Weak Second Quarter For Linn Energy Not A Cause For Concern

(NSDQ:LINE) second-quarter results fell short of expectations, prompting management to reduce its full-year forecast for distributable cash flow (DCF). The limited liability company (LLC) generated $0.70 per unit in DCF, which fell slightly short of the declared quarterly payout of $0.725 per unit. In contrast, Linn Energy covered its payout by 114 percent in the first quarter.

Despite these disappointing results, the firm grew its hydrocarbon output by 76 percent from a year ago, to 630 million cubic feet equivalent per day. Much of this upside stemmed from the integration of new acquisitions, though Linn Energy also posted solid production increases in core operating regions such as the Permian Basin and the Granite Wash.

Linn Energy’s efforts to improve drilling efficiency and the implementation of an innovative system for handling the water used in hydraulic fracturing, a production technique that unlocks hydrocarbons from low-permeability reservoir rocks, also reduced expenses from year-ago levels.

What drove the LLC’s disappointing second quarter? The price of conference call to discuss the LLC’s second-quarter results:

[I]f you look back and say, okay, when we looked at hedging it [Linn Energy’s NGLs exposure] it’s backwardated by 30, 40 percent, how bearish do you want to be? But having said that, you would have endured that king of lowered pricing for six months and so you saw the lower pricing that we are seeing today. So, probably nets up to about the same. It just didn’t look that compelling honestly, and even looking back it’s still questionable as to whether it’s compelling.

So, until there is a longer-dated, less-backwardated NGL hedge market–and we look at it, trust me, we will look at it every day, because if we had the ability to hedge NGL for 100 percent and then they would be consistent with everything else we do at LINN–we would be all over that. But the economics has just never looked compelling at the times we’ve looked at it. So we’ll keep looking but I don’t regret it really at this point.

When a producer hedges its output, the firm sells that commodity forward. That is, if an upstream operator expects to flow 1,000 barrels of oil per day in May 2013, the firm’s traders would sell May 2013 futures contracts for 31,000 barrels of oil (31 days in May times 1,000 barrels of oil per day). At present, the contract for WTI crude oil to be delivered in May 2013 sells for about $90 per barrel, while the current quote in the spot market is about $88 per barrel. In this case, the hedge locks in a guaranteed price on this future production that exceeds prevailing prices.

The differentials between the current price of natural gas and futures contracts are even more favorable: Whereas the fuel fetches $3.25 per million British thermal units (mmBtu) in the spot market, natural gas to be delivered in July 2013 goes for $3.65 per mmBtu. Producers can lock in natural gas prices of more than $4 per mmBtu on futures contracts for December 2013. In this situation, the market is in a state of contango–that is, futures contracts trade at a premium to spot prices and near-term futures contracts.

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The NGL market, in contrast, finds itself in steep backwardation, where future prices are significantly lower than prevailing spot prices. In other words, a producer seeking to hedge its NGL prices would lock in a price on future production that’s 30 percent to 40 percent lower than the current quote.

The lack of an efficient means of hedging NGL output, coupled with a sharp drop in the prices of these commodities, explains why Linn Energy’s DCF failed to cover its quarterly distribution. Excluding the effect of weak NGL prices, the LLC would have generated enough cash flow to cover 115 percent of its quarterly payout.

Even if NGL prices remain at depressed levels, management expects the publicly traded partnership’s distribution coverage to improve to 120 percent in 2013. This forecast could ultimately prove conservative; butane prices have climbed about 18 percent since their June nadir, propane prices have recovered by more than 30 percent and ethane prices have rebounded by almost 40 percent.

Management’s bullish outlook reflects three upside drivers: the integration of new acquisitions, a focus on growing oil production organically and a shift in NGL volumes from Conway, Kan., to Mont Belvieu, Texas.