Chesapeake Energy May Fare Better Keeping Its Pipeline Unit

Chesapeake Energy Corp., which is looking for assets to sell to cut debt and close a funding gap, may want to hold onto its cash-generating pipeline unit, Chesapeake Midstream Partners LP.

Chesapeake, the second-biggest U.S. natural-gas producer, is seeking to sell as much as $20.5 billion assets through next year to fill a cash-flow shortfall. Facing gas prices near a 10-year low and scrutiny of its chief executive officer, the company has said it may sell part of its midstream assets by the end of September to help raise cash.

Billionaire investor Carl Icahn, who helped pressure the board into replacing almost half its members, said in a filing yesterday that he wants to discuss selling the pipelines.

Chesapeake rose 6 percent to $16.52 at the close in New York yesterday.

Selling its stake in Oklahoma City-based Chesapeake Midstream, which was spun off two years ago, may be the wrong move because the pipeline partnership offers a steady source of income, said John Cusick, an analyst with Wunderlich Securities in New York. Chesapeake Energy’s 45.2 percent share of Chesapeake Midstream’s common units is worth about $1.6 billion. It also owns half of Chesapeake Midstream’s general partner.

“It would be in their best interest to try and hold onto those assets if they can,” said Paul Jacob, an analyst with Raymond James & Associates Inc. in Houston. He rates Chesapeake Midstream’s units outperform, meaning investors should buy, and doesn’t own them.

Chesapeake Energy’s biggest shareholder, Southeastern Asset Management Inc., also urged the company in a May 7 letter to shed its pipelines division and other non-core business and concentrate on drilling for oil and gas.

Asset Sales

Chesapeake needs to sell at least $7 billion of its assets by year-end to avoid a credit downgrade, Moody’s Investors Service said May 31.

As a master-limited partnership, Chesapeake Midstream pays most of its cash flow after capital spending to unit holders each quarter, Standard & Poor’s said in a May 16 report.

Chesapeake Energy’s cash flow from the partnership will probably increase if it keeps the pipeline unit, Jacob said. Chesapeake Midstream is structured to pay an increasing dividend to its controlling partners as its profit increases, Jacob said.

Chesapeake Energy stands to gain about $68 million a year from the midstream business’s investor payouts as well as continued sale of assets to the former subsidiary, said Cusick, who has a buy rating on Chesapeake Midstream and doesn’t rate the parent company.

Payments to Rise

Those payments will increase as Chesapeake Midstream grows, making it a good long-term investment for the parent company, Cusick said. Chesapeake Midstream plans to buy $500 million worth of pipelines a year from Chesapeake Energy annually over the next 10 years, according to company presentations.

Icahn and Southeastern Asset Management didn’t specify whether Chesapeake Energy should sell its internally-owned pipelines, or its interest in Chesapeake Midstream.

Chesapeake Energy declined to comment on any potential sales, Jim Gipson, a company spokesman, said in an e-mail.

Chesapeake Energy is responsible for about 75 percent of the pipeline partnership’s revenue, leading S&P to reduce the outlook on Chesapeake Midstream as its parent company’s shares slid 29.7 percent this year.

Chesapeake Midstream has fallen 18.5 percent this year, in part because of its close ties to its parent company. Chesapeake Midstream has 4,000 miles (6,500 kilometers) of pipelines and is one of the largest natural-gas gatherers and processors in the U.S., according to the company website.

Pipeline Independence

The drop in the unit price is because of “overdone fears and under appreciated upsides,” Curt Launer, a New York-based analyst for Deutsche Bank AG, said in a May 17 note.

Chesapeake Midstream CEO Mike Stice has sought to reassure investors by stressing the pipeline company’s independence.

Chesapeake Midstream is trying to reduce the percentage of revenue it gets from the parent company to 50 percent, Stice said in a May 16 meeting with analysts. Its transportation contracts with Chesapeake Energy will produce revenue even if it sells gas fields, Stice said.

Also, any transactions between the pipeline company and the parent company have to be reviewed by a committee of independent directors, Stice said.

Global Infrastructure Partners, a $10 billion private-equity firm, owns the other half of Chesapeake Midstream’s controlling partnership, and brings “rigor” to its finances, Stice said during a May 23 presentation to shareholders. That system prevents Chesapeake Energy from selling assets to Chesapeake Midstream at inflated prices, Stice said.

Small Blocks

If it does decide to sell its units, it would have to do so in “relatively small blocks in order to avoid significant price discounts,” Moody’s said in a May 31 report.

Stice said it would make more sense for Chesapeake Energy to sell all its holdings in Chesapeake Midstream, both the common units and general partner stake, as one package.

Chesapeake Midstream is healthy compared to its peers in the pipeline industry, Cusick said. “Their balance sheet is pretty good and there’s not a lot of debt,” he said.

Chesapeake Midstream’s ratio of debt to equity is 48 percent, the third lowest among its peers, according to data compiled by Bloomberg. Chesapeake Energy is 10 times more likely to default on its debt than Chesapeake Midstream, according to data compiled by Bloomberg.

It’s “smarter to hold on,” Bernard Colson, an analyst with Global Hunter Securities LLC, said of the Chesapeake Energy stake.

Cash Constraints

Other analysts are less enthusiastic about the pipeline company.

“In a company like Chesapeake that’s cash-constrained, what’s the best use of that incremental dollar?” said Bob Brackett, who has an “outperform” rating on Chesapeake and owns none of its stock. “Is it to hold onto Chesapeake Midstream, or is it to use it on something even better?”

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