Originally, I thought that Chesapeake may have been using its midstream deals to inflate its profits. I was mistaken. Chesapeake’s midstream vehicle (now named Access Midstream Partners) was structured in a very one-sided deal that heavily favored Chesapeake.
I don’t think that many people give credit to Aubrey McClendon for this deal.
Excessive fees
Access Midstream Partners (formerly Chesapeake Midstream Partners) is controlled by its General Partner. The GP is entitled to “incentive distribution rights” (IDRs). At the minimum quarterly distribution, the GP receives 2% of all distributions. This is fine as it would be proportionate to the GP’s 2% interest in the company. However, as the distributions increase, the IDR payments ramp up to 50% of all distributions.
Needless to say, these fees strike me as excessive.
The interesting part about the IDRs is that the GP has a lot of leeway in determining the level of distributions. The distributions are affected by subjective determinations such as the estimated level of maintenance capex. The GP has control over the election of the company’s accountants, external auditor, board of directors, and officers. To some degree, the GP can simply pay itself more by increasing the level of distributions.
On top of that, the GP had additional options:
- If the GP owns over 80% of the company, the GP can buy out the entire company.
- The GP has an option to reset the IDRs.
I don’t think that these options are worth that much but they are sources of additional upside for the GP.
Overall, I’ve never seen a structure that is so one-sided. Usually shareholders at least have the option of firing management, even if management is contractually entitled to golden parachutes on the way out.
ACMP common shareholders can easily get screwed
The common shareholders have virtually no control of the company. They cannot vote on the election of directors. ACMP shareholders do not get to even nominate any of the directors, officers, or “independent” directors.
If the GP controls a third of ACMP’s equity, then the common shareholders cannot remove the GP against the GP’s wishes. Removing the GP would require two thirds of the vote including the GP’s votes.
To discourage changes in control, any party that acquires more than 20% of the stock will lose their voting rights.
The GP’s fiduciary duties are intentionally limited as explained in the Risk Factors section of the regulatory filings.
To be fair, ACMP shareholders used to enjoy minor protections. Initially, the parties which owned the GP also owned subordinated units (in addition to the GP’s 2% interest). The common units would receive their minimum distributions before the subordinated units. The common units would also have a liquidation preference. If things were to go badly during the Subordination Period, then the common units would do better than the subordinated units. Currently, the Subordination Period has expired (e.g. see the 424B7 filing):
Upon payment of the cash distribution for the 2013 second quarter, the subordination period with respect to our 69,076,122 subordinated units expired and all outstanding subordinated units converted into common units on a one-for-one basis on August 15, 2013.
Midstream economics
As far as I can tell, ACMP mostly owns gathering pipelines at this point in time. Almost all of its assets are classified as “gathering systems” on its balance sheet. In the future it may own more processing facilities.
As I understand it, the economics of gathering pipelines are intimately tied to the economics of shale wells. If the region continues to maintain or increase shale production, then the economics of the gathering pipelines will be better. Most of the pipeline is already in place and paid for. The midstream gathering company will require some capex to build new gathering pipelines to new wells to connect them to the existing network of gathering pipelines.
On the other hand, the midstream company will have a big problem if production from shale wells decline. The 10-K states:
We do not obtain independent evaluations of natural gas and NGL reserves connected to our gathering systems; therefore, in the future, volumes of natural gas and NGLs on our systems could be less than we currently anticipate.
We do not obtain independent evaluations of natural gas and NGL reserves connected to our systems. Accordingly, we do not have independent estimates of total reserves dedicated to our systems or the anticipated life of such reserves. Notwithstanding the contractual protections in certain of our gas gathering agreements, including minimum volume commitments in our Barnett Shale region, and Haynesville Shale region, and fee redetermination and cost of service provisions, if the total reserves or estimated life of the reserves connected to our gathering systems are less than we anticipate and we are unable to secure additional sources of natural gas and NGLs, it could have a material adverse effect on our business, results of operations, financial condition and our ability to make cash distributions to our unitholders.
I believe that ACMP’s revenues are largely proportional to the amount of natural gas flowing through its system. If the shale wells have lower than expected recoveries or decline faster than originally thought, the gathering-related assets will see less revenue. The assets will also see less revenue if shale companies do not continue to build new shale wells.
It seems to me that the overall economics are complicated and uncertain. Originally, I mistakenly thought that ACMP’s midstream assets would have stable cash flows that are low-risk and easy to analyze. They are not. The 10-K often states that contracts “will be redetermined based on a cost of service calculation that targets a specified pre-income tax rate of return on invested capital“. However, the 10-K doesn’t seem to state any numbers for the specified rate of return.
Looking into the contracts filed on EDGAR doesn’t help either. In my opinion, the contracts are heavily redacted. Here’s an example:
Things I couldn’t figure out
ACMP doesn’t actually own its compressors. It pays Chesapeake fees for the compressors. It would make more sense to me if the compressors were sold alongside the midstream assets.
Something else I wasn’t sure about is where all the SG&A expenses end up. SG&A went from 3.5% of revenue in YE2007 to 11.1% of revenue in YE2012 (*calculated from data from gurufocus.com). The GP may have an incentive to try to push its expenses onto ACMP; the partnership agreement has allowances for this. From the latest prospectus:
Reimbursement of Expenses
Our partnership agreement requires us to reimburse our general partner and its affiliates for all expenses they incur or payments they make on our behalf. These expenses include salary, bonus, incentive compensation and other amounts paid to persons who perform services for us or on our behalf and expenses allocated to our general partner by its affiliates. Our general partner is entitled to determine in good faith the expenses that are allocable to us.
