linn energy (line, lnco): where there’s smoke, there’s...

LINN ENERGY (LINE, LNCO, BRY): WHERE THERE’S SMOKE, THERE’S FIRE

HEDGEYE ENERGY MARCH 21, 2013

DISCLAIMER • Hedgeye Risk Management is a registered investment adviser, registered with the

State of Connecticut.

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3/21/2013 © HEDGEYE RISK MANAGEMENT 2

http://www.hedgeye.com/�

- KOLJA ROCKOV, CFO OF LINN ENERGY

“SINCE OUR INCEPTION, LINN HAS ALWAYS BEEN ON THE FOREFRONT OF CREATIVITY AND INNOVATION.”

“HISTORY HAS SHOWN THAT WHEN THERE IS A DISCONNECT BETWEEN ACCOUNTING AND TRUE ECONOMICS, THE RESULT WILL ALWAYS (EVENTUALLY) LAND IN FAVOR OF ECONOMICS. YET, THE DIFFERENCE IS OBSCURED UNTIL THE INVESTMENT TIDE GOES OUT, AT WHICH POINT IT IS TOO LATE.”

- CHUCK JOYCE & KIMBALL MAYER, GMO

ROADMAP

1. Introduction: Thesis and Background

2. LINN’s Financials: Fear Not?

3. Derivatives Accounting

4. Maintenance Capex

5. What’s LINN Worth? A New Valuation Approach

6. Catalysts, Risks, and Conclusion


1. INTRODUCTION

THESIS • We believe LINN’s business model is unsustainable. Our analysis indicates

future free cash flow may be significantly lower than amounts required to fund current distributions. Its ability to fund its distribution relies mostly on additional capital raises.

• We estimate that LINN’s actual Distributable Cash Flow (DCF) during 2006 - 2012 may have been as much as 70% lower than the amount LINN reported. We take issue with LINN’s accounting in such key areas as gains & losses on its derivatives book, the cost of maintaining production, and general costs of operating. We believe the accounting standards LINN applies may not accurately depict actual DCF, creating a significant mispricing.

• We believe a fair value for LINN is approximately $15 per share. We suggest that investors are mistaken in valuing LINN like a midstream MLP or REIT. We believe that LINN should be valued like an E&P company - based on the underlying assets - not on yield targets and an announced distribution which we believe may not be attainable.


UPSTREAM MLP PRIMER • E&P or “upstream” MLPs typically own, develop, and acquire legacy oil and

natural gas fields with low decline rates, and pay out excess cash flow to unitholders in the form of distributions.

• Growth is largely via acquisition, as upstream MLPs use their (perceived) competitive advantaged of not being subject to corporate income tax rates to realize more accretion from an E&P asset than a C-Corp.

• Today there are 11 publicly-traded upstream MLPs in the US; LINN’s $19B enterprise value is greater than the other 10 combined.

• LINN’s 2006 IPO marked the return of the E&P MLP structure after the sector failed in the late 1980s.


OUR UPSTREAM MLP BIASES • The upstream MLP sector is over-valued and riskier than most unitholders

(predominantly retail investors) realize.

• Emblematic of today’s “reach for yield” macro environment.

• Underlying cash flows are not stable.

• Assets that have perpetually-declining cash flows do not belong in MLPs (LINN’s base production decline is 20 - 25% per year according to management). Oil and gas wells are not like pipelines or apartment buildings.

• Hedging can offset some price volatility, but we don’t consider gains (losses) from hedging a recurring cash flow stream.

• Upstream MLPs can buy assets when capital markets are strong (and overpay) but struggle to grow when capital markets are weak and asset valuations are low. This makes the group super pro-cyclical (see ’07-’08 when the group fell 70-90%).

• E&Ps – both the MLPs and C-Corps – don’t generate much taxable income because of high DD&A expense, a reflection of how capital-intensive the industry is. What then explains the cost of capital advantage?


Pro Forma $4.3B acquisition of BRY:

Market Cap: $11.4B

Net Debt: $7.7B

EV: $19.1B

YE12 production: ~175k boe/d

YE12 1P reserves: ~1B boe

7th largest MLP/LLC and 11th largest domestic E&P in the US

LNCO is a C-Corp for tax purposes, holds only LINE units, gives LINN access to institutional investors, allows LINN to acquire C-Corps without tax consequences

The majority of LINE holders are retail investors; the majority of LNCO holders are institutions


LINN SNAPSHOT

Sources: Bloomberg data; LINN Presentation


LINN IN THE RECENT SPOTLIGHT TIMELINE OF RECENT KEY EVENTS…

• 2/15/13 – LINN publishes: “LINN’s Hedging Strategy and Response To Inaccurate Statements Made by an Anonymous Short Seller”

