Linn Energy: An Explanation Of The Effect Of Recent Transactions And Preliminary 2015 Guidance

| About: Linn Energy (LNGG)

Summary

Q3 results in excess cash available of $12M after adjustments for maintenance capital and distributions.

Q4 projects a deficit of cash available of $94M after adjustments for maintenance capital and distributions.

Pro-forma leverage ratio of 4.5 after divestitures and calendar year 2014 with distribution coverage ratio of 1.02.

Three solutions to low commodity pricing.

[Author's Note: Please read my response to Alpha Wolf for update and changes to 2015 NG projections in the comment stream below]

Overview:

Although everyone's mind is on the effect of OPEC's decision to keep production levels at 30 Million barrels of oil a day, a review of Linn's (LINE) Q3 results and the expected shortfall of 94M for the 4th quarter will give us a foundation that we can build upon to determine how resilient Linn's operation is to commodity stress. I will take a closer look at Linn's debt and provide my rendition of what 2015 results will be based on a review of current hedges and projected spot prices. Finally we will evaluate various alternatives open to Linn if distributable cash flow for 2015 is below that needed for a DCR of 1.00 including, but not limited to, a distribution cut. The preliminary "guidance" is primarily based upon the following sources of information:

a. Q2-Q3 2014 Conference call

b. Q-3 2014 Supplemental

c. Q-3 Quarterly report (10-Q)

d. Numerous other sources referencing cost of production and identification of the "swing producer". This preliminary guidance is nothing more than my opinion. It does not reflect any definitive positions announced by Linn.

1. The company's operations

Linn Energy is an upstream LLC that for tax purposes is treated like a Master Limited Partnership. The company also has a subsidiary, LNCO, whose sole purpose is to hold LINE units. Combined, the two entities have 331,903,326 units outstanding as of October 31, 2014. The company is undergoing a radical and sudden shift in their emphasis from high decline-high maintenance assets to low decline-low maintenance assets. A graphical depiction of these transactions has been included for simplification.

Transaction Graph

Transaction

Press date

Eff. date

Closing date

Reserves

Daily production

Declinerate

Net acreage

Consideration

EXXON I trade

5/21/2014

6/1/2014

8/15/2014

700 B cfe, 79% PDP

85MM cfe/d, 80% NG, 20% liquids

6%

500,000 acres, 2,300 wells

25,000 acres, 2.0 MBoe/d

2.3B Devon purchase

6/30/2014

4/1/2014

8/29/2014

1.3-1.5 T cfe

275MM cfe/d

14%

900,00 acres, 4,500 wells

$2.3B cash

Stack divestiture

7/24/2014

p.s-7 424 B IV Filing

Q4

N/A

N/A

N/A

26,000 undeveloped

$90M to be received

PXD purchase

8/4/2014

7/1/2014

9/11/2014

348 B cfe, 82% PDP

40MM cfe/d, 60% NG, 51% of Santana

6%

235,000

$340M paid to PXD

EXXON II trade

9/18/2014

6/1/2014

11/21/2014*

27 MM Boe

3.4M Boe/d, 100% Oil, 51% PDP

10%

500

17,000 net acres Midland 4.7 Boe/d 19 MM Boe reserves

1.95 B Midcon Sale

10/3/14

9/1/14

12/15/2014

755 B cfe

195MM cfe/d

EST 35%

145,000

$1.95B to be received

350M Permian sale

10/3/14

8/1/14

11/14/2014*

19 MM BOE

4.6M BOE/d

EST 35%

7,200

$350M to be received

Remaining Permian sale

N/A

N/A

N/A

N/A

8M Boe/d

N/A

6,600 acres

$750M per RBC capital to be received

* Why these transactions haven't closed is a concern for me.

-

2. Q3 results

Although the company reported an excess of $88M in distributable cash flow (DCF), $46M was properly allocated to Q2 but was reported with the Q3 results because the Devon purchase didn't close until August 29, 2014. That reduced the excess to $42M. The reported Q3 results also benefited from approximately $30M of cash flow associated with the pending asset sales of the Granite Wash and Cleveland assets, along with certain Midland Basin assets in the second trade with ExxonMobil.

