Linn Energy LLC's Latest Asset Swap Achieves 2 Important Things

Source: Permian Basin oil field. Photo by Adam Levine. 

Late last month Linn Energy (NASDAQ: LINE  ) (NASDAQ: LINE  ) (NASDAQ: LINE  )  announced it would swap 25,000 acres of its horizontal drilling position in the Permian Basin in exchange for 500,000 gas-producing acres in the Hugoton Basin in Kansas. Linn, following its acquisition of Berry Petroleum, inherited a good bit of Permian acreage well-suited for horizontal drilling.

Source: Linn Energy Investor Relations.

The Hugoton acreage is very mature, provides little to no growth, and production is 80% gas. ExxonMobil (NYSE: XOM  ) (NYSE: XOM  ) (NYSE: XOM  ) was happy to take Linn's Permian acreage and expand its foothold in one of the most prolific new shale plays in the U.S. in exchange for its own Hugoton position. So, why would Linn trade away its acreage in such a favorable position for gas-producing acreage, which provides a significantly lower return?

Structured as an upstream master limited partnership, or MLP, Linn's objective is to maximize distributable cash flow. This means that high-growth acreage, which requires large up-front investment and does not become cash flow positive for a couple years, is not appropriate for Linn. Developing this kind of acreage would take away from distributable cash flow, or DCF, which ultimately flows to a lower distribution. 

In swapping its Permian position for mature, cash flow-positive acreage in Kansas, Linn added somewhere between $30 million and $40 million in annualized DCF. How big of a deal is that? Well, as of last quarter, Linn estimated that its DCF would be only 0.98 times its 2014 distribution. However, when we add $30 million to DCF, it then becomes 1.01 times distributions on an annualized basis. In short, this deal secured Linn's 10% distribution for the immediate future.

Mind the decline
Another important consideration is the decline rate of Linn's resource base. Although 'maintenance capex' is a non-GAAP metric, it is important for upstream master limited partnerships because this metric is subtracted from DCF. This makes sense because one wants to subtract from DCF capital expenditure that is required to mitigate declines. A higher decline rate will, of course, require higher maintenance capex.

This is exactly why Linn wants to reduce its overall decline rate in the long run, and has pursued acreage in geographies with some of the lowest decline rates. Linn's horizontal Permian acreage, presumably, has a decline rate well into the double digits. The new Hugoton acreage, however, has a relatively low decline rate of just 6%. This acquisition lowers the company's overall decline, and is in tune with management's long-term goal to reduce its use of capital.

Bottom line
Linn's swap with Exxon was a great deal for Exxon, but it was also a good deal for Linn. Investors should be careful not to see these deals as a zero-sum transaction; I believe this deal works well for both parties. In significantly increasing its Hugoton position, Linn may also benefit from economies of scale at its Jayhawk gas plant, which sits on Linn's acreage.

I believe we will see more deals like this. Shale plays in the Permian are now highly desirable, and Linn still has nearly half of its original Permian horizontal acreage. The next transaction will hopefully also be a cash-positive acreage swap. In any case, this was a step in the right direction for Linn.

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  • Report this Comment On June 03, 2014, at 9:36 AM, gabby1945 wrote:

    I seriously doubt the addition to DCF will be $30-$40 million, but probably closer to $17 million and that includes a reduction in CAPx costs that were reduced by the acreage trade. The Berry deal was more expensive than planned and will incur addition costs in the form of debt payments and CAPx (Berry and the new acreage).

    In the short run there will be some pain, but in the long run Linn should be able to extract the oily profits above and beyond what they are losing with the Exxon trade. The Linn management team has a track record of delivering and although a more complex balancing act will be required, they seem to know how to handle complexity.

    In my opinion any distribution growth, although important, will be a lower priority in the short run until all of these pieces/parts are running like a well oiled machine. If things work out as expected by management, I won't be surprised to hear talk about an increased distribution in 2015 or early 2016.

    Opinions are like belly buttons....everyone has one.

  • Report this Comment On June 03, 2014, at 7:26 PM, Chippy55 wrote:

    For those who think "the DCF will be closer to _____ [insert your WAG] rather than the $30 - 40 million that is needed to keep the distribution at the amount it currently is, i.e. .2416 per month, here's what my pals and myself are saying and why we are still buying: What if they decided to cut the distribution, currently at $2.90, to "only" $2.50 or even $2. Wouldn't there be an increase in buyers since people would be assured that even though its lowered, they would be more assured of receiving it? At $2.50 it would still be paying 8.8% and at $2, that yield is 7%. Frankly, I don't understand why the stock hasn't really recovered from last years plunge when the Berry deal kept dragging on with the final outlay being raised from I believe it was 1.25 shares to 1.68 shares. I mean, even at the higher number of shares being given to Berry shareholders, and after running the all the data, it should still be apparent that they can continue with the distribution.

    I'm happy, especially since it's paid out monthly. My gut tells me that we're going to see a nice little pop of $2 to $3 in the near offing, because with summer approaching the price of oil should start creeping up due to vacations. Now is as good as time as any to get in with LNCO below $30.

  • Report this Comment On June 03, 2014, at 10:45 PM, critterlitter wrote:

    chippy --- Pretty much the opposite would happen should Linn cut its distribution. It would be perceived that trouble is in the wind that the market hasn't even seen or heard of yet and they cant make the present distribution or meet at least a 1.0 ratio. A distribution cut, in my mind, would again kick the share price right in the keister.

    The market is watching this stock quite closely and ANYTHING that is considered less than good news loads the cannons of detractors and the shorting "strategists". A cut in the dividend would manifest itself also in a barrage of articles that would compound the actual news.

    Linn needs to get their distribution ratio above 1.0 and that probably has been just barely met with the XOM deal recently. The other portion of the Midland deal is forthcoming --- probably this year, and that should additionally solidify the distribution at .2416.

    Linn also must show that their present, and any future acquisitions are not only productive, but accretive; in that they need to hold their own in how they contribute to Linn. In other words, if ANY portion of Linn holdings behaves as a liability rather than an accretive asset, the shorts, the articles, and the detractors will once again come out of the woodwork.

    Linn needs to maintain its distribution, bolster its production and stay out of the "non-positive" limelight.

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