Hedgeye Risk Management earned a great deal of attention for its apparent takedown of Linn Energy LLC (NSDQ: LINE); after adopting Bronte Capital's criticism of the upstream operator as its own, the research firm waged a savvy (and unsavory) media campaign to publicize this view.
Whereas the upstream operator's exposure to the declining price of natural gas liquids (NGL) and reliance on acquisitions to offset this unfavorable production mix provided convenient catalysts for short sellers, Hedgeye's short case against Kinder Morgan Energy Partners LP (NYSE: KMP) likely will struggle to gain traction-much like its claims that Breitburn Energy Partners LP (NSDQ: BBEP) is a mini Linn Energy.
For one, Kinder Morgan Energy Partners is the second-largest master limited partnership (MLP) by market capitalization and is covered by 20 Wall Street analysts. Shorting this stock amounts to a bet that a lot of knowledgeable people have ignored or overlooked critical facts. Although the report raises some familiar gripes-for example, that the general partner's incentive distribution rights (IDR) burden Kinder Morgan Energy Partners with a higher cost of capital-claims that the stock is "a house of cards on the verge of collapse" amount to pure sensationalism.
For one, Hedgeye cites Kinder Morgan Energy Partners' carbon dioxide (KMCO2) segment as a potential liability, noting that this business line involves direct exposure to energy prices through its 1,313 net producing wells in the Permian Basin. The MLP and its partners inject carbon dioxide into these mature fields to increase reservoir pressure and enhance oil production. Hedgeye contends that Kinder Morgan Energy Partners tricks investors by emphasizing the reliable cash flow generated by its midstream operations, while downplaying the contribution of its commodity-sensitive KMCO2 business.
One key question is whether the volatility of KMCO2's results has ever restricted Kinder Morgan Energy Partners' ability to grow its distribution. The short answer: It hasn't. The MLP has increased its distribution on 13 occasions in the past 14 quarters and has more than doubled its quarterly payout over the past decade, to $1.32 per unit from $0.625 per unit. Moreover, the blue chip has never cut its payout since going public in the 1990s.
As for the future, this graph of KMCO2's quarterly financial metrics-revenue, segment earnings (income plus non-cash expenditures such as depreciation, depletion and amortization) and segment margin (earnings as a percentage of revenue)-shows a solid growth trajectory despite the occasional ups and downs. Segment revenue in the second quarter of 2013, for example, was almost seven times what it was 10 years earlier. Segment profit, meanwhile, rose more than eleven-fold. In short, KMCO2 has proved to be a highly profitable business.
What has driven that profitability? In 2012 oil and NGL production accounted for about 73 percent of KMCO2's distributable cash flow, while the MLP's CO2 sales and transportation accounted for about 27 percent.
Over the past decade, Kinder Morgan Energy Partners' liquid hydrocarbon production has remained relatively flat; the lone exception is 2003, which reflects the integration of newly acquired assets in the Yates play.
Against this backdrop, much of the upside in revenue and profitability has come from the significant increase in crude-oil and NGL prices. Check out this graph of KMCO2's average annual price realizations for these commodities.
Although Kinder Morgan Energy Partners hedges the majority of its crude-oil production, this business unit clearly entails some exposure to commodity prices and accounts for much of the MLP's distributable cash flow that isn't fee-based.
However, does the growth of Kinder Morgan Energy Partners' CO2 business necessarily threaten the sustainability of its quarterly distribution? The contribution of this business line to the MLP's overall revenue had increased steadily to a high of 19.4 percent in 2012.
Lower NGL prices and growing revenue from the MLP's midstream business lines appear to have reversed this trend over the past several quarters; in the second quarter of 2012, KMCO2 accounted for 15.2 percent of Kinder Morgan Energy Partners' revenue. We would expect this trend to continue as the MLP brings new growth projects onstream and integrates the assets acquired in its takeover of former joint-venture partner, Copano Energy LLC (NSDQ: CPNO).
Within the CO2 segment, Kinder Morgan Energy Partners has moved to expand both its hydrocarbon production and CO2 transportation and sales. The MLP sold its 65 percent working interest in the Claytonville oil field unit and purchased another property that currently produces 1,250 barrels of oil per day, with the goal of ramping up output to about 10,000 barrels of oil per day over the next decade. If this endeavor succeeds, the MLP will generate some net production growth while offsetting the natural decline rates on its existing fields.
During Kinder Morgan Energy Partners' conference call to discuss second-quarter results, Chairman, CEO and leading unitholder Richard Kinder noted that KMCO2 is expected "to be slightly above its plan for the full year 2013." That was partly due to improved oil production, offset by the negative impact of a maintenance turnaround at a processing plant and weak prices for natural gas liquids (NGLS). Kinder also highlighted plans to spend $2 billion to boost CO2 sales and transportation volumes to 2.0 billion cubic feet per day by 2017 from 1.2 billion cubic feet per day. This initiative also demonstrates the robust demand for CO2 in the Permian Basin.
Hedgeye has also questioned whether Kinder Morgan Energy Partners' growth-related capital expenditures in its upstream operations should be classified sustaining capital spending. The rationale behind this claim: Despite significant investment in these operations, production volumes have remained flat over the past decade.
So is Kinder Morgan Energy Partners' CO2 division a ticking time bomb?
First, let's tackle Hedgeye's claims that Kinder Morgan Energy Partners is understating maintenance-related capital expenditures in its upstream operations. Even if we reclassify the $185.3 million in growth spending that the MLP planned to make last year on oil and NGL production as maintenance capital expenditures (an extreme assumption), the MLP would have covered 91 percent of its distribution in 2012.
Answering this question depends on your outlook for crude-oil prices-a topic that Hedgeye hasn't addressed in their public commentary on the stock-and the natural decline rate of Kinder Morgan Energy Partners' fields in the Permian Basin. Assuming that oil prices hold steady at $95.00 per barrel over the next decade, the MLP's internal estimates call for KMCO2's distributable cash flow to peak in 2016.
Given Kinder Morgan Energy Partners' extensive midstream asset base and long track record of distribution growth, we would anticipate that management has a plan to address this shortfall.
Although we applaud Hedgeye for making investors scrutinize their investments more closely and raising awareness of Kinder Morgan Energy Partners' limited exposure to commodity prices, claims that the MLP is "a house of cards on the verge of collapse" amount to nothing more than a cry for attention. We address Hedgeye's other criticisms of Kinder Morgan Energy Partners in Kinder Morgan: A Hard Target.
Despite our defense of the stock, we prefer other MLPs to Kinder Morgan Energy Partners. On Sept. 23, Elliott Gue and I will host a free webinar on our top three publicly traded partnerships for 2014 and beyond.