Under the terms of the original all-equity deal announced Feb. 21, 2013, investors in Berry Petroleum would receive 1.25 shares of LinnCo LLC (NSDQ: LNCO), a C corporation whose sole asset consist of shares in Linn Energy.
The day before the three parties announced the initial deal, LinnCo fetched $36.99 per share and Berry Petroleum went for $38.60 per share; the proposed acquisition price of $46.25 represented a 20 percent premium--ample inducement for Berry Petroleum's shareholders to approve the transaction.
But things began to unravel when Hedgeye Risk Management adopted Bronte Capital's criticism of the upstream operator as its own and waged a savvy (and unsavory) media campaign to publicize this view. This criticism of how Linn Energy accounts for the puts in its hedge book and allegations that the master limited partnership (MLP) overstates its maintenance capital gained traction after Barron's published a series of articles by Andrew Bary that borrowed heavily from Hedgeye Risk Management's research.
The nadir for Linn Energy came on July 2, when the limited liability company (LLC) voluntarily disclosed that the US Securities and Exchange Commission's (SEC) regional office in Fort Worth, Texas, had launched an informal inquiry into the two companies. At that point, the regulator had asked the firms to preserve documents and communications related to the proposed merger with C corp Berry Petroleum and its hedging strategy.
Although the SEC investigation shouldn't have come as a complete surprise given complexity of Linn Energy's acquisition of Berry Petroleum and the heated public debate about the upstream MLP's accounting practices, we warned investors against treating this announcement as a confirmation of the bearish argument against the stock.
By October, the proposed deal appeared to be on thin ice. On Oct. 31, 2013, shares of LinnCo closed at $29.49, implying a takeover price of $36.86 per share of Berry Petroleum. Meanwhile, Berry Petroleum's strong earnings results pushed the stock to almost $48.00 per share in late October. At that juncture, Linn Energy's takeover of Berry Petroleum had turned into a take-under and was clearly at risk of failure at the existing terms.
The Real Issues for Linn Energy: NGL Prices and Hogshooter Results
Believing that panic is always the worst possible reaction, we counseled investors to hold their position in Linn Energy at a time when many others advised bailing out.
My colleague Roger Conrad and I reiterated on numerous occasions that Barron's and Hedgeye Risk Management's attacks on Linn Energy glossed over the real driver of the upstream operator's disappointing quarterly results.
In A Deep Dive into Linn Energy LLC's Disappointing Second Quarter (an Alert issued exclusively to Energy & Income Advisor subscribers), we argued that the issues plaguing the company had nothing to do with accounting. Rather the upstream operator's distributable cash flow had come under pressure from two headwinds: a precipitous decline in NGL prices and poor well results in the Hogshooter play.
In the second quarter, Linn Energy's NGL price realizations declined by $6.69 per barrel, to $26.69-well off management's assumption of $34.02 per barrel. If NGL prices had met Linn Energy's expectations, the firm's revenue would have been $17.8 million higher. This challenging price environment accounted for the majority of Linn Energy's distributable cash flow (DCF) shortfall in the quarter.
The second major problem facing Linn was the underperformance of its Hogshooter wells in Texas. The partnership drilled a total of 28 wells in this region in the latter part of 2012 and early 2013; the first half of the wells performed well but the second half fell well short of expectations.
Management announced a credible strategy for addressing these issues over the summer and began shifting capital away from the Texas portion of the play to the Oklahoma side of the border where results have been far more consistent.
The company also highlighted its potential to grow crude oil production by targeting the Wolfcamp Shale formation in its Permian Basin acreage. Whiting Petroleum (NYSE: WLL) and other operators have posted strong well results in the region, and Linn Energy holds acreage near the heart of the basin. A successful campaign in the Wolfcamp would boost high-value oil production, helping to blunt the company's exposure to NGLs prices over time.