Kolja Rockov, CFO, simplifies the moving parts in the Q3 conference call by stating:

"Positively impacting third quarter results with the inclusion of 80 million of acquisition related cash flow, primarily associated with the Devon assets acquisition, of which 46 million was associated with results from the second quarter. In addition, the third quarter benefited from approximately 30 million of cash flow associated with the pending asset sales of the Granite Wash and Cleveland assets and certain Midland Basin assets in the second trade with ExxonMobil. Therefore, the excess cash number of 88 million will be approximately 12 million excluding the amounts which related to second quarter results and pending asset sales in trade in the fourth quarter." (page 4 conference call)

Rockov goes on to quantify cost reduction, expected financial liquidity and the positive effect that the transformation will have upon the borrowing base redetermination, which may become a major issue:

"In the third quarter, Linn's costs were well below our guidance… Total operating expenses were $2.72 per Mcfe, which was 9% better than our guidance. Lease operating expenses of $1.67 per Mcfe were 12% better than our guidance. Pro-forma for all announced transactions, we estimate that the company will have liquidity of approximately $2.5B. Wells Fargo, our agent bank, has taken a preliminary look at reserves pro-forma for our portfolio changes and noted a material improvement in asset value. The semiannual redetermination of the borrowing base ($5.9B and $2.5B undrawn) has been deferred until the Granite Wash sale closes in mid-December. However, we anticipate upon redetermination later this year that it will return to the previous combined level of $5.9B, which will result in approximately $2.5B of undrawn capacity.

The new portfolio borrowing base should be very resilient to a downturn in commodity prices. We intend to use the net proceeds from the $2.3B of the pending asset sales to fully repay the $1.3B term loan which is the only remaining portion of interim financing from the Devon acquisition and approximately $1B of revolver borrowings." (see page 4 conference call - emphasis added)

I believe they should utilize $500M of the designated revolver funds for buybacks. Linn substitutes excess available after maintenance capital and distributions for DCF.

3. Q4 results

Despite all of the moving parts, Linn produced a DCR of 1.02 for 2014. But Q4 results are troubling enough to warrant a closer look. Rockov states in the Q4 conference call:

"In the 4th quarter, we expect the shortfall of excess cash of approximately $94M. The 4th quarter is impacted by negative acquisition related cash flow of approximately $45M related to the sale of Granite Wash and Cleveland assets, and certain Midland Basin assets, partially offset by the positive effects of acquisition related cash flow from the second trade with ExxonMobil of which approximately $30M is associated with results from the 3rd quarter…The remainder of the expected shortfall for the 4th quarter is due to weaker commodity prices, differentials, and the near term of shifting from higher decline assets to lower decline assets. We believe the long term effect of the portfolio shift reverses significantly in the future." (see page 4 conference call - emphasis added)

At the time of this writing, the expected 11-14-14 and 11-21-14 closings have not been announced but assuming they take place, the Q4 shortfall would be $64M not $94M. Keeping in mind the fact that the Q3 revenue figures for NG - NGL - OIL sales totaled approximately $937M, it is difficult to determine why the company projects a $64M deficit for Q4 2014 because my calculations for Q4 show commodity sales of $983,625,038. However I reach about the same number that Linn does for their deficit, in their guidance found on page 7 of the Q3 supplemental. But I believe my calculations (which follow), may enhance your understanding of the approximately $94M shortfall for Q4.