• 2/16/13 – Barron’s publishes critical LINN piece: "Drilling into the Numbers“

• 2/20/13 – Bronte Capital publishes a critical blog post of LINN

• 2/21/13 -- LINN acquires Berry Petroleum (BRY) for $4.3B in an all-stock transaction

“We've been kind of embroiled in a firestorm around puts and issues that we feel are meaningless. But, look, we stand behind everything we've done in the past.” - Kolja Rockov, CFO, 2/21/2013 conference call

Source: Bloomberg Transcripts

http://files.shareholder.com/downloads/LINE/2329075738x0x636135/22DDB43A-DBD2-49FF-AAF6-683B949CBDB2/LINN_Energy_-_Heading_Strategy_Explained.pdf�

http://files.shareholder.com/downloads/LINE/2329075738x0x636135/22DDB43A-DBD2-49FF-AAF6-683B949CBDB2/LINN_Energy_-_Heading_Strategy_Explained.pdf�

http://online.barrons.com/article/SB50001424052748704852604578298253512225108.html�

http://online.barrons.com/article/SB50001424052748704852604578298253512225108.html�

http://brontecapital.blogspot.com/2013/02/linn-energys-queen-gertrude-moment.html�


SHORTS ARE THERE… …BUT HAVE NOT BEEN RIGHT ON THE STOCK (YET)

Empirical data suggests a strong negative correlation between short interest and future returns, particularly in stocks with a high % of retail ownership: “Short interest predicts stock returns in the cross-section because short sellers are informed traders who generate value-relevant information. We show that short sellers correctly anticipate negative earnings surprises, bad public news, and downgrades in analyst earnings forecasts several months ahead. Their ability to predict future fundamental news events appears to be the dominant driver of their ability to predict future returns. Shorts seem to be particularly well informed about stocks with low levels of institutional ownership, which are presumably harder to short” (Akbas et al., 2013).

Source: Bloomberg Data; Akbas et al., 2013

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2216919�









2. LINN’S FINANCIALS

NET INCOME VS. DISTRIBUTIONS Cumulative 2006 – 2012 (7 years):

– LINN Energy’s net income: $190MM

– Distributions paid to LINE unitholders: $2,210MM

That typically ends poorly:


Source: LINN filings; GMO White Paper

LINN SAYS FEAR NOT… “LINN does not pay distributions with net income; the company pays them with cash flow and clearly has sufficient cash flow to do so.”

– LINN 2/15/13 8-K

How is LINN defining “cash flow”?

It’s not Free Cash Flow*…

Or Cash Flow from Operations…


2006 2007 2008 2009 2010 2011 2012 Cumulative

Cash Flow from Operations (6.8)$ (44.8)$ 179.5$ 426.8$ 270.9$ 518.7$ 350.9$ 1,695.2$ Distributions Paid 32.1$ 155.0$ 289.9$ 303.3$ 365.7$ 466.8$ 596.9$ 2,209.7$

delta (38.9)$ (199.8)$ (110.4)$ 123.5$ (94.8)$ 51.9$ (246.0)$ (514.5)$

2006 2007 2008 2009 2010 2011 2012 Cumulative

Free Cash Flow (69.2)$ (264.2)$ (160.2)$ 248.6$ 47.9$ (111.2)$ (694.2)$ (1,002.5)$ Distributions Paid 32.1$ 155.0$ 289.9$ 303.3$ 365.7$ 466.8$ 596.9$ 2,209.7$

delta (101.2)$ (419.2)$ (450.1)$ (54.8)$ (317.8)$ (577.9)$ (1,291.1)$ (3,212.1)$

*We define FCF as CFFO minus Capital Expenditures (excluding acquisition capex) Sources: Hedgeye estimates; LINN filings


LINN VS. GAAP • LINN encourages analysts and investors to focus on two non-GAAP measures when judging

its financial performance: “adjusted EBITDA” and “distributable cash flow (DCF)”

– DCF = Adjusted EBITDA - interest expense - maintenance capex

• LINN’s financial performance on these metrics looks great…

• But LINN’s GAAP financials imply something quite different…

2004 2005 2006 2007 2008 2009 2010 2011 2012 Cumulative

LINN Adjusted EBITDA 11.3$ 21.7$ 70.2$ 257.7$ 514.5$ 566.2$ 732.1$ 997.6$ 1,402.7$ 4,574.1$ YoY % Change 92% 224% 267% 100% 10% 29% 36% 41%

LINN Distributable Cash Flow 4.1$ 9.0$ 34.5$ 175.2$ 348.3$ 395.3$ 457.5$ 590.2$ 679.3$ 2,693.3$ YoY % Change 122% 281% 408% 99% 13% 16% 29% 15%

2004 2005 2006 2007 2008 2009 2010 2011 2012 Cumulative

Income before taxes (4.8)$ (56.3)$ 75.8$ (351.4)$ 828.4$ (300.1)$ (110.0)$ 443.9$ (383.8)$ 141.6$

