Description

Long: LNGG common equity (OTC), +45%

Summary: LINN Energy (LNGG) is a post-reorganization special situation equity offering an attractive risk/reward profile. In a nutshell we think that the security’s current valuation is supported in a bear case by cash-flowing PDP & midstream assets with a debt-free balance sheet and offers 45% upside if the new management can execute their upstream business plan. Prior to bankruptcy LNGG was a highly leveraged MLP that expanded aggressively across the US purchasing mature oil and gas assets. The acquisition of Berry Petroleum at the height of the oil boom furthered an already unsustainable capital structure which ultimately led to a Chapter 11 reorganization in 2016. During bankruptcy LNGG right-sized its capital structure, reduced debt, and separated from Berry Petroleum. 2nd lien creditors Elliot Management, York Capital, and Fir Tree received the majority of the equity in reorganization and control the post-emergence entity with a view to maximizing shareholder value. Since emergence in February 2017 the company has sold legacy assets, paid down debt to a net cash position, reduced SG&A, and created a compelling upstream E&P investment opportunity in Roan Resources which controls 140,000 acres in the SCOOP/STACK/Merge.

Per the company’s announcement in December 2017, by mid-2018 LNGG is going to split up into three different companies: Roan Resources, Blue Mountain Midstream, and SpinCo which houses LNGG’s legacy proved developed producing (PDP) reserves. The current LNGG stock will eventually contain only the 50% ownership stake in Roan Resources and possibly the Northwest STACK acreage, while SpinCo will be distributed to shareholders and Blue Mountain will likely pursue an IPO process. We argue that Blue Mountain midstream and the PDP assets generate downside support versus the current equity valuation while upside comes from LNGG’s 50% ownership of Roan Resources and the northwest STACK acreage position. Regarding downside protection, the midstream and PDP assets have considerably less variability in asset valuation than a traditional upstream company given their current cash flow profile and reduced sensitivity to commodity prices. With a WTI $35/bbl breakeven profile, we believe the Merge acreage will be drilled and produce midstream EBITDA in the overwhelming majority of commodity price scenarios. In our estimation the valuation of current LNGG trading levels embeds a commodity price correction to $45/$2.00 in 2019-2020.  Furthermore, the company has no leverage and is actively repurchasing stock. On the upside, the stock is 26% cheap using strip commodity prices and 7x EBITDA on 2019 Roan upstream EBITDA. If the new management team from EOG is capable of delivering on Roan’s drilling locations to earn a market multiple of 8x 2019 EBITDA, the stock is 45%+ cheap. This is the same management team that assembled EOG’s latest premium inventory position in the nearby SCOOP/Woodford.  Over the next twelve months we expect the new management to raise market awareness of Roan’s current 40,000 BoE/d production and high cash margins, the IPO of Blue Mountain, the delineation of the Northwest STACK acreage, and further sales of PDP assets with proceeds returned to shareholders. Valuation and share price targets are based on a one year forward date (Dec 2018), which incorporates “current year” multiples on 2019 financials. In summary, the company’s troubled past, a relative lack of Street coverage (one analyst) and limited buyside following have yielded a rare situation offering attractive upstream upside with a downside valuation near current trading prices.

Business description:

• Roan Resources: Roan Resources is a 50/50 joint venture between LNGG and Citizen Energy / JVL Advisors with 140,000 net acres across the SCOOP/STACK/Merge, of which 103,000 net acres are located in the Merge. Well-level IRRs in the Mississippian and Woodford targets in the Merge are extremely attractive at ~80%. We commissioned consultants to analyze the geology in Roan’s acreage, which supports at least 8 wells per section (2 benches), and more likely 12-15 wells per section assuming between one and two benches in the Mississippian and eight wells per section in the Woodford. LNGG believes that upside beyond 15 wells per section is possible using 3 benches including the Hunton formation, which we exclude from this analysis. The new management team of Roan Resources is composed of well-regarded executives from EOG Resources, including Tony Maranto who previously ran EOG’s Oklahoma City division. As of December 2017, Roan is currently running 6 rigs with production of 40,000 BoE/d online by January 2018. Field level cash margins are very attractive at $22-$22.50/BoE assuming $55/$2.75 commodity pricing. Given the significant EBITDA generated from current production Roan will not require any funding from LNGG on a go-forward basis.

• Blue Mountain (Chisolm Trail) Midstream: Chisolm trail is a gathering & processing operation for the 70,000 acres of former LNGG acreage that were dedicated to Roan Resources. The other 70,000 acres from Citizen are already dedicated to EnLink. LNGG is currently expanding the capacity of Chisolm by 250mmcf/d with construction on track to be finished by mid-2018. At the new capacity Chisolm should generate between $100mm-$125mm EBITDA in 2019 on the current drilling schedule. Last week Chisolm announced a third-party dedication of 7200 acres to their system from Gaedeke Merge. Although the terms of the dedication were not provided, the announcement would lend credence to their ability to reach the higher end of guidance all things being equal (as guidance was provided before the 3rd party dedication).

