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Units of upstream MLPs have traditionally offered a higher yield than their midstream counterparts in part because natural production declines require consistent access to the capital markets to fund growth projects and acquisitions. With MLPs enjoying a record low cost of capital and high-quality assets available on the cheap, this segment of our coverage universe offers some of the best values and upside for savvy investors.

The largest upstream publicly traded partnership by market capitalization, Linn Energy LLC (LINE) went public in early 2006 and has grown into the eighth-largest independent oil and gas producer in the US.

Over the past six years, the limited liability company has expanded its reserves to 5.1 trillion cubic feet of natural gas equivalent, of which oil and natural gas liquids (NGL) account for 45 percent. Although the firm's asset base spans oil- and gas-producing acreage in California, Texas, Oklahoma, Kansas, North Dakota and Michigan, one commonality unites these properties: their low operating costs and reliable production profiles.

Given its size and scale, Linn Energy can pursue ambitious organic growth opportunities such as its horizontal drilling and hydraulic fracturing program the Granite Wash and its joint venture with Anadarko Petroleum Corp (APC) at the Salt Creek field in Wyoming

Linn Energy has amassed about 30,000 net acres and identified an inventory of more than 600 high-probability drilling locations in the Granite Wash, a liquids-rich basin in the mid-continent region that contains eight least eight productive zones.

With the price of natural gas likely to remain depressed for at least the next two to three years, Linn Energy and other operators two years ago shifted their focus from deep-lying gas-bearing deposits to the liquids-rich formations that are highlighted in green.


(Click to enlarge) Source: Linn Energy LLC

However, the rapid decline in NGL prices in the first half of 2012-a downturn that was particularly pronounced at the oversupplied hub in Conway, Kan.-compressed profit margins in the region. Although Linn Energy aggressively hedges its oil and gas output, the relative immaturity of and lack of liquidity in the NGL futures market present an impediment to hedging this exposure directly.

In this situation, the firm's strong presence in the Granite Wash proved its worth. Linn Energy responded to deteriorating NGL prices by shifting its drilling activity to target the oil-rich Hogshooter, a shallower formation within the Granite Wash.

On Sept. 28, 2012, Linn Energy announced that the nine horizontal wells that the firm drilled and fractured in the third quarter boasted an average initial production rate of 1,983 barrels day of crude oil per day and 3.4 million cubic feet of natural gas per day. These results correspond with flow rates from the three Hogshooter wells that the limited liability company drilled earlier this year. The upstream operator plans to drill about 20 horizontal wells in the Hogshooter this year. We expect this drilling program to continue apace in 2013.

We're also bullish on Linn Energy's joint venture with Anadarko Petroleum in Wyoming's Salt Creek play, a mature oil field that the two partners will seek to exploit through carbon dioxide injection. The project's operator estimates that about 20 percent of the field's reserves were extracted during primary production. Water-flooding-an enhanced recovery technique that involves pumping large volumes of water into a mature field to artificially increase reservoir pressure-is estimated to have produced another 25 percent of reserves. With an estimated 1 billion barrels of oil in place, tertiary production methods could boost the end recovery rate.

Linn Energy's acquisition of a 23 percent stake in this project once again demonstrates management's savvy efforts to build expertise and pursue low-cost sources of production. One of the world's largest independent exploration and production companies, Anadarko Petroleum is the ideal partner for the MLP's first foray into enhanced oil recovery. The experience that the limited liability company gains over the course of this project could help extend the life of mature assets in its portfolio and expand the universe of potential acquisitions.

And let's not overlook the potential production growth at Salt Creek: Management expects Linn Energy's share of the oil output to increase to double to 3,200 barrels per day by 2016.

These growth opportunities in the Granite Wash and Salt Creek demonstrate the advantages of Linn Energy's size; no other upstream MLP would be able to fund a horizontal drilling program or a joint venture of that scale, let alone pursue both projects simultaneously.

Like most upstream MLPs, Linn Energy relies primarily on acquisitions to buffer against natural production declines and grow distributable cash flow.

In recent quarters, the upstream operator's canny management team has taken advantage of producers' haste to monetize mature gas-producing properties in favor of expensive developments in liquids-rich shale plays.

With North American natural-gas prices expected to remain depressed for at least the next two years to three years, Linn Energy has acquired high-quality reserves at fire-sale prices that guarantee a solid return in the current environment. The potential long-term upside is even more impressive: If and when the price of natural gas recovers, Linn Energy can drill additional wells to take advantage of improving economics.

Thus far in 2012, the upstream MLP has closed two major deals with BP (NYSE:BP), one of the market's most motivated sellers.

On Feb. 27, Linn Energy announced the $1.2 billion purchase of BP's 600,000 net acres in Kansas' Hugoton Basin. This property is home to more than 2,400 long-lived wells that produce an average of 110 million cubic feet per of natural gas equivalent per day, about 63 percent of which is natural gas and 37 percent of which are NGLs. These wells exhibit an annual decline rate of about 7 percent. BP had also identified an inventory of about 800 high-probability drilling locations, providing plenty of potential upside.

About four months later, the two sides announced that Linn Energy had agreed to pay $1.025 billion for BP's gas-producing assets in the Jonah Field, located in southwest Wyoming. The transaction covers the international oil company's working interest in 260 operated wells that produced an average of 80 million cubic feet of natural gas equivalent per day, as well as non-operated wells with average net production of about 65 million cubic feet of natural gas equivalent per day. The roughly 12,500 net acres involved in the deal contain an estimated 1.2 trillion cubic feet equivalent in resource potential.

Not only are these deals accretive to distributable cash flow without additional drilling and development, but Linn Energy's return on investment will only increase when the price of natural gas recovers. Moreover, Linn Energy has hedged 100 percent of expected production from these properties for several years into the future, taking advantage of higher prices down the futures curve.



(Click to enlarge) Source: Bloomberg

With these hedges in place, Linn Energy has effectively locked in a risk-free profit margin that will boost distributable cash flow for years to come. Although a number of other upstream MLPs have cribbed Linn Energy's game plan, we wouldn't be surprised if management announced another major deal in coming months.

Meanwhile, the limited liability company has hedged 100 percent of its expected oil production through 2016 and 100 percent of its anticipated gas production through 2017, making it the safest bet among its upstream peers.

Source: Linn Energy: The Best Upstream MLP Around