Linn Energy LLC (NASDAQ:LINE) investors started 2015 off on the wrong foot when they found out, on the first business day of the new year, that the oil and gas driller had cut its dividend by more than 50%. It was the right move since it ensures the safety of the dividend and the ability to continue investing in the business, but was it enough? The answer depends on how long oil prices stay low.
The big drop
If you follow the energy markets at all, you are well aware of the precipitous drop in oil prices since roughly the middle of 2014. The implications of that fall are starting to flow through the industry, with oil drillers pulling back on spending, contractors laying off staff, and companies throughout the industry warning investors to expect lower top- and bottom-line results. Linn has been no different.
The company said it had trimmed its 2015 drilling budget by some 50% at the same time it announced its dividend cut. In a press release, CEO Mark Ellis said:
...the Board of Directors approved a 2015 budget that contemplates a significantly lower current crude oil price than in 2014. In order to solidify the Company's financial position and regain a useful cost of capital, we have reduced the oil and natural gas capital budget and distribution while balancing cash flow and spending.
In other words, Linn is getting ready for tough times.
Linn, however, must keep expanding its footprint in order to replace the oil it pulls out of the ground. If it doesn't, production will fall. That means it can't stop buying additional oil properties. At the same time, the company is structured to pay out lots of cash to shareholders -- this is the stock's big allure. The frequent volatility in the energy patch can put those two things at odds. That's why the company makes extensive use of hedging to lock in sales prices. But when oil prices fall and stay low, the company's hedging activity can create something of a looming cliff.
A deep cut
Why is that? Right now Linn has about 75% of its expected 2015 oil production locked in at roughly $94 a barrel. That's well above current oil prices and should allow it to pay its dividend and invest in the business. The company likely has around 50% to 60%, depending on actual production numbers, of next year's production locked in at about $90; there is much less leeway there to pay for the dividend and investments because less oil is protected. And Linn likely has less than 20% of its oil hedged in 2017 at prices in the high $80s, making it unlikely the company could pay the current dividend and sustain a reasonable capital budget that year if oil prices don't recover.
To provide a different perspective, Linn's revenue from actual production of oil and gas was about $940 million in the third quarter, with a little over $600 million coming from oil. Total revenue, though, was a touch over $1.4 billion. Gains on the company's hedges, at $450 million, made up the lion's share of the difference. Clearly, Linn's hedging activity makes a big difference. If the oil revenue line and the hedging line both go down, the driller has a big problem.
The real issue with Linn is how long oil prices remain low. If prices pick back up this year or even early next year, then Linn's hedging will have worked perfectly and the dividend should survive with just a single cut. If, however, low prices linger into the second half of 2016 or longer, when Linn has less oil hedged, the company could face material problems. It would be like falling off a hedge cliff.
Could oil prices stay depressed for that long? BP CEO Bob Dudley recently told Bloomberg that prices could linger at low levels for up to three years, using history as his guide. So, for Linn Energy, you need to watch the price of oil, but you also need to pay keen attention to the company's hedging activity for a real understanding of how much risk there is of another dividend cut.
Reuben Brewer has no position in any stocks mentioned. 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.