Another boring quarter from Linn Energy (LINE, LNCO). And as an investor who weathered through all the horrors of last summer, I'm actually enjoying the uneventfulness.
Not surprisingly, the first thing on everyone's mind is the integrity of Linn's distributions. This quarter, the metric formerly known as distributable cash flow came out to 0.9875 times distributions. While that number is below par, and there certainly is little room for error here, this coverage ratio is not so bad when one considers that organic production is growing steadily and that the first quarter often tends to be the weakest for North American energy companies.
Concern would be warranted if Linn's coverage was in the 0.8s or low 0.9s, as a number of other upstream MLPs, such as Vanguard, have reported. But Linn Energy is off to an OK start, and with a coverage ratio about 0.99 times, Linn does not have such a big hurdle to jump. I am more than confident that Linn can make up for this small shortfall in Q2 and Q3, for a couple of reasons.
- Organic production growth - This quarter, management reported production growth consistent with its goals for the year: 3%-4%. Not surprisingly, this production growth was led by the Uinta Basin in Utah and the North Midway-Sunset in California, both of which are former Berry properties. While it is tempting to claim that Linn paid too much for Berry, it is really much too early to tell.
- Movement away from high-decline assets - Management is reducing capital expenditures in higher decline acreage, namely, the Jonah gas field. In the long run, doing so will reduce overall decline.
- Reduction in capital intensity - Linn Energy's specialty is definitely not horizontal shale drilling. Shale drilling is capital-intensive and not really appropriate for distribution - maximizing upstream MLPs. That's why Linn is looking to sell off or swap the Permian shale acreage it acquired in the Berry Petroleum deal. Linn hopes to swap that acreage for mature Permian waterflood or CO2 flood acreage. This will either add profitable production or raise much-needed cash for debt-reduction.
Berry operations "optimized already"
When asked about further cost synergies, management implied that Linn had already squeezed out all the synergies it could. Much of the cost benefit realized from the Berry transaction was the movement of capital spending from high-decline areas into higher-growth areas or high-margin, low-decline areas such as the Permian and South Midway-Sunset.
Puts to swaps
Linn continues to have the most conservative hedging strategy among its upstream MLP peers. However, CFO Kolja Rockov quipped that 100% coverage will be "less important" as the company grows in size. Linn's hedging strategy has switched from puts to swaps. The company now has more low-cost or no-cost swaps, which have little to no upside. Puts, which on their own limit the downside but allow for unlimited upside in realized price, account for only 41% of total gas hedges and 16% of oil hedges. However, management is not afraid of adding more puts, should pricing become more favorable.
Distribution growth ahead? Not anytime too soon.
In the question and answer portion of yesterday's conference call, management said that before it would consider distribution increases, coverage must first reach 1.1 times distributions. The good news in that announcement is that management is interested in providing some kind of cushion for distributions, where it has traditionally not done so. The bad news is that distribution growth is not likely until 2015, and distribution growth may not even happen then.
This was a "boring" quarter from Linn, but that is just fine by me. Management is confident in its goal to meet coverage targets for the year, and thus far, it seems that management will achieve this goal.
Did Linn overpay for Berry? It's far too early to tell. While some on Seeking Alpha are now decrying the acquisition, investors will enjoy the steady organic production growth which that acreage provides. I believe that we will know whether the Berry acquisition was worth it by the time Linn gives 2015 guidance.
Although there will be no distribution growth in 2014, LINE's 10.1% yield and LNCO's 10.5% yield more than make up for the lack of growth, in my opinion. Overall, I give Linn's quarter a B-; a big improvement over last quarter's C-. Those who are long Linn should continue to hold. Those looking for a meaningful way to build income should consider Linn one option among other upstream MLPs.
Disclosure: I am long LINE, LNCO. 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.