Last week in our local paper, the Obituaries section ran to three pages. 17 people were listed. 14 of them were over 80, and three were in their 60s. The steady drumbeat of death, economic destruction and lockdown is why the stock market looks as if it’s divorced from reality. The S&P500 is only down 11.7% for the year, after being up 31% in 2019. In late March it briefly dipped below 2,200, where it registered -32% YTD. If instead it had simply spent the last four months meandering down to its present level, performance would be just moderately poor.

The stock market may not be right, but the collective outlook of investors is that we’re enduring an economic blip that will pass within a year or so. Bottom-up S&P500 earnings forecasts are for next year to be higher than last year – and 2021 earnings forecasts have already been revised 12% lower since January.

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The news and the mood are terrible. The stock market is heartless, but is it also irrelevant? If earnings come in as expected next year – admittedly still a big “if” since revisions continue to be down – stocks are cheap. The Equity Risk Premium (ERP — S&P500 earnings yield minus ten year treasury yield) is at the levels of the 2008 financial crisis, even following a 27% rebound from the March lows. Unless 2021 earnings are revised down substantially, the relative attraction of stocks will draw them still higher. If the market keeps rising, the resulting headlines will coincide with, and perhaps cause, a lifting of the popular mood.

What is the cold-hearted analysis that’s reflected in today’s valuations? What follows is not a run at amateur scientist, for which we’re not qualified. It’s a virus-driven upside explanation for stocks.

As much as it pains me to write this, and with deep sympathy for the many families who have lost a loved one, the fact is that not that many people are dying. In two months, 50,000 Americans have died from Coronavirus. We probably undercounted somewhat at the beginning, and it’s likely the virus was killing people as early as January. We may be overcounting now, because if a patient dies with Coronavirus it’s more likely to be recorded as the cause of death even if they suffered from other, serious illnesses.

In 2018, the CDC reports 2,839,205 deaths in America. People are a bit more likely to die in the winter, but on average around 7,780 people die every day. Over the past two months, we would have expected just over 473,000 deaths anyway. The 50,000 Coronavirus-attributed deaths is, without doubt, 50,000 too many. But the demographics are by now widely known to be heavily weighted towards older people, just as in our local paper’s Obituaries section. The virus is denying as full a life as all these people deserve, but its lethality for younger people overwhelmingly relies on other serious health conditions.

One bright spot is that the most recently weekly CDC figures report only 62% of “Expected Deaths from All Causes”. This is partly because nobody is driving anywhere, so road deaths are down. On average, 730 people die every week in car accidents. The fortunate souls who are alive thanks to lockdown don’t know who they are, but they’ll be consuming products and services for many years to come.

The infection numbers are largely useless, because in the U.S. we’ve only tested 1.4% of the population and you generally have to be sick to get a test. 5.7% of those who tested positive have died, a catastrophically high figure. However, serology tests which look for antibodies as evidence of prior infection are implying that Coronavirus has spread much wider than as measured by reported infections. Lots of people suffer mild symptoms or even none at all (they are “asymptomatic”). Results from LA County and Santa Clara in California suggest the true infection rate is 50X higher in those regions. New York City estimates that 21% of its residents have been infected.

An infection rate fifty times higher means a fatality rate fifty times lower. At the outset, health professionals told us that the vast majority of us weren’t in mortal danger from contracting it. This seems to be true. Economically, that brings a return to new normal closer. The many constraints on our liberty and enormous economic damage have been imposed not to protect everyone, but to prevent the small percentage who will require hospitalization from overwhelming the system (‘flatten the curve”). Widespread compliance has been an enormously selfless act, but this has its limits and we’ll transition to more targeted means of protecting our most vulnerable citizens. Earnings forecasts dispassionately reflect that.

