Linn Energy's Queen Gertrude Moment

Linn Energy (Nasdaq:LINE) is the biggest oil-and-gas production Master Limited Partnership (MLP) inward the US. The marketplace seat cap is a footling over $7 billion too at that topographic point is a footling over $7 billion inward debt.

Like many MLPs it raises a lot of coin too it pays big, fatty too increasing dividends.

I have got a number of listed companies including Linn Energy on "Ponzi watch" because they could potentially live Ponzis attracting majuscule amongst large too increasing dividends inward an ultimately unsustainable spiral.

There are 2 things that brand Linn Energy stand upward out. One is the voraciousness amongst which it raises coin too the innovative ways it chooses to practice so. In 2009 it raised $292 million. In 2010 it raised $844 meg inward equity too borrowed over $1.1 billion net. In 2011 it raised a farther $679 meg too borrowed some other $1.2 billion. In 2012 until September it raised some other $761 meg too borrowed over $2.8 billion net. (Source cash catamenia statements from the last similar points.

Whatever - the brusk seller said (according to the MLP) that the MLP purchased "deep inward the money" puts. This led to an amazing 8-K released yesteryear Linn Energy - an 8-K leaves me thinking of almost naught except Queen Gertrude inward Hamlet proverb "methinks the lady doth protestation also much".

This weblog ship service repeats the whole press release with annotations. The master copy is in italics.

LINN’s Hedging Strategy too Response To Inaccurate Statements

Made By An Anonymous Short Seller

“Since our IPO, hedging our fossil oil too natural gas production has ever been an of import strategy for the companionship too our investors. Our hedge strategy has served LINN too our investors good through a multifariousness of commodity cost cycles,” said Mark E. Ellis, Chairman, President too Chief Executive Officer. “Hedging volition maintain to live an integral business office of LINN’s strategy.”

Below is an overview of the company’s hedging strategy too the company’s comments related to inaccurate statements made yesteryear an anonymous brusk seller.

Hedging Rationale

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Reduce commodity cost risk

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Lock inward acquisition margins

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Lock inward margins on organic drilling (capital investment)

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Provide stability too growth inward distributions

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Preserve might to brand acquisitions during downwardly markets

Hedging Strategy

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

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Continually maintain a 4-6 twelvemonth hedge book

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Use some 70% swaps (fixed cost contracts) too 30% puts (floor contracts amongst unlimited upside)

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Typically budget upward to 10% of the cost of an acquisition for lay expenditures

This concluding line is an admission that they purchase puts too capitalize them. They also ain gas swaps (ie forwards) which are a long way out of the money. Do they also budget cost for buying those? I would similar to know.

Fact #1 – LINN is confident inward the validity too accuracy of its audited fiscal statements.

Well they would say that wouldn't they? However at that topographic point is no allegation I am aware of that the P&L or the balance canvas is incorrectly stated. The allegation is that EBITDA (which is non a GAAP concept) is overstated too they are paying unsustainable distributions.

Indeed the thought that they are paying unsustainable dividends is supported yesteryear their audited accounting statements. Linn Energy made an audited GAAP loss of $298 meg during 2009. It paid $303 meg inward distributions. It made an audited GAAP loss of $114 meg inward 2010 too paid $366 meg inward distributions. In 2011 it made a (rare) turn a profit of  $438 meg too paid $466 meg inward distributions. (Source: the concluding 10-K).

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

The designing is increasing losses too increasing distributions - something that would live a criterion characteristic inward a Ponzi.

As a brusk seller I am relatively confident inward the accuracy of Linn Energy's audited accounts. Far to a greater extent than confident than I am inward their Definition of distributable EBITDA.

Fact #2 – LINN generates sufficient cash catamenia to embrace its distributions.

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

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Amortization of puts is a non-cash expense too should non live deducted from EBITDA (hence the Definition of EBITDA; earnings earlier interest, taxes, depreciation and AMORTIZATION).

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LINN considers the cost of puts equally a “capital” investment too views it equally an additional cost of an acquisition (hence the target to pass upward to 10% of the cost of an acquisition on puts). No i disputes that “depreciation” of fossil oil too natural gas assets should live excluded from EBITDA or distributable cash catamenia because it is a “capital” expense, too the companionship views puts the same way.

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When LINN purchases puts, the companionship pays 100% of the cost inward upfront cash too capitalizes them equally an property on the balance sheet.

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The cost of LINN’s puts is deducted from Net Income over time. Net Income is non a cash metric.

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

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Anonymous brusk sellers are improperly mixing the definitions of cash catamenia too non-cash catamenia metrics (Net Income vs. Cash Flow).

This is a direct admission of the short-case against Linn Energy. Linn Energy purchase puts. They pay coin for these. They practice non consider amortization of those puts an expense that should live deducted from their "distributable amount". They acknowledge it should live deducted from the GAAP income.

