Linn Energy: Walk the Line

Oct.19.08 | About: Linn Energy, (LINEQ)

A little bit about Linn Energy (LINE) from their site:

Linn Energy, LLC (Linn Energy) is an independent oil and gas company focused on the development and acquisition of long-lived properties in the United States. The Company’s oil, gas and natural gas liquids (NYSE:NGL) properties are located in three regions in the United States: Mid-Continent, which includes the core operating areas Texas Panhandle and Oklahoma; Appalachian Basin, which includes fields in West Virginia and Pennsylvania, and Western, which includes the Brea Olinda Field of the Los Angeles Basin in California. The Company’s proved reserves, at December 31, 2007, were 1,616.1 billion cubic feet equivalent (Bcfe), of which approximately 64% were gas, 20% were oil, and 16% were NGL. Approximately 73% were classified as proved developed. At December 31, 2007, Linn Energy operated 5,638, or 77%, of its 7,305 gross productive wells.

LINE is one of my favorite stocks to buy right now. With a market cap of 1.52 billion and an Enterprise Value of 3.6 billion, LINE is the largest public E&P MLP/LLC in the country. This offers them a little more stability in an unsure market. They also have a 21 year reserve life, also one of the best in the sector. The MLP space has been rocked in the recent market drama and I was drawn to LINE as a high yield play with the least amount of risk. The big reason they are less risky than most is because of their aggressive hedging program.

One huge factor in what separates LINE from the competition going forward is that they hedged their production as far out as any energy company I have seen. They have 100% or more of their estimated production covered until 2012. In 2012 it is currently 67% of total production.

Now they did have a problem being that Lehman Brothers was counterparty to their oil and gas hedges, but they were smart enough to re-hedge all of their contracts at the same price and for the same duration very quickly before oil and gas took a dive. They are seeking to recover 68 million from Lehman but I do not factor the recovery of that money into my estimates.

The market is extremely volatile right now and natural gas and oil have been under pressure the same as all commodities. This creates a headwind for the energy sector and calls into question the huge yield, currently 20% or an annual yield of $2.52 per share. They currently project a distribution coverage ratio of 1.3.

We have to play the devil's advocate when we are researching the stocks; if oil were to go to $50 and gas to $4 and stay there for four years, that would not be good for LINE, and if I think that is going to happen then I wouldn’t want to stick around. Other risks with a company in this sector include problems or accidents with some of their drilling projects, having to find new buyers and problems securing new drilling rigs. LINE develops proved producing properties so it’s not finding oil and gas that is an issue just keeping the drilling on track. Since they have been public this has not been an issue but in this industry it is always a risk.

Looking at their competitors, LINE also sticks out as having the best yield of the group that isn’t in danger. I looked at Atlas Energy (ATN), Legacy Reserves (NASDAQ:LGCY), Pioneer Southwest (PSE), Eagle Rock (NASDAQ:EROC), BreitBurn Energy (BBEP), Encore Energy (NYSE:ENP), Vanguard Natural Resources (NASDAQ:VNR), EV Energy (NASDAQ:EVEP), Constellation Energy (CEP) and Quest Energy (QELP).

Now, QELP, VNR , EVEP and CEP have higher yields than LINE, but they have over-hanging issues. CEP is part of Constellation Energy, which just got taken over by Buffett. They forced them before that happened to sell off some of their assets and they are not sure exactly what their future is going to look like. QELP had a CEO who was funneling money out of the company, ENRON-style, using it for personal uses. He’s now probably going to prison. VNR is also a company I like, but they have only hedged out a little over a year. This leaves EVEP, which also looks like a good company and insiders have been buying like crazy. They are not as hedged as LINE, which was a negative for me. If oil and gas are looking like they will spike higher, I would buy EVEP and VNR.

Looking at the insider transactions for these three companies are all very positive as insider buying has really stepped up recently. That is good to see as these companies share prices are getting beaten down along with the rest of the market. Oil and gas has come down so you would expect to see some weakness, but I think the selling is overdone, in part because of the Lehman Brothers (LEH) factor.

How does LEH figure into all of this? LEH had big stakes in many MLP companies. Many small oil and gas companies also used LEH as their counterparty to their oil and natural gas hedges which they now may have to take some losses because of it. LEH provided lines of credit to some of these companies. LEH is most likely being forced to sell some of their holdings putting further pressure on the share prices. Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) may also be forced to sell some of their LINE holdings as they transition from investment banks to regular banks. I think that creates a unique opportunity that doesn’t come around very often as their share prices may be getting artificially depressed.

One other note is that LINE uses Put options on about 30% of production; should natural gas go back above 9 or oil back above 100, that could offer further upside. On top of the 20% yield, I see at least a 30% plus return per year over the next 3 years. That is 20% distribution, 10% equity appreciation, and I believe that is conservative.

Should electric cars, solar, nuclear power and windmills take over the world, I’ll dump LINE, but I just don’t see that happening for another 10 years.

Position: Author holds a long position in LINE