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Summary

  • Linn announced a deal to trade some of its Permian acreage to Exxon Mobil for existing wells elsewhere.
  • This deal will boost current year cash flow but will hurt cash flow in coming years as production declines 6% annually while the Permian assets can grow production.
  • Weak growth, a bloated cap-ex budget, and rising debt threaten the distribution over the medium term, and this deal worsens those problems.

Since reporting mediocre quarterly results several weeks ago, investors in Linn Energy (NASDAQ:LINE) and sister company LinnCo (NASDAQ:LNCO) have eagerly awaited what Linn would do with some its Permian acreage that it wanted to divest. On Wednesday afternoon, Linn announced it will be trading some of its prime acreage for existing wells that Exxon Mobil (NYSE:XOM) owns, and shares jumped over 4% after-hours. Bulls often give Linn the benefit of the doubt when it announces a deal will be accretive, but it is important to remember that for every buyer there is a seller, and the folks at Exxon Mobil aren't idiots. In other words, there is a reason why XOM wanted to do this trade as well. After looking through this deal, I don't believe this trade is a major win for LINE, and investors who bid shares up on the news are making a mistake.

First, it is important to go over the details of the transaction (Linn's press release available here). No cash is trading hands; instead, the two companies are swapping property. Linn is receiving 500,000 net acres in the Hugoton Basin. These acres are producing about 85 MMcfe/d with reserves of 700 Bcfe, 78% of which are proven and probable. This is a mature field with a decline rate of 6%. Given this decline rate, reserves should last for around 22 years. It should also be noted this production is mostly gas (80%) with 20% NGL. Linn also thinks it can develop another 400 wells. In exchange for this acreage, it is giving up 25,000 acres in the Midland Basin and 1,000 acres in New Mexico, which are producing 2 MBoe/d.

As you can see, Linn is getting more acreage and more current production, which are positive. However, you don't get more production and land for nothing. Linn traded liquid-rich land for gas-rich land, and for the past few year, liquid prices and margins have tended to be better. Importantly, Linn is trading for assets that will generate significant cash flow upfront, but that cash flow will decline over time as production falls by 6% annually. It is trading assets that are generating less cash today but could deliver significant growth over time. The Permian Basin has been consistently outpacing estimated reserve with companies like Pioneer (NYSE:PXD) and EOG Resources (NYSE:EOG) finding far more oil and gas in their lands than they previously thought. These acres in Midland are prime real estate with significant long-term upside. Linn is trading future production for near term production.

As Linn notes in its supplemental presentation (available here), this transaction will increase current year distributable cash flow by about $30-$40 million on an annualized pace this year. On a per unit basis, that is about $0.09-$0.12. Given the tight coverage of its current $2.90 annual distribution, this deal should help Linn maintain the payout for the next twelve months. At the end of the day, both parties agreed to this deal because they have different needs.

Linn is barely generating enough cash to pay its current distribution. In fact, last quarter, it only covered 99% of the payout (financial and operating data available here). Therefore, its primary objective seems to be maximizing current cash flow while Exxon Mobil has the financial flexibility to invest in assets that will generate significant production in several years. With this deal, Linn is investing in the present while Exxon is investing in the future. While Linn will generate an additional $30-$40 million in DCF this year, that number will fall in coming years as production falls by 6% per annum.

As I have explained in a past article, Linn's problem is not an immediate term one. It is generating enough cash and has enough borrowing capacity today to meet its distribution. Its problems are more medium term because its capital program is not driving the type of organic growth it should be. Linn's cap-ex budget is consuming 40% of revenue, but organic growth is merely 3-4%. Because of Linn's distribution policy, all growth cap-ex spending is funded by debt and equity and issuance. Linn is borrowing money to invest, and these investments are generating sufficient return. This problem can only be rectified by a distribution cut or significant equity raise to pay down debt. Neither are good for current unitholders.

Linn's debt load continues to grow, yet it continues to generate no free cash flow. As this debt load and interest expense grows but production growth remains weak, Linn will have no choice but to make a painful distribution cut to unitholders. I suspect we will see that cut sometime in the second half of 2015. This trade actually exacerbates Linn's problems as the acres it is divesting had solid growth potential while the new assets will be generating less cash flow in coming years, which is when Linn will need more cash flow to manage interest and the distribution. This trade is a short-sighted effort to maintain the current distribution policy while further endangering long term prospects.

The facts are that Linn generates no free cash flow, is spending 40% of revenue on cap-ex, and is growing production organically by 3-4%. All the while, it is forced to issue debt and equity to fund the underperforming expansion problem. While this trade is accretive today, it will cause problems in the future when Linn's failure to generate sufficient organic growth at a reasonable cost catches up to it. Long term investors should take advantage of this short-sighted pop in LINE to sell. This trade exacerbates Linn's medium term distribution coverage.

Source: Linn Energy: Permian Trade Heightens Likelihood Of 2015 Distribution Cut