• Northwest STACK acreage: LNGG controls net 105,000 acres held by production in the Northwest STACK counties of Major, Blaine and Dewey with significant potential in Meramac/Osage targets. While not all of the acreage would be considered “core” STACK, offset operators CHK, DVN, and CLR have produced attractive well results with 50-60% oil cuts. In our understanding no decision has been made on whether this acreage will go into Roan or SpinCo. We would argue these assets will be best monetized inside Roan.

• SpinCo legacy PDP assets: These are mature natural gas-oriented production assets with stable decline rates. Although some investors see the gas exposure as a negative in the current environment, the stable nature of the production makes these assets attractive to private investors who can avail of low cost financing to generate levered 10%+ IRRs. It is highly likely that the majority, if not entirety, of the fields will be sold with cash returned to shareholders.

From a security selection perspective, the primary attribute of LNGG that interests us is its risk-reward. We like the upside exposure from the E&P program but didn’t want to take on the volatility inherent in a pure drilling program. We’d characterize the investment upside as primarily stemming from operational execution on the Roan acreage rather than optionality on commodity price exposure although that’s obviously inherent as well. We believe that the cases we have constructed represent realistic economic outcomes, and have provided detail on our thinking in each of them. Clearly the main variables to debate are the longer-run (post 2019) assumptions of $55 WTI and $3.00/mcf. We would only note that the company has 45% upside to those prices, that the commodity risk is two-way, and that the risk can be hedged outright or with other E&P securities.  

From a pure tactical standpoint, two observations are worth noting. The company is tendering for 7.4mm (~9%) of its shares on Jan 19th at $44.00 per share. Clearly someone could buy the security today at 40.38 and expect to realize at least 9% of their position at $44.00 in a few weeks in the tender, although in our opinion the upside is in the bull case rather the tender. Secondly, the new team from EOG at Roan is going to be conducting its initial meetings with investors next week at the Goldman conference in Miami, evidencing their willingness to answer questions on their plans from interested parties directly for the first time.  

Description of cases:

Best: This case represents a best-case outcome for the company on drilling inventory and operational execution, resulting in an above-average market multiple. Commodity prices for 2018-2019 remain at 1/2/18 strip of $58/$56 WTI and ~2.85/mcf before reverting to $55 WTI and $3.00/mcf for the outyear forecasts in NAV. Roan Resources maintains their current 6 drilling rigs and we value LNGG’s 50% ownership in the company at 9.5x 2019 EBITDA, which assumes that the market gives full credit for the management case of 15 wells per section (~21 years of drilling inventory at 6 rigs drilling one well per month). The valuations implied by NAV & 2019 EV/EBITDA are the same, with the explanatory variable for choosing the given EBITDA multiple being the drilling inventory / wells per section. 9.5x is an above average E&P multiple, similar to high quality companies such as EOG, PXD, CXO. Chisolm trail produces EBITDA at the high end of guidance at 125mm and is valued at 11x EBITDA. Northwest STACK achieves 12 wells per section. SpinCo sells PDP assets at values implied by flowing mcfe multiples from precedent transactions (106% of PDP values on average) and incurs 6 years of G&A to do so.

Bull: This case approximates management’s operating plan as conveyed in investor presentations for NW STACK, Chisolm, SpinCo but with slightly lower wells per section for Roan. Commodity prices remain the same as the best case above. Roan Resources runs their current 6 drilling rigs and we value the 50% ownership in the company at 8x 2019 EBITDA, which assumes that the market gives credit for 12 wells per section (~15 years of drilling inventory) resulting in an average peer multiple. Chisolm trail produces EBITDA at the midpoint of guidance at 112.5mm and is valued at 11x EBITDA. Northwest STACK achieves 8 wells per section. SpinCo sells PDP assets at values implied by flowing mcfe multiples from precedent transactions (106% of PDP values on average) and incurs 6 years of G&A to do so.

Base: This case is designed to approximate a “nothing happens” scenario where management moves forward but struggles to achieve their production goals, resulting in mediocre results and lower multiples. Commodity prices remain at the same levels as above. Roan Resources runs their current 6 drilling rigs and we value the 50% ownership in the company at 7x 2019 EBITDA, which assumes that the market gives credit for 8 wells per section (~11 years of drilling inventory). Chisolm trail produces EBITDA at the midpoint of guidance at 112.5mm and is valued at 10x EBITDA. Northwest STACK achieves 4 wells per section. SpinCo PDP valuations are PV10-based using the base case price deck above with 6 years of SG&A cost incorporated, implicitly assuming that these assets are held for the medium term and not sold.

Bear case: This case represents a realistic downturn in commodity prices to the marginal cost of production of many north American shale plays. WTI realizes $45/bbl throughout 2019 and 2020 before reverting to a long run price of $50 as shale production would be significantly curtailed at that point. Natural gas falls to $2.00/mcf in 2019-2020 before reverting to $3.00 in 2021. Roan 2019 EBITDA based on lower commodity prices is valued at 7x EBITDA, implying 8 wells per section and ~11 years of inventory. Chisolm trail produces EBITDA at the midpoint of guidance at 112.5mm and is valued at 10x EBITDA. Given the $35/bbl breakeven nature of the Roan dedicated acreage, we assume that drilling continues at $45 WTI. Northwest STACK achieves 4 wells per section. SpinCo PDP valuations are PV10-based using the bear case price deck with 6 years of SG&A cost incorporated, implicitly assuming that these assets are held for the medium term and not sold. Many who are bearish on energy would say that this case is actually their base case, albeit the implied valuation for LNGG in such an outcome is quite close to its current trading price.

