Tuesday, March 6, 2012

Chesapeake and KKR to Invest in Royalties

Chesapeake Energy and KKR announced this morning that they have created a joint venture to invest in royalties and overriding interests in "key oil and gas basins in the United States."  The partnership will be staked with $250 million:  Chesapeake will provide 10% of the cash but getting a promoted interest to boost its ownership in the entity.

This is an interesting deal for a number of reasons.  For Chesapeake, buying up royalty interests is a natural extension of the company's land deal making machine.  The company is based around a land acquisition strategy, which comes from the top, as CEO Aubrey McClendon started off in the energy business as a landman.  Given the company's cash crunch and the lack of a big catch on the horizon (at least publicly) and the need to be more fiscally conservative, the land team needs to be kept busy.

Economically, it should be a good deal for Chesapeake.  Royalties - assuming they are paying - are a good long-term money maker.  But the the deal doesn't help the company's current cash flow problem.  Compared to its other multi-billion dollar deals and its multi-billion dollar funding gap, this deal is lose change, especially in the short run.  Expect more big "monetization" announcements in the coming months.

For KKR, it looks like a good deal, as it has staked probably the best land gobbling machine in the industry.  Interestingly, an investment in royalties implies a long-term commitment when private equity is a notoriously short to mid-term, asset-based business.  Owning royalties is a round peg in a square hole business.  I'm assuming they will package the interests together and sell them off as an entity once gas prices turn around.  If they don't sell right away, once the royalties start paying consistently, they should be able to leverage the entity and get back a good bit or all of the original equity investment, making the deal relatively risk free at that point.

But the deal also shows an important aspect of private equity, namely buying out of favor assets when they are cheap.  This is a great time to be buying natural gas assets.  It is unlikely we will see $10/MMBtu natural gas in the next 10 years, but with new demand drivers coming into view and the relative consistency of shale gas formations, we will see a recovery in prices to make drilling economic again.  At that point, people are going to want gas assets, and KKR will have some to sell.

Lastly it also shows who has the money right now.  Private equity is making a bunch of investments in natural gas these days, including Apollo's $7.15 billion acquisition of El Paso's E&P business, Blackstone's $2 billion investment in Cheniere Energy's new liquefaction plant and KKR's $7.2 billion acquisition of Samson.  I imagine we will see a number of other PE/natural gas deals in coming months.

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