Does Chesapeake have hidden liabilities in its midstream deals?
As far as I can tell, this doesn’t seem to be the case. Profitability of ACMP has been declining instead of increasing.
YE2010 operating income was $204,982K.
YE2012 operating income was $178,478K. That’s -6.6% growth annualized.
YE2010 throughput was 1.595 bcf/d.
YE2012 throughput was 2.819 bcf/d.
The metric I would suggest is operating income (OI) divided by throughput. OI/throughput has declined 50.7%, which is -29.8% growth annualized. Some of this is explained by the rise in SG&A. Some of this can be explained by the drop in revenues from minimum volume commitments (see page S-9 of the Dec 12 2012 prospectus):
YE2010 – $56.8M
YE2011 – $17.4M
YE2012 – $0M
The bottom line
I have to give credit to Aubrey McClendon. This piece of financial engineering was a very good deal for Chesapeake.
I have no idea if Doug Lawler, Chesapeake’s new CEO, will be as good at wheeling and dealing.
Originally, I decided to short Chesapeake because its accounting and reserve estimation are both much more aggressive than their publicly-traded peers such as SWN and UPL. Currently, I am still trying to figure out (A) Chesapeake’s economics and (B) how its financial engineering works. The underlying assets have been sliced and diced into the following:
- Common shares.
- Various layers of debt.
- VPPs (Volumetric Production Payments).
- Preferred interests and overriding royalties in CHK C-T and CHK Utica.
- Midstream carve-outs through sales of assets to ACMP.
- Chesapeake Granite Wash Trust.
- Joint ventures.
- Founder Well Participation Program.
I still haven’t been able to pin down all of the parts.
*Disclosure: Short CHK via put options. No position in ACMP.
Links
ValueInvestorsClub.com has various long and short writeups on Chesapeake. The writeups do not analyze ACMP (formerly CHKM).
Glenn Chan's Random Notes on Investing 
Welcome to the world of the MLP, where IDRs and GPs that answer only to themselves are the norm!
I can’t believe these things exist and that the major investment banks (e.g. Goldman) have underwritten this crap. The underwriters should have pushed for a structure that is fairer for shareholders.
This is midstream mania.
A few comments:
I enjoy the blog.
Note that it tends to be hard to (non-naked) short MLP units due to the fact that lending the units out can have major tax disadvantages for the owner.
Related party transactions are a necessary evil in the MLP space, which makes the question of who the related parties are, paramount. As an investor I would have been leery of any such arrangement with McClendon in control. My view has long-been that virtually only secured (and possibly unsecured) creditors with strong legal documents could profitably do business with him. (To borrow from Greenblatt, he seemed a lot like that crazy cop, you know the one who’s partners always end up getting shot.) The exception would be in the case of very sophisticated control shareholders. Enter Carl Icahn and exit Aubrey. I would politely suggest that your analysis is lacking by not contemplating Icahn, who is one of the savviest operators in the MLP space.
Slight digression: opacity is the norm for disclosures in the gathering and processing space in particular. It is kind of perverse though, that the most opaque disclosures surround instruments that are marketed to a frequently very unsophisticated investor base, which appears to look only at current yield and next twelve months yield growth.
Finally, I would suggest that you and more or less all of the market commentators are using the wrong mental model when thinking about the common units in MLPs. For most midstream MLPs, where there is a GP with IDRs going up to 50:50 splits, the pre-tax economics (and the voting rights) surrounding common LP units are much more like that of preferred stock, with a bit of inflation protection and residual business upside attached. How much residual business upside exists tends to be a function of how low the MLP currently is in its splits, and how much free (or distributable) cash flow can be grown without deploying growth capital. If the GP only has 25% splits as a max, then the economics are a hybrid of the above and a yield oriented piece of common stock. And if there are zero IDRs (i.e. EPD, MMP, and a few more), then the pre-tax economics revert to that of a common stock with a yield oriented investor base. Upstream MLPs are an entirely different beast, and a rather hairier one at that.
1- Icahn has a stake in Chesapeake, not in ACMP.
2- The General Partnership (is that the right phrase?) can be sold… which is what Chesapeake did with ACMP. Now Williams owns half and GIP owns half.
3- I think the right mental model for MLPs is that the limited partners are clients in a perverse hedge fund- one that they can’t get out of.
4- I think that ACMP may have a deceptively high yield that cannot be sustained because they own gathering pipelines.
I would expect more from Icahn on this though I hadn’t followed CHK’s divestiture of its General Partner stake.
The perverse hedge fund idea is an interesting one— whether the LP’s are “preferred” owners or not, it seems pretty clear that they have economics that are very different from classical common equity owners, possibly without even realizing it. That said, MLP investors over the last ~15 years, have done very well relative to what most would say the opportunity cost is.
My sense is that the more this halo of past performance exists, and the longer we have historically low interest rates, the more opportunists will enter the space. If you have any interest in doing a deep dive on an E&P MLP, or a Frac Sand MLPs, that would no doubt be quite interesting reading.
I’m honestly surprised by how few of them have gone bankrupt. And yes performance has been excellent.
I should probably look at ACMP first. I have a feeling that their revenues are proportional to well production. If that’s the case, then their revenues will drop dramatically as shale wells decline. I think most of the shale companies are way too optimistic about EURs.
Linn Energy is a bad MLP. It has been discussed on other blogs.
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