It also means that society will learn to live with Coronavirus long before everybody’s been vaccinated. This is not a widely held view. If the fatality rate is 5%, we’re all going to want a vaccine as quickly as possible. Shortening the testing period and taking some risks with side effects is a worthwhile trade-off. But if the fatality rate is less than a tenth of that, and maybe as low as the flu at 0.1%, widespread vaccination will occur at a more measured pace. Higher risk groups such as the elderly will derive more benefit, even from a vaccine that’s not been subjected to normal testing. But if you’re young and healthy, medical authorities will determine that the years-long testing schedule remains appropriate. A vaccine that’s used prematurely would lower participation in all types of vaccination program, creating a real health catastrophe. And many people may decide for themselves to wait until the Coronavirus vaccine has been widely used safely, with no meaningful side effects. Only half the adult population gets an annual flu shot. It could be several years before a Coronavirus vaccine reaches a sizeable majority of Americans.

Most pipeline companies have maintained guidance at or close to prior levels. Cuts in growth capex more than make up for lower expected cash flow from operations, which will support their free cash flow. Kinder Morgan raised their dividend by 5%. Other large cap companies including Enbridge, Enterprise Products, TC Energy and Williams (all members of the American Energy Independence Index) have maintained payouts, even though every company has a free pass on cutting dividends right now. Like the rest of big American business, midstream energy infrastructure companies are assessing their own outlook, and it’s not as dire as the news.

The virus could take an unexpected turn. We have no scientific insight to offer on that. But today’s market reflects today’s facts as we know them. Rather than the stock market not reflecting reality, maybe it’s telling us to be more optimistic.

We are invested in all the stocks mentioned above.

Client interaction has been overwhelmingly constructive – we haven’t had a single call from anyone wanting to “sell everything.” Our fund has seen very modest net outflows, and new money has been coming in every day.

One investor said on the weekend that we need to present the positive case more forcefully. So, here it is:

• Our midstream energy infrastructure investments and the components of the American Energy Independence Index are >75% investment grade companies. The industry has been reducing leverage and strengthening balance sheets since the 2014-16 oil collapse. Growth projects are increasingly funded with cash from operations, with less reliance on debt and no equity issuance. 4X Debt:EBITDA is common, using 2020 guidance which will be revised down in the coming weeks.
• We estimate around 80% of the customers of our portfolio companies are themselves investment grade. Cheniere Energy is 100% in this respect, so although they’re in the 25% of our companies that’s not investment grade, the credit quality of their customer base provides some comfort. .avia-image-container.av-q9cdnq-c376cf74d693c85eb38fbf92ff46600f img.avia_image{ box-shadow:none; } .avia-image-container.av-q9cdnq-c376cf74d693c85eb38fbf92ff46600f .av-image-caption-overlay-center{ color:#ffffff; }
  
• While energy demand will dip, and economic activity is contracting, there’s plenty of reason to think that in the weeks and months ahead all the efforts at mitigation and control will leave society confronting a new but manageable virus. Getting through the near term is understandably everyone’s focus, but life will eventually return to something we all recognize. Global crude demand fell just 2%% from 2007 to 2009. Natural gas volumes were unaffected. Demand may fall more than then, and supply further still. Although exports are more important than before, the U.S. pipeline business is mostly natural gas and NGLs (primarily petrochemical feedstock), and is mostly about U.S. consumption. We estimate that crude & refined products contribute just 20% of cash flows.
• Companies can improve cash flow by curtailing growth projects. Upstream companies are likely to cut production and growth capex by 20-40%. So far, Oneok (OKE) is the only midstream company to have issued any revised guidance, and they reduced 2020 growth capex by $500MM (20%), while surprisingly reaffirming EBITDA guidance. In Updating the Coming Pipeline Cash Gusher we forecast 2020 Free Cash Flow (FCF) of $22BN (up from $9BN last year). This forecast relies on guidance from companies that is all pre-Coronavirus. However, it also incorporates $37BN of capex spending this year. It’s quite conceivable that pipeline companies’ capex reductions could more than offset any drop in cash flow from operations. We were assuming Distributable Cash Flow (DCF) of $59BN. FCF is derived from DCF minus growth capex. If DCF fell by 20%, which is not in any forecast we’ve seen so far, growth capex would likely drop by more, which would cushion the ultimate impact on FCF.
• Unlike the 2015 downturn, capex is now internally financed. Midstream energy infrastructure companies stopped accessing public markets for equity a couple of years ago, and have no need to do so now. Moreover, debt is long-term and staggered. We don’t see near-term debt financing problems.
• Lastly, assuming an average 20% decline in growth capex similar to Oneok’s announcement, the sector trades at a 2021E 15.6% FCF yield (that’s after capex), fully supporting its 13% dividend yield. Few other sectors have such valuation support today.

