Up until the start of this year, Linn Energy (NASDAQ:LINE) had never reduced its distribution to investors. The company was able to keep its payout stable during the financial crisis as well as through rough patches that saw natural gas prices plunge and its own reputation questioned. However, a lot has gone wrong over the the past year, as the price of oil dropped 50% at a time when Linn's oil production wasn't as well hedged as it had been in times past. This left the company with no choice but to cut the payout to avoid getting any deeper in debt. With so much having already gone wrong this year, it begs the question of how much worse things could get.
The first cut's the deepest?
While LINN Energy has already cut its distribution by more than 50% this year, that might not be the last cut the company has to make. That became evident after its closest peer, BreitBurn Energy Partners (NASDAQ:BBEP), recently made its second 50% distribution cut this year. BreitBurn's second cut came after the company raised a billion in debt and equity to bolster its beleaguered balance sheet.
In hindsight, BreitBurn used too much leverage to buy oil assets over the past couple of years; its credit facility was almost maxed out, as it had drawn 88% of its capacity. BreitBurn had intended to pay down its credit facility, but oil prices tumbled before it had the chance. Then, because oil prices dropped so dramatically, the company actually ran the risk that its credit facility would be cut below what it had borrowed, leaving it to scramble to find the cash needed to pay off its banks. This looming scenario left BreitBurn with few options, so it made the tough decision to raise cash as well as reduce its distribution again so it had a better chance of surviving the downturn.
Linn Energy's credit situation isn't as dire as BreitBurn's, as only 45% of its credit facility is drawn, however, it does still carry a lot of debt. The concern here is that if oil prices don't meaningfully recovery over the next year or so, LINN's debt could really weigh on the company, and in order to reduce that weight, the company might have to further cut the distribution -- or in a worst-case scenario, even eliminate it in order to keep from going bankrupt.
The sum of all fears?
That brings up the worst fear of any investor, which is that a stock he owns goes all the way to zero. It is certainly a risk for Linn Energy investors, though the company's situation isn't as dire as it is for others in the industry. That being said, the credit situation in the energy industry will continue to worsen if oil prices stay weak. In fact, recently, the number of financially stressed energy companies reached its highest percentage ever as the sector moved from 8% to 14% of the population of a rating agency's list of most financially stressed companies.
Linn isn't on that list, but its credit situation could deteriorate over the next few years, as its oil and gas hedges begin to roll off. As the following slide shows, the company's natural gas is 100% hedged through 2017, while oil is 70% hedged this year, and 65% hedged in 2016.
These hedges largely insulate the company over the next two to three years, but if oil prices remain weak for several years, it would cut even deeper into Linn's cash flows starting in 2017, making it much harder for the company to maintain its large debt load. Such a situation would hit other drillers first, but that scenario could lead to a wave of bankruptcies in the energy industry, which could potentially take Linn Energy down, too. It's a nightmare scenario for the energy industry, but not beyond the realm of possibility.
Investing always carries risks. A lot could still go wrong for Linn Energy's investors, with the worst being another distribution cut and a future bankruptcy. While I don't foresee either in Linn's future, given the surprises of the past year in the energy sector, I'm not about to make a bold proclamation that Linn is safe from either risk.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends BreitBurn Energy Partners. 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.