Alliance Resources: astoundingly good - but why?

Alliance Resources (ARLP:NASDAQ) is a listed master limited partnership (MLP) in the coal mining space. The General Partner (AHGP) is also listed. The GP is also structured as an MLP.

Alliance mines roughly 35 million tonnes of coal annually which makes it a big mining operation but only about a seventh of the size of the American giants (Peabody, Arch Coal) and those are small compared to BHP which has over 13 billion dollars in coal revenue.

Alliance is unique among large coal companies in that the stock price and profitability is at an all time high.

Everyone else is suffering - or at least guiding to some sufferance.

This is the first of a series of notes to try and work out why. You can color me skeptical up front. The performance of Alliance is - relative to the competition - flat-out extraordinary. And that gets my spidey-sense on full alert.

Background to Alliance's operations and the current state of the coal industry

Alliance mines are mostly high sulfur and underground - some in the (very) high cost Appalachia but most in the lower cost Illinois Basin.

It is also no secret that the coal mining industry in America is stretched. Very stretched. There are a bunch of reasons - but for thermal coal the main one is that coal fired power stations are closing - driven by two main factors:

• 1. Very low natural gas prices are making gas-generated electricity very cheap - cheaper than coal generated electricity in many cases and

• 2. High environmental costs (especially mercury amelioration) causing plants to close.

These are related problems. It might be worth retrofitting old boilers with scrubbers for mercury if the electricity price were high. But because of cheap gas there is no prospect of that.

And there are plenty of signs of the stress. I am going to quote the last conference call of CSX - the railway company that hauls lots of coal - because it is Alliance's main carrier:

Finally domestic coal declined 21% although the rate of decline moderated somewhat from what we saw earlier in the year. Now let’s take a closer look at some of the individual markets in more detail and let’s start with coal. Coal revenue declined 18% to $747 million. Domestic volume declined 21% as natural gas prices remain low leading to the continued displacement of coal and high stockpiles at many utilities. In addition, electrical generation declined in the Eastern United States. Export coal volume declined 10% as demand for metallurgical coal softened particularly in the Asian markets. Total revenue per unit was flat as core pricing gains in domestic markets offset lower export rates. Looking ahead at this point export coal volume is expected to decline in the first quarter and our best estimate of full year volume is about 40 million tons. 

Furthermore we anticipate our rates to be pressured as we work with producers to keep U.S. coal competitive globally in an environment where underlying commodity process for thermal and metallurgical coal are low. At the same time domestic coal headwinds will persist but we expect them to continue to moderate throughout 2013. As a result we anticipate domestic volume will decline in the 5% to 10% range for the full year.

It is however fair that in this misery Illinois Basin coal has done relatively well. Whilst Powder River Basin (PRB) coal is still cheaper Central Appalachian Coal is flatly noncompetitive. Quoting from the question and answer session in the same conference call:

David Vernon - Sanford Bernstein 

Okay. And just as a quick follow-up with the length of haul increase on the domestic, is that a change in type of coal is it the Illinois Basin coming in perhaps going into a plant that used to be taking PRB or is it just the ebbs and flows across the network? 

Michael Ward - Chairman, President and Chief Executive Officer of CSX 

Some of it is Illinois Basin coal, but it’s not going into plants that took PRB, it was going into plants that took Central App. And the rest of it has just been the ordering patterns of the utilities fulfilling their coal contracts.

This appraisal of Illinois Basin coal displacing Appalachia coal is widely reported. The Energy Information Administration has reported the same thing - with rising volumes for Illinois basin coal but falling prices. They have reported falling prices and volumes for Appalachian coal.

Alliance has bucked these trends. It has produced rising volumes in both the Illinois Basin and the Northern Appalachia (with falling volumes in the Central Appalachia due to regulatory issues). And - contrary to all industry trends - they are reporting rising prices in the Illinois Basin. Specifically in the recently filed 10-K the price achieved in the Illinois Basin rose from $50.45 per ton in 2011 to $52.51 per ton in 2012. Not only are these prices not following industry trends but they are several dollars per ton higher than prices reported on Bloomberg for Illinois Basin coal of similar grades.