Net Income (Loss) (4.8)$ (56.4)$ 79.2$ (356.2)$ 825.7$ (295.8)$ (114.3)$ 438.4$ (386.6)$ 129.2$

Net cash provided by operating activities 10.4$ (29.5)$ (6.8)$ (44.8)$ 179.5$ 426.8$ 270.9$ 518.7$ 350.9$ 1,676.1$ Net cash used in investing activities (61.4)$ (150.9)$ (551.6)$ (2,892.4)$ (35.6)$ (282.3)$ (1,581.4)$ (2,130.4)$ (3,684.8)$ (11,370.7)$ Net cash provided by financing activities 31.2$ 189.3$ 554.0$ 2,932.1$ (116.7)$ (151.0)$ 1,524.3$ 1,376.8$ 3,334.1$ 9,673.9$

CFFO minus CFFI (51.0)$ (180.4)$ (558.4)$ (2,937.2)$ 144.0$ 144.5$ (1,310.5)$ (1,611.6)$ (3,333.9)$ (9,694.7)$

Sources: Hedgeye estimates; LINN filings

WHY DOES LINN INSIST ITS NON-GAAP FINANCIAL

RESULTS ARE PREFERABLE TO GAAP ACCOUNTING?

1. IMPROPER DERIVATIVES ACCOUNTING

2. UNDERSTATED MAINTENANCE CAPEX

3. DERIVATIVES ACCOUNTING


LINN’S HEDGING STRATEGY • LINN hedges 100% of production ~5 years out, typically 60-70% with swaps

and 30-40% with put options. LINN paid $1.4B cash for put options from 2006 - 2012, and $838MM over the last 3 years.

• LINN says it uses put options because its debt covenants only allow LINN to hedge 70-80% of production with swaps or collars, and it wants to be 100% hedged.

• LINN pays cash for put options, capitalizes them as assets on the balance sheet, and amortizes the full amounts paid (SORT OF, more on this to come). From a GAAP standpoint, there’s nothing wrong with that, but it leads to a significant overstatement of DCF.

• LINN defends the strategy by saying that DCF/unit is fully burdened by the cash cost of the premiums in the form of higher interest expense or additional units.

Source: LINN filings and statements


NOT THE ONLY ONE • LINN’s upstream MLP peer, Vanguard Natural Resources (VNR), did this too (but has

since stopped); in 2012 amortization of put premiums increased adjusted EBITDA by ~20%.

Source: VNR 2012 10-K


LINN’S DEFENSE “Amortization of puts is a non-cash expense and should not be deducted from EBITDA (hence the definition of EBITDA; earnings before interest, taxes, depreciation and AMORTIZATION).”

“LINN considers the cost of puts as a “capital” investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that “depreciation” of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a “capital” expense, and the company views puts the same way.”

- LINN 2/15/13 8-K (EMPHASIS is LINN’s)

• A few points:

1. Just because LINN says it’s fine, doesn’t make it fine.

2. LINN pays cash for puts; we believe that amount should be deducted from DCF.

3. In a way, depreciation of oil and gas assets is excluded from DCF - it’s called maintenance capex.

4. We believe LINN’s reporting on this key issue is not transparent.

Source: LINN 2/15/13 8-K


SOMETHING’S MISSING… WHERE IS THE “AMORTIZATION OF PUT PREMIUMS” LINE?

Source: LINN 2012 10-K

IN HERE


LINN IS MORE CLEVER.. REDEFINING (UN)REALIZED GAINS (LOSSES)…

“Realized gains (losses), excluding canceled derivatives, represent amounts related to the settlement of derivative instruments, and for commodity derivatives, are aligned with the underlying production.” – LINE 2011 10-K

“Unrealized gains and losses from commodity derivatives represent adjustments in market valuations of derivatives from period to period and include the premiums associated with put option contracts over time.” – LINE 2012 10-K

• In conventional derivatives accounting, a “realized gain (loss)” on a put option equals the settlement price minus the cost of the put, or the premium paid. One buys a put for $50, sells it for $100, and realizes a gain of $50. An “unrealized gain (loss)” is the change in fair value of the derivative, and all derivatives must be marked-to-market each reporting period, and unrealized gains (losses) reversed when the put is sold.

• LINN does it differently. For LINN, a realized gain on a put equals the settlement price. If LINN buys a put for $50, sells it for $100, it books a realized gain of $100 (not $50). The premium paid for the put is included in unrealized gains (losses), so that “total gains (losses)” on derivatives – and net income – match up with the conventional accounting method.

• Thus, the line item “Amortization of put premiums” does not exist on LINN’s cash flow statement or in the reconciliation of adjusted EBITDA to net income.

