In the upstream (E&P) MLP sector, Linn Energy (LINE) is most definitely the 800 lb. gorilla as the company is by far the largest and most well-known stock in the sector. However, Linn Energy has also been the target of a series of bearish attacks which have added increased price volatility to the stock. To make matters worse, Linn Energy has also disclosed that the SEC has commenced an informal inquiry regarding its planned merger with Berry Petroleum (BRY), its use of non-GAAP financial measures, and hedging strategy. Linn Energy has also recently implemented its previously announced monthly distributions and reported a not very well-received Q2 2013. Linn Energy's last declared distribution was for $0.2416 per unit, or $2.90 annually, which at current prices equates to an 11.70% yield.
Q2 2013 Overview
On August 8, Linn Energy reported its Q2 2013 results. For the quarter, Linn Energy posted revenues of $838.8M, up 5% from the $800.6M last year. However, oil, natural gas, and NGLs sales, which excludes the impact of derivatives and other items, were $488.2M, up 40% from the $347.2M last year. Adjusted EBITDA, which is a non-GAAP metric often used in the MLP sector, came in at $362M, up 14% from $319.0 last year.
Distributable cash flow ("DCF"), which is basically adjusted EBITDA minus interest expense and maintenance capital expenditures, came in at $152M, up from $139.5M last year. However, on a per unit basis, DCF declined to only $0.65, down from $0.70 per unit last year. Linn Energy's DCF coverage ratio was therefore only 0.89X in the quarter. This resulted in distributions paid to unitholders exceeding DCF by over $18M in the quarter, compared to a $5M shortfall last year.
Ethane Rejection Continues to Hinder Results
A large factor in Linn Energy's disappointing results lie in operational issues. Linn Energy reported production volumes of about 780 MMCFE/D, up 24% from 630 MMCFE/D last year. However, this production was well below guidance and even below Q1 2013 levels. The company noted that several of its capital projects, especially its Jonah Field, were impacted by ethane rejection due to the low price of ethane. In total, ethane rejection resulted in a 6 MMCFE/D decline in quarterly production. Also impacted results were infrastructure issues in the Permian Basin, an asset divestiture, and poor performance in a Texas oil field. Do note that Linn Energy mentioned that its current production levels have improved. For July 2013, Linn Energy's production averaged about 815 MMCFE/D, a 5% improvement quarter-on-quarter.
However, if current prices continue, ethane rejection will have a serious impact on Linn Energy's Q3 and Q4 2013 production levels. As shown below, the projected level of ethane rejection for Q3 2013 is estimated to be about 10 MMCFE/D. For Q4, this jumps to about 26 MMCFE/D.
DCF and Coverage Trends
As noted above, Linn Energy's coverage ratio declined to 0.89X for the quarter. YTD, Linn Energy's coverage ratio has now averaged about 0.885X. This is clearly not a sustainable trend. In dollar terms, this means Linn Energy has paid out nearly $40M more in distributions than it has received in DCF. For the past six quarters, Linn Energy's coverage ratio has been fluctuated wildly, but has trended downwards in recent quarters. To get a better picture of Linn Energy's current situation, a look at its DCF, adjusted EBITDA, and distributions paid is warranted.
Below, we can see that Linn Energy's adjusted EBITDA peaked in Q3 2012. That same quarter DCF also peaked. In essence, Linn Energy is earning less now with more production than it did in 2012 with lower production which point towards operational or capital efficiencies issues.
While Linn Energy's last quarter was subpar, the company did paint a rosy picture for the latter half of 2013 in its conference call. For Q3 and Q4 2013, Linn Energy now anticipates production to average 820 MMCFE/D and 850 MMCFE/D, respectively. Do note that this updated guidance does not take into account the pending Berry merger nor any impact from ethane rejection.
As shown above, one major area for concern is regarding the estimates for Linn Energy's DCF and coverage ratios for Q3 and Q4 2013. The company anticipates its coverage ratio to be 0.87X for Q3 2013 and 0.95X for Q4 2013. This is clearly not a good sign as it would indicate a coverage ratio below 1.00X for all four quarters of 2013. Assuming the current share count, this would also indicate that Linn Energy would pay out about $35M more in distributions than it received in DCF for the latter half of 2013, for a full year total of $75M.
Linn Energy's continued struggles have had a chilling effect on the entire upstream MLP sector. Once the SEC inquiry was announced, every stock in the sector suffered a sharp correction. However, most have since recovered from this decline. The same cannot be said in regards to Linn Energy or its dividend-paying peer Linn Co. (LNCO).
Apart from the SEC inquiry and bear attacks, Linn Energy seems to be suffering from operational issues. While ethane rejection has played a part, Linn Energy is just not executing well on its capital program. Production has been lackluster for two straight quarters, which makes the company's claims of improvements in Q3 and Q4 hard to believe. Also troubling is the updated guidance, which points towards a very weak coverage ratio even with this extra production.
It is my opinion that Linn Energy needs Berry's assets to achieve any sort of stability in the stock. This is not generally a good situation to be in. According to the merger documents, Berry owners are to receive a fixed amount of Linn Co. stock (1.25 shares of LNCO for every 1 BRY share). However, Linn Co. stock price has fallen so much that there is now no premium to be had. Indeed, at current prices, Berry owners would actually lose 16%. Given its numerous ongoing issues, owning Linn Energy or Linn Co. carries very high risk. So much risk that even an 11% does not seem to be nearly enough of a reward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long the upstream MLPs QRE, MEMP, and VNR.
Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.