Linn Energy's Queen Gertrude Moment

Linn Energy (Nasdaq:LINE) is the biggest oil-and-gas production Master Limited Partnership (MLP) in the US. The market cap is a little over $7 billion and there is a little over $7 billion in debt.

Like many MLPs it raises a lot of money and it pays big, fat and increasing dividends.

I have a number of listed companies including Linn Energy on "Ponzi watch" because they could potentially be Ponzis attracting capital with large and increasing dividends in an ultimately unsustainable spiral.

There are two things that make Linn Energy stand out. One is the voraciousness with which it raises money and the innovative ways it chooses to do so. In 2009 it raised $292 million. In 2010 it raised $844 million in equity and borrowed over $1.1 billion net. In 2011 it raised a further $679 million and borrowed another $1.2 billion. In 2012 until September it raised another $761 million and borrowed over $2.8 billion net. (Source cash flow statements from the last 10-K and 10-Q.) The company is the most innovative money-raiser in the MLP space having made a parallel structure (Linn Co - NASDAQ:LNCO) to appeal to institutional investors.

The second thing which makes Linn Energy stand out is their strange hedging policy. Linn Energy buys in-the-money puts. It also appears to have entered in-the-money-swaps on gas it intends to sell.

It sells the gas and collects money on its puts and its swaps. The proceeds when the puts and swaps are exercised is considered as distributable income. This is bizarre - so bizarre that I could scarcely believe it was real.

It was as if I owned a Microsoft Share with a market price of $28. And for $12.90 I purchased a $40 January 2014 put for it. [This contract is real - it can be purchased.].

Then come January I exercised the put, sold my Microsoft Share for $40 and declared a big capital gain. I told my clients all about the capital gain and told them they could spend it. I even gave it to them  in distributions. And I told them to ignore the $12.90 I paid for the put which I had amortized away. After all the put premium disappears in depreciation and amortization - and amortization is a non-cash expenses.

If a mutual fund did this I would call it fraud. But just as the water goes down the bath hole differently in the Southern Hemisphere what is fraud in a mutual fund is acceptable in a very large MLP. Much to my disbelief Linn Energy seem to do precisely this.

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Recently some anonymous short seller argued that Linn Energy's accounts were fake because they were doing precisely what I said they were doing above. Barrons recently made similar points.

Whatever - the short seller said (according to the MLP) that the MLP purchased "deep in the money" puts. This led to an amazing 8-K released by Linn Energy - an 8-K leaves me thinking of almost nothing except Queen Gertrude in Hamlet saying "methinks the lady doth protest too much".

This blog post repeats the whole press release with annotations. The original is in italics.

LINN’s Hedging Strategy and Response To Inaccurate Statements

Made By An Anonymous Short Seller

“Since our IPO, hedging our oil and natural gas production has always been an important strategy for the company and our investors. Our hedge strategy has served LINN and our investors well through a variety of commodity price cycles,” said Mark E. Ellis, Chairman, President and Chief Executive Officer. “Hedging will continue to be an integral part of LINN’s strategy.”

Below is an overview of the company’s hedging strategy and the company’s comments related to inaccurate statements made by an anonymous short seller.

Hedging Rationale

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Reduce commodity price risk

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Lock in acquisition margins

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Lock in margins on organic drilling (capital investment)

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Provide stability and growth in distributions

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Preserve ability to make acquisitions during down markets

Hedging Strategy

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Hedge up to 100% of expected production for 4-6 years

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Continually maintain a 4-6 year hedge book

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Use approximately 70% swaps (fixed price contracts) and 30% puts (floor contracts with unlimited upside)

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Typically budget up to 10% of the cost of an acquisition for put expenditures

This last line is an admission that they buy puts and capitalize them. They also own gas swaps (ie forwards) which are a long way out of the money. Do they also budget cost for buying those? I would like to know.

Fact #1 – LINN is confident in the validity and accuracy of its audited financial statements.