Source: LINN filings


LINN’S SPECIAL DEFINITIONS • Typically:

– Realized Gain (Loss) = Cash Settlement - Cash Cost – Unrealized Gain (Loss) = Change in FV

• = ZERO upon settlement

• LINN: – Realized Gain (Loss) = Cash Settlement – Unrealized Gain (Loss) = Change in FV - Cash Cost

• = (Cash Cost) upon settlement

• WHY THE UNIQUE* METHOD? – As Unrealized Gains (Losses) are excluded from adjusted EBITDA and

DCF, so are the premiums paid for derivatives.

*We have found no other company that accounts for derivatives this way.


EXAMPLE WALKING THROUGH LINN’S DERIVATIVES ACCOUNTING…

Source: Hedgeye estimates


CONSEQUENCES The consequences of this accounting method are that:

1. Compared to conventional accounting methods, LINN’s realized gains, Adjusted EBITDA, and DCF appear overstated equal to the cost of the put premiums.

2. Compared to conventional accounting methods, LINN’s unrealized losses appear overstated equal to the cost of the put premiums.

3. LINN can “buy” future DCF equivalent to the cost of a put.

4. LINN cumulates unrealized losses on derivatives that have been sold.

5. The GAAP net income line, cash flow statement, and balance sheet look as they should.

6. This accounting approach should prevent LINN from ever booking a realized loss on a put option – which should give its derivatives book a very good track record.


LINN’S DERIVATIVES STATS The table below shows the key line items related to LINN’s hedge book. Note that:

1. LINN has reported cumulative $1.4B of realized gains on commodity derivatives since 2004, $1.3B since 2009,

and has not reported an annual realized loss since 2005.

2. Realized gains on commodity derivatives approximately equal cash settlements of commodity derivatives in aggregate and in timing.

3. LINN has a cumulative realized loss on canceled commodity derivatives of $168MM. Realized gains (losses) on canceled derivatives are excluded from adjusted EBITDA. We assume these are on swap contracts, as LINN cannot realize a loss on a put option as it defines it.

4. LINN has a cumulative unrealized loss on commodity derivatives of $507MM since 2004, and $909MM since 2009, despite natural gas prices largely moving in the favor of the hedge book (lower) over this time.

5. LINN has paid $1.4B for put premiums since 2006.

2004 2005 2006 2007 2008 2009 2010 2011 2012 CumulativeRealized Gains (Losses) on Commodity Derivatives (2.2)$ (13.1)$ 20.2$ 37.3$ 9.4$ 401.0$ 307.6$ 230.2$ 381.1$ 1,371.6$ Cash Settlements of Commodity Derivatives (2.2)$ (13.1)$ 20.4$ 40.8$ (7.0)$ 404.6$ 314.0$ 237.1$ 390.8$ 1,385.4$

Delta -$ -$ (0.2)$ (3.5)$ 16.4$ (3.6)$ (6.4)$ (6.9)$ (9.6)$ (13.8)$

Realized Gains (Losses) on Canceled Derivatives -$ (38.3)$ -$ -$ (81.4)$ 49.0$ (123.9)$ 26.8$ -$ (167.8)$ Cash Settlements of Canceled Derivatives -$ (38.3)$ -$ -$ (81.4)$ 49.0$ (123.9)$ 26.8$ -$ (167.8)$

Delta -$ -$ -$ -$ -$ -$ -$ -$ -$ -$

Unrealized Gains (Losses) on Commodity Derivatives (8.8)$ (24.8)$ 83.1$ (382.8)$ 734.7$ (591.4)$ (232.4)$ 193.0$ (277.9)$ (507.3)$

Premiums Paid for Derivatives -$ (1.6)$ (49.8)$ (279.3)$ (129.5)$ (93.6)$ (120.4)$ (134.4)$ (583.4)$ (1,392.0)$



MAGNITUDE OF THE ISSUE (1) • To quantify the magnitude of the DCF overstatement due to LINN’s classification

of put premiums, we need to differentiate between the cost of puts that have already been excluded from DCF and the cost of puts that will be excluded from DCF in the future.

• This can be done a few ways, none of which is easy or straightforward.

• We attempted it by estimating the cost basis of LINN’s put options for 2013 and beyond as of December 31, 2012. We know when LINN bought the options (by quarter), the expiry dates (by year), and the strike prices, so we can use historical price data to estimate the premiums paid.

• The first time that LINN purchased a put with an expiration date in 2013 or beyond was in 1Q10, so we know for sure that the cumulative overstatement is at least the sum of the premiums paid prior to 2010, or $554MM. But we think that it’s higher than that…



MAGNITUDE OF THE ISSUE (2) • LINN has paid $1.4B for put premiums since 2006. We estimate that

LINN’s cost basis on its put options that expire after 1/1/13 as of 12/31/12 was ~$600MM.

• With $600MM of cash paid for put options yet to be accounted for, we estimate that LINN overstated realized gains, unrealized losses, adjusted EBITDA, and DCF by ~$790MM between 2006 and 2012. That’s ~29% of reported DCF ($2.7B) over that time.

