Last week LINN Energy (NASDAQ: LINE ) reported its fourth-quarter and full-year results. I've already drilled down into its financial and production results as well as looked into its deal for Berry Petroleum (UNKNOWN: BRY.DL2 ) by way of its LinnCo (NASDAQ: LNCO ) affiliate. Today, I want to dig a little deeper into one area I think LINN investors need to watch closer in light of those reported results.
I have a reservation
In LINN's press release announcing results, the company noted that it increased its total proved reserves by 1.4 trillion cubic feet equivalent to 4.8 trillion cubic feet equivalent, or up 42% over 2011 reserves. However, LINN actually purchased more than 1.7 trillion cubic feet equivalent over the course of the year. That's why the company had been reporting approximately 5.1 trillion cubic feet equivalent of reserves pro forma after its more than $2.8 billion shopping spree in 2012. That begs the question: Why is there a difference?
The first obvious answer is that LINN produced from its reserves over the course of the year. As it turns out, for the year that number was 246 billion cubic feet equivalent, or Bcfe. However, there are two more moving parts we need to look at: additions and revisions.
LINN was able to add 709 Bcfe to its reserves over the course of the year through extensions, discoveries, and other additions. These additions mainly came by way of the 436 gross wells the company drilled over the course of the year. This is exactly what you want to see as the company replaced all of its production and then some through the drill bit.
Where investors need to watch are the revisions of prior reserve estimates. For LINN that was 803 Bcfe, or about 100 Bcfe more than it added over the course of the year through drilling. Taken together with production and you cans see why LINN's reserves slipped a bit over the course of the year. Let's drill down and see what caused these reserves to be revised.
Why the well ran a little dry
Three factors came into play which contributed to these negative revisions. First, a total of 340 Bcfe of reserves were nixed due to poor asset performance. This was followed by 248 Bcfe of reserves coming off the books due to low natural gas prices. Finally, another 215 Bcfe of reserves were shelved due to the SEC's five-year development limitation on proved undeveloped reserves.
Really, the only concern here are those 340 Bcfe of reserves that were removed due to poor asset performance. Drilling for oil and gas is risky business and not every well that's drilled will pan out. If LINN starts to drill a lot of dry holes, and it only drilled four last year, or if the company has a string of poor acquisitions it could mean that its distribution will one day be in jeopardy. The worry here would be that LINN buys assets that simply don't have the resources that the company thought it was getting.
My Foolish take
The drop in reserves is not a huge red flag but it is something to keep an eye on. Its simply one of the costs of doing business in the oil and gas industry. As long as LINN can continue to build its reserves over time it should continue to produce the stable results we've come to expect.
The company is one that's built to grow by way of its checkbook.That's why a bulk of LINN's future reserves will come via acquisitions similar to its deal for Berry Petroleum. That deal will boost reserves by 1.65 trillion cubic feet equivalent or 34%. LINN's further identified 3.8 trillion cubic feet equivalent of probable and possible reserves that if proved would make this past year's negative revisions seem like a drop in the bucket.
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