Coal mining is not a complicated business - and unless you have a substantially better resource than anyone else it is difficult to make these sort of numbers. Moreover whist one mine may be extraordinary  Alliance operates eleven mines. It is unlikely they are all extraordinary.

So it must be something done by the management. Something truly extraordinary done by the management. The main point of this series of blog posts is to work out precisely what.




John

PS. As readers know I am a short seller. Whenever I see something like this I am skeptical. In this case you can assume I am short.

Revisiting Titanium Asset Management

I had almost entirely forgotten about Titanium Asset Management in outer Sydney until Friday when an anonymous person left this comment on my blog:

Hempton, you are one sad person. Look at the crap you write. Your mother must be ashamed of you.

And yes - I confess they got the first bit right. There is a little bit of sadness here.

But to explain my sadness you need to revisit my post on Titanium Asset Management and their fictional returns.

Titanium's website is not there any more (and I attribute that partly to my post and partly to the related articles in the Sydney Morning Herald).

Whatever: you can still find the website at archive.org.

Here is a picture of Titanium's returns versus the ASX200.

(The original along with a long series of monthly entry and exit prices can be found at this link...)

These returns were of course fictional (the "fund manager" later said they came from "paper trading" even though the original documents described them as audited).

When the auditor confirmed to me that he never audited the returns - well that sort of clinched it.

As I said Titanium Asset Management's website has disappeared.

Briefly Titanium Asset Management renamed themselves "Wedgetail Asset Management" but that website has also disappeared. The website contact in the whois database is Andrew Blanchette*.

One of the fund managers at Titanium has wound up as the "Investment Governance and Reporting Manager" at a reputable financial institution.

And Blanchette remains the Chief Executive Officer of a large financial planning dealer group called - you guessed it - Titanium.

Nobody has been criminally charged for marketing a funds management business on false returns.

So unfortunately I am sad.

Whether my mum is proud of me - that is another question. She always had a penchant for calling a spade a shovel - and I am proud of her.




J

*An aside. Australians may know why Blanchette is otherwise famous. Short version: he was a boyfriend of a model - Carolyne Byrne. Carolyne Byrne was found dead at the Gap - a Sydney suicide spot. Her later boyfriend Gordon Wood was convicted of murder. Blanchette publicly accused Wood of the murder. Wood protested his innocence and accused Blanchette of the murder. Blanchette was investigated and cleared. Wood's conviction was later overturned as a miscarriage of justice. Probable truth - she committed suicide - possibly induced by SSRIs - and nobody is guilty of murder. The longer version is more colorful because it involves prominent but now dead members of the Sydney business community - alas the longer version is a probable mash of falsehoods too...

Gulfport energy's accounts payable and accrued liabilities

Gulfport Energy reports later this week. Strangely one of the balance sheet items that most intrigues me is their accounts payable and accrued liabilities.

Here is the current liability section from the last 10-Q.

GULFPORT ENERGY CORPORATION CONSOLIDATED BALANCE SHEETS (Unaudited)
	September 30, 2012				December 31, 2011
Current liabilities:
Accounts payable and accrued liabilities	$	107,058,000			$	43,872,000
Asset retirement obligation - current	60,000				620,000
Short-term derivative instruments	8,816,000				—
Current maturities of long-term debt	147,000				141,000
Total current liabilities	116,081,000				44,633,000

I just want you to note that accounts payable and accrued liabilities are just over 107 million. That is up from 44 million at December 2011 and from 96 million in the second quarter.

And here is the profit loss statement listing all expenses for the past nine months.

GULFPORT ENERGY CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
	Three Months Ended September 30,								Nine Months Ended September 30,
	2012				2011				2012				2011
Revenues:
Oil and condensate sales	$	58,609,000			$	56,447,000			$	187,633,000			$	154,559,000
Gas sales	973,000				923,000				2,127,000				3,155,000
Natural gas liquids sales	874,000				653,000				2,374,000				2,346,000
Other income	81,000				58,000				189,000				248,000
	60,537,000				58,081,000				192,323,000				160,308,000
Costs and expenses:
Lease operating expenses	6,638,000				5,744,000				18,201,000				15,103,000
Production taxes	7,070,000				6,281,000				22,411,000				18,520,000
Depreciation, depletion, and amortization	25,377,000				14,736,000				70,424,000				40,606,000
General and administrative	3,098,000				2,034,000				9,370,000				6,209,000
Accretion expense	176,000				168,000				529,000				491,000
	42,359,000				28,963,000				120,935,000				80,929,000
INCOME FROM OPERATIONS:	18,178,000				29,118,000				71,388,000				79,379,000

I want you to notice that the only expenses in the past nine months are:

• 18.2 million of lease operating expenses
• 22.4 million of production taxes
• 70.4 million of depreciation, depletion and amortization
• 9.4 million of general administrative expenses, and
• 0.5 million of accretion expense (though I am not sure I know what that is).

