This is the second in our series of energy company CEO Interviews, with C. Park Shaper, the president of Kinder Morgan, Kinder Morgan Energy Partners, L.P. (KMP), Kinder Morgan, Inc. (KMI) and Kinder Morgan Management, LLC (KMR). Joining Contributor Simon Lack of SL Advisors to conduct the interview were SA Editor Yigal Grayeff and Leland Montgomery. Simon’s accompanying article appears here.
One of the largest companies in the energy infrastructure industry, the three Kinder Morgan entities feature a complex corporate structure and an equally complex division of dividend distributions between the limited partners and the general partner. Kinder Morgan's factsheet and presentations help explain some of these factors.
Also read Douglas Rachlin’s article on how low-priced unconventional gas is revolutionizing manufacturing, transportation and exports. Rachlin is a noted expert on the natural gas industry for The Rachlin Group at Neuberger Berman investment advisors.
The following is our interview.
Contributor Simon Lack (SL) - Given today’s low natural gas prices, are we going to see a gradual shift in energy use from coal to gas?
Park Shaper (PS) - There’s currently a huge game-change underway in the industry. At the highest level, it has become apparent that we have an abundant supply of clean, inexpensive natural gas from unconventional sources. Over time, this will mean greater demand for natural gas, which means more gas will be consumed, and needs to be moved. And that puts the infrastructure owners and providers in a pretty good situation. What we see happening first is increased utilization of our existing pipeline assets and then as it continues you’ll get opportunities to extend that to new assets. I think it’s a significant trend that will play out over a number of years. It may also have a significant impact on price, and could very well take prices up from multi-year lows.
This is why we see such long-term strategic value in the Kinder Morgan-El Paso combination. With the largest natural gas system in the U.S., we will be in a great position to take advantage of this dynamic.
SL - Where do you see the biggest sources of demand growth, over both the short-term and the long-term?
PS - Over the short term, we’re seeing that industrial demand is probably responding the quickest. Chemical plants and fertilizer plants that depend on natural gas as an input are ramping up. Over a longer period of time you’ll probably see new facilities built, especially fuel oil conversions, and that will drive demand. Because price security is such a huge part of the equation, that will drive some incremental demand. Clearly the export of natural gas is a source of incremental demand, but that will take a few years.
On the other hand, residential and commercial use is driven much more by weather and I don’t think we’ll see big changes there.
As to power demand, in the short-term we have already seen some anecdotal evidence of switching. One of El Paso’s largest customers in the Southeast said that February was their largest month in terms of natural gas consumption, so there are indications that it’s already happening, but I really expect to be more of an evolution than a dramatic shift. So I think we’ll see decreased use of coal plants and increased use of natural gas power plants, which typically have a fair amount of excess capacity available. What you’ll see over time is more shifting that way, even though a number of these plants have long-term coal-supply contracts, and those will roll off over time. The other thing you will see because of the clean-air regulations is coal plants being retired and getting replaced with natural gas, a trend that will happen over a number of years.
SL - What did you think about the EPA’s new discussion paper on new coal-burning plants – were you surprised?
PS - I wasn’t close enough to have significant expectations, my sense is that it wasn’t overly surprising, although I know it was disappointing to some of the utilities and the coal producers.
Now, understand that we handle a fair amount of coal as well – we have a network of coal facilities on the inland waterways and the coast. And the inland waterways serve a number of utilities and power generators, and on the coast we handle a fair amount of coal that is exported. That’s a big growth opportunity for us. We take it off of barges and off of rail, and also offer some value-added services such as blending at our facilities and then load it onto ships bound for South America, Europe or Asia. That is a big source of activity for us and a big opportunity for us because there is still an abundance of coal in this country and as more of it is produced more of it will be exported. And we are actively engaged in a number of expansions of our facilities, supported by contracts from coal producers who are looking for opportunities to export more coal.
SL - Do you expect to make any investments in LNG facilities?
PS - We’d be happy to if we could find the right situation.
Leland Montgomery (LM) - What are the major sources of growth for the Kinder Morgan companies going forward?
PS - We’re in some of the most exciting growth opportunities in the energy infrastructure business. Our natural gas pipelines business will benefit from the strong organic growth mentioned above. Our eight main products pipelines are well-located, with origins in refinery or port hubs and their terminus in major cities, and these businesses enjoy modest volume growth with price escalators based on the Producer Price Index. I’ve mentioned our coal terminals infrastructure opportunity. We also have an increased tertiary oil production domestically, and are the largest seller and transporter of CO2 used for enhanced oil recovery.
LM - Many investors get confused between KMP, KMR and KMI - could you help them handicap the key features and different growth prospects between the three?
