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Kinder Morgan Inc. (KMI-NYSE) bills itself as “the largest midstream and third largest energy company (based on enterprise value) in North America.” Enterprise value is a fancy term for the market value of the whole company — it’s an estimate analysts like to use to measure how much a buyer would have to fork over to purchase the entire enterprise. Think of it as equity plus debt minus available cash. Last December, it would have cost $144 billion (US) to buy KMI, now it's 20-per-cent cheaper; KMI’s selling price is $115 billion (US).
KMI is the sole owner of the Trans Mountain pipeline system, the only Alberta heavy oil and petroleum product transportation system with marine access in western Canada. Kinder Morgan has applied to the National Energy Board for a certificate of public convenience and necessity to allow it to expand its operation from 300,000 barrels a day to 890,000 barrels a day by building a second pipeline to the west coast. The pipeline expansion is very important to KMI’s growth, and its cash flow.
Trans Mountain’s feeds voracious appetite of Houston-based parent
Until about a year ago, Kinder Morgan thought its Trans Mountain project would receive federal government approval by this time, this year. Construction was to begin in mid-2016 and the company said it would start shipping along its new line by December 2017. In 2018, after a full year of operation, KMI told investors it would siphon from the Canadian economy more than $850 million a year through the operation of the Trans Mountain system — a net increase of $720 million over the $130 million Trans Mountain’s existing line already feeds its owner.
For KMI, Trans Mountain’s expansion represents an increase in cash flow (earnings before interest, taxes, depreciation and amortization) six times what it already generates. The expansion, however, only represents an increase in transportation capacity of three times. A more aggressive increase in financial returns is possible because Kinder Morgan obtained approval from the NEB in May 2013 to effectively double the toll rates it charges on its current pipeline — the line that delivers 90 per cent of the gasoline southern B.C. consumers rely on — if the expansion proceeds.
Kinder Morgan too highly leveraged
On Aug. 10, 2014, KMI announced it would undertake a major transaction and buy the shares and units of three of its publicly traded subsidiaries that it did not already own: Kinder Morgan Energy Partners LP (the then 100-per-cent owner of the Trans Mountain Pipeline); Kinder Morgan Management LLC; and El Paso Pipeline Partners LP. KMI promised the $76-billion purchase would enhance enterprise value over the long term and result in an “immediate and significant value uplift.” KMI told its shareholders it would deliver a $2 per share dividend in 2015, growing by 10 per cent a year through 2020 with an excess $2 billion in dividend coverage over the same period. The transaction also promised $1.4 billion in annual corporate tax savings — $20 billion over 14 years.
To finance its $76-billion shopping spree KMI became more highly leveraged — it increased its debt and printed more shares. Increased leverage means increased interest expense and, because of the promises KMI made to its shareholders, an expectation of rapidly rising dividends.
Bond rating agencies like Moody’s, Standard and Poor’s and Fitch — paid by KMI to assess and rate its ability to service its growing debt — expressed concern. KMI provided them comfort by cross-guaranteeing its debt among, and between, Kinder Morgan’s more than 250 entities. KMI also promised to implement a de-leveraging strategy; it would begin to reduce its debt load with cash flow generated from Trans Mountain’s expansion when it came on stream in 2017.
Kimberley Dang, Kinder Morgan’s CFO, told analysts during a conference call last August that, “The target leverage ratio that we have talked to the agencies about is between 5 and 5.5 times, and so we expect to be at about 5.6 times at the end of 2015. And that’s probably the level we’ll be when we close the transaction. After some of our larger expansion opportunities come on line in 2017 and 2018, I think we’ll come down into the lower end of the 5 to 5.5 times range.”
The only major expansion opportunity identified by KMI last summer when Dang was advising investors about the role “larger expansion opportunities” played in their debt management strategy was Trans Mountain’s expansion. The project represented almost 60 per cent of the capital spending KMI identified for the years 2017+. (Slide 21).
KMI received an investment grade rating from each of the agencies after its purchase closed in November 2014, but it was the lowest investment grade rating: BBB- from Standard and Poor’s, Baa3 from Moody’s and BBB- from Fitch. The agencies identified KMI’s vulnerability to a downgrade. A downgrade would lead to a non-investment grade rating. Non-investment grade debt is what most of us know as junk bonds.
The market initially reacted positively to KMI’s low tier investment grade credit rating. It seemed to like the simplicity of a single entity where there used to be four. It was lured by the prospect that the tax paying public would underwrite KMI’s private gain simply because assets were moved from KMI’s subsidiaries to KMI, the parent. When KMI’s restructuring was finalized its enterprise value climbed in one day from $95 billion (US) to $142 billion (US); by Dec. 26, 2014 the company’s market value reached a peak of $144 billion (US).
