How the oil bust has wounded Linn energy

The suspension of distributions to unitholders has killed the primary rationale for investing in the company. Some odd deals and the CFO’s departure only raise more questions. For investors there are simply too many better options. If you are a long-term oil and gas investor looking to buy a stable income stream, you have to consider the oil majors.

Their shares may be down 25% to 35% in the past year as oil prices have plunged, but that means their dividend yields are getting juicy. Exxon Mobil XOM +0.68% yields 4%, Total 6%, Royal Dutch Shell 7%, and BP 7.5%. And none of them have shown any indication of cutting those dividends. Exxon has continued a massive stock buyback program on top of the dividend.

Contrast that with Linn Energy LLC. Unlike most oil companies, which are C-corps, Linn is a limited liability company. That means it has units instead of shares and it passes its taxable income and some of the tax benefits through to unitholders in the form of cash distributions, not dividends.

Those cash payouts were why people invested in Linn. From the time of its IPO in 2006 Linn increased its annual payouts from $1.28 per unit to $2.90. In recent years yield-starved investors had gladly bid up Linn units to get at that cash. A year ago, before the bust, Linn units were trading at $31.50 and yielded 9%. But now that Linn has announced that it is suspending all distributions, investors are struggling to find reasons to own Linn units. At $3.50, they are down 90% since last year.

Some of Linn’s biggest assets are mature giant oil fields like these near Bakersfield, Calif.  (Photo credit: MARK RALSTON/AFP/Getty Images) In better times Linn had used its inflated units as currency to buy oil fields and even entire companies, like the $4.9 billion takeout of Berry Petroleum in 2013. Linn has grown by acquiring the castoffs of other oil companies, rather than wildcatting in frontier regions. As a result it owns mostly tired old oil and gas fields that have been producing for decades and will continue to do so (with relatively shallow decline rates and minimal capital expenditure) for many years to come.

Well hedged oil production and predictable cash distributions were supposed to make Linn as stable as those pipeline companies that commonly use the MLP structure. Adding cash-producing assets meant Linn could turn around and keep increasing its distributions. Bigger payouts helped up its unit price and its market cap. That in turn enabled Linn to accumulate $10.3 billion in long-term debt.

But now that model is broken. In the three months ended June, Linn generated $300 million in net cash, compared with $480 million in the year-ago period. Over on the income statement Linn has recorded massive net losses in the past year due to non-cash writedowns in the value of its oil and gas fields.

The downcycle has gotten so bad that to conserve cash Linn slashed its distributions in the quarter, and after September it is suspending its payouts altogether. The move will save $450 million a year in cash. But it didn’t go over well with investors, who sold off units on the news.

“We’re all shareholders, we’re all losing value,” said CEO Mark Ellis in a phone interview. “But you have to think about the long-term financial stability of the company. We’re going to do everything we can to get back to paying distributions.” What oil price would enable Linn to reinstate distributions? He wouldn’t say.

And if Linn permanently torpedoes its relationship with unitholders, so be it. Management has shown in recent months that its more concerned with currying favor both with bondholders as well as with even deeper pocketed private equity groups. Linn’s bonds have plunged to distressed levels and are now trading in the 30s, with yields of 40% or more, according to FINRA data. To placate bondholders, Linn this year has “invested” $500 million to buy back and cancel roughly $800 million (principal amount) of its debt.

Buying back bonds was an odd use of that $500 million in cash, which was enough to make an entire year’s worth of interest payments on all of Linn’s $10.3 billion in debt. Besides, Linn has always been about buying unloved oil and gas fields at a discount. I asked Linn CEO Mark Ellis how buying back Linn’s bonds was a better business strategy than buying up distressed oil assets at the bottom of the market? “It was an assurance of a guaranteed return on investment, an attractive return,” of greater than 50%, said Ellis. That move will save $54 million a year in cash interest payments.

Besides, Ellis says, there’s surprisingly not much to buy out there right now. “It’s a slow market so far. A few deals, but not a world of opportunities. And some assets that make it to market might not be the best assets for us.”

It’s unlikely that Linn will be making any acquisitions for its own account any time soon. But thanks to two unusual financing deals, Linn execs will be scouting out opportunities for their private equity friends.

Quantum Energy Partners, the private equity group that birthed Linn back in 2006 has agreed to put up $1 billion and form a joint venture with Linn. Together they will go out and find new exciting acreage. Quantum will pay to drill the prospects and will enjoy the lion’s share of the high-volume initial production. Then after the best juice has been squeezed out, the JV will sell the assets on to Linn Energy. The new JV company, says Ellis, “will capture assets, have assets on layaway, then flip them into the structure,” meaning into Linn.

