The hedging activities and actual cash flow results of Linn Energy LLC (LINE) have been under fire over the last few days, starting with an article in Barron's questioning Linn's bookkeeping practices. John Hempton piled on with a couple of scathingly negative articles on his Bronte Capital blog. John makes his money looking for short sale candidates and I like to read his analysis but I think he missed the mark with Linn Energy.
However, Thursday's announcement that Linn Energy will acquire Berry Petroleum Company (BRY) in a $4.3 billion deal should put a halt to any plans the short selling crowd has to undermine the viability of Linn Energy as an ongoing success and profit from a falling unit price. The market likes the announcement, with the LINE share price up about 2% while the rest of the market is strongly down.
Note: MLP/LLC companies such as Linn Energy have units and pay distributions. The words stock, shares and dividends may be used here with the understanding that the rules of MLP units apply including the tax consequences of investing in MLP units.
Background on The Deal
As the press release notes, the purchase of Berry Petroleum is the "First Ever Acquisition of a Public C-Corp by an Upstream LLC or MLP". According to comments made during the earnings report conference call, Linn Energy's development and spin-off of LinnCo LLC (LNCO) as a non-K-1 issuing company facilitated the purchase of Berry Petroleum. The acquisition will be funded by the issue of 1.25 LinnCo shares for each outstanding BRY shares plus the assumption of debt. The use of LinnCo shares makes the stock-for-stock transaction a non-taxable event for BRY shareholders.
The deal is expected to close early in the second half of 2013. Cash flow will be immediately accretive to the tune of 40 cents per year per LINE unit. Linn Energy management has recommended to the board that the LINE distribution be increased by 6% to 77 cents quarterly and the LNCO dividend by 8.5% to the same 77 cents as soon as the acquisition is completed. Distributable cash flow coverage ratio will increase to 1.2 to one even with the higher distribution rates.
Comments on the Hedging Controversy
The questions about the hedging practices at Linn Energy centered around the company's using the value of deep-in-the-money put options as part of the distributable cash flow. The company capitalizes the cost of puts used to hedge and questions wondered how/why the puts were not counted as expenses. The articles made is seem like Linn was buying the in-the-money puts, calling them capital investments and then changing the game to use the value as distributable cash flow. From my reading of the Linn Energy response, the puts were not in-the-money when they were purchased years ago and the increase in value accomplished the purpose of the hedge - protect the cash flow from falling natural gas prices.
During the conference call, management stated that at the current time the company was not using puts to hedge, and would possibly revisit the issue in the future. There are other ways to hedge energy prices, so the issue of the day seems to have quickly become a non-issue.
Linn Energy has been very successful applying its business model of buying producing oil and gas energy assets and profitably managing those assets even as individual well production declined. Although Linn works its properties to bring in new, producing wells, the business model is heavily dependent on a continuing stream of new asset purchases. Linn Energy has grown from a $700 million market cap company at its 2006 IPO to a combined - LINE plus LNCO - $12 billion or so when the Berry Petroleum acquisition is complete.
Investors own LINE or LNCO for the 7% plus yield and steadily increasing distributions. Linn Energy has taken another big step to keep that record going and there is no reason to believe the business model will not continue to work.