The energy sector has taken a triple hit from Coronavirus, OPEC+ collapse and Saudi supply hikes. Investors are most worried about which names will survive. Those with leverage were forced to sell last week, notably including MLP closed end funds. We don’t use leverage and haven’t been forced to sell anything, either for ourselves or for client accounts. Today for example, we have not made a single sale. Sit tight. This will eventually pass. It’s not inconceivable that prices could eventually double from here.

Once America confronts a challenge, history shows that we deploy unmatched resources to take it on and defeat it. The impact on society arrived like a thunderbolt in recent days, and as a country we’ve been knocked on our heels. But our response is coming, and no country is better equipped to come right back and do whatever is required to overwhelm this threat.

Thursday’s fall in equity markets was the worst since the October 19^th, 1987 stock market crash. I was a young interest rate trader then, and that evening I warned my wife that we should stock up on canned food while we prepared for another 1930s Depression. She scoffed that only Wall Street had a problem, and that Main Street was fine.

1987, 2008 and today have different causes, but the need for some solid valuation guideposts is the same. The Equity Risk Premium (ERP) is the difference between the S&P500’s Earnings Per Share (EPS) yield (inverse of the P/E) and ten year treasury yields. Assuming, EPS drop 15%, the ERP is showing stocks to be attractive. A 15% drop seems conservative, and would be approximately the same as 2008, but we’ll emerge from this crisis into a different world. Based on what we know today, broad equity exposure looks cheap.

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Energy sector investors have endured several years of underperformance. The industry has invested more in exploiting the Shale Revolution than investors wanted them to. Crude oil has been hit by the Covid-19 demand shock, collapse of OPEC+ and Saudi Arabia’s subsequent decision to increase supply into an over-supplied market.

Domestic energy demand will drop, but it will eventually recover. The upstream companies that drill for oil are at the epicenter of the price collapse. Midstream energy infrastructure companies care about the financial health of their customers as well as the volumes flowing through the system. The sector entered this downturn with stronger balance sheets than in 2014 and with a developing very positive free cash flow story (see Updating the Coming Pipeline Cash Gusher).

We expect most to follow Oneok (OKE) in cutting spending on growth projects this year, which will free up cash to further reduce debt. The American Energy Independence Index consists of 75% investment grade companies doing about 80% of their business with investment grade customers. The index is down around 50% YTD, roughly the same as U.S. airline stocks, which are regarded as needing some type of short term Federal government support.

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Finally, an interesting chart from Ethan Bellamy at RW Baird, which illustrates the shift in the crude oil curve over the past three months. Spot prices have moved much more that deferred futures contracts. Saudi Arabia and Russia are generally sellers into the spot market, while shale drillers tend to hedge future output for the next couple of years. Because the curve is in contango, sales in the spot market have the lowest realizations.

A strategy to damage the shale industry would create backwardation, as existed in December. In that environment, forward sales of output realize lower prices than spot, which is good for big producers like Saudi Arabia. Their goal is to drive down futures prices along the curve, and the chart shows that spot prices have dropped $30 to produce a far smaller change at, say, the 36 month point. It’s a very expensive strategy for the sellers. At least the Strategic Petroleum Reserve is being replenished cheaply.

Energy had the worst week any of us can recall, and few readers probably have much appetite for a bullish view. For investors and asset managers in the sector, Friday’s rally was welcome but well short of compensating for prior losses. So we’ll just let the chart speak for itself.

Bankruptcy risk is the topic investors want to discuss in calls this week. Within the American Energy Independence Index, the pipeline industry is 80% investment grade companies. We estimate that around 20% of it is direct exposure to crude oil pipelines. 80% of their customers are themselves investment grade.

