Linn Energy: A Shale Play Challenged at $55 Oil

Linn Energy (LINE) (LNCO) traded closed below $10 a unit on December 15, 2014, marking both a 52 week low, and lows not experienced since the December 2008 financial crisis.  During the 2008 crisis, oil reached a bottom in the $35 range, whereas currently we are just reaching the $55 per barrel range.  Why is the panic so much more acute today than the time period politically labeled as the “Greatest Recession since the Great Depression?”  Are we entering an even bigger Depression?  That question I may have an opinion, but will not attempt to answer in this article.  What I will provide readers is a clear nuts and bolts view of why there is a run on the Linn Energy units, and why as the market approaches $55 oil per barrel on the front-end of the curve, the investor sentiment is warranted. 

 

The big issue facing common unit holders of Linn Energy is the over-extended financial structure of the business, i.e. financial leverage.  While Linn Energy is well hedged with favorable $90 oil derivative contracts for the next several years of production, the reassessment of the value of its proven reserves is expected to severely stress its financing capacity in the very near future.  In addition, even with the hedge program, the drop in oil price will still place a burden on cash flow to pay distributions while continuing to maintain a steady capital expansion program.  If drilling is constrained for any period of time at Linn Energy, the current high oil production rate will decline rapidly given the characteristics of the proven undeveloped reserves that Linn Energy owns (light oil, high concentration of NGL and Natural Gas).  The cost structure of the company makes the oil production “cliff” a particularly onerous problem.  Based on an assessment of the financial position of the company contained in this article, investors should expect a radical down-sizing, or even complete elimination of the $.24 monthly distribution level which is currently a 28.76% yield.

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SandRidge Permian Trust – Struck by the Saudi Oil Shock

On October 30th SandRidge Permian Trust (PER) announced its quarterly distribution for production during the time period of June through August 2014.  During the summer the energy market showed high oil prices throughout that benefited the Permian Trust which has 86% its production in crude oil.  The spread between WTI and WTS crude oil widened during the quarter causing a slight decline in price level realized by the Trust.

The distribution announcement was greeted with a rally in the market as the units traded up from $9.50 to $9.93 per unit on the day after the press release.  However, the information released may not have been the primary factor in share price movement during the day.  On Halloween the entire market experienced what is being reported by experts as a massive global shortcovering rally because of the announced changes in Japan monetary policy and pension fund allocation.  The unit price movement in Permian Trust units in the five day period leading up to the announcement was probably more indicative of the change in short-term sentiment about the Trust units, rising from $9.00 to the most recent $9.93 closing price on October 31^st.

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Stocks Post QE3 - Pay Attention to this Data

For years the Fed Funds rate has been the sacred measure that investors followed to determine if the Federal Reserve was promoting and accommodative or restrictive policy.  Fed rate hikes were a signal that the market was a little too juiced on the punch, and margin calls or a reduction in lending in the market was considered prudent.

What about today?  The Fed Funds rate has been at 0% since December 2008 yielding the rate meaningless in understanding just how Fed policy is influencing the financial markets, much less the economy as a whole.  I separate the stock market from the economy because increasingly, and particularly since the new Fed policy of using excessive amounts of QE as a tool in its policy, the two have diverged in correlation.  In fact, from a pure numbers standpoint, it can be argued that over the last 6 years, Fed policy has been an outstanding success in pumping up the stock market.  Stocks have risen from the depths of 666 on the S&P500 to over 2000.  Economic growth, however, has struggled to exceed 2% in real terms, and 3%-4% nominally.

The Fed has announced that it will now end for the foreseeable future, its bond buying program known as QE3 in the market (the program followed QE1 in early 2009 and QE2 in early 2011).  Stocks went progressively higher with QE as a backstop.  With the QE program ending for the time being, will the stock market suffer from the change?  Logically given the correlation one might suspect trouble; but what indicators should an investor monitor?

The answer to these questions is completely up to what happens to the bubble the Fed has created on its balance sheet, and correspondingly the high level of excess liquidity that it has created within the U.S. banking system.  One such indicator that is likely to become useful in the post QE3 distorted financial market is the level of excess reserves in the U.S. banking system. (Excess Reserves of Depository Institutions)

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Investors Beware, U.S. Fiscal Spending Shift Coming

As we approach the 2014 mid-term elections, U.S. fiscal policy is an economic headwind without any apparent current political movement to change.  The relatively tight policy as measured by rate of growth is a counter inflationary force foremost, but also potentially slows down economic growth.  You can see the evidence that the present fiscal policy is currently tight by reviewing the August 2014 year over year fiscal expenditure growth rate compared to previous years when the stock market peaked.