The depreciation, depletion and amortization is - I presume - non cash. Cash expenses for the nine months add up to about $50 million.

I presume most of those were paid relatively promptly. (It does not endear you to regulators for instance if you do not pay your production taxes.)

Simple question

What sort of business is it that accrues $107 million in (unpaid) current liabilities but incurs only about $50 million of expense over the past nine months?

I have spent a bit of time puzzling out the answer - but I will leave that for another post.






John

Disclosure: short Gulfport.

Linn Energy: that did not work so well

From the original 8-K which triggered this series of posts:

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

Drolly I note that for 2012, the company reported net loss of $387 million, or $1.92 per unit. For the quarter the loss was $187 million. (Source here.) Obviously a good part of this loss was write-downs from writing off oil and gas properties that became less valuable as gas prices fell.

However there should be an offsetting write-up in the value of the hedges so that defense will get only so far.

Whatever: unusually for a stock I write about in Linn's case I (mostly) believe in the validity of the accounts. The accounts say quite bluntly that

(a). This is a loss making enterprise.
(b). That this business pays out large and increasing distributions despite those losses and
(c). The business raises ever increasing amounts of funds using ever-more-novel ways of doing it.

To me that looked like a Ponzi scheme on its last legs. Indeed to come to a different conclusion I thought you had to accept some non-standard non-GAAP measures as reality. In other words you have to ignore the audited bottom line for the company.

Many people it seems do ignore the bottom line. They are encouraged by the management - and they might be right - but for the moment I have (and retain) a different opinion.

But I was wrong

Despite not changing my opinion on the fundamentals of Linn I will confess to being wrong on one important (nay critical) point.

When Linn launched Linco (their non-MLP associate which exists only to hold interests in Linn) I thought the money-raising was on its last legs. Specifically I thought that rather than target the non-sophisticated mom-and-pop investors who buy MLPs they were being forced to target more sophisticated investors as they had run the non-sophisticates out of money.

I thought LinnCo meant Linn was on its last legs.

I was wrong. Spectacularly (and unprofitably) wrong.

Yesterday (as many will have noticed) Linn used Linco stock as a currency to buy a C-Corp - a very big acquisition - their biggest to date.

I did not see it coming. It was not even on my original list of risks in the position. Wrong!

This is a great deal for Linn. They get to swap what I believe to be near-worthless stock for some old - but still valuable oil assets. Those assets will generate cash - cash that can keep this whole thing rolling along for a few more years.

So even if I am right that Linn is a Ponzi (and many company supporters disagree with me) it is not a Ponzi that will collapse next week. And so my opportunity to profit will not be next week.

I covered most of my short.

For a loss.




John

PS. The company now has some time to prove that it is not a Ponzi. Substantial GAAP profits might be a start - but hey - ten more years of distributions would also be effective.

Linn Energy per flowing barrel

A fairly standard oil-and-gas valuation metric is the price per flowing barrel for oil and gas.

Oil at $100,000 per daily flowing barrel is considered high end - but some transactions happen at higher prices when there are further development opportunities in the field and the oil is light, sweet crude.

Flowing gas (per BTU) is typically worth about half flowing oil. [Use a conversion that 6 Mcf of gas is equivalent to about 1 barrel of oil]. So lets call this $50,000 per flowing barrel equivalent.

Natural gas liquids trade at about half the price of oil - and so a flowing barrel should be worth about half a flowing barrel of oil. Also lets call this $50,000 per flowing barrel equivalent.

These are fairly standard metrics and any oil and gas analyst should be able to confirm that I am not rigging the numbers here.

