It's hard to be unloved. LINN Energy (LINEQ) exited a tough year with an excellent quarter. Yet investors were singularly unimpressed, selling off LINE and its sister security LinnCo (NASDAQ: LNCO). The unloved pair were already twisting in the wind despite finally closing the long-delayed Berry Petroleum acquisition. Then on Monday, JPMorgan ratcheted up the pressure with a downgrade that sent shares into a complete tailspin.
At some level, guessing about market moves is a fool's game. But when you're holding a stock that's under pressure—especially a public short attack – at some level, you must listen to the market. At the very least you need to be certain that you disagree. How bad is it and what will it take to turn it around?
The company has to be relieved that 2013 is gone. Slumping NGL prices hurt cash flow and squeezed DCF coverage uncomfortably. NGL differentials are critical to LINN's success. They're a large proportion of LINN's liquids production. More importantly, hedging them effectively is nearly impossible.
Ironically, the same NGLs that wrecked the year ended up saving LINN's bacon in the fourth quarter as prices stabilized, especially for propane as a result of the harsh winter weather. Coverage ratios improved substantially on improving revenue, reaching 1.19 times DCF in Q4.
That's the good. How about the bad?
So why the worry? Even management confessed to being confused about the market's initial response when quizzed on the quarter's call. While last quarter was nice, investing is about the future. Investors need to worry about next quarter's coverage, and guidance was not exactly comforting.
LINN Energy forecasts only a $12 million distribution excess year-end 2014 with a scant $1 million distribution increase. That $1 million works out to a 0.1% increase. Needless to say, holders seemed less than thrilled. Monday, JPMorgan made it that much worse when it declared that even that distribution level is not safe.
Can LINN avoid a cut?
The poor guidance comes paired with a looming distribution increase in the first quarter. The Berry deal closed so late in December that no payments were made to former Berry shareholders in Q4, so that comfortable fourth quarter coverage ratio may be tighter than it appears considering dilution from the merger.
Unit count popped 40% as a result of the Berry merger. Yet, LINN's low-end forecast projects only a 20% increase in production to offset that dilution. With equity holders already spooked by the drawn-out acquisition process and swirling short attacks, that's the kind of math that breeds uncertainty—maybe even panic. According to management, this will be an accretive deal. How can that math work?
Follow the cash
Focusing on production is misleading. Ultimately, we don't care how much oil and gas LINN produces. Heck, we don't even care what LINN produces. It could be oil, gas, cell phones, or razor blades. We care how much money LINN produces.
What's missing from the analysis above is accurate consideration of how significantly LINN's production mix is altered by Berry. That incremental production provided by Berry's operations is 80% oil, and at these oil and gas prices, oil is the lion's share of any company's revenue.
Oil companies all produce a mix of oil and gas. To make production numbers easier to follow, headline numbers are reported collectively in equivalents based on the relative energy content of oil and gas. LINN converts all its oil production to 'mcf equivalents' or Mcfe when it reports its headline number.
At these prices, all that oil makes Berry significantly more valuable per Mcfe than LINN's current gas production. One Mcfe of oil—one sixth of a barrel – is worth roughly $16.50 compared to an Mcf of gas at $5. That's the equalizer in the deal.
It's all about the oil
A quick back of the envelope calculation illustrates this. LINN's Q4 production was 889 MMcfed (million cubic feet equivalent per day), and 44 MMcfed came from Berry at quarter's end. So, LINN ex-Berry averaged 845 MMcfed in Q4 of 2013. The low end of Q1 guidance is 1,070 MMcfed for an incremental boost of 225 MMcfed due to Berry's expected production.
With Berry producing 80% oil, that works out to 180 MMcfed or 30 MBbld (thousand barrels per day) of incremental oil production. At the $93 per barrel realized in Q4, Berry will add $251 million in oil revenue over a 90-day quarter.
Add in the little bit of gas revenue and Berry's $265 million boost to revenue is far more appealing. The 42% revenue increase Berry brings over Q4 can in fact offset the deal's 40% dilution. Oil is simply much more valuable economically, and that's exactly why LINN snatched up Berry. Its strong oil project inventory adjusts LINN's portfolio favorably—both now and in the future.