Well they would say that wouldn't they? However there is no allegation I am aware of that the P&L or the balance sheet is incorrectly stated. The allegation is that EBITDA (which is not a GAAP concept) is overstated and they are paying unsustainable distributions.

Indeed the idea that they are paying unsustainable dividends is supported by their audited accounting statements. Linn Energy made an audited GAAP loss of $298 million during 2009. It paid $303 million in distributions. It made an audited GAAP loss of $114 million in 2010 and paid $366 million in distributions. In 2011 it made a (rare) profit of  $438 million and paid $466 million in distributions. (Source: the last 10-K).

The last 10-Q reveals the situation has worsened: Linn Energy made a loss of 199 million in nine months - but it made 430 million loss in the last quarter. And it paid distributions of 426 million.

The pattern is increasing losses and increasing distributions - something that would be a standard feature in a Ponzi.

As a short seller I am relatively confident in the accuracy of Linn Energy's audited accounts. Far more confident than I am in their definition of distributable EBITDA.

Fact #2 – LINN generates sufficient cash flow to cover its distributions.

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Since the company’s IPO in 2006, LINN has paid its distribution for 27 straight quarters. These distributions were paid in CASH.

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Amortization of puts is a non-cash expense and should not be deducted from EBITDA (hence the definition of EBITDA; earnings before interest, taxes, depreciation and AMORTIZATION).

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LINN considers the cost of puts as a “capital” investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that “depreciation” of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a “capital” expense, and the company views puts the same way.

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When LINN purchases puts, the company pays 100% of the cost in upfront cash and capitalizes them as an asset on the balance sheet.

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The cost of LINN’s puts is deducted from Net Income over time. Net Income is not a cash metric.

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What does flow through to Distributable Cash Flow per Unit is the cost of debt and equity securities (interest and distributions) that were needed to purchase both the oil and natural gas assets and the puts. This is a CASH expense.

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Anonymous short sellers are improperly mixing the definitions of cash flow and non-cash flow metrics (Net Income vs. Cash Flow).

This is a straight admission of the short-case against Linn Energy. Linn Energy buy puts. They pay money for these. They do not consider amortization of those puts an expense that should be deducted from their "distributable amount". They admit it should be deducted from the GAAP income.

This is an absolute analogue of me buying $40 puts on Microsoft and considering the gain when I deliver my Microsoft shares to be distributable. [Of course my GAAP accounts will tell the truth. Linn Energy's GAAP accounts also tell something approximating the truth. The truth is that Linn Energy is a loss making enterprise.]

Fact #3 – LINN does not always buy “in the money” puts.

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Most of the company’s hedge positions consist of swaps (approximately 70%), which are entered into on “market” terms.

Now here is where the company completely loses me. All this legerdemain is alright because most of it is done through swaps on "market" terms. The give-away is that the word "market" is in inverted commas. You see this is a definition of "market" that I am not normally familiar with...

In particular the company swaps seem to be at the same price or higher than the company puts. And the puts are purchased "in the money". Moreover they invest money in their swaps so the swaps are purchased in the money.

You can see this in the last 10-K. In 2012 the price of their gas swaps is $5.85 (a fair way in the money). The price of their puts is $5.83. There is not much difference. There is not much difference in the out years except that for 2014 the price of their swaps is $5.69 and the price of their puts is only $5. In some years it seems the company "invests" just as much in their swaps as in their puts.

So they use swaps to fudge their distributable amount too.

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The remaining balance of the hedge position consists of puts, the majority of which were purchased BELOW the market.

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Out of 40+ hedging transactions over the last 10 years, only 7 were purchased “in the money.”

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Some of the confusion arises due to the fact that certain investors do not know the difference between the prompt price (today’s price) and the 4, 5 or 6 year average market price.

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For example, if the spot price for natural gas is $2.00 per Mcf but the 5 year average is $4.50 and LINN purchases a $5.00 put, that could hardly be considered “deeply in the money” when compared to the 5 year average market price.