PS - I’ll refer you to our presentation for full details, but here’s a short version:
First of all, KMR is KMP:
- KMR shares are pari passu with KMP units
- KMR dividend is equal to KMP cash distribution, but is paid in additional shares; effectively as a dividend reinvestment program
- Like KMP units, KMR shares are tax efficient - but with simplified tax reporting (no K-1s, UBTI)
Second, KMI, which was brought public in 2011, has a higher growth goal, and a slightly different financial profile than KMP. In 2012, our Dividend Target (declared) for KMI is $1.35 per share, representing 12.5% growth, versus the distribution target for KMP of $4.98 per unit, representing 8.0% growth. Similarly, we have a targeted long-term dividend growth rate for KMI of 12.5% through 2015, whereas KMP has a targeted 7% long-term distribution growth rate, driven by expected asset dropdowns resulting from the El Paso transaction.
SL- Is there any reason for KMR to trade at a discount to KMP - shouldn’t they trade at the same value?
PS - I believe they should trade at the same price as one another, and in truth, KMR has the added advantage of allowing you to control when you pay your taxes: There are no current taxes due unless you sell your shares. In fact, I think there is a legitimate argument that KMR shares should trade at a premium.
Now, so why does it trade at a discount? I don’t know - It’s a great mystery. I think it’s an opportunity as well that will prove to be very rewarding for KMR holders, because I don’t believe there is any fundamental reason for the discount. And while they benefit from the earnings and even higher yield, and ultimately if that discount goes away, then they will have picked up that value.
SL - So those KMR distributions that are reinvested back in, they’re not taxable when they’re made and they’re only taxable when you sell?
PS - That’s right. And so you’re getting additional KMR shares every quarter, and it’s like a stock dividend. So you pay no current taxes, and in truth it’s even more efficient than that. Once you get a year past your original purchase, then every share that you sell, even if it’s a share that you just received in a dividend; every share that you sell is long-term capital gains.
SL - I’d bet that’s not that widely understood by investors.
SL - I wanted to ask you about the LP-GP distribution splits. Because of your tremendous success in growing the business over the years, KMP has one of the highest GP shares of distributions in the industry - 44% - meaning that you need to get almost double the return on invested capital on new projects relative to some other MLPs in order to keep providing the same level of distribution yield. Can you comment on your confidence in your ability to be able to meet that and still hit market return expectations for new projects? [Editor’s note: According to JPMorgan Research, KMP’s general partner now receives about 44% of every dollar distributed, leading JPMorgan to believe that KMP’s cost of equity capital is almost twice the partnership’s yield].
PS - Sure, we’ve been in the high splits since 1997. And so when we talk about the kind of returns that we’ve delivered, and I believe it’s 26% return to the KMP investors on an annual basis since the beginning of 1997. We’ve done that while we were in the high splits. Now clearly, we’re much larger now, we’re not expecting to be able to grow the distributions at the same rate – we’ve grown distributions at 14% a year over that timeframe. We expect that going forward, KMP will grow them at 7% a year. And so that is something that we have managed historically, and we believe that we’ll be able to continue to manage.
You mentioned that we might have to earn twice as great a return relative to somebody else. But that’s not exactly how the GP math works. Bottom line, our cost of capital, long term we believe is around 9%, and that’s all-in and it includes the impact of the GP distribution share and in truth right now, it’s significantly below that because interest rates are very low right now [KMP recently floated a 10-year, $1 billion bond issue with a 3.95% coupon rate].
And we believe that we’ll continue to find opportunities to invest capital at well north of 12%. These are numbers that we present every January in our conference materials, I go through them in detail. We’ve averaged about a 14% cash-on-cash return, year-in and year-out. And you should recognize that another source of growth is just pure internal growth. And we believe that we have attractive opportunities to generate internal growth as well.
And so we’re comfortable that we will continue to find opportunities to invest capital at rates of return that are significantly in excess of our cost to capital, including the impact of the GP distributions. What that translates into is growth and distributions for our limited partners. And again as we look forward, we believe that we can deliver 7% a year growth in the distributions per unit to our KMP unit holders and our KMR shareholders.
SL - You’ve got a great, high-margin CO2 business, both in terms of transporting CO2 for customers, and that being used to your own oil production. But in terms of the actual assets, the reserves that you have outside of what you have in the Fulton, what is the longevity of your CO2-producing assets?
PS - I think there are tremendous growth opportunities for increasing production of CO2, and we did just buy an interest in a new field called St. Johns, which is on the border of Arizona and New Mexico. We’re stilling doing our technical work there, but we’re optimistic that will be another attractive source of CO2 for us.
And in this high oil-price environment, domestic oil production is very valuable and we know that demand for CO2 has gone up significantly over the last couple of years and we believe it will continue to grow and be strong going forward.
The other piece of the business you’re asking about is our proprietary oil production located in Texas, which is primarily at the Scurry Area Canyon Reef Operators, or SACROC field, the Yates field, and then growing production from the Katz field where we’ve initiated a CO2 flood.
There is no question that over time, we expect that production from SACROC will decline. Yates is different from SACROC. We don’t expect any significant decline at Yates. And Katz of course is going the other way, production at Katz is growing and we expect that to continue for a number of years.
