels of oil equivalent.

The acquired portfolios of assets are of a similar size. Small private conventional outfit Alliance Petroleum was bought outright for $95m and non-core wells were picked up from CNX Gas for $85m. Both are located close to Diversified’s existing assets in the Appalachian.

PROSPECTS FOR FUTURE DEALS

With a larger production base, the company has been able to refinance its borrowings on much more advantageous terms, reducing levels of interest from 8.5% to between 2.5% to 3.25%.

This suggests further M&A can be completed using debt and without diluting existing shareholders.

Mirabaud comments: ‘Our back of the envelope calculation suggests the company could comfortably execute around $120m of future deals at four times earnings (adding around $30m of earnings) whilst keeping its gearing (debt) ratio the right side of two times.’

Significantly, the business is generating plenty of profit and cash flow despite depressed natural gas prices in the US. According to chief executive and founder Rusty Hutson Jr the business could be profitable at gas prices upwards of $1.20 per million cubic feet (mcf) against current levels of around $2.60 per mcf.

Any recovery in prices as, for example, industrial users switch out of coal and US exports of liquefied natural gas (LNG) ramp up, could see Diversified’s earnings and dividend expectations upgraded. (TS)

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