Tuesday, October 21, 2008

Bookkeeping: Starting Linn Energy (LINE) Position

A few readers have been sending me some great information/recommendations on energy royalty trusts, and I've been doing a lot of homework on the group. There is also another subset of companies which are energy related master limited partnerships which I only started doing homework on the past week - but I'm going to get on this train in case it takes off now and then continue doing homework. [Seeking Alpha - Outrageous Opportunities in Upstream MLPs]
  • Publicly traded Master Limited Partnerships (MLPs) are great income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor.Depending on the MLP, quarterly distributions may be either partially, or entirely, tax-deferred.
  • The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies, such as Kinder Morgan Partners (KMP) and Oneok Pipelines Partners (OKS). However, in recent years, a number of upstream Oil and Gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market.
[Seeking Alpha - Why Buy MLPs?]
  • Master Limited Partnerships (MLPs) are a new type of investment with an excellent record of high rates of stable growth & mostly tax-free (until the ultimate sale) high yields. Despite this performance, they are still little appreciated & understood partially due to poor investor relations by the companies.
  • Their business typically involves building pipelines & terminals for transporting oil & gas. Capital additions are their form of addiction. They have to keep investing in more assets to build more pipelines & terminals, a national priority.
  • Commodity prices do not correlate with MLPs. For example, oil prices doubled in the last year while MLPs have been sliding. Changes in oil prices are similar to changes for other fuel commodities and they also do not correlate with the MLP index. In addition, MLPs have a very low beta, unlike the high volatility for fuel prices. However, especially this year, changes in the MLP index have followed or at least took cues from changes in oil & other fuel prices.
There have also been a bevy of stories in financial blogs of late on these groups as their "stock" price has dropped to such a degree that we are seeing double digit yields in many names. So effectively if the underlying entity just sits and does nothing in terms of capital appreciation you can get 12-14-16% yield in some of these. Which in this market, is a godsend.

Some more background
Seeking Alpha - October 10th: Fire Sale in Oil & Gas (Upstream) Limited Partnerships
  • Lehman Brothers owns substantial stakes in nearly every upstream MLP -- more than 10% in several cases. If circumstances force Lehman to dump those units, it might present great buying opportunities for holders with new money and a long term perspective, but really stressful times for current unitholders." This was sadly prescient. Lehman and hedge funds liquidated these stocks with wild abandon.
  • The upstream MLP sector now features extremely compelling valuations. Even using a $6.75-natural gas, $80-oil price deck, the group is trading at an approximate 30% discount to the net value of their proved reserves (accounting for hedges and projected production costs). The average yield for the group is an unreal 21%.
  • The best scenario for companies in this sector is to hedge high and produce/sell in a low-price environment. That way their revenue is high and their production taxes and expenses are low. That’s where these companies are today.
Reuters had an article about a month ago (and that was before the most recent of the carnage)
  • Energy-related master limited partnerships were slammed this week as hedge funds threw in the towel and investors fretted over bankrupt Lehman Brothers' wide exposure to the sector, and the meltdown may not be over yet.
  • Lehman marketed the master limited partnerships -- or MLPs -- to their high net worth customers and also runs the Lehman Brothers MLP Opportunity Fund. The firm also was a lender to some of the partnerships and has been a mergers and acquisition adviser.
  • Energy MLPs are typically made up of assets such as pipelines, gas processing operations or long-lived producing fields that generate steady, stable earnings. The partnerships have been popular with those looking for a steady stream of income because they pay out nearly all their operating cash flows to investors in the form of distributions and offer tax advantages to corporations.
  • So far in September, the Alerian Capital index of MLP has fallen 19 percent
  • Heavy hedge fund selling tied to redemptions and tax-loss selling were also playing a role in the sector's sell-off. (sound familiar?) Fund managers and retail brokers are in capital preservation mode and are selling MLP equities at depressed prices, Blum said.
  • "The market is clearly not focused on fundamentals, (sound familiar?) but we can't help liking MLPs with limited near-term capital market needs, strong general partner support, solid growth prospects and attractive valuations," research firm Tudor, Pickering, Holt & Co. Securities Inc told clients in a note on Wednesday.
Both Doug Kass and Jim Cramer mentioned Linn Energy (LINE) in the past 24 hours and the events surrounding that company specifically due to its association with the now bankrupt Lehman Brothers (LEH) is creating a unique buying opportunity. Despite the "Cramer effect" of running a stock up once it appears on the show (LINE is up 12% today) I think the company offers a compelling story and valuation, despite a large upswing in the past few days. Effectively a lot of misperception has been relieved in the past few days, and the stock price has acted accordingly. Also a lot of people who jump in on Cramer's mentions should be out within 24-48 hours and the stock price should settle from there. Again, we're happy with the yield in this market, and any appreciation would be upside - the "security" is, despite a large gain, only back to where it was a few weeks ago.

