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Kinder Morgan (KMI)

In August 2018 we reviewed Kinder Morgan's progress on its turnaround as well as its long-term growth profile. Read the analysis here.

Since 1997, Kinder Morgan (KMI) has spent more than $60 billion building one of North America's largest midstream (gathering, storage, transport, and processing) infrastructures serving the oil & gas industry.
Source: Kinder Morgan Investor Presentation
Kinder's immense footprint means the company is vertically integrated into almost all parts of the North American oil & gas industry, including: 

  • Every major gas and oil shale formation
  • Canada's booming oil industry
  • U.S. liquified natural gas (LNG) export industry
  • The recently revived oil & gas export industry
  • The U.S. petrochemical industry 
  • It's the largest provider of CO2 for enhanced oil recovery in the U.S.

Natural gas pipelines generate 50% of Kinder Morgan's EBITDA, and products pipelines (18% - America’s largest transporter of oil products) and terminals (18% - America’s largest oil and petroleum product storage network) are meaningful operations as well. 

The vast majority of cash Kinder generates is supported by multi-year fee-based customer contracts and therefore is not directly exposed to commodity prices. The company's CO2 segment (12% of EBITDA - used in enhanced oil recovery projects) does have commodity price exposure but is hedged for the year ahead. 

Overall, management estimates that every $1 change in the average crude oil price impacts the company's distributable cash flow (DCF - similar to free cash flow) by just $7 million, or about 0.15% of its total DCF. Kinder Morgan's sensitivity to natural gas prices is even lower. 

Business Analysis

Operators in the midstream industry often enjoy meaningful competitive advantages thanks to three main factors. First, the industry is highly regulated at the state, local, and federal level. In addition, it's extremely costly (up to $6 billion) and time consuming (an average of three years) to receive approval for new pipeline projects. 

Only so many pipelines are needed within a particular geographic area as well, often resulting in a consolidated market. Pipelines also have few substitutes given their safety and cost-efficiency, along with geographical constraints (many oil & gas formations are in hard-to-access areas). 

Add to this the fact that midstream infrastructure runs off a largely tollbooth business model, with many contracts being "take or pay." In other words, companies like Kinder Morgan are entitled to be paid a fixed amount by oil & gas producers for access to their pipeline and storage networks, regardless of energy prices and whether or not they actually ship product (assuming the energy producers are financially healthy enough to honor their contracts). 

This creates a very commodity price insensitive and stable stream of cash flow from which to pay generous and usually secure dividends and distributions (tax-deferred dividends). 

Kinder Morgan was founded by Richard Kinder in 1997 and fit this profile for many years. Mr. Kinder, who owns 11% of the the shares, launched Kinder Morgan with unwanted assets he bought for cheap from the now-infamous Enron. Over the next 18 years, Kinder used a combination of cheap debt, accretive Kinder equity, and the MLP structure he helped pioneer to build a vast continent-spanning energy transportation empire.

However, where Kinder Morgan famously went wrong was in being too aggressive with its growth, both in terms of assets and dividends. Specifically, Kinder became a dividend darling by retaining very little cash flow (it paid out 93% of DCF as dividend) and taking on a lot of debt to grow its asset base as quickly as possible. 

This included a large amount of borrowing in 2014 to fund its $71 billion acquisition of its MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management, and El Paso Energy Partners. That helped drive Kinder's debt to a high of $46 billion, just in time for the worst oil crash in over 50 years to decimate the shale oil industry. 

OPEC (an organization of 14 of the world's major oil-exporting nations who work together to "stabilize" the oil market), wary of U.S. low-cost shale producers stealing market share, threw open the production taps and caused U.S. oil prices to fall from a peak of $107 in mid 2014, to a low of $26 in January of 2016. 

Fears of a slew of bankrupt shale producers defaulting on their contracts with Kinder Morgan caused the credit markets to freeze out the company (and many other highly-leveraged midstream players), triggering a liquidity crisis. 

In late 2015, Kinder Morgan faced an ultimatum from Moody's (MCO), the credit rating agency. The company would either have to cut its dividend, which management had guided for 10% annual growth through 2020, and use the cash flow to pay down debt, or face a credit downgrade to junk status. That would have sent Kinder's future borrowing costs (and its cost of capital) soaring, threatening the economics of its future growth plans. 

