By Justin Carlson and Matthew Lewis, CFA
Fears of a potential bankruptcy for Chesapeake Energy (NYSE:CHK) has the market scrambling to analyze risk tied to their midstream counterparties. Several news articles have been recently written which paint counterparty exposure broadly, describing any company with contractual ties as being "at risk". In bankruptcy, debtors and trustees are authorized to reject executory contracts that are burdensome and retain contracts that are beneficial. And while we are not bankruptcy experts, we believe this risk can be measured by deeply understanding the midstream assets and markets they serve. In our previous article we quantified Williams Pipeline Partners (NYSE:WPZ) exposure to Chesapeake by lowering rates to current market and eliminating minimum volume commitments on gathering contracts in the Eagle Ford and Barnett. For our sixth article in our "What Lies Beneath" series we analyze risk to existing natural gas interstate pipeline contracts with Chesapeake.
The Federal Energy Regulatory Commission (FERC) requires interstate pipelines to file data for every natural gas transportation contract they hold. Utilizing this publicly available dataset, we pulled every interstate pipeline contract that lists Chesapeake as the counterparty (Figure 1). From the data listed below, revenue exposure to Chesapeake is approximately $600 million/year. But not all of these contracts have the same level of risk. Understanding natural gas price spreads, production data, commodity flows, and transport rates are imperative for assessing the future of these contracts in a reorganization scenario. Through our analysis, we assigned each pipeline contract with a level of counterparty risk. The higher risk contracts are those which we believe are burdensome for Chesapeake, while the lower risk contracts are beneficial. For illustrative purposes we will show our analysis on the two high dollar contracts highlighted below.
Spectra Energy's Texas Eastern Pipeline
Spectra's (NYSE:SEP) Texas Eastern Pipeline has two contracts with Chesapeake, both of which we categorize as "low risk" in a reorganization scenario. The larger of the two contracts is from a 2013 system expansion which opened 800,000 Dth/d of additional pipeline capacity into Manhattan (Figure 2). The contract contains ship-or-pay provisions and has a rate of ~$0.52 which expires in late 2033, giving it an undiscounted value of approximately $1.35 billion.
In analyzing this contract, it is important to note that despite the large supply of natural gas in the Northeast, many urban markets are still constrained due to lack of pipeline capacity. Local regulators, landowners, and special interest groups have and continue to make it extremely difficult to build new pipelines or expand existing ones in certain areas of the Northeast. Basic economics teaches us that less pipeline capacity leads to less gas supply which leads to higher prices, particularly in winter months where heating demand is high. The higher winter prices are beneficial to producers like Chesapeake who have the ability to ship into these constrained markets and sell their natural gas for a premium. Figure 3 shows the natural gas prices the past four winters at the Transco Zone 6 New York hub, a good proxy for the New York City market.
As the figure shows, natural gas prices blow out in the winter. The polar vortex in early 2014 sent prices skyrocketing to over $100/MMbtu on some days. Even this winter, one of the warmest in Northeast history, has seen pricing premiums over most markets. Chesapeake is unlikely to renegotiate or let go of this contract in reorganization because it is too valuable. Even in the event they did break the contract, there would likely be other parties lining up to take the capacity. Hence, the counterparty risk here is low.
Energy Transfer's Tiger Pipeline
On the other side of the spectrum is the contract between Chesapeake and Energy Transfer's (NYSE:ETP) Tiger Pipeline (Figure 4). Tiger was built in 2010 during the initial boom of shale production and was designed as a supply push pipeline to move natural gas from the Haynesville Shale in Louisiana to the east. The contract is ship-or-pay, has a rate of ~$0.32, and expires at the end of 2025, giving it an undiscounted present value of approximately $1.15 billion.
Unfortunately for Tiger, shale economics shifted drastically after the pipeline was built. The discovery of the Marcellus/Utica, shifts to more liquid rich basins, and lower commodity prices made drilling in the Haynesville much less competitive. As drilling declined and spreads changed, Chesapeake slowed drilling and shifted some of their shipments elsewhere. Using pipeline flow data, we estimate that Chesapeake is only utilizing half of their contracted capacity on Tiger (Figure 5). However, since the contract is ship-or-pay, Chesapeake is paying for the full capacity regardless of their deficient volumes. Given that they are significantly underutilizing their capacity, the risk of this contract being deemed burdensome and renegotiated is high. Additionally, it is unlikely the capacity would be picked up by another party given current economics. As such, the counterparty risk tied to this contract is high.
Unfortunately for the midstream sector, the counterparty risk does not end with interstate gas pipelines. Chesapeake also has substantial long-term agreements in place for gathering, processing, and other pipeline transport (liquids and gas intrastate). The large gathering contracts with Williams have been well documented, but other companies like Kinder Morgan (NYSE:KMI), MPLX (NYSE:MPLX), and Enterprise (NYSE:EPD) also have counterparty risk in these areas. Although contractual information is not as transparent in these areas, deep analysis using production, processing, and asset level data can still help quantify the risk.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.