Kinder Morgan: The sell-off is probably a little overdone

Kinder Morgan does have some problems:

  1. Under its new CEO, Kinder Morgan has been stretching its numbers slightly.
  2. The big drop in oil prices will hurt the CO2 business.
  3. The big drop in commodity prices will lower infrastructure demand in the short term.

However, I think that the 60%+ drop in the share price YTD is a little overdone.  Kinder Morgan’s problems don’t seem that bad compared to other companies.

Capitalized overhead costs (very minor)

In its April 15, 2015 press release (EDGAR), Kinder Morgan changed its policy to include capitalized overhead costs in its project backlog.

“Our current project backlog of expansion and joint venture investments is $18.3 billion. Beginning this quarter, our project backlog includes capitalized overhead (which added approximately $850 million) to more accurately reflect the total investment in our projects.  Without this adjustment, our project backlog decreased by approximately $200 million from the fourth quarter earnings release. Since the fourth quarter earnings release, we have placed nearly $400 million of completed projects into service, removed approximately $900 million in projects (primarily in the CO2 segment as a result of projects being delayed beyond the time horizon of our five-year backlog due to lower commodity prices) and added approximately $1.1 billion driven by new projects. Projects in the backlog have a high certainty of completion and drive future growth at the company across all of our business segments.”
This is more aggressive than their previous practice and boosts their backlog numbers.  This makes it look like Kinder Morgan has been able to identify more opportunities to deploy capital.  Without the inclusion of capitalized overhead, the backlog would have fallen slightly as indicated in the press release.  I would point out that the backlog is highly subjective; including marginal projects would also increase the backlog.

According to the latest investor presentation from Nov. 18 2015 (PDF), the effect of capitalized corporate overhead on the backlog is $1,104M as shown below.

KMI-capitalized-overhead-costs-2

I did not figure out whether or not capitalized overhead costs affect the Distributable Cash Flow (DCF) metric that Kinder Morgan uses.  I don’t think that KMI is trying to inflate its DCF metric by capitalizing more overhead.  The latest 10-Q does not contain the word overhead.  However, it does mention lower capitalized costs:

Our consolidated general and administrative expenses before certain items for the three and nine months ended September 30, 2015 as compared to the respective prior year periods increased $11 million and $33 million, respectively. The quarter over quarter increase was primarily driven by lower capitalized costs partially offset by lower benefit costs. The year over year increase was primarily driven by lower capitalized costs and higher benefit costs, payroll taxes and labor expenses, in part due to the Hiland acquisition, partially offset by lower insurance costs.

So it seems like Kinder Morgan has always been capitalizing overhead costs.  I believe that this would be consistent with US GAAP.  The amount of capitalized costs may have fallen due to reduced expansion capex spending, as alluded to on the Q3 2015 conference call:

We’ve got lower volumes from some of our product assets. And we’ve got lower capitalized overhead as a result of reduced expansion CapEx.

Lower capitalized costs would generally deflate earnings as well as DCF.

Where DCF is a bad metric

In my opinion, DCF is not a very good metric for Jones Act shipping, gathering networks, and oil production.  As mentioned in one of my earliest posts on Kinder Morgan (“When free cash flow isn’t a good metric”), not all businesses have cash flows that will last as long as that of a pipeline (the non-gathering kind of pipeline).

Gathering networks

The economics of a gathering network are somewhat messy:

  1. The contracts have a huge impact on the cash flows.  Right now, minimum volume commitments are especially relevant given that many E&Ps are trying to cut back on production given the crash in commodity prices.  Minimum volume commitments essentially cushion some of the downside for the gathering network operator.
  2. The existing pipeline’s cash flow will likely be linked to the decline curve of the attached well(s).  New shale gas wells often have decline rates of 30-70% in the first year.  Over time, that decline rate will decelerate to somewhere in the range of 5-20%.  In either case, the decline rates are fairly significant.
  3. A lot of the upside in gathering networks depends on expansions of the network.  This is linked to overall production and the amount of new production added in a given play.

Given low commodity prices, it is very likely that gathering pipelines will see their cash flows decline going forward.  Compared to pipelines, gathering networks have quirky cash flows, shorter lives, and more volatility.

Jones Act shipping

In general, the economics of shipping tends to be dominated by shipping rates and boom/bust cycles.  We are probably at the boom part of the cycle and should see a bust cycle come sooner or later.  Shipping rates may be dramatically lower when Kinder Morgan’s contracts end.  In my opinion, this is not a good business to get into because it is difficult to generate value by operating the ships more efficiently than somebody else.

Compared to pipelines, Jones Act ships have shorter lives and more volatility in their cash flows.

Oil production + CO2

The CO2 segment basically involves transporting carbon dioxide over fairly large distances, where it is injected into old oil fields to squeeze what’s left out of the old mega-fields.  Kinder Morgan owns some of the oil fields attached to its CO2 transportation pipelines.

I really liked Kinder Morgan’s E&P business.  If it were a standalone business, it likely would have been the only E&P stock in my portfolio.  (Note that I generally dislike E&Ps and shorted a number of them in 2014.)  Unfortunately, low oil prices have destroyed the economics of this business.  Once the hedges roll off, the cash flow from this segment will drop a lot.  Management has indicated that they are cancelling/mothballing projects from this segment.

Compared to pipelines, oil producing assets have much shorter lives and more volatility.

My opinion on management

The move into Jones Act shipping is something I’m not a fan of.  My hunch is that Steven Kean isn’t quite as brilliant as Richard Kinder.

