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1 Hidden Risk Energy Investors Must Watch Very Closely

As an investor you're likely keenly aware of the fact that plunking down your hard-earned money for a sliver of ownership in a company involves risk. The amount you're investing for your share of the company could decrease in value significantly, and a worst case scenario could lead to your investment becoming worthless. That's why it's so important to consider what could go wrong ahead of time so you have an idea of what to watch out for as you hold your position.

That's why I love the quote by Carl Richards in which he reminds us that "[risk] is what's left over when you think you've thought of everything else." All too often we only look at what could go right and typically don't dig too deeply into what could go wrong. Instead of being reminded that the real risk is something we are not considering, all too often we are blindsided by a risk that was hiding in plain sight.

If you are like most investors, you have some sort of energy exposure in your portfolio. You're well aware that oil and gas prices are volatile -- I think most of us would label that as risk No. 1 when investing in an energy company. When listing what might go wrong you've likely thought about the environmental risks or the geopolitical risks, but I'd be willing to bet that few investors have ever considered the role that related party transactions can play in poor investment returns.

Sure, we probably all know the story of Chesapeake Energy's (NYSE: CHK  ) former CEO Aubrey McClendon. From the Founder's Well Program to a sale of an antique map collection, there were several instances where the company was engaged in questionable, related-party transactions with its CEO. Yet, if natural gas prices had never collapsed then none of these questionable activities would likely have mattered to investors. Unfortunately, the risk that was missed is that McClendon's attention was not always on the company; in hindsight investors might have realized that all these related-party transactions might not have been in the best interests of all stakeholders.

Source: Chesapeake Energy

The problems with related-party transactions don't end with Chesapeake. Another one of its co-founders, Tom Ward, has more recently been questioned by investors for his dealings with the company he now leads: SandRidge Energy (UNKNOWN: SD.DL  ) . At the behest of activist investors, the company has hired an independent firm to review an assortment of related-party transactions between Ward, his family, and SandRidge. If the newly expanded board doesn't like what it finds, Ward could be removed as CEO at the end of next month.

One of the major issues that activist investors have with SandRidge, other than poor stock performance, is that Ward's family owns 475,000 acres in the Mississippian adjacent to SandRidge's acreage. For perspective, that makes it one of the five top acreage holders in the play. The concern is that this company could be front-running SandRidge in acquiring acreage, which could have a negative effect on SandRidge. Further, SandRidge could decide not to develop some of its acreage, let it's leases expire, only to have Ward's company pick that acreage up. Because he has inside knowledge, this is an apparent conflict of interest. 

Stories like these don't end there. The drilling boom has created a lot of wealth for the founders of oil and gas companies which they've used to diversify into separate entities. Another example of this is found at Continental Resources (NYSE: CLR  ) whose CEO, Harold Hamm, happens to also own a pipeline company. That company, Hiland Partners, is a former affiliate of Continental that was taken public but subsequently bought by Hamm. That history provides important context because earlier this year Continental signed a $95.8 million deal for pipeline capacity on an unnamed and unbuilt oil pipeline with Hiland. While the deal was fully vetted to avoid conflict of interests, it is one of many recent related-party transaction between Hamm and Continental. Other examples include the $23 million purchase of its headquarters building by Continental and the acquisition $340 million in oil and gas assets from a company owned by Hamm and Continental's vice chairman.

Now it should be noted that Hamm owns 68% of Continental's outstanding shares so his interests appear to be well-aligned with outside investors. Though, I will point out that both Ward and McClendon owned big stakes in their respective companies as well. The reason investors have an issue with the dealings of Ward and McClendon can best be explained by the following chart:

CHK Chart

CHK data by YCharts

When things are good no one really cares what goes on. It's when things turn south that other risks such as questionable related-party transactions are brought to light and compound the problems. While low natural gas prices exposed the debt issues at SandRidge and Chesapeake, the media attention surrounding the related-party transactions has kept the lid on the shares of both companies. It can take the market a long time to get past these practices after they've been questioned.

In closing, I want to draw your attention to one last related-party relationship that you should watch. In this case its not repeated transaction with a founder but with another company. As an example, liquids-focused driller Gulfport Energy (NASDAQ: GPOR  ) has a very close relationship with Wexford Capital and if you read through Gulfport's last two annual reports you'll see a lot of activity between the two. In fact, virtually every deal Gulfport has been involved in was with an affiliate of Wexford. In one example, the company's 2012 annual report states:

We, through our wholly owned subsidiary Grizzly Holdings, own a 24.9% interest in Grizzly. The remaining interest in Grizzly is owned by Grizzly Oils Sands, an entity owned by certain investment funds managed by Wexford Capital LP, or Wexford. An affiliate of Wexford owned approximately 13.3% of our outstanding common stock as of December 5, 2011, and approximately 9.5% as of March 13, 2012, which ownership was reduced to less than 1% as of September 28, 2012.

You'll see similar disclosures in almost every transaction Gulfport completes. This was most recently seen when Gulfport acquired 22,000 acres in the Utica from an affiliate of Wexford for $220 million, or $10,000 an acre. While the Utica still appears to be a great play and Gulfport's acreage is in the sweet spot, it paid a lot of money for those acres. This is a story that could go either way, if the Utica turns out to be as good as or better than Gulfport expects then the relationship with Wexford will have turned out to be a tremendous asset. However, if Gulfport starts to perform poorly, investors could begin to question these deals.

That's why as an investor you have a tough choice to make. You can see these related-party relationships as something to avoid as it adds another layer of risk. On the other hand, these relationships could turn out to be very beneficial as the related parties tend to have a significant vested interest in the company's success. That's why I'd encourage you to dig a bit deeper into an independent oil and gas company before you buy to make sure you are comfortable with any related-party relationships before you've invested your hard-earned money.

The final report on the related-party dealings by SandRidge CEO Tom Ward are likely to be the big story at the company in the month ahead. The clouds surrounding the company have really kept the stock depressed even as SandRidge has built up quite a compelling position in the Mississippian, which has its future looking optimistic. If you'd like to learn more about the future of this emerging oil and gas junior and follow the news surrounding the board's findings, then check out The Motley Fool's premium research report detailing SandRidge's game plan and what to expect from the company going forward. To get started, simply click here now!

Read/Post Comments (4) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 22, 2013, at 10:59 PM, nicholasblack wrote:

    I hate to bang on about this but you have it all wrong about $CHK... I'm almost completely convinced by this analysis:

  • Report this Comment On May 23, 2013, at 10:06 AM, billmitts wrote:

    If SD decides to let leases expire why should Ward let someone else pick them up if he can, if SD has no interest there can be no conflict just sour grapes. I would expect Ward to cure any conflicts with his leases to SD and get his $90 mil severance then start another E&P just like McClendon.

  • Report this Comment On May 24, 2013, at 11:24 AM, navydog11 wrote:

    Well researched. Well written. Thank you Matt.

  • Report this Comment On May 28, 2013, at 3:19 PM, slimback wrote:

    Matt, Thanks for researching the underbelly of these high flying companies. I believe some of these companies are not only using off book accounting but trans-company asset valuation schemes.

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