Friday, February 22, 2013

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.

26 comments:

Anonymous said...

you get hit in the head with a boomerang

Anonymous said...

Dey is still mightee highs price ja? I sell dem on de numbers alone.

Revilo said...

More of a dent to the ego than anything. Hey ho, on to the next one!

Anonymous said...

I always assumed one of the main goals of creating clearly overvalued stock [via Ponzi, fraud, or other] was to acquire real assets before you got discovered.

Poor Jerry Levin.

Anonymous said...

If you live and work in MLP land, LINN looks a little more normal. E&P and pipeline MLPS are going to report basically no income for years to come, while piling up and depreciating more and more assets. The cash flow is real. The runway is pretty long. There are probably a trillion dollars worth of assets to buy out there and more to build. Who knows really. It's a big number.

At some point the gravy train has to end, but it's hard to know which shoe will drop. Credit markets? Disruption in energy markets? Regulatory change? And when will it happen?

Until things go south, the value proposition to the individual investor/yield zombie, is pretty huge, just because of tazes. You basically pay no taxes on that yield for 10 years. And if you roll some of your income over, you can avoid taxes almost indefinitely. If you are elderly you can bequeath them to a spouse, roll over the basis, and he/she pays no taxes for another ten years.

I totally agree that it's a bubble. But it's a bubble with stronger economic foundations that most. The fracking revolution is real. At some point the music will stop, but I suspect it won't be for a while. They are in a pretty big sweet spot....

Cobra_Investor said...

Thank you for your all the information you laid out. You may ultimately be correct in your analysis, but sometimes mgmts are clever.

Anonymous said...

Couldn't have happened to a nicer guy.

Don Petty said...

" This is a loss making enterprise."

I have to disagree with you here. LINE generates a profit in almost every year it has been a public company. It's not that much, nevertheless, it is not a loss for most years.

For 2012, there are 277 million in unrealized losses on derivatives used in hedging. That has to be added back to the reported GAAP Net Loss to get a more reliable number. The fair value of the hedges has lost value, but the other side of the hedging transaction is that the if the hedges lose value, the hedged item, which is the oil/gas reserves, increases in value. But GAAP keeps the reported value of the oil/gas reserves at historical cost, not the fair value.

So, only one side of the change in fair values is reported. That creates a material distortion in Net Income/Loss on a GAAP basis. The asset impairment is in addition to this. So, the GAAP Net Loss is wayyyyyy off the economic reality. Check this out with a CPA with experience with hedge accounting. You owe your audience that much. What you are saying about a loss making enterprise simply is not based on facts.

The asset impairment, as you say, is due to the decrease in NG prices. I view that as temporary, though GAAP will not allow a write-up if prices should recover back to previous levels.

GAAP has serious problems that need to be addressed, and hopefully they will be in the next few years. AT present, financials with serious distortions due to hedging transactions get approval by the auditing firm. Sad, very sad. Having been an accountant, the profession is destroying its own credibility with such nonsense. With a company like LINE, you cannot accept the GAAP audited financials as creditable. They aren't.

I don't see the MLP model, like LINE, as a good model. Too much debt, not that much profit. It could be a house of cards. But, as long as oil and gas prices generally increase over time, the reserves will be worth more and more. That adds value to the company which GAAP does not recognize.

Steven D Heller said...

John,
Thanks for posting you opinions regardless of whether they turn out right or wrong.

A quick question. Why do you feel individuals who buy MLPs are getting ripped off?
I haven't invested in one yet, but I think the tax advantages mediate much of the risk.
If you put in 100k and are in a thirty percent tax bracket that 100k only cost you 70k because of the 100% first year write off. If the MLP was only able to return your investment (the 100, no dividends etc, nothing else) you have almost a 43% return. If that takes five years it's 8.6% annualized and all the MLP has done is return the 100K.
Curious about what you and your readers think about this. Am I missing something?

Steven D Heller said...

John,
Why do you feel individual investors are getting ripped off by MLP's?

Supposedly there is 100% write off of your investment the first year.
If you are in a 30% tax bracket putting in 100k costs you only 70K
If the MLP only returns the investment and nothing else you have almost a 43% return? If it takes five years and is annualized that's still over 8.5%.
Am I getting this wrong? I have assumed it is these tax advantages that supports the industry.

Don Petty said...

The link below explains the different accounting under SFAS 133, depending on if a derivative is designated a hedge or not. LINE does not designate its hedging activities as hedges, so "Case 3: speculative or derivative not designated", in the link, is where LINE's hedging would fall.

Note in that example, that while an $800,000 loss in fair value of the NG futures contract was recognized in September, that the corresponding $1,000,000 increase in fair value of the inventory was not. Only one side of the economic reality was recognized.

That is what I am saying about the $277 million unrealized loss for LINE for 2012. The other side of the coin, the increase in fair value of the reserves is not reflected.

In the end, when the NG sale takes place and the derivative contract is settled, the interim period gains/losses is irrelevant.

http://www.pageout.net/user/www/a/h/ahwang/Research/JAE%20FAS%20133%20Comparative%20Analysis.pdf

Steven D Heller said...

Thanks Don.

John Hempton said...

The degree of bogus analysis posted here by supporters of the stock makes me convinced I want to go back to this short!

John

Ken said...

I wonder if there's a fundamental misunderstanding of the price Linn pays for their puts. One normally thinks of puts as American style options where you are paying for the right to put the asset AT ANY TIME prior to expiration. In this case the price of the put is equal to the exercise price minus current price plus time premium. Linn's puts AREN'T American style, they're European style. In the European case you can only put the asset AT EXPIRATION. Thus the purchase price of the put equals the exercise price minus THE MARKET'S EXPECTED PRICE OF THE ASSET ON THE EXPIRATION DATE plus some premium related to the probability that this future expected price is correct. So let's take a simple example. Linn wants to hedge nat gas 5 years out at $5/mcf. The current price is $2.50/mcf. If it were an American style put the cost would be $5 - 2.50 + time premium. However because Line puts are European style and, for example, the future expected price of nat gas in 5 years is $4.50/mcf the cost of the put is $5 - 4.50 + risk premium. This is why Linn can accurately say they aren't buying deep in the money puts. In the above example their puts are only $.50 in the money.

I think a lot of the confusion about Linn has been by people who are used to dealing with stock options. Stock options are almost always American style so this is what people are used to. But if you deal with options on the VIX, for instance, they are European style. I believe that if John had understood the difference he never would have shorted the stock.

Philip Trinder said...

John,

For full disclosure, everyone should feel free to view me as biased in favor of the MLP space. I have no desire to get into any adversarial low brow type of discussion (which sometimes happens from “Anonymous” commenters) but have no problem having an intelligent discussion with anyone who has a directly opposite view because I believe that avoiding confirmation bias helps make better investors.

In one of your earlier posts you had the following question:

“They also own gas swaps (i.e. forwards) which are a long way out of the money. Do they also budget cost for buying those? I would like to know.”

An oil and gas producer entering into a hypothetical 5 year oil or natural gas swap can enter into the trade with a counterparty and it will initially cost it zero dollars out the door. The swap is priced by the counterparty using the forward futures price curve at the time they make the trade (http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html). The spot price of natural gas is not the correct way to assess whether or not the 5 year swap is “a long way out of the money” because it is actually based on the remaining life of the swap position each month compared to the current forward curve (for example, the current spot price of Henry Hub natural gas is around $3.30 but in the link above the average monthly futures price for calendar year 2019 is around $5.06).

How does the counterparty make any money?

They offer the price to the producer after taking some profit for themselves, so if the forward curve shows a 5 year average price of $92 per barrel then they could offer the swap to LINE at say $91.50. The counterparty trading desk can then layoff that exposure to lock in the $0.50 profit per barrel (this is a high profit number by the way) times the total number of barrels hedged.

What about mark-to-market exposure to the counterparty, how do they get comfortable?

If the oil and gas producer has a Secured Revolving Credit Facility you will typically find all of the producer’s hedging counterparties to also have exposure to the company in the Revolver (i.e. they are also a secured lender to the company). This situation then means that when the forward curve shifts higher compared to the swap price (making the company have a non-cash mark-to-market loss) the producer will not have to post any collateral to the hedge provider (LINE explains this on page 53 of their 2011 10-K, Counterparty Credit Risk http://files.shareholder.com/downloads/LINE/2324302444x7165155xS1326428-13-7/1326428/filing.pdf). The hedge provider is comfortable because they have a secured claim against the oil and gas reserves (i.e. they already have a collateral position) that have now increased in market value based on the increased forward commodity price curve.

To Ponzi or Not to Ponzi

In a big picture sense do you view all 90+ U.S. Master Limited Partnerships as “Ponzi schemes” or is your thesis primarily for the upstream/oil and gas producing MLPs because they have producing assets with a decline curve? I’ve often kicked around the idea of shorting Royalty Trusts as a hedge for Upstream MLP exposure due to the finite lives of Royalty Trusts and their inability to directly add to their assets but just haven’t gotten around to the full analysis yet.

Also as a side note, if you look at all of the wells in the United States on average and compare that to all of the wells in say Saudi Arabia you might come to the conclusion that on average the entire United States has “really clapped out assets.”

Cheers,
Phil

Mark said...

With big interest I have been reading these analysis. Really wondering how it is going to turn out in the long run

Anonymous said...

'convinced I want to go back to this short!'

next time you do this figure out who they might buy to shore up their finances and run it as a pair trade

Don Petty said...

I'm not a supporter of the stock. If you are referring to my explanation of why GAAP is wrong as "bogus" then I would challenge you or any CPA to counter it.

KPMG says the same thing I have in their short explanation of derivatives and hedge accounting in link below. It seem obvious to me that GAAP is wrong in this instance.

"The accounting for derivative instruments at fair value creates a common issue for organizations that hedge risks using such instruments. Specifically, such organizations may face an accounting mismatch between the derivative instrument which is measured at fair value, and the underlying exposure being hedged, as typically underlying exposures are recognized assets or liabilities that are accounted for
on a cost or an amortized cost basis, or future transactions that have yet to be recognized. This
accounting mismatch results in volatility in the financial statements as there is no offset to the change in the fair value of the derivative instrument."

http://www.rfpconnect.com/Content/userfiles/hedge-accounting-kpmg-whitepaper1%281%29_612.pdf


The fact is that in most cases, when a company like LINE uses derivatives as cash flow hedges, but does not "designate" them as such, the reported unrealized gains/losses of these derivatives, which are included in Earnings, never materialize. They simply create volatility in a company's Earnings, creating irrelevant and unreliable information before the hedges are settled. The link explaining the hedge accounting is a good example of this.

Bottom line, the NG hedge allowed BestGas, Inc. to realize $1.8 million more in revenues than without the hedge, the difference between the futures price at the beginning, versus the end when the contract is settled. If the hedge is used as a cash flow hedge but is not "designated" as such, the reported changes in fair value of the contract before settlement simply create volatility in the earnings numbers. As can be seen from this example, these changes in fair value were materially different than what BestGas Inc. realized upon settlement of the contract. Therefore, as a cash flow hedge, to have such changes in fair value reported in Earnings materially distorts the Earnings prior to the settlement of the contract.

IMO, LINE's changes in fair value of the derivatives would be better reported in OCI than earnings because they are using the hedges for cash flow purposes, even though they are not "designating" them as such.

The GAAP numbers are not reliable, IMO.

Don Petty said...

As I see it, one very important aspect of LINE which keeps it a going concern is the underlying value of the assets it acquires. We're talking about oil/gas reserves. Over time, that value tends to increase, not decrease. GAAP fails to recognize this. However, the economic reality of this trend is that LINE's Net assets tend to increase in value over time not only from Earnings, but also from this general increase in value of the reserves. Failing to recognize that will result in miscalculating LINE's actual Net Worth and ability to continue its operations, IMO.

The increase in value of reserves adds to its Net Assets, just as Earnings does.

bjroberson said...

This is like deja vu. I had the exact same analysis and the exact same braindead arguments with the bulls on Kinder Morgan. Fraudulent accounting plus big divvy plus acquisitions with overpriced currency = short trap.

Welcome to the MLP Zone

bjroberson said...

http://www.mcdep.com/2kmp.htm

Don Petty said...

bjroberson's situation looks like a good example of getting it wrong as far as the accounting goes.

Let's look at BestGas, Inc., in the link I provided, again.

Let's say that instead of the futures contract price being $3.39 in December, that it remained at $3.52, the same as September. Also, that the Chicago spot price in December remained at September's price of $3.55.

So, in September the Futures contract purchased to guarantee a $3.48 delivery price, has dropped in value by 4 cents or by $800,000. So, you would write down your futures contract by $800,000. Since it had no value when you purchased it, it is now a liability on your books, something you will have to pay out if prices don't change by December. You would also charge Other Comprehensive Income (meaning reduce) with $800,000. So, your equity section of the Balance Sheet is showing $800,000 less in equity in September.

If these prices remain the same through December, then you can sell your NG for $3.55 per unit or for $71,000,000. But, then you have to settle the futures contract which requires you to pay $800,000. So, the net result is that your profit is $10,200,000. You are fine with that because the hedge is simply to protect your cash flows. The bottom line is, you wanted to sell your NG for at least $3.48 to yield $69,600,000 in revenues and a $9,600,000 profit. You did better than that by $600,000.

Even though the loss in value of the hedge caused a reduction in Equity prior to settlement. Once the transaction was consummated and you sold your NG, the hedge and the hedged item offset one another so that the cash flows and profit are close to what you desired at the start.

So, the $1.4 billion Other Comprehensive Loss for KMP in the 2nd qtr of 2008 was irrelevant, as was the $800,000 OCL in the above example. What is overlooked in both these examples is that the fair value of the hedged item, what is to be sold in the future, also increases in value and offsets the loss on the hedge.

In the end both Best Gas and KMP were able to sell their product and receive what they desired from the transactions. This is not fraudulent accounting, but a lack of understanding of how the accounting works, i.e not able to see the Big Picture and the end result.

bjroberson said...

Don, I agree with you about the KMP accounting. The OCL accounting is not what I was talking about, and is in fact irrelevant. I provided the McDep link just to show that the short case on MLPs has been around for a long time, and has burned many sophisticated investors. In fact, I would say that KM didn't have fraudulent accounting, it had misleading accounting. I don't want to get into the short case against KM, and this is not my blog, but you can read about it at the McDep links.

Don Petty said...

bjroberson,

I'm no expert on MLPs or their accounting. But, the accounting for the cash flow hedges I think I do understand.

YOu said or seemed to imply to me that KMP was selling their product at $50 per barrel when the market price was $98. What would keep them from settling the hedge for $50 per barrel, not selling the oil, taking that loss, then selling it on the market for $98? Something similar to what I just described takes place doesn't it? In the end they achieve what they wanted, a stable cash flow for their sales with no significant losses.

I'm simply asking a question, nothing more.

David said...

Should you revisit your assumptions and/or conclusions? I have not had time to look into this but when I saw this article, I recalled your original post.

http://www.denverpost.com/breakingnews/ci_23583447/linn-energy-falls-it-discloses-sec-probe-berry

David said...

Should you revisit assumptions conclusions on this one in light of recent investigation?

http://www.denverpost.com/breakingnews/ci_23583447/linn-energy-falls-it-discloses-sec-probe-berry

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