LINN Energy (OTC:LINEQ) units are under pressure amid a short attack, poor natural gas liquids (NGL) pricing and an unofficial SEC inquiry. At the center of the storm is its merger with Berry Petroleum (NYSE: BRY). LINN Energy and Berry Petroleum both jumped recently after they finally set the record date for shareholder approval. Ultimately, the deal comes down to whether or not it makes sense for Berry shareholders. Although LinnCo (UNKNOWN:LNCO.DL) shares are down, I think the merger still makes sense.
Merger delays battered LINN shares.
This closing's dragged on for months. Originally scheduled for June 30th, the final vote is now set for September 30th. In between, LINN reported two soft quarters and shortfalls on its distributable cash flow (DCF).
Things got really messy when the SEC launched an informal inquiry into LINN's treatment of its hedge options, seemingly validating the shorts' thesis. Units plunged 32% in a period of days and the merger's death watch was on. Shares rallied briefly in June, only to derail again as critically weak NGL pricing torpedoed LINN's second quarter results. Circumstances seemed to conspire against the merger at every turn.
Is the merger back on track?
Now that the SEC is presumably all squared away, the vote is the last hurdle. That's a great relief for LINN and LinnCo holders. LINN's current problems go from overwhelming to irrelevant after folding Berry in. The big question is does it still make sense for Berry shareholders? I think the answer is yes, despite some challenging math.
LINN's offer of 1.25 shares of LinnCo had a value of $46.24 on the day of the offer and arbs quickly pumped Berry shares. The offer now stands at $39.29 per Berry share as of Friday, September 13th. Needless to say, that's darn unattractive given Berry's near $45 a share. Despite that, there are three good reasons to push the merger through.
LINN's Deep Pockets
Berry's not without its short term challenges. There's $200 million in debt due June of 2014. It can handle the maturity, but its capital is better put to use drilling. LINN can easily handle the maturity and future drilling capex. Its cost of capital is lower and its pockets are much deeper.
Nothing illustrates that better than LINN's recent acquisition. LINN raised $0.5 billion that included new term loans on top of its $4 billion revolver in the face of all this uncertainty. Even amid the turmoil, the bankers aren't concerned in the least.
Those deep pockets can unlock Berry's potential.
Berry's assets are a nice set of bolt-on opportunities with a sprinkling of new growth potential for LINN. Like Berry, LINN cut its teeth in California, and Berry's Permian assets would add to LINN's already active Wolfberry drilling program. These are basins LINN Energy understands.
Berry's Uinta basin assets also provide LINN access to a newly rejuvenated liquids-rich play with growth opportunities. Newfield Exploration (NYSE:NFX) proved its potential. The Wasatch sandstone has produced there for decades, but the shallower shales weren't economical until horizontal fracking made everything work.
Newfield tripled Uinta production from 2004 to the present drilling these shallower Green River formation targets. Additional drilling efforts now focus on deeper Uteland Butte and Wasatch objectives.
While Berry focused initially on the Wasatch, more recently it's been drilling and commingling these same Green River formation shales with the deeper Wasatch. With only 2 rigs running, production is actually down from the fourth quarter of 2012. The merger affords an opportunity to throw more capital into the basin and realize its growth potential.
Berry's newest liquids-rich assets are Permian. LINN already has a lot of acreage in the basin, and recently acquired more in a separate transaction. The combined company would have an expansive 160 MMBOE (million barrels of oil equivalent) of Permian reserves.
There's a lot of rig activity taxing infrastructure. Both Berry and LINN are feeling that pinch. New prospects in shale make it a playground for some of the big operators. Apache (NYSE:APA), the leader in basin activity has over 30 rigs running and its production was up 18 % year over year. Apache's focus is unlikely to change given its massive Permian resource potential.
Infrastructure improvements will eventually catch up to the needs of this bustling basin. In the meantime, the large combined footprint provides the opportunity to patiently pick and choose the most ideal opportunities.
It's also noteworthy that LINN has substantial organic growth potential of its own. Altogether, there are 250 MMBOE of proven, undeveloped reserves waiting behind LINN's drill bit. The combined entity would have substantial organic growth potential.
LinnCo's high yield offers a predictable, solid return that's sure to grow.
Post-merger, LINN's distribution will increase and its coverage issues disappear. Berry is expected to add 40 cents of DCF for LINN and the recent Permian purchase should add even more. It's difficult to envision a scenario where share weakness persists given resolution of the merger impasse and its hard to beat 10% yield. Berry's earnings yield is currently 6% and it provides only a token dividend. The distribution's a big cash-in-hand boost for Berry shareholders.
It's also important to consider that this isn't a cash deal. This deal's for stock, so current Berry holders participate in the future upside. Ultimately, access to capital at LINN's cost makes Berry better. Its assets become more profitable and its drilling program could accelerate. Berry shareholders benefit from this merger, because LINN's the key that can unlock Berry's potential.