Linn Energy (LINE) is a leading upstream MLP which has completed a year that it will long remember. While the company has grown from organic growth, it is better known for making 60 acquisitions worth $15 billion since its IPO in 2006. However, 2013 was a turbulent year as shown below.
Linn Energy - 2013
Early in 2013, there were negative articles in the press and online questioning its accounting treatment for its hedging activity and faithful LINE investors were severely tested. As a result of the controversy, the SEC requested financial documents from LINE regarding its accounting and on a proposed merger with Berry Petroleum (BRY), creating doubts about the merger. LINE plunged from the 40s to a low of 20 at a start of July. Since then, the units stabilized around 30 when a sense of relative calm returned.
Many of the writers of negative articles were short LINE, giving them a bias. They must have made millions and it's hard to understand their motivation besides making money. Following the plunge at midyear there was hardly a peep from those shorts. During this turbulent period, prominent investors and financial analysts gave support to LINE management.
Midstream MLPs move oil and gas from the source in the ground to destination markets. Their assets are largely pipelines and terminals used for storage. Unlike most MLPs, LINE is an upstream MLP that extracts energy from the ground using fracking technology. To help plan for the future it uses hedges (as do many corporations that deal in commodities) to lock in future selling prices. Accounting for hedging gets complicated and that caused problems for detractors. They said income was overstated which would lead to cuts in the distributions going forward.
In October 2012, LINE augmented its equity with a $1.2 billion offering of LinnCo (LNCO) shares. Each share of LNCO is backed by one unit in the partnership and the dividend (paid in stock) is based on the distribution. The 2012 dividend was not taxable and the taxable portion of this year's and future dividends is guided to be less than 10%. The offering raised funds for operations and provided a security for purchasing energy corporations, such as BRY.
When the BRY merger was proposed, LINE offered 1.25 shares of LNCO for each share of BRY. After the price relationship changed, the ratio was increased to 1.68 LNCO shares. At stockholder meetings two weeks ago, the LNCO-BRY merger was approved by both companies. The protestors, who had been so vocal months earlier, did not contest the merger.
BRY will be accretive to Linn Energy. BRY production in Q3 grew 20% over the prior year with almost 80% coming from oil. BRY mature assets have a life of 18 years with reserves of 630 million barrels of oil equivalent (MMBoe). BRY strategy is to grow oil production 10%-15% annually while generating high operating margins to increase cash flow (above 10% annually). LINE reserves are 832 MMBoe (47% oil) and now LINE + BRY reserves are 1,100 MMBoe (54% oil). The BRY merger increases market value of LINE/LNCO from $7 billion to $10 billion.
LINE continued its acquisition ways despite doubts created by some investors. In September it agreed to pay $525 million (financed with a loan) for the East Goldsmith Field in the Permian Basin (in western Texas). That closed October 31. It has proved reserves of 30 MMBoe with about 70% in oil. The reserves are expected to last 17 years with 124 producing wells on 6,250 acres.
LINE continues to use hedging. It is hedged on expected natural gas production through 2017 and on expected oil production through 2016. BRY is 90% hedged on expected oil production for 2014.
During this turbulent year, LINE energy business has been moving forward. LINN reiterated Q4 estimated production guidance of 840-860 millions of Cubic Feet Equivalent Per Day (a gas exploration measure). Management is standing by its forecast of organic production growth for 2013 of 8%-10% (in spite of severe winter weather). Updated Q4 for "excess of net cash" made at a December presentation said it is expected to be 5%-10% above the current distribution, compared to previous guidance of 0%. NGL prices continue to increase and the company is continuing to reduce operating expenses. BRY 2013 production is expected to be 40.8 MBoe/d, representing the high end of its previously updated guidance. This leads to improving the distribution stability following excess net cash in Q3.
The chart below for LINE describes its history, although it is too busy for my taste because it includes oil and gas prices. The vertical blue bars are distributions which have been paid quarterly until mid-year when the distribution/dividends were changed to monthly payments. Notice that there were no reductions in 2009 during the last recession.
Since the IPO, the performance for LINE units has been impressive as shown in the chart below. LINE (yellow line) has beaten popular averages (2 of the 3 lines on the lower level) and it did well against the Alerian MLP Index (AMZ) until the volatile period in 2013. But recently it caught up with AMZ which has been going sideways for 9 months.
LINE and LNCO are still offering 9½% yields because naysayers continue to sell these securities. At December 13, the short position for LINE was almost 13 million shares, the highest level in the last year (one business day before the LNCO-BRY merger was approved). The management purchased 355,000 shares on December 17, the day after the merger was approved.
I have written several articles about LINE and still like their securities for the high yields and growth in distributions/dividends. My LNCO dividends have been reinvesting to buy more shares for 3 reasons:
First, management survived a very significant turmoil. Detractors were saying that management didn't know what it was doing, and that's being kind. Its credibility was called into question, but the SEC had no comments after its investigation and independent analysts gave favorable reviews. Secondly, LINE continued its acquisition program despite disruptive legal and government challenges. More acquisitions and internal organic growth will bring increased cash flow. And third, the 9½% yield feels good at a time when a 3% yield is considered "good" for a quality stock or the 10-year Treasury bond. A 10% rate of return is a popular target rate for many investors and the compounding effect with stock dividends and reinvested distributions is a bonus.
Of course, high yields bring added risk. That and a high short position are discouraging to some. There are doubters about management's ability to earn enough to support the distribution. But management has delivered earnings and will continue going forward. When a 9½% yield is reinvested, the market value and annual income will double in less than 8 years. LINE and LNCO are for brave investors who accept risk for high yield and rising income at a time when the Dow faces a nearly impossible task of replicating the 25% advance in 2013.