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Upstream master limited partnerships (MLP) traditionally have offered higher yields than the benchmark Alerian MLP Index, a premium that reflects the risks associated with oil and gas production.
Most upstream MLPs hedge a much higher percentage of their anticipated production than the typical exploration and production company in an effort to insulate their cash flow from fluctuating commodity prices and protect their distributions.
However, no company can hedge all its exposure to commodity prices indefinitely and at favorable terms.
Financial institutions are reluctant to hedge more than 80 percent of a producer’s expected oil output using swap contracts because if production falls short of expectations, the lender can be exposed to significant credit risk.
Moreover, there’s no liquid market for hedging natural gas liquids (NGL), which have become an important part of some MLPs’ production mixes.
Some upstream MLPs employ three-way collars to hedge their expected output, a less expensive strategy than buying put options that offers solid downside protection from moderate to midsize swings in oil and gas prices.
But this strategy also reduces a producer’s upside exposure when energy prices rally and offer limited downside protection during selloffs—a concern after the recent collapse in oil prices.
Bottom Line: Even conservatively hedged upstream MLPs have some uncovered exposure to oil, gas and/or NGL prices. And when oil prices plummet as quickly as they have over the past three months, any exposure can produce shortfalls in distributable cash flow and force MLPs to reduce their payouts.
Linn Energy LLC (NSDQ: LINE), the largest upstream MLP by market capitalization, was the first to buckle to this pressure, slashing its annualized distribution by 57 percent.
Although this move disappointed investors who relied on Linn Energy’s distribution for monthly income, management ultimately made the right decision for the company. The partnership has about $2.2 billion in borrowing capacity and could have funded its higher payout for another six to 12 months while hoping for a rebound in oil prices.
By conserving cash, Linn Energy will have more opportunities to enhance unitholder value by paying down debt, buying back units or taking advantage of financial distress in the energy sector to acquire new acreage at bargain prices six to 12 months from now.
Linn Energy’s 5-year $500 million deal with GSO Capital Partners, a unit of private-equity giant The Blackstone Group LP (NYSE: BX), also marks a step in the right direction.
Under the terms of the yet-to-be-finalized deal, GSO Capital Partners will fund 100 percent of the drilling costs associated with packages of wells on Linn Energy’s acreage. In exchange, the private-equity outfit will receive an 85 percent working interest in these wells until it realizes a 15 percent annualized return on investment. After clearing that return hurdle, GSO Capital Partners’ working interest drops to 5 percent and Linn Energy’s stake jumps to 95 percent.
This agreement will enable the partnership to drill acreage that might otherwise be too risky or inappropriate for the MLP structure.
Upstream MLPs usually focus on mature fields because these assets exhibit a predictable production profile and lower decline rates and involve limited development risk. Stable production lends visibility to these operators’ cash flow and quarterly distributions.
This legacy acreage may also include the opportunity to drill expensive horizontal wells that target hydrocarbons trapped in shale formations.
For example, before the shale oil and gas revolution picked up steam, many upstream MLPs focused on acquiring producing wells in the Permian Basin, an area in West Texas that had a long production history. Fragmented ownership in this region created ample opportunities for bolt-on acquisitions.
Although horizontal wells deliver superior returns to the MLP’s legacy wells, the higher initial decline rates don’t mesh well with the firm’s goal of generating sustainable cash flow from steady, long-lived production.
The structure of Linn Energy’s proposed arrangement with GSO Capital Partners effectively shelters Linn Energy’s unitholders from the risk of high decline rates and the extra expense associated with hydraulic fracturing and horizontal drilling.
Without this private-equity capital, much of this drilling inventory would go undeveloped.
In addition, Linn Energy’s management indicated that the firm continues to pursue similar agreements with private-equity groups to help finance opportunistic acquisitions once lower oil prices forces sellers to adjust their expectations.
