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[Editor's note, June 28: This article has been revised since original publication, as the author erred in the numbers in the table on Capital Expenditures, which have been corrected now. Apologies for any confusion this may have caused.]

Linn Energy (LINE), an upstream petroleum producer, has the enviable goal to:

  1. eliminate commodity price risk with 100% hedging;
  2. pay a high and growing dividend; and
  3. grow value for shareholders by increasing production and reserves.

LINE's track record shows that it has been able to grow both reserves and production on a per unit basis, despite share dilution. Regrettably this achievement is overshadowed by debt increases that exceed the increase in measurable value. Linn Energy is borrowing more than the combined value of its dividend and reserve value-added.

Introduction

Linn Energy, an MLP (having "units" instead of "shares"), has taken a lot of heat for its hedge accounting lately, with many defenders. For investors, especially dividend-focused investors, accounting technicalities are less important than whether a company is building tangible value and can afford to pay the dividend, without having to borrow the money to do it.

Basic Business Model

Linn Energy and the upstream petroleum MLPs are the successors of the Canadian oil and gas trusts business model, like survivors Baytex (BTE), Penn West (PWE), Enerplus (ERF), and Pengrowth (PGH). This business plan centers on drilling high-probability locations, producing and selling the petroleum to raise enough money to both pay the dividend and finance enough new drilling to maintain production and reserves in the face of normal well decline, so that the cycle could be repeated year after year. LINE's model goes one better and promises growth, even if they have to borrow to get it.

Normal Challenges to the Model

If the company pays out too much in dividends, it has to raise money in order to drill enough new wells to counteract production decline. Likewise, if the company has to spend more money to drill, and does not have enough left to pay the dividend, it either has to reduce the dividend and take a hit to the stock price or raise money to pay the dividend. MLPs and trusts raise money by selling shares and/or incurring added debt. Eventually, shortly before they run out of high probability of drilling locations, they have to buy more drilling locations or merge with a company that has them. LINE has made acquisitions before and is in the process of buying Berry Petroleum now.

Selling shares increases the future dividend cash requirements for the company. Incurring more debt requires more revenue to handle the debt service costs in addition to drilling capex and dividend payments. But there is more to debt than just the servicing costs. Debt is a charge on the value of each unit and creates leverage that increases volatility, which is not a characteristic sought by dividend investors.

Obviously, it costs less to add debt at 4% than to sell more shares where the dividend incurs an 8% servicing cost. A well run company with good credit will therefore choose to increase debt in this situation. As a general rule, being forced to sell shares and/or incur more debt eventually creates an untenable situation -- unless the company can grow production so that cash flow gets so prolific, even with normal production decline rates, that surplus cash flow can fund debt retirement and/or share buybacks. Regrettably, as you will see, the opposite is the case with Linn. Debt increases and dilution counteract gains in production and reserves.

Production

Upstream petroleum producers make their money by pumping oil or gas out of a limited reservoir. Production rates from each well declines over time and eventually becomes uneconomic, even after various ways to stimulate the wells. To remain steady-state, companies need to drill enough new wells to replace normal production declines from all the existing wells. It is like walking the wrong way on an airport moving sidewalk. You have to walk just to remain in place. If you want forward movement, you have to walk fast, or jog.

Linn Energy

data from the LINE 2012 or 2010 10K SEC Report

PRODUCTION

At or for the Year Ended December 31,

in units as noted

Average Daily Production data:

2012

2011

2010

2009

2008

Natural gas (MMcf/d)

349

175

137

125

124

NG as % of Production

52%

47%

52%

57%

58%

Total NG, NGL & Crude (MMcfe/d)

671

369

265

218

212

Total Yearly Production (Mmcfe)

244,915

134,685

96,725

79,570

77,380

Production/ unit (Mcfe)

1.20

0.78

0.68

0.67

0.68

Linn has been jogging lately. Production per unit, although small, has increased nicely in 2011 and 2012. Note that although most companies, like Chesapeake (CHK), have tried to focus more on liquids, while LINE's production has been increasing, it has also been slowly getting more gassy. That means a lower amount of revenue per Mcfe (1,000 cubic feet equivalent, where 6 Mcfe = 1 barrel of crude in BTU content). You make more money with more liquids in the production mix.

The data clearly shows that Linn has been growing production as a company, but more important, has been growing production on a per unit basis. Let's see how that has translated to the bottom line (no pun intended).