$1,390 $600 $790

2006 - 2012

Total Premiums Paid Estimated Cash Cost of Current Hedge Book

- = Estimated Cumulative DCF Overstatement



MAGNITUDE OF THE ISSUE (3) LINN’S 2012 UNREALIZED LOSS IS CURIOUS…

• LINN took a $278MM unrealized loss on commodity derivatives in 2012, despite future commodity prices moving in the hedge book’s favor from the start of year to the end (see charts below).

• Remember that for LINN, unrealized losses = “actual” unrealized losses + put premiums paid on settled derivatives

• If one assumes that the fair value of LINN’s hedge book increased in 2012, then it appears LINN overstated realized gains, adjusted EBITDA, and DCF by at least $278MM (41% of reported DCF).

Sources: Hedgeye estimates; Bloomberg data

4. MAINTENANCE CAPEX


WHAT’S MAINTENANCE CAPEX?

DCF = Adjusted EBITDA - interest expense - MAINTENANCE CAPEX

• Maintenance capex is a non-GAAP metric, and is not explicitly defined in LINN filings

• LINN defines it as “the cost of keeping production flat”

• A common MLP term. Williams Partners LP (WPZ) defines it as:

“Maintenance capital expenditures, which are generally not discretionary, including (1) capital expenditures made to replace partially or fully depreciated assets in order to maintain the existing operating capacity of our assets and to extend their useful lives, (2) expenditures which are mandatory and/or essential to comply with laws and regulations and maintain the reliability of our operations, and (3) certain well connection expenditures.” – WPZ 2012 10-K

Sources: LINN statements; WPZ 2012 10-K


THE PROBLEM…AND OPPORTUNITY • For a pipeline company, if an existing line needs to be replaced, it’s maintenance

capex; if a new line is built, it’s growth capex - rather straightforward.

• In our view, the term “maintenance capex” has no place in the E&P industry. The only way to “keep production flat” is to drill new wells to replace natural production declines. Only recompletions and workovers can legitimately be considered maintenance spending, in our view.

• Maintenance capex for upstream MLPs is highly discretionary, and most upstream MLPs use that to their advantage, often in ways that may overstate their abilities to generate free cash flow.

“The amount of estimated maintenance capital expenditures deducted from operating surplus will be subject to review and change by our conflicts committee at least once a year.” – MCEP S-1

Source: MCEP S-1


A SECTOR ISSUE LINN’S NOT THE ONLY ONE… BUT BY FAR THE BIGGEST

Sources: Company filings; Hedgeye estimates

Maintenance Capex as a % of Total Capex "Maintenance Capex" Total Organic Capex

ARP 8% 10.2$ 127.2$ MCEP 13% 4.2$ 32.7$ PSE 20% 24.8$ 126.0$ LINE 37% 362.4$ 984.5$ MEMP 43% 14.7$ 33.9$ QRE 49% 62.8$ 127.4$ BBEP 49% 67.0$ 135.9$ EVEP 57% 74.6$ 129.8$ LRE 69% 21.0$ 30.4$ VNR 100% 50.4$ 50.4$ LGCY 100% 68.2$ 68.2$

2012


DEPLETION METRICS • LINN’s maintenance capex per unit of production is not close to either its

DD&A rate or Drill Bit F&D Cost:

• All-in RRC should approximately equal (or at least lead) the DD&A rate.

• Depletion is calculated on a per unit of production basis: “The Company accounts for oil and natural gas properties in accordance with the successful efforts method. In accordance with this method, all leasehold and development costs of proved properties are capitalized and amortized on a unit-of-production basis over the remaining life of the proved reserves and proved developed reserves, respectively.” - LINN 2012 10-K (our emphasis)

• How can these numbers be so different?

2010 2011 2012 3Y Avg 2013G

DD&A per Mcfe produced ($/Mcfe) 2.47$ 2.48$ 2.47$ 2.47$ 3.00$ RRC All Sources + FDC - Price Revisions ($/Mcfe) 1.87$ 2.50$ 2.12$ 2.15$

Dril l Bit F&D Cost + FDC - Price Revisions ($/Mcfe) 1.62$ 2.89$ 9.92$ 4.36$

Maintenance Capex ($/Mcfe) 0.91$ 1.24$ 1.48$ 1.27$ 1.64$

Sources: LINN Filings; Hedgeye estimates


LINN’S METHOD HOW LINN COMPUTES “MAINTENANCE CAPEX” AND THE IMPLICATIONS

• LINN walked us through how it calculates maintenance capex. We summarize it as follows: LINN ranks all wells to be drilled in a given year in order of rate of return. It then select all of the highest RoR wells needed to replace production in that year as the maintenance wells. All capital employed on other wells, facilities, land, etc. is considered growth capex.

• Implications

– Maintenance capex is indicative of the capital employed per year 1 production on LINN’s highest rate wells. We believe it does not at all represent the true cost of keeping production flat across the entire asset base.

