Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

There, there. Now that wasn't so bad, was it?

Kinder Morgan finally ripped off the Band-Aid, slashing its dividend by 75 percent on Tuesday in response to long-building financial pressures. This decidedly unfriendly gesture to income investors was actually greeted by an initial jump of 10 percent in the stock price on Wednesday, before a renewed selloff in oil and energy stocks took some of that back. So the only question now is: Who's next? 

Ripping Higher
Kinder Morgan's shares bounced on Wednesday following news of its dividend cut
Source: Bloomberg
Note: Intraday prices

Kinder Morgan made the cut because, with its stock sporting a dividend yield of 13 percent, investors didn't see it as being sustainable, and the company was effectively locked out of the public equity market. Now, cash that was earmarked for dividends will go toward growth projects and defending the company's investment-grade credit rating. The yield on the stock is now just around 3 percent.

With one fell stroke, Kinder Morgan has simultaneously thrown the spotlight back on the funding struggles of the oil pipeline and master limited partnerships sectors, while demonstrating that there is life after cutting. More than half of the members of the Alerian MLP Index yield more than 10 percent, and a similar proportion are carrying net debt of at least 4.5 times trailing Ebitda, according to figures compiled by Bloomberg. Barring a big and speedy recovery in energy prices rekindling investors' fascination with the sector, those numbers look unsustainable.

Take Plains All American. On the same day as Kinder Morgan's announcement, Plains told investors at a conference that it didn't plan to raise its dividend next year, but also didn't plan to cut it. The stock bounced 9 percent off its 52-week low and rallied again on Wednesday. Even so, it still yields more than 12 percent.

Similar to Kinder Morgan, Plains's profits have come under pressure as fewer barrels than expected are flowing through its pipes, due to higher competition and exploration and production companies throttling back on drilling. Based on current analyst forecasts, Plains doesn't look like it can cover its dividend and growth spending plans with cash flow, despite saying it will cut capital spending and won't raise payouts next year.

Raining on the Plains
Source: Bloomberg

Analysts forecast that Plains will make total Ebitda of just over $3 billion this quarter and through to the end of next year, according to data compiled by Bloomberg. Interest on its debt, which was $10.6 billion at the end of the third quarter, will take north of $600 million of that, and capital expenditure for maintenance perhaps another $250 million. That would leave just under $2.2 billion, which would not quite cover the amount due to be paid out in dividends to limited partners and the company's general partner, Plains GP Holdings. So spending on growth projects of roughly $2 billion -- assuming spending of about $500 million this quarter -- essentially would need to be funded some other way.

Selling more units in the public market doesn't look attractive with the dividend yield where it is. In its presentation, Plains -- which said it had gotten lots of questions on its spending plans and funding capacity -- said it would focus on growing profits and could potentially tap other funding sources, sell assets or even get unspecified support from the general partner to cover its needs. The plan seems to be to get through a difficult 2016 and then grow beyond that to improve coverage of dividends. 

That may well work out. But it isn't a given. Kinder Morgan was touting its commitment to its dividend just a couple of months ago, and this is a very uncertain climate. For example, Plains assumes that U.S. oil production will drop by 150,000 barrels a day next year, yet the Energy Information Administration's latest forecast is for a decline of almost four times that amount. There is also a curious side effect implicit in Plains's assumption: If U.S. output doesn't actually drop by much next year, that supply will likely prolong the pain in oil prices

If Plains were to cut its dividend, it would strengthen its balance sheet and reset the baseline for growth when oil prices recover in the future. Cutting by 50 percent would cut its the projected cash shortfall through the end of 2016 to less than $1 billion, and the implied yield would still be above 6 percent. Emulating Kinder Morgan's 75 percent cut would reduce the shortfall to less than $600 million. This all assumes it didn't cut its growth spending plans further, which would be another way to close the gap, albeit at the expense of future earnings growth.

Would income investors desert Plains? Some might. But the blow could potentially be softened by the company using the opportunity to take out its general partner, an anachronistic element in Plains' structure that serves to further increase its cost of capital. In any case, the value of Plains GP Holdings would likely take a big hit if the dividend was cut by a lot. Above all, as Kinder Morgan's experience shows, a reset for Plains -- and some of its peers -- might not be the end of the world.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net