Over the past year or so LINN Energy LLC (NASDAQ:LINE) investors have likely become familiar with what is known as the decline rate. This is the rate at which oil and gas production from a well owned by an energy company like LINN Energy is affected as the pressure within the reservoir is relieved and the oil reserves begin to deplete. In order to combat this rate, LINN Energy needs to spend money to drill new wells just to keep its production rate consistent. The problem the company has been facing is that it has to spend so much money to offset its decline rate that it simply hasn't been able to increase its distribution to investors despite the fact that its production has been increasing. Because of this dynamic it makes for an interesting money trail to see how the company's depreciation charges are forcing the company to spend a higher amount of capex on its cash flow statement.
Maintaining a steady business
As a rule any company, whether it be an energy company or otherwise, will depreciate assets on its balance sheet as the useful life of those assets passes. In order to combat depreciation a company needs to invest capital just to maintain its current business operations, which is sometimes known as maintenance capital. Any capex spent above this maintenance line is typically referred to as growth capex, which is used to grow revenue and earnings.
Using data from S&P Cap IQ we can see how LINN Energy is doing at maintaining its assets, or in its case production, by comparing the amount it depreciates from the capex it spends. Here's what that looks like over the past five years.
What we see here is that other than 2009, LINN Energy has steadily spent more money than it depreciates, thus indicating that the company not only spends adequate capital to maintain its business but is also spending money to grow production organically on top of the capital it typically spends to acquire new oil and gas assets. Over the past five years the company has spent just over a billion dollars more than it depreciated in growth capital, which yielded solid organic production growth.
However, while this increased spending is boosting production, it has yet to provide a boost to the company's distribution. The reason behind this issue is related to where the company has been spending its cash.
Drilling down into capex
For an example of this we'll take a closer look at last year's spending. When LINN Energy announced its plans for 2013, those plans called for a $1.1 billion capital program, which would enable the company to drill around 500 wells throughout its acreage. Those wells were not only expected to maintain LINN Energy's production levels, but actually provide the company with 10% organic production growth. Fast forward to the end of the year and LINN Energy ended up delivering 22% production growth thanks to this capital as well as money spent to acquire additional assets. So, clearly the company's investments more than offset its depreciating production as the organic growth capital added more production than the company started with that year.
In hindsight there is only one problem with all of this: The production boost has been tough to maintain, which is why depreciation has more than doubled over the past few years. Of the $1.1 billion LINN Energy spent in 2013, 35% of it went to the Granite Wash, 18% went to the Permian Basin and another 9% went to the Cleveland play. Add it up and 62% of the capital was spent on drilling in areas that have very steep decline rates. In the case of the Permian Basin, for example, the decline rate is about 35%. These assets depreciate faster, forcing the company to spend more capital just to maintain its production.
This is why we've seen LINN Energy switch gears this year and swap this higher declining production, which, while yielding strong organic growth rates, was becoming tougher to maintain. In its place the company has filled its portfolio with lower declining assets that should decrease the company's rapidly rising depreciation and capex while replacing it with stronger excess cash flow.
LINN Energy spends a lot of money to maintain its production. But, the days of rapidly increasing capital spending appear to be over as the company has reshuffled its portfolio so that it doesn't need to spend as much to offset depreciation. Because of this, organic growth capital spending in the future should provide more than a one year bump as the company won't have to invest as heavily to maintain that production going forward.
Matt DiLallo owns shares of Linn Energy, LLC. The Motley Fool has no position in any of the stocks mentioned. 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.