KMI – Divestor

Enbridge Line 3 – Another setback

I do not have shares in Enbridge, but investors today (and probably tomorrow as the news came out mid-day and institutions will look at it overnight to digest the impact on valuation) will be feeling slightly less rich after today’s news that the Minnesota court of appeals deemed the environmental assessment concerning Line 3 to be inadequate.

The net result is that Line 3 will have their construction halted until Enbridge can file an appeal or an amended environmental assessment. This will also result in another round of legal battles with the 3Cs of regulation – committees, commissions and courts and my initial estimate would be at least half a year of delays. I could be wrong.

The reason for the delay is not terribly relevant from a financial standpoint, but the impact of it will be for both Enbridge (who will not be realizing increased cashflows from the increased volume that would be flowing through the pipes the second they are activated – not to mention the capital that has already been sunk into the project), but more importantly, land-locked Albertan/Saskatchewan oil producers that were seeing a light ahead of the tunnel after the presumptive second half of 2020 activation of Line 3.

At CAD$50/share, Enbridge was priced for perfection. Although Enbridge is mostly a cash flow story, an investor is paying a lot in advance in order to realize those cash flows – in addition to the requisite risks to pay back the debt, interest and preferred share dividends. Just wait until Line 3 or Line 5 experiences a spill, or some other adverse event which is currently not baked into the stock (or perhaps another adverse legal ruling that will stall it another couple years). Although the company in 2019 is expected to generate around $4.50/share in cash ($8.9 billion), the inherent growth that is available to Enbridge is a limiting factor – and as such, the accounting income P/E in the 20s (which takes into account depreciation) is unjustified. Coupled with large future capital expenditures, if there is any sort of credit situation that may occur in the future, equity owners will be taking a lot more price risk than the current potential for reward – which wasn’t going to be a stock price that much higher than CAD$50/share.

I would especially take issue with the common share dividend, which is currently $6 billion a year – while they can certainly afford to pay this at present (and management continues to escalate the dividend each year), it is not a financial perpetual motion machine – given the capital expenditure profile, this is currently being partially financed with debt.

There aren’t many free lunches in the stock market, including the pipelines. Companies like Inter Pipeline (TSX: IPL), which has less legal risk than Enbridge, are still at valuations that aren’t incorporating much risk to their future expected cashflows (albeit, in IPL’s case, it is a lot better today than it was a couple years ago where it was trading about 30% higher). It wouldn’t surprise me to see Enbridge follow a similar trajectory, but still maintain its equity dividend.

Students of history will want to pay attention to Kinder Morgan (NYSE: KMI), a supposedly safe and stable pipeline company in 2015:

I’ll leave it at that – pipeline companies are supposed to be stable for their cash generation capabilities, but financially it can be a completely different story.

Trans-Mountain Pipeline / Enbridge / TransCanada

Nobody is laughing out louder today than the management of Kinder Morgan (NYSE: KMI) who have sold their $5 billion pipeline (TSX: KML) to the government of Canada, when a federal court effectively ruled the trans-mountain expansion project to a halt (the reasons of which are not too relevant to the analysis in this post).

(Update, August 31, 2018: See Kinder Morgan’s “laughing to the bank” announcement here)

I’m ignoring the fact that the original Trans-Mountain pipeline still exists and still operates and pumps oil down to the old Chevron Burnaby refinery now owned by Parkland Fuels (TSX: PKI). There is enough pipeline capacity to supply the refinery, but not enough for any meaningful export quantities. This doesn’t make it a complete disaster for Canada, but they sure paid a lot more for it what it is worth.

There are two big economic winners with this court ruling, and it is not Kinder Morgan (they had their victory back in May when the Government of Canada agreed to the sale).

It is Enbridge (TSX: ENB) and TransCanada (TSX: TRP).

The only way to get meaningful amounts of oil out of Alberta and Saskatchewan (other than by much more expensive rail) is now going through the Enbridge Line 3 project or the TransCanada Keystone Pipeline.

(Here’s a map of oil and gas pipelines in Canada)

The economic losers are the Government of Canada, and every major oil producer in Alberta or Saskatchewan: they still have to go through Enbridge or TransCanada pipelines and pay a very heavy differential to prevailing energy prices for a long, long time. Inevitably this will hurt the Canadian public as the purchasing power of their currency will be less than what it could be had we actually have a fully functioning economy, but these indirect effects are typically never measured nor felt as the absence of an effect is rarely lamented in the minds of most people.

Politically, there is one big winner: The BC Government. Premier John Horgan has a huge victory to show to the environmental activist wing of his political party (the BC NDP) and this will give him more clearance to operate in the province without internal opposition (which is historically how the BC NDP loses power).

I am somewhat surprised Enbridge and TransCanada are not doing better in trading today.

Another bullet shot in the heart of Canadian oil production – Kinder Morgan

Paying attention to Kinder Morgan’s (Parent: NYSE: KMI, daughter: TSX: KML) announcement that they’re stopping non-essential expenditures in relation to the Trans-Mountain pipeline (that goes roughly between Edmonton, Alberta to Burnaby, BC) expansion.

There’s a lot of political rumblings and a ton of public ignorance displayed, which usually is a good recipe for market reactions that lead to opportunity.

