It’s a simple rule: When the Securities & Exchange Commission (SEC) gets involved with a company, investors need to take a good, hard look at their positions.
See, energy producer Linn Energy has come under fire from several analysts and hedge funds about the how it uses derivatives to hedge production and how it accounts for those calls and puts on its balance sheet.
As a result of using derivatives for its production, Linn has been able to realize significant gains on what it pumps out of the ground. However, while the put expense is properly reflected in Linn’s GAAP financials, the E&P MLP excludes it from distributable cash flow.
Now, the SEC has noticed too.
Through a statement, the E&P partnership disclosed that the SEC was conducting a “private, non-public inquiry” with the firm. Specifically, the regulator’s informal review will take a look at the questionable hedging practices implemented by the firm and has requested the preservation of any documents with regards to how non-GAAP financial measures are relayed to investors.
On top of that, the SEC will begin investing the firm’s proposed merger with Berry Petroleum (BRY) and how it plans to use LinnCo shares in that acquisition.
Both Linn and LinnCo announced they are fully cooperating with the SEC and — according to the company’s statement — Linn remains confident that it will complete the buy-out of the smaller rival. Plus, the firm has maintained its monthly dividend distribution and seems to be working hard to reinsure investors that the informal inquiry shouldn’t be viewed negatively.
Still, I’m skeptical at best.
Regardless of whether or not Linn has actually done anything wrong, it’s never a good day when the Feds come knocking at your door. This is evident by the fact that Linn and Berry dropped 19% and 6% respectively, yesterday.
But beyond that, the worry is two-fold.
First, should the probe find that Linn’s DCFs are suspect and lie outside compliance rules, it will be the death knell for the E&P firm. The thesis for the stock is based on Linn digging up oil and paying out that cash flows to shareholders. No “real” cash flows mean essentially that there is no LINE stock.
Secondly, part of my enthusiasm for Linn — and why I personally bought LNCO shares — had to do with the pending merger.
Upstream MLPs, like their standard E&P twins, build, operate and maintain wells for various energy resources. However, unlike their C-corp rivals, the MLP tax structure requires 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.
And that was exactly what the Berry deal gave Linn.
By purchasing Berry, the upstream MLP will add nearly 3,200 long-life and low-decline producing wells on more than 200,000 net acres, located in Linn’s core drilling regions in California, the Permian Basin, East Texas and the Rockies. These are exactly the kind of assets upstream MLPs crave and need to keep those hefty dividends flowing.
Given the inquiry, that deal could close late or not at all — especially if BRY shareholders are spooked by the SEC’s findings and vote against the acquisition, opting to instead remain a stand-alone company.
That would hurt LINE significantly considering one of the major criticisms of the firm has been its declining production. The company’s first-quarter earnings report showed total energy production averaging 796 million cubic feet per day — down from 800 million cubic feet in the previous quarter. And declining production could come back to bite Linn’s distributable cash flows and the company’s dividend policy.
While the SEC might find that everything is sunshine and lollipops at LINE and LNCO, the stocks are going to bounce around pretty heavily over the next few weeks until everything is settled down. And if there is a problem, look out below. Some of the worst-case analyst predictions for LINE shares are in the $8 to $10 range — as much as 70% lower than where we are today.
That’s not exactly what you are looking for in a steady dividend-paying MLP.
The bottom line: Investors may want to consider taking their lumps and bailing out of shares to look at some of the other MLPs out there. While the dividends may not be as high, you’ll probably sleep better at night.
I know I will.
As of this writing, Aaron Levitt planned to sell his LNCO position within 72 hours of this posting.