During the 2008 financial crisis, crude oil consumption dropped 10% and natural gas was unaffected (see With Energy Uncertainty, Natural Gas Offers Stability).

These are some of the facts and figures investors should rely on in assessing the outlook. Then we have to judge how Americans are going to respond to the spread of coronavirus. Everybody can form their own judgment, because none of us has any prior experience with the issue. Avoidance of the virus is far more economically destructive than the sickness itself.

German chancellor Angela Merkel said two in three Germans may become infected in the years ahead. It seems that it’ll be hard to avoid.

Companies are lowering their growth capex plans for this year, which will improve Free Cash Flow (FCF) from what it would otherwise be. Oneok (OKE) yesterday reaffirmed their 2020 EBITDA guidance, while cutting capex.

The OPEC+ collapse and subsequent Saudi production increase are a direct hit at a sector that’s been under pressure for years. A month ago, the outlook was positive with FCF set to rise sharply.

None of us knows how society will respond in the weeks ahead. The best advice we can offer is that this is generally an investment grade industry, and that while energy consumption will temporarily drop, it will recover. The components of the index have a trailing dividend yield of 13%, with payout ratios of just 60%.

Yesterday’s blog on the positive free cash flow story was largely written before Saturday’s news that precipitated today’s sharp sell off. It’s doubtful any company would reaffirm prior guidance if asked right now.

Investment grade names are better to own than high yield issuers; exposure to natural gas infrastructure is better than crude oil pipelines; corporations are preferred over partnerships.

We would not recommend outright sales at present.

We doubt $30 crude oil will produce enough supply to meet demand over the long run, but we have to get through the short run first.

One of the challenges facing solar energy in providing electricity is that demand often peaks at the beginning and end of the workday. When people are preparing to head to work or school, electricity demand rises. The second peak occurs during early evening during dinner. Solar output peaks around midday, inconveniently between the twin household peaks.

The Energy Information Administration (EIA) produces more detailed data on electricity consumption that shows intra-day consumption by region and at different times during the year. It presents a much richer picture of how we use electricity.

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The twin peaks around breakfast and dinner apply most clearly during winter. There are clear regional differences too. In the southwest, consumption during the day is barely above nighttime, which is normally the trough in all cases. In the northeast and Pacific coast, evening demand is higher than morning, while in Texas and the southeast the reverse is true. It’s probably driven by relatively fewer hours of daylight in northern latitudes, but perhaps Texans watch more morning TV as well.

In summer, the need for air conditioning dominates, and intra-day electricity consumption is highest around mid-afternoon in every region, which aligns more conveniently with solar output. As a result, demand is highest in the summer, with spring and fall being lowest.

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You can also see how we source our electricity on an hourly basis. The chart takes a recent seven-day period. Solar and wind are intermittent, so they produce when they can. Natural gas and to a lesser extent coal produce when they’re needed, which highlights a huge advantage fossil fuels have over renewables. Often the intra-day peak for natural gas is when renewables generation is low. Coal burning power plants are less able than natural gas plants to change output easily in response to shifts in demand. Over the sample period, natural gas output had a -0.40 correlation with wind, neatly capturing the symbiotic relationship that exists between the two. As a grid increases its reliance on renewables, fluctuations in output must be balanced either with battery storage or natural gas. Nuclear output is steady, making it a poor renewables partner, although an energy policy focused on reduced emissions would favor increased nuclear power.

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Although renewables receive substantial press coverage, solar provided only 1.5% of our electricity in mid-February. Wind has been more successful, at 9.1%. But the big change in mix has been the steady displacement of coal by natural gas, which drove America’s 2.5% drop in CO2 emissions last year. Natural gas burns cleaner and runs when it’s not sunny or windy. It’s part of our energy future.

S&P earnings are estimated to be +8% this year, according to Factset’s most recent publication. The sharp sell-off in stocks last week shows that markets are looking ahead to revised guidance. Covid-19 is a true black swan event that is challenging people to assess its impact. For example, my daughter just canceled a Caribbean cruise because she has three young children, including a four month old. The cruise line’s “Coronavirus update” spooked her, even though it only applied to Asia. My nephew, a UK-based virologist sequestered to work on the virus, advises that we will adapt to a new, seasonal flu for which annual vaccinations will eventually be available. A week ago I bought some face masks on Amazon.