On October 19th a Seeking Alpha Contributor posted [Linn Energy - Walk the Line]
  • LINE is one of my favorite stocks to buy right now. With a market cap of 1.52 billion and an Enterprise Value of 3.6 billion, LINE is the largest public E&P MLP/LLC in the country. This offers them a little more stability in an unsure market. They also have a 21 year reserve life, also one of the best in the sector. The MLP space has been rocked in the recent market drama and I was drawn to LINE as a high yield play with the least amount of risk. The big reason they are less risky than most is because of their aggressive hedging program.
  • One huge factor in what separates LINE from the competition going forward is that they hedged their production as far out as any energy company I have seen. They have 100% or more of their estimated production covered until 2012. In 2012 it is currently 67% of total production.
  • Now they did have a problem being that Lehman Brothers was counterparty to their oil and gas hedges, but they were smart enough to re-hedge all of their contracts at the same price and for the same duration very quickly before oil and gas took a dive. They are seeking to recover 68 million from Lehman but I do not factor the recovery of that money into my estimates.
  • This creates a headwind for the energy sector and calls into question the huge yield, currently 20% or an annual yield of $2.52 per share. (more on this later)
  • Looking at their competitors, LINE also sticks out as having the best yield of the group that isn’t in danger. I looked at Atlas Energy (ATN), Legacy Reserves (LGCY), Pioneer Southwest (PSE), Eagle Rock (EROC), BreitBurn Energy (BBEP), Encore Energy (ENP), Vanguard Natural Resources (VNR), EV Energy (EVEP), Constellation Energy (CEP) and Quest Energy (QELP).
  • Now, QELP, VNR , EVEP and CEP have higher yields than LINE, but they have over-hanging issues. CEP is part of Constellation Energy, which just got taken over by Buffett. They forced them before that happened to sell off some of their assets and they are not sure exactly what their future is going to look like. QELP had a CEO who was funneling money out of the company, ENRON-style, using it for personal uses. He’s now probably going to prison. VNR is also a company I like, but they have only hedged out a little over a year. This leaves EVEP, which also looks like a good company and insiders have been buying like crazy. They are not as hedged as LINE, which was a negative for me. If oil and gas are looking like they will spike higher, I would buy EVEP and VNR.
  • Looking at the insider transactions for these three companies are all very positive as insider buying has really stepped up recently. That is good to see as these companies share prices are getting beaten down along with the rest of the market.
  • How does LEH figure into all of this? LEH had big stakes in many MLP companies. Many small oil and gas companies also used LEH as their counterparty to their oil and natural gas hedges which they now may have to take some losses because of it. LEH provided lines of credit to some of these companies. LEH is most likely being forced to sell some of their holdings putting further pressure on the share prices.
So to address the potential of that $2.52 in yield being called into question - Linn put out a press release yesterday afternoon. No longer a question.
  • Linn Energy, LLC (Nasdaq:LINE) announced today a cash distribution for the third fiscal quarter of 2008 of $0.63 per unit, or $2.52 per unit on an annualized basis, for all of its outstanding units. The distribution will be payable on November 14, 2008 to unitholders of record at the close of business on November 7, 2008.
  • ``Given the positive trends in our core business, financial liquidity and strong hedge position, we feel confident in our ability to continue to pay our distributions,'' said Michael C. Linn, Chairman and Chief Executive Officer.
Further, the company instituted a smaller buyback program of $100M worth of shares in the past two weeks (the company has a less than $2B market cap even with today's move) Again this is one of those "maybe we will, maybe we won't" buybacks - I much prefer the "we WILL buy XXX shares by XXX date" type but those are very rare in this day and age.
  • Linn Energy (LINE) the Houston oil-and-gas producer, said it would buy back as much as $100 million of units, saying they're "significantly undervalued. he units may be purchased "from time to time" on the open market or in negotiated deals, and the timing and amounts of the purchases will be up to management, the company said.
Last we have the Cramer interview from yesterday - most important is they are hedged well into the future and they've moved their hedges quickly, mostly to Barclays it appears.

Lehman Brothers’ bankruptcy and failure can’t be understated. The company’s demise had any number of victims, LINN Energy, an oil and gas company, not the least among them.

Lehman [LEHMQ 0.05 -0.004 (-7.41%) ] was LINN’s [LINE 16.34 1.62 (+10.99%) ] largest shareholder and also its banker. So when Lehman went down, the broker’s LINN holdings were liquidated and LINN’s hedges against future oil prices were seen as worthless, supposedly leaving the company vulnerable to the whims of the market. LINN stock suffered accordingly.

But LINN Energy Chairman and CEO Michael C. Linn, speaking to Cramer Monday, debunked any such notions about his firm. Lehman was a counterparty to only a “very small portion” of LINN’s hedges – LINN was smart and locked in prices before oil and gas came down – and those were immediately re-traded to other banks after Lehman’s collapse. Now Lehman owes $68 million for those hedges.

And as for being vulnerable to the market, LINN is 100% hedged against natural gas fluctuations through 2010 and oil through 2011. So the price of oil and gas could rise or fall by 15% and LINN’s 17% dividend yield would be unaffected, the CEO said.

With Linn guaranteeing the dividend, and the stock of a strong company only down because of the Lehman collapse, not any legitimate problem with the business, “I think this stock should be bought,” Cramer said.

So the downside is this is not a secret and there has been a quick and tremendous move. The upside is a lot of confusion and fear that caused the last portion of the drop (the past two weeks) has now been cleared up, and the stock is still significantly below where it was a month ago. Despite today's gains the stock is still effectively yielding just below 16%. So the first time ever I am following Cramer's army into a stock....

But... I am also following insiders (although at a higher price) - 2 directors, and a SR VP of Operations have been buying heavily the past week

The stock jumped to $16.99 earlier today but now that is has pulled back to the low $16s we're going to take a stab with a 2.8% stake. Since there was a gap created today by Cramer Nation, we'll see if we can pick some more up near $15 in the future. In just over 3 weeks we should get our first dividend payment. Interestingly many of the peers in this group all now sit right below their 50 day moving averages so are right at resistance. In this market, we'd expect pullbacks across the board but at least have dividends to offset it. If we can see a return to the $20 or so area of August, that would be about a 25% gain on top of the 15-16% yield. Not bad for something grandpa usually owns ;)

Hopefully these begin to trade with less correlation to the market now that a lot of the purging has been completed in the sector.

Long Linn Energy in fund; no personal position

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