Linn Energy: Navigating The Confusion Of Puts And Sustainability

Linn Energy, LLC has come under fire in recent months for its treatment of derivative expenses as well as the sustainability of its distribution. Given the backdrop of vocal critics, and the uncertainty of the SEC inquiry, LINE's share price has dropped significantly. I am of the opinion that the treatment of Puts by LINE is appropriate and that the sustainability of the distribution may be incorrectly evaluated by both critics and supporters alike.

Swaps vs. Puts (Skip this section if clear with distinctions between the two)

There are multiple ways to hedge commodity price fluctuations but the most common would be a swap. Generally speaking, Linn could enter a swap at no upfront cost to hedge its production and effectively lock-in a future fixed sale price. As an example, suppose Producer X enters a swap with Consumer Y to sell natural gas at $4.50 (note the swap counterparty doesn't necessarily need to be the same as the commodity consumer, but that wouldn't change the outcome for Producer X). On the first swap payment date, Consumer Y buys natural gas from Producer X when the market price is $4.00. Consumer Y will pay $4.00 (market price) + $0.50 (swap payment to Producer X) = $4.50. On the second payment date, the market price has increased to $5.00 so Consumer Y buys at $5.00 but receives a $0.50 payment on the swap from Producer X. In both cases, the Producer X will receive $4.50, regardless of the market price. If Linn had solely this type of derivative to hedge production there would probably be no concern here; however they also use Puts.

Ownership of a put contract grants the holder the option to sell the underlying asset (think natural gas or oil here) at a predetermined strike price. Unlike a swap, entering/purchasing a put requires an upfront cash payment known as a premium. Also unlike a swap, the put holder makes a single upfront payment and then can only receive cash payments from the seller of the put. In order to receive these payments from the seller, the put holder would "execute" the put and receive the difference between the market price and the strike price. As an example, Producer X purchases 100 puts with a strike price at $4.50, for a premium of $0.25 each from Consumer Y, to hedge production evenly over 4 quarters. In quarter 1, the market price of natural gas is at $4.00 and Producer X sells natural gas at $4.00 but also executes 25 puts at the strike price of $4.50, receiving the difference between the strike price and the market price ($4.50 - $4.00 = $0.50 per put). In quarter 2, the market price of natural gas is at $5.00 and Producer X sells at $5.00 but doesn't execute any puts since the market price is higher than the strike price. However, the 25 puts expire worthless and are still expensed during the period. In both these cases, the Producer X paid cash upfront but received cash benefits in the future and recognized 1/4 cost of the 100 puts in Q1 and 1/4 the cost of 100 puts in Q2.

Evaluating Treatment of Puts

But is it unique to capitalize the cost of a put, and recognize the cost overtime in the future rather than when the upfront payment is made? In order to better understand this, let's describe the same put example above a little differently. Producer X purchases an asset for $100 but doesn't recognize this cost initially. This asset will allow the producer to generate additional revenue and has a useful life of 4 quarters and no salvage value. In each quarter, Producer X recognizes D&A of $25 and eventually the asset has a carry value of $0. Does this sound similar to anything else? How about capital expenditures? Capital expenditure costs are recognized over time and contribute to a firm's ability to generate revenue (i.e. Ford needs equipment to manufacture cars).

Turning back to Linn, imagine if they recognized the cost of their puts upfront in their DCF. They would have low or even negative DCF coverage in the period in which they purchased the puts. However, the puts would provide future economic benefits as they are executed but have no associated costs in future periods (already recognized upfront). This would result in significantly higher DCF coverage in these future periods. Is this really more accurate? In the first period in which the puts were purchased, one would conclude the distribution must be cut while in the next period, one may conclude the distribution could easily be increased. As a logical alternative, Linn recognizes both the cost and benefits of each put in the same period. This is consistent with the principals of accrual accounting and provides a more accurate representation of sustainability by matching costs and benefits.

Determining Sustainable DCF

Sustainable DCF is the level of cash flow that can be internally generated and distributed to unitholders over the long-term. Broadly speaking, this would be the amount of cash flow generated from existing operations less cash required to replace or maintain the assets that sustain existing operational performance. Thus any capital expenditures or reserve acquisitions costs above those required to maintain existing operations would be excluded from this analysis.

Sustainable DCF = Cash Flow from Operations (CFO) - Replacement Capital Expenditures (CapEx) - Replacement Reserves (RR).

CFO may require adjustments for items that are not sustainable, such as cash inflows from reductions in working capital balances or potentially cash inflow from financial instruments in excess of hedging purposes. For example in the case of put options, any cash outflows for the purchase of put options should be added back and the original costs of any puts that have expired or have been executed in that period should be subtracted out. Also, cash received from put option executions may require adjustment. For example, if 1 put contract covers 1 unit of natural gas and Producer X sells 10 units of natural gas but executes 20 units of put contracts receiving a cash payment, then their cash flow for the current period without adjustment would be overstated. I don't see evidence that this is happening with LINE, this is just an example. However, LINE may benefit from providing such clarification.

It is important to reiterate, that capital expenditures and replacement reserve costs that appear on the statement of cash flows are often in excess of what is required to sustain current operational cash flows. Natural resource producers often spend well in excess of what is required because they wish to expand their operations or obtain assets at what they believe to be at attractive prices. As this excess spending is not required to maintain the current DCF, it would be excluded from consideration.

Applying Sustainable DCF to LINE

Note: If the premise that put treatment is not a material concern is accepted, it will make sense to post a much more detailed version of this section next week and I will also provide a valuation estimate. Please consider this as a summary.

In order to scrutinize Linn Energy's Sustainable DCF, let's take a look at their Q1 2013 Supplemental Presentation found at: http://ir.linnenergy.com/eventdetail.cfm?eventid=129104

Using the midpoints provided in this supplemental presentation, I have projected forward an Adjusted CFO of approximately $1.2 Billion. However, we must now separate replacement capital and reserve expenditures versus the totals. LINE provides us with an estimated total annual amount of $457 million, labeled "Maintenance Capital Expenditures." Assuming that amount to be correct, Sustainable DCF Coverage for FY2013 is 0.97x under my calculations, slightly below LINE's full year estimate of 1.00x. However, it is worth noting that a pro forma analysis with BRY included would produce a figure above 1.00x and that my projections have Sustainable DCF Coverage above 1.00x for the years 2014 through 2017 even without any merger.

In my opinion, with LINE having historically provided reliable estimates and their put accounting to be inconsequential, the real question for a critic should be whether their "maintenance capital expenditures" are truly indicative of the replacement costs discussed above. However, please note that I have no reason to believe they are not indicative and have been surprised that this has not been a major focus of criticism. Perhaps such criticism is just more difficult than accusations of accounting irregularities.

Disclosure: I am long LINE.