According to the Farmer's Almanac, temperatures this winter were to be much colder than in previous years. That forecast was likely one of the reasons why natural gas spiked to nearly $4 this past November. Unfortunately for natural gas drillers, that forecast hasn't come to pass as warmer temperatures have sent natural gas prices lower.
As the price of natural gas has fallen, so have the stock prices of those who drill for it. Southwestern Energy (SWN +0.00%) for example is down about 10% from its highs last fall, its but one of a number of examples. Southwestern, like a lot of its peers, doesn't pay a dividend so the only return for investors is from capital gains. Over the past 52 weeks, the company's shares bounced between a low of $25.63 to a high of $36.87. That type gut-wrenching volatility unfortunately is the norm for energy investors; but, what if there was a better way?
A different kind of energy company
With a third less volatility and a dividend nearing 8%, Linn Energy (LINE +0.00%) really is a different kind of energy company. Structured as an LLC, the company's tax structure more closely represents that of an MLP. That tax advantaged structure unfortunately comes with a bit of extra work come tax time in the form of a Schedule K-1.
To help broaden its investor base the company launched LinnCo (NASDAQ: LNCO) which is structured as a more familiar C-Corp. LinnCo's sole purpose is to invest in shares of Linn Energy. After it takes care of all that extra paperwork and taxes, it distributes the rest of its income to investors. Lately that means a more than 7.5% yield.
Three keys to Linn Energy's success
While the dividend is a good reason to invest in Linn, there's more to the story that just a quarterly paycheck. The company's business model is simple: It acquires, develops and maximizes the cash flow from mature oil and natural gas assets. Its success is built upon three pillars: acquiring, hedging and drilling.
Linn is a master at buying producing assets from sellers that need the cash to fund expensive drilling programs. Among the company's four acquisitions over the past year is $175 million worth of predominantly natural gas assets it plucked from none other than Southwestern Energy. The deal added 430 producing wells in East Texas with low decline rates of less than 10% along with a reserve life of 15 years. The company has also identified multiple upside recompletion and infill-drilling opportunities.
Once Linn closes on its deals the company then hedges 100% of the production for the next few years. In fact, Linn's natural gas production is 100% hedged through 2017 while its oil production is fully hedged until 2016. Not only does this lock in the floor of the company's cash flow, but also allows for some upside. Linn's peers on average have hedged less than half of 2013 production and only 20% of 2014 production. That leaves cash flows much more vulnerable to commodity prices which will lead to continued volatile stock prices.
While a majority of the company's growth over the years has come from acquisitions, its drilling program has the potential to really boost production. Linn has a large inventory of low-risk and liquids-rich development opportunities that it can drill each year. Chief among these opportunities is the Hogshooter formation of the Granite Wash. Linn is focusing its drilling program on the formation because it has a much higher concentration of oil. That concentration is generating 71% more in revenue per thousand cubic feet equivalent than the average Granite Wash well, giving Linn some very nice upside as it keeps drilling.
What to look for in the year ahead
One of the driving forces behind the LinnCo IPO was that the company sees a very robust acquisition market over the next two years. Because of the price of natural gas is low, many of its drilling peers are running out of options to fund ambitious drilling programs. With selling more mature assets one of the only remaining options, Linn can really go on the offensive.
Linn has averaged just under $2 billion of acquisitions in each of the past three years, with 2012 seeing the company complete $2.8 billion in deals. A large portion of that capital funded two separate deals with BP (BP 1.07%). These were great deals that took advantage of BP's balance sheet issues to scoop up $2.225 billion of both producing assets and future drilling locations.
The company is likely to spend between $2 billion-$3 billion (if not more) in 2013, as it has the scale and greater access to capital to compete for larger deals. A number of drillers are looking to shed assets over the next year, with Chesapeake Energy (CHK +0.00%) being just one of the company's many potential trading partners. The No. 2 natural gas producer is looking to unload between $5 billion-$7 billion of assets in 2013. That's on top of the approximately $12 billion of assets it sold in 2012. Many other exploration and production operators will be looking to offload mature assets to fund higher growth, liquid-rich opportunities. Expect Linn to have a busy year.
Bottom line
Linn Energy is a great choice for investors looking to buy a high quality oil and gas company. Not only does the company pay a very secure and growing dividend but it offers upside with less volatility. I expect 2013 to be another year of solid growth for the company and that's why Linn is my top choice for 2013. I'll personally be adding to my positions in both Linn Energy and LinnCo in the very near future while I'm having LinnCo join Linn Energy as a thumbs-up in CAPS.