KMI owns 70% of KML. KML owns the assets relating to the Trans-Mountain pipeline. The assets currently pump about 300,000 barrels per day and very roughly, in 2017 produced $250 million in operating cash flow (allow me to ignore the very relevant capital expenditures in this post – they spent $618 million, the majority of which was on the Trans-Mountain expansion project – $445 million on pipelines and $173 million on terminals).

There are about 350 million shares outstanding in KML, so the most elementary analysis possible is that if KML decided to pack up shop and just keep the existing (and aging) infrastructure in place, they will generate about 65 cents of cash for shareholders – this is subtracting the amount given to preferred shareholders. Other than the preferred shares and pension liabilities, there are no other material amounts of debt or obligations on the balance sheet that is noteworthy for this analysis.

Obviously this amount would not be enough to sustain the existing stock price – currently CAD$18.44/share – the earnings yield would be around 3.5%, although this would be a very stable yield given that this is the only oil pipeline connecting the west coast of Canada to oil-rich Alberta. The expansion project is expected to bring in $900 million in EBITDA in the first 12 months of operations, plus spot volumes up to another $200 million. Since the project is expected to cost around $7 billion, a financing at 5% would still result in substantial after-tax cash flows.

A tripling of the pipeline capacity will, suffice to say, be extremely profitable for Kinder Morgan. Strategically speaking, the asset is the only oil-carrying pipeline from Alberta to Vancouver (good pipeline map resource here). Vancouver’s sole oil refinery is the Chevron facility, west of SFU. The nearest competitor is refined fuel product from Cherry Point, WA, which makes Vancouver extremely vulnerable to any slowdown/shutdowns in both oil capacity and refining capacity.

Politically speaking, there are a set of huge competing interests at play:
– The federal Liberal government attempted to play a “middle ground” by supporting the pipeline, but they are dragging their feet on doing anything to getting it approved, and one can infer from Bill C-69 that the government intends to create so much regulatory uncertainty in the approval of any major national projects that they simply are not going to be built. Bill C-69 makes it impossible to know what conditions (and thus costs) it will take to approve projects requiring federal environmental assessment (soon to named “impact assessment”) approval. The Liberal government probably realizes at this point there is zero vote-getting ability for them to support the Trans-Mountain expansion, so they will only give lip service toward its approval – and lip service so they can avoid being seen as flip-flopping.
– The Alberta Government, led by NDP Premier Rachel Notley, has a huge economic interest in the pipeline. While inherently most of the people in her party are against pipelines in general, a lot of Alberta’s economy depends on the fortunes of the oil industry and if the NDP are going to have any chance of being re-elected, they need to galvanize the feelings of voters that they (and not UCP leader Jason Kenney) are best to fight Ottawa and British Columbia.
– The BC Government, led by NDP Premier John Horgan, is fighting on a side which inherently favours them. They attempted to enact some provincial regulatory reforms to make it more difficult for the pipeline to proceed, and they can do this because they have the support of their party and also the 3 Green Party MLAs that are strongly against the pipeline (the government is a narrow minority government that requires the support of the 3 Green Party MLAs in order to maintain supply). They have everything to gain by combating Alberta and Ottawa and only a modest amount to lose as not too many NDP supports would support the economic-creation aspects of pipeline construction. In addition, the majority of gains to be made if the pipeline expansion is completed is Albertan oil companies, so this does not favour BC. The BC Government will likely do anything it can to stall the project and will only yield way if required to do so by court judgement – that will be their “out” to explain to the public that they tried.

It appears pretty obvious to me that the current Nash Equilibrium is the pipeline expansion will be indefinitely stalled. It will probably take a Supreme Court ruling to unlock the situation and one is not forthcoming due to the Federal government intentionally deciding to not participating in a planned BC-Alberta reference case – lest the reference (info) definitively decide the matter (which works against the three governments’ existing interests).

For knife catchers only – Kinder Morgan

Kinder Morgan (NYSE: KMI) is in a chicken-and-egg situation. It needs financing to implement capital projects, but the cost of its financing has been steadily increasing due to its financing requirements.

Energy pipeline equities are a staple income producer for a lot of funds out there, but if they have their dividends threatened, the supply dump is going to be gigantic.

I sense this is a falling knife situation where it will be very difficult to predict the bottom. You can make an excuse for US$16.84/share being the bottom, or you can also make an excuse for US$9/share. It just depends on how many funds are hitting that sell button, irrespective of price.

Cash-wise, it is very evident they will have to cut their huge dividend. They are giving out US$4.5 billion a year and it is completely obvious they cannot sustain it given their capital spending profile (offset with their not inconsiderable positive operating cash flows). Refinancing their debt ($3 billion of it current as of September 30, 2015) is going to be progressively expensive as bond yields rise and their equity price drops. They do have a credit facility with $3.4 billion availability, but their buffer is thin!

I am sure Kinder Morgan will recover this financial earthquake, but how low will their common stock go before they recover?

Finally, let this be a lesson those that invest in highly leveraged industries (e.g. power generation, pipelines, etc.) – you never know when the market will arbitrarily pull the rug on your refinancing program.