Why We Love This Guy Named Rich
The collapse of oil prices was clearly the biggest surprise to commodity and financial markets in 2014. Few people could believe that just last summer black gold reached its peak at $107 before plummeting to $44 in January. Despite oil’s recent recovery to around $55, market participants who invested in energy stocks still have tremendous ground to make up.
KMI is outstanding in the oil industry
The oil industry suffered a catastrophic event in 2014, but not all companies in the industry succumbed to the same fate. There are some players with solid fundamentals and less exposure to commodity prices that remain outstanding. One such company is Kinder Morgan, Inc. (NYSE:KMI). KMI is the largest energy infrastructure company in North America with 80,000 miles of pipeline in operation. About 85% of its cash flow is fee-based, which exemplifies its extremely low exposure to falling energy prices. Most of the remaining 15% of their cash flows are hedged. Imagine a business operating a toll road. Would a sharp increase in petrol prices adversely affect that company’s performance? Some drivers would likely find alternative transportation to counter the price storm, but those drivers would certainly account for just a small percentage of the whole.
At Phoenix Capital, we began researching KMI in June 2014 at the recommendation of one of our executives based in Houston, Texas. We were immediately impressed with its sound fundamentals and ambitious business expansion plans. Those expansion plans went into action in early 2015 with the $3 billion acquisition of Hiland Partners in North Dakota's Bakken shale formation. Hiland Partners is a pipeline and logistics company founded by Continental Resources Chief Executive Officer Harold Hamm. Hiland was sold to KMI at a distressed price when Continental came face to face with the oil price collapse.
A strong point for KMI is its high dividend payment plan, which represents a dividend yield of about 4.4%. This figure is considerably more attractive than the 3.3% from Exxon Mobile, the company with the industry’s largest market capitalization (KMI ranks 4th in market capitalization with $87 billion).
Kinder Morgan raised its quarterly dividend by 10% in February to $0.45 per share, for a dividend yield of about 4.4%. Ultimately, the company plans to increase its dividend by 10% annually over the next five years, and the projected 2015 payout currently stands at $2.00 per share. This dividend growth will be supported internally by the company’s $17.6 billion five-year project backlog as well as by continued growth in North American hydrocarbon production, and externally from acquisitions of distressed businesses in the industry.
We all like a game where the insiders have their own skins on the line. Over the past 2 years, KMI’s CEO and Chairman, Richard Kinder, has accumulated stock in KMI worth nearly $100 million, and he recently bought $4 million more. In total, the CEO possesses nearly 245 million shares worth 11.37% of the firm’s value. His enormous ownership and ultra long-term vision for KMI is very important and often underestimated in the investment and energy industries. Rich Kinder "saw" the future many times in the oil and gas space and positioned his company accordingly to reap the rewards. Since last February, company insiders have bought a net 812,599 shares worth over $33 million at today’s prices.
High performance in tumbling market
We began accumulating KMI stock on July 25th, 2014 at the average price of $38.89, and we consider KMI as a core investment in our Global Growth & Income Fund. Upon receiving some market confirmation following our initial entry, we tried to get more exposure to KMI, especially when the stock showed some signs of a temporary pullback stemming from the dramatic decline in oil prices in October 2014. Due to our fund’s percentage limits on any long position on one stock, we used options to enhance our bet on the position. On the 9th of October, we sold a deeply out-of-the-money option contract at the exercise price of $55, expiring in January 2016 at a premium of $19.26. Based on the premium of $15.45 that ended March 25th, 2015, we generated a return of 20% for the derivative position along with more than 5% from our long position on underlying assets, a handsome return for an 8-month holding period.
KMI’s performance looks stronger if we examine some benchmarks. First, compared to the S&P 500, which has broken the all time highs time and time again over the past 6 months, KMI has outperformed significantly. Specifically, in the past 6 months KMI has gained 7.27% compared to just 4.01% for the S&P 500 in terms of price return. In the same period XLE, an ETF representing the energy industry, has plunged nearly 16%. With dividends reinvested taken into account (around 2.2% for a 6 month holding period), the margin becomes much wider.
