- LINE/LNCO's acquisition of Berry Petroleum has improved its financials significantly.
- LINE has approximately 55,000 net development acres in the Midland Basin that it plans to spend $275 million in CapEx on in 2014.
- LINE management is indicating that it would like to do a 1031 like kind exchange for more mature assets.
- If LINE manages a like kind exchange, that should have a highly positive impact on its cash available for distribution.
- LINE's apparent net loss in Q1 2014 appears to be a mirage created non-realized derivatives losses that seem likely to be regained over time.
Linn Energy (NASDAQ:LINE) is an oil and natural gas MLP. Its mission is to acquire, develop, and maximize cash flow from a growing portfolio of long-life oil and natural gas assets. It has a diverse asset base with core focus areas in the Mid-Continent, Granite Wash, Permian, Basin, Hugoton Basin, Rockies, Michigan, California, and East Texas. Recently Linn Energy and LinnCo (NASDAQ:LNCO) merged with Berry Petroleum. LNCO gave Berry Petroleum 1.68 shares of LNCO for each share of Berry Petroleum. LNCO then contributed its interest in Berry Petroleum to LINE in exchange for the issuance of LINE units. LNCO is essentially a pass through company that owns interests in LINE. LNCO pays standard dividends (not distributions as LINE does). With this addition (Berry Petroleum), LINE has proved reserves of approximately 1.1B Boe (54% liquids). The deal completed December 16, 2013. LINE pays approximately a 10.1% annual distribution/dividend. LINE provides K-1 Tax support on its web site or by calling (800)-203-5179.
As part of the Berry Petroleum (BRY) merger (and partly as part of other deals), LINE acquired an approximately 55,000 net acre position in the Midland Basin that is prospective for Wolfcamp drilling. The problem with this is that LINE likes assets that are already mostly developed and producing. That way the assets are immediately accretive to earnings and cash flow. In contrast LINE is planning on spending $275 million on developing its Midland Basin assets in FY2014.
An incentive for LINE to do a 1031 like kind exchange for the Midland Basin property is that newly developed oil and gas wells tend to have steep decline curves over the first two years of production. The rapid decline trends of new wells tend to skew LINE's overall decline figures to the upside, which makes LINE look worse than it is to its investors. LINE would naturally prefer to look continuously good to its investors.
Citigroup's Faisel Khan and Vikram Bagri estimate that LINE's Midland Basin package may be worth $2.0B. They base this estimate mostly on a recent purchase of 23,000 net acres in the Midland Basin by Athlon Energy (NYSE:ATHL) for $873 million.
LINE had an enterprise value of $18.78B as of May 7, 2014. It had a distribution of approximately $240 million for Q1 2014 (or about $12.78 million per billion dollars in enterprise value). As a ballpark figure I estimate that it would have approximately another $25 million in payout if it exchanged the above Midland Basin property for more mature assets.
On top of that it would get rid of its $275 million CapEx need for the Midland Basin property. LINE currently has a FY2014 CapEx of about $1.55B for its $18.78B enterprise value. If you subtract the $275 million from the CapEx and the $2B from the enterprise value, you get a CapEx of approximately $1.275B for $16.78B of enterprise value (or about $76 million per $1B in enterprise value). If you estimate a like CapEx for a mature replacement, you get a total 2014 CapEx of about $1.427B. This is a savings of about $123 million. When you add the increased payout figure of approximately $25 million to this, you get a benefit to net cash of approximately $150 million.
My working assumption is that the production level of the swapped properties will be about the same as that of the Midland Basin properties. However, it seems likely that a mature property would have higher production. This would add further to the total production and to the gain in cash available for distribution. Such a benefit would easily put LINE into strongly positive territory in its distribution coverage ratio.
LINE only missed full distribution coverage in Q1 2014 by approximately -$3 million, which was a large improvement over its -$20.4 million miss in Q1 2013. Still it is easy to see why LINE would like to do a like kind exchange of its Midland Basin development assets for more mature assets. Even a partial exchange one would be greatly beneficial to cash available for distribution. LINE is considering partial deals too. It has 180 days after any full or partial Midland Basin direct asset sale to make a like kind exchange deal (buy something to replace it in order to avoid extra taxes). Since LINE is perpetually considering new properties, this should not be hard to accomplish. LINE has already screened 48 acquisition opportunities. It has already bid on 6 transactions for approximately $5.5B; and the year is young yet.
The map and data below more fully describe the 55,000 net Midland Basin acres.
The chart below shows LINE's acquisition history over the last four years.
LINE should have no problem doing a $2B like kind exchange (or a sell and then a buy serving as an exchange).
LINE expects full distribution coverage for FY2014. It expects 3%-4% organic growth in production. LINE increased average daily production 39% to approximately 1,104 MMcfe/d for Q1 2014 year over year. LINE increased oil, natural gas, and NGLs sales by 103% to $939 million year over year. LINE grew net cash provided from operating activities to $434 million for Q1 2014 from $335 million for Q1 2013. It decrease its shortfall of net cash to approximately -$3 million for Q1 2014 from -$20 million for Q1 2013. LINE still had a net loss of $85 million (or -$0.27 per unit) for Q1 2014. However, this number includes a reduction in put option premium over time of approximately -$219 million (or -$0.67 per unit) of unsettled derivatives. Given that oil prices are higher than fundamentals dictate, those put options seem likely to regain their lost value (or most of it). Some attribute the high oil prices to the unrest surrounding the Ukraine. If this is true, LINE did not really lose any money in net terms in Q1 2014. With the current LINE/LNCO distribution/dividend of $2.90 per unit or share, the above all make LINE and LNCO solid buys.
The two year chart of LINE provides some technical direction for this trade.
The slow stochastic sub chart shows that LINE is neither overbought nor oversold. The main chart shows that LINE is just starting to recover from its attack by the hedge funds last year. As part of that it was accused of accounting shenanigans. However, it brought its accounting up to full compliance with the SEC before the Berry Petroleum deal was allowed to go through. That is no longer an issue; and the SEC never accused LINE of any accounting fraud. It was more a case of LINE not doing everything in exactly the way the SEC wanted.
The two year chart of LNCO provides some technical direction for this trade.
The slow stochastic sub chart shows that LNCO is neither overbought nor oversold. The main chart shows that LNCO may finally be recovering from the downturn mediated by the events described above for LINE.
Both LINE and LNCO appear to be good investments. A like kind 1031 exchange of LINE's Midland Basin 55,000 net acres for more mature assets would put LINE/LNCO firmly into more than complete distribution coverage for FY2014. When you consider that LINE will likely do other deals, which will be accretive to distribution cash, LINE's distribution looks very safe. In fact it seems likely to grow nicely in 2014.
CAPS gives LINE a four star rating (a buy); and it gives LNCO a five star rating (a strong buy). The mean analysts' recommendation for LINE is 2.4 (a buy). For LNCO it is 2.3 (a buy). With virtual universal approval of these stocks, investors will not go too far wrong buying either. Don't forget the 10.1% distribution/dividend.
The only real concern is the overall market. Many think the overall market may be in for a large fall in FY2014. The bull market is over 5 years old. Further many world economies seem to be slowing. Therefore it may be wise to average into either or both LINE and/or LNCO over the course of 2014. The low Betas of LINE and LNCO (0.66 and 0.116 respectively) should help the above stocks resist downward moves. No stock is completely safe, but both LINE and LNCO look like they should be a good buys if one averages in.
NOTE: Investors interested in good oil and gas stocks may also wish to read, "Chesapeake Energy Is Finally Joining EOG Resources In Its Oil Success Story."
NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.
Good Luck Trading.