LINN Energy (LINE +0.00%) has done a good job mitigating the traditional risks associated with owning an energy company. Its unique model has eliminated much of the exploration risk and commodity price volatility common to all exploration and production companies.
That said, LINN Energy as well as its affiliate LinnCo (NASDAQ: LNCO) are not investments without risk. LINN faces many of the other general risks as its industry peers including competition for drilling rigs, equipment, pipe and personnel which all could have an impact on its ability to operate. In addition to that, LINN faces three more risks that are more specific to its operations. Let's take a closer look.
Overpaying for growth
LINN Energy recently raised its bid to buy Berry Petroleum (NYSE: BRY) by $600 million. That represented an increase of 14% from the original bid price earlier this year. While Berry's operations have improved since the bid was made, it's a reminder that LINN's growth by acquisition model can prove challenging. LINN could find out down the road that Berry was no bargain even at the first offer.
Larger mergers like the Berry deal should be a much more regular occurrence now that LINN has proved the value of LinnCo as an acquisition vehicle. That said, it might be tempted to go on a shopping spree, which might not add much value to existing investors. LINN also runs the risk that one or more of its future acquisitions won't pan out as planned.
Not only that, but LINN's success has not gone unnoticed. Other yield starved institutional investors could form their own competing companies or ventures and bid up the price of assets that LINN likes to acquire. LINN will likely encounter stronger competition from other independent operators and master limited partnerships who see greater value in properties LINN bids to acquire, which could price LINN out of the market. This could put severe pressure on LINN's future returns and even inhibit its ability to grow.
Drilling dry holes
While LINN Energy isn't an exploration company, it is beginning to take more exploration risk in an effort to grow its production. Because of this, LINN's first two quarters saw the company earning less than it was paying out to investors. One of the issues was that some of the wells it drilled turned out to be duds. As LINN spends more capital to drill above what's required to maintain production, the risk is real that it will drill more dry holes in the future.
For example, LINN has the potential to tap the Mississippian Lime as well as additional areas of the Permian Basin. If the company is unsuccessful it could impact the its ability to grow its distribution in the future. This will be an area to keep an eye on when LINN announces its 2014 capital budget. If the company decides to invest more of its capital on growth in areas like the two I mentioned, it means that LINN will be taking on a bit more risk.
Access to capital
As most investors have has seen first-hand, units of LINN and shares of LinnCo have been pretty volatile this year. That's the main reason the company had to increase the shares of LinnCo stock it was offering for each share of Berry Petroleum. This volatility could impact its future access to the capital markets.
In order to buy oil and gas assets, LINN needs to either sell stock/units or take on more debt since virtually all of its profits are returned to investors. Depressed equity prices would make it difficult for LINN to offer shares to buy assets and still create value for investors. Likewise, borrowing at unattractive rates could make it harder to pay cash for assets like LINN's most recent deal in the Permian Basin and still come out ahead.
Investors need to realize the rising interest rates or a falling stock market could also have an impact on LINN's ability to grow. While either event could also reduce the valuation of the assets LINN likes to acquire, asset price might not move down as fast as LINN's ability to acquire them. While not a major worry for investors, it is a risk none the less.
Investor takeaway
Despite these risks, LINN Energy is one of my favorite dividend paying stocks. I've owned it for years and have enjoyed cashing in on the steadily rising payouts. The company has weathered the Great Recession and this year's volatility to come out a stronger company both times. So, that's why the risks need to be monitored, but shouldn't keep investors up at night.
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