Linn Energy per flowing barrel

Here - from the last form 10-Q is the average daily production of Linn Energy for the last quarter by different types of hydrocarbon:

	Three Months Ended September 30,
	2012				2011				Variance
Average daily production:
Natural gas (MMcf/d)	409				170				141	%
Oil (MBbls/d)	30.8				22.6				36	%
NGL (MBbls/d)	31.4				12.2				157	%
Total (MMcfe/d)	782				379				106	%

The increase is not driven by field development but by buying almost $2.5 billion in new assets.


Using the metrics above:

• The gas production is worth 409,000*$50,000/6 = $3.41 billion. 
• The oil production is worth 30,800*$100,000 = 3.08 billion and
• The NGL production is worth 31,400*$50,000= 1.59 billion

The total valuation of the hydrocarbons is thus 8.08 billion as per the flows in the last 10-Q.

The last 10-Q also showed LINN as having debt of $6.84 billion in debt. So the equity would be worth 1.24 billion.

There were 199 million units outstanding as per the last 10Q. This gives an equity valuation of $6.22 per unit - a fair bit lower than the current price of $36.65 per unit. Longs can expect an 80 percent loss on their units using these valuations.

My view is that Linn Energy's gas and oil fields are pretty clapped out - and worth considerably less than the above metrics. The average well flows about 6 barrels per day! [My personal view: the debt will be impaired.]

However even at a full price this MLP is worth under $7 per unit.

To be fair though - this company has purchased a lot of in-the-money options and its option position is valuable. The value of those is about $900 million - which is almost $4 more per unit.

To get anything like the price targets of the bullish analysts are putting on it you need to think these clapped out assets are worth $200,000 per flowing barrel.

I know, I know you object: MLPs are not valued on their underlying assets. They are valued on their yield.

And they are. Until the yield stops.




John

Linn Energy: A bizarre definition of distributable cash hides really clapped out assets

The last post explained just how bizarre the definition of EBITDA/distributable cash is at Linn Energy. This bizarre definition of EBITDA in my opinion allows a zany and unsustainable level of distributions to be paid and hence attracts investors.

This stock is sold on the yield.

I think you should buy shares on the underlying assets and not a running yield.

So it is worth looking at what the underlying assets are.

Here from the last 10-K is a disclosure on the number of productive wells owned:

Productive Wells

The following sets forth information relating to the productive wells in which the Company owned a working interest as of December 31, 2011.  Productive wells consist of producing wells and wells capable of production, including wells awaiting pipeline or other connections to commence deliveries.  “Gross” wells refers to the total number of producing wells in which the Company has an interest, and “net” wells refers to the sum of its fractional working interests owned in gross wells.  The number of wells below does not include approximately 2,500 productive wells in which the Company owns a royalty interest only.

		Natural Gas Wells								Oil Wells								Total Wells
		Gross				Net				Gross				Net				Gross				Net
Operated (1)			3,889				2,925				3,870				3,578				7,759				6,503
Nonoperated (2)			1,843				369				1,628				207				3,471				576
			5,732				3,294				5,498				3,785				11,230				7,079

(1)	The Company had 12 operated wells with multiple completions at December 31, 2011.

(2)	The Company had no nonoperated wells with multiple completions at December 31, 2011.

The previous year the total was not dramatically different - this from the 10-K for the year ended 2010:

Productive Wells

The following table sets forth information relating to the productive wells in which the Company owned a working interest as of December 31, 2010.  Productive wells consist of producing wells and wells capable of production, including wells awaiting pipeline or other connections to commence deliveries.  “Gross” wells refers to the total number of producing wells in which the Company has an interest, and “net” wells refers to the sum of its fractional working interests owned in gross wells.  The number of wells below does not include approximately 2,700 productive wells in which the Company owns a royalty interest only.

		Natural Gas Wells								Oil Wells								Total Wells
		Gross				Net				Gross				Net				Gross				Net
Operated (1)			3,751				2,707				3,346				3,088				7,097				5,795
Nonoperated (2)			1,717				342				1,572				175				3,289				517
			5,468				3,049				4,918				3,263				10,386				6,312

(1)	Ten operated wells had multiple completions at December 31, 2010.

(2)	Three nonoperated wells had multiple completions at December 31, 2010.

