As we noted in a Flash Alert issued on Oct. 26, 2010, Linn recently boosted its quarterly distribution from $0.63 per unit to $0.66–its first quarterly hike since the payout covering the fourth quarter of 2007. Linn’s third-quarter earnings report shows why management felt comfortable boosting its payout for the first time in nearly three years: Strong growth in distributable cash flow (DCF) means that Linn still covers its distribution 1.13 times after the increase. The firm also reduced its commodity price risk by hedging additional crude oil and natural gas volumes.

Linn’s average daily production stood at 283 million cubic feet equivalent per day, up 30 percent compared to the third quarter of 2009 and above the midpoint of management’s own guidance range. Note that although Linn reports total production in terms of cubic feet of gas equivalent, that doesn’t mean the company solely produces gas. In fact, natural gas accounted for roughly half of its output; Linn also produced 14,600 barrels per day of crude oil and 8,900 barrels per day of NGLs. Linn also boosted its fourth-quarter production estimates to 290 to 310 million cubic feet per day, a roughly 60 percent increase from a year ago. 

Linn has achieved this growth through a combination of acquisitions and organic expansion. On the acquisitions front, Linn has completed or will soon complete $1.2 billion worth of acquisitions this year, with a particular focus on building out its presence in the Permian Basin, an oil-rich play in Texas. The Permian now accounts for about 20 percent of Linn’s reserves and production, up from zero a little over a year ago, and 76 percent of this output is either oil or NGLs.

Linn was able to accelerate its acquisitions activity thanks to easy access to capital. Between new bond and unit issues, Linn raised a total of $2.7 billion in 2010. This allowed the partnership to fund acquisitions and pay off its revolving credit facility. With long-term debt with maturities of seven to 10 years and access to a $1.5 billion credit facility, Linn’s balance sheet is in fine shape.

The improvement in Linn’s finances is staggering. Many MLPs suffered in late 2008, when banks cut the size of their revolving credit lines. In some cases, rates also spiked, as the interest rates on credit lines are often indexed to the London Interbank Offered Rate (LIBOR). Thanks to solid operational management and a conservative hedging strategy, Linn never had its credit lines pulled during the crisis. But management learned the lesson and has eliminated the firm’s dependence on fickle short-term bank lending markets.

Management noted that the acquisitions market around its core areas of operation remains active. Thanks to its strong financial position, Linn should be in a great position to pursue accretive deals.

Two of Linn’s key plays offer plenty of organic growth potential: the Wolfberry Trend in the Permian Basin and the Granite Wash Play in the Texas panhandle.

Linn currently has two rigs operating in the Wolfberry and plans to drill 14 new wells before year-end. In 2011 the company plans to ramp up to run four or five rigs and drill a total of 100 wells; Linn has identified at least 400 drilling locations, so it has years of drilling inventory on its existing properties. Linn estimates that it costs about $14 to find and develop a barrel of oil in this play, and about three-quarters of production from wells in the area is oil. The Wolfberry is an extremely valuable play at current oil prices.

The company has also drilled some truly astounding wells in the Granite Wash. Horizontal wells that Linn has drilled in the Granite Wash produced about 38 percent natural gas, 38 percent NGLs and 24 percent condensate. In an environment where oil trades at $70 a barrel and natural gas is $4 per million British thermal units (BTU), management estimates that Granite Wash wells pay back their costs in three to 12 months and generate a total rate of return that exceeds 100 percent.

One of Linn’s most impressive wells drilled to date is Black-50-1H, a black horizontal well with an initial production rate of 60 million cubic feet of natural gas equivalent–a real gusher. Output has declined from that initial surge, but averaged 33 million cubic feet of natural gas equivalent per day in the first three months. As of the end of October, the well is flowing 25 million cubic feet of natural gas equivalent.  About 65 percent of this production is liquids.

Linn now has four rigs operating in the Granite Wash and plans to drill 30 to 35 wells perm month in 2011. The partnership will also step up its interest in well in which the partnership owns a stake but doesn’t do the actual drilling work.

There’s also the potential for an expansion of this play. Linn is drilling wells on the Oklahoma side of the Granite Wash play. The first well to be drilled in the Cooprider 1-34H, and results should be ready in the next few weeks. If the Oklahoma side pans out, it will expand the number of Granite Wash drill locations.

We’ve always liked Linn’s conservative hedging policies. The company usually hedges much of its oil and gas production for years into the future, limiting its exposure to volatile commodity prices. Because Linn offers growth and income, the last thing we want is cash flows and distributions that swing wildly from quarter to quarter depending on energy prices.

Management reported in its third-quarter conference call that the partnership had hedged all of its natural gas output through 2015 and all of its oil production through 2013. In addition, Linn now has hedges in place covering 70 percent of its expected 2014 crude oil production. This all but eliminates the largest source of uncertainty surrounding Linn.

Also impressive is the prices that Linn has locked in thanks to prices on natural gas futures that are significantly higher than current levels in the spot market. Linn’s 2011 gas production is hedged at $8.24 per million BTUs; 2012 production is hedged at $6.07 per million BTUs; and natural gas output from 2013 to 2015 is hedged at $5.65 to $6.06 per million BTU.

At these prices, Linn’s core areas such as the Granite Wash can deliver strong returns. Oil prices are hedged at between $84 and $100 per barrel.

Because about one-third of all hedges are puts, Lin has retained a bit of upside exposure if commodity prices surge.

In its third-quarter conference call management strongly hinted that it’s planning additional increases to Linn’s distributions next year. Although the company didn’t provide an exact target, management estimates that organic DCF will grow of 25 percent from a year ago in 2010, covering the distribution 1.2 times.

The company plans to both boost distributions and increase that coverage ratio even further. Under that scenario, it’s not at all unreasonable to expect that Linn could grow its payout by more than 10 percent in 2011, even if we assume the firm makes no additional major acquisitions. Given these growth prospects, Linn now rates a buy under 38.