– LINN’s portfolio is very diverse, with a small number of high RoR horizontal shale locations (like Hogshooter wells with +100% RoR) and a large number of legacy, conventional locations with relatively poor economics.

– LINN is incentivized to drill high IP, hyperbolic decline rate shale wells to keep maintenance capex low, but that increases the base decline and makes the asset base more capital intensive. It’s a bit of a Catch-22…

Source: Hedgeye estimates; LINN statements


CASE STUDY THE REAL COST OF “KEEPING PRODUCTION FLAT”

• LINN’s maintenance capital spending is more than 4x efficient as its growth capital spending.

• We estimate that LINN can build production for ~$25,000/boe/d.

• We estimate LINN understated maintenance capex by $95MM in 4Q12, or 47%. DCF appears overstated by the same amount, or 115%.

• DD&A in the quarter? $178MM



2013 GUIDANCE LOOKS SIMILAR • LINN’s 2013 guidance implies

maintenance capital efficiency of $15,000/boe/d and growth capital efficiency of $47,000/boe/d.

• Excluding the BRY assets, LINN has guided 2013 maintenance capex to $468MM and DCF to $756MM.

• We calculate true maintenance capex to be $767MM, dropping DCF to $457MM (down 40%).

• Guided DD&A? $947MM ($3.00/Mcfe)

– $789MM at $2.50/Mcfe



DOES BRY HELP OR HURT? • Positive near-term, accretive deal.

• LINN may have acquired one of the most capital intensive E&P companies in North America in Berry Petroleum (BRY).

• LINN’s production mix gets oilier, but the asset base is significantly more capital intensive.

• No synergies expected.

• BRY’s 2013 guidance implies no production growth from the beginning of 2013 to the end of 2013.

• BRY’s 2013 capex budget is $500 - 600MM. The consensus CFFO estimate is ~$520M.

Sources: BRY Filings; Hedgeye estimates


HOW OBVIOUS IS THIS ISSUE? HOW CAN ANALYSTS AND INVESTORS IGNORE THIS…

• BRY’s 2013 guidance implies that it will keep production flat from YE12 to YE13 while spending $500 - $600MM in D&C capex. By LINN’s definition, that entire budget should be considered maintenance capex, right?

• A consequence of getting really big, is that it gets harder to grow organically. What will the consequences be for LINN’s capex accounting when LINN can only grow production 0% - 5% per year (likely by 2014)? Will LINN be forced to change its definition of maintenance capex?

2011 2012 2013G* 2014E

Total Development Capex 574.6$ 984.5$ 1,100.0$ 1,500.0$ Maintenance Capex 167.3$ 362.4$ 468.0$ 1,500.0$ Implied Growth Capex 407.3$ 622.1$ 632.0$ -$

Average Annual Production (boe/d) 61,500 111,833 144,167 191,375

"Growth Capex" as a % of Total Capex 71% 63% 57% 0%Organic Production Growth (YoY) 30% 15% 10% 0%

*2013 LINN guidance excluding BRY

We estimate that in 2014 LINN will have to spend

$1.5B to keep production flat and $1.9B to grow it

5%

Sources: BRY Filings; LINN filings; Hedgeye estimates


BOTTOM LINE • Reported maintenance capex appears to be purely at the discretion of LINN. We

believe this makes LINN’s representation of its ability to generate DCF unreliable.

• LINN’s maintenance capex is ~4x as efficient as its growth capex, and ~2x as efficient as the true cost to keep total production flat.

• To keep maintenance capex low, LINN is incentivized to drill high IP rate, high decline shale wells. There is an inverse relationship between the maintenance capex rate and the base production decline.

• DD&A/Mcfe produced is a more appropriate measure of the cost of keeping production flat, in our view.

• The cumulative difference between LINN’s reported maintenance capex and DD&A from 2006 - 2012 is $798MM, or 30% of reported DCF.

• It may be difficult for LINN to continue to report maintenance capex according to the same standards:

– BRY’s assets are very capital intensive

– The bigger LINN gets, the harder it is to organically grow production. How will the maintenance capex budget compare to the total capex budget if LINN does not grow production organically?

Sources: BRY Filings; LINN filings; Hedgeye estimates

5. REALITY & VALUATION


CUMULATIVE DCF OVERSTATEMENT

• We find LINN very aggressive in what it excludes from adjusted EBITDA and DCF, like unit-based compensation, cash income taxes, and other capitalized expenses… We deduct recurring, economic expenses from adjusted EBITDA. EBITDA does not = “non-cash.”

• Here we assume “maintenance capex” = DD&A

• This method is really only useful in determining the extent of the overstatement and security mispricing.

