Linn Energy: Safe Dividends, Speculative Upside

Sounds like an oxymoron, safe dividends and speculative upside. How could that be possible?

Oil has fallen over 70% over the last year due to declining projections of future oil demand. While I have argued that long oil exposure is a prudent and wise move for any portfolio, there’s no better time than today to be adding long oil exposure given the potential upside available. It’s hard to argue that, despite increased focus on alternative energies and alternative fuels, these new technologies will not likely affect oil demand in any significant manner over the next decade. The first American electric car will not reach production until the end of 2010 and will take years before wide spread adoption changes consumer behavior. New power plants also take between 2 and 5 years to complete and truly efficient new technologies such as solar power could take at least another two to three years before they become competitive with current oil prices.

But, despite the 240% upside should oil reach back towards its $150 high, it’s hard to predict just when oil might rebound. As such, I’ve been looking for oil stocks that pay dividends. One in particular, Linn Energy (LINE), has been on my radar for months.

Linn Energy is an exploration and production MLP. An MLP is a publicly traded vehicle that is structured as a limited partnerhsip. As a result, “dividends” are actually classified as distributions and treated as a return of principal. As a result, there are some additional tax complications, but ultimately provide an opportunity to gain the advantage of having your distributions taxed as capital gains as opposed to ordinary income.

Investment Strengths and Weaknesses
Linn Energy produces and sells oil and gas in the Western and Mid-Continent regions of the U.S. What separates Linn from its competitors is an aggressive hedging program for which they have hedged current production levels through 2011 at prices in excess of $80/barrel of oil and $7/Mcf of natural gas. Even more savvy, the Company uses puts on 40% of its hedging to allow it to take advantage of any upside price action.

The worry for Linn and other MLPs is that frozen credit markets will limit their ability to grow through acquisition. Linn, however, has demonstrated an ability to grow proved reserves organically and maintains $440 million in borrowing capacity, enough to selectively target new assets.

Valuation
Linn currently pays $2.52/share in distributions a year. Strong hedging through 2011 should provide at least three years of security even without continued growth through acquisition. If the Company were truly unable to grow its proven reserve assets, it could still produce at current levels for 21 years. Assuming oil and gas prices were never to rebound from current levels, one might assume that the dividend would be halved from 2012 and onwards. Applying a 10% discount rate, the NPV of these dividends alone would be $14.63, a 12% premium to current prices.

Full Disclosure: Author is long shares of LINE at the time of writing.

Comments

[longoil:]

Very good article, my sentiments exactly.

Although, the debut of the electric car on a large scale might be much later than 2010.

1) The retooling of existing auto manufacturers from gasoline cars to electric cars will cost billions. The primary purpose of the current bailout billions for auto makers is very short term; to preserve jobs and prevent the economic collapse of the American auto industry.

2) The current electric infrastructure (power plants and transmission lines) can barely handle the existing demand. Add electric cars charging off the grid and you have just double or triple the demand.

3) Batteries in electric cars require rare earth elements such as lithium that might not be sufficient for the large scale deployment.

4) There is still many technical issues outstanding; performance in cold weather, interior heating and A/C usage would greatly reduce an electric car's range. There is also safety issues, what EMT would want to get near an electric car that has been in accident and possibly get electrocuted by the car's 300 volt batteries ?

I think oil will be a great investment for the next 50 years. I like MLP and Canroys. They still pay nice dividends even when their stock prices are in the basement.

Mar 06 02:30 PM

[Conan the B...:]

Agree on oil and gas for the future. think Linn is probably doing what it did last year, selling future contracts.

But doing so at vastly lower prices. This will translate into Underperformance next year. They are primarily NG.

Management got lucky last year because they sold off their future earnings as oil prices were rising and Oil collapsed in the 2nd half. If they are doing what they did last year, they will underperform next year.

When their 1st QTR 10k comes out, that's the first place to scrutinize, hedges.

IMO

Mar 06 04:13 PM

[zayttrader:]

Sorry Paul, you're completely wrong. They have hedged for 4 years out - 100% for the first 3 years. Their basis hedges go six years into the futures. They have no need to put any more hedges in place for at least two years.

They are NOT primarily NG. That's a bunch of crap. They are 48% NG.

Mar 06 04:35 PM

[another.ana...:]

These wonderful hedges until 2011. Are they the same guaranteed breathing room for solid safe dividend/distributions the Canroys were given by the Canadian Government when they pulled the rug out from under the Canroys in 2007?

Ayuh

Mar 06 05:31 PM

[elliot_mllr:]

I have large holdings in Linn Energy because of the hedges described by Zayttrader. One nuance should be mentioned. Since the distribution is a return of capital it reduces one's basis rather than being currently taxed, as mentioned in the article. However, sad to say, I have such large capital loss carryovers that they will absorb the reduction in basis and then some, so the Linn distribution are actually tax free to me.

Mar 06 06:10 PM

[Linn_holder:]

One correction on the article - the distributions for MLPs are indeed often characterized as return of capital (in recent years, LINE distributions have been entirely characterized as r-o-c) - but that does not mean the distributions end up being taxed as capital gains. Rather, the taxation on the distribution is deferred and when the units are sold, the distributions are taxed as regular income. (For longtime unit-holders, if the cumulative r-o-c distributions exceed the original cost basis, then subsequent distributions are no longer tax-deferred, but are taxed as regular income.)

