SEC probe targets cash flows in Linn Energy deal

The West Texas sky silhouettes a Linn Energy pumpjack in the Permian basin. (Linn Energy)
The West Texas sky silhouettes a Linn Energy pumpjack in the Permian basin. (Linn Energy)

Linn Energy disclosed Tuesday morning that it is the subject of an informal U.S. Securities and Exchange Commission inquiry related to the proposed merger of its former unit LinnCo LLC with Berry Petroleum Co.

The Securities and Exchange Commission has asked for more information on the merger with Berry Petroleum Company on the hedging strategies used for the cash flows. Because these cash flows are outside of generally accepted accounting principles, or GAAP, the companies were not required to disclose the inquiry, but did so voluntarily.

“The SEC has stated that the fact of the inquiry should not be construed as an indication that the SEC or its staff has a negative view of any entity, individual or security,” Linn Energy said in a written statement on Tuesday. “LINN and LinnCo are cooperating fully with the SEC in this matter.”

Houston-based Linn Energy made a deal valued by the company at $4.3 billion to buy Denver’s Berry Petroleum in February, the first such purchase of an entire corporation by a master limited partnership. The deal was intended to extend its production assets and boost its future cash flow.

Upstream MLPs: New roles emerge for partnership structure

Ensuring stable cash flows are at the heart of master limited partnerships, a corporate structure which allows it to pass on tax liabilities to its distribution unit holders. LINN Energy is the oldest and by far the largest upstream master limited partnership, making the success or failure of of the structure a model for the other partnerships.

“How this plays out is a big deal for LINN and for the 14 other upstream MLPs that are much smaller for LINN,” said Hinds Howard, chief investment advisor with Guzman Investment Strategies. “LINN is the flag bearer as the first upstream MLP and the MLP that proved the upstream business model.”

Master limited partnerships have become increasingly popular because they pay out a regular distribution with yields than can range as high as 6 to 8 percent, typically quarterly. However, regulations limit the company’s ability to hold cash for large investments in new oil and gas exploration, making the purchase of assets key to growing the distribution.

In the time since the deal was announced, the cash flow required to fund these distributions has been under scrutiny by LINN Energy investors, and some analysts say that short sellers have been aggressively undermining the stock, questioning LINN’s ability to fund these distributions and possibly triggering the SEC inquiry.

“The thing about shorting a stock, whether or not the issues are real are immaterial,” said Ethan Bellamy, a senior analyst with Robert W. Baird & Co. “Based on what we know and what we have seen in the financials, we don’t see any problem with LINN being able to pay their distributions.”

A prominent sell-side research firm tailored to hedge firm, HedgeEye, has focused its scrutiny on LINN, saying that the inquiry could undermine the merger with Berry – which, in turn, could make it more difficult for LINN Energy to increase future distributions, as it had said it would do upon approval of the merger.

Pipelines: Devon plans to form master-limited partnership for midstream

HedgeEye also questioned the underlying fundamentals, including the proposed purchase of a corporation, that have enabled LINN Energy to consistently grow its distributions for several years.

“The SEC shining a light on LINN’s non-GAAP measures will likely show investors how far they are from economic reality (net income per unit, for instance),” wrote HedgeEye in a blog. “And with the Berry Petroleum merger now in serious doubt, the ‘LINN will buy every C-Corp E&P out there’ bull case doesn’t seem like such a great idea.”

But Bellamy and other analysts focused on the master limited partnership market said that HedgeEye’s criticism is self-interested.

“The only thing that matters to a short is if the stock goes down,” Bellamy said. “The validity of the criticisms is less important than the end result, which is that they have been successful in scaring investors out of the stocks. It is reasonable that the rest of the group is going to be assaulted as well.”

Linn Energy stock had fallen $5.96 to $27.33 in afternoon trading on the Nasdaq.