What Kinder's Earnings Mean For Midstream

As is the case every three months,
Kinder Morgan
(KMI) has kicked off earnings reporting season for the US energy midstream sector. The most noteworthy takeaway: No real surprises.

The $2 billion Elba Island liquefied natural gas export facility did not open before June 30. That arguably held back the bottom line, as distributable cash flow inched up just 1 percent. But distribution coverage was still 2-to-1 after the 25 percent payout increase in April, with debt-to-EBITDA on budget at 4.6 times. That keeps the company squarely on target for next year’s planned 25 percent dividend boost.  

Natural gas pipelines contributed 58 percent of Kinder’s second quarter earnings before depreciation and amortization, or EBDA. They’re also 80 percent of the company’s $5.7 billion targeted capital projects. Second quarter division EBDA increased by 7 percent and growth will accelerate in the second half of the year, as Elba Island and the ahead of schedule Gulf Coast Express Pipeline Project enter service.

By October 2020, Kinder will open a second major natural gas pipeline out of west Texas, the Permian Highway Pipeline. That project is already fully contracted, permitted and financed and will immediately boost distributable cash flow when it enters operations.

The company is also building out substantial new gas transport capacity in the Bakken that will enter service in November. And it’s announced a third Permian pipeline, as well as a new agreement to bring more natural gas to supply constrained utility
Consolidated Edison
(ED) by November 2023.

In contrast, Kinder’s commodity price-sensitive CO2 unit shrank below 10 percent of EBDA in the second quarter. That’s fast reducing what has at times been a source of earnings volatility.

The company’s Products Pipelines and Terminals divisions are producing steady results, as asset optimization and expansion efforts continue. The terminals division has now mostly transitioned to liquids from bulk goods, another step reducing past years’ ups and downs.

Kinder’s results confirm the recovery strategy in place since late 2015 is still very much on track. Selling the CO2 division and/or the remaining Canada assets at good prices could speed progress in reducing debt, and tilt the revenue mix further towards natural gas.

But even without these moves, the company is in great shape to grow its 40 percent market share of US gas transmission. That’s even as management projects a 30 percent lift in US demand by 2030,” driven by coal-to-gas switching in electricity, industrial growth and exports through LNG and Mexico pipelines.

We expect Kinder to deliver sustainable annual dividend growth of mid-to-upper single digits starting in 2021. That adds up to an exceptionally solid value proposition, especially since management’s plans are largely internally financed. The shares are a buy whenever they trade under 22.

Self-funding remains a key goal for other US midstream companies as well, whether organized as master limited partnerships or corporations as Kinder is. For the healthy like Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP), this means restrained dividend growth. For companies struggling to cover distributions and burdened with hefty debt loads, it means elevated risk to dividends.

Even after dozens of US energy sector payout cuts, more than a few companies are still in danger, especially many yielding 8 percent or more. There are some real values, including some paying north of 10 percent. But you’ve got to distinguish them from the value traps.

We closely scrutinize high yielding energy companies on several criteria. Necessary strengths include strong and most importantly rising distribution coverage, consistent progress reducing debt leverage, ability to self finance the bulk of capital expenditures and limited refinancing needs for the next 24 months. We also look for ownership structure that discourages disruptive changes, like “roll-up mergers” by general partners and conversions from MLPs to corporations.

We won’t go near a company or MLP that doesn’t stack up, no matter how attractive its yield looks. Fortunately, nearly five years after oil prices first broke under $100 a barrel, a growing number are thriving in the “lower for longer” price environment we forecast back in 2014.

Midstream businesses in general aren’t directly exposed to price swings in oil and gas. But such moves can greatly affect midstream volumes. And even companies that earn capacity payments can take hits, if enough of their primary customers can no longer afford their contracts.

Even more devastating to many midstream companies is the way capital markets have shunned them. Even the strongest companies have been challenged in recent years to fund expansion by issuing new debt and/or equity. That’s even when proposed new assets are fully contracted in advance and future revenue is assured. The weakest companies have come under extreme pressure even to refinance existing debt.

Capital markets are still largely hostile, demonstrated by the Alerian MLP Infrastructure Index’s current value of less than half its September 2014 high point. That’s why some degree of self-funding remains key for midstream companies to convert new projects into higher revenue.

A lofty first quarter coverage ratio indicates a large degree of self-funding. Therefore, it’s the best forecaster of new projects adding to revenues, and by extension strong second quarter coverage.

As for operations, still wide price differentials between regions continue to augur well for companies tapped into investments in takeaway capacity. That definitely includes Texas, where oil prices on the Gulf Coast were recently as much as $10 a barrel higher than Midland, Texas.

On the other hand, Kinder’s second quarter results at its Products Pipelines and Terminals while solid also indicate general softness in this area of midstream. Of particular concern is the effect on the storage sector of backwardation and regional supply interruptions, such as Venezuela’s impact on Caribbean facilities.

Bottom line is wise selection has rarely been more important in discerning midstream values. But if you’re willing to look for the growing number of companies that have adapted to the high demand/low price environment, the future is bright and the stocks are cheap. It’s time to buy.