Linn Energy's third-quarter results demonstrated that the company's strategies to address its cash flow shortfall have begun to bear fruit. The firm changed the way it accounts for hedges and maintenance capital to address some of the concerns raised by Hedgeye Risk Management and, quite likely, the SEC. Under this new methodology, Linn Energy covered its monthly distributions for this three-month period by 1.01 times, generating $2.293 million in excess cash flow.
Third-quarter production of 823 million cubic feet of natural-gas equivalent per day slightly exceeded Linn Energy's guidance. Management reiterated its projection for the MLP production to average 850 million cubic feet of natural-gas equivalent per day in the fourth quarter.
Linn Energy also plans to begin drilling its first operated wells in the horizontal Wolfcamp in late 2013 or early 2014.
Moreover, Linn Energy's third-quarter results didn't factor in contributions from the upstream operators' $525 million acquisition of acreage in the Permian Basin that's home to 124 producing wells.
Crude oil accounts for about 70 percent of the production and reserves acquired in this deal, and management indicated that these properties contained another 300 low-risk drilling locations.
This transaction, which is expected to close by year-end, should also help to boost the percentage of crude oil in Linn Energy's overall production mix.
Barron's and Hedgeye Risk Management Were Wrong
The SEC pursues informal inquiries privately. If the staff decides not to escalate the investigation to the formal stage, the subject of the inquiry is rarely informed of this decision--the matter simply drops.
Accordingly, investors shouldn't necessarily expect Linn Energy to announce that the SEC has halted its informal inquiry.
However, mounting evidence suggests that the SEC's informal inquiry won't become more serious. Not only did Linn Energy in September announced a $525 million acquisition in the Permian basin, but the upstream operator also issued a press release stating that the SEC had "no further comments" on the sixth amendment to the S-4 filing related to the proposed acquisition of Berry Petroleum.
It's inconceivable that the regulator would effectively sign off on the blockbuster deal if staff had questions about Linn Energy's accounting practices.
When Linn Energy amended the terms of its planned acquisition of Berry Petroleum, the bears' argument against the stock collapsed. Based on LinnCo's closing prices of $33.21, the takeover bid values Berry Petroleum at $55.80 per share--a 15 percent premium.
Linn Energy has indicated that the acquisition of Berry Petroleum will still be accretive to the LLC's cash available for distribution. Given Berry Petroleum's oil-weighted production mix and reserve base, the transaction will help to reduce Linn Energy's exposure to weak NGL prices.
When the LLC first announced the acquisition, management indicated that the publicly traded partnership would boost its annualized distribution to $3.08 per unit from $2.90 per unit. The higher exchange ratio associated with the deal suggests that Linn Energy could wait a few quarters after the deal closes to boost its monthly payout. However, the transaction will shore up the MLP's distribution coverage and dramatically reduces the risk cut its disbursements to unitholders.
If the acquisition closes and the integration of these assets proceeds smoothly, expect Linn Energy to hike its quarterly payout at some point in 2014.
Linn Energy's announcement should also act as an upside catalyst for other upstream MLPs, a group that has lagged the Alerian MLP Index significantly this year. (See MLP Performance: Upstream and Downstream Operators Take Their Lumps.) Concerns that Linn Energy's alleged accounting improprieties could extend to other names in the space has weighed on their stock prices.
Linn Energy's recent announcements strongly suggest that the SEC has cleared the LLC's accounting practices, a development that should carry a great deal of weight with investors; during the informal inquiry, the regulator undoubtedly had access to far more detailed and complete financial information than what's available in the public sphere.
Investors should also regard this news as a welcome development for Kinder Morgan Energy Partners LP (NYSE: KMP), a name that Hedgeye Risk Management claimed is "a house of cards on the verge of collapse." My colleague Roger Conrad and I disputed the validity of this dubious attack in Kinder Morgan Energy Partners: Not a House of Cards and Kinder Morgan Energy Partners: Reality versus Hyperbole.
Want to learn more about our favorite names in the North American energy patch? Roger Conrad and I will host a free webinar on Nov. 21 highlighting our favorite oil and gas producers. You can also check out a free replay of a webinar that Roger and I conducted about our top MLPs for 2014 and beyond.