CFO Kolja Rockov discussed the environment for mergers and acquisitions during a recent conference call to discuss Linn Energy’s 2015 outlook:
Analyst: Just a couple of quick questions. You mentioned that, it was a pretty attractive buyers’ market on the M&A [mergers and acquisitions] side. Could you just provide a little color on that? Is it the multiples that you’re seeing? Is it the willingness to sell? Any thoughts there would be helpful
CFO Kolja Rockov: Yes, I mean, I think our comment there is more forward-looking, I mean I think that E&P [exploration and production] companies, as they go into 2015 are facing a pretty challenging environment with respect to managing cash flow and managing spending and trying to focus on liquidity. And we think that if the environment persists, there is going to be a buyers’ market.
Now I can’t – the last whatever big letdown in crude over the last three weeks or four weeks is kind of in primarily right over the holiday period. So I don’t have a lot of specific transactions that I could reference to but I think one could logically conclude that if this environment persists that we are going to be in a buyers’ market.
In this except, Rockov explains that oil prices will need to remain depressed for an extended period before sellers abandon hopes of a v-shaped recovery akin to what happened after energy prices collapsed in late 2008 and early 2009.
We also like Linn Energy’s efforts to high-grade its portfolio by selling acreage in the Granite Wash (where production rates had disappointed) and exchanging property in the Permian Basin for producing acreage in mature fields.
For example, Linn Energy in September 2014 announced plans to transfer some of its acreage in the Permian Basin that’s prospective for the Wolfcamp Shale to Exxon Mobil Corp (NYSE: XOM) in exchange for some of the energy behemoth’s properties in California’s South Belridge field.
Whereas the higher expenses and decline rates associated with targeting the Wolfcamp Shale didn’t make sense for Linn Energy, the assets in South Belridge exhibit an annual decline rate of 10 percent and are located in an area where the partnership boasts relevant operational experience after its acquisition of Berry Petroleum.
At the end of 2013, Linn Energy’s average decline rate exceeded 20 percent, compared to about 15 percent today; with production dropping at a slower rate, the partnership doesn’t need to expend as much capital to sustain output.
We defended Linn Energy vociferously in 2013, when Barron’s popularized Hedgeye Risk Management’s dubious criticisms of the company’s hedging and accounting practices—bearish arguments that made no mention of the potential for lower crude oil and NGL prices. (See, for example, Barren of Legitimate Critique.)
That Linn Energy subsequently completed the acquisition of Berry Petroleum, albeit at a higher premium, and the Securities and Exchange Commission never formally investigated the partnership’s accounting bears out our conclusions regarding these issues.
Linn Energy has made all the right moves over the past six months, but even the best management teams can’t fight a cyclical downturn in commodity prices or completely wall unitholders off from a 60 percent drop in oil prices.
As I explain in this Free Video, oil prices could dip to as low as $30 per barrel over the next six months, followed by a lengthy period where the commodity averages $50 per barrel. Oil prices could spike higher from time to time, but six to 12 months of consistently low prices will be needed to rebalance global supply and demand.
Based on this outlook, Linn Energy’s distribution cut may not be enough; we expect the MLP to cut its distribution once again over the next 12 months, a move that would result in significant additional downside for the stock.
As my colleague Roger Conrad points out in More Dividend Cuts to Come in Energy Sector, the MLP’s expectations for energy prices remain overly optimistic. At the same time, the proportion of the partnership’s unhedged oil production will increase to between 40 and 50 percent next year from 60 percent to 70 percent in 2015.
Although such exercises always entail a high degree of uncertainty, I modeled Linn Energy’s cash flow and distributions over the next two years using the guidance the company provided in its Jan. 2, 2015, press release and Jan. 5 conference call.
Let’s start with Linn Energy’s 2015 cash flow outlook.
The first column of this table shows the midpoint of Linn Energy’s guidance for 2015 cash flow, operating expenses and maintenance capital expenditures (the portion of capital spending needed to maintain output from the partnership’s existing acreage).
To calculate revenue, I used the data on oil and natural-gas hedges that Linn Energy provided in its third-quarter 2014 earnings release; given the precipitous drop in energy prices, the MLP probably did not take on any additional hedges in the fourth quarter.
Linn Energy doesn’t hedge its NGL output, as a lack of liquidity in this futures market means that the cost of these transactions would exceed the potential benefits.