So Kinder made the difficult but necessary decision to cut its dividend by 76% in December of 2015, adopt a fully internally-funded business model (which requires no equity growth capital), and focus on deleveraging its bloated balance sheet. 

Since then Kinder has paid down over $6 billion in debt, part of which was from the sale of assets, including:

  • 50% of the southern natural gas system to Southern Company (SO)
  • 50% of the Utopia ethane pipeline to Riverstone Investment Group
  • Selling its remaining 50% position in the Parkway refined products pipeline to Valero Energy (VLO)
  • Entering into a joint venture with Brookfield Asset Management (BAM) to acquire new gas pipelines
  • Apache (APA) was sold an option to buy a 15% stake in a $3.4 billion Permian gas pipeline that Kinder has a 50% stake in

Additionally, Kinder raised $2 billion via the IPO of 30% of Kinder Morgan Canada, which is responsible for the completion of its largest growth project, the $5.7 billion Trans Mountain expansion.

The deleveraging efforts have borne fruit in that Kinder's leverage ratio (debt/adjusted EBITDA) has now fallen to 5.1, with management planning on keeping it at 5.0 or below in the long-term. This is in comparison to the industry average leverage ratio of 6.4, meaning that Kinder's debt is no longer a dangerous albatross that threatens its future.

The company also recently announced it would once again start returning more cash to shareholders, via a 60% dividend increase in 2018, with further plans to raise that dividend by additional 25% increases in 2019 and 2020. In other words, 150% dividend growth over three years. The company also authorized $2 billion in share repurchases.

Kinder's ability to once more be highly generous with its shareholders is largely due to its internally-funded business model, which relies purely on excess DCF that is retained and modest amounts of low-cost debt to fund its $11.8 billion growth backlog. That backlog is expected to boost adjusted EBITDA by more than 20% by the time it's complete in 2020.

Kinder's 2018 capital budget calls for $4.6 billion in DCF, $2.2 billion of which will be spent on growth projects, and $1.6 billion on the larger dividend. The company expects that about $570 million will be left over to be used for further debt reduction, or buying back up to 1.5% of its shares. That could help drive DCF per share growth from its currently projected 2.5% to as high as 4.0%.

The key to Kinder's ability to once more grow its dividend is that it's not so much relying on new cash flow to drive payout growth. Instead, the company's much smaller growth backlog (down about $10 billion since its peak in 2015) means that the company simply has less of a need to spend on growth. That results in plenty of remaining cash flow to fund a safe and fast-growing (for now) dividend.

Of course, the company's lower backlog of projects doesn't mean that Kinder expects to be unable to grow at all. As America's largest midstream company, it is well situated to benefit from the International Energy Agency projections that $700 billion to $900 billion in new midstream infrastructure will be needed by 2040.

This is because, according to the U.S. Energy Information Administration, rising global populations and strong economic growth in emerging markets will create ongoing growth in demand for U.S. oil & gas, with production volumes expected to rise more than 30% through 2046.
Source: Kinder Morgan Investor Presentation
Demand growth is expected to be increasingly serviced by the U.S. shale industry, which rather than being killed by OPEC's price war, was made stronger by it. Sheer necessity forced many of the biggest players to deleverage and cut costs to the bone. That included innovative methods of maximizing oil & gas production at a far lower per unit cost than previously was thought possible, including: 

  • Multiple wells per drill pad (as many as eight wells from one rig)
  • Longer laterals (how far a rig drills), up to three miles 
  • Multiple frac stages per lateral (resulting in higher production)
  • Massive increases in low-cost frac sand (which props open shattered shale and increases production flow), up to 20,000 tons per well

The end result was break-even production prices for U.S. shale falling from $70 to $80 per barrel to as low as $25 to $40. Even at much lower prices, shale producers could still generate very strong internal returns on investment and abundant cash flow. 

Once OPEC partnered with Russia to cut production by 10% through the end of 2018, growing global demand for oil allowed the massive glut to ease and reverse. Global inventories fell back to near historical levels, too. 

Oil prices are now about $60 per barrel, which bodes very well for the future of the U.S. shale industry. In fact, the industry just achieved a new U.S. record for oil production (10.4 million barrels per day). This is expected to keep rising to about 12 million barrels per day and eventually make the U.S. the world largest oil producer, topping even Russia and Saudi Arabia. 

