Capturing Margins

Linn Energy LLC, structured similarly to a master limited partnership, bolted out of the gate this year at a full gallop, charging through $1.8 billion in acquisitions via three deals. That figure already surpasses the Houston-based company’s total deal value for each of the past two years. And don’t expect Linn to skip stride: funds are flowing, and the opportunity field is stacked.

When queried about the limitations of its financial firepower for further transactions, Linn executives seem honestly perplexed. “It’s large,” ponders Kolja Rockov, Linn executive vice president and chief financial officer. “Multiple billions, easily.”

“We’re continuously in the marketplace,” says Mark Ellis, Linn chairman, president and chief executive officer. Hedging is key to the company’s business strategy.

Holding a $2-billion undrawn credit facility and its proven depth in the equity and bond markets ($10 billion over five years), the company is hardly blowing at this early turn. “Given the right opportunity, we can raise a tremendous amount of money. We’ve got a lot of firepower for acquisitions,” Rockov states.

Since its IPO in 2006, Houston-based Linn has built an MLP dynasty propelled by continuous race cards of accretive acquisitions—deals that immediately increase cash flow per partnership unit, the ultimate goal. Simply, the company targets three cents of accretion per unit for every $100 million spent. Starting with a $12-million deal in its first public running, the company has to date stood in the winner’s circle for 52 transactions with an aggregate total deal value of $8 billion. Its resulting $12.3-billion enterprise value nearly laps all of its 10 upstream MLP peers, which have a combined enterprise value of $14.4 billion.

“We’re continuously in the marketplace,” says Mark Ellis, Linn chairman, president and chief executive officer. Sheer size, he says, gives the partnership the edge.

The deals

The 2012 acquisition season began in February, two months off of a $544-million deal for bolt-on Granite Wash assets from Plains Exploration & Production. Linn saddled up $1.2 billion in mature, producing gas and natural gas liquids assets in the Hugoton Basin in Kansas from BP America. The field, in production since the 1940s, included 110 million cubic feet equivalent (MMcfe) of production—37% gas liquids—from 2,400 operated wells across 600,000 contiguous net acres. Proved reserves total 730 billion cubic feet equivalent (Bcfe), 81% proved developed producing (PDP).

The assets fit an upstream MLP model to a T: immediately accretive to distributable cash flow per unit, long lived with an 18-year reserve-life index, and a low decline rate of 7%.

“It’s about as stable and predictable as we can buy,” says Ellis.

With 800 drilling locations and 500 recompletion opportunities, Ellis also sees inventory for the future. “They may not be opportunities we pursue in today’s gas-price environment, but over the long term these will serve us well.”

A bonus: the deal included the Jayhawk gas plant, currently 41% utilized and barely valued in the deal. Just a stone’s throw from expanding plays in the Texas and Oklahoma panhandles, Linn foresees taking third-party gas from Granite Wash, Cleveland sands and potentially Mississippian Lime producers.

Quickly following the BP transaction, Linn announced a smaller but no less relevant acquisition. It will make its first print in East Texas for $175 million, contracting for 24 MMcfe per day on 19,800 acres with 136 Bcfe proved. Again, the deal is gas and 100% PDP. Like the other, the decline rate is below 10%, the reserve life 15 years.

What motivated the East Texas purchase? Like the Permian Basin position it has built over the last couple of years, the East Texas deal positions the company to broaden its base here. “It’s an opportunity for us to get into an area we’re not in—in a big way,” Ellis says.

Subsequent to the Hugoton and East Texas deals, Linn corralled 23% of Anadarko’s interest in Salt Creek Field in the Powder River Basin, where Anadarko has been implementing CO2 enhanced oil recovery to increase production. For $600 million in development costs over the next three to six years, the company will harness 1,600 barrels of net oil per day today, anticipating 3,800 by 2016. Yes, all current production is hedged through 2014. And yes, it is accretive to distributable cash flow.

But with a twist this time: Linn wants knowledge of CO2 flooding. “We have the potential to apply this knowledge and technology to several of our existing legacy oil fields,” says Ellis.

Capturing the arbitrage

Upon his retirement last December, founder Mike Linn stated, “The company has been far more successful than I ever envisioned.”

Linn launched the company in 2003 with funds from Quantum Energy Partners to buy and exploit natural gas in Pennsylvania, West Virginia, New York and Virginia. Rockov, a former investment banker, pitched the idea of an upstream limited partnership that would aggregate mature assets akin to the midstream MLPs in the U.S. and royalty trust model in Canada. After all, the U.S. had more mature assets than the rest of the world in total.

Pondering Linn Energy’s financial firepower for further transactions, Kolja Rockov, executive vice president and chief financial officer, says, “It’s large. Multiple billions, easily.”

When Linn went public, it was the first E&P LLC/MLP in the U.S. Today, it is the eleventh-largest independent E&P company, and far and away the largest E&P LLC/MLP.

Unlike traditional E&P companies that don’t like to limit upside commodity exposure, hedging acquired production is key to Linn’s business strategy. One investment banker calls the strategy Linn’s “secret sauce.”

Rockov notes that the greatest knock against the upstream MLP model was commodity price risk. “To that question we’ve been able to boldly answer with a hedging strategy that protects us from the downside, but still preserves a reasonable amount of upside as well,” says Rockov. “We reduce the financial exposure and lock in the margin we bargained for.”

Linn typically seeks to hedge production for five years, thus capturing the pinnacle of the futures market wave. This strategy explains why a natural gas acquisition makes sense in today’s marketplace. For the Hugoton deal, due to contango in the market, Linn locked in hedges north of $4 per Mcf, contrasted with the spot price that languished near $2.25.

