From Linn's most recent 10Q.
The first of these statements seems to indicate that risk is alleviated by counterparty netting (offset by credit lines from the counterparties?). The second seems to indicate counterparty failure is still a risk to the company.
Any thoughts on how to reconcile these statements?
The Company’s counterparties are participants in its Credit Facility (see Note 8) which is secured by the Company’s oil and gas reserves; therefore, the Company is not required to post any collateral. The Company does not require collateral from the counterparties. The maximum amount of loss due to credit risk, based on the gross fair value of financial instruments that the Company would incur if its counterparties failed completely to perform according to the terms of the contracts was approximately $8.4 million at September 30, 2008. In accordance with the Company’s standard practice, its commodity and interest rate swap derivatives are subject to counterparty netting under the agreements governing such derivatives and therefore the risk of such loss is mitigated at September 30, 2008.
Disruptions in the capital and credit markets as a result of the global financial crisis may adversely affect our hedge positions.
To achieve more predictable cash flow and to reduce our exposure to fluctuations in the prices of oil, gas and NGL, we enter into hedging arrangements for a significant portion of our production. Given the recent failures of major financial institutions, we cannot be assured that our counterparties will be able to perform under our hedge contracts. If a counterparty fails to perform and the hedging arrangement is terminated, our cash flow, and ability to pay distributions could be impacted.
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The counterparty risk analysis is a moving target. Here is what the statement about $8.4 million of credit risk exposure if the counterparties completely failed to perform as of Sept 30 means in the context of the financial statement footnote:
If you read the entire footnote, you will see that LINE had derivative assets of $299 million and derivative liability of $379 million. That is simply a statement that if all of its contracts in effect at Sep 30 had to be settled as of that date, some of its contracts were assets (meaning that the counterparty would have to pay LINE in the event of settlement) and some of its contracts were liabilities (meaning LINE would have to pay the counterparty in the event of settlement). So lINE had a net liability to counterparties of about $80 million.
We assume that all counterparties fail to perform.
LINE can offset the derivative asset balances due from each individual counterparty against the derivative liabilities due to each individual counterparty. But that offset is only available on a counterparty by counterparty basis. You cannot offset a derivative asset owed by Bank A against a liablility owed to Bank B.
So when LINE says it has $8.4 million derivative credit risk, all it is saying is that if all counterparties failed to perform, it could recover all but $8.4 million of its derivative assets by offsetting them against derivative liabilities. It would have a net liability of $80 million plus it would lose $8.4 million because in its counterparty group, it has some bank or banks which owe $8.4 million more to LINE on derivatives than LINE owes to those banks.
LINE is not saying that it can offset derivative obligations against credit line balances. In general, that would not be permitted by credit agreements and if banks use different entities -- pne to make loans and another to enter into the counterparty hedge arrangements (which would be the norm), setoff would normally not legally be available.
is polite buttcovering. It's the equivalent of "past performance etc etc...The risk may or may not be palpable..the statement protects them legally because it recognizes a possibility before it occurs.
In this environment EVERYTHING is questioned and counterparty risk is grabbing liquidity by the throat.
I'm investing in PWE..LINE..EPD..LGCY..even if the distributions are cut every negative factor has already been built into the low prices....
Given what is going on they have to put that footnote in there. They have already had one coutner party (Lehman) go belly up so of course any auditor is going to make them disclose this risk. I don't know how likely it is to happen I guess it depends on who the hedges are with. You wouldn't have thought Lehman was going to go belly up but they did. The market seems to be pricing in a chance that the hedges won't hold. Otherwise there is no reason for the stock to be where it is oil prices dropping have no real affect on LINE if the hedges hold. Lower oil prices should actually help them by increasing demand from where it would be otherwise as long as the hedges hold. If we can get through the next month or with no majors financial instituation blow ups I think LINE will start to go up as people realize the financial system is stable.
Sounds to me like the one time hit if counterparties failed would be a net 8.4 mil upfront due to netting of credit facility. This tells me that the hedges cost them 8.4 million more than they borrowed from the counterparties.
Ongoing, the loss of the price protection provided by the hedges could impact cash flow. The impact would be negative if prevailing prices of oil and gas were less than the hedged price or positive if greater. So the impact of lost price protection could go either way.
Of course, if the counterparties failed the world would have much bigger problems than LINE's cash flow due to the international makeup of those counterparties. In a sense, this means LINE is TOO BIG TO FAIL because of its links to institutions that world economies have already deemed "too big to fail".
Vol96, I am not sure that your understanding of the hedge disclosure is completely accurate although I agree with your comments about the effect on cash flow of having no hedges. I have posted below an explanation of what I understand the hedge footnote means:
LINE really has benefitted from its hedging on two fronts. One, it has a very high percentage of production hedged, which not only is good for cash flow, but should also keep LINE's credit line base solid even with the lower market prices for commodities. Two, it was wise to put basis differential hedges in place for its mid-continent production due to the extreme divergence between NYMEX and Waha hub prices.
Management was wise to have immediately replaced the LEH hedges when LEH defaulted and fortunate that it had a war chest from the sales of Applalchia and Verden properties to fund that action. Replacing those positions today would be much more costly.
The counterparty risk in September is minimal as the replacement cost of the contract - or then prevailing commodity price oil of $90 a barrel or so. The counterparty risk of non-performance goes up materially since the price of the replacement commodity in the event of default is realized.
In otherwords, if the put contracts at $90 are replaced by market contracts at current $50 barrel rates the loss to operations becomes substantial.
The key thing here is, can the counterparty meet its obligation to purchase oil at $90 a barrel if they don't have the $$ to buy it and create wealth at $50 a barrell sold into the market? Without collateral?
Obviously, right now, it would make some sence for Line to buy $50 a barrel oil and sell into the $90 contracts as opposed to producing it?
There may be a hedge here for them to start putting collars on the prices to lock in the gains?
If Linn trades lower.... I will add a few shares.
Would be nice at these levels if they'd start repurchasing some units or give us monthly distributions so we could accumulate.
Good luck to all