In February, following our criticism of Kinder Morgan’s (KMI) return on invested capital (see Kinder Morgan’s Slick Numeracy) the company, to their credit, reached out to us so as to better present their perspective. Our point was that capital allocation decisions in recent years had not always been accretive to equity. We offered the company an opportunity to write a rebuttal which we promised to publish, unedited, but they declined. So we summarized their response (see Kinder Morgan Responds to our Recent Criticism).

Not long after, Covid dominated the news, and historic returns on invested capital took a backseat to gauging current demand destruction. KMI’s stock sank from $21 to under $10, before recovering roughly halfway to $14.

KMI kicked off earnings reports for the sector last week. We were most interested in their outlook, but also in their planned growth capex. Industry-wide spending reductions are driving improved profitability (see Pipeline Cash Flows Will Still Double This Year).

KMI announced a $1BN goodwill writedown on natural gas gathering and processing assets previously acquired. Although a non-cash expense, this is an example of capital deployed whose cash generation will no longer meet its target. KMI will blame Covid, but nonetheless it’s a loss for shareholders.

The company confirmed guidance of $1.7BN in “expansion opportunities” (we winced) for 2020. This is well below their prior range of $2-3BN annually over the next decade, as initially communicated in April during the depths of lost production. Several questions followed on the earnings call – in response to Shneur Gershuni of UBS,  CEO Steve Kean allowed that future capex, “looks like it hangs around the level we’re seeing in 2020, maybe a little less.”

This cheered us, and later JPMorgan’s Jeremy Tonet asked, “…is there a scenario where 2021, or maybe in 2022, where growth CapEx could be as low as $1 billion?” We were left positively giddy when Steve Kean replied, “We’re close, yes. We’re close.”

When it comes to pipeline company growth capex plans, they share the qualities of an overly vigorous golf swing – less is more.

KMI’s adjusted EBITDA came in at $1,568MM versus expectations of $1,634MM. They also lowered full year DCF to 11% below budget (was previously 10% below). They still plan to increase their dividend to  $1.25 annually, which would yield over 8.5% at the current stock price. They expect to reach 4.5X Debt/EBITDA although conceded 4.7X is their likely year-end level.  They also pushed back the date at which they expect to be a corporate taxpayer to 2026.

Meanwhile, domestic production is recovering along with demand. In recent weeks, oil production has risen from 9.7 Million Barrels per Day (MMB/D) to 10.9 MMB/D, and the industry now expects it to settle in around 11 MMB/D. That’s still well below the pre-Covid level, which was on track to hit 13 MMB/D by year’s end. But it’s improving. “It’s a slow, slow recovery, but it’s happening,” said Alexandre Ramos-Peon, a senior analyst at Rystad Energy, a consultancy.

Natural gas demand of 85.5 Billion Cubic Feet per Day (BCF/D) remains close to a year ago of 89.4 BCF/D, exhibiting very little response to Covid. LNG exports of 3.7BCF/D are down by 2.4 BCF/D, representing more than half the drop as global LNG demand has softened somewhat. Overall, the market hasn’t registered much impact.

Pipeline stocks such as KMI have dividend yields that reflect considerable market skepticism regarding their longevity. Bond investors harbor few doubts, as we noted recently in comparing Enterprise Products Partners 30 year debt yields of around 3% with the almost 10% dividend yield (see Pipelines Are Becoming Less Risky). KMI just announced a 2050 maturity with a 3.25% coupon. The chasm between dividends and bond yields in this sector reflect rigid investor segmentation, and a misallocation of capital by fixed income buyers who would greatly benefit from the flexibility to incorporate some equity risk.

Earnings reports from other big pipeline companies over the next few weeks should provide confirmation of growing free cash flow and secure dividends.

We are invested in EPD, KMI and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Earnings season for pipeline stocks begins on Wednesday 22^nd, with Kinder Morgan (KMI) reporting after the market close. We expect the quarterly updates from the sector’s biggest companies will confirm the progress towards improved profitability (see Pipeline Cash Flows Will Still Double This Year). We’ll also hear from management teams how they regard the prospects for new projects.