Linn uses a combination of swaps and puts, with the puts allowing participation in price upside for an up-front cost. A typical Linn deal involves 70% swaps to 30% puts, but the BP acquisition layered in 50% puts.

“Natural gas puts are fairly inexpensive right now,” says Rockov. As a rule of thumb, puts cost about 10% of the purchase price, but Linn spent just $90 million to buy puts on half of the Hugoton production. “Not only have we locked in margins between $4 and the $1.50 lifting cost, we have 50% of the upside.”

Rockov says a clear arbitrage exists between the price paid for assets and the hedged price over five years. “We’re locking in a nice margin for five years and don’t have to drill.”

And capturing a margin is the bottom-line metric. “To be able to capture margin is paramount—that’s the heart of the business model. The margin allows us to deliver growth. We’ve been able to grow our distribution 73% in a gas market that’s gone from $8 to $2.”

Linn uses a combination of swaps and puts, with the puts allowing participation in price upside for an up-front cost.

The organic factor

Notably, the partnership has paid out 24 consecutive distributions due in part to favorable hedges when other cash-constrained MLPs had to rein in during hard times. Yet growing distributions through the financial crisis hasn’t been without challenges, leading the team to deploy atypical MLP strategies. “We made a lot of money hedging gas at $8 for five years compared with where it is today,” says Rockov.

But as the natural gas price trended down through 2009, so did forward hedge book value. Today, that value stands at approximately $5.50 per Mcf for 100% of gas produc- tion through 2015, and approximately $100 per barrel of oil 100% through 2013 and 80% for 2014 and 2015.

How to deal with a forward curve clipped from $8 to $4? First, says Rockov, you’ve got five years. Second, grow organically.

Capex-hogging organic growth is anathema to most upstream MLP models, which thrive on low-maintenance, mature producing assets—drilling budgets are solely to arrest production declines. But Linn’s accretion target of three-cents-per-$100-million-spent could also be achieved via an organic program.

Its existing Granite Wash properties acquired in 2007 from Dominion proved an unexpected rich development opportunity and a backstop to growth erosion. Bought for the existing long-life producing wells with the intention of drilling only vertical maintenance wells, the advent of horizontal drilling on the play was pure upside. Not to mention the Granite Wash today features some of the best returns in the U.S.

“We looked at how best to value that asset for our unit-holders, and it came down to drilling it,” says Ellis. “If we can generate a rate of return of 50%-plus, why wouldn’t we do that? It’s going to generate the most cash flow and per-unit growth.”

Already in 2012, Linn’s deals surpass its total deal value for the past three years.

Additionally, through 2010 and 2011, Linn spent the better part of $3 billion acquiring assets high in proved undeveloped locations (PUDs), primarily in liquids-producing regions like the Permian Basin, Williston Basin and Midcontinent, to grow production through the drill bit. The company sought assets only in proven plays with high rate-of-return drilling opportunities absent of lease expirations.

“We’re taking a paced approach to development, mindful that we are an MLP structure,” says Ellis. “We’re not running those assets like we would if we were a growth-oriented E&P.”

Drilling capex for 2012 currently stands at $880 million, subject to incremental increases per acquisition. And it is not at the expense of distributions. “If we finance $2 billion of acquisitions, we’ll typically prefund growth capital for drilling—that’s how we pace our growth.”

Ellis says that capex spend is about half what an E&P would invest, and that’s on purpose. While drilling dollars are more accretive than acquisition dollars, they’re harder to maintain because of the decline rate. The program has achieved its goal: organic growth for 2011 was 30%. Cash flow remains on the incline.

Ellis admits success with growing organically has put pressure on the decline rate. Thus, the company is managing organic growth to 20% in 2012. So far in 2012, Linn has made $1.8 billion of acquisitions of sub-10% decline assets. “When you blend high-return organic growth with low-decline acquisitions, the diverse-portfolio approach works,” says Ellis.

Systemized acquisitions

The sheer volume of assets coming in house via acquisitions would paralyze most companies , big or small, as they digested the deals. Not so with Linn. Once the president of ConocoPhillips’ Lower 48, Ellis has used that expertise to systemize evaluation and integration to accommodate an unrelenting deal flow.

“When competitors make an acquisition, they’re out of the game for a year while they absorb it. We’ve made acquisition evaluation, capture and integration core competencies of the company. We put all the things into place that allow us to move quickly.”

The business development team processes between 100 and 200 opportunities each year. These are culled against a screening list of attributes. Some 30 to 40 go to bid with set bid parameters. Acquisitions are evaluated running the five-year strip price through the model. About one-third of those close—and that seems to be accelerating.

The integration team gets involved in the purchase and sale negotiations and includes accounting, land and technical expertise. With only a short transition period post-closing, the assets are fully integrated. “We don’t run parallel systems when we buy assets,” says Ellis. “That is confusing. We get everything into the system as quickly as possible and move on.”

In spite of the dichotomy between oil and gas prices, Ellis insists Linn is commodity neutral when targeting acquisitions. Just the margin matters. “Where we can capture margins, have it fit our accretion targets and meet seller expectations, then that deal closes.”

He anticipates more gas properties will come to market. “The sale of mature assets is going to be one of the ways for companies to generate cash flow to fund their capital needs. We might see a robust opportunity set.”

Its $2-billion revolver is money good: “There’s no financing contingency in our bids,” says Rockov.

Stability created by its hedging practices results in a lower cost of capital for acquisitions as well. In March, Linn issued $1.8 billion in bonds at 6.25%, an attractive rate that translates to the bid process.

Would Ellis be surprised if total deal value this year approached $4 billion, as one analyst postulated? “With the right opportunities and our ability to access the capital markets, all is in place to do that. We’re not done.”