Profits

LINE has accompanied its increasing production with an increasing dividend each year since 2009, paying out over half a billion dollars in 2012, while reporting losses except in 2008 and 2011.

Linn Energy

Data from the LINE 2012 or 2010 10K SEC Report

Data in 1000s except for unit amounts, for Years Ending

2012

2011

2010

2009

2008

Weighted average units outstanding (1000s)

$ 203,775

$ 172,004

$ 142,535

$ 119,307

$ 114,140

Oil, natural gas and natural gas liquids sales (1000s)

$ 1,601,180

$ 1,162,037

$ 690,054

$ 408,219

$ 755,644

Gains (losses) on oil and natural gas derivatives (1000s)

$ 124,762

$ 449,940

$ 75,211

-$141,374

$ 662,782

Depreciation, depletion and amortization (1000s)

$ 606,150

$ 334,084

$ 238,532

$ 201,782

$ 194,093

Interest expense, net of amounts capitalized (1000s)

$ 379,937

$ 259,725

$ 193,510

$ 92,701

$ 94,517

Income (loss) from continuing operations

-$386,616

$438,439

-$114,288

-$295,841

$825,657

Income (loss) from discontinued operations, net of taxes (1000s)

-

-

-

-$2,351

$ 173,959

Net income/loss (1000s)

-$386,616

$438,439

-$114,288

-$298,192

$999,616

Net Income/ unit, Diluted

-$1.92

$2.51

-$0.80

-$2.50

$8.70

Distributions declared per unit

$ 2.87

$ 2.70

$ 2.55

$ 2.52

$ 2.52

Change in Dividends Paid per Unit

6.1%

5.9%

1.2%

0.0%

Total Distributions (1000s)

$ 583,815

$ 464,411

$ 363,464

$ 300,654

$ 287,633

Cash Flow

Given that profit/loss is not an especially relevant metric for petroleum companies because of non-cash deductions like depletion allowances, dividends exceeding the size of profits is not worrying. To get a better idea about how the business is really doing, we need to consider how much money they have left after they pay for everything that requires the real expenditure of cash money.

Linn Energy

Data from the LINE 2012 or 2010 10K SEC Report

Cash flow data:

2012

2011

2010

2009

2008

Income (loss) from continuing operations (1000s)

-$386,616

$438,439

-$114,288

-$295,841

$825,657

Depreciation, depletion and amortization (1000s)

$ 606,150

$ 334,084

$ 238,532

$ 201,782

$ 194,093

Impairment of long-lived assets 2012 & 2010 10k (1000s)

$ 422,499

$ -

$ 38,600

$ -

$ 50,505

Cash Available to Distribute: Profit+DDA+impairment (1000s)

$642,033

$772,523

$162,844

-$94,059

$1,070,255

Distributions declared per unit

$ 2.87

$ 2.70

$ 2.55

$ 2.52

$ 2.52

Distributable cash/ unit (includes premiums paid for hedges

$3.15

$4.49

$1.14

-$0.79

$9.38

Simple Payout Ratio (Div/Cash Available)

91%

60%

223%

-320%

27%

As the table above illustrates, after adding back non-cash items to profit/loss, LINE had insufficient cash flow to fund dividends in 2009 and 2010. In those years, Linn had to borrow the remaining dividend money and all its capex money (see below). The situation improved in 2011 and 2012, when the cash covered the dividend, leaving them a bit of cash to spend on drilling, but they still had to borrow a lot more than they spent on the dividend to fund drilling.

Capital Expenditures

Linn Energy spends a lot of money on Capex. They have to acquire lands, build wells and gathering systems, and they sometimes buy other companies. This takes cash; an increasing amount of cash each year. LINE has not been able to rely only on its leftover cash, because there has not been anywhere near enough cash in the till to cover the dividends and the capital expenses they have incurred. I have ignored cash used in acquisitions for purposes of this analysis, although the effects are felt in share dilution and assumed debt. Even ignoring cash spent on acquisitions, the yearly amount of capex and the yearly increase in Capex is significant.

