Linn Energy Endures Short-Term Pain for Long-Term Gain

By Markets Fool.com

Linn Energy LLC is an oil and gas driller, which hasn't been such a wonderful business since oil prices started to plummet in the middle of 2014. Although a deep dividend cut is probably what most investors took note of as oil prices sank, the driller also inked a deal with a Blackstone Group LP subsidiary for financing. Blackstone is getting some pretty big benefits up front, but it's what happens further down the line that's so interesting.

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There's no way to sugarcoat it; oil prices have dropped fast and hard. In mid-2014, they were well over $100 a barrel. Within six months or so, they had fallen by roughly 50%. And they are still wallowing along at relatively low levels. Although Linn Energy uses hedges to protect itself from falling oil prices, it can only hedge into the future so far.

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With the writing on the wall, Linn Energy took decisive action and cut its dividend nearly 60%. Needless to say, investors weren't too pleased. However, the reasoning behind the cut was all about the long term. The money the company saved by not paying as large a dividend is being used to fund the company's continued growth. It's a trade-off, to be sure, but one that, long term, is in the best interest of the company and, thus, unitholders.

Blackstone steps in
Even with the dividend cut, Linn has been forced to pull back hard on capital spending, trimming that budget by around 50% this year. That's a big cut, and it's a risk to the company's future growth since less drilling means less oil comes out of the ground. In the same move, Linn inked an interesting deal with a subsidiary of Blackstone Group. At first glance, it might look like Linn had to give up the ship to get the money.

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Blackstone's GSO Capital Partners will provide Linn with up to $500 million over a five-year period for drilling. GSO is willing to foot 100% of the tab for Linn's drilling, but Blackstone is getting its pound of flesh -- it receives an 85% working interest in the wells drilled with its cash. So, Linn can continue to drill without increasing the capital budget, but in the end, it does all the work and gets just a 15% working interest.

This debt deal is a gusher in the making. Source: Chappell, Oil City, Pennsylvania, via Wikimedia Commons.

However, there's a light at the end of the tunnel that could mean a big boost to Linn's top line... down the road. Blackstone's take stays at 85% until it has earned a 15% internal rate of return, or IRR, on its investment. Not a bad return for a debt investment that requires Blackstone do nothing but open its wallet. Once that target is reached, though, Blackstone's working interest drops to just 5%, and Linn's jumps to 95%. So, at some point, Linn will see a big top-line boost from the wells it drills with Blackstone's money.

How long it takes Blackstone to get to a 15% IRR, however, will depend on a number factors, including the often-volatile price of oil and the success of each well. But the deal is pretty interesting since it will allow Linn to keep drilling with little to no up-front expense while oil prices are low and cash is tight. And while the near-term financial benefit to Linn is muted, it allows Linn to benefit in the future once Blackstone gets paid.

Waiting for an updraft
In the near term, the Blackstone-financed wells will allow just incremental increases on the top line. But at some point in the future, that drip will turn into a gusher. Keep an eye out for updates on this financing deal -- it could mean a sudden updraft for revenues and units once Blackstone hits its numbers.

The article Linn Energy Endures Short-Term Pain for Long-Term Gain originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.