Acquiring Growth In Oil And Gas

Thus far in 2012, Linn Energy has announced $2.8 billion in acquisitions and joint ventures–almost as much as it completed in 2010 and 2011, combined. Management also disclosed that, through the end of June, the firm had bid on 11 deals worth about $6 billion; in 2011 the LLC had submitted offers on 31 transactions worth $7.5 billion.

This year, the firm has announced two blockbuster deals with BP (LSE: BP, NYSE: BP) for natural gas-producing properties: the $1.2 billion acquisition of acreage in the Hugoton Basin and the $1.025 billion purchase of properties in Wyoming’s Jonah Field. Natural gas accounts for about 73 percent of production from the Jonah Field and 63 percent of output from Linn Energy’s new acreage in the Hugoton Basin.

Although the price of natural gas remains depressed in North America, Linn Energy acquired this acreage at bargain valuations that guarantee a solid return on investment, paying about $1.65 per thousand cubic feet of natural gas equivalent in the Hugoton Basin and $1.40 per thousand cubic feet of natural gas equivalent in the Jonah Field.

As usual, Linn Energy has hedged all expected natural-gas production from these properties through 2017, locking in solid profit margins on this future output.

Once these newly acquired assets contribute to Linn Energy’s results for a full quarter, the LLC’s production mix will shift toward gas and its DCF will receive a welcome boost.

I wouldn’t be surprised if Linn Energy were to ink other low-risk acquisitions in the back half of the year, especially as producers seek to monetize older natural gas-producing assets drilling activity in unconventional plays. During a July 26 conference call, management noted that the size and quality of acquisition opportunities had increased this year. I would expect any forthcoming deals to be immediately accretive to DCF.

Linn Energy’s operations in the Granite Wash, a liquids-rich play in Oklahoma and the Texas Panhandle, accounts for much of the firm’s exposure to NGL prices. Natural gas represents for about 35 percent of the field’s production, oil makes up 30 percent and NGLs account for 35 percent. To worsen matters, ethane accounts for 45 percent of the natural gas liquids that Linn Energy extracts from the field.

Although some producers elect to leave ethane in the natural-gas stream when processing costs exceed the value of the hydrocarbons, Linn Energy hasn’t pursued this practice because the value of the other NGLs in the gas stream offsets weak ethane prices.

Instead, Linn Energy has opted to focus on the Hogshooter, a shallower formation in the same region which yields a superior production mix that’s 72 percent crude oil, 14 percent natural gas and 14 percent NGLs. The firm has reassigned the eight rigs that had operated in the liquids-rich Granite Wash to target the Hogshooter, where it expects to sink another 20 wells in the back half of the year. To date, the LLC has drilled three Hogshooter wells in the Texas Panhandle that have yielded initial production rates of about 2,500 barrels of oil equivalent per day and yielded a total of 285,000 barrels of oil equivalent over the first 90 days.

Meanwhile, the company continues to evaluate the potential of the Hogshooter formation in its Oklahoma acreage, a process that could further expand its inventory of drilling locations.

Management’s expectations for the drilling program in the Hogshooter call for an initial production rate of 1,700 barrels of oil equivalent per day–about two-thirds the rate that the firm achieved on its first three wells.

Some of the shortfall in Linn Energy’s second-quarter DCF also reflects the destination of the NGLs produced from its wells in the Granite Wash. Robust drilling activity in the Mid-Continent region has led to an oversupply of NGLs at the hub in Conway, Kan., depressing prices relative to the delivery point in Mont Belvieu, Texas. Propane, for example, fetches about $25 per barrel at Conway, compared to $38 per barrel at Mont Belvieu.

Linn Energy’s existing processing contract expires at year-end, and the firm has invested considerable sums on infrastructure and pipeline interconnections to support drilling its operations in the Granite Wash. Without providing too much detail, management indicated that the firm should be able to redirect a significant portion of its NGL volumes to Mont Belvieu, a development that would boost price realizations.

The Verdict
Based on these factors, Linn Energy’s management team expects to generate enough DCF to cover its annual distribution by 110 percent in 2012 and 120 percent in 2013. This guidance, which excludes the benefits of a recovery in NGL prices or any additional acquisitions, will likely prove overly conservative.