Kinder Morgan holding its own

Kinder Morgan is one of the largest energy transportation, storage, and distribution companies in North America. The company owns more than 35,000 miles of pipelines and 170 terminals on the continent through Kinder Morgan Energy Partners (NYSE: KMP), Kinder Morgan Management (NYSE: KMR), and Kinder Morgan, Inc., a privately-held company. Kinder Morgan is headquartered in Houston, Texas.

C. Park Shaper is president of the Kinder Morgan companies.  He received a Masters of Business Administration degree from J.L. Kellogg Graduate School of Management at Northwestern University, and also has a Bachelor of Science degree in Industrial Engineering and a Bachelor of Arts degree in Quantitative Economics from Stanford University.

 

PGT: Please tell us a little bit about the immediate outlook for energy transportation, storage, and distribution markets in the U.S., given at this point that it’s pretty unclear where we stand in terms of recovery?

Park Shaper:  If you’re talking about immediate impacts, it’s a little bit different when referring to midstream energy assets.

In general, these are assets that generate cash flows in just about any environment. We’re typically paid either based upon a capacity lease — meaning capacity on our pipelines or in our terminals — or based upon volumes. Capacity leases tend to be contracts and they don’t have much short-term impact at all. Some of our other assets are a bit more volume sensitive,
but the changes in volumes are relatively small. If you look at what’s going on right now, the weak economy has had an impact on volumes for some of the products that we handle.

Most of our assets are part of Kinder Morgan Energy Partners and we have five business segments. On the natural gas side, demand has declined primarily in industrial and commercial sectors. So you have chemical plants that have shut down or are running at reduced levels and again, other industrial facilities, steel-manufacturing plants or steel-processing plants that may be running at reduced levels. That reduces demand, which will reduce volumes across our pipelines. But since, on that particular set of assets, we tend to just lease capacity to our customers, they pay us regardless of what volume they send.

The other four segments are Products Pipelines in which we’re transporting gasoline, diesel fuel, and jet fuel. Terminals, where we handle a lot of the same refined products —including gasoline, diesel fuel, and jet fuel. But we also handle a lot of bulk materials like coal, steel, petroleum, coke, and cement.

In our CO2 business we’re transporting carbon dioxide and selling it to third parties who use it for enhanced oil recovery — they inject it into the ground to produce more oil. We also own a couple of oil fields ourselves in West Texas where we are using CO2 [in the same way].

And the fifth segment is Kinder Morgan Canada. There we own primarily pipelines that are transporting crude oil and refined products, generally out of Alberta. We have the only system out of Alberta to the west coast of Vancouver and Washington State. And then we own a line that runs south of out of Alberta into the Rocky Mountains and across the Midwest into Illinois. We also own some terminal facilities in Canada.

Now, as I mentioned, natural gas volumes are a little bit lower, but it doesn’t have much of an impact on us. On the refined products side, with a weaker economy we have seen lower demand, and there a number of our pipelines are volume sensitive. What you’re talking about is volume that we normally expect to grow at two to three percent, we’re seeing decline at maybe five percent last year and this year. So that has an impact on our earnings, although it’s not huge. I mean, you’re talking about a five-percent impact. And truthfully, there are ways that we can overcome that. It’s largely fixed costs, but a large portion of our variable cost is power and that has come down and so that helps to offset it. And then there are also tariff adjustments and other things that can be made to offset that impact.

Unlike our other business segments, commodity prices matter to a certain extent on the CO2 side. It’s actually the one area where we do have some direct commodity exposure and that’s relative to our oil production. Now, we hedge that away for the most part, but there is a portion of that production that is un-hedged. The largest portion of the un-hedged sliver is really natural gas liquids, which are a little bit more difficult to hedge. But they tend to be correlated to crude oil. And so what has impacted us in the last 12 months there is a lower price of crude oil. It’s impacted just that un-hedged portion. So it’s not necessarily related to the economy, except to the extent the two [the price of oil and the immediate economic picture] are tied together.