Our expectation for SACROC is based upon the activities that we are performing right now and we think the decline is a few years out. What we have been able to do successfully over the last five-plus years is postpone that decline by finding new opportunities to get more oil out of the ground. In the part of the SACROC field that we’re targeting, I think we still have about 1.7 billion barrels of oil still in place. And so there is a lot of oil down there, and so our real goal is to continue to find opportunities to continue to produce that oil at around the rates where we’re producing right now. The reason why we project a decline is because we can’t tell you right now exactly what we’re going to do in order to generate that production. But what we can tell you is that, again over the last six years-plus, we have been successful in finding incremental ways to get that oil out of the ground so that the decline has been pushed back. Year-over-year, we have delayed when we thought that decline would start. And again this is all public, you can go to our January conference materials, if you went back to the 2005 presentation, you would see a chart that shows the decline starting in earnest in 2010, but that hasn’t happened.
In each year, we update that, and in each year we have pushed back that point. So again, I can’t tell you exactly what we’re going to do or how we’re going to do it. But we have been successful in doing it for a number of years, and we know that we have a tremendous resource in a field with a lot of oil that is still in place.
SL - What do you think of the INGAA’s [the Interstate Natural Gas Association of America] forecast of $130 billion in energy infrastructure spending over the next 10 years? Is the need that great?
PS - I haven’t studied it enough to make a definitive statement, but if I had to make a bet, I’d probably take the high side of that estimate. Because as the shale plays develop, and natural gas demand grows, and as the liquids production in the U.S. increases, there will be more demand for infrastructure. And, it just gets more and more expensive to build. Environmental rules and other regulations make it more difficult and expensive to build. But you also have basic inflation that increases that cost. And while I can’t remember when the INGAA did that calculation – whether 2009 or 2010 – I’m not sure that it fully takes into account on the full extent of the activity in the shale plays today.
Yigal Grayeff (YG) - Our last question is what you’d like investors or potential investors to know about KMP?
PS - What I’d say is, we are in a great position for continued growth. Clearly we’re going to be a very large entity upon completion of the El Paso merger. And we’re in a good position to draw all of those El Paso pipelines down to the MLPs over a relatively short time period; and we’re in a great position with respect to the strength and stability of the cash flows that come from those assets. We have tremendous opportunities for growth, whether it’s from the shale plays, whether it’s from coal exports, whether it’s from increased demand for CO2 or any of the other opportunities that are going to impact energy infrastructure in North America, and there are many of them. We’re in a great position to take advantage of those and continue to grow.
And so – for a long time we’ve been answering the question of, how can we continue to grow, with our GP incentive distribution so big, our operations so big, how can we do anything that makes a difference? And I think we’re in a great position right now, where we’ve laid out with clear visibility the next few years of growth, which largely comes out of the El Paso transaction. But what we haven’t put in there are all of the incremental opportunities that will arise outside of that,. And so, I really think that it’s an exciting time for us as the management of Kinder Morgan, and I think it will turn out to be a great time for investors of Kinder Morgan.
YG - Two quick questions on your growth. What are the risks you’re facing in terms of your growth and have you ever thought of looking beyond the American borders for international expansion?
PS - As to the risks that we face, clearly, we operate a lot of regulated assets. Sometimes the rates on our assets can be challenged. We’ve gone through a number of rate cases on our products pipeline, especially on the West Coast. And so, regulation and especially evolving regulation. So, when regulation stays constant, then you know what it is and you know how to manage it. As it changes under your feet, it makes it more difficult to know how you should be running your assets, and it makes it more difficult to invest incremental capital. And so, we’re always hoping for a stable regulatory environment.
We also have exposure to interest rates, and so a portion of our debt is floating and a portion is fixed. Now, that being said, we have some natural hedges there in terms of some revenues, in that rates that are allowed to rise at the rate of inflation. And so there is a natural offset there.
Finally, we handle a lot of hazardous materials. We need to prevent incidents from happening. We’ve been successful with that over the last few years. But that is an ongoing focus and it’s something that you can never stop paying attention to. That is every day, by every one of our employees, ensuring that we are operating our assets safely, reliably, and in an environmentally friendly manner. And again, we can’t ever drop our guard there. So I think those are some of the major risks that we deal with.
Your second question was around international. We do have some international assets. Now, it’s primarily North America, and so when we go outside the U.S., our biggest presence is in Canada and a little bit in Mexico. We will continue to look for opportunities across North America. We will consider opportunities outside of North America. But one of the main things to keep in mind is that our tax efficiency comes from our [U.S.-based] MLP structure. And that tax efficiency does not apply when we get outside the U.S. So when we make those investments, we take that into account; we take the taxes that we’ll have to pay into account. So we do lose, again, some of our efficiency when we go outside the U.S.
YG - Frankly, does the economy worry you at all?
PS - It does. We’re hopeful that we’re in a slow-growth environment. One of the things that I think is most impressive about our assets over the last few years is that we continue to grow, ’07 to ’08, ’08 to ’09 and ’09 to ’10, in what was a pretty ugly economic environment. We grew our distributions every year. And again, I think that’s a testament to the stability of our assets. Now, I don’t think there’s any question that if the economy were stronger then our growth would be a little bit stronger, that’s mostly from the organic side, and so we’d like to see that. But that being said, we think we’re in a good position to manage through just about any economic environment.
SL - Thank you very much.