Quantum, through Linn, declined to talk with Forbes, but Claire Poole of the Daily Deal did a recent Q&A with Wil VanLoh, managing director at Quantum and asked him about the JV.

“It was a $1 billion equity commitment for an acquisition partnership. The access to capital for some upstream MLPs is more difficult than for c-corps, and how much equity they can access is the biggest driver of a deal. A lot of assets that are more mature than a c-corp would be interested in buying still have a lot of production in them. So we came up with a unique solution: Let’s buy those assets together, not what they would normally buy because they have too high of a decline and require too much development capital. And as those assets mature, there will be less capital required, and Linn will have the opportunity to buy them [from us]. We’re looking at a lot of stuff already.”

Linn unitholders should keep a close eye on this. Quantum’s portfolio is invested in a host of other non-public E&P companies that are sitting on lots of acreage they would no doubt love to dish off to Linn. Linn has also forged a JV with GSO Capital Partners, a unit of Blackstone. GSO is putting up $500 million to finance drilling on Linn’s existing inventory or even on some of the new assets to be acquired with Quantum. Explains Ellis, “GSO provides 100% of the capital, with 100% Linn carry, then it flips back.”

As explained in their press release announcing the deal:

GSO will fund 100% of the costs associated with new wells drilled under the DrillCo Agreement and is expected to receive an 85% working interest in these wells until it achieves a 15% internal rate of return on annual groupings of wells, while LINN is expected to receive a 15% carried working interest during this period. Upon reaching the internal rate of return target, GSO’s interest will be reduced to 5%, while LINN’s will increase to 95%.

This deal should be troubling to unitholders. Linn management just gave away $500 million in cash to repurchase debt that was much less expensive than this new financing with Blackstone. With its own $500 million in cash Linn presumably could have made the same investments that it will seek to make with Blackstone, but instead of helping Blackstone make that 15% internal rate of return it could have generated the same return for itself — which in time should have been more than enough to keep paying interest on that repurchased debt.

Naturally, a troubled, overleveraged company has to grab onto whatever life rafts it can find, but these deals are pretty convoluted. What reason do unitholders have to believe that Linn could even hold up its side of the deal — finding and developing the assets in a profitable way? They don’t do this now. Indeed, why would any potential Linn unitholder be interested in owning a piece of a company that is planning on deploying a skillset that is not its core competency (high-growth horizontal drilling of tight oil formations) on behalf of two entirely separate companies in exchange for the promise that if everything goes well it will get the opportunity to acquire those assets after the other companies already sucked the best juice out? Why would you want to be a bystander?
If you’re impressed by these Linn JVs, then you ought to take a closer look at some U.S. tight oil developers with far less leverage and the ability, when things get better, to fund their own drilling. Nomura Securities E&P analyst Lloyd Byrne likes EOG Resources EOG -0.65%, and thinks Marathon Oil MRO +0.00% is particularly underappreciated.
In the background, there remain lingering concerns about Linn’s accounting. Linn is one of the biggest commodity price hedgers in the oil patch, regularly spending hundreds of millions of dollars a year to buy puts on oil and gas. The idea was to smooth out its commodity exposure and to have a more predicable stream of cashflow. In recent years Linn has been accused by Barron’s, Hedgeye Research, and others of being too aggressive in accounting for its oil and gas derivatives. In 2013 these accusations delayed Linn’s acquisitions of Berry Petroleum and also triggered an informal SEC investigation that presumably didn’t turn up anything. Linn felt compelled to issue a point-by-point refutation of the allegations. Linn remains better hedged than many other E&Ps, but, as we’ve shown, even the deepest hedge book has proved to be no match for the plunge in oil prices.
Linn’s CFO Kolja Rockov resigned in August. I asked Ellis what Rockov did wrong that led to his departure. “There were no policies or procedural issues,” he said. Maybe not, but there is a bigger issue: Linn is a company struggling to show that it has any competitive advantage. For investors there are simply too many better options out there. Eliminating cash distributions has eliminated unitholders’ primary rationale for investing in the company. Until oil prices recover to the point that the company can reinstate its distributions, Linn is a broken vehicle.

http://www.forbes.com/sites/christopherhelman/2015/09/18/how-the-oil-bust-has-wounded-linn-energy/3/