In an abundance of caution, 14% of regular drinkers of Corona beer are shunning the beverage. Since comparing the fatality rate of Corona with coronavirus is a few clicks away on a smartphone, employed Corona drinkers likely exhibit limited mental dexterity.

Covid-19 is both more infectious and deadly than the seasonal flu, with a fatality rate that is estimated at 2-4% for Hubei Province where it started, and 0.5-1.0% in other parts of China. Locking down entire cities, as the Chinese government has done, promoting “social distancing,” and numerous canceled sporting events all hint at severe economic disruption. The results will show up in most corporate earnings reports for this quarter and possibly beyond. The S&P500 moved from another record high to a 10% correction in just six sessions, the fastest in history. On Friday it closed 12% below its February 19 high.

Crude oil fell $8 per barrel, dragging the S&P Energy ETF (XLE) down 17%, and the rest of the sector with it. Unlike the S&P500, XLE was not retreating from a recent all-time high either. The attractive yields on pipeline stocks offered only modest valuation support, with the American Energy Independence Index (AEITR) falling 14% from its February 19 recent high.

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We updated our Equity Risk Premium (ERP) model to offer a guidepost in all the uncertainty. In December, we noted that the spread between the earnings yield on the S&P500 and ten year treasuries (the ERP definition) still favored stocks, but not as much as it had in the past. We also pointed out that fixed income buyers were keener to invest in energy infrastructure than stock investors (see Pipeline Bond Investors Are More Bullish Than Equity Buyers).

Today’s investors in stocks confront substantial near term uncertainty and the possibility that extended economic disruption will lead to a recession, a warning offered by ex-Fed chief Janet Yellen.

At its recent peak on February 19, the ERP was at 4.2. Following the recent drop, assuming 2020 earnings are flat rather than the +8% from Factset’s forecast, equity valuations are roughly unchanged with an ERP of 4.5.

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The problem is that it’s still difficult to assess the earnings hit covid-19 will cause. Economic activity in China appeared to collapse, with coal consumption 40% below normal. Japan has closed all its schools until early April, affecting 13 million students. The U.S. Center for Disease Control (CDC) described the potential public health threat as high, both globally and to the United States. We can imagine the consequences of a U.S. region or major city confronting an outbreak.

A 20% drop in earnings would exceed the 2008 financial crisis. A very severe covid-19 recession in the U.S. would be required to cause this kind of fall in profits. The ERP might not be many people’s first thought in such an outcome, but suffice it to say that stocks aren’t cheap if you rate this as a real possibility.

Although crude oil’s fall in response to economic weakness has hurt energy infrastructure stocks, we continue to expect substantial growth in free cash flow this year and next. Other than Cheniere Energy, who have seen a couple of shipments of liquefied natural gas cancelled, the virus has had very limited impact on the sector’s outlook. The components of the AEITR yield 8.2%, with mid-single digit percentage dividend increases expected for the next several years.

We are invested in all the constituents of the American Energy Independence Index, which includes Cheniere Energy, Inc.

Few sectors are immune from coronavirus fears, and energy is no exception. Although U.S. midstream energy infrastructure is overwhelmingly domestic, growing oil and gas exports have increased business sensitivity to global export demand.

Liquified Natural Gas (LNG) prices for Japan and South Korea (the Japan/Korea Market, JKM) have fallen dramatically in recent months. This was initially driven by weak U.S. prices because of the glut of domestic natural gas. Softening demand due to coronavirus has added to this.

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Consequently, Cheniere Energy Inc. (CEI) had fallen more than most, down 16.7% YTD through Monday prior to earnings, and substantially worse than the American Energy Independence YTD at -6.5%. CEI has always asserted that their business model limits their exposure to LNG prices, since they typically don’t take delivery. Nonetheless, canceled shipments and softening demand would still be expected to hurt.

