With the year half gone Linn Energy (LINE) and hence LinnCo's (LNCO) strategy this year is becoming clear. It is to trade in high maintenance cost, high decline rate properties for low maintenance cost, low decline rate properties. Management is also trying to make sure that the new properties fit well geographically into LINE's portfolio of properties. The obvious target of this is to make the distribution coverage ratio healthy for the long term.
If this is the target, is the distribution coverage ratio bad now? For Q2 2014 the distribution was $240,510,000 out of net cash of $481,153,000 provided by operating activities. The excess of net cash provided by operating activities was $32,056,000. Hence the distribution coverage ratio was 1.13x, which was a solid, healthy result.
After the Berry Petroleum acquisition in December 2013, LINE announced that it intended to acquire or trade for $4B - $5B of long life, low decline assets. It said it intended to trade or sell about $4B - $5B of higher decline, more capital intensive assets to fund the acquisitions of the aforementioned shorter decline assets mentioned. LINE hopes to do most or all of the new acquisitions through 1031 exchanges. LINE expects completion of all of the announced transactions, including selling the Granite Wash and Cleveland assets and the remaining Midland Basin assets in the Permian Basin, to reduce its capital expenditure run rate by $300 million to $400 million. That is, LINE intends to do less development because it will have to do less maintenance development when the decline rate of its assets is lower. The above actions should lower LINE's decline rate to 15% per year. This should make for a more stable asset base. Plus it should increase the distribution coverage further (due to less capital spent on maintenance), which should make investors very happy. It may mean that investors will see an increase in the distribution sooner.
LINE has announced a number of acquisitions and sales that fit into this plan:
- On May 21, 2014 LINE announced that it had signed an agreement to trade 25,000 net acres of its Midland Basin holdings and 1,000 net acres in Lea County, New Mexico for approximately 500,000 net acres of Exxon Mobil's (NYSE:XOM) Hugoton Field holdings. These have proved reserves of about 700 Bcfe (78% PDP), about 400 new potential well sites, future synergies with the Jayhawk gas plant, a low decline rate of about 6% per year (with a reserve life of 22 years) and about 85 MMcfe/d of production (80% natural gas and 20% NGLs). XOM got only 2 Mboe/d of production in the Midland Basin in exchange for the approximately 14 Mboe/d of Hugoton production. This swap is expected to significantly reduce LINE's capital spending plan for $275 million for the Midland Basin for FY2014. As a ballpark estimate, this might save LINE about $100-$125 million of the aforementioned capital expenditures in FY2014. This transaction is set to close on August 15, 2014.
- On June 30, 2014 LINE announced a definitive agreement to acquire assets in five operating areas from Devon Energy Corp. (NYSE:DVN) for $2.3B. These assets are currently producing 275 MMcfe/d (approximately 80% natural gas). Their decline rate is about 14% per year. Total proved reserves are estimated to be 1.3-1.5 Tcfe (approximately 75% PDP) with a potential resource of 3 Tcfe. This deal packages about 900,000 net acres in five regions: the Rockies, the Mid-Continent, east Texas, north Louisiana, and south Texas. The properties have approximately 4,500 total wells. LINE has identified over 1,000 future drilling locations and over 600 recompletion opportunities. These properties fit well geographically into LINE's current portfolio of holdings in those areas (see map below). LINE secured $2.3B of interim financing to finance this acquisition. This transaction is expected to close on Q3 2014, with an effective date of April 1, 2014. Eventually LINE intends to replace its interim financing solution with funds from the sale of its Granite Wash and Cleveland plays of approximately 147,000 net acres. LINE may sell the ancillary infrastructure in this area along with these acres. These properties have a very high rate of decline from new wells, which skews LINE's decline rate data far too much to the high side. LINE hopes to make this combination of buy and sell into a 1031 exchange.
- On August 4, 2014 LINE announced the purchase of Pioneer Natural Resources (NYSE:PXD) assets in the Hugoton Basin for $340 million. The current production is 40 MMcfe/d (about 60% natural gas). These have a shallow decline rate of 6%. Total proves reserves are about 340 Bcfe (about 95% PDP). The asset package is approximately 235,000 net acres, all HBP. There are about 1200 producing wells. LINE has identified 180 future drilling locations and 150 recompletion opportunities. These assets fit nicely in with LINE's other Hugoton Basin assets. This acquisition is expected to be accretive to "excess net cash flow" (and to the distribution coverage ratio).
- LINE also announced August 4, 2014 that it has entered into an agreement to sell its rights to the Woodford and Meramec horizons in the STACK play (about 26,000 net acres in the Anadarko Basin) for $90 million. This transaction is expected to close in Q4 2014 with an effective date of December 1, 2013.
- In the earnings report LINE also announced that it received a favorable ruling by the US District Court for the Southern District of New York. The Court dismissed with prejudice a securities class action lawsuit against LINE.
LINE guided upward on production in its Q2 earnings report. It increased its Q3 2014 guidance to 1,210 to 1,2600 MMcfe/d. It increased its FY2014 guidance from the previous range of 1,075 to 1,135 MMcfe/d to 1,217 to 1,268 MMcfe/d. the engineers are executing well too.
Hopefully all of the 1031 swaps will work out well. LINE seems to be refraining from comment until those deals are consummated. However, management does seem to be making moves that are good for the investor. They should also be good for the long term health of the company, especially if natural gas prices rise in future years as many people expect.
LINE is a buy on good execution, good management of the distribution coverage and alignment of assets, and its 9.3% dividend. However, it is a sell on greater lease operating expenses, greater transportation costs, and greater taxes. The compromise rating is then a hold. This makes LNCO with its 9.6% dividend a hold also. I am not sure how long the extra costs will persist, but they are significant; and I want management to show me that they can do away with them. They didn't explain that to my satisfaction in the earnings release.
The two year chart of LINE provides some technical direction for a trade.
The two year chart of LNCO provides some technical direction for a trade.
The slow stochastic of each chart above indicates that neither stock is overbought nor oversold. The main charts shows a sideways consolidation pattern. The guide higher on production, the 1.13x distribution coverage for Q2 2014, and the management intent to both decrease the average company production decline rate to 15% and the capital expenditure run rate by $300 million to $400 million in 2014, all argue for the stock to go higher or at worst sideways some more. They should mean a stable distribution of about 9.3% for LINE and 9.6% for LinnCo. The increased expenses argue for the stock to go sideways or downward. It sounds like sideways may be the compromise until the company makes the situation clearer.
Some think LINE has been acquiring too much natural gas recently. However, for Q2 2014 it still had a well distributed production breakout of 44% natural gas, 39% oil, and 17% NGLs. LINE/LNCO also has significant hedges to protect its revenue stream. LINE and LNCO are both holds. You really have to admire the management's tack this year. They are trying to both align and streamline. It looks like that will be a success for the company and for the investors. I am still unsure what will happen with all of the extra costs seen in Q2 2014 compared to Q2 2013.
NOTE: Some of the information above is from Yahoo Finance.
Good Luck Trading.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.