Linn Energy

Data from the LINE 2012 or 2010 10K SEC Report

Capital Expenditures

2012

2011

2010

2009

2008

Non-Acquisition Capex (1000s)

$ 1,045,079

$ 629,864

$ 263,000

$ 150,000

$ 321,300

Total Distributions (1000s)

$583,815

$464,411

$363,464

$300,654

$287,633

Cash Available to Distribute: Operating Cash Flow+DDA+impairment (1000s)

$642,033

$772,523

$162,844

-$94,059

$1,070,255

All-In Payout Ratio (Dist+nonA Capex/distrib. Cash)

254%

142%

385%

-479%

57%

The 2012 $1.04 Billion Capex was almost twice the amount of its dividend and about $0.5 Billion more than the cash available from operations. Spending more money than available is not a new development explained by the increase in Reserves in 2012. In each year, from 2009 onward, the dividends plus non-Acquisition Capex exceeded the total Cash available. With an increasing number of new quick-decline shale wells, each year they will need to drill an increased number of wells to make up for the decline. I would guess that LINE Management hope their pending acquisition of Berry Petroleum (BRY) will help with this, given their older conventional wells tend to have lower decline rates. I hope so, because the acquisition is going to boost the share count (and dividends requirements) by 69.46 million LINE shares and add $2.15 Billion in assumption of BRY's obligations.

Presumably, investors and banks would be happy to lend you an unlimited amount of Capex money, if spending it created much more net present value than the amount of the loan. To see if that is the case, we have to look at the debt and reserve growth.

Reserves

Drilling new wells to produce petroleum increases reserves only if the amount of new production exceeds the normal production decline in existing wells. LINE management likes to talk about the cost of drilling wells that make up for decline as if they are different that wells that grow overall production. To determine value-added, we can ignore that distinction. Capex spent, for whatever reason, is real cash that needs to be earned or raised.

Growth in a petroleum company reserves requires that each year its reserves are increased more than the amount produced. LINE deserves credit for managing to grow reserves for the company as a whole and per unit. Given their gassy mix of reserves, the added amount does not really amount to a lot of money on the basis of their net present value. Of course, proved reserves does not tell the whole story, but that is the only reserve data that the SEC allows -- presumably to keep investors from being confused by too many facts.

Linn Energy

Data from the LINE 2012 or 2010 10K SEC Report

PROVEN RESERVES

2012

2011

2010

2009

2008

Total NG, NGLs, Crude (Bcfe)

4,796

3,370

2,597

1,712

1,660

Total Reserves/unit (Mcfe)

23.54

19.59

18.22

14.35

14.54

Added Proven Reserves/unit (Mcfe)

3.94

1.37

3.87

-0.19

Net CF/Mcfe

$ 2.62

$ 5.74

$ 1.68

-$ 1.18

$ 13.83

Nominal Value of Reserve Added/unit if all sold immediately at average price/Mcfe

$ 10.34

$ 7.87

$ 6.52

$ 0.23

$ -

Reserve Life Index

19.58

25.02

26.85

21.52

21.45

Assumed RLI for NPV calculation

20.00

25.00

27.00

22.00

21.00

As the above table shows, Linn was able to increase reserves every year since 2009 and increase them on a per unit basis. It is obvious that the huge and increasing capex expenditure has been successful in growing the company and growing the amount of "assets in the ground" per share.

Debt

The increases in the debt each year is part of the true cost of increases in reserves. Without borrowing money each year since 2008, there would have been declines of reserves and production.

Linn Energy

Data from the LINE 2012 or 2010 10K SEC Report

Balance sheet data: DEBT

2012

2011

2010

2009

2008

Long-term debt

6,037,817

3,993,657

2,742,902

1,588,831

1,653,568

net long-term debt/ unit

$ 29.63

$ 23.22

$ 19.24

$ 13.32

$ 14.49

Added debt/unit

$ 6.41

$ 3.97

$ 5.93

-$ 1.17

The years in which reserves increased were accompanied by an addition of $16.31 in debt, with $6.41 being added, per unit, last year. Each unit of LINE (closed at $33.51 Monday, June 24, 2013) now comes with $29.63 in debt (and they plan on assuming another $2.2 billion in liabilities with the BRY acquisition).

The question that determines whether LINE is a sustainable or, better yet, a growing company is simple: Does the borrowing to fund capex and dividends actually produce more value for a unit-holder than the added debt?

Total Value Added

The formula is simple. On the positive side, we have dividends and any increased value created by adding reserves. The question is whether these benefits are greater than the debt added.

To find the value of the reserves, you need to calculate the net present value of their eventual production, based upon the average amount of cash Linn would have netted in the year the reserves were added. A reasonable assumption is that the new reserves are produced over the reserve life of the company starting at an initially high rate and declining. I therefore calculated the reserve life Index and used an 8% to 11% decline rate to distribute the income over time. I ran the numbers twice; once with a net present value discount of 10% and then again with the discount at a more demanding 15%.

