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.
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.
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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