I was an expert intervenor in the National Energy Board review of Trans Mountain’s expansion at the time. I explained to the board that Kinder Morgan’s acquisition was questionable. A promised gain in dividend growth predicated on tax savings is not only a contradiction with how Kinder Morgan presents the benefits of its expansion project in Canada, increased tax savings are generally a function of increased earnings. If earnings become compromised, tax savings do as well. Cross-collateralization of debt is also a red flag. So is the fact that the debt rating agencies granted KMI the lowest possible investment grade for its ballooning long and short term debt obligations.
KMI’s financial viability is important if Trans Mountain is to make good on a major or catastrophic oil spill so Canadian don’t end up footing the bill. When KMI depends on Trans Mountain’s $5.4-billion expansion to support its corporate financial stability and keep its shareholders happy, it becomes tempting for Trans Mountain’s parent to pressure the pipeline operator to scrimp on spill prevention, emergency preparedness and response. When the inevitable spills occur, there is a further incentive to aggressively fight legitimate claims because the parent’s revenue stream becomes compromised.
The NEB is supposed to examine the financial viability and commercial impact of the project as part of its public interest review. It is not. The NEB does not care if Trans Mountain’s parent’s leveraged position and vulnerable financial performance poses a significant risk to the Canadian economy and Canadian public. The NEB avoids its job by pretending KMI’s financial viability is outside the scope of its review.
Stock market has not internalized delay or failure of Trans Mountain’s expansion
Stoked by investor demand, KMI’s share price and enterprise value climbed post acquisition. It was short lived. By early August enterprise value had fallen to less than $115 billion. The main reason for the almost $30 billion decline in enterprise value is the concern investors have about the general downturn in the energy sector and KMI’s ability to service its debt. That concern is reflected in the company’s stock price. The market price for KMI shares has fallen from a high of $44 per share to about $33 per share — the lowest in more than a year.
What’s interesting to me is that in all the Kinder Morgan investor presentations and earnings call recordings that I have listened to during the past two years, there has been nothing to suggest the Trans Mountain expansion project may not proceed. KMI has not publicly entertained the prospect.
Dax Sanders, Kinder Morgan’s vice-president of corporate development and former Enron employee, gave a presentation at the 2014 Energy Conference in Miami Florida on November 14, 2014. He spoke in depth about the status of Trans Mountain’s approval and the Harper government’s committed support. He summed up the situation as, “We still feel very optimistic about the pipeline. We are expecting NEB authorization… the federal government is enormously supportive of it.”
This is the same presentation where Sanders said: "The real opposition is really, you know, some of the… um... few pockets of the more radical views in the Lower Mainland; in Burnaby and Vancouver."
KMI is mischaracterizing the public push-back of its project to its U.S. audience. It has downplayed the vehement opposition from a majority of average citizens, numerous First Nations, municipal governments, opposition MLAs and MPs, and environmental groups.
By emphasizing the project’s likelihood of success and ignoring realistic forces that will bring about its failure, KMI avoids addressing the decades-long impact on KMI’s financial performance if Trans Mountain’s expansion does not proceed. It also avoids addressing what the delay in the project’s in-service date from December 2017 to late 2018 means to KMI’s cash flow, its ability to meet shareholder dividend expectations or the deleveraging promises made to bond-rating agencies.
About an hour and seven minutes into the second quarter earnings call on July 15, 2015, an analyst pointed out four reasons why he thought KMI’s stock price might be under attack. He listed the expectation of rising U.S. interest rates, falling crude oil prices, an attack by a tabloid that KMI’s debt was not serviceable, and the retirement of Richard Kinder as CEO. After pointing to these factors, the analyst systematically explained why each of these reasons were not valid and then asked Richard Kinder, KMI chair and former Enron president, “What am I missing?”
Kinder answered, “You tell me. What’s the old saying? I’m mad as hell and I won’t take it any more. I can’t use the latter part of that, obviously. No, I think in the long-run markets are rational. In the short term they can be irrational… we’re very disappointed with the performance.”
Rich Kinder is Kinder Morgan’s largest shareholder, directly holding 234 million shares. Since Christmas, Kinder has suffered a paper loss of more than $2.5 billion. No wonder he’s mad; he thought his clever reorganization would send his share price soaring.
Kinder didn’t take the opportunity in the most recent earnings call to discuss what the impact of Trans Mountain’s expansion’s delay, or its likely demise, would have on the company’s stock price. There was no warning of the impending Canadian federal election and what the loss of a willing Harper doing Kinder Morgan’s heavy lifting means for the project. Kinder Morgan may have effectively and secretly lobbied the Harper administration for its “enormous support”, but the company hasn’t garnered “enormous support” from any of the other political parties.
If the market is skittish over KMI’s financial vulnerabilities in current market realities, wait until it understands the importance of Trans Mountain’s expansion to KMI’s cash flow and the increasing likelihood it will never take place.
The in-service date of the Trans Mountain expansion has been delayed a year because Kinder Morgan couldn’t decide on its pipeline route. The NEB extended the hearing by almost seven months so Kinder Morgan could test whether boring a hole through Burnaby Mountain was possible. This means the additional $720 million KMI expected would flow to Houston during 2018 definitely won’t happen.
A change in government in Ottawa after the Oct.19 election means that the flawed NEB process will be fixed. The NEB Trans Mountain expansion report, expected in January 2016, will not be accepted or acted upon. A proper environmental assessment process has been promised and will need to be conducted before a decision to proceed could possibly be made. This would delay the project a further two or three years and depending on proper due diligence, and a reasonable scope of issues, could kill it altogether.
Irrespective of the outcome of the federal election, there are other significant developments that could derail Trans Mountain’s expansion. A number of court actions are anticipated from First Nations, environmental agencies, municipalities and concerned citizen groups. These would cause further delay and with a court decision in favour of a plaintiff, could spell the end of the project.
If the Trans Mountain expansion were to successfully obtain government approval and court sanction, there remain commercial considerations that could cause Trans Mountain’s long-term committed shippers to take a pass.
Steve Kean, KMI’s new CEO and Enron alumni, gave a quick update on the “$5.4 billion expansion of Trans Mountain” last April at about minute-15 of KMI’s 2015 first quarter earnings results conference call. KMI continuously cites the project capital cost as $5.4 billion (US) in its communication with analysts and in Security and Exchange Commission filings, despite the steady devaluation of the Canadian dollar since 2013. At today’s exchange rate this would put the price tag for the Trans Mountain expansion project at $7.1 billion CDN, not $5.4 billion.
While Kinder Morgan tells its shareholders that the project is $5.4 billion US, it tells the NEB the project’s $5.4 billion capital cost is in Canadian, as-spent, dollars. It can’t be both unless Kinder Morgan is assuming the Canadian dollar will be at par with the US dollar until 2018. The near term price of oil makes an appreciation in our currency highly unlikely. KMI’s par assumption is reckless.
Kean informed his audience last April that Kinder Morgan is halfway through the permitting process and has made good progress that may not be “readily apparent from the press and social media. And, again, a reminder here: this project is under long term contracts which have been approved by the NEB.” Kean did not explain that the long-term contracts have a number of termination clauses for the benefit of shippers.
During its open season in in 2011 and 2012 Kinder Morgan was successful in obtaining 13 long-term take-or-pay contracts for a total of 707,000 barrels a day of the pipeline system’s 890,000 barrels-a-day of capacity. All but one of these contracts are for a 20-year term and become a long-term liability on the shippers’ balance sheets. Shippers expect a revised capital cost estimate for the project within 60 days of Kinder Morgan having received its certificates from the NEB. The revised capital cost estimate must come in under $6.8 billion (CDN). If not, each of the shippers are free to walk.
On the basis of currency risk alone, there is good reason to believe the termination clause could be triggered. If, on the other hand, Kinder Morgan misled its investors and not the NEB, and the capital cost budget is actually estimated in Canadian as-spent dollars, it would be prudent for Kinder Morgan to adjust the project capital cost in its communications with its U.S. investors based on a reasonable medium-term forecast of the value of the Canadian dollar. That is, Kinder Morgan should stop talking about the expansion as if it's a $5.4 billion US project and a $5.4 billion CDN project. Assuming an average value of the Canadian dollar at 80 cents between 2015 and 2018, a Canadian-dollar $5.4 billion project becomes a $4.3 billion (US) project.
Both KMI in Houston and Kinder Morgan Canada in Calgary were asked to confirm the currency relationship relied on in Trans Mountain’s capital budget so as to provide clarification on the discrepancy. They elected not to respond.
Even if the initial capital cost estimate is $5.4 billion (CDN) there are other reasons to anticipate that the CPCN Estimate will rise by at least 25 per cent and the shippers’ termination rights will become exercisable. The CPCN Estimate will be developed using a more detailed Class II/III estimation technique than the preliminary Class IV estimate prepared in 2012 and will incorporate project delays. As well, NEB conditions will likely mean unanticipated capital costs.
Trans Mountain Lacks a Social Licence
Kinder Morgan needs to develop a better understanding of the character of Canadians and our history of social progress. Our dollar may be devalued, but the currency of our culture is not. We put more value in the democratic process, our environment, the rights of First Nations and a sustainable future for our children than Richard Kinder and his company are used to. The Trans Mountain expansion, simply put, does not have a social licence. If, after all other avenues have failed it boils down to Kinder Morgan versus the people, my money is on the people.