by Aaron Levitt | February 22, 2013 10:34 am
While most investors are familiar with traditional energy exploration and production firms like Chesapeake Energy (NYSE:CHK), some companies have taken a different path in going public: structuring as master limited partnerships.
These “upstream” MLPs feature many of the same benefits as their more commonly known pipeline twins — including high dividends and tax breaks — and also provide a direct way to play the long-term growth in energy pricing.
One company in the space has more to offer than that solid foundation though, and that company is Linn Energy (NASDAQ:LINE).
After an analyst questioned the company’s hedging practices — echoed in a negative Barron’s article over the weekend — shares slipped hard. But Linn and its C corporation subsidiary LinnCo (NASDAQ:LNCO) recently showed exactly why they are the king of the upstream MLP hill: They made another smart reserve acquisition.
With the spotlight now shining brightly on the firm and much of the negativity in the rear-view, investors may want to give Linn Energy a go.
Upstream MLPs generally build, operate and maintain wells for various energy resources and — like their standard E&P twins — thrive on generally higher oil and natural prices. Unlike their C corp rivals, their tax structure require them to pay the bulk of their earnings back to unit-holders and doesn’t allow for a “rainy day fund.” This requires upstream MLPs to focus on developed acreage with mature production profiles.
So, while analysts were questioning the firm’s derivatives practices, Linn quietly made its largest acquisition to date. It agreed to pay $4.3 billion — including the assumption of debt — for relatively unknown Berry Petroleum (NYSE:BRY).
Berry shareholders will get 1.25 shares of LinnCo, and LinnCo will then sell the Berry assets to Linn Energy in exchange for additional partnership units. LinnCo’s sole asset are units in the MLP. Overall, the deal values Berry at roughly a 20% premium to the shareprice before the deal was announced and will convert the company to an LLC. That allows Linn to own Berry’s assets in a pass-through entity without any immediate payment of tax.
Aside from the historical precedence (this is the first time that an upstream MLP has ever acquired a C corp E&P firm) Linn and LinnCo are making out like bandits with the deal. By purchasing Berry, Linn will add nearly 3,200 long-life and low-decline producing wells on more than 200,000 net acres. These are exactly the kind of assets upstream MLPs crave and need to keep those hefty dividends flowing.
Those purchased acres are located in Linn’s core drilling regions in California, the Permian Basin, East Texas and the Rockies. The deal also adds wells in the Uinta Basin — an area in which Linn had no exposure.
Overall, the purchase will significantly bolster Linn’s oil production. The company estimates that the acquisition will increase its proven reserves by 34% and its production capabilities by roughly 30%. Perhaps more importantly, Berry’s reserves are estimated to be about 75% oil and natural gas liquids (NGLs). With natural gas prices still hovering around historical lows, those wells are extremely valuable. After the deal closes, Linn’s total liquids exposure will rise to 54% of reserves — up from about 46%.
Plus, the Berry acquisition follows up last year’s $2 billion worth of asset purchases Linn made from struggling BP (NYSE:BP).
Linn’s CEO Mark E. Ellis said in a press release that “Berry’s assets are an excellent fit for Linn, and we believe this transaction generates significant accretion to our distributable cash flow per unit.”
And boy is he right.
The Berry asset purchase is so accretive to distributable cash flow that Linn estimates it will be boosted by 40 cents a unit. That pending boost has already prompted management at Linn to recommend a distribution increase once the deal closes. Investors in the MLP can expect to see their payout rise 6.2% to 77 cents per quarter, while investors in LinnCo will see an 8.5% pay raise to that same quarterly rate since the Berry conversion will add an extra tax-free “boost” to LNCO’s payout.
Additionally, the asset purchase will boost Linn’s distribution coverage ratio as well as be credit rating positive, since it is technically an all-stock deal.
All in all, Linn and LinnCo have proven once again that they are the leaders in the upstream MLP space. As such, the firms generally trade at slight premiums to other production MLPs like BreitBurn Energy (NASDAQ:BBEP) or Mid-Con Energy (NASDAQ:MCEP). However, given their leadership status that premium — and the enviable cash flows that come with it — are worth it.
As of this writing, Aaron Levitt was considering initiating a long position in LNCO within the next 72 hours.
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