Linn Energy - Is there any value in the equity?

A few years ago, a number of bloggers pointed out Linn's Ponzi-like financial structure, with a strong bear case spelled out by Bronte Capital, Hedgeye, and James Kostohryz on Seeking Alpha (links to these blogs are in the footnotes).  While Linn has since declined significantly since then, but the worst may be yet to come.

Linn’s Ponzi Like Returns

Looking at Linn’s characterization of distributions for the past two years would indicate that the payouts were predominantly a return of capital and therefore not taxable.  While this might sound appealing, the reason these distributions are not taxable is because Linn is not making money, they are simply returning shareholder money back to shareholders.  However, paying your investors returns from their own capital, rather than from profits sounds quite a bit like the definition of a Ponzi scheme as provided below:

 “A Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator.”

Let’s say a business takes money from investors, and returns that money to investors in the amount of 10% a year.  Well after 10 years that business would be out of money to return to investors and fold, unless of course that business is a Ponzi scheme which successfully attracts capital from new investors to return to old investors.  As Bernie Madoff proved, given a level of obfuscation, Ponzi schemes can go undetected for a while and even grow quite large before inevitably imploding.  Madoff successfully obfuscated his Ponzi scheme behind a large trading operation.  In the case of Linn energy, the Ponzi like financial structure is obfuscated in the form of an oil and gas company. 

To illustrate, let’s think about how a Ponzi scheme works:

Step 1: Raise money from investors

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since profits are small to non-existent, most of the distributions are a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue paying old investors from fresh capital.

Step 4: Repeats steps 2 and 3 until investors stop giving you money

Linn energy effectively works the same way, but with a few additional steps.

Step 1: Raise money from investors

Step 1a: Convert that money into oil and gas reserves by buying energy assets

Step 1b: Produce from those reserves, converting the oil and gas back to cash

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since actual profits are small, and in recent years non-existent, most of the distributions have been a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue buying more oil reserves, allowing you to continue paying distributions to investors.

Step 4: Repeats steps 1a through 3 until investors stop giving you money

Now I call Linn Ponzi like rather than a straight out Ponzi scheme, because there are actually a couple of ways this business model can work.

1.  Oil prices rise faster than the rate the company is paying out distributions.
2. The company is unbelievably good at generating value from acquisitions.

If you believe either of the above to be true, then it might be possible for Linn to offer a sustainable return to investors. Case 1 is easy enough to address - if you believe that the price of oil will rise faster than Linn’s distribution yield, you would better off putting your money in the commodity as opposed to Linn equity.  Case 2 requires a little thought.

When it comes to making acquisitions, every transaction has both a buyer and a seller and information is asymmetric.  Typically, the seller knows much more about the asset he’s selling then the buyer and is unlikely to take less than market value except in distressed situations. Furthermore, the transaction costs involved in buying and selling energy assets are significant as, much like in real estate, there are all sorts of middlemen, such as investment bankers and lawyers, who need to be paid off.  These transaction fees can easily add another 5% to the price of an acquisition. Finally, acquisitions must often be made at a premium to gain support from shareholders of the selling company. For these reasons, it is very hard to create value in acquisitions except in the following situations:

1. Situations where there are significant synergies created due to the combination of entities.
2. Strategic situations where the buyer is acquiring a company for access to technology or new markets.
3. When the buyer has a lower cost of capital than the seller and can finance growth in the acquired company.
4.  Distressed asset acquisitions..

None of Linn's acquisitions really appear to have created major synergies for the company.  Linn may argue that the assets bought from Devon had significant operational overlap, but this in itself does not mean much in the way of synergies.  Certainly not enough to justify the price Linn paid for Devon’s assets.

It also does not appear that any of Linn’s acquisitions provided Linn with new technologies it could use elsewhere in its portfolio, nor did any of Linn’s acquisitions provide the company with new markets.

Early in Linn’s history, Linn may indeed have had a lower cost of capital than the companies it was buying, due to the marked up valuations of MLPs.  But this is not a sustainable advantage because as company issues more shares and more debt its liabilities rise until the cost of capital difference deteriorates.  As Linn's cost of capital has risen, it's ability to generate value in this way has evaporated.

Far from picking up assets at distressed valuations, it actually appears the Linn has been selling or otherwise shedding assets at distressed levels.  Linn needed to sell its Granite Wash assets to shore up liquidity and did so at a price that may have been lower than similar transactions in the area, and the DrillCo JV appears to be distressed financing deal in disguise.