2010 2011 20122010 - 2012 Cumulative

2006 - 2012 Cumulative

LINN Adjusted EBITDA 732.1$ 997.6$ 1,402.7$ 3,132.4$ 4,541.1$ Minus:

Write-off of deferred financing fees (2.1)$ (1.2)$ (7.9)$ (11.2)$ (24.9)$ Unit-based compensation expenses (13.8)$ (22.2)$ (29.5)$ (65.6)$ (130.5)$ Exploration costs (5.2)$ (2.4)$ (1.9)$ (9.5)$ (28.3)$ Cumulative Overstatement due to Improper Derivatives Accounting (790.0)$

Hedgeye Adjusted EBITDA 711.1$ 971.8$ 1,363.4$ 3,046.3$ 3,567.4$ Minus:

Cash interest expense (186.4)$ (240.1)$ (361.0)$ (787.5)$ (991.1)$ Capitalized interest expense (7.1)$ (19.6)$ (18.9)$ (45.7)$ (93.7)$ Cash income taxes (1.2)$ (5.2)$ (3.2)$ (9.5)$ (15.6)$ Hedgeye maintenance capex (DD&A) (238.5)$ (334.1)$ (606.2)$ (1,178.8)$ (1,667.9)$

Hedgeye Distributable Cash Flow 277.9$ 372.8$ 374.1$ 1,024.9$ 799.1$

LINN Distributable Cash Flow 2,680.2$ % Difference vs. LINN DCF -70%



CFFF FUNDS THE DISTRIBUTION • Where’s the cash come from? Distributions are paid out of CFFF, not FCF:

• It appears that LINN may not have the cash required to pay its guided distributions of $2.99/unit in 2013 and $3.08/unit in 2014…

2012A 2013E 2014E 2015E 2016E 2017E

Cash at Start of Year 1.1$ 1.3$ (0.0)$ (0.0)$ (0.0)$ (0.0)$ CFFO 350.9$ 1,592.7$ 1,958.4$ 2,045.7$ 1,919.1$ 2,010.3$ Capex, ex. Acquisitions (1,045.1)$ (1,450.0)$ (1,946.9)$ (2,039.8)$ (2,137.3)$ (2,239.6)$ Acquisitions, net (2,639.8)$ (4,300.0)$ -$ -$ -$ -$ Net cash provided by financing (BEFORE distributions) 3,931.0$ 4,300.0$ -$ -$ -$ -$ Cash Available for Distribution (Increase in Debt) 596.9$ 144.0$ 11.4$ 5.9$ (218.2)$ (229.3)$ Change in cash 0.2$ (1.3)$ -$ -$ -$ -$

Cash at the End of Year 1.3$ (0.0)$ (0.0)$ (0.0)$ (0.0)$ (0.0)$

Units Outstanding (MM) 204 271 305 307 309 311 Distribution per Unit 2.93$ 2.99$ 3.08$ 3.08$ 3.08$ 3.08$ Total Distributions ($MM) 596.9$ 810.9$ 939.4$ 945.6$ 951.7$ 957.9$ Cash Shortfall ($MM) -$ (666.9)$ (928.0)$ (939.6)$ (1,169.9)$ (1,187.2)$



QUESTION ARE YOU BLINDED BY THE…YIELD?

• What is LINN Energy? – An E&P with a diversified portfolio of onshore oil and gas assets,

mostly legacy conventional fields

– Base production decline is 20-25% per year

– No “shale scale”

– High cost producer: half-cycle cost = ~$27/boe or ~$4.50/Mcfe

– Production = 48% gas, 34% oil, 18% NGLs (2014, pro forma)

– Over-levered: 4X debt/EBITDA pro forma BRY

– Single-digit organic growth going forward

– Does not generate any taxable income

– Does not generate any free cash flow

Sources: Hedgeye estimates


WHAT WOULD YOU PAY FOR THAT?

• We know a lot of E&Ps like LINN - and most of them have better assets.

• Investors will typically pay 4 - 6X EBITDA for a low growth, diversified E&P.

APA 3.4 COP 4.1 NFX 4.1 SFY 4.2 WLL 4.4 OXY 4.5 DVN 4.9 WPX 5.1 BBG 5.3 CWEI 5.4 QEP 5.6 BRY (before takeout) 5.8 FST 6.3 DNR 7.0 Average 5.0

EV/2013 Consensus EBITDA

Sources: Hedgeye estimates; Bloomberg data


HEDGEYE VALUATION METHOD 1 LINN IS WORTH ~$2 - $15/SHARE ON A MULTIPLE OF EBITDA

LINN Valuation (pro forma a FY of BRY) 2013E

Production 3.0 (4.00)$ Natural Gas (Bcf) 184 4.0 2.00$ Oil (Mbbls) 23,739 5.0 8.00$ NGLs (Mbbls) 12,471 6.0 14.80$

% natural gas 46% 7.0 21.00$ 8.0 27.00$

Realized Prices Before Hedging 9.0 33.00$ Natural Gas ($/Mcf) 3.75$ 10.0 39.00$ Oil ($/bbl) 88.00$ 11.0 45.00$ NGLs ($/bbl) 33.00$ 12.0 52.00$

