Last Friday, LINN Energy LLC (NASDAQOTH:LINEQ) caved into pressure from falling oil prices and slashed both its distribution and its drilling budget. It was a move the market largely expected, which is why units soared on the news. However, while the headlines pointed out the dramatic cut in payments to investors, it was easy to overlook the other big announcement from the company -- which is a strategic alliance with GSO Capital Partners, an affiliate of The Blackstone Group L.P. (NYSE:BX). It's a deal that could have far-reaching implications down the road.
Drilling down into the deal
LINN Energy's management team spent a great deal of time on a conference call earlier this week detailing this alliance, which it is calling DrillCo. On that call, the company's Chief Financial Officer Kojia Rockov broke down the deal so that analysts and investors could better understand how it fits into LINN Energy's future plans.
Rockov started off by saying, "This agreement creates a dynamic alliance, combining world-class expertise from a highly respected investor with Linn's ability to acquire and develop oil and natural gas assets." It's important to note here that this is an alliance, which combines GSO's money with LINN Energy's proven history of acquiring and developing oil and gas assets.
Rockov then went into a bit more detail on the actual framework of the deal by saying:
Linn has signed a non-binding letter of intent with GSO to fund oil and natural gas development. Subject to final documentation, funds managed by GSO and its affiliates have agreed to commit up to $500 million, with five-year availability to fund drilling programs on locations provided by Linn. Subject to adjustment, depending on asset characteristics and return expectations, GSO will fund 100% of the cost associated with new wells drilled under the DrillCo agreement, and is expected to receive an 85% working interest in these wells until it achieves a 15% internal rate of return on annual groupings of wells, while Linn is expected to receive a 15% carried working interest during this period. Upon reaching the internal rate of return target, GSO's interest will be reduced to 5%, while Linn's increases to 95%.
Basically, GSO is going to fund 100% of the cost and take on 100% of the risk to fund the development of new wells on LINN Energy's acreage. In exchange, its cut will be 85% of the cash flow these wells produce until GSO receives 115% of its initial cash outlay.
What this means for LINN Energy is that it can invest $500 million of GSO's money during the next five years to drill new wells, and it gets to keep 15% of the cash flow from those wells until GSO is paid back all of its initial investment plus its desired return. Once GSO earns that 15% return, the ownership shifts back to LINN Energy, and it keeps 95% of the cash flow while GSO receives 5% until the wells run dry.
Why LINN Energy is doing this deal
Rockov then spent some time commenting on the strategic benefits of this deal by saying that:
DrillCo provides several strategic advantages for Linn. It allows us to develop assets without increasing capital intensity. It gives us the potential to add a steady and growing cash flow stream with no capital requirement. It increases our long-term ability to fund oil and natural gas development capital, and the distribution with internally generated cash flow. It mitigates drilling risk. It potentially broadens our universe of acquisition targets, and finally, upon meeting the return hurdle, it would provide incremental lower decline production growth for Linn.
Rockov notes six distinct benefits to LINN Energy; but to sum it up, the deal allows the company to grow without spending any of its own money or taking on any additional risk. Instead, it will provide the DrillCo partnership with drilling locations from its acreage or, more likely, acreage it will acquire in the future. In return, LINN will enjoy incremental growth without the incremental risk.
The drilling risk mitigation is a real important part of this deal, as LINN Energy has been burned in the past when wells underperformed expectations. Two years ago, the company expected big growth from the Texas portion of the Hogshooter formation in the Granite Wash; however, those wells underperformed expectations causing the company to miss production guidance. With DrillCo, the company can test new drilling intervals and let GSO foot the bill and take on 100% of the risk. That said, Kockov did make it a point to note that, "the goal is to work together as partners and develop assets in a prudent way that ends up as a win-win for both parties."
The DrillCo alliance with GSO could pay big dividends for LINN Energy down the road. It can use the funds from the partnership to drill higher-risk wells that also offer a higher reward without having to foot the bill or take on the drilling risk. Instead, it can enjoy 15% of the cash flow these wells produce until GSO earns its desired return, and then keep 95% of the cash flow after that. It's a unique structure that should provide LINN Energy with steadier growth without impacting its balance sheet.
Matt DiLallo owns shares of Linn Energy, LLC. The Motley Fool owns shares of The Blackstone Group L.P.. 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.