Here are some details from the press release and conference call that provide the basis for Linn's 2015 cash flow expectations:
The budget is based on an unhedged price deck of $60 per barrel crude oil and $3.50 per Mcf natural gas.
Production allocation of 54% natural gas, 32% crude oil and 14% NGL.
Expected natural gas production is 100% hedged through 2017.
Hedge prices are $5.12 this year and $4.48 for 2016 and 2017.
Forecast crude oil production is 70% hedged in 2015 and 60% for 2016.
Crude hedge values are $94.48 this year and $90.44 per barrel next year.
NGLs are not hedged and in the budget at $23.40 per barrel - 39% of NYMEX crude.
The 2015 budget does not make allowances for:
Capital cost improvements
Higher commodity prices
Positive impact from any acquisitions
Cash flow from the new DrillCo agreement - see below.
With these assumptions, Linn Energy expects that cash flow will improve quarter over quarter through the upcoming year.
The other news from Linn was an announcement that it has signed a non-binding letter of intent with private capital investor GSO Capital Partners LP, the credit arm of The Blackstone Group LP (NYSE:BX) to fund oil and natural gas development. Funds managed by GSO and its affiliates have agreed to invest $500 million to fund drilling programs on drill sites owned and provided by LINN. GSO will pay 100% of the costs of drilling in exchange for 85% of the profits until it has reached a 15% internal rate of return. After the IRR target is reached, GSO will continue to earn 5% of the profits and Linn's share increases from 15% to 95%.
This new "DrillCo" arrangement lets Linn develop wells using outside money, and then when the target IRR return for GSO is reached, Linn will be left with the majority ownership of low decline wells that fit the MLP high cash flow model.
The new lower prices on crude oil and natural gas have forced Linn to make significant changes its budget plan for 2015. These commodity prices have continued to decline in the couple of weeks since Linn developed its budget, but the conservative planning for distribution coverage and opportunities for cost efficiencies should allow the new distribution rate to be secure at the current prices of $50 oil and $3 gas.
The most interesting investment potential for Linn occurs if oil recovers to more than $60 per barrel. At that point, a growing cash flow could result in distribution growth. Any accretive additions or successful results from the DrillCo program will just enhance the distributable cash flow. With current yields of 11%, LINE and LinnCo LLC (NASDAQ:LNCO) provide an attractive opportunity to profit from any increase in energy commodity values.
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Last Friday, LINN Energy LLC (NASDAQ: LINE ) caved into pressure from falling oil prices and slashed both its distribution and its drilling budget. It was a move the market largely expected, which is why units soared on the news. However, while the headlines pointed out the dramatic cut in payments to investors, it was easy to overlook the other big announcement from the company -- which is a strategic alliance with GSO Capital Partners, an affiliate of The Blackstone Group L.P. (NYSE: BX ) . It's a deal that could have far-reaching implications down the road.
Drilling down into the deal
LINN Energy's management team spent a great deal of time on a conference call earlier this week detailing this alliance, which it is calling DrillCo. On that call, the company's Chief Financial Officer Kojia Rockov broke down the deal so that analysts and investors could better understand how it fits into LINN Energy's future plans.
Rockov started off by saying, "This agreement creates a dynamic alliance, combining world-class expertise from a highly respected investor with Linn's ability to acquire and develop oil and natural gas assets." It's important to note here that this is an alliance, which combines GSO's money with LINN Energy's proven history of acquiring and developing oil and gas assets.
Rockov then went into a bit more detail on the actual framework of the deal by saying:
Linn has signed a non-binding letter of intent with GSO to fund oil and natural gas development. Subject to final documentation, funds managed by GSO and its affiliates have agreed to commit up to $500 million, with five-year availability to fund drilling programs on locations provided by Linn. Subject to adjustment, depending on asset characteristics and return expectations, GSO will fund 100% of the cost associated with new wells drilled under the DrillCo agreement, and is expected to receive an 85% working interest in these wells until it achieves a 15% internal rate of return on annual groupings of wells, while Linn is expected to receive a 15% carried working interest during this period. Upon reaching the internal rate of return target, GSO's interest will be reduced to 5%, while Linn's increases to 95%.