Tail risk case: This case represents an extended commodity price correction. WTI pricing falls to $35/bbl throughout 2019 & 2020, before reverting to a long run price of $45. Natural gas falls to $1.50/mcf for 2019 and 2020 before reverting to a long run price of $2.50. The equity value for Roan is significantly impaired (-65% versus base case) as the company moves to one drilling rig and the Northwest STACK acreage is deemed worthless. Chisolm Trail facility is completed in 2Q’18 and still generates 112.5mm of EBITDA given that the merge acreage drilled in 2018 will still be flowing, valued at an 8x EBITDA multiple similar to market midstream multiples in February 2016. SpinCo PDP valuations are PV10-based using the tail case price deck above with 6 years of SG&A cost incorporated, implicitly assuming that these assets are held for the medium term and not sold. Unlike the actual experience of early 2016, this case assumes two years of commodity prices realized at $35/$1.50 as opposed to a quick snap-back.

SpinCo PDP assets: All PV10 values below in the asset descriptions reference the values given in LNGG IR presentations with long run commodity assumptions of ~$55/$2.85. Valuations are presented below on a gross basis, as we do not explicitly allocate asset retirement obligations on a field-by-field basis (only netting them out of the aggregate). We value the total PDP portfolio at 106% of the IR figures for our best and bull cases (93% for Hugoton gas, above 100% for East TX and North LA fields with growth potential). Our base, bear, and tail cases are 100% of the PV10s we calculate using the commodity price decks in those scenarios.

Hugoton: $716mm PV10 - net production of ~144 mmcfe/d (68% Natural Gas, 32% NGL), 6% base decline. The Hugoton position is the largest single PDP asset in SpinCo by far. The position consists of 6500 producing wells and ownership of the Jayhawk processing plant with 450mmcf/d capacity and 60% current capacity utilization. During bankruptcy LNGG rejected an uneconomic processing contract with the Satanta plant which allowed processing volumes to be redirected to Jayhawk, improving that facility’s capacity utilization significantly. 25% of the PV10 comes from helium production. Support for the PV10 valuation is derived from using the precedent transaction valuation from Berry’s sale of its adjacent Hugoton asset in July 2017 to a financial buyer. Berry’s sale implied $4640 per flowing mcf/d, implying a $668mm valuation for LNGG’s asset, and Berry’s acreage did not include a captive processing facility like Jayhawk generating positive EBITDA. To note, the PV10 listed valuation of $716mm does not include the Jayhawk facility. We believe it likely that LNGG sells the Hugoton asset including the Jayhawk facility to a financial purchaser seeking a mid-teens levered IRR. Even in our best & bull case scenarios we assume that the Hugoton sells at $668mm per precedent transactions, or 93% of the above PV10.

East TX: $156mm PV10 - net production of ~52 mmcfe/d (94% NG, 4% NGL, 2% Oil), 11% base decline.

Michigan / Illinois: $122mm PV10 - net production of ~29 mmcfe/d (97% NG, 3% Oil), 4% base decline.

Arkoma: $75mm PV10 - net production of ~27 mmcfe/d (76% NG, 24% NGL), 9% base decline. Jones Energy sold Arkoma assets in June 2017 at a valuation of ~$3150 mcfe/d, implying an $85mm valuation for LNGG’s asset.

Drunkards Wash: $45mm PV10 - net production of ~19mmcfe/d (100% NG), 6% base decline

North Louisiana: $31mm PV10 - net production of ~24mmcfe/d (81% Natural Gas, 11% NGL, 8% Oil), 8000 net acres in Ruston and 19000 net acres in Calhoun county. LNGG completed two new wells in 3Q’17 with production of 19mmcfe/d in Ruston county, hence the lack of an updated decline rate for the field as a whole.

Assets currently being marketed for sale:

o   Altamont Bluebell: $89mm PV10, 45000 acres with 9mmcfe/d production primarily in oil.

o   Permian: stub acreage remaining after $31mm sale of Permian assets earlier this year, estimated $83mm PV10

As a reference, LNGG sold its TX Panhandle and OK waterflood assets in December for a net price of $122mm, including the buyer’s assumption of substantial asset retirement obligations. We estimated around $30,000 plug and abandonment cost per well and 2040 wells for a $61mm ARO, making the “enterprise value” of the sale $183mm including liabilities. $183mm was 112% of the PDP values from LNGG IR presentations that we use in the best and bull case, so in line with asset-sale assumptions. The properties had field-level cash flow of $21mm and SG&A of $5mm, so the EV/EBITDA of the asset sale was 11.4x.

Catalyst

Company continues to sell PDP assets and repurchases stock

LNGG security listed as ROAN and receives greater Street coverage / liquidity

IPO / Sale of Blue Mountain in mid-2018