4. Q4 Calculations

Q4-2014 guidance in Q3-2014 supplemental calculations (page 7)

A. NG

Midpoint 732.5 MM cfe/d x 92 Days = 67,390 MM cfe

-NG Hedged 44,621,000 Mcf @ $5.14 = $229,351,940

22,769,000 Mcf x $3.82 midpoint = $86,977,580 Un-hedged NG

-

$86,977,580 Un-hedged NG

+ $229,351,940 Hedged NG

$316,329,520 Gross NG

-

-NG Differential 67,390,000 Mcf x .1 = $6,739,000

$316,329,520 Gross NG

(- $6,739,000) Less differential

$309,590,520 Net NG

-

B. OIL

Midpoint of Guidance 72,565 Bbls/d x 92 Days = 6,675,980 Bbls

-

6,675,980 Bbls

(- 6,298,000) Hedged Bbls

377,980 Un-Hedged Bbls

-

-Hedged 6,298,000 Bbls x $92.46 P/Bbl = $582,313,080

-Un-Hedged 377,980 Bbls x $81.80 P/Bbl = +$30,921,283

-

$582,313,080 Hedged

+$30,921,283 Un-Hedged

$613,234,363 Total Gross OIL proceeds

-

-OIL Differential 6,675,980 Bbls x $7.75 Bbl = $51,738,845

$582,373,080 Hedged

$30,921,283 Un-Hedged

(-$51,738,845) Differential

$561,495,518 Net OIL proceeds

-

C. NGL

Midpoint Guidance

34,950 Bbls/d x 92 Days = 3,215,400 Bbls

3,215,400 Bbls x $35 P/Bbl = $112,539,000

-

D. Summary of Proceeds Q4 2014

$309,590,520 NG

$561,495,518 OIL

+$112,539,000 NGL

$983,626,038

(This figure does not include marketing or "other" as the Jay Hawk NG processing plants, gathering systems, electricity sales, and other assets will not produce positive results in the 4th quarter)

-

E. XPS Midpoints (Figures are given on P7 Supplement)

$350,000,000 Total Operating XPS

$69,500,000 G & A

$154,000,000 Interest XP

$45,000,000 Divestiture

$217,000,000 Main Cap Ex

$241,000,000 Distributions

$1,076,500,000 Total XPS

$983,625,038 Total Revenue

($92,874,962) Shortfall

-

5. Lack of transparency

Linn's reporting of the effect of derivatives on the Statement of operations and cash flows are opaque. The varied cash settlements in the gains (losses) on OIL and NG derivatives include a mark to the market but no disclosure of the cash settlements. See pages 4-6 of the supplemental. Going to page 4 of the 10Q you can find the cash settlements for the 9 month period resulted in a loss of $12,507,000. The total "losses" on derivatives for the 9 month period totaled $198,579,000. Total gains for Q3 on derivative settlements were about $10M but that reference only appears on page 30 on the 10-Q.

Linn reports a net loss of $4,100,000 for Q3 operations on page 4 of the supplemental. On page 3 of the supplement Linn shows net cash of $520,175,000 provided by operating activities. Nowhere in any documents that I have examined can I find a detailed calculation of how they transitioned to that number from the $4,100,000 loss on the statement of operations. I can do my own calculations but Linn should provide this information in a separate table.

-

6. Debt structure and financial flexibility

Another important factor in determining where Linn will be after the transactions in the graph have been completed is Linn's debt structure. On page 11 of the 10-Q Linn provides a detailed description of their debt as it existed on September 30, 2014. We will modify that information to reflect application of the funds from the Midcon and Midland sales in a manner that is consistent with the stated intentions of paying off the variable interest entity debt of $1.3B but will only pay down $500M of the remaining revolver. $500M will then be applied to buybacks.

Linn announced on August 7, 2014 that the board of directors approved a buyback of 250,000,000 of LINE units and/or 250,000,000 of LNCO shares. Rather than paying down the revolver by $1B as Kojla Rockov stated on page 11 of the transcript, it might behoove Linn to apply $500M of that $1B for buybacks. That move would provide Linn with a structure in which distributions would only be $226M a quarter rather than the current $241M per quarter. If Linn exercises their buyback now, the distribution per quarter may drop to $205M per quarter. But with the deterioration in commodity prices, the buyback may no longer be an option.

