Let me be clear. This article will be much shorter than my average tome. But, it will be an important piece. You see, a lot of controversy has come up over the deal between Linn Energy (LINE), the main operation of Linn Co. (LNCO) and the huge merger with Berry Petroleum (BRY). In my last piece on LINE, LNCO and BRY, I wrote that the merger will indeed be a catalyst.
Without a large repetition of what was in that article, I want to reiterate the highlights of the piece to provide context for the controversy I will address. We recently learned (see this press release) that the final Registration Statement on Form S-4 had been declared effective by the Securities and Exchange Commission and that LINE, LNCO and BRY have now filed definitive proxy materials with the Securities and Exchange Commission. The deal now has to move each company's respective unitholders for a vote on whether to bless the merger. LINE, LNCO and BRY will hold meetings on December 16, 2013 and ultimately the votes will be cast and tallied. I view the deal as important for LINE and LNCO because BRY is heavily involved in oil production. LINE will assume all of BRY's impressive assets including over 3,000 producing wells covering more than 200,000 acres of land. Given the location of BRY's assets and operating wells, the deal will help LINE expand its growth into markets in California, Texas, the Permian Basin and the Uinta Basin. With BRY's annual production numbers, LINE could see an increase in production anywhere from 20%-40%. What's more, about three quarters of BRY's reserves are in oil. Thus this merger will increase LINE's liquid oil exposure by approximately 16%-17% on a relative scale. Production will grow, revenues will rise, and ultimately distributions to unitholders should rise.
So where is the controversy? Well, it all stems from the increased cost of the deal. Recall that on Monday November 4th, LINE and LNCO raised the bid for the BRY merger. Many were questioning if LINE was desperate to get the deal done. Why would investors and readers here on Seeking Alpha think this would be the case? The reason is that there is a standing belief that LINE and LNCO have to keep acquiring and merging in order to grow; there is a growing belief that they cannot grow organically. I believe there is some truth to this, but my prior analyses have suggested with existing operations, the distribution could decline slightly but is safe. So what are the details of the increased bid? Well first off, the share ratio of the transaction jumped 34% from 1.25 to 1.68 LNCO shares per BRY share. At the time of this announced increase, the deal was a premium to where both stocks were trading. Ever since the deal was first announced, BRY shares have traded 1.3 to 1.6 times that of LNCO. So, there is a fear that LNCO and LINE are simply overpaying for the deal.
Costs Versus Benefits
I do not think LINE and LNCO are overpaying. The 34% premium to the original deal gives investors that 'sticker shock' feeling. However, we need to look at the full cost of the deal not just the share offering piece of the merger. Recall that when first proposed, the deal totaled about $4.3 billion and was comprised of LNCO equity, cash and assumption of the debt/assets of BRY. When I do a paper napkin cost estimate, which seems to be fairly accurate, the adjustment of the equity transfer ratio slides the total deal cost up to $4.9 billion. On a relative scale, the deal is less than a 15% increase over the original terms. So as opposed to the deal being phenomenal for the master limited partnership, its now only a very good deal. Remember, this merger will increase LINE's liquid oil exposure by approximately 16%-17% on a relative scale and as such, production will grow, revenues will rise etc. Knowing the status of the amount of oil LINE stands to gain from this deal is key. LINE will gain approximately 270 to 280 MMBOE, which translates to costs of approximately $17.50 to $18.50 per barrel of oil equivalent being paid. It is true that this increase in the deal is expensive, as the $17.50 to $18.50 price per barrel cost is up from the $15.25 to $16.00 per barrel cost under the original deal.
But what about past deals? For example, the recent Permian acquisition that I wrote about earlier this year for $525 million, increased oil by roughly 30 MMBOE at costs around $17.40 to $17.65 per barrel. Historically, most of LINE and LNCO's oil related deals have been between the $16.50 and $17.50 range. That recent Permian acquisition for $525 million led to a cost of ~$110,000 per flowing barrel. The original deal with BRY was well less than $110,000 per barrel. With the new deal, the costs will increase to around $115,000 to $120,000 per flowing barrel. So yes, there is an increased cost, but given historic transactions, I cannot agree with critics that LINE and LNCO are paying too much for the BRY merger. In my opinion, the acquisition of all of BRY's 3,000 producing wells and the subsequent increase in LINE's production of anywhere from 20%-40% far outweighs the increased costs. The new terms sweeten the deal for BRY shareholders to vote "yes."
Before closing, I should caution that oil appears to be trending lower. This will pressure margins if the trend continues into summer 2014. It is possible that the return on this investment will not be realized for several quarters or more. However, in the long-term, this deal is cost effective in my opinion. I expect the merger to occur, and with it, a bounce in the price per unit of LINE and LNCO.
Disclosure: I am long LINE. 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.