It has taken more than a year and a half, but the SEC has finally closed its informal inquiry of LINN Energy LLC (LINEQ) and its affiliate LinnCo LLC (NASDAQ: LNCO). In the end, the SEC found that LINN Energy was doing nothing wrong, and because of this, it does not intend to recommend any enforcement action against the company. However, while the company didn't officially receive any punishment from the inquiry, the whole ordeal wasn't without cost to the company or its investors.
Reliving the past
LINN Energy first notified its investors of the informal inquiry on July 1, 2013. Prior to that, the company had been making headlines as short-sellers and the media began to wage a war of words with LINN. That caught the attention of the SEC, which decided to look into the matter.
Once the SEC got involved, LINN Energy issued the following press release detailing the informal inquiry:
The SEC has requested the preservation of documents and communications that are potentially relevant to, among other things, LinnCo's proposed merger with Berry Petroleum Company, and LINN and LinnCo's use of non-GAAP financial measures and hedging strategy [...] LINN and LinnCo are cooperating fully with the SEC in this matter.
That voluntary disclosure led to a dramatic sell-off in the stock, as we see in the following chart.
In the span of just a few days, units of LINN and shares of LinnCo lost about $10 in value, or about 30%. It's a sell-off from which the company has never recovered, as the overhang weighed not only on the stock price, but it snowballed into other issues down the road. Two of the issues stemming from that inquiry are quite honestly the reason LINN Energy's units are trading where they are today.
The domino effect
As LINN Energy noted, the SEC was looking into two key areas of its business: its deal to buy Berry Petroleum and its hedging practices. That review ended up costing the company time and money, both of which have burned investors.
For example, the Berry Petroleum deal was originally expected to close in the summer of 2013. However, LINN Energy was forced to revise its Registration Statement for the deal several times. Those delays ended up costing the company $600 million, as that's the revised price it needed to pay in order to get the Berry transaction to close. Part of the revision was due to the fact that the value of Linn Energy's units had fallen because of the SEC inquiry at the same time Berry Petroleum's operations continued to improve. So, when the deadline under the original deal passed, LINN Energy had no choice but to up its offer in order to get the deal done.
The other big impact from the inquiry was that LINN Energy changed its hedging practices. The company had used puts to hedge a lot of its production, but short-sellers argued that it was misusing these. So, the company just gave up buying puts, as there are other ways to hedge. However, this still tied LINN Energy's hands a little bit, which is why the company's oil and gas production was no longer 100% hedged several years into the future, as had been its practice.
The company was especially light on the oil side almost entirely because it struggled to hedge all of Berry Petroleum's production before the oil market went off the deep end. The company's CFO noted on several conference calls that it wanted to opportunistically hedge more of its oil production, however, those opportunities never came up. This was because the oil market at that time was in backwardation, which meant oil was selling for a lower future price rather than the current spot price. So, when the oil market cratered, LINN Energy was left a bit too exposed, as only about half of its oil production is hedged over the next two years, as opposed to all of it.
Investor takeaway
While the SEC has finally cleared LINN Energy of all wrongdoing, the process ended up costing the company a lot in hindsight. Not only was it forced to pay more for Berry than its original offer, but those delays, as well as changes the company made, caused it to fall behind in hedging Berry's oil production. Because of this, the company was burned again when the oil market turned south. That being said, the fact that the company wasn't in the wrong should give investors hope that the company might eventually catch a break or two, and that over time, it can recapture this lost value, and then some.