This data is surprising to many investors because they are so accustomed to hearing how Washington is out of control from a spending standpoint.  The data, however, is actually pointing in a different direction presently.

Lending Activity Heats Up – Should Stock Investors Worry?

One aspect of the recent U.S. economic growth not widely recognized is that it is being fueled by renewed high levels of debt being taken on by consumers, businesses and investors.  Unsustainable debt levels are notorious for derailing GDP growth.  This phenomenon was evident prior to the last two stock market peaks, and the risk has returned to the U.S. market once again.

If you review the statistics shown in the table below, you will see that just like 2000 and 2007, debt levels in 2014 have risen to warning zone levels relative to the size of the U.S economy (red = historically high, yellow = approaching historical high levels).

Stocks Expensive, Force Building to Knock Bull Down

Many articles have been released in the media in recent weeks concerning whether the stock market is over-valued or “very expensive” and may be approaching a peak.  One highly regarded researcher is Robert Schiller, who in August of 2014 was interviewed by many media outlets concerning the high level of the CAPE Ratio (cyclically adjusted P/E) to give his views.  Using this analytical approach he notes, “The United States stock market looks very expensive right now.”

I take a slightly different approach to look at the relative value of stocks compared to historical norms, but reach the same conclusion as Dr. Schiller.  The analysis, as summarized in the graph below, simply looks at the ratio of the traded value of the DOW relative to the nominal GDP (stated in billions) during the same time period.  Most recently the U.S. nominal GDP was just over $17.3 Trillion, and the DOW was trading at 17,098 at the end of August giving a ratio of .98.

The ratio is functionally useful in highlighting periods when the market is in outlier territory.  Presently, the stock market indices (DIA) (SPY) (QQQ) by relative measure are expensive.  However, history has demonstrated stocks can trade at these levels for extended periods before a steep correction occurs.  Since the 1990s, expensive in relative terms is a necessary but not sufficient reason for a major decline.  Saying stocks are expensive is different from trying to assess whether they are at a peak, and a portfolio adjustment toward higher liquidity and lower risk is a good play.

What is the likelihood that the S&P500 at 2000 is a peak?

Trend in U.S. Treasury Ownership Highlights Precarious Fed Rate Policy

Fed policy continues to be aggressively accommodative going into year-end 2014, even as it is projecting a wind down of the massive $1.54T QE program begun in January of 2013.

The easiest way to see the market rate impact of the Fed’s QE program and ZIRP (zero interest rate) policy is to review the current Treasury yield curve.  As the above graph shows, the current yield curve is

Watch Out for the Stock Buy-Back Taper

Back in the year 2000 I got a call from a broker wanting me to take a look at particular large cap financial stock.  The pitch was “the company has lagged its peer group, but it has announced a major share re-purchase program.”  I asked what the company plans were for growth.  Awkward silence was evident on the other end of the line.  I then said, “So you are asking me to buy-out certain shareholders who don’t want to own the company anymore because the management team is struggling to find ways to invest?”  Needless to say, I did not invest in the company.  But I did follow it.  Sure enough it did rise in the following months, only to be cut in half within the next 2 years.

I tell this story because I have always been wary of common stock buy-back plans.  Not because they are all bad.  Many companies have a disciplined approach of returning capital through this process rather than paying dividends.  However, when the buy-backs are not backed up by fundamental growth in the company, they turn into little more than the company entering the debt market to finance dividends, or worse, robbing from needed capital investment to maintain future cash flow.

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Quantitative Easing – Is it Inflationary or Deflationary?

On May 15, 2014 the CPI index was published in the U.S. which showed general price increases as measured by the BLS were a meager 2% annually.  This was after a year of massive bond buying by the Federal Reserve.  During the same year over year period, the Fed added $1.162 Trillion dollars of liquidity into the worldwide economy.
 
What exactly is going on?  The population has been led to believe that when the Federal Reserve “prints” money, the economic result is inflation.  Chances are that the current path taken will result in a similar outcome.  However, if you are looking at the present financial market and believe the Fed may have found the Golden bullet on how to tame inflation – simply lower interest rates to zero percent and flood the market with cash – think again.  Why?  It is actually very simple.  It depends on where all the cash, goes.  And eventually, the Fed is not in total control of where the excess money goes.

Nervous Investors Move to Bonds just like Belgium?