They would have averaged about 3,170 net productive gas wells and 3,520 net productive oil wells. The average total productive wells would have averaged about 6,700.

And here from the form 10-K is the average daily production.

The following sets forth information regarding average daily production, average prices and average costs for each of the periods indicated:

		Year Ended December 31,
		2011				2010				2009
Average daily production:
Natural gas (MMcf/d)			175				137				125
Oil (MBbls/d)			21.5				13.1				9.0
NGL (MBbls/d)			10.8				8.3				6.5
Total (MMcfe/d)			369				265				218

They produced 175,000 Mcf/d of natural gas and 21,500 barrels of oil per day with another 10,800 barrels of natural gas liquids.

The total gas equivalent is 369,000 Mcf/d of natural gas.

Lets do some division. The oil wells produce 21,500 barrels of oil per day from an average of 3,520 wells. This is an average of 6 barrels per day.

There are going to be an awful lot of wells that produce less than two barrels per day.

The gas wells produce 175,000 Mcf/d of natural gas from 3,170 wells. This works out at 55 Mcf/d in gas. At a $3 gas price these wells are producing - get this - $165 in natural gas per day. Presumably these wells are also declining...

Fortunately they also produce 10,800 barrels of natural gas liquids per day. That is 3.4 barrels of liquids (at about $45 a barrel as an estimate).

I have a few questions of management:

Question 1

How many of the much-vaunted wells produce less than $100 gross revenue per day? Oh, that $100 needs to be before hedging!

Question 2

How many wells were shut down or went out of production in each of the last five years because the flow rates were so low the wells became non-economic?

Question 3

What is the right level of maintenance capital expenditure for wells with flow rates this low? How does this level of maintenance capital expenditure differ from the maintenance capital expenditure used for calculating distributable amounts?

High valuations for clapped-out assets

This company sports a premium valuation for very old and very run-down-low-production wells.

I believe this premium valuation is because people see the (high and attractive) dividends not the (clapped-out) underlying assets.

The fact that the dividends are - at least in part produced by financial engineering not cash flow (as per the last post) is besides the point. This company buys and manages clapped out oil and gas properties and maintains a perception of asset backing. After all the MLP is issuing large numbers of units and they are selling both dividends and the perception of asset backing. Telling a good story about run-down assets is necessary.

The long term future of Linn Energy: Who would normally own the wells?

These wells are valuable. A well flowing 3 barrels per day still generates $70-100 thousand a year of gross revenue. There is only a small fraction of that left after production taxes and maintenance. Someone has to fuel and maintain the nodding-donkey oil pump after all. And someone has to drive the truck around to collect the oil.

This is gritty work. Apart from anything these fields are laden with environmental problems - because typically the pump is pulling up a barrel of oil and fifty barrels of salt water per day. The salt water needs to be disposed of. And the oil collected and spills dealt with.

So you are under no illusions this what a typical unit producing one barrel per day (and 150 barrels of salt water) looks like check out this video from You Tube.




What you own if you own Linn Energy is simple. It is thousands of these things.

But lets get back to the natural owner of this well. I know the guy. Sun burnt but would be far more sun burnt without the hat. A pick-up truck. Dog and a shot-gun in the back. Political views well to the right of mine.

You have to admire this guy - he is a self-reliant individual who works without much corporate overhead. Has nobody to blame when the electric motor burns out than himself. And he works hard. Real hard.*

This assets owned by Linn Energy are not normally the sort of asset owned by a 14 billion dollar enterprise valuation listed entity. They are owned by the red-necked, gun-toting self-reliant individual who works hard and does not mind getting his hands dirty.

When this MLP runs out of cash to distribute it is likely to be dismantled and the assets will be sold to those those fine people with their politics, dogs and shotguns. Assets like these tend to find their natural owners.

In liquidation I seriously doubt if there will be anything like enough to make whole the $7 billion owned to the banks and other lenders. If you are Linn Energy debt-holder beware.

Something substantial for the residual equity holders? Surely you must be joking?



John

*Please understand I am not mocking the natural owner here. If my (non-existent) daughter married him I would be pleased for her even if social conversation at Christmas dinner was awkward. I have far more respect for that-type than I have for many financial or CEO types...