Linn’s clever idea didn’t survive

Investors want a good story for how a company will make them money, and Linn Energy told a good one. Unfortunately, that story led the company into bankruptcy.

The Houston-based company must use Chapter 11 reorganization to do more than simply shed debt, but management needs to find a new business plan that can survive the cyclical oil business and regain investors’ trust.

Linn Energy started as the anti-fracking investment for those looking to make money from an independent oil exploration and production company. The company purchased inexpensive conventional wells that promised longlasting, steady oil production.

The goal was to offer investors a high dividend with tax advantages, so founder Michael Linn and his team created a limited liability company with a partnership tax status. That made Linn Energy similar to a master limited partnership, with most of the company’s revenues passing through to holders of partnership units bought on the Nasdaq exchange.

Linn hoped to attract income investors by offering a unicorn company, a reliable oil exploration and production company with long-term income potential and little risk. And it worked, sending the unit price upward.

The key to continued income and growth, though, was to borrow money to lease land and

drill new wells, and then rely on revenue from high oil prices to pay creditors. Like most oil analysts, Linn Energy executives expected OPEC to manage output to keep prices high and guarantee income.

Those expectations created a glut of oil, and prices started falling in August 2014. By Thanksgiving, OPEC was clearly not going to do anything about it.

In January 2015, Linn had about $10 billion in long-term debt due in 2019 and a debt-to-earnings ratio of 5.6, a high number even for the E&P business. Chief financial officer Kolja Rockov announced Linn was cutting the quarterly distribution to unitholders by 56 percent and slash spending on drilling from $1.55 billion to $730 million.

At the time, I joined Moody’s in praising the decision as necessary to keep the company afloat. But I also noted that Rockov’s numbers relied on oil remaining above $60 a barrel, a risky bet.

Income investors started abandoning Linn, and the unit price plummeted. Speculative investors were interested in other E&P companies with better balance sheets.

Oil prices kept dropping, forcing CEO Mark Ellis to eliminate the distribution completely in August 2015. After that, there was no one interested in Linn’s story. The unit price dropped from $31.80 to $2.97. The market value of the company’s outstanding shares was down from $11.3 billion to $1.1 billion.

The company was clearly on the road to bankruptcy in March. The only question was whether executives and creditors could prepackage a bankruptcy deal. The company entered into Chapter 11 reorganization on Wednesday.

While I respect the creativity that goes into business, innovations in company structures and financing are easy during the good times when everyone is making money. The real test comes when an industry hits the skids. Can these newfangled ideas survive a downturn as well as the tried and true?

Linn’s too-clever idea to create something in between a partnership and a corporation didn’t survive. Linn must now do more than simply shed billions in debt during bankruptcy proceedings. It must come up with a new story to tell investors. Only then can it raise the money to get back to producing oil and natural gas when prices rise again.