The recent weakness and volatility in oil prices has materially impacted the global economy as worldwide lockdowns and other containment measures – in response to the Covid-19 pandemic – caused a sudden, substantial decline in oil demand. Consequently, the share prices of most oil companies collapsed as oil prices dropped sharply.
Kinder Morgan, one of the largest energy infrastructure companies in the US, also fell victim to the share price rout despite the company’s stable, fee-based income that is not directly affected by oil price moves. We discuss whether their midstream infrastructure will remain impervious to the effects of the current energy market distress.
A market in (turm)oil
The global oil market has been in a state of oversupply for the last few years as many oil producing countries increased their respective production levels to offset the lower prices – with Russia and the US focussed on growing their market shares. In 2019, the OPEC grouping of oil producing countries implemented voluntary production cuts to reduce the supply of oil and invited non-OPEC countries like Russia to do the same. However, in February 2020 (as OPEC and Russia tried to negotiate a production cut due to concerns that Covid-19 would massively reduce oil demand) Russia walked away from negotiations and Saudi Arabia responded by increasing supply and undercutting oil prices by $6-8 per barrel.
Excess oil production continued despite global lockdowns and a concomitant demand collapse and, while Russia and Saudi Arabia then agreed to further supply cuts, prices had already plummeted 60% from the February 2020 levels.
The US oil price futures contracts require the physical delivery of oil to settle each contract. In April 2020, US oil storage facilities were full, with a record-setting 160 million surplus barrels of oil stored on tankers at sea1.
Normally, futures contracts would be rolled over to the following month without physical settlement taking place. However, the market turmoil with the US in lockdown and little visibility on oil demand recovery, prompted oil traders to view the May contract as untouchable. With no one willing or able to accept deliveries and storage filled to capacity for the first time in history, producers were willing to pay buyers to take oil off their hands. This resulted in oil prices sinking to below zero, with May futures for West Texas Intermediate (WTI) oil closing at -$37.63 on 20 April 2020.
Kinder Morgan hitches a price-ride
Oil prices have somewhat recovered, and the chart below highlights the contiguous performance of US oil prices alongside Kinder Morgan’s share price since the start of the year. Evidently, Kinder Morgan’s share price has declined in lockstep with the oil price and, at mid-June, both were trading close to 20% lower than the January 2020 levels.
Unparalleled asset footprint
Kinder Morgan is a ‘midstream’ energy company – a term used to describe one of the three major stages of the oil and gas industry. Midstream activities include the processing, storing, transporting and marketing of oil and natural gas. Upstream (raw crude oil and natural gas exploration and production) and downstream (refining crude oil into gasoline, diesel and other fuels) are the two other stages.
The company operates across five divisions including the transportation of natural gas and crude oil, as well as the storage of refined energy products and carbon dioxide. Assets are dominated by the vast network of pipelines used to transport natural gas from various production and processing facilities to customers across the US – accounting for 60% of profits. Their considerable pipeline network spans almost 113 000 kms, moving approximately 40% of the natural gas consumption of the US, further augmented by over 4 800 kms of crude oil pipelines, 147 terminals and 16 product tankers (illustrated below).
In 2015, natural gas surpassed coal as the largest consumed fuel source for electricity generation in the US, becoming the fuel of choice to drive the US economy (left chart below). Kinder Morgan remains well-placed to continue to benefit from the increasing domestic consumption of natural gas in the US.
Earnings stability amid pandemic-induced volatility
Kinder Morgan uses its unparalleled $73 billion asset base to generate fee-based revenues, with over 90% of the company’s revenue linked to take-or-pay contracts or fixed-fee revenues based on volumes moved through the vast pipeline infrastructure. Take-or-pay contracts entitle the business to receive payments regardless of throughput or utilisation of the company’s assets by its customers, therefore ensuring a high degree of certainty and revenue stability. Their asset base shares some of the desirable characteristics of a “toll bridge-like business” in that:
• the vast infrastructure of pipelines that span the breadth of the US is not easily replicable, ensuring a monopoly position;
• the company earns a reliable and predictable revenue stream from the use of its infrastructure that offers long-term earnings visibility; and
• the business model is uncomplicated and relatively easy to manage.
Kinder Morgan’s customers are primarily the end-users of the products transported and handled by the pipeline infrastructure. Typically, they include large integrated state utility companies such as oil refineries and other industrial users, many of which are substantial businesses with strong balance sheets and excellent credit ratings. Consequently, the business’s quarterly profits have remained stable over the last 21 quarters.
The right chart below depicts Kinder Morgan’s quarterly adjusted earnings (EBITDA) together with the US oil price. In 2018, oil prices dropped by approximately $25, yet operating earnings only declined by $15 million, which is less than 1% over the period. The company has consistently generated more than $1.7 billion in operating earnings over the last five years despite periods of significant oil price volatility and weakness.
Covid-19 impact expected to be less severe
The Covid-19 pandemic has had a profound impact on the US economy, which ground to a halt as many states implemented lockdown measures to slow the spread of the virus. Energy demand declined significantly, forcing Kinder Morgan to assess the likely impact of the pandemic on the business.
Notwithstanding a $40 per barrel decline in US oil prices since the start of 2020, the company is only expecting an 8% decline in earnings and cashflow for the 2020 financial year. In addition, the business announced that it will be increasing its dividends by 5% in 2020, from the 2019 level of $1 per share. This is a positive indication of the company’s highly resilient earnings amid unprecedented volatility and weakness in energy prices, particularly at a time when many energy companies are cutting or suspending dividend payments.
Prepared to weather the storm
The economic impact of Covid-19 is still evolving and it is, therefore, too early to distinguish genuine value opportunities from potential value traps among the energy companies. Those such as Kinder Morgan that are structurally sound, with stable cash flows, manageable balance sheet debt and disciplined management, are likely to weather the storm.
1 According to Reuters