Revenues ($MM)Natural Gas 691.2$ Oil 2,089.0$ NGLs 411.5$ Other 16.0$ Total Revenues 3,207.8$

ExpensesLOE and Other 678.5$ Transportation 133.0$ Production Taxes 253.5$ Cash G&A 215.0$ Unit-Based Compensation 55.0$ Total Expenses 1,335.0$

EBITDA 1,872.8$

Target Multiple on E&P Business 6.0 Value of E&P Business 11,236.6$ Plus: Fair Value of Derivatives 900.0$ Minus: Net Debt (7,700.0)$ Equity Value 4,436.6$ per unit 14.73$

Target Multiple on E&P Business

LINE Value Per Unit

typical range

now

Source: Hedgeye estimates; LINN filings


HEDGEYE VALUATION METHOD 2 LINN IS WORTH ~$16/SHARE USING A SIMPLE NAV APPROACH

• LINN’s After-Tax PV-10 value is $6B.

• LINN holds only 51,000 net undeveloped acres (Granite Wash, Permian, other); we give it a (generous) $5,000/acre value based on recent transaction metrics.

• BRY was trading ~1.0X its YE12 After-Tax PV-10 value before LINN acquired it. We adjusted the PV-10 to reflect the new tax structure, and we don’t that there is any undeveloped acreage upside.

Net Asset ValueLINN After-Tax PV-10 6,073$ LINN's Undeveloped Acreage (51k net) 255$ BRY Tax Adjusted PV-10 5,300$ Value of E&P Business 11,628$ Plus: Fair Value of Derivatives 900$ Minus: Net Debt (7,700)$ Equity Value 4,828$ per unit 16.03$


6. RISKS, CATALYSTS, AND CONCLUSION


RISKS… ARE WE TOO SOON? • We think that being early is the greatest risk to a short position, as

LINN represents a simple positive feedback loop:

• “One of the main causes of instability in dynamics is positive feedback. In contrast to stabilizing negative feedback, positive feedback accentuates or amplifies changes in state and is the force behind population explosions, inflation spirals, arms races, and organic evolution. Positive feedback can also create unstable breakpoints or thresholds in dynamic systems” (Berryman, A., 1997).

Source: Berryman, A., 1997

http://classes.entom.wsu.edu/529/Stability.htm�


THE ACQUISITION MACHINE HOW BIG CAN IT GET?

Sources: LINN filings; Hedgeye estimates

$47 $122

$469

$2,678

$593

$131

$1,351 $1,500

$2,640

$4,300

$898

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD

Acquisitions ($MM) Divestitures ($MM)


WHY WE WON’T BE THAT EARLY • Positive sentiment is crucial, and it’s starting to turn.

– Short interest now at an all-time high.

– Sell-side analysts beginning to waver.

– LINN’s derivatives accounting is generating controversy.

• How big can LINN get? – Already over-levered, can’t take on much more debt… Pro forma BRY net debt is $7.7B,

or 4X CFFO. Annual interest expense ~$500MM.

– Asset acquisitions often are now not big enough - LINN needs to acquire entire C-Corps like it did with BRY.

– Are there a lot of BRY’s out there? Will they take an all-stock deal?

– Difficult to grow organically, which is an issue for maintenance capex.

PERCEPTION VS. REALITY PERCEPTION • LINN’s assets are mature oil and gas

fields with low decline rates

• LINN’s cash flows are stable because of its hedging strategy

• LINN generates sufficient cash flow to pay and grow its distribution

• With an 8% yield, LINN is an attractive fixed-income alternative

• LINN is creative and innovative

REALITY • LINN’s base decline is 20 - 25% per

year

• LINN’s cash flows are overstated because of its hedging strategy

• LINN does not generate any FCF, and must raise additional capital to pay its distribution

• LINN equity is more than 50% overvalued today

• LINN is financially creative and innovative



HOW TO PLAY IT • Preferred Play: Short LNCO

– LNCO currently trades at a 5% premium to LINE, which is justified only by scarcity value. Should trade at a discount when additional liquidity hits from the BRY deal.

– Drawback - borrowing LINE/LNCO shares is difficult/expensive

• 2nd Best Play: Short BRY – BRY trades at a 5% discount to implied LNCO/BRY deal price

– Easy/inexpensive borrow

– Competing bid highly unlikely

– Deal expected to close by June 30, 2013

– When deal closes, BRY short turns into LNCO short

– If deal doesn’t close? BRY down ~20%?

THANK YOU.

QUESTIONS? SEND TO [email protected]


This presentation was prepared by Kevin Kaiser. For more information contact

[email protected] or [email protected].

mailto:[email protected]�

mailto:[email protected]�

linn energy (line, lnco): where there’s smoke, there’s...

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