Compared to other midstream operators such as Williams Companies (WMB), Spectra Energy (SE), and ONEOK (OKE), Inc., KMI has shown solid relative strength in stock performance in the past 6 months. Although midstream operators are not directly exposed to the decline in oil price, their performance has also been affected due to the hardships faced by upstream producers. This can be seen in the poor performance of the three companies mentioned above. In the past 6 months, OKE has lost nearly 30% in value while WMB and SE have slid 13.07% and 8.62% respectively. KMI performance has been smoother than any companies operating in the oil industry. One would be hard pressed to find a company comparable to KMI that could generate positive returns with the oil market in the midst of a black swan.
It is not a coincidence that KMI can perform much better than other industry incumbents. The difference between KMI and the rest can be understood when looking at charts for 1-year return. Oil pipeline stock accelerated for more than one year before oil prices began tumbling in early September. Before the oil crisis broke out, KMI actually underperformed its peers in the industry, which implied more momentum for other stocks in its pricing. KMI has chosen a steady development path with steady annual growth over the past 3 years. They have created a combination of organic and external growth through acquisitions strictly in North America. They have focused exclusively on the pipeline segment, specifically midstream targets while other competitors have diverged their operations upwards in the value chain. OKE and WMB have expanded many exploration and production projects, which exposed them to commodity price risks. The projects implemented by those companies must be delayed, pending the recovery of oil prices.
KMI’s solid fundamentals are creating anti-fragility in their operations. This means they will not only survive when black swan events happen but will also emerge as a winner. One of the main reasons for the decline in oil prices last year was the dramatic increase in oil supply from the US. Recent statistics have shown that US daily crude oil supply increased from 7.9 million barrels in January 2014 to 9.2 million barrels in January 2015. The increase in oil supply from the US has had negative effects on nearly all oil players in the world but has become a positive for pure midstream players operating in the US. Companies operating in the pipeline industry with less exposure to commodity price risk have become winners in the market, with KMI being one such winner.
Still more space for expansion
Is there still time for investors to jump on the bandwagon? Absolutely. The current price still does not reflect the growth potential that comes from both organic and external forces like business acquisitions of distressed midstream operators. Most security firms have agreed on a low-end valuation for KMI of $47, which is more than a 12% potential return from where it sits currently. With capital gains aside, one must like the dividend yield of 4.4% in such a low interest rate period. If you take into account 10% dividend growth compounded annually, KMI could touch a cumulative dividend growth of 61% in the next 5 years. That would bring an investor a new yield of nearly 7%.
KMI’s real growth could be magnified even more if they are able to find additional distressed acquisition targets stemming from the oil price crisis. Based on our own analysis, Spectra Energy could be one such target for KMI.
If the Spectra acquisition is realized, KMI will become a strong option for income-oriented investors. Spectra is a midstream player similar to KMI. However, they are complimentary to each other rather than being competitors due to the fact that Spectra’s business primarily involves natural gas and NGLs. Thus, it would not be a big regulatory issue if a merger were to occur--some asset sales is a given, of course. Spectra has some incredible assets, just like KMI, although they have quite a bit of manageable debt, which happens to be a common feature in the industry. Spectra owns Spectra Energy Partners (SEP), Union Gas in Canada, half of DCP Midstream and much more. Its backlog and growth projects are estimated at $35 billion, a dollar amount twice that of KMI's backlog. If this backlog was under KMI’s roof on top of a natural gas pitch, KMI could easily go to Europe and borrow cheap, almost free money to expand and conquer. In the coming years, Spectra will be the growth and KMI the slow and steady safety net, and as a result the KMI-SE umbrella may well be bigger than ExxonMobil.
Natural gas is a growth play relative to oil. It may not look like much now, or even by 2020, but at the current rate and if coupled with more US exports, growth of natural gas and the increasing need for its infrastructure are only logical. After all, Kinder Morgan is founded upon natural gas. {And its terminals business is a whole other growth story...that plays superbly into natural gas and exportation.