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When making decisions regarding spending money for puts, LINN focuses on achieving the best value for its money.

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Additional confusion arises when some investors look at the price levels for the company’s hedge positions. This is largely due to the fact that most of LINN’s hedges were executed when prices were higher.

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Obviously this is the reason the company hedged in the first place. LINN wanted to insulate the company from just such an event.

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LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream.

I am just going to call BS on this. The company is claiming that it purchased substantial numbers of below market hedges. I want to point out the average price of gas sold after hedging in 2009, 2010 and 2011 was $8.57, $8,22 and $8.20 respectively. It is an awful long time since the natural gas prices - even forward natural gas prices - let alone say five year strip natural gas prices were that high. There is simply no way that these prices were obtained except by purchasing substantially in-the-money positions with large amounts of cash.

The last sentence - that LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream is a real Queen Gertrude moment as will be discussed below.

Fact #4 – LINN does not restructure its hedge book to manipulate earnings.

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On rare occasions, LINN has restructured its hedge book.

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One example was in 2008, when oil soared to $150 and LINN’s put strikes were approximately $70. At the time, that hardly felt like adequate protection. LINN paid a nominal sum to raise the strike prices for 2009 and 2010 to $120 and $110, respectively. First, both transactions were well BELOW the market, and second, oil later that year declined to a low of roughly $35.

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Two other examples came in July 2009 and September 2011:

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Both instances involved a precipitous decline in prices in the “long” part of LINN’s book (i.e. in years 4-6).

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LINN realized gains of approximately $75 million by unwinding these positions. The company’s intent is always to leave the value in the hedge book instead of taking the cash. Therefore the company used the proceeds to raise hedge prices in near term years by a nominal amount.

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Shortly thereafter, LINN rehedged the outer years again.

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Bottom line is this is extremely rare and the magnitude of the trades is immaterial.

I agree LINN does not restructure its hedge book to manipulate earnings. The hedges are accounted for properly on a GAAP basis. What this does do is change its measure of EBITDA. In every instance they have reduced the price received in out years (reducing the EBITDA in out years) and increased the price received (and hence their measure of EBITDA) in the near-years. What they are doing is manipluating their dodgy definition of EBITDA and hence distributable cash flow.

They do this to continue to fake-up their distributable income and hence allow them to pretend to have a sustainable dividend.

They say the trades are immaterial - however the last 10-K contains this amazing section:

In September 2011, the Company canceled its oil and natural gas swaps for the year 2016 and used the realized gains of approximately $27 million to increase prices on its existing oil and natural gas swaps for the year 2012.  In September 2011, the Company also paid premiums of approximately $33 million to increase prices on its existing oil puts for the years 2012 and 2013.  In addition, during the fourth quarter of 2011, the Company paid premiums of approximately $52 million for put options and approximately $22 million to increase prices on its existing oil puts for 2012 and 2013.

Lets count that out. The company used 27 million of gains (taken out of 2016 hedges) just to increased their estimated distributable income in 2012. But that was not enough. So they paid $33 million to increase the price of their oil puts for 2012 and and 2013. They also paid 52 million for more put options and 22 million to increase prices on oil puts for 2012 and 2013. Funnily enough all this legerdermain is additional to the ones disclosed above in the press release.

This is beginning to look (a) material and (b) like a pattern.

The company says that it has never and will never purchase deeply in the money puts to manipulate its cash flow stream. That was the Queen Gertrude moment - after all they have a pattern of paying to make options and swaps more in the money to manipulate their cash flow stream.

Fact #5 – During 2012 LINN purchased $583 million of puts for the following reasons:

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During 2012, LINN completed approximately $3 billion of acquisitions. Consistent with its hedging strategy to reduce commodity price volatility and lock in margins associated with the acquisitions, LINN purchased approximately $320 million of puts (again roughly 10%).

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The remainder of the $583 million spent during 2012 was used to add puts for 2013 through 2017 for volumes that were not yet hedged.

