Linn Energy: When Hedges Are Not Enough

| About: Linn Energy, (LINEQ)

Summary

Linn Energy went under despite its large hedge book.

The hedges were put in place to protect against lower oil prices.

However, Linn Energy’s real undoing was access to easy debt at the oil market top.

Linn Energy (NASDAQ:LINEQ) was by far one of the largest bankruptcies in the oil patch. As the leader in the upstream MLP model, the stock was widely held by income investors thanks to its outsized distributions. However, the company undoubtedly took on way too much risk in an effort to maintain that level of income. This turned out to be their undoing as the oil price crash of 2014-2016 did them in.

Linn Energy's hedges were not enough to stave off bankruptcy

Some publications are now wondering how Linn Energy went under given that the company had a pretty robust hedge book. Though there is a problem with that thesis -- Linn Energy's hedge book served to protect the lenders from a commodity price crash just as much as it did to protect the company itself.

To provide themselves a cushion against sharp drops in oil prices, drilling companies often buy hedges-financial contracts that pay off when prices fall. Now a quirk of bankruptcy law has stripped some shale drillers of that insurance just when they need it most.

Houston-based Linn Energy, for example, bought contracts that guaranteed a price of $90 a barrel, even if prices were lower. It paid off: By the end of March, with oil below $45 a barrel, Linn's hedges were worth $1.5 billion, making them among the company's most valuable assets.

First off, Linn Energy was never really a "drilling company" -- they never had much of a growth bent. What they did was to buy already developed assets, via debt and equity, and milk the cash flow, spending only as much cash needed to keep production flat.

Second, the hedges were not just insurance for Linn Energy -- they were also insurance for the lenders. By far the biggest beneficiaries of the hedges were the lenders -- Linn Energy kept paying interest well after it became obvious that its core operations stopped being profitable due to low oil prices.

As much as $546 million was spent in 2015 by Linn Energy on interest payments and another $719 million in debt extinguishment -- neither of which were likely to be made without the $1.2 billion in hedging cash settlements collected that year.

Layering on hedges was often a strategy used by Linn Energy to make many of its deals. The lenders often were along for the ride, acting as financial advisors for these deals. Furthermore, the lenders would usually increase Linn Energy's access to credit after a deal was made. For an example see Linn Energy's 2012 Hugoton Basin transaction with BP.

Just like insurance, hedges were initially just another cost of doing business. And, for large chunks of 2012/2013, when oil prices were high, were actually a drag on Linn Energy's profitability.

The hedges weren't enough, however, to keep Linn out of financial trouble after the oil price plunge. This put Linn's lenders, a syndicate of more than 20 companies, in an odd position. Linn owed them $4 billion and was about to go into bankruptcy. Yet some of those same lenders-it's not clear which ones-were also on the other side of Linn's hedges, paying $100 million per month to Linn to settle the contracts as they came due. Put simply, Linn's bankers had two losing bets at once.

The logic here is way off. Remember, Linn Energy lenders were not going to make these loans without the company first hedging its production.

Linn Energy was receiving hedging settlement proceeds which allowed them to make interest payments despite low oil prices. The hedges were working out just as they wanted them to.

Then came the solution. In the weeks leading up to Linn filing for bankruptcy protection in May, its oil and gas hedges were sold off for their market value. The resulting $1.2 billion in cash was applied to paying off its loans. Linn agreed to the sale, but if it hadn't, bankruptcy law would have allowed the lenders to seize the contracts anyway.

There was no "solution" to be had. Rather, selling the hedges was an obvious method to raise cash to pay off the lenders as the alternative, such as selling oil and gas producing assets, did not make a ton of sense given the bear market in commodities.

Linn Energy went bankrupt because it took on too much debt to buy oil and gas assets at the market top. Lenders took on a lot of risk here, but were earning a fairly high interest rates for their trouble. Plenty of bankers made a lot of money doing business with Linn Energy.

Conclusion

Simply put, The hedges worked fine. What didn't work was Linn Energy's business model. Now that they are in bankruptcy, the lender pecking order is in play. Those on the top, the secured group (credit facility bankers) will likely be left less than whole, left with a mix of cash and equity for their efforts. The unsecured lenders, will be left with the scraps, if any.

Without its sizable debt burden and massive interest expense, Linn Energy, or whatever the post-bankruptcy entity is called, will emerge as a much healthier company, even without a hedge book.

Make no mistake, if it were not for the hedges, there would be much less of the Linn Energy pie to go around. Though, at the same time, these hedges allowed Linn Energy to take on much more risk than it should have, which ended up sinking the company at the end of the day.

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