Units of LINN Energy (NASDAQ:LINE), and to a lesser degree its affiliate LinnCo (NASDAQ:LNCO), where hit with a one-two punch last Friday. First, an analyst began to question the company's hedging practices, saying its accounting for those derivatives is questionable at best. Those questions were then amplified in a Barron's article over the weekend. With the spotlight now shining brightly on LINN, what's an investor to do? Before we get to that, let's take a deeper look at what's at issue.
A word about risk
Let's state the obvious here and note that investing is a risky business. You are buying ownership interests in companies that themselves face a set of risks that could put any one of them out of business. The ability to navigate those risks in an effort to survive and then thrive is what makes winners and losers.
Investing in energy is no different. One of the big risks investors face is from commodity prices which are notoriously volatile. Just ask investors in Chesapeake Energy (NYSE:CHK), who went from riding high as natural gas prices rose, only to collapse along with them. To help mitigate that risk and navigate past it many energy companies will use hedges. Most energy companies, though, will only hedge a portion of production, and usually only for the next year or so.
Using Chesapeake as an example, as of its last hedging update in November, the company had only hedged 76% of its fourth-quarter oil and natural gas production. Further, the company has hedged just 69% of its 2013 oil production. What's most interesting is that the nation's No. 2 natural gas producer had not hedged any of that production for 2013, leaving it completely vulnerable to the whims of the market. While operational risks abound at Chesapeake, the added risk of commodity exposure leads investors to endure a potentially wild ride.
LINN's secret sauce
LINN Energy takes a different approach -- the company hedges 100% of its oil and natural gas, not just for the next year, but through 2016 for oil and 2017 for natural gas. The company refers to this as its "secret sauce" because this long-term, 100%-hedged discipline is unique to LINN. It's unique even among its peer group of oil and natural gas producers organized as master limited partnerships.
Within that group is BreitBurn Energy Partners (NASDAQ:BBEP), which, while well hedged, isn't hedged for as long nor to the same extent as LINN. The company's stated goal is to consistently hedge a high percentage of future production. Specifically, 80% of current production, 75% of the following year's production, dropping to 60% in year three, and 50% in year four. Like LINN, its hedging program is a core of its business strategy and not a trading tool.
LINN sees hedging as its way to lock in a minimum cash flow for the next few years. How it hedges leaves room for some upside but most of LINN's growth comes from either acquisitions or through the drill bit. When you invest in LINN you're not investing in the upside of commodity prices, you are investing in the constancy of its cash flow. Put another way, you are investing in the thesis that we need energy each and every day, but not in the price that is paid to keep the lights on and the car running.
A practical example
Let's take a look at what LINN does in a more practical way that you, as an investor, might understand. Last year LINN bought $2.8 billion in assets. Each time LINN buys an asset two things in the press releases stand out that you would'nt see elsewhere. LINN will note that the deal was immediately accretive to distributable cash flow per unit. Typically, for every $100 million of assets LINN acquires it expects to generate $0.02 additional distributable cash flow. LINN spends up to 10% of the acquisition price to hedge the production out four to six years.
Let's say you, as an investor, want to lock in a dividend and future sale price but did not want to expose your portfolio to the volatility of the underlying stock. Your options are limited, but you do have, well, options. For this example we'll use Royal Dutch Shell (NYSE:RDS-A), which currently has a dividend over 5%, global operations, and a fortress-like balance sheet. You can, as of this writing, buy shares for around $65.50 and hedge those shares for the next two years using options. You can buy a January 2015 $65 put for around $7.70 a share. Your total investment would be $7,320 and you would, in essence, lock in a 4.7% yield with virtually no downside risk for the next two years. The upside is yours to keep.
This is the essence of what LINN does, but instead of hedging 100% through buying puts, LINN's hedging strategy is to use 70% swaps, which are fixed price contracts, and 30% puts. Swaps are no more than fixed rate contracts where LINN is essentially selling tomorrow's production at an already agreed upon price. Taken together, LINN is locking in its minimum future sales price, which locks in its cash flow for the next four to six years, with the puts providing some additional upside.
Foolish bottom line
Investors need to realize that LINN was the first MLP-type upstream oil and gas producer to go public. Now that the company has gained popularity among investors in this low yield environment it's not surprising that the company is also now being put under a brighter spotlight. This is not necessarily a bad thing as it keeps management accountable to investors.
LINN Energy is a different kind of oil and gas company. There is virtually no commodity price risk here; instead you're buying stable, growing cash flows. That stability does not come cheap: Investors can certainly pay less for an oil and gas investment, but in doing so they expose themselves to the underlying commodity. You need to ask yourself what you are buying and why. We're here to help you along the way, stay tuned to Fool.com all this week for more coverage on LINN Energy, including its earnings release on Feb 21.
Fool contributor Matt DiLallo owns shares of LINN Energy, LLC and LinnCo, LLC . The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.