Basically, GSO is going to fund 100% of the cost and take on 100% of the risk to fund the development of new wells on LINN Energy's acreage. In exchange, its cut will be 85% of the cash flow these wells produce until GSO receives 115% of its initial cash outlay.
What this means for LINN Energy is that it can invest $500 million of GSO's money during the next five years to drill new wells, and it gets to keep 15% of the cash flow from those wells until GSO is paid back all of its initial investment plus its desired return. Once GSO earns that 15% return, the ownership shifts back to LINN Energy, and it keeps 95% of the cash flow while GSO receives 5% until the wells run dry.
Source: LINN Energy LLC.
Why LINN Energy is doing this deal
Rockov then spent some time commenting on the strategic benefits of this deal by saying that:
DrillCo provides several strategic advantages for Linn. It allows us to develop assets without increasing capital intensity. It gives us the potential to add a steady and growing cash flow stream with no capital requirement. It increases our long-term ability to fund oil and natural gas development capital, and the distribution with internally generated cash flow. It mitigates drilling risk. It potentially broadens our universe of acquisition targets, and finally, upon meeting the return hurdle, it would provide incremental lower decline production growth for Linn.
Rockov notes six distinct benefits to LINN Energy; but to sum it up, the deal allows the company to grow without spending any of its own money or taking on any additional risk. Instead, it will provide the DrillCo partnership with drilling locations from its acreage or, more likely, acreage it will acquire in the future. In return, LINN will enjoy incremental growth without the incremental risk.
The drilling risk mitigation is a real important part of this deal, as LINN Energy has been burned in the past when wells underperformed expectations. Two years ago, the company expected big growth from the Texas portion of the Hogshooter formation in the Granite Wash; however, those wells underperformed expectations causing the company to miss production guidance. With DrillCo, the company can test new drilling intervals and let GSO foot the bill and take on 100% of the risk. That said, Kockov did make it a point to note that, "the goal is to work together as partners and develop assets in a prudent way that ends up as a win-win for both parties."
The DrillCo alliance with GSO could pay big dividends for LINN Energy down the road. It can use the funds from the partnership to drill higher-risk wells that also offer a higher reward without having to foot the bill or take on the drilling risk. Instead, it can enjoy 15% of the cash flow these wells produce until GSO earns its desired return, and then keep 95% of the cash flow after that. It's a unique structure that should provide LINN Energy with steadier growth without impacting its balance sheet.
Management is going to have a real tough time getting stock holders trust back, or new investors buy keeping silent through all of this.
Unit price nov. 2008 was $7.73. During that time oil was at a high of $147 p/b. I believe it went down to as low as the upper 30's
Revised sensitivity analysis based on my model
With Linn's new information, I made some model updates, and here you can see the handy sensitivity analysis that results. It probably doesn't track 100% to Linn's own financial models, but it looks very close to the data it provided in its release, and it's easier to grasp visually. I used the midpoint of its production numbers for this purpose, and updated the NGL pricing to use its methodology of 39% of oil prices.
Coverage ratio for 2015
DCF per unit
Thoughts on the upside
While I think these charts paint an attractive picture, Linn was helpful to point out the room for improvement based on some slightly less pessimistic assumptions. The above charts assume that lease operating expenses, transport costs, and development costs stay level in 2015. If others in the industry reduce capex as Linn has, costs will drop. Furthermore, Linn is devoting some capex to growth, and it indicated a modest 5% increase in production would result in coverage going from 1.18x to 1.43x at the sample prices it provided. That 5% increase is within the production ranges the company estimated for 2015. Cost decreases would have a similar positive impact. Thus, I get the clear impression that Linn is setting a low bar for the coming year, and unless we see really poor commodity prices, it will clear the bar easily.
If things get bad enough, anything can happen. If countries get backed into a corner with no way out they have nothing to lose. Unfortunately, war seems to be the answer in these cases. That's our major flaw, for being human idiots.
Read the headline from the street today. I don't even want to post it. I hate headlines.