Last year, a stand-off over Kinder Morgan Canada’s proposed Trans-Mountain Expansion halted construction. Opposition from environmental extremists in British Columbia thwarted oil-rich Alberta’s goal of increasing its access to export markets. The Canadian government bought the pipeline, saving KMI from a costly, intractable problem between two Canadian provinces. Enbridge commented in a call that they wouldn’t attempt to build a new oil pipeline in Canada, unless it was wholly within energy-friendly Alberta (see Canada Looks North to Export its Oil).

Following the cancelation of the Atlantic Coast Pipeline (see Pipeline Opponents Help Free Cash Flow), the continued legal uncertainty over already completed Dakota Access Pipeline (listen to  Judicial Over-Reach on the Dakota Access Pipeline) and the perennially delayed Keystone XL, big projects look similarly stymied in the U.S. Given the trends in election opinion polls and economic uncertainty over Covid, we expect few new initiatives for the balance of the year and possibly some further cancelations.

Although management teams will be frustrated, long-time investors in pipelines are realizing that poorly informed yet effective environmental extremists are an unlikely ally in leaving the sector with few options for its excess cash beyond returning it to investors through dividend hikes and buybacks. We expect this theme to play out over a couple of years. We suspect Berkshire’s interest in acquiring Dominion’s natural gas pipeline network is to redeploy the cash it generates to other Berkshire subsidiaries where capex is not controversial.

Investors continue to withdraw money from MLP-dedicated open-end funds. JPMorgan recently reported that during the first half of this year such outflows totaled $764MM, with June marking the fifth straight months of redemptions.

This is clear from relative performance, which shows the Alerian MLP Infrastructure Index (AMZIX) down 33% so far this year, lagging by 10% the more broadly representative American Energy Independence Index (AEITR). Corporations, which dominate the AEITR, have more numerous buyers than MLPs, which is why AMZIX is slumping. A broader set of investors and better governance are widely regarded as favoring corporations. Investor behavior is confirming this trend, which we expect to continue.

Stocks and bonds have appeared to reflect wildly different economic forecasts for years, which is why stocks always look cheap. The contrast between fixed income and equity investments is most dramatic in pipelines (see Pipeline Bond Investors Are More Bullish Than Equity Buyers). To cite one example, Enterprise Products Partners (EPD) has several 30-year maturity bond issues outstanding with yields from 3-3.2%. The company is a third owned by insiders, never cut its distribution and pays a 9.8% dividend. Skeptics of its equity might benefit from chatting with a few EPD bond holders.

We are invested in EPD and KMI, and all the holdings of the American Energy Independence Index via the ETF that tracks it.

Sunday’s blog (see Pipeline Opponents Help Free Cash Flow) drew some interesting feedback. It seems odd to favor constrained growth opportunities, and it’s contrary to how most management teams will assess their outlook. But for many pipeline investors, including your blogger, the pre-Shale years of steady returns were what made the sector attractive. Anti-fossil fuel activists refuse to acknowledge how the world works, but they are making new pipelines cost-prohibitive, just as nuclear opposition has done for that source of power.

Investors have asked about the prospects for the Dakota Access Pipeline, DAPL (listen to Judicial Over-Reach on the Dakota Access Pipeline). Judge Boasberg ruled that DAPL should shut down, and allowed only 30 days for it to be emptied of crude oil even though the owners argued that was too little time. Once shut down, there is a real question as to whether it will ever re-open. Since the pipeline is built and in use, you’d think shutting it would require extraordinary circumstances.

Yesterday evening, a U.S. Appeals Court granted an administrative stay while it considers whether the line, long opposed by local tribes and environmental activists, should be shut.

In this case, the government has been found to have incorrectly issued the permit allowing it to be built. Ludicrous analogies are easily constructed – if you can’t safely build with government approval in hand, nothing much could get done in this country. The courts will decide if Judge Boasberg is correct on the law, but if he is it means the law is wrong and needs to be fixed. We think this is a unique case, and that existing pipelines are not at risk of being shut down.

Even if the shut-down order is ultimately overturned, the Army Corp of Engineers has been told to carry out a more robust environmental study than was originally done. Although the Trump administration could appeal this requirement, it appears that there is insufficient time to do so before the election. One of Trump’s first acts following his inauguration was to direct the Army Corp of Engineers to issue the necessary permit. That legal challenges have outlasted the term of this administration with DAPL’s prospects still not resolved further highlights the challenges of new projects.

