LINN Energy LLC (NASDAQOTH:LINEQ) recently announced that it will acquire natural gas-weighted assets from Devon Energy for $2.3 billion. Devon will shed its non-core assets so it can focus more on liquids-rich areas as LINN Energy expands its low decline production base to safeguard its distribution in the future. To Devon, the divested assets didn't fit in with its long-term plan, but for LINN Energy and its sister company LinnCo LLC (UNKNOWN:LNCO.DL), these assets are perfect.
The two recent deals LINN and LinnCo made shifted the production mix toward natural gas, but this comes on the heels of its very oil-weighted acquisition of Berry Petroleum. LINN is repositioning its asset portfolio so that it's weighted heavily toward low decline wells, which may annoy Wall Street in the short term but will be greatly appreciated in the long term. To get an idea of why these assets are perfect for LINN Energy and LinnCo, investors should first take a look at LINN's recent asset swap.
Funding the distribution
When LINN Energy traded part of its position in the Permian Basin to ExxonMobil, some questioned why LINN would trade away premium acreage for miles and miles of natural gas-weighted acreage in the Hugoton Field. What those investors missed was that developing the Permian Basin, while profitable, is very capital intensive. It would take years of development and tons of cash for that asset to generate free cash flow, which would take away from LINN Energy's distribution, and LinnCo's dividend.
Before the asset swap, LINN Energy's distribution coverage ratio was 0.993, meaning that LINN would pay out more than it was taking in this year. If LINN were to have spent the extra cash developing its horizontal Permian position, it would have exacerbated the payout funding problem. On top of that, shale wells have first-year production decline rates around 60%-80%, which means LINN would only be raking in distributable cash flow for a short period of time unless it purchased and developed more acreage.
Investing in LINN Energy and LinnCo isn't about growth; it's all about income, which is why LINN Energy and LinnCo pay out 8.9% and 9.3% yields, respectively. After the asset swap, LINN Energy and LinnCo's payouts are now fully funded, relieving investors of the worry that the distribution or dividend would be cut. On top of fully funding its distribution, LINN will now be able to use its new asset from Devon to grow production and payouts in the future. Low decline wells, combined with organic and acqusition generated production growth, will safeguard the distribution for years to come.
Safeguarding future payouts through organic growth and cost synergies
When the deal with Devon is completed in the third quarter of this year, LINN will add 275 MMcfe/d, or million cubic feet equivalent a day, of output (80% gas) to its estimated 2014 production of 1,100 MMcfe/d. A low production decline rate of 14% will enable LINN to slowly grow output by developing the 1,000 future drilling locations, and 600 recompletion opportunities, on its new 900,000 net acre position. As production increases, the additional cash flow will be transferred to investors due to the low capital intensity of developing this asset.
Beyond production growth, LINN will also realize substantial cost savings due to most of the new acreage overlapping with its existing holdings, providing logistical synergies. In the asset swap deal with Exxon, LINN will also be able to realize cost savings through overlapping acreage, as it could feed more natural gas into its Jayhawk gas plant. In 2013, the approximately 3,880 active wells on this acreage generated $350 million in EBITDA for Devon, earnings that will now go toward LINN and LinnCo's payout. As costs trend lower while output slow increases, investors will start to truly appreciate the income opportunities from conventional wells.
While funding this purchase will require the sale of its Granite Wash assets, those assets should fetch a high price, as LINN Energy has successfully found 17 hydrocarbon-producing intervals on its 147,000 net acres in Oklahoma and the Texas Panhandle. While the production mix is liquids rich, the first year decline rate averages around ~40%. By selling off this asset, LINN will lose 230 MMcfe/d of liquids-rich natural gas production, but the distributable cash flow will be replaced through the Exxon asset swap, the Devon acquisition, cost savings, organic production growth, and new, low-decline assets that LINN will be able to acquire.
LINN Energy and LinnCo are in it for the long run. For most E&P players, liquids-rich shale plays are the best locations to deploy capital, but LINN isn't like most E&P companies. Shale plays require plenty of time and capital to bring enough production online to generate free cash flow, while low decline conventional assets are already generating free cash flow (distributable cash flow for an MLP). With production decline rates and maintenance costs low, conventional assets will keep pumping out free cash flow for years to come, making LINN Energy and LinnCo's recent deals ideal for income oriented investors.
Combined with the cost savings from its overlapping acreage and existing infrastructure, LINN's recent deal making will more than cover its already high payout, providing room for income growth. Backed by long lasting, low decline assets with plenty of opportunities for organic growth, LINN Energy and LinnCo are two of the best income plays in the energy sector.
Callum Turcan owns shares of LinnCo. The Motley Fool owns shares of Devon 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.