Linn Energy: Don't Believe The (Negative) Hype

| About: Linn Energy (LNGG)
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Panic is an investor's best ally. Some of the most lucrative buying opportunities occur during the fear-driven sell-offs that occasionally afflict even the highest quality names.

For example, in the notorious Flash Crash of 2010, investors could have scored units of blue chip master limited partnership (MLP) Enterprise Product Partners LP (NYSE: EPD), for as little as $29.05 and locked in an almost 8 percent yield on one of the safest names in our Coverage Universe.

And investors who bought large-cap US stocks in fall 2011, the height of the panic surrounding the debt ceiling and the loss of the nation's AAA credit rating, have also made out like bandits. After bottoming on Oct. 3, 2011, the S&P 500 has rallied almost 50 percent.

Corrections in the major equity indexes give investors a broader array of discounted stocks from which they can choose. But stock specific fire sales can also prove lucrative, though acting on these pullbacks requires conviction.

Linn Energy LLC (NSDQ: LINE), the largest upstream MLP by market capitalization, has come under fire once again.

The Feb. 18, 2013, issue of Barron's included a negative piece by Andrew Bary that questioned how the limited liability company (LLC) accounted for its oil and natural gas hedges. The article summarized arguments made by Bronte Capital, a hedge fund that was short the stock and published a series of critical blog posts about Linn Energy in the week leading up to the Barron's piece.

Units of Linn Energy took a hit on the Monday morning after Barron's published the article, falling about 5 percent intraday before recovering into the close.

In response, we issued an Alert on Feb. 19, 2013, refuting the spurious arguments against Linn Energy and counseling readers to regard the pullback as a buying opportunity.

This advice proved opportune: A few days later, Linn Energy announced an agreement to acquire Berry Petroleum (NYSE: BRY) in a blockbuster deal. (See A Game-Changing Acquisition.) We also analyzed these developments and the LLC's fourth quarter results in A Long Week for Shorts, which appeared in the Feb. 24, 2013, issue of Energy & Income Advisor.

Investors who purchased Linn Energy the day after Barron's ran Andrew Bary's first hit piece were up more than 12 percent at the end of last week. After Linn Energy announced an agreement to acquire Berry Petroleum, even Bronte Capital - one of the company's most vocal critics - threw in the towel and covered its short position.

Andrew Bary's latest bearish piece on Linn Energy, Twilight of a Stock-Market Darling, gives investors another chance to buy the stock on the cheap. In his latest sensationalist attack, Bary describes Linn Energy as "the country's most overpriced large energy producer" and warns that the units "may be worth less than half their current quote, based on a range of financial measures, including book value, cash flow and the value of energy reserves."

Although Bary has ratcheted up the bearish rhetoric in his most recent article, his argument is equally specious and misleading as in his first piece on Linn Energy.

Accounting Issues and Distributable Cash Flow

Once again, Bary drags out the tired, widely refuted criticism of how Linn Energy accounts for its hedges, asserting that the firm overstates its distributable cash flow by failing to account for the cost of puts on natural gas and other derivatives.

One of a handful of upstream operators structured as MLPs, Linn Energy produces oil and natural gas - a notoriously volatile business. To insulate its cash flow against fluctuations in commodity prices, Linn Energy and its peers hedge their hydrocarbon production through a mix of put options and swaps. These derivatives allow the partnerships to lock in oil and gas prices and provide visibility for investors.

Linn Energy stands out among its peers because the firm usually hedges 100 percent of its expected oil and gas production for four to six years into the future; when the MLP closes an acquisition, management usually enters into hedges to lock in prices on expected output from the underlying acreage.

At the end of the first quarter, Linn Energy's hedge book covered between 450 and 500 million cubic feet per day of natural gas production annually through 2017 and about 40,000 barrels of oil per day through the end of 2015. The partnership lifted an average of 443 million cubic feet of natural gas and 30,000 barrels of oil per day in the first three months of 2013.

These transactions have protected the firm's cash flow from the precipitous decline in US natural gas prices, which tumbled to a low of $1.90 per million British thermal units (MMBtu) from more than $10 per MMBtu in 2008. Even though natural gas accounted for more than half of Linn Energy's total hydrocarbon output over this period, these defensive hedges enabled the firm to grow its quarter distribution to $0.725 per unit from $0.63 per unit.

Bary contends that Linn Energy's stock remains overvalued because of "its strong base of retail investors who mistakenly liken [the LLC] to a stable energy pipeline MLP, rather than the riskier energy producer that it is."

This statement is rather misleading. Unlike Linn Energy, most energy producers don't hedge 100 percent of their production for four to six years into the future, leaving their cash flow far more exposed to fluctuations in commodity prices. That the partnership has managed to grow its distribution despite volatile energy prices is a testament to its hedging program's efficacy.

Much of the bearish case against the stock hinges on claims that Linn Energy artificially inflates its distributable cash flow by purchasing in-the-money put options.

