Sometimes, the best investment ideas are shaped in conversation with others. So fool.com contributor Tyler Crowe reached out to fellow fool Matt DiLallo to discuss a stock they both own: Linn Energy . Here's what ensued in a series of emails.
: Hey, Matt, so I have been going back and forth about Linn for a little while now. There are lots of things that I like about the company, but one thing I'm really questioning is this move into the Mississippi Lime formation. I know that you are a fan of this move, but we have seen companies like Chesapeake Energy and Apache get burned there. So sell me. Why is this a good move?
: There is no doubt about it; the Mississippi Lime has proved to be a tricky play to develop. On top of that, the approach taken by Chesapeake Energy and Apache is risky by its nature. The model these companies took was to lock up as much acreage as possible and then drill exploratory wells. Sometimes that works spectacularly, and other times it's a waste of capital.
Linn's approach has always been much different. Its business is to acquire producing wells, though these acquisitions typically also come with proven acreage that it can slowly develop. So, in this case, Linn actually didn't go out and lease acreage in the Mississippian; instead it ended up with the acreage as part of earlier deals where Linn was targeting production in other zones.
So, now Linn has all this acreage, more than 450,000 net acres in Oklahoma and Kansas, that's prospective for the Mississippian and other oil- and gas-producing zones. However, what it's doing is farming it out this development to other producers instead of spending a lot of capital to develop the acreage itself.
For example, one format it's pursing is a joint venture where its partner will carry a portion of Linn's cost to drill a number of horizontal Mississippian wells. This allows Linn to accelerate the development of the play, while spending a lot less capital. While the returns might not be as high, it's a much less risky approach.
Tyler: Fair enough. It's certainly reassuring that Linn isn't spending a ton of capital on leaseholds. Also, with SandRidge Energy turning a 50% or greater internal rate of returns on these assets, it shows this play can be a very attractive investment.
But there is still one thing that I'm a little hung up on. The Mississippian has been a "hit it and quit it" kind of play with really high initial production rates but high decline rates as well. I have a hard time seeing how with Linn, more of a "put a ring on it" kind of company that looks for long-life assets to generate predictable cash flows, would be interested in these kinds of plays.
It would seem to me that they would be more interested in developing its Jonah field assets that it bought from BP last year. Producers like Ultra Petroleum are seeing one-year decline rates in the mid-20s in this region, which would seem much more up Linn's alley. I'm a little concerned that going into the Mississippi Lime is a bit like buying a sports car when it really needs a station wagon.
Matt: I wouldn't worry that Linn is having a mid-life crisis. Sure, there is no denying that horizontal plays like the Mississippian have a reputation for giving up their goods rather quickly. However, after the initial decline, these wells continue to produce for an awfully long time. That's why I see today's hot play eventually becoming the steady producer that Linn likes to pick up.
Using SandRidge Energy as an example, its typical Mississippian well earns a quick two-year payback. However, that well is estimated to ultimately produce about 369,000 barrels of oil equivalent over its lifetime. So it's not like these wells drain quickly. What Linn is doing right now is taking advantage of an opportunity that was basically handed to it by virtue of the fact it already has these acres.
That's only part of the story. The amount of oil a well ultimately produces is an estimate based on the industry's current technical abilities to recover the oil and gas. The problem today is that horizontally drilled oil plays don't give up a very much of the oil that's in place. That leaves the door wide open for Linn to figure out ways to get more oil out. This is a company whose bread-and-butter business is built upon its ability buy wells and figure out a way to suck more of the oil out.
If Linn were going out and acquiring acreage in the Mississippian, I'd be concerned. However, I think a small bet on this liquids-rich play is a smart move. The oil and gas is just sitting there on land it already has leased; why make some money by extracting it?
Tyler: OK, you've got me convinced. For a while I have been worried that the Mississippian was where companies went to throw captial expenditure dollars down the toilet. But many people, myself included, have a tendency to underestimate the rate of technology growth in the shale sector.
Thanks for the lesson, Matt!
These Fools don't agree on everything, but they do agree on this
Record oil and natural gas production is revolutionizing the United States' energy position. This renaissance has created a slew of investment opportunities, but not every one is built for the long term. For this reason, our analysts have put together a comprehensive look at three energy companies planting roots during this transformation in the energy industry. Let us help you discover these three companies that are building a solid future by checking out our special report, "3 Stocks for the American Energy Bonanza." Simply click here and we'll give you free access to this valuable investing resource.
The article Is Linn Energy Making a Mistake? originally appeared on Fool.com.Fool contributor Matt DiLallo owns shares of Linn Energy and SandRidge Energy. Fool contributor Tyler Crowe owns shares of Linn Energy. The Motley Fool recommends, owns shares of, and has options on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.
Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.