Virgilio Guma is Managing Director of Veotoro Management LLC, a Miami-based hedge fund specializing in the energy market. Virgilio is a former oil trader at Merrill Lynch.

In this Q&A, Virgilio talks about his single highest conviction holding in his fund.

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Q: What is your highest conviction stock position at Veotoro - long or short? 

Virgilio Guma (VG): Our highest conviction stock position continues to be our long position in Linn Energy Company (NASDAQ:LINE). Linn is an independent oil and gas company with a market cap of over $3 billion. Linn's activities are focused on the development and acquisition of "long life" properties in the United States.

A high yield investment in Linn is also a low Beta investment in a $3+billion market cap energy producer at near book value. The company has a solid track record of performance and is paying an 8% dividend yield to investors. At $25, it sells for a P/E ratio of less than 5. 

This is a highly leveraged play (35% long term debt/assets) for a firm that owns assets (proven oil and natural gas reserves) in premium markets and is a prime candidate for a buyout from the cash rich and reserve hungry major oil companies in the sector.

Q: Can you talk a bit more about this sector? How much is this an "industry pick" as opposed to a pure bottom-up pick?

VG: Oil company stocks, particularly smaller companies like Linn Energy, are poised for strong growth over the next year as the economic recovery bolsters oil demand growth. While much of the underlying growth is forecasted to remain in the Far East, Linn will benefit from higher oil prices because oil markets are global. 

U.S. natural gas markets have stabilized and the Barnett shale production is fully priced into the underlying natural gas prices now. New LNG terminals all over the world mean natural gas markets will also become more global in nature. That is important because of the steep decline in production of Natural Gas Liquids in South East Asia and the Australian Northwest Shelf.

Three points make Linn stand out from the sector crowd to me:

1. As their cash is stretched as far as it can go for now, the virtual takeover of the company by the former head of operations seems like the perfect move for Linn. Mark Ellis, the new CEO, comes from the position of COO at Linn and knows the production business operation intimately. The new management hits the ground running operationally and this is important as Linn looks to bring their production to the market and capitalize on its somewhat heavily leveraged investment in reserves. A solid production operation will enable an optimal monetization of the reserves they have acquired.

2. Linn's position in the market is strong. Baker Hughes reported that rig counts at the end of 2009 in some cases are almost on par with the levels seen at the end of 2008. The drops in the US of over 5% on a year over year basis were the largest standouts here. The Company's properties are located in the Mid-Continent and California - two of the strongest premium consumer markets in the United States for hydrocarbons. 

3. Linn has reserves that are a hot commodity. Exxon's (NYSE:XOM) move in the acquisition of XTO was the tip of the iceberg in terms of upcoming M&A activity on the US nat gas front. Linn announced that it has signed a definitive purchase agreement to acquire certain oil and natural gas properties in the Permian and Anadarko Basins for a contract price of $154.5 million, subject to closing conditions. The Company anticipates that the acquisition will close on or before January 29, 2010, and will be financed with borrowings under Linn Energy's existing credit facility. 

Rising oil prices will make companies like Linn a prime target for consolidation as oil majors struggle to replace their reserves through new production abroad because of the expansion in drilling activity directly by the local, state-owned oil companies.

The price of the stock has had a small pullback as the market moved into profit taking mode. LINE is still up over 50% in a year, outpacing most of their competitors. Other analysts saw the spike in natural gas prices caused by the cold weather as an opportunity to sell some producers that were outperforming.

Still, some investors even increased shorts in Linn by 3% last month. Linn is a highly leveraged bet and that also puts some investors off. This is particularly true since Linn made even more acquisitions at the end of 2009, putting further strains on their cash flows.

However, I would argue that the shorts do not understand the bet Linn is making: if they own reserves that can produce revenues to pay off their leverage and generate earnings, they should leverage everything they can while they are in acquisition mode. Linn's long term debt/assets currently stands at around 35%. They have been in acquisition mode, simply put, because they are borrowing money at historically low interest rates and purchasing natural gas and oil assets in premium markets at historically low prices.

In addition, the energy complex futures contango alone pays for most of the 8% dividend yields they were passing along to investors last year.

Their marginal reserves are at least in the right markets and the underlying commodity is on solid footing.

Moreover, Linn's strong reserves position and almost counter-intuitively, its high leverage makes it a very attractive M&A target for the cash rich majors in the sector hungry for reserve replacements. Finally, Linn is without peer in terms of its value to investors - assuming they continue paying 8% dividend yield, have a P/E ratio under 5 and enjoy and EBITDA of 83% and a book value/share of $24.20

Q: Does the company's management play a role in your position?

VG: Yes. This year Mark Ellis was recently named the new CEO, replacing founder Michael Linn, who remains executive chairman and will focus on the long-term strategy of the company. Ellis joined the natural gas and oil producer in December 2006 and was named president and operating chief a year later. He has more than 30 years of experience in the oil and natural gas industry, including more than 20 years in leadership roles at Burlington Resources and ConocoPhillips (NYSE:COP).

Q: What could go wrong with this stock pick?

VG: The risk to owning this stock are falling energy prices, production profile falls off or that Linn management does not eventually change course from more acquisitions and instead focus on harvesting what they have already invested. While some of these risks can be mitigated, Linn has to be careful that any additional acquisitions/leverage or increases in energy market volatility will start to pump up the pressure on their cash flows.

An investment in Linn offers investors what I believe to be asymmetrical return profile to the upside given our market views of the underlying commodities. However, energy market volatility may make this high yield investment a wild ride in 2010 and so it is not for the faint of heart.