Distributable cash flow is the most important metric to watch when evaluating an MLP's ability to pay its quarterly distributions. Net income and other traditional accounting measures include depreciation, depletion and other noncash charges. In contrast, distributable cash flow excludes noncash charges and subtracts expenditures classified as maintenance capital - investments made to keep the partnership's assets in working order. Investors should note that the manner in which MLPs calculate their distributable cash flow can vary slightly.

Put options give the holder the right to sell a commodity at a predetermined strike price. For example, natural gas put options with a strike price of $6 per MMBtu would give the holder the right to sell the fuel at this price before the expiration date. As natural gas currently fetches about $4 per MMBtu in the US, this put option to sell the commodity for $6 per MMBtu is in the money and has an intrinsic value of $2 per MMBtu. Options typically trade at a premium to their intrinsic value, reflecting the possibility that natural gas prices could decline further in value.

The bears allege that Linn Energy purchases in-the-money put options on oil and natural gas without factoring in the cost of purchasing these puts.

These arguments don't hold water. As we explain at length in A Long Week for Shorts, these in-the-money puts were purchased years ago when prevailing natural gas prices were much higher than they are today. The sharp decline in the price of natural gas explains why these puts are deep in the money.

By the same token, the no-show winter of 2011-12 that depressed natural gas prices to record lows widened the spread between the spot market and five-year futures. Whether put options purchased at the peak of this divergence are in the money depends on future natural gas prices. To allay investors' concerns, the company has stopped purchasing puts for its hedging program; as the firm's existing outs roll off, all its derivatives will take the form of swaps that entail no upfront costs.

Second, the charge that Linn Energy does not subtract the cost of buying put options directly from its distributable cash flow is true. However, this metric does account for these costs. When Linn Energy takes on hedges to cover anticipated production from newly acquired assets, the partnership finances these expenses via bond of equity issues; the LLC includes the added interest cost and quarterly distributions associated with these transactions in its calculation of distributable cash flow.

In short, questions about how Linn Energy accounts for its put options have little validity.

New Arguments and Linn Energy's First Quarter Results

Why did Bary turn his focus to Linn Energy once again? The author's most recent article for Barron's highlights "a bigger problem" than questions about the LLC's accounting policies: "The company's energy production has now flattened despite heavy capital expenditures."

Linn Energy's first quarter results definitely disappointed, with total hydrocarbon output slipping to 796 million cubic feet of natural gas equivalent per day from 800 million cubic feet of natural-gas equivalent per day in the final three months of 2012. This translated into a distribution cash flow that covered only 88 percent of the MLP's quarterly payout.

Although we're not pleased with Linn Energy's performance in the first three months of 2013, Bary's article goes out of its way to emphasize the negative and gives short shrift to two important points: The MLP's longer-term coverage ratios remain healthy; and temporary headwinds were behind much of the firm's poor results.

Even the strongest publicly traded partnerships have the occasional quarter where cash flow fails to cover the quarterly payout. Although such shortfalls are cause for scrutiny, we tend to focus on full-year distribution coverage. The MLP covered its payout by 1.07 times in the fourth quarter of 2012 and 1.14 times on the year.

The temporary headwinds that weighed on Linn Energy's first quarter output include weather-related disruptions in the Mid-Continent region, midstream constraints in the Permian Basin and ethane rejection at the Jonah Field in western Wyoming.

Severe winter weather in Kansas, Oklahoma and the Texas Panhandle forced Linn Energy and other operators to shut in wells and delay projects in February and March. Activity levels have since returned to normal.

Midstream capacity constraints in the Permian Basin, a mature play in West Texas that's been revitalized by new production techniques, won't be resolved right away. Robust output growth in this oil-producing region has overwhelmed existing pipelines, increasing pressure on the small-diameter gathering lines that collect hydrocarbons from individual wells. In this instance, the geological pressures that impel the oil and gas from the reservoir struggle to overcome the pressure in the pipeline itself. Fortunately, several midstream projects are planned to alleviate this bottleneck.

CEO Mark Ellis addressed this subject during a conference call to discuss the MLP's first quarter results:

Yeah, the problem we're running into out there is, as most operators are, is you've got pretty mature systems and a lot of people putting a lot of effort out there in trying to grow their assets. So we're overrunning a little bit of the gathering systems and the processing capabilities. There are a number of announced expansions and are in progress.

We don't anticipate a whole lot of recovery there until the second half of this year, but we are starting - we are anticipating some relief in the second half of the year. So we've kind of pulled back our capital program there, we're running less rigs in the Permian than we did last year at this same time. And we're also trying to focus on where the best place is to develop in the Permian because they're - the western side of that play seems to be better from an infrastructure standpoint than the eastern side. So we're looking at ways of redirecting our effort there as well.

So we anticipate that they will make the appropriate adjustments and we'll be able to get some constraints off. But we're seeing higher line pressures really put some back-pressure on our wells and you keep from seeing the full potential of the work that we've done.