So that sounds "bad" - regular income rate instead of qualified dividend rate - but the MLP structure itself means that the distributions are only taxed for the unit-holders, not for the MLP as an entity. This "escape" from double-taxation (among other MLP aspects) allows the yields to be higher than compared to typical corporate tax structures.

(And technically, Linn is not an MLP; it is an LLC - but now I am splitting hairs.)

Here is a link to an article on Linn from Dec. 2007: seekingalpha.com/artic...

Mar 06 09:02 PM

[john s. gordon:]

accident damage to electric cars -

a similar problem has existed for some time with vehicles with 'air bags' (actually these are actuated by a pyrotechnic sodium azide cartridge) that go to salvage with one or more units not discharged. technicians have to be trained to 'demilitarize' these things without getting injured. also sodium azide + copper or other heavy metals form explosive copper azide so you have to watch out for corrosion.
> jack

Mar 07 08:26 AM

[elliot_mllr:]

That's a good analysis with which I largely agree. However, as to Canroys please note that the exchange rate with USD is now only $0.77, so that you will be receiving only 77% of the nominal dividends if you live in the US (not taking into account the 15% Canadian witholding, which is creditable vs. US taxes).


On Mar 06 02:30 PM longoil wrote:

> Very good article, my sentiments exactly.
>
> Although, the debut of the electric car on a large scale might be
> much later than 2010.
>
> 1) The retooling of existing auto manufacturers from gasoline cars
> to electric cars will cost billions. The primary purpose of the current
> bailout billions for auto makers is very short term; to preserve
> jobs and prevent the economic collapse of the American auto industry.
>
>
> 2) The current electric infrastructure (power plants and transmission
> lines) can barely handle the existing demand. Add electric cars charging
> off the grid and you have just double or triple the demand.
>
> 3) Batteries in electric cars require rare earth elements such as
> lithium that might not be sufficient for the large scale deployment.
>
>
> 4) There is still many technical issues outstanding; performance
> in cold weather, interior heating and A/C usage would greatly reduce
> an electric car's range. There is also safety issues, what EMT would
> want to get near an electric car that has been in accident and possibly
> get electrocuted by the car's 300 volt batteries ?
>
> I think oil will be a great investment for the next 50 years. I like
> MLP and Canroys. They still pay nice dividends even when their stock
> prices are in the basement.
>

Mar 07 11:09 AM

[jeerio:]

interestingly, the graph shows that LINE peak-to-today's price virtually mirrors the drop in oil. with the distribution of gains and the hedge angle as good margins of saftey, this makes me think the upside here is quite strong.

Mar 07 05:10 PM

[throwerw:]

BBEP is better

Mar 09 12:05 PM

[Mmarrkk:]

As to the return of capital discussion, a neat trick to avoid some of the taxes:

When your "return of capital" gets to the point where you basis in the stock is near zero, donate the shares to charity and then buy new shares. You get 1) a tax deduction for the full value of the donation, 2) reset your cost basis to the value at which you buy the new shares.

This assumes you were going to donate that money anyway. Rather than giving cash to your charity of choice, give them the shares. Most churches and charity groups have this mechanism in place.

Say you own 100 shares of Linn and bought at $20/share ($2000 cost basis). Over the years, the return of capital will slowly take your cost basis down to zero and you will have a very high taxable gain. Plus you'll have to pay taxes on all subsequent "returns of capital" as income. So, donate the 100 shares at today's price, take the donation as a charitable contribution, then go buy 100 more shares.

Mar 09 02:04 PM

[Linn_holder:]

Mark - Very interesting... Thanks!



On Mar 09 02:04 PM Mmarrkk wrote:

> As to the return of capital discussion, a neat trick to avoid some
> of the taxes:
>
> When your "return of capital" gets to the point where you basis in
> the stock is near zero, donate the shares to charity and then buy
> new shares. You get 1) a tax deduction for the full value of the
> donation, 2) reset your cost basis to the value at which you buy
> the new shares.
>
> This assumes you were going to donate that money anyway. Rather than
> giving cash to your charity of choice, give them the shares. Most
> churches and charity groups have this mechanism in place.
>
> Say you own 100 shares of Linn and bought at $20/share ($2000 cost
> basis). Over the years, the return of capital will slowly take your
> cost basis down to zero and you will have a very high taxable gain.
> Plus you'll have to pay taxes on all subsequent "returns of capital"
> as income. So, donate the 100 shares at today's price, take the donation
> as a charitable contribution, then go buy 100 more shares.

Mar 10 12:52 PM

[El Jefe:]

I am more concerned by the large carbon foot print needed to make electric cars.

Between the heavy cabling and battery manufacturing, these cars are worse than conventional autos.

Battery technology has been wonderful in many fields, but for the auto, very questionable. Except when they can replace the lead/acid battery with something as powerful in cold weather.

Mar 10 02:18 PM

[einstein p ...:]

That is likely to reverse if the US continues to print money and the dollar weakens. If anything, to buy the Canroys may be a good hedge against a weakening dollar and inflating oil prices.


On Mar 07 11:09 AM elliot_mllr wrote:

> That's a good analysis with which I largely agree. However, as to
> Canroys please note that the exchange rate with USD is now only $0.77,
> so that you will be receiving only 77% of the nominal dividends if
> you live in the US (not taking into account the 15% Canadian witholding,
> which is creditable vs. US taxes).

Mar 13 07:23 PM