Investors have to consider the possibility of a Biden victory, which will lead to a changed emphasis towards climate change in the White House. In this scenario, DAPL’s prospects would be unclear. If it’s been shut down pending a revised environmental study, it may never re-open. The hit to Energy Transfer (ET) is around 3.5% of EBITDA, which we think is already priced in.

Although Biden is calling for $2 trillion to be spent on clean energy, Covid is causing a ballooning Federal budget deficit, currently $2.7 trillion with three months of the fiscal year remaining. As a % of GDP we’re approaching World War II levels. Being better prepared for another pandemic is likely to be more important than in the past, so cheap, plentiful domestic natural gas will continue to gain market share in providing energy to Americans. It’s confidence in this future that underpinned Berkshire recent acquisition of Dominion’s pipeline and storage assets.

Meanwhile, existing pipelines are more valuable. Dominion and Duke Energy abandoned their Atlantic Coast Pipeline (ACP) even though they had successfully fended off legal challenges and had plenty of customer commitments. So Transco, owned by Williams Companies (WMB) and operating from Texas to New York, is well positioned to meet some of this unsatisfied demand. They may even find a way to bring Appalachian natural gas to customers in North Carolina by building on to their existing network. They’ll have no competition.

Since the ACP cancelation WMB has outperformed the sector, as defined by the broad-based American Energy Independence Index. Both have outperformed the Alerian MLP Index, since investors continue to avoid concentrated MLP exposure.

We are invested in ET and WMB.

We publish the American Energy Independence Index

Client meetings for many businesses have had to conform to local Covid-19 restrictions. Most of us have found that working remotely is fine, although I suspect it’ll become increasingly problematic in the months ahead. As Zoom calls suddenly became part of daily life, we were all chatting with people with whom we had recently shared an office. Relationships already existed. But we’ll see how it goes when newcomers have to build a rapport over Zoom. Training is also harder. Remote learning is widely believed to have been a bust (see The Results Are In for Remote Learning: It Didn’t Work). Research is finding that students achieved only 70% of the reading gains compared with a typical year, and less than 50% of the Math. This is why it’s critical that schools reopen in-person in September.

Meeting with clients has to take place outside – the photos are from a recent breakfast with two long-time clients and friends, Ron and Jeff Karp from Summit Private Investments. In March all the large investment firms we deal with quickly suspended visits by outsiders. Every contact now carries some risk, and it’ll be interesting to see how much old attitudes are restored once the general population is vaccinated or otherwise immune. It’s likely that the risk of infection disabling an entire department or firm will be a permanent consideration, just as business continuity plans took on added importance following the 2001 attack on the World Trade Center. In finance, we can expect regulators to start looking at how firms protect their employees, as well as their plans if another pandemic occurs.

Nobody misses their daily commute into New York City from the suburbs. Numerous conversations reveal that the 2-3 hours of time previously dedicated to daily travel is highly valued. People will return to the office, but it seems that schedules have permanently changed. Mass transit in the New York area and presumably others is likely to experience a permanent drop in demand, which will pressure finances.

JPMorgan expects to operate with offices only half full, even once restrictions have been lifted. “Hot desks”, available to different users each day will be a used at least temporarily. I understand from a friend that satellite offices are being considered in the suburbs, where enough formerly commuting employees live. Edison, NJ and Stamford, CT are two locations apparently under consideration. Although big corporations will want a more dispersed labor force, they’ll also want their people working in a secure IT environment subject to corporate oversight.

Another friend from Goldman Sachs told me seasoned employees in his department will work from home two days a week, and that such schedules will be fixed — i.e. if Tuesday and Wednesday are your at-home days, you’ll generally be required to stick to that. Interestingly, new hires will be expected in the office five days a week, recognizing that working remotely relies in part on existing professional relationships that have been built through in-person interaction.

I’ve also heard that ground floor office space is becoming more sought after, because workers don’t need to use the elevator. The WSJ noted the other day that some employers, “…can’t figure out how to send people up a 50-story skyscraper.” This is because, “… limiting riders on some elevators would create dangerous crowding in lobbies.”

What does all this mean for energy consumption? U.S. gasoline demand has recovered to around 85% of last year’s levels, a surprisingly strong rebound given the recession. The re-imposition of types of lockdown in some southern states hasn’t yet shown up in the figures. But over the longer term, even when masks and social distancing are mostly a memory, some reduction in demand is still likely.

