Update: MLPs Getting Hit And Chesapeake's Worst Divestiture To Date

by: Josh Young

As I wrote last week, MLPs have significant exposure to interest rate movements, as they are exposed both at a fundamental level (cost to borrow to fund projects) as well as on a securities level (the spread of their distribution yield vs. the 30-year interest rate). Interest rates moved significantly a few weeks ago when the Fed first indicated that it might start cutting back on bond buying, which is being called "tapering." And future movement seems possible if the Fed does follow through, despite continued weak economic performance.

I pointed out a couple of securities with particular exposure to interest rate movements, due to their low yields and their dependence on debt and equity issuance to fund growth. These companies are Kinder Morgan (NYSE:KMI) and Enterprise Partners (NYSE:EPD). I still think that, in the medium term, these securities are particularly vulnerable to higher interest rates.

However, I missed the more obvious idea. Linn Energy (LINE) has been under public scrutiny by investors such as HedgeEye, and has been criticized in two articles in Barron's. Linn has a similar dynamic to Kinder Morgan and Enterprise, although its yield is significantly higher. However, the attention from Barron's and HedgeEye plus the announcement of a review by the SEC of certain non-GAAP accounting practices by Linn have caused the stock to drop precipitously.

Other "upstream" MLPs like BreightBurn (BBEP) and LRR Energy (NYSE:LRE) traded down in sympathy, particularly after HedgeEye came out and called BreightBurn a "mini-Linn" due to high priced natural gas hedges that will roll off in the next few years. I still think that GPs of pipeline MLPs like KMI are the most exposed to interest rate movements, but obviously they were not the first to fall. There is a valuation argument to be made but I won't make it here, other than to say that a 4% yield from a levered equity is probably insufficient in a rising 3.5% 30-year interest rate environment.

I also mentioned a potential energy investment well positioned for rising interest rates, Gastar Exploration (NYSEMKT:GST). Gastar recently completed the second part of one of the best acquisitions in the energy space in 2013. Gastar bought an asset for $74 million and re-sold half of the asset, the part that it didn't even really want, for $74 million. The implied value of the part Gastar kept is over $74 million, which means Gastar more than doubled its investment in a three-month period. This is significant for a company with a ~$180 million market cap, and is likely not priced into the stock yet.

The flip side to that is that some company sold Gastar that asset. That company is Chesapeake Energy (NYSE:CHK). Chesapeake has been divesting assets aggressively, and in this case it appears they dropped the ball. They could potentially have discovered the value of their assets prior to agreeing to the divestiture to Gastar. And it looks as if they could have sold the asset for twice what they sold it for with some more work and perhaps waiting a few months. This is bad news for investors in Chesapeake, as the company has been relying on divestitures to "unlock value."

There is a lot of embedded value in Chesapeake, as the company has exposure to numerous shale gas and oil plays, but management may have to do better than they did with the Gastar deal to unlock it. More recent deals, such as the one announced the other day with Exco Resources (NYSE:XCO), looks more favorable for Chesapeake than the Gastar deal.

Disclosure: I am long GST. I may buy or sell any security mentioned without further notice. 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.