The current structure of Kinder Morgan incentivizes them to grow.  As a corporation, Kinder Morgan can only defer its taxes by spending a lot of money on new investments that generate tax-deductible depreciation expenses quickly.  This may push management into entering new areas that they don’t necessarily understand very well.

The other problem is that Kinder Morgan’s size will become more and more of an anchor on performance.  Because their size prevents them from putting all of their money into their best ideas, they increasingly have to chase more marginal projects.

The effect of the oil price crash on KMI’s CO2 business

The KMI investor presentations don’t really explain how much the drop in oil prices has affected their business.  Right now, hedges are propping up the operating performance of the oil production segment.  The presentations don’t state what the business would have earned without the hedges.  Once the hedges fall off, the CO2 segment will generate a lot less cash.

The 10-Q has “EBDA” metrics that give a pretty good idea of what the CO2 segment would have earned without impairments and without hedging.  The table in the 10-Q adjusts for certain items, which mainly consist of the impairment charges and hedging gains realized as revenue.

KMI-CO2-EBDA

After the adjustments, we can see that EBDA has fallen 22.3% quarter-over-quarter.  This is much less than the drop in oil and NGL prices.  (NGL prices have dropped a lot more than oil prices.  Recall one of my earlier posts on the glut of wet gas.)  I believe the reason for this is because Kinder Morgan sells a lot of CO2 via contracts, so that income stream is somewhat insulated against drops in commodity prices.

A small issue I have with KMI’s 10-Qs and 10-Ks

They ‘hide’ the gathering pipeline businesses inside the pipeline businesses, even though the gathering pipelines have very different economics.

They ‘hide’ the Jones Act shipping stuff in terminals, even though the economics of the ships are quite different from terminals.

Infrastructure demand

In the short term, a lot of E&Ps are cutting back on new production due to:

  1. The crash in commodity prices, especially in natural gas liquids.  I believe that there were some cases where E&Ps had to essentially pay money to get rid of their NGLs.
  2. Less access to capital markets.  I’m surprised that people still give money to E&Ps.

Less production means lower demand for infrastructure like gathering networks, wet gas processing plants, pipelines for the various products, etc. etc.

I feel like the current situation won’t persist.  My guess is that:

  1. Hydrocarbon production in the US will grow over the next decade, as long as technology continues to improve.  This is partially dependent on investors continuing to fund oil production via debt and equity.
  2. The US will build more infrastructure transporting processed products from areas of low demand to areas of much higher demand (e.g. Mexico, LNG export, etc.).
  3. Areas of higher demand will see prices plunge.
  4. Hydrocarbon prices will stay low.
  5. Oil sands operations will be in serious trouble as they may all have negative cash flow.  I should do more research on shorting oil sands miners and other oil sands producers.
  6. Infrastructure associated with oil sands (e.g. Kinder Morgan Canada) will not be as profitable as other midstream infrastructure.

In general, most areas of the US will see more infrastructure demand while some areas (e.g. infrastructure related to oil sands, Gulf of Mexico) will see demand fall dramatically.  As long as investors don’t flood the infrastructure space, Kinder Morgan should be able to generate healthy returns on capital.

What happens if KMI’s counterparties go bankrupt?

My guess is that contracts would likely stay in place; KMI’s cash flows would be unaffected.  (*I am ignoring the hedging contracts as well as the derivatives with financial institutions because there isn’t much concern over those counterparties.  The weakest financial institution is Macquarie with a BBB rating.)

A SEC filing from ATPAQ (which declared bankruptcy around 2012) seems to show that many contracts were transferred to the new owners of the assets.  Exhibit 10.1 mentions Larose, which is a gas processing plant that WPZ has a stake in.  I did not read through the hundreds of pages in that SEC exhibit so I could be wrong about contracts not being broken by bankruptcy.

Cutting the dividend

Paying out the dividend was an artifact from the KMI/KMR/KMP/EPB merger.  In general, it doesn’t make too much sense to unraise capital via dividends and then pay underwriting fees to raise capital.  The dividend existed to appease retail investors who can’t see past a dividend yield.  I suppose that it will still exist to appease investors who can’t see past a yield… and also because Richard Kinder collects no salary and needs money to fuel his philanthropy, token/symbolic purchases of KMI stock, etc. etc.

Retaining the dividend should help the value of the warrants slightly.  In the past several months, KMI repurchased a very small amount of its warrants.  (Actually, I wasn’t sure if this was a great move because it may have been a better idea to invest that money into new projects.)

KMI’s cash flow should be fairly stable

Maybe I’m crazy here, but I don’t think management is lying when they point out that most of their rates are locked in via contracts.  If so, this is a chance to buy one of the best-managed midstream companies at a good valuation.

*Disclosure: Long KMI warrants.  I’m not sure what the best way to play KMI is (stock, options, out-of-the-money $40 strike price warrants, bonds, mandatory convertible preferred, etc.).  Do your own research, long or short.

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3 thoughts on “Kinder Morgan: The sell-off is probably a little overdone

  1. Glenn, I appreciate your thoughts. Although, I am a bit surprised to see that you bought the warrants. Given that they are substantially out of the money at this point and only have about 18 months till expiration, I am not sure KMI gets back above 40 before then. Why not just buy the stock or a long dated call spread? Or just LEAPS. I believe 18s are already listed.

    • I’m gonna be honest with you. I did not put in the work to figure out the best part of the capital structure. Sometimes when I say that you should do your own homework… I’m really not kidding.

      It’s a small position.

      And for some reason I don’t like the idea of paying US withholding tax. I do agree with you that the warrants will likely expire worthless.

  2. Pingback: Sentieo: a better way to perform due diligence | Glenn Chan's Random Notes on Investing

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