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Linn Energy Poised to Survive Nat Gas Plunge

Monday, 9 Apr 2012 | 2:37 PM ET

A deep and prolonged slump in natural gas prices has thrown much of the industry’s largest produces into a state of panic and turmoil. As prices have fallen, so have stock prices — with shares of natural gas giants like Chesapeake Energy , Devon Energy , and Encana have fallen twenty-plus percent over the last year.

Design Pics | Michael Interisano | Getty Images

But among the ruins of larger companies, traders have singled out a small and relatively unknown U.S. producer called Linn Energy that could thrive in a low-price environment.

The reason is simple they say: Linn runs one of the best hedging programs in the industry.

“We’re 100 percent hedged through 2015 on natural gas at a pretty attractive price,” says Mark Ellis, the company’s CEO. “It’s an absolute critical part of our success.”

That success is thanks to simple math: while other producers are selling the natural gas from their wells at prices hovering around $2 (natural gas sank to decade-low levels of $2.06 in Monday trading), Linn will be selling theirs, on average in 2012, for around $5.44 — a massive margin for a company that produces an average of 370 million cubic feet of gas every day.

Linn Energy CEO on Hedging Strategy
Mark Ellis, Linn Energy CEO, explains why he's hedged 100% through 2015 on nat gas with the average price above $5.

The engineering of such a price advantage has its complexities. Linn uses a combination of financial instruments like puts and swaps to lock in future prices. These instruments can either lock in an exact price, or commit the trader to set a range of prices (a floor and ceiling).

Linn’s structure as an MLP, or master limited partnership, has allowed it to take a more aggressive and constant approach to its hedging book, Ellis says. MLPs pay investors through mandatory pre-set distributions each quarter, which means its investors are expecting a more-or-less constant payout from owning stock — regardless of where fuel prices may go.

For Linn, and others that are strongly hedged – including names like Range Resources , Pioneer NaturalResources , and Venoco , it’s a strategy that is not without its costs, or risks.

Ellis says the company is willing to expose up to 10 percent of its profits on certain deals just to pay the banking fees for the hedges. And then there’s the risk that prices go higher leaving Linn potentially locked in to below-market prices on some of its hedge book.

Hedging the Nat Gas Plunge
CNBC's Kate Kelly discusses the winners and losers as a result of the nat gas plunge. Natural gas hit a 10-year-low today.

And while on the face of it, it may seem like a strategy that is pegged to a specific price prognostication, Ellis maintains that the company is not in the business of guessing where exactly future prices will go.

“One thing we can’t do is predict price,” he says. “Invariably you’re going to be wrong.”

For that reason, Linn hedges its production on a 5-year time horizon, meaning that the company has locked in an average price for much of its future production through 2016. It’s a strategy that takes a long view in the hopes of riding out short-lived volatile price shocks. However, it does leave the company vulnerable to being on the wrong side of a trade.

“There were some times, like in early 2008 we were at an 8 dollar gas hedge book [when prices were above 12 dollars] and it didn’t look like such a good position.”

But Ellis is quick to note that within 6 months of that, prices plummeted.

“We looked like heroes,” he adds.

Follow Jesse Bergman on Twitter: @JBergmanCNBC
Follow Kate Kelly on Twitter: @KateKellyCNBC

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