DrillCo a bad deal for both shareholders and bondholders

Far from being a vote of confidence in Linn's, Blackstone's DrillCo joint venture appears to be more of an opportunistic distressed financing deal, which effectively results in Blackstone getting a 15% rate of return with Linn's reserves serving as collateral.  Furthermore, the DrillCo deal subordinates existing bondholders and Linn shareholders, as much of the economic value of those reserves will be transferred from Linn to DrillCo as part of the deal.  It's important to note that Linn itself does not even generate 15% returns on a corporate level, so it's hard to see how this deal creates value for the company.

Where things went wrong

I previously noted that there were a couple of situations where Linn’s business model could work.  The first is in an environment of continually rising oil prices and the second is if Linn can consistently make acquisitions that generate value.  The current falling oil price environment is a disaster for Linn, as the company has levered up its balance sheet buying assets that are now worth far less than what Linn paid.  Complicating matters is the fact that Linn’s cost of capital has risen to the point where the company is unable to make the acquisitions required to keep it’s Ponzi like business model going.  Since Linn’s business model has imploded, future growth seems almost out of the question, and the only question left to ask is how much residual value is left in the units?

So how much value is left in the equity?

Answering this question requires a close look at Linn’s valuation and posing the question “If Linn was valued like any other company, what would it be worth?”.

A peer group for Linn might be composed of Anadarko, Apache, Continental Resources, Devon Energy, EOG, among a few others.  The EV/EBITDA ratios of these companies are as follows:

Anadarko – 5.20

Apache – 3.18

Continental – 6.59

Devon – 4.8

EOG – 5.83

Average – 5.12

By comparison, Linn’s EV/EBITDA ratio is 8.26, much higher than the 5.12 average of the companies I listed above.  For Linn to be valued similarly to other E&Ps by this metric, the companies EV would need to drop by roughly 38%.  The unfortunate problem for Linn’s equity holders is that roughly 80% of Linn’s EV is debt.  This means that if Linn was valued as an E&P rather than an MLP, the shares would be worth close to zero.

Bulls may argue that MLPs are valued on their tax advantaged distributions and not their earnings, but this ignores the fact that for distributions to be sustainable they need to come from earnings and not from returning capital to shareholders.  Secondly, bondholders do not receive the same tax advantages as MLP unitholders and don't view the assets any differently.  If all the value of the company is in the debt, as opposed to the equity, the (unwarranted) MLP premium enjoyed by Linn should no longer apply.

Linn’s asset quality is low

I assumed in the above comparison that Linn’s asset quality was on par with its peers, but in reality, Linn’s assets are very marginal.  Given its business model, Linn has been incentivized to make a lot of acquisitions, and it the process the company has accumulated a disjointed portfolio of assets that other oil companies did not want.

• Linn’s assets in the Rockies, while not bad, do not compete against other North American shale plays.
• The assets in the Hugoton basin, Mid-Continent, and Permian are primarily mature wells nearing end of life.  The company did have some prospective wells in these area’s but they were sold (Granite Wash), or traded for more mature wells (Exxon trade).
• The California assets primarily produce thermal heavy oil, not unlike what is being produced in Alberta’s oilsands.  It’s expensive to produce and fetches a discount on the market because it is difficult to refine.
• Linn’s remaining assets in Michigan and East Texas are failed exploration plays that other companies did not see economic potential in.

When you compare Linn’s assets to those of the North American onshore peers I noted above, one would have to think Linn should trade at a discount, rather than a premium, to those companies.  Linn’s assets also make for a poor takeover target.  After all, why would anyone buy a company composed entirely of assets similar to those being jettisoned in favor of core positions in the Bakken or Eagle Ford shales?

(1) http://brontecapital.blogspot.ca/2013/02/linn-energys-queen-gertrude-moment.html
(2) http://brontecapital.blogspot.ca/2013/02/linn-energy-bizarre-definition-of.html
(3) https://app.hedgeye.com/insights/27487-looking-at-linn-energy
(4) http://seekingalpha.com/article/1535352-linn-energy-many-ponzi-like-mlp-blow-ups-to-follow
(5) http://seekingalpha.com/article/1545382-ponzi-or-mlp-linn-energys-unsustainable-distributions

Disclosure: The author is short Linn Energy

Moving back to the short side on oil stocks

In my last post, I noted that the major opportunity to be short oil and gas company stocks had passed, and the comment was fortunately timed.  Yet I did not expect oil stocks to rally as much as they have - Rather, I had been expecting an opportunity to become long oil stocks to materialize.  However, since mid December, the XOI index of oil and gas equities has risen nearly 10%, while benchmark WTI crude prices have dropped by approximately the same amount.  Far from being a buying opportunity, this may be a chance to make more money on the short side.

Before waving away the recent rally in oil stocks, we need to be able to understand it's drivers.  Here I see three possibilities.