On the plus side, these hydrocarbons will account for a smaller proportion of the partnership’s total production in 2015 after the sale of its Granite Wash acreage and the exchange of some of its properties in the Permian Basin for producing assets in California and Wyoming’s gas-rich Pinedale field. All told, management expects NGLs to account for 14 percent of Linn Energy’s output in 2015.
Movements in the spot price of natural gas shouldn’t affect Linn Energy’s cash flow in 2015 or 2016 because the MLP has hedged 100 percent of its marketable output, which excludes volumes that Linn Energy uses in California to produce steam used to produce heavy oil.
Although we remain bearish on natural-gas prices for the next 24 months, these headwinds won’t present a major issue for Linn Energy.
Linn Energy hedges most of its oil production at prices on the New York Mercantile Exchange, but much of its actual output faces regional price discounts that remain unhedged. To account for these differentials, I used a discount of $5.20 per barrel—the midpoint of management’s guidance.
The MLP assumes that its cash operating and general and administrative costs will remain on par with last year, a conservative outlook that ignores recent cost cutting.
Based on these assumptions, my model of Linn Energy’s 2015 cash flow projects $75 million in excess cash flow, an amount that would cover the annualized distribution by 1.18 times.
This estimate matches Linn Energy’s internal projections, suggesting that my model provides a useful tool for stress-testing the company’s cash flow under a variety of assumptions for costs and commodity prices.
Note that my model and Linn Energy’s estimates for 2015 and 2016 distributable cash flow exclude growth-related capital expenditures, discretionary spending that aims to help the MLP grow its production.
Linn Energy’s budget calls for $730 million in capital expenditures for 2015—$640 million for maintenance and $90 million for growth. Even if we subtract all of Linn Energy’s planned capital expenditures from my 2015 cash flow estimate, the MLP would still almost cover its distribution.
This focus on sustainability reflects management’s efforts to pursue a strategy that enables the MLP to maintain its 2015 capital spending and distribution without having to tap its credit facility—capacity that the firm would prefer to deploy for opportunistic acquisitions when the time is right.
The table’s second column projects Linn Energy’s cash flow if crude oil averages $50 per barrel in 2015—a more realistic outlook, in our view.
Linn Energy’s hedges cover 70 percent of its anticipated oil production at almost $95 per barrel, exposing about 30 percent of its output to lower prices. The MLP’s 2015 outlook also assumes that a mixed barrel of NGLs trades at about 39 percent of a barrel of NYMEX crude oil, an estimate that reflects recent trading history.
Plugging these commodity price assumptions into my model results in a cash flow shortfall of about $43 million, equivalent to a distribution coverage ratio of 0.9 times. The supplemental materials issued in connection with Linn Energy’s Jan. 2 outlook call estimate that the MLP will cover 95 percent of its distribution with oil prices at $50 per barrel.
This difference of $21.5 million ($0.065 in annual cash flow per unit) between my model and Linn Energy’s internal estimates are within an acceptable margin of error; the purpose of this exercise is to determine whether Linn Energy will need to cut its distribution and by how much.
How I accounted for Linn Energy’s three-way collars may explain the divergence between my model and the MLP’s guidance.
In 2015, three-way collars covering about 1.095 million barrels of the partnership’s crude-oil production. These trades involved the purchase of put options with a strike price of $90 per barrel, the sale of a call with a strike of $101.62 per barrel and the sale of a put option with a strike price of $70 per barrel.
The $90 puts Linn Energy purchased give it the right to sell crude at this price, protecting the company against a drop in oil prices below that strike point.
However, buying puts costs money. In a three-way collar, the cost of the $90 puts is financed by selling puts at a lower strike price and calls at a higher strike price.
In this case, Linn Energy has sold the right to buy oil at $101.62 a barrel and the right to sell oil at $70 per barrel.
This means that if oil prices were to rally above $101.62, the holder of the calls Linn Energy sold would exercise its option to buy oil at that price. In other words, Linn Energy gave up its upside on these 1.095 million barrels if oil prices rally to more than $101.62 per barrel.
