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 Corporation (NYSE:CHK)‘s 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.
The problems with related-party transactions don’t end with Chesapeake Energy Corporation (NYSE:CHK). 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 Inc. (NYSE:SD). 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 Energy Inc. (NYSE:SD). 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 Energy Inc. (NYSE:SD)’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 Energy Inc. (NYSE:SD) in acquiring acreage, which could have a negative effect on SandRidge. Further, SandRidge Energy Inc. (NYSE:SD) 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, Inc. (NYSE:CLR) whose CEO, Harold Hamm, happens to also own a pipeline company. That company, Hiland Partners, is a former affiliate of Continental Resources, Inc. (NYSE:CLR) that was taken public but subsequently bought by Hamm. That history provides important context because earlier this year Continental Resources, Inc. (NYSE:CLR) 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 Resources, Inc. (NYSE:CLR). Other examples include the $23 million purchase of its headquarters building by Continental Resources, Inc. (NYSE:CLR) 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 Resources, Inc. (NYSE:CLR)’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: