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.

Rich Kinder hopes you will join him someday in a "happy sunlit meadow." There's just some rocky ground to traverse first.

Analysts asking questions of Kinder Morgan on its Wednesday evening earnings call spent a fair bit of time trying to quantify how big that rough stretch will be. Kinder's guidance said a lot about how the pipeline giant's prospects have changed in the past nine months -- and gave some clues for the wider energy sector.

The meadow is a place where Kinder Morgan has cut leverage enough that it can get back to the good times of raising dividends and buying back stock -- hardly poetic, but at least focused on what matters. Serious strains began to show on Kinder Morgan's balance sheet last fall, when it sold high-cost, convertible preferred stock and then slashed its dividend.

To that same end, Kinder Morgan has also been scaling back its growth plans, something which continued on Wednesday. The company now expects to invest $2.9 billion in expansion this year, down from the $3.3 billion budget announced in January and seriously down from the $4.2 billion figure given a month before that.

Kinder has also trimmed its Ebitda guidance for 2016 to $7.5 billion. Taking off $2.7 billion of interest costs and maintenance capex and $1.3 billion of preferred and common dividends leaves just over $3.5 billion of cash flow. So the cuts to expansion spending represent the difference between generating free cash flow and having to go out and raise new money, something Kinder Morgan has ruled out (or, rather, something the capital markets have largely ruled out on its behalf).

Here Comes the Sun
Kinder Morgan's 2016 free cash flow implied by different expansion capex budgets
Source: The company, Bloomberg Gadfly analysis

What is incredible about these projections is that in order to get to that cushion of projected free cash flow, Kinder Morgan has chopped its expansion budget by almost one-third in the space of four months, after it already cut 75 percent, or $3.4 billion, from its annual dividend bill.

It shows just what a product of the supercycle Kinder Morgan's balance sheet is. At the end of March, net debt of $41.2 billion was 5.6 times trailing Ebitda. Holding all other assumptions flat -- including that eviscerated dividend -- Kinder Morgan would need Ebitda to grow by about 6 percent in 2017 to get that ratio below 5 times, at which point the company would enjoy a little more flexibility. And indeed, Kinder indicated on the call that 2018 could be meadow-time.

While the path Kinder Morgan has taken is the right one, it also suggests the stock could be dead money in the meantime. Kinder, replying to a question, said that if the stock was still $19 when the debt-clearing was done, then the company would be a buyer. Which sounds bullish until you consider that it relies on the logical equivalent of an Escher staircase: We'd buy back our shares at this bargain price if we weren't carrying all this debt which makes the shares so cheap.

There are broader lessons for the sector here.

Kinder isn't alone in needing to work off the excesses of the past, and it should trouble its peers that the company is now essentially writing off 2017 as a transition year. It also assumes average oil and natural gas prices this year of $38 a barrel and $2.50 per million British thermal units, respectively -- implying some recovery, but not the bounce-back expected by the likes of Plains All American. The 23 percent cut to Kinder's project backlog is another telling signal, even if it partly reflects regulatory obstacles to one or two projects.

Moreover, Kinder's profits have been hit, in part, by its exposure to some bankrupt customers, namely coal miners such as Peabody Energy that used its bulk terminals, as well as lower volume on its infrastructure serving the Eagle Ford shale in Texas.

Credit counter-party risk weighs heavily on the minds of investors in the pipeline sector these days, though more in terms of exploration and production companies than miners. Even if that risk is sometimes overstated, the fact that pipeline operators, long regarded as reliable as utilities, might suffer consequences if struggling E&P clients shipped less oil and gas through their pipes has also come as a bit of a shock. Sometimes you build it and they don't come.

Indeed, there is a paradox at work here. Despite its large natural gas transportation business, Kinder Morgan, like many of its pipeline peers, has seen its stock become a play on oil prices. Take a look.

Barreling Up
Kinder Morgan's stock has become highly correlated with the oil price
Source: Bloomberg
Note: Rolling 90-day correlation coefficient. A reading of 1 indicates perfect positive correlation.

For now, a big rally in Kinder Morgan's stock looks dependent on oil doing the same. And yet oil's recovery depends to a large degree on the pipeline sector's E&P clients shipping less of the stuff, which undermines revenue and growth prospects for the pipelines. The path to the meadow is not without its twists and turns.

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