On Saturday, February 16, concerns regarding the accounting and hedging practices of the upstream master limited partnership ("MLP") Linn Energy (LINE) were reported in an article by Barron's. Last week, Linn Energy and LinnCo (LNCO) units had been under heavy selling pressure, declining 5% on much heavier-than-average volume. I strongly suggest that investors in Linn Energy read the company's response to these concerns, which can be found here.
Tuesday was the first day of trading after the Barron's piece was released, and as was widely expected, units of Linn Energy initially declined sharply, over 4%, on heavy volume. However, this was not to last. By 11AM, Linn Energy had recovered nearly all its losses, and eventually ended the day in the green by better than 1%. This begs the question: Are the accounting issues at Linn Energy much ado about nothing?
Let us start with the valuation concern mentioned in the article:
Linn's units trade for 10 times 2012 pretax cash flow, roughly double the valuation of energy exploration and production companies such as Apache (APA), Devon Energy (DVN), and Canada's Suncor Energy (SU), and in excess of valuations accorded smaller energy producers structured as MLPs.
This first jab against Linn Energy seemed unwarranted and unfair. Linn Energy is an upstream MLP, and is vastly different to the above-mentioned companies. A better comparison would be to similar upstream MLPs such as QR Energy (QRE) and Vanguard Natural Resources (VNR). However, this is a minor gripe, what really had investors spooked comes next:
Moreover, Linn may be overstating the cash flow available for distribution, by not deducting the cost of financial derivatives-mainly put options-from its realized gains on hedging activities in its quarterly results. Bears argue that funds invested in derivatives should be treated as an expense, and at least one of Linn's major competitors follows that approach. Linn says its energy derivatives are an integral part of its corporate strategy and amount to an asset, much like an oil and gas property. The value of such assets typically gets depreciated over their useful life.
Note that the author fails to mention which "major competitor" of Linn Energy he is referring to. Upstream MLPs, as far as I can tell, all follow the same playbook: they buy mature, long-life assets, with stable production profiles, and then hedge (by buying puts and or swaps) the expected production from these assets.
Below, is an excerpt from Linn Energy's response:
(click to enlarge)
Note that Linn Energy's rationale for hedging is primarily to lower risk. By doing this, they "lock-in" prices, mainly to protect their margins and to reduce their exposure to commodity price shocks and provide a steady and predictable cash flow. Also note that Linn Energy's strategy for hedging is typically 10% of the cost of an acquisition. Linn Energy also tends to hedge 100% of expected production for 4-6 years.
Next, the Barron's piece notes that an analyst lowers his estimate for distributable cash flow:
But David Amoss, an analyst at Howard Weil, broke ranks on Friday and downgraded Linn to Sector Perform from Outperform, citing the company's treatment of its hedging costs. Amoss cut his estimate of 2013 distributable cash flow to $2.45 per unit from $3.03, "to better reflect the underlying cost of the hedges" that he estimates at $120 million annually, he wrote in a client note. Linn might have to make accretive acquisitions this year to cover its $2.90 distribution, he added. Alternately, it is possible the distribution could be cut. Linn shares fell 3.8% on Friday, but still trade for two times book value.
We can see that the analyst at Howard Weil believes that Linn Energy will not have distributable cash flow to cover its distribution in 2013. However, Linn Energy disagrees. Below is relevant quote from Linn Energy's response:
It seems odd that the author later explains exactly how Linn Energy has benefited from its hedging policy. Below is an excerpt from the Barron's article which details this:
LINN'S DERIVATIVES PORTFOLIO has insulated the company from a weak natural-gas market, and allowed it to pay a steadily rising distribution. In the third quarter, it received a price of $2.71 per thousand cubic feet for its natural gas, but realized more than $5 per Mcf after accounting for hedging gains.
MLPs and other energy companies can use swaps or purchase put options to lock in future oil and gas prices. (Puts give the holder the right to sell a security or commodity at a fixed price by a predetermined date.) Some companies prefer swaps to puts because puts are more expensive. Most swaps are executed "at the money," meaning they are based on future oil and gas prices implied in the futures market. The advantage of a put is that the holder gets upside above the put price.
We can see that the puts actually helped cushion Linn Energy from the fall of spot prices for natural gas. However, the article later wonders how Linn Energy can afford these in-the-money puts. Below is the quote from the article asking this:
It appears from Linn's financial statements that the company bought a considerable amount of in-the-money put options on natural gas last year. These are more expensive than at-the-money puts. Specifically, Linn bought a lot of puts struck at $5 per Mcf from 2013 through 2017 at a time when the "strip" (the average price for that five-year period) was in the $4 to $4.50 range. The puts would have had an intrinsic value of 50 cents or more. Gas now trades around $3.15 per Mcf, after averaging $3 in 2012, making the puts more valuable still.
However, Linn Energy explains in detail why they can achieve higher prices from puts, the answer being that the market price is currently much lower than the 4, 5 and 6 year average market price:
As a parting shot, the Barron's article again tries to compare Linn Energy to another major energy company.
LINN CONTENDS THAT ITS "cost of capital" is one of its main advantages over rival energy producers. Essentially, that means it has a more richly valued stock, which has helped it outbid other companies for oil and gas assets, which in turn have been accretive to cash flow. The company relies on equity offerings and debt to fund acquisitions. A lower share price would hinder its acquisition strategy, and thus, the growth of distributable cash. Linn has ample debt of $5.5 billion, resulting in a junk-grade credit rating from both Moody's and Standard & Poor's.
Given that 5% dividends are available from fortress-like energy companies such as Royal Dutch Shell (RDS.A), investors might want to steer clear of riskier bets like Linn. At the very least, Wall Street should start asking harder questions about what Linn calls its "industry-leading hedge program."
Linn Energy is actually correct in stating that their "cost of capital" is an advantage. When Linn Energy issues units, the cash received is either used to pay off high interest debt or to purchase assets. The interest rate on Linn Energy bonds and/or the ROE on the new assets is usually more than the current 8% yield that Linn Energy units offer, hence they are typically accretive to distributable cash flow. Linn Energy is the largest upstream MLP. Indeed, Linn Energy is nearly as big as nearly all of the other upstream MLPs combined. However, upstream MLPs are a tiny fraction of the overall E&P and MLP market:
That Linn Energy recovered most of its losses on Tuesday in less than 2 hours is impressive. I am a believer in the upstream MLP business model, as shown with my ownership of VNR and QRE units. Though, I do understand why some may be wary of these accounting issues. I suggest that unitholders of Linn Energy listen to the Q4 CC, which is scheduled for February 21, at 11AM EST. I am sure this topic will be the main item of discussion during the call.
Additional disclosure: I may go long LINE or LNCO.
Disclaimer: Please note, that the views I express are mine alone and do not constitute legal or accounting advice.