Linn Energy also sold puts that give the MLP the right to sell oil at $70 per barrel. With oil trading under $50, these puts are worth more than $20 per barrel. That is, Linn Energy is not hedged on these 1.095 million barrels with oil prices below $70 per barrel.
With oil at $50 per barrel, this exposure amounts to about $21.9 million (1.095 million barrels times $20 per barrel), which I factored into my model for Linn Energy’s 2015 cash flow.
Albeit a minor quibble that involves only 3,000 barrels per day of Linn Energy’s more than 60,000 barrels per day in projected oil production, the MLP hasn’t always factored in this aspect of its hedging strategy its cash flow models.
The $21.9 million effect of the three-way collars is almost exactly the difference between the partnership’s internal model and my estimate of Linn Energy’s 2015 distribution coverage with oil at $50 per barrel.
Regardless, the MLP could easily cover a $20 million to $40 million shortfall in distributable cash flow by borrowing money rather than reducing its payout. A modest 5 percent cut to operating expenses or a 5 percent increase in total production would also be enough to bridge this gap.
However, the outlook looks far less sanguine with crude oil at $40 per barrel, a scenario that would result in a cash flow shortage of more than $160 million and a distribution coverage ratio of about 0.6 times. At that level, even significant improvements on costs or output would be unlikely to close the gap.
Based on its recently reduced distribution, Linn Energy’s units yield 12.6 percent, compared to the Alerian MLP Index’s 6.4 percent current return—a spread of about 620 basis points. Since the end of 2007, the yield spread between Linn Energy and the Alerian MLP Index has averaged 320 basis points.
If Linn Energy’s units were to trade in line with this historical average, the stock would be worth $13.45 per unit, or 36 percent above its current quote.
However, when commodity prices fluctuate significantly or the perceived risk of a distribution cut increases, Linn Energy’s stock has traded at a much higher yield relative to the Alerian MLP Index.
For example, in summer 2013 the market unfairly punished Linn Energy after Barron’s ran a series of sensationalist stories based on Hedgeye Risk Management’s criticism of the company’s accounting. Plummeting commodity prices also widened this yield spread in late 2008 and early 2009.
If our forecast for crude oil to slip to less than $40 per barrel in the first half of 2015 pans out, investors would need to worry about the potential for another distribution cut. In that scenario, we would expect the units to yield between 13 and 15 percent based on its current annualized distribution of $1.25 per unit. This outlook implies a unit price of $8.30 to $9.60.
This unfavorable risk-reward balance doesn’t tempt us to buy Linn Energy at this juncture.
By mid-2015, the market will start to value Linn Energy based on expectations for the MLP’s distribution in 2016.
Unfortunately, the proportion of the partnership’s oil production covered by hedging transactions will shrink next year. The average hedged price for its natural-gas production will also decline.
Our model for Linn Energy’s 2016 cash flow assumes that the MLP’s production volumes and cost structure doesn’t change.
In reality, the costs of basic services and workovers likely will fall if commodity prices remain low. However, Linn Energy may also struggle to maintain production levels without increasing its spending on maintenance capital.
In this environment, the challenge of fighting its portfolio’s 15 percent annual decline rate will become much more difficult.
Plugging an average oil price of $60 per barrel into my model suggests that Linn Energy would generate enough cash flow to cover 69 percent of its distribution in 2016. If crude-oil prices average $50 per barrel next year, the MLP would cover only 40 percent of its current payout.
Our outlook for oil prices suggests that Linn Energy will adjust its future capital spending plans and reduce its annualized distribution to between $0.50 and $0.75 per unit to bolster its coverage ratio.
A target yield of 10 percent implies that Linn Energy’s stock would fetch between $5 and $7.50 per unit.
Readers shouldn’t misconstrue this analysis as a rationale for shorting Linn Energy or a sign that the MLP will be forced into bankruptcy. In fact, we believe that the MLP’s management team continues to make the right moves and that the firm’s bonds offer a favorable risk-reward proposal.
However, investors shouldn’t look to catch this falling knife. Although the stock has dropped considerably, it’s still not a great value.
Elliott and Roger on Oct. 30, 2017
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