Debt

Amount

(thousands)

Rate %

Yearly Interest

(thousands)

Linn Credit Facility 04/2019

2,010,000

2.15%

$43,215

Berry Credit Facility 04/2019

1,173,175

2.67%

$31,323

Linn Term Loan

500,000

2.67%

$13,350

Senior Notes 5/2019

1,200,000

6.5%

$78,000

Senior Notes 11/2019

1,800,000

6.25%

$112,500

Senior Notes 4/2020

1,300,000

8.625%

$112,125

Berry Senior Notes 11/2020

299,970

6.75%

$20,247

Senior Notes 02/2021

1,000,000

7.75%

$77,500

Senior Notes 09/2021

650,000

6.5%

$42,250

Berry Senior Notes 09/2022

+ 599,163

6.375%

$38,196

10,532,308

$568,706

The effective interest rate of the loan portfolio is 5.4%.

These calculations assume out of $2.3B in proceeds, $500M is used to buy back units and shares and $500M is applied to the revolver.

-

7. Borrowing base determinations

The borrowing base determination may be troublesome for Linn if commodity prices continue to tumble. Borrowing capacity under Linn's revolving credit facility is limited to the lesser of the then effective borrowing base reduced by the $500M term loan and the maximum commitment amount of $4.0B, and is currently $3.725B. September 30, 2014, the borrowing base under the Linn Credit Facility was $4.225B and availability was approximately $1.2B which includes a $5M reduction for outstanding letters of credit (page 11-10Q). During the conference call on page 4, Kolja Rockov Linn's CFO had this to say about the borrowing base:

"The semiannual re-determination of the borrowing base has been deferred until the Granite Wash sale closes in mid-December. Our borrowing base was reduced by $275 million or 25% of the gross proceeds of our $1.1 billion bond offering in September for the provisions of our credit facility. However, we anticipate upon re-determination later this year that it will return to the previous combined level of $5.9 billion, which will result in approximately $2.5 billion of undrawn capacity."

Investors should be aware that significant declines in commodity prices may result in a decrease in the borrowing base. However Rockov concluded his comments by stating the following in reference to the flexibility than Linn has:

"Our sources of liquidity are not limited to the pro forma 2.5 billion estimated revolver capacity. For example, we still have significant unrealized value in our remaining Midland Basin properties. Further resource assessment across our portfolio could create other sources of liquidity with little to no impact on our current cash flows."

The Stack sale and remaining Midland sale may provide more than $800M in liquidity.

-

8. Nine Month 2014 Metrics

Linn provided a cash flow analysis for the 9 month period ending September 30, 2014 but does not do so for the 3 month period ending September 30, 2014. It is important for every investor to know the cash flow as it has a direct bearing on the company's ability to meet its obligations including payment of distributions. However, to get to the cash flow number you have to first work through the condensed consolidated statement of operations on page 30 on the 10Q. My adjusted summary of this statement and statement of cash flows is as follows for the 9 month period ending September 30, 2014 found on page 32 on the 10Q. My modifications exclude changes in the cash flow related to changes in asset and liabilities including working capital.

9 month cash flow 2014

$2,844,185,000 OIL - NG - NGL

$-12,507,000 Derivatives- Cash Settlements

$100,655,000 Marketing

+ $19,392,000 Other

$2,951,725,000 Revenue

-

$576,564,000 LOE

$143,896,000 TRANSP

$75,920,000 MKT

$221,518,000 G and A

$10,492,000 XPL

$201,014,000 Taxes

$422,160,000 Interest

+$6,699,000 Other

$1,652,263,000 Total Expenses

-

$2,951,725,000 Revenue

-$1,652,263,000 Expense

$1,299,462,000 Cash Flow

-

$43,692,000 Unit Based Compensation

$29,236,000 Amortization - Deferred Financing Charges

+ $27,750,000 Losses on sale of assets

$1,400,140,000*

*Operating Cash Flow for 9 Month Period Ending Sep 30, 2014

The operating cash flow as a percentage of the revenue: $1,400,140,000 ÷ 2,951,725,000 = .4743%

This ratio may not hold in a drastically lower commodity period.