Gas production has benefitted as well from the fracking revolution, especially in low-cost Marcellus and Utica formations of Ohio, Pennsylvania, and West Virginia. Going forward, further technological advancements (internet of things) are expected to allow shale production to achieve even better efficiencies and profitability. 

All of which means that Kinder Morgan appears to have a bright short-term dividend growth future, as well as solid long-term prospects for generous, safe, and steadily-rising payouts. 

However, while the Kinder turnaround has been impressive, keep in mind that there are numerous challenges and risks still facing the industry. 

Key Risks

The same strong regulatory environment that makes the midstream industry lucrative for incumbents can also serve as a major risk to Kinder's growth.

For example, the Trans Mountain expansion, which makes up close to half of the company's growth backlog, has been mired in years of costly litigation and court challenges.

And while the Canadian federal government has officially approved the project, the government of British Columbia is attempting to kill the project at the urging of various environmental and indigenous groups. While still likely to eventually be approved (Canada's prime minister has personally vowed the federal government will do whatever it takes to see it go forward), the project is now officially one year delayed and won't enter service (or start producing cash flow) until 2020.

Then there's the simple fact that Kinder's massive size, while offering many benefits (such as cash flow diversification), is also a determinant. That's because Morningstar estimates that it would require $3 billion to $4 billion in annual growth projects to keep Kinder's cash flow growing at the same rate as smaller rivals.

In other words, Kinder needs a $15 billion to $20 billion growth backlog in order to keep growing its dividend at a fast pace beyond 2020. While the U.S. energy industry is likely to provide many opportunities for adding new projects to Kinder's backlog, it's unlikely that the company can find enough profitable new opportunities to achieve its historical growth rates.

And even if it did, that level of capital spending would almost certainly force Kinder Morgan to once again rely on volatile equity markets to fund much of its growth. As we saw during the oil crash, whether or not midstream cash flows are sensitive to oil prices, share prices certainly can be.

Overly bearish investor sentiment can trap highly leveraged midstream operators like Kinder in a downward spiral as their access to affordable capital becomes restricted. This can create a lack of liquidity which forces management to make painful decisions that can alter a company's growth potential and quickly wipe out what was once a promising long-term dividend growth thesis. 

Finally, we can't forget that the long-term growth thesis for Kinder Morgan relies on the U.S. energy renaissance actually happening, which is far from guaranteed.

First, remember that oil & gas prices are commodities set on largely global markets and driven by both supply and demand. Strong long-term energy prices assume rather steady global economic growth driving greater demand for oil & gas.

However, as the world gradually but steadily moves towards more renewable energy sources, the rate of fossil fuel demand growth could come in far lower than expected. 

For example, analyst firm McKinsey estimates that, though oil & gas will still supply 72% of global energy in 2050 (compared to 84% today), the fast adoption of electric cars (estimated to be 30% by 2030) could cause global oil demand to peak in that year.

In other words, Kinder's long-term growth runway, as well as that of the entire midstream industry, might end up being a decade or two shorter than some investors currently expect. 

No one can accurately forecast how all of these macro variables will play out, especially that far into the future, but it's important to recognize the company's dependence on the U.S. energy renaissance.

Closing Thoughts on Kinder Morgan

Kinder Morgan was a painful lesson for many income investors that even apparently safe blue chip dividends are not guaranteed (Kinder Morgan's Dividend Safety Score was an 8 prior to its dividend cut). Kinder was a company who had enough customers' fates tied to volatile commodity prices and whose weak balance sheet ultimately resulted in a liquidity crisis that forced a massive dividend cut at the end of 2015. 

Fortunately, management appears to have learned its lesson, and Kinder's days of dangerous debt levels appear to be permanently behind it. And while the company's growth backlog isn't ever likely to allow for a return to the strong growth days of the past, Kinder's stable and recurring cash flows mean that the business can still make for a potentially decent higher-yielding dividend growth stock to consider. 

However, before deciding to invest in Kinder, or any midstream stock, investors need to understand the unique risks these operators face (especially those dependent on tapping fickle equity markets for growth capital), and don't forget the painful dividend safety lessons of the most recent (and likely not the last) oil crash. 

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