So CEI’s earnings, released yesterday morning, provided a welcome confirmation of their business model’s resiliency. 4Q EBITDA of $987MM beat expectations, and was +56% Y-O-Y. CEI dispatched 429 cargoes last year, +57% versus 2018.

Coronavirus wasn’t a factor in 4Q earnings, so investors were more interested in the outlook. Although CEI reaffirmed 2020 EBITDA guidance, at $3.8-$4.1BN, in their comments they noted it was tracking towards the lower end of the range. LNG shipments are similar to pipeline take-or-pay contracts, in which shippers have to pay for capacity whether or not used. For now anyway CEI expects a muted impact over the full year, although they did note two April shipments had been cancelled. Asia used to dominate LNG trade, but last year European provided most of the demand growth, reaching 50% of all U.S. LNG exports in 4Q19.

On the earnings call, CEO Jack Fusco noted several highlights, including their 1,000^th LNG cargo. It took less than ten minutes to get to the ESG slide – Fusco correctly noted that switching from coal to natural gas for power generation is one of the most meaningful steps countries can take to lower CO2 emissions. China, which burns half the world’s coal, is where such efforts must start.

CEI’s stock opened higher, but slid during the day on comments from the call as well as the market’s broad-based slump. It’s still too soon for investors to look at fundamentals; coronavirus dominates every move.

Earnings season for pipeline companies is drawing to a close, with just a few more names left to report. Results have been mostly as expected with a couple of surprises. Targa Resources (TRGP) handily beat expectations for 4Q19 EBITDA at $465MM versus $362MM. CEO Joe Bob Perkins drew criticism last year for his flippant comment about “capital blessings” when responding to investor questions about growth capex. A charitable assessment of TRGP’s capital allocation would concede that they embrace investing for future cashflow more than most of their peers. However, it does look as if they’re in the middle of a big swing in Free Cash Flow (FCF) 2019-2021. Following earnings, TRGP jumped 7%.

Energy Transfer (ET) reported another strong quarter and guided long term growth capex down to $2.0-2.5BN. 2018 FCF was ($412MM), and this year it should come in above $2.5BN, illustrating the very positive FCF improvement across most of the industry as financing of growth projects recedes. ET was also ready for the predictable question on structure – a “c-corp option” was their response, presumably meaning they’ll create a 1099-issuing entity that holds ET units. This will broaden the investor base but leave whatever concerns investors have about governance unresolved – by offering investors a c-corp without traditional corporate governance, its price may shed some light on the valuation discount partnerships endure.

Williams Companies (WMB) reported in-line earnings, but the conference call offered some useful insights. Upstream companies (i.e. oil and gas producers) are the customers of midstream energy infrastructure, and E&P bankruptcies often cause concern that pipelines will be left stranded, running to wells that no longer produce. WMB CEO Alan Armstrong had this to say,

“After a very long time in this midstream business, I have seen and experienced many instance of producers’ stress and even bankruptcy, and it’s very clear to me that the most protected service by far is that a wellhead gathering. Wellhead gathering is absolutely essential to any reserves that are going to be produced. Gas could not get to market and cash flow cannot be realized, if wellhead gas gathering is not available.

“While counterparty credit is important, the physical nature of the service is even better security.”

History has shown that in general an E&P bankruptcy just leads to a change of ownership – initially often the bondholders as equity is wiped out. Where production covers operating costs but earns an inadequate return on capital, the drilling lease was purchased at too high a price with excessive debt. Bankruptcy alters the capital structure. Pipeline operators are generally kept whole.

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On another topic, opposition by environmental extremist to new pipeline construction represents an undemocratic effort to achieve what they’ve failed to democratically. For an investor interested in FCF, making pipelines harder to build lowers growth capex, leaving more cash to be returned to investors. So while pipeline opponents betray only a passing familiarity with how modern civilization functions, their wrongheaded moves aren’t necessarily unfriendly to investors.

Making new pipelines harder to build can also increase the value of existing ones. Alan Armstrong had this to say about Transco, WMB’s extensive natural gas pipeline network:

“The forces you see working in the market today are only increasing the competitive advantages of Transco. Low prices continue to incent demand in all sectors, and our access to many geographies and types of demand is unmatched. LNG, industrial, power, residential, commercial are all growing along Transco.