Although Ellis expects midstream challenges to persist into the second quarter of 2013, the upstream operator is seeking pipeline capacity to ease this bottleneck and support production growth in the back half of the year. Meanwhile, Linn Energy has opted to pursue projects in parts of the Permian Basin with well-developed pipeline infrastructure.

We explained the concept of ethane rejection in the Dec. 23, 2012, Graph of the Week. This phenomenon occurs when the natural gas liquid trades at natural gas-equivalent prices that make it uneconomic to remove from the raw gas stream. With ethane rejection occurring on a large scale in the Rockies, Linn Energy's price realizations have suffered considerably. This headwind will likely continue throughout 2013. (We discuss the dynamics of the US ethane market in Another Leg Lower for NGL Prices.)

Of greater concern were Linn Energy's disappointing well results in the Texas portion of the Hogshooter formation. The publicly traded partnership has sunk wells at 28 of 50 identified drilling locations. Although early results were encouraging, recent wells have fallen short of internal expectations, prompting management to shift activity and capital spending to the promising Mayfield area in Oklahoma. The company may return to the Texas portion of the Hogshooter after reviewing and revising its drilling strategy in the play.

Unfortunately, Linn Energy's working interest in these Oklahoma wells averages 25 percent compared to more than 60 percent in Texas. The lower net output associated by these wells will be partially offset by a corresponding reduction in capital expenditures.

These developments contributed to management's decision to reduce its 2013 production forecast to between 740 and 860 million cubic feet of natural gas equivalent per day from between 820 and 910 million cubic feet of natural gas equivalent per day.

However, the divestment of the partnership's 40 percent stake in assets in the Anadarko Basin to Midstates Petroleum (NYSE: MPO) was the primary factor behind this downward revision to its full-year production guidance. Linn Energy had planned to acquire its partners' 60 percent stake and take over as operator. But rising drilling costs and a higher bid from Midstates Petroleum convinced management to monetize this asset and redeploy capital elsewhere.

Nevertheless, Linn Energy still expects distribution coverage levels to improve in the second quarter and to generate enough cash flow to meet its full-year obligations. More important, this guidance excludes contributions from the firm's pending acquisition of Berry Petroleum. Management expects to boost the quarterly payout to $0.77 per unit from $0.725 per unit once this blockbuster deal closes.

Factoring in projected production from Berry Petroleum's assets in California, Linn Energy should generate sufficient cash flow to cover its distribution by 107 percent in the back half of the year.

As we explained in A Long Week for Shorts, Linn Energy's offer for Berry Petroleum is an all-stock deal. The target's shareholders will receive 1.25 shares of LinnCo LLC (NSDQ: LNCO) for each share of Berry Petroleum. Structured as a corporation, LinnCo went public on Oct. 12, 2012, raising about $1.1 billion that was used to purchase a 13.2 percent equity stake in its parent company, Linn Energy. Each share of LinnCo represents one unit of Linn Energy, and its qualified dividends mirror its parent's quarterly distributions.

After the acquisition, Berry Petroleum will convert to an LLC and LinnCo will contribute the assets to Linn Energy in exchange for units in the LLC. This complex arrangement will enable the MLP to acquire Berry Petroleum without incurring any immediate tax liability.


The bearish article that Barron's ran over the weekend also suggests that Linn Energy is expensive relative to any US-listed energy producer - an irresponsible claim that betrays a fundamental misunderstanding of the differences between MLPs and corporations.

Here's how we value Linn Energy. Let's make the conservative assumption that the MLP maintains its quarterly distribution of $0.725 per unit and then boosts this disbursement to $0.77 per unit for the third quarter. We also assume that the upstream operator grows its payout at an average annual rate of 2.5 percent over the next five years, after which the distribution remains flat.

Applying a 10 percent annualized discount to these conservative assumptions, which are well below our expectations and Wall Street analysts' consensus estimates - yields an estimated value of $36.00 per unit. Bear in mind that this valuation model implies a 10 percent annualized return if you buy the stock at this level.

Bary's comparison of Linn Energy to Exxon Mobil Corp (NYSE: XOM) is laughable. A pure-play upstream operator, Linn Energy lacks the Super Oil's extensive refining and chemicals operations as well as its global asset base.

Nevertheless, we'll continue with Bary's absurd comparison of apples and oranges - they're both fruits, after all.

Units of Linn Energy fetch about 11 times the consensus estimate for distributable cash flow. The closest metric for Exxon Mobil would be free cash flow (FCF), a measure of operating cash flows minus capital spending. FCF is often used as a proxy for how much money a company has available to return capital to shareholders via dividends or share buybacks. Shares of Exxon Mobil currently trade at more than 18 times FCF - well above Linn Energy's valuation.

Andrew Bary's latest attack on Linn Energy doesn't hold up to even the most cursory scrutiny. We look for units of Linn Energy to bounce back from the latest Barron's hit piece just as they did in February.

Disclosure: I am long LINE, EPD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.