We may calculate adjusted EBITDA for the 9 month period as follows:

$1,400,140,000 Cash Flows

$422,160,000 Interest

$+ 2,674,000 Income Tax

$1,824,974,000 Adjusted EBITDA

If we add the projected EBITDA from Q4 of 519,126,038 we end up with EBITDA of $2,344,100,038 for 2014.

Leverage ratio would then result in the following calculation 10,532,308,000 ÷ 2,344,100,038 or approximately 4.5.

A DCR (Distribution Coverage Ratio) may also be calculated by using the figures on page 3 of the supplemental. Linn, to their credit, makes an adjustment for changes in operating assets and liabilities of $69,249,000. The net result for the 9 month period is that we both come in with coverage ratios of about 1.16. Even subtracting out the $79,555,000 for transactions, results in a capital DCR of 1.05 for the 9 month period.

-

9. 2015 guidance

Numerous assumptions have been made but many may not prove to be accurate. The obvious current outlier is the assumption of $80.00 oil for Linn's unhedged production in 2015. However this is what long term producers like BP utilize in their 10-20 year plans. If you feel that $65 oil will persist then the modification are easily calculated.

2015 guidance table 850MMcf/d

$972,262,400 Hedged

$480,420,000 Un-Hedged

$1,452,682400

The above assumes an increase in production of 16% and $4.00 Mcf for unhedged production

$1,523,017,600 OIL 70,000 Bbls/d Hedged

+ 754,400,000 Un-Hedged

$2,277,417,600 Total

( 153,300,000) Less Differentials

$2,124,117,600 Net OIL

The above assumes a decrease in production of 2,565 Bbls/d and an unhedged price of $80 P/Bbl

-

$415,735,000 NGL 34,000 Bbls/d

$35,000,000 Marketing & other

The above assumes a decrease in production of 950 Bbls/d and a price of $33.50 p/Bbl

-

$1,452,682,400 Total revenue NG

$2,124,117,600 OIL

$415,735,000 NGL

+$35,000,000 Marketing & Other

$3,992,535,000 Total Revenue

-

Total Operating Expenses

LOE 538,010,000 Mcf x 2.43 = $1,307,364,300

--assumes 12% reduction

G & A 538,010,00 x .55 = $295,905,500

-

$899,356,770 Distributions(b)

(b)assumes buyback of 21,780,302 units, 310,123,024 units remaining

$1,307,364,300 OP XP

$295,905,500 G & A

$574,331,000 INT

$500,000,000 Maintenance

$899,356,770 Distributions

$3,576,957,569 Total cash expense

$3,992,535,000

$415,577,431(superceded see below)

-Please see my changes to the 2015 "guidance" which now shows an excess of DCF of about 82 million for 2015 rather than $415,577,431 in a comment dated 12-10-14 at 12:37 A.M.

These figures probably project a set of facts that may be too favorable to Linn but in the original version the NG revenue was understated by more than 400 million. If they realize $72 rather than $80 for unhedged oil then there may be no excess. Also they still may have to pay closer to 960 million in distributions than 899 million which would eat into the excess projected for 2015. If the sales fail to materialize then other adjustments will have to be made as the VIE loan has a 364-day maturity and a principal due of 1.3 billion.

Keep in mind that in the conference call, Koljo Rockov stated that the new portfolio borrowing base should be very resilient to a downturn in commodity prices. It looks as if that theory will be tested to the max.

10. Possible solutions, other than a distribution cut, if low commodity prices persist

Linn may monetize hedges which were valued at $377M in current assets and $315M in non-current assets in the Q3 2014 report.