1.  Investors believe there is significant value in oil stocks at current oil prices.
2.  Investors are expecting oil prices to recover sharply.
3.  Investors are adding to risk positions in general.

I hypothesize about these possibilities below.

Do investors see value in oil and current oil prices?

The first potential explanation for the rally is that oil stocks had become undervalued given current oil prices, but this hypothesis can be quickly dismissed.  While oil prices have fallen by over 50% in the past 6 months, the XOI has only fallen about 25% in the same period.  Even clearer evidence that oil stocks are overvalued given current oil prices is seen in an RBC research note showing that large cap Canadian oil stocks are still discounting an $80 oil price, as shown in the figure below.

Implied WTI price in oil stocks (RBC Research)

Are investors expecting a rally in oil prices?

A second explanation is that investors are expecting a significant rally in oil prices and are discounting that ahead of time.  My experience is that oil stocks do indeed tend to lead oil prices, but a closer look at the data is necessary to make conclusions here.

First, looking at the NYMEX WTI Futures curve, we are starting to see a fairly steep contango developing in the oil markets.  That is to say, oil is more expensive to buy for future delivery than it is to buy in the spot market.  Steep futures curves greatly incentivize building inventories and buying oil in the spot market, because the oil can be sold for a higher price in the futures market at a virtually risk free profit.  Such arbitrages never last long, and it's likely that we will see a lot of inventory building demand supporting the oil price going forward.

WTI Futures Curve (Alhambra Partners)

Second, oil nearing bottom of my expected trading range of $40-60 based on production costs.  At current prices in the low $40s, only the most profitable core areas of shale plays can be economically produced.  Furthermore, cash flows at oil companies are becoming a major constraint to drilling.  It's therefore not surprising that we are seeing a rapid decline in the US rig count and that decline will continue until we see oil in the $50-60 range, which is a price that I believe will incentivize more drilling and stabilize the rig count.

The combination of a steep contango which incentivizes oil buying the the spot market, along with a drilling slowdown which will eventually constrain supply growth in the spot market, could support a short term rally.  However this is not a high confidence prediction - while the overall picture is supportive of an oil price rally, poor economic data or more bearish inventory/production data could continue to be a drag.

Are investors merely adding to risk positions?

A third explanation for the rally in oil equities is a general move into risk assets that has spilled over into oil equities.  While I don't have data to support this hypothesis, it does seem very likely. Surprise rate cuts and larger than expected stimulus measures in countries around the world have lifted equities across the board.  It should not be surprising that some of the money flowing into equities has found it's way into oil stocks.  However, risk based inflows can quickly reverse into outflows and this is not a sustainable driver for a rally.  At some point, oil will need to rally to justify the valuations of oil equities.

Oil may rally, but even so, oil equities are still overvalued.

For the reasons stated above, we should not be surprised to see a rally in oil prices in the coming weeks or perhaps even months ahead.  But would such a rally continue to support oil stocks?  Intuition would say yes, but data suggests otherwise.

Most alarmingly for investors in oil equities, the gap between oil and oil stocks has reached unprecedented levels.  The chart below shows the ratio of the WTI oil prices and the XOI oil stock index.  Until the recent sell-off in oil, this ratio was dropping gradually indicating moderately better returns for oil stocks than the commodity itself.  This gradual decline in the WTI:XOI ratio is expected behavior, as oil producers are able to find more oil and increase production (and profits) over time.  However, the sudden drop in the WTI:XOI ratio is not sustainable.  The XOI:WTI ratio is normally remarkably stable around it's trend line, and the concept of mean reversion almost certainly applies here.

Looking at the trendline on the WTI:XOI ratio, the bottom of the trend line would indicate a ratio of approximate 0.050.  This implies that even if oil rebounds to $60, assuming the XOI/WTIC returns to it's long term trend we would see a 10% decline in oil stocks.  This in itself is not a great result for oil stock investors, but the downside case is much, much worse. If oil prices continue to fall to $40, which is a very real possibility given deteriorating economic data, the XOI could drop 40% from current levels.

Based on this analysis, it appears that going short oil stocks is once again a very good bet on a risk/reward basis.

Short Positions

As a note of warning, never short companies with great assets or great management teams.  Companies with great assets often become acquisition targets, and companies with great management often find ways to persevere through tough times.   Instead, look for companies with the combination of marginal assets and poor management teams, because these companies are likely to go to zero.  It's not hard to think of names, Canadian Oil Sands and Linn Energy are two that come to mind immediately (and I am short both of these names).

Disclosure: The author is short Canadian Oil Sands (COS.TO) and Linn Energy (LINE)