A Gas Company That’s a Natural

05/22/2008 12:00 am EST

Focus: COMMODITIES

Neil George

Editor-in-Chief, Income Publication and Products, Agora Financial

Neil George, editor of Personal Finance, says a partnership with big gas reserves in Texas is worth much more than its current price.

Unlike many petrol companies around the world, Linn Energy (NSDQ: LINE) pays a nice, fat piece of the profits to the shareholders rather than just the management.

The company continues to ramp up its profits and the amount of distributable cash flows for dividends, which are up more than 37% and currently yield more than 10%.

All told, Linn has between 4 trillion and 5 trillion cubic feet (tcf) of natural gas equivalent in total reserves. Roughly 1.2 tcf of Linn's reserves are those that have actually been developed and are under production and those that have been developed and tested. Linn's management assigns these reserves a value of $2.4 billion to $3.6 billion.

The next level is proven undeveloped reserves (PUD) where the producer has 90% certainty that the estimated quantities can actually be recovered in the future. Linn has 0.5 tcf of PUDs and offers a valuation of about $1 billion to $1.5 billion for those; this is also in line with industry valuation norms.

On top of proven reserves, Linn has 1.3 tcf in what management calls "high-confidence" inventory. These are reserves that management is very confident in but don't quite fit the technical definition of proven. Linn estimates it could have another 1 tcf to 2 tcf of reserves in its fields that it will be able to exploit over time but hasn't yet booked as reserves.

Management used a valuation of roughly $2 to $3 per thousand cubic feet of proved reserves and roughly $1 per thousand cubic feet for its high-confidence inventory.

Natural gas currently trades at more than $10 per thousand cubic feet, and Linn has hedged its forward production at around $8 per thousand cubic feet. A valuation of roughly $2 to $3 per thousand cubic feet reflects the price a company would have to pay to buy proved reserves.

On that conservative basis, Linn's net asset value is roughly $4.7 billion to $6.7 billion. On a per-share basis, assuming all debt is paid off, that works out to $26 to $37 per share, a range far above the current trading price [of around $24].

Management believes it can generate organic growth of roughly 3% to 4% without taking on any acquisitions whatsoever.

For example, in 2008, Linn plans to spend 45% of its capital spending budget (about $113 million) on its Texas Panhandle Granite Wash Play. At its hedged gas prices, management estimates a 25% to 40% return on Linn's investment.

Elliott [Gue] and I are convinced the firm's estimate of a 2% to 4% annualized organic growth rate is reasonable, if not conservative. And any further strategic expansion or other deals should only add to its overall growth of cash flows, which would easily put Linn in the upper range of cash growth compared to its peers in the petrol patch.

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