“Difficulties seen by Greenfield pipeline projects will also benefit Transco in the long run, as Transco has uniquely positioned to meet new capacity demand by expanding along its existing rights of way, which are irreplaceable and unmatched in terms of their proximity to demand.”

As we’ve mentioned in the past, growing FCF remains the strongest reason to invest in pipelines. Last year the two big Canadians, TC Energy (TRP) and Enbridge (ENB) were half the FCF of the sector as defined by the broad-based American Energy Independence Index. Consequently, TRP and ENB both outperformed the S&P500 in 2019, providing solid evidence that strong operating performance trumps any investor aversion to the energy sector.

This year the two Canadians’ share of FCF should drop if, as we expect, other companies finally start to emulate them.

We are invested in all of the names mentioned above.

To their credit, Kinder Morgan (KMI) responded to our recent blog (see Kinder Morgan’s Slick Numeracy). We exchanged several emails, although they declined our invitation to write a rebuttal which we promised to publish unedited. The company stands by their presentation, but did concede that some slides might have been more clearly labeled.

We had noted in our blog that the 5.9X EBITDA multiple on $12.3BN invested didn’t foot to the $1.8BN EBITDA from growth projects in the Bridge Chart. KMI explained this was because some investments they made had been sold in the meantime.

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They believe that attractive returns on more recent investments have been masked by headwinds in their existing business. The EBITDA Bridge Chart blames the 2014-17 energy downturn for $0.6BN in reduced EBITDA from their CO2 business, which is net of new investment (i.e. CO2 growth projects are included in this figure). The $0.3BN drop in the Midstream segment was from lower volumes and tariffs in their pipelines.

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KMI’s return on invested capital has drawn questions from others. A January 6 research report from Morgan Stanley placed KMI’s 2017-18 Return on Invested Capital (ROIC) at 4.5%, worst out of 12 peers. In October, Wells Fargo calculated a 2013-18 cash return on investment of 4%, 2^nd worst in the group and declining.

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In response, KMI referred us to a slide showing ROIC by segment. They say they have discussed the Wells piece with the firm, and make a distinction between recently invested capital and returns on legacy assets.

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The ROIC slide incorporates some complexity. The footnote reminds that pre-2014 returns are from Kinder Morgan Partners (KMP) and El Paso (EPB), which is where KMI’s operating assets were held before being rolled up into the parent. Those were the days of Incentive Distribution Rights (IDRs), when KMP and EPB both paid a share of their returns back to their controlling general partner, KMI.

Once the IDRs went away, returns might have been expected to jump. That they didn’t suggests that the chart treats IDRs as a cost of capital and not as an expense to KMP and EPB, which they most assuredly were. So we think the returns are on the assets, not on what KMP and EPB unitholders earned on those assets.

KMI believes they are making a genuine effort to present their case, and in providing so much detail they create opportunities for investors like us to look for inconsistencies. But we think that EBITDA multiples aren’t a good way to do it. The declining ROIC chart is hard to reconcile with higher recent returns. It also highlights the volatility of the CO2 business, which they evidently believe can get back to the returns it generated a decade ago. The fact that they haven’t yet received a sufficiently attractive offer for this segment means few share their optimism.

The company uses IRR in allocating capital. They say new projects require unlevered pre-tax returns of 15-20%, but their ROIC chart shows returns sliding towards 10%. At some point the high return investments of recent years must lift their overall ROIC. EBITDA multiples can flatter – a project with declining EBITDA (like a CO2 investment) might look superficially attractive based on Year 2 returns but ultimately not cover the cost of capital. The company is adamant they’re not allocating this way. So why not show expected IRRs on new investments?

We appreciate KMI’s effort to reach out – “slick numeracy” probably didn’t gain us any additional friends there. Along with countless other long-time investors, we’re frustrated that KMI remains well below the highs of 2014. Their stable, fee-generating assets ought to draw a higher valuation.