I have run across data that belongs in the category of strange and unusual in the May 15^th publication of the TIC data (Treasury International Capital Report).

The strange aspect of the data is that in the published figures, the tiny country of Belgium with a GDP of only $509B, somehow managed to purchase $40.2B in Treasury securities in the month of March.  The purchases follow a six month barrage of purchases by Belgium in which $214.6B in Treasuries were added to security accounts held in the country.  Based on the data, Belgium has escalated to third, behind only Japan and China (mainland) in the rankings of foreign countries which hold the most U.S. Treasury reserves.

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Theory of Financial Relativity: Powerful New Book Helps Protect Investments, Exposing Framework for Predicting Market Trends.

Masterfully crafted by investment guru Daniel Moore, ‘Theory of Financial Relativity’ explains why financial markets suddenly change course and how these changes can be predicted. By meticulously studying U.S. financial markets from WWII to the present day, Moore has uncovered fourteen market corrections that display a predictable pattern of change. Sharing this information with the public for the first time, Moore’s work is poised to help millions protect their investments and take advantage of their movements for success.

For Immediate Release

Durham, NC –Both consumers and critics traditionally treat U.S. financial markets as a volatile and unpredictable world that could drastically change direction at a moment’s notice. While this theory holds a shred of truth, a powerful new book exposes the previously unknown and systematic pattern of ‘ups and downs’ that can actually help investors predict when a bull will become a bear.

Everything is showcased in ‘Theory of Financial Relativity’ by Daniel Moore. Hailed as “the most interesting man in the financial world,” Moore has spent hundreds of hours combing over seventy years worth of market trends to expose a game-changing and predictable pattern.

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Fed Cornered by QE Program – Reverse Repo Path Being Considered

In Fed Chair Janet Yellen’s testimony to the Senate Banking committee on May 7, 2014 there were many questions about when the Fed would “normalize” its interest rate policy, specifically the Fed Funds rate.  She stuck to the party line, saying it is expected to be a “considerable time” before the Fed will raise short term interest rates.  When pressed for a definition of “considerable”, she did a political dance and left the definition to “it depends on economic circumstances”.  In other words, it depends on what will do the least amount of damage to the political party in charge.

One path to actually raise interest rates, but escape the consequences that raising the Fed Funds rate entails, is to use a technique known as the Reverse Repo.  The "experiment" that the Fed is currently actively

Market Winds are Shifting – Time to Assess the Signals

On Friday, May 2^nd the April jobs report was published by the U.S. Bureau of Labor Statistics showing that 288,000 new non-farm payroll jobs were created in the month.  It was the strongest month to month growth since January of 2012.  In addition the unemployment rate fell to 6.3%, with 138.252 million people estimated to be employed during the month.  This is the highest total number of employed people since March of 2008 and is on the verge of becoming an all-time high in terms of total employment.

The information was published a day after both the DOW and S&P500 (DIA) (SPY) set new all-time highs.  The immediate response by the market when the jobs information was released was a jump higher.  However, by mid-day the market was slightly down, seemingly unimpressed by the job figures, and ended the day on a down tick.  Why?  Research has shown that while jobs are of course an important economic indicator, they are always a trailing indicator.  Anyone trading stocks on the jobs report is searching for fool’s gold.  The more important aspect of the jobs report is whether the data causes an unexpected change in the expected direction of market influential factors that do impact stock valuations.

Emerging Market Debt Options to Hedge Fed Taper and Stock Volatility

Managing money in the current financial market is beginning to resemble the game of musical chairs I played years ago in grade school.  Last year, at virtually the same moment in the year, the market “forces” decided that the music would stop and the debt market, primarily the longer duration bond market as well as high dividend paying stocks such as utilities (VPU), telecom (VZ) (T) and REITs (VNQ), would not have a seat at the table.  Municipal bonds (MUB) last summer were also ostracized from the game, with the fears of bankruptcies in Detroit and Puerto Rico looming large and investors warned to stay away as the market was far too risky for entry.

The T-Bond (TLT) (TLH) (IEF) route moved the 10 year from around 2% in early 2013 to a high touching 3% precisely at year end.  The longer duration securities such as the 30 year also traded down in value, up in yield in 2013, about 90 basis points to end the year at almost 4%.  All the related interest-sensitive markets were beaten into submission going into year end.  Opportunities for savvy income investors were plentiful – for a brief moment.

Market Dancing to a Different Tune in 2014

Since the beginning of 2014, however, the music has been noticeably different.

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