On page 54 of the 10-Q the company says at:

"At September 30,2014, the fair value of fixed price swaps, put option contracts, collars and (community hedges of $619M +/- 10% change = $1.2B) and three-way collars was a net asset of approximately $619 million. A 10% increase in the index oil and natural gas prices above the September 30, 2014, prices would result in a net asset of approximately $27 million, which represents a decrease in the fair value of approximately $592 million; conversely, a 10% decrease in the index oil and natural gas prices below September 30, 2014, prices would result in a net asset of approximately $1.2 billion, which represents an increase in the fair value of approximately $608 million."

Linn may also sell off the 8,000 Bbls/d of liquids production in the Permian or other acreage which proves too expensive for a master limited partnership to develop.

To summarize:

1) Reduction of the distribution should not be necessary in 2015 with a revised excess of DCF of around 82 million.

2) Sell non-producing land and/or last 8,000 Bbls/d of Permian production and use these funds for buybacks

3) Partial or total monetization of hedges if permitted by loan covenants.

4) Linn may, if permitted, eliminate the distribution and buyback over 10% of the units at current prices with their 08-07-14 authorization to buyback $500M dollars worth of units. This would make the Berry transaction more palatable and save nearly $100M in cash flow.

Conclusion

Linn's production mix in Q3 was 48% NG, 36% OIL, and 16% NGLs. Pro-forma for all announced transactions except the final divestiture of remaining Midland Basin properties, a very preliminary estimate of Linn's production mix for 2015 shows approximately 55% NG, 35% OIL, and 10% NGL. Linn has reduced their average annual decline rate to around 15% pro-forma for the transactions outlined in the graph. In the conference call they take every opportunity to point out the fact that they are cutting their operational expenses significantly.

For example, they indicate that the lease operating expense of $1.67 per Mcfe for Q3 was 12% better than their guidance. If Linn continues to shed oil producing properties, their hedges will cover a greater percentage of their oil production. Assuming that they divest their remaining Permian assets which produce 8,000 barrels equivalent per day (primarily liquids) their oil hedges will cover 70% of their production for 2015 based on a yearly production figure of 22,995,000 barrels. They have hedges for 2015 which cover 16,120,000 barrels at an average price of $94.48 per barrel. The hedges drop off to approximately 65% in 2016, assuming the divestiture of the remaining Permian assets because they are still hedged for 14,736,000 barrels at $90.44. However as they decrease oil production and increase NG production, hedges begin to fall below the 90% level for NG.

I believe they have repositioned their assets so that they can shed approximately $300,000,000 per year in capital maintenance expenditures. It is important to note the total outlay for capital expenditures in Q3 totaled $369,000,000 and for the 9 month period totaled 1.2B. These figures do not include acquisitions. Subtracting out the maintenance capital expenditures noted on page 3 of the supplement for 3 & 9 month period results in the following:

3 month period

$369,000,000 Capital expenditures

($213,252,000) Maintenance capex

$155,748,000 Growth capital expenditures

-

9 month period

$1,200,000,000 Capital expenditures

($606,120,000) Maintenance capex

$593,880,000 Growth capital expenditures

Although I believe that Linn has the ability to pick and choose which assets will optimize their results based upon current commodity price swings and have a balance sheet which withstands moderate commodity price swings, they are not impervious to significant commodity declines.

It is certainly possible if commodity prices continue to be low for an extended period of time, that Linn will be forced to cut the distribution. I believe the "NEW" Linn may be better suited for a long term distribution in the $2.00 range. Those of us who held Breitburn through the elimination of the distribution in 2008 - 2009 can remember prices in the mid single digits. Breitburn did the intelligent thing in eliminating their distribution and paying down their debt. That particular move saved the company. Cutting the distribution at Linn, which I view as a distinct possibility, due not only to the lower commodity prices and potentially lower margin assets, may be the correct course of action. But it now looks as if 2015 will not necessitate a cut and will provide a small excess of about 82 million. See author comments 12-10-14 12:37 A.M.

Disclosure: The author is long LINE, LNCO, BBEP.

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.

Additional disclosure: The author wrote this article, and it expresses his 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.

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