Linn Energy NPV = 10% discount

2012

2011

2010

2009

NPV (10%) of New Reserves Added/share

$5.79

$3.94

$3.29

$0.13

Distributable cash/ unit (includes premiums paid for hedges)

$3.15

$4.49

$1.14

-$0.79

Less Change in Amount of Debt/unit

$ 6.41

$ 3.97

$ 5.93

-$ 1.17

TOT. VALUE ADDED (NPV10%): Distrib.Cash+Reserves-debt/share

$2.53

$4.45

-$1.49

$0.51

Dividends as % of total value added (NPV10%)

113%

61%

-171%

496%

To calculate the total value added per share, I added the net present value of added reserves to the amount of distributable cash and subtracted the addition debt. That debt represented the borrowing required to spend much more in capex than was coming in. The new shares sold in each of the years are covered in the per share unit calculations for production and reserve growth.

For the net present value 10% scenario, LINE failed to create more value than it added debt in three of the last four years. It lost value in every year except 2011, including last year.

Linn Energy NPV = 15% discount

2012

2011

2010

2009

NPV (15%) of New Reserves Added/share

$4.65

$3.07

$2.57

$0.10

Distributable cash/ unit (includes premiums paid for hedges)

$3.15

$4.49

$1.14

-$0.79

Less Change in Amount of Debt/unit

$ 6.41

$ 3.97

$ 5.93

-$ 1.17

TOT. VALUE ADDED (NPV15%): Distrib.Cash+Reserves-debt/share

$1.39

$3.59

-$2.22

$0.48

Dividends as % of total value added (NPV15%)

207%

75%

-115%

524%

As expected, using a 15% discount factor (i.e., requiring a higher return) made the results look even worse. The only good year was 2011, once again -- the only year LINE added more value than it added in debt. Optimists may assume that land values and the addition of probable reserves may have added enough value to a net increase in value added in the years when value declined because of increased debt. Regrettably, I have no hard data supporting that assumption and the shortfall is not small in the aggregate.

I am left to conclude that the company has had one good year in the last four and that the risk here is from a business plan that requires an increasing amount of borrowing to fund an increasing amount of capex each and every year. While it is obvious that management knows where and how to drill to increase production and reserves on a per unit basis, the business plan remains faulty because they have to borrow too much money to fund much of capex and all of their dividend.

You can say it another way and assume that they pay the dividend and borrow the capex, but it makes no difference. When they reach the borrowing limits of their assets, which are increasing slower than their debts, they can switch to selling more equity, but that will likely reduce production and reserves per unit. Capex needs are mounting and if they stop issuing debt, they are going to need to issue a lot of shares to counter normal production decline, much less increase production and cash flow.

Strategy

It is apparent that Linn Energy's business plan is to continue to borrow to spend. Their increasing capex and production demand they spend more each year, or start to see reserves and production shrink. Their unit-holders presumably prefer they pay the dividend, even though they have to borrow it, although my impression is that LINE has convinced unit-holders that the company only borrow to grow the business. If you pay the dividend in cash but then have to borrow three times as much to drill, it is not significantly different than borrowing to pay the dividend.

It seems obvious that LINE would have to borrow about a half-billion less if they did not pay the dividend, but that would disappoint unit-holders who are really invested for the dividend. Without a dividend, they'd sell. Is there a fix for Linn Energy's problem?

Acquisition: A Way Out?

One of the ways high dividend-paying MLPs and non-static petroleum trusts try to break out of the downward spiral is to buy another company with lands and opportunities that can be exploited. Linn Energy is now part way through the process of buying Berry Petroleum (BRY). LINE management thinks this is a very good deal and that it is accretive.

So far, I have confirmed that BRY is accretive to production. On the other hand, BRY has growing debt and no real reserve growth. LINE has promised to increase the dividend of the Berry shareholders about 1200%, from 32 cents to $3.85 ($3.08 for the 1.25 shares of LINE for each of their shares of BRY). It seems to me that Linn Energy has just significantly increased their dividend costs. I wonder whether LINE management of the BRY asset will likely increase production and reserves enough to justify the acquisition expense and the added liabilities. I hope to have a full value-added analysis completed within a few days.

So far, it looks like a great deal for Berry shareholders.

Source: Linn Energy: Added Debt Is Greater Than The Dividend Plus The Reserve Addition Value