What receives less attention is the continued robust demand for natural gas. The latest weekly figures show total demand slightly ahead of this time last year, at 80.7 Billion Cubic Feet per Day. Across the midstream energy infrastructure industry, we calculate 58% is involved in natural gas with petroleum products only 26%. Although altered work habits are likely to dampen transportation demand, this is a smaller part of midstream than many realize. Earnings reports over the next few weeks will provide an important update on overall energy demand.

Covid-19 is probably the biggest political issue in America today. Liberals see a worsening situation in need of a slower return to normalcy requiring additional fiscal stimulus. Rising infections in Arizona, Texas and Florida provide plenty of quantitative support for this view. Conservatives reject this argument, presenting their own set of data. The restrictions on movement imposed by most states have offended those who perceive an unneeded loss of freedom – some even put face masks in this category, although masking up when in close contact with others seems a fairly trivial courtesy.

The sensational headlines continue to inspire fear, such as Newsweek’s “Texas’ Largest Hospital Reaches 100 Percent ICU Capacity”. The article goes on to add that 72% of that capacity is being taken up by non-Covid-19 patients, which nullifies the headline. This is why “liberal media” has become a term of disparagement.

There is data to support the view that the pandemic continues to moderate, and is far less fatal than originally feared.  A well-run hospital is always at 90-100% ICU capacity.  Hospitals can free up ICU beds  by canceling elective surgeries, and redesignate certain beds as ICUs, allowing them to operate at multiples of normal capacity.

Making an optimistic case shouldn’t imply that the proponent isn’t worried about getting sick. A conversation with a friend who was hospitalized for four days convinced me this virus is better off avoided.

Conservatives note that positive test results are going up, but that it’s due to increased testing. We’re finding more infections because we’re counting more. Liberals counter that the percentage of tests that are positive has edged up over 6%, which means it’s not all down to increased testing. However, this is still far below its peak of 21.8% in April. The criteria for testing have evolved, and riskier groups such as nursing home or prison populations will test higher. Because young people represent a bigger proportion of positive test results, some argue that they’re not following social distancing guidelines. While there are lots of photos to support that, hospitalization data continues to moderate, which suggests that people who are testing positive aren’t as sick. This is true even in Texas, where positive tests results are rising. Nationwide, hospitalizations and the fatality rate continue to fall. Doctor visits for flu-like symptoms are down.

The strongest argument that Covid-19 is unlikely to kill millions comes from estimates of the overall infection rate. U.S. fatalities are 120,000 (defined as people who died where Covid-19 was a contributing factor, although it’s now well known that other contributing factors such as obesity are usually present). Older people are far more vulnerable. CDC data shows that just 19% of fatalities are people under 65 years old.

We referenced a research paper on Wednesday (The infection fatality rate of COVID-19 inferred from seroprevalence data) that estimated an Infection Fatality Rate (IFR) for those younger than 70 years old of 0.04% (see Still Spreading, But Less Deadly). CDC data doesn’t precisely align, because they define age cohorts as 55-64 etc., rather than 60-70. But a reasonable estimate is that 30,000 people under 70 have died.

The 0.04% IFR implies that for every 10,000 people under 70 who are infected, four have died. This suggests that 75 million Americans have been infected (30,000 divided by 0.04%). It seems an impossibly high number – and yet, CDC Director Robert Redfield said on Thursday that, “5-8% of the American public has experienced infection, whether they recognized it or not.” This implies somewhere between 16 and 26 million Americans have been infected. With 2.2 million confirmed cases, that means for every positive Covid-19 test, another 7-11 people are infected but not bothered enough to visit a doctor. Redfield’s estimate is for the entire U.S. population, while the 0.04% IFR is for <70. But the two estimates are broadly consistent.

As with much of the data, it can confirm contrasting views. How the Virus Won reflects a Liberal view. Alternatively, for most of this year excess deaths have been below normal, partly because road fatalities are down (usually around 38K annually).  It’s possible that we’ve avoided more deaths from all other causes than Covid-19 has caused, although nobody knows who those fortunate souls are. One Covid-19 death is one too many, but policymakers are responsible for making judgments for society as a whole based on the best data available.