This is an absolute analogue of me buying $40 puts on Microsoft too considering the gain when I deliver my Microsoft shares to live distributable. [Of course of didactics my GAAP accounts volition 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 non ever purchase “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 hither is where the companionship 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 discussion "market" is inward inverted commas. You encounter this is a Definition of "market" that I am non unremarkably familiar with...

In detail the companionship swaps appear to live at the same cost or higher than the companionship puts. And the puts are purchased "in the money". Moreover they invest coin inward their swaps so the swaps are purchased inward the money.

You tin dismiss encounter this inward the concluding 10-K. In 2012 the cost of their gas swaps is $5.85 (a fair way inward the money). The cost of their puts is $5.83. There is non much difference. There is non much divergence inward the out years except that for 2014 the cost of their swaps is $5.69 too the cost of their puts is solely $5. In some years it seems the companionship "invests" exactly equally much inward their swaps equally inward their puts.

So they role swaps to fudge their distributable amount too.

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The remaining balance of the hedge seat consists of puts, the bulk of which were purchased BELOW the market.

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Out of 40+ hedging transactions over the concluding 10 years, solely seven were purchased “in the money.”

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Some of the confusion arises due to the fact that for sure investors practice non know the divergence betwixt the prompt cost (today’s price) too the 4, 5 or half-dozen twelvemonth average marketplace seat price.

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For example, if the spot cost for natural gas is $2.00 per Mcf but the 5 twelvemonth average is $4.50 too LINN purchases a $5.00 put, that could hardly live considered “deeply inward the money” when compared to the 5 twelvemonth average marketplace seat price.

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

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Additional confusion arises when some investors facial expression at the cost 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 argue the companionship hedged inward the firstly place. LINN wanted to insulate the companionship from exactly such an event.

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LINN has never too volition never purchase deeply inward the coin puts to manipulate its cash catamenia stream.

I am exactly going to telephone outcry upward BS on this. The companionship is claiming that it purchased substantial numbers of below marketplace seat hedges. I desire to betoken out the average cost of gas sold after hedging inward 2009, 2010 too 2011 was $8.57, $8,22 too $8.20 respectively. It is an awful long fourth dimension since the natural gas prices - fifty-fifty forwards natural gas prices - allow lonely say v twelvemonth strip natural gas prices were that high. There is but no way that these prices were obtained except yesteryear purchasing substantially in-the-money positions amongst large amounts of cash.

The concluding judgement - that LINN has never too volition never purchase deeply inward the coin puts to manipulate its cash catamenia current is a existent Queen Gertrude 2nd equally volition live discussed below.

Fact #4 – LINN does non restructure its hedge bulk to manipulate earnings.

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On rare occasions, LINN has restructured its hedge book.

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One illustration was inward 2008, when fossil oil soared to $150 too LINN’s lay strikes were some $70. At the time, that hardly felt similar adequate protection. LINN paid a nominal amount to heighten the strike prices for 2009 too 2010 to $120 too $110, respectively. First, both transactions were well BELOW the market, too second, fossil oil afterwards that twelvemonth declined to a depression of roughly $35.

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Two other examples came inward July 2009 too September 2011:

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Both instances involved a acute refuse inward prices inward the “long” business office of LINN’s bulk (i.e. inward years 4-6).

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LINN realized gains of some $75 meg yesteryear unwinding these positions. The company’s intent is ever to exit the value inward the hedge bulk instead of taking the cash. Therefore the companionship used the proceeds to heighten hedge prices inward close term years yesteryear 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 too the magnitude of the trades is immaterial.

I concord LINN does non restructure its hedge bulk to manipulate earnings. The hedges are accounted for properly on a GAAP basis. What this does practice is alter its mensurate of EBITDA. In every instance they have got reduced the cost received inward out years (reducing the EBITDA inward out years) too increased the cost received (and therefore their mensurate of EBITDA) inward the near-years. What they are doing is manipluating their dodgy Definition of EBITDA too therefore distributable cash flow.

They practice this to maintain to fake-up their distributable income too therefore allow them to pretend to have got a sustainable dividend.

They say the trades are immaterial - withal the concluding 10-K contains this amazing section:

In September 2011, the Company canceled its fossil oil too natural gas swaps for the twelvemonth 2016 too used the realized gains of some $27 meg to increment prices on its existing fossil oil too natural gas swaps for the twelvemonth 2012.  In September 2011, the Company also paid premiums of some $33 meg to increment prices on its existing fossil oil puts for the years 2012 too 2013.  In addition, during the 4th quarter of 2011, the Company paid premiums of some $52 meg for lay options too some $22 meg to increment prices on its existing fossil oil puts for 2012 too 2013.

Lets count that out. The companionship used 27 meg of gains (taken out of 2016 hedges) exactly to increased their estimated distributable income inward 2012. But that was non enough. So they paid $33 meg to increment the cost of their fossil oil puts for 2012 too and 2013. They also paid 52 meg for to a greater extent than lay options too 22 meg to increment prices on fossil oil puts for 2012 too 2013. Funnily plenty all this legerdermain is additional to the ones disclosed inward a higher house inward the press release.

