Chesapeake: Private Equity's Shale Real Estate Agent (Update 1)

(Chesapeake Energy, KKR story updated for Carrizo Oil & Gas deal, analyst commentary)

NEW YORK ( TheStreet) -- If there is one man synonymous with the shale land grab it has been Chesapeake Energy ( CHK) CEO Aubrey McClendon, but Chesapeake has run into a problem recently (no, not the Rolling Stone article): It's running out of money to acquire shale acreage.

McClendon may have happened upon a solution: He's becoming private equity's shale real estate agent as private-equity players like Blackstone Group and KKR ( KKR) become much more active in shale investment.

Blackstone recently invested in natural gas export play Cheniere Energy ( LNG), while KKR recently acquired oil and gas company Samson Investment.

Chesapeake and KKR announced on Tuesday a $250 million joint venture through which Chesapeake will source, own and manage shale assets that will provide future revenue royalty streams. KKR will provide $225 million of the $250 million in cash to buy up the royalty assets.

Details in a press release were scant, but with KKR putting in the lion's share of the money to buy up the shale acreage royalty rights, it would stand to reason that KKR will receive a lion's share of the revenue from the assets.

That's why a cynic could argue that Chesapeake Energy, known by detractors as a shale asset "flipper," has now become private equity's shale real estate agent. As it is strapped for cash , Chesapeake now has to reduce its role to getting a finder's fee and management fee for going out and finding good shale investments for the deep-pocketed private-equity players.

In a way, it makes perfect sense. If there is one thing that has driven investors and Wall Street crazy about Chesapeake Energy, it has been McClendon's penchant for saying one thing -- becoming more financially disciplined -- while doing another like buying up assets and spreading the Chesapeake balance sheet even thinner. Yet if there is one thing that Chesapeake knows better than just about any other company it is how to source and operate shale assets.

Chesapeake has had to get a lot more serious in a hurry about showing its financial discipline to investors, especially with the recent slide in the price of natural gas crimping cash flow for the company and magnifying its funding gap.

If an investor wants to view this deal with KKR positively, it would be as a sign that Chesapeake won't continue to spend its own cash on shale buys when it doesn't have the cash to spend. It also is one more way for McClendon to keep his company's position as second only to Exxon Mobil ( XOM) in the shale without even having to lay out the cash to do so.

Details were few on the exact type of shale royalties to be acquired, but if it allows Chesapeake to own the equivalent of bolt-on acquisitions in its key shale plays like the Utica and Eagle Ford and also in the Permian, it would make sense for the company. Chesapeake can tie up acreage that McClendon can't seem to resist without having to tie up his balance sheet in even more knots than already exist.
Chesapeake/KKR deal: A sign of the times for cash-strapped Chesapeake Energy.

In the grander scheme of things, this KKR deal is a relatively small one for Chesapeake, which has said that it may monetize up to $10 billion assets this year to meet its funding needs. Argus Research analyst Phil Weiss said that after he "yawned" reading the announcement, he did notice that it referred to the $900 million in royalty assets Chesapeake already has and this is one more sign of what a "simple" company Chesapeake is as it tries to grow its business.

The deal is one more sign of the delicate balancing act known as Chesapeake Energy. Neal Dingmann, analyst at Suntrust Robinson Humphrey, said that while it's a relatively minor deal, the KKR agreement does get to the heart of the Chesapeake story.

"Chesapeake clearly realizes there are material issues the market is concerned with, and between the divestitures and recent JVs and this, it tells me that they are listening to the market," Dingmann said.

On the other hand, unlike previous royalty trusts in which Chesapeake maintained a significant revenue stake, it's fair to believe, without more information, that KKR will be the revenue winner after putting in 90% of the cash for the acquisitions. Chesapeake said it will receive a "promoted interest" as owner contributing 10% of cash to this deal.

"They clearly won't have a majority ownership here, even if they are the manager," Dingmann said. "If I'm Chesapeake, why do I do this for 10% of the royalty stream?"

Chesapeake said in an email that it, "earns a promoted interest in the partnership for finding, executing, and managing these interests for the partnership, which will result in CHK earning more than its original 10%. The exact amount is not disclosed per the partnership."

It's important to note that the KKR deal is not a royalty trust of the type that Chesapeake has done in the past, but "simply a partnership with KKR to pursue buying minerals," in the words of Chesapeake. "Yes, down the road once there is royalty revenue from the acquired minerals, they can be sold. But this is not the same structure as a royalty trust," Chesapeake said in an email to TheStreet.

There were several unanswered questions in the deal, including whether Chesapeake and KKR will seek to work on additional joint ventures based on royalty streams since this one is relatively small, whether this royalty venture can acquire leases already held by Chesapeake, or if Chesapeake as a driller can buy the right to the acreage included in the KKR/CHK royalty deal, or if the venture will be limited to oil and gas assets unaffiliated with Chesapeake as an E&P.

Chesapeake said in an email, "If CHK/KKR partnership owned 50 acres of minerals and CHK planned to drill a well there, CHK would acquire a lease from CHK/KKR to drill the acreage. CHK would be the working interest operator and CHK/KKR would receive royalty revenue (without paying any of the drilling costs)."

KKR said it's just getting started in the shale, while McClendon recently said the shale "land grab" is ending and the company transitioning from asset acquisition to asset management. In fact, Chesapeake has said on recent earnings that it has very little buying left to do but has still been buying in areas where acreage is cheap and has little impact on its balance sheet.

Michael Kelley, analyst at Global Hunter Securities, said that these deals are starting to become more common, and Chesapeake has shown an ability to use "use other people's money" in a way that is beneficial to it. He pointed to a deal between much smaller Carrizo Oil & Gas and KKR ( CRZO) and Avista Capital Partners, in which Avista paid 90% of the upfront costs yet Carrizo retained the right to acquire at a later date up to 50% of the venture's stake for a marginal cost over the original acreage acquisition.

Private-equity players have seen the likes of Chesapeake Energy of the shale world go out and acquire land at $200 per acre and a few years later sell for thousands if not tens of thousands of dollars and the PE players want a piece of that action, Kelly said. The analyst also is betting that this kind of deal won't become a core part of Chesapeake business going forward. "I would be shocked if it was," he said.

Chesapeake may be getting more than the 10% royalty interest that the deal implies, as Kelly argued, and in addition to a finder's fee and management fee there could be performance bonuses for production targets that would increase its royalty take, and it may have the right to buy the assets as Carrizo retained in its recent deal.

However, none of those details were provided in the release and the best answer might be simple: Even if the KKR deal doesn't become the norm for Chesapeake, the company is doing the deal because as its CEO attempts to sublimate his appetite for acreage acquisitions it has run out of other options to continue to buy on the margins.

-- Written by Eric Rosenbaum from New York.

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