Linn Energy Is A Major Opportunity

| About: Linn Energy (LNGG)
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Linn Energy (LINE) was only founded in 2003, but it has a history of success, being currently the 11th-largest independent oil and natural gas company in the U.S. with around 19,000 productive oil and natural gas wells. Linn Energy is publicly traded since 2006, and its market capitalization is now about $7.8 billion. The company has more than 1,000 employees throughout the company's core focus areas in the Mid-Continent, Permian Basin, Hugoton Basin, Rockies, Michigan and California. It owns more than 6 trillion cubic feet equivalent of proved reserves with a reserve-life index of approximately 16 years. By commodity, natural gas is the most important, representing about 55% of the company's proved reserves, followed by oil, with a weight of about 25%.

Linn Energy isn't a speculative driller; instead, it buys established oil and natural gas properties and uses its expertise and economics of scale to maximize profits from those existing wells. Therefore, it isn't surprising to see that since 2003 it has spent about $14 billion in 58 acquisitions. Despite its very good track record of successful acquisitions, Linn Energy's organic growth is also impressive, with production growth of 30% in 2011 and 15% in the last year. The combination of acquisitions and organic growth has resulted in very good production, revenue and profit growth over the last few years.

Since last year, investors have also another way to invest in Linn Energy, which is through LinnCo (LNCO). LinnCo was created to enhance Linn Energy's ability to raise additional equity capital to execute on its acquisition and growth strategy. LinnCo is a Delaware limited liability company that has elected to be taxed as a corporation for U.S. federal income tax purposes.


Linn Energy is a publicly traded limited liability company with partnership tax status. Unit holders receive distributions instead of dividends. This makes it especially attractive for income investors, as this is a tax-advantaged yield. However, for simplicity, I will also sometimes refer to distributions as dividends. Linn Energy is a high-dividend company, providing, at the current stock price, a yield of 8.7%. This is more than three times the 10-year treasury bond yield and even more compared to the S&P 500's (NYSEARCA:SPY) dividend yield.

Since its IPO in 2006, it has consistently paid out a quarterly distribution to its unit holders, even during the financial crisis of 2008-09. Furthermore, it has grown its cash distributions by more than 80% since its first payment. In 2006, its annual distribution was $1.15 per unit, which increased considerably to $2.86 in the past year. The last distribution was $0.725 paid in May, but this distribution is expected to increase soon if the Berry Petroleum (BRY) transaction is successfully closed. According to Linn Energy, the deal is expected to be accretive to unit holders from the first year, and the company expects to increase its distribution by 6.2% to $3.08 on an annualized basis. The company recently reviewed its distribution schedule, and from now on will pay monthly distributions, with the first $0.2416 per unit payable July 15, 2013.

This very good dividend history is supported by the company's hedging operations. Through its commodity hedge positions, it can provide long-term cash flow predictability and therefore pay a regular income stream to its unit holders. By hedging a significant part of the forecasted production, it reduces exposure to fluctuations in the prices of oil and natural gas. These hedges provide stability for the company and investors.

Over the long-term, Linn Energy will still be exposed to oil and natural price swings, but for its distributions, this policy provides very good visibility. The company usually looks to hedge about 100% of its expected production over the next 4-6 years. Currently, Linn has hedged about 100% of its expected natural gas production through 2017 and oil production through 2016. As the company uses swap agreements to hedge its expected production, it is protected against lower natural gas and oil prices, but through the use of put options, it has also some exposure to rising prices, enabling Linn Energy to grab the best of both worlds. For income investors, this strategy secures a guaranteed stream of future cash flow by hedging away risk.

However, given the recent pressure on the accounting treatment of Linn Energy's put options and resulting sell-off on its unit price, the company decided to stop using puts for hedging purposes. As it usually paid cash upfront for the contracts, going forward there is no future cash cost related to the puts options as they are already made. Recently the company announced that the SEC initiated an inquiry that also covers this issue. This is negative in the short-term and the stock price collapsed naturally. I'm not an accounting expert, so I won't make any consideration on this subject, but if the SEC does not find any wrongdoing as the management claims, this may be the required catalyst to unlock Linn Energy's value.

Despite this hedging policy, Linn's dividend is not completely safe. If the price of natural gas or oil declines considerably due to a structural change within the industry, the company may decide to review its distribution policy. A catalyst for this scenario to happen can be, for instance, a hard landing on the Chinese economy that will certainly lead to a sharp fall in prices of oil and natural gas. This could cause a new global crisis like the one experienced in 2008-09, putting significant pressure on the company's cash flow over the long term. Even though Linn is hedged for the next few years, management could play it safe and decide to maintain cash in its balance sheet. However, historically the company has performed well through all kinds of commodity price cycles, and even during 2008-09, the quarterly distributions to unit holders remained stable.


Linn Energy is a growth company with a very good track record of successful acquisitions that add value for investors. Its yield is among the highest in the stock market and its hedging operations provide a stability that is uncommon even in mature businesses, providing a huge opportunity for income investors. There are some doubts about its accounting practices that make this bet risky, but investors are well compensated to see its outcome. For those with a long-term view and who are willing to give management the benefit of doubt, this may be a good entry point. Despite its high growth during the past few years, the stock only trades at 14x its current earnings. This strengthens the argument that Linn Energy is a compelling buy opportunity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LINE over the next 72 hours. 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.