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As a reminder, this $583 million cost has a true finance cost (interest and distributions). The puts were purchased with cash. The potential benefit may not be realized for years to come. However, the cost is reflected now in LINN’s distributable cash flow per unit.

I have read this several times. All it means (I think) is that they paid out $583 million in cash which they will receive back when they sell gas and oil in the out years. That cash (which was borrowed as far as I can tell) will wind up being counted as distributable cash flow and be distributed. In a round about way then the company is borrowing to pay distributions.

Fact #6 – LINN’s publicly stated Adjusted EBITDA is the same that the company provides to its lenders.

Bluntly: Linn Energy uses the same misleading definition of EBITDA with the people it borrows from as it does with the unit holders. Does this make the lenders nervous? Should it make the lenders nervous?

Fact #7 – LINN’s taxable income is low relative to its cash flow.

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The company’s taxable income due to non-cash deductions is relatively low compared to cash flow. So is every other oil and gas company.

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LINN does not pay distributions with net income; the company pays them with cash flow and clearly has sufficient cash flow to do so.

I agree Linn's taxable income is very low relative to its cash flow. This company makes GAAP losses. It also - as far as I can tell makes tax losses - there is no taxable income.

Linn Energy however has raised its distributable cash flow with its strategy of buying in-the-money hedges. They just don't think that is faking EBITDA. I report: you decide.

Fact #8 – LINN only cancels out of the money hedge positions to comply with lender covenants.

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On two occasions the company cancelled hedge positions, which happened to be out of the money at the time, to comply with its bank covenants when selling assets.

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LINN also cancelled interest rate hedges when issuing long-term fixed rate bonds, again to comply with its covenants.

This is maybe the most extraordinary admission I have ever seen from a richly valued company. This company has has rejigged its hedging to comply with its covenants. Which covenants? Is it necessary to use this convoluted and unusual definition of EBITDA to comply with covenants? How do lenders feel about this? Do lenders even know they are being fed an unusual definition of EBITDA?

Fact #9 – LINN does not issue debt and equity securities to pay its distribution.

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Since the company’s inception, LINN has issued approximately $12 billion of debt and equity securities:

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$10 billion to finance acquisitions

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$1 billion to finance puts (roughly 10% of the cost of the acquisitions)

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$1 billion primarily to repay higher cost debt

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Since its IPO, LINN has paid $2.4 billion in distributions. The only way that would be possible is by earning a sufficient amount of cash to pay the distribution, which LINN clearly did.

I agree the company does not raise money to pay distributions. Linn borrows money to buy things including put options and other derivatives. The money paid for these derivatives turns to cash as the company sells gas and oil at inflated prices. It is then distributed to unit holders.

Unit holders and debt holders would not countenance raising money to pay distributions. That is the essence of Ponzi.

So a really strange and opaque derivative maneuver gets inserted in the process. Then they sell equity and debt securities to buy derivatives that turn to cash. Then they distribute that cash. Whether interposing the strange derivative maneuver is sufficient to remove the whiff of Ponzi I cannot tell. I report: you decide.

As for the statement the only way that paying $2.4 billion in distributions would be possible if they earned the money - well I just present the GAAP accounts. All they have earned is losses. This company clearly has a different definition of "earnings".

Other Information:

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In evaluating this issue, LINN has identified other publicly traded partnerships that purchase derivatives, and all of these companies account for derivatives the same way LINN does.

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In fact, LINN has yet to identify any publicly traded partnerships that account for it differently.

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LINN’s hedge policy strictly prohibits any speculative trading or manipulation in the hedge book. The company adheres strictly to this hedge policy.

The GAAP accounting is correct. I have said this above. What is unusual is the definition (non GAAP) of distributable amount. I have yet to see any other partnership that estimates its distributable amount in this way - but hey - there are always other things to short as well.

So there.

That Queen Gertrude does protest too much. And she is so transparent.





John