This is kickoff to facial expression (a) cloth too (b) similar a pattern.

The companionship says that it has never too volition never purchase deeply inward the coin puts to manipulate its cash catamenia stream. That was the Queen Gertrude 2nd - after all they have got a designing of paying to brand options too swaps to a greater extent than inward the coin to manipulate their cash catamenia stream.

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

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During 2012, LINN completed some $3 billion of acquisitions. Consistent amongst its hedging strategy to cut back commodity cost volatility too lock inward margins associated amongst the acquisitions, LINN purchased some $320 meg of puts (again roughly 10%).

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The residuum of the $583 meg spent during 2012 was used to add together puts for 2013 through 2017 for volumes that were non yet hedged.

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As a reminder, this $583 meg cost has a truthful finance cost (interest too distributions). The puts were purchased amongst cash. The potential practice goodness may non live realized for years to come. However, the cost is reflected directly inward LINN’s distributable cash catamenia per unit.

I have got read this several times. All it agency (I think) is that they paid out $583 meg inward cash which they volition have dorsum when they sell gas too fossil oil inward the out years. That cash (which was borrowed equally far equally I tin dismiss tell) volition current of air upward existence counted equally distributable cash catamenia too live distributed. In a circular nigh way too then the companionship is borrowing to pay distributions.

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

Bluntly: Linn Energy uses the same misleading Definition of EBITDA amongst the people it borrows from equally it does amongst the unit of measurement holders. Does this brand the lenders nervous? Should it brand the lenders nervous?

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

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

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LINN does non pay distributions amongst internet income; the companionship pays them amongst cash catamenia too clearly has sufficient cash catamenia to practice so.

I concord Linn's taxable income is really depression relative to its cash flow. This companionship makes GAAP losses. It also - equally far equally I tin dismiss tell makes revenue enhancement losses - at that topographic point is no taxable income.

Linn Energy withal has raised its distributable cash catamenia amongst its strategy of buying in-the-money hedges. They exactly don't recollect that is faking EBITDA. I report: yous decide.

Fact #8 – LINN solely cancels out of the coin hedge positions to comply amongst lender covenants.

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On 2 occasions the companionship cancelled hedge positions, which happened to live out of the coin at the time, to comply amongst its banking concern covenants when selling assets.

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LINN also cancelled involvement charge per unit of measurement hedges when issuing long-term fixed charge per unit of measurement bonds, i time to a greater extent than to comply amongst its covenants.

This is perchance the most extraordinary admission I have got ever seen from a richly valued company. This companionship has has rejigged its hedging to comply amongst its covenants. Which covenants? Is it necessary to role this convoluted too odd Definition of EBITDA to comply amongst covenants? How practice lenders experience nigh this? Do lenders fifty-fifty know they are existence fed an odd Definition of EBITDA?

Fact #9 – LINN does non number debt too equity securities to pay its distribution.

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

$10 billion to finance acquisitions

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

$1 billion primarily to repay higher cost debt

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Since its IPO, LINN has paid $2.4 billion inward distributions. The solely way that would live possible is yesteryear earning a sufficient amount of cash to pay the distribution, which LINN clearly did.

I concord the companionship does non heighten coin to pay distributions. Linn borrows coin to purchase things including lay options too other derivatives. The coin paid for these derivatives turns to cash equally the companionship sells gas too fossil oil at inflated prices. It is too then distributed to unit of measurement holders.

Unit holders too debt holders would non countenance raising coin to pay distributions. That is the essence of Ponzi.

So a actually foreign too opaque derivative maneuver gets inserted inward the process. Then they sell equity too debt securities to purchase derivatives that plough to cash. Then they distribute that cash. Whether interposing the foreign derivative maneuver is sufficient to withdraw the whiff of Ponzi I cannot tell. I report: yous decide.

As for the disceptation the solely way that paying $2.4 billion inward distributions would live possible if they earned the coin - good I exactly acquaint the GAAP accounts. All they have got earned is losses. This companionship clearly has a dissimilar Definition of "earnings".

Other Information:

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In evaluating this issue, LINN has identified other publicly traded partnerships that purchase derivatives, too all of these companies job concern human relationship for derivatives the same way LINN does.

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In fact, LINN has yet to seat whatever publicly traded partnerships that job concern human relationship for it differently.

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LINN’s hedge policy strictly prohibits whatever speculative trading or manipulation inward the hedge book. The companionship adheres strictly to this hedge policy.

The GAAP accounting is correct. I have got said this above. What is odd is the Definition (non GAAP) of distributable amount. I have got yet to encounter whatever other partnership that estimates its distributable amount inward this way - but howdy - at that topographic point are ever other things to brusk equally well.

So there.

That Queen Gertrude does protestation also much. And she is so transparent.





John