On the liquids side of our terminals business, we store and transfer petroleum products and chemicals. There, we tend
to lease capacity so economic fluctuations or demand fluctuations don’t have a big impact on the performance of the business. Now, on the bulk side, the amount of tonnage we handle doesn’t typically fluctuate that much. When it does, we are protected in most cases with minimum volume guarantee contracts. However, we do have contracts with some of our steel customers that don’t have these guarantees. We do handle a lot of steel, so we have felt the impact of the economy there since the recession has impacted steel production output, and thus, the amount that we handle.

And then on the Canadian segment
we really don’t see much impact from the economy on these assets. Those are all our assets and the immediate impact of the economy on them, that’s what’s going on.

But it’s also worthwhile to think about the long term. If you are in an environment where demand stays depressed for an extended period of time, what it means is that there will be less demand for incremental midstream assets. Over the years, we have done a fair amount of expansion of our assets or built new assets, almost always in conjunction with contracts from our customers that will ensure a reasonable rate of return. If you have lower demand for an extended period of time, a period of years, then you would expect to see lower demand for those new assets.

In general, the expectation is that demand is going to pick back up. It might not be where it was 18 months ago, but it will pick back up. And there are enough shifting dynamics in the energy marketplace that our expectation is that there will continue to be demand.

 

PGT: Is it fair to say then that, as we saw it recently described, the midstream sector is actually thriving in this economy?

Shaper: I would probably not say ‘thriving.’ I would say if you look back a couple of years, there really was tremendous demand for incremental midstream assets. I think that the midstream sector is one that is very resilient in just about any environment, for a couple of reasons.

I mean, one, demand for energy products, while it does fluctuate, it doesn’t fluctuate dramatically. You’re talking about what might normally grow at two percent instead declining at five percent. It’s not going to shift that much. Second, in the midstream sector, we typically are not exposed to commodity prices. Now, that does vary. I mean, if you’re big in processing, which a lot of people put in the midstream, then you have compounded commodity price exposure because it’s both the crude price coming in, or really the natural gas price coming in, and the crude price — or the correlation of the natural gas liquids to crude — coming out that impact you. And you can really get whipsawed even when prices are strong. But you know we don’t do much of that business for specifically that reason. We don’t want the commodity-price exposure.

If you are in a business that’s largely fixed-asset-related, that generates a good cash flow stream, that has fairly stable demand for your products, and has minimal commodity price exposure, you’re pretty resilient in just about any environment. Now, again, I think a weak economy is bad for everybody and so it probably depends upon your definition of thriving. If you wanted to define it relative to a whole lot of other businesses out there, then you might define it as thriving. If you wanted to define it as how these businesses are, how the midstream energy business is in other economic environments, then you wouldn’t call it thriving.

 

PGT: Kinder Morgan announced recently the completion and opening of the 133-mile Louisiana pipeline from a liquefied natural gas plant in Cameron, La. This is the first of three natural gas pipeline projects that the company expects to complete this year. The final leg of the Midcontinent Express is expected to be in service by August 1, and the final leg of the Rockies Express pipeline is expected by be in service by November 1. Could we talk a little about the significance of each of these projects for Kinder Morgan, and the current status of the latter two?  

Shaper: Here is where the natural gas dynamics that I talked about earlier come into play. What we really saw over the last five years were shifting sources of supply for natural gas. There are three main components to these new sources of supply. One was Rockies gas and a tremendous ramp-up in production for Rockies gas. It was getting trapped in the Rockies and it needed an outlet. Rockies Express is one of among several projects to help alleviate that, but it’s also — by far — the biggest project and the most significant one.  It will be transporting about 1.8 Bcf per day of natural gas through about 1,680 miles of pipeline from the Rockies all the way to eastern Ohio. So it’s a very significant new pipeline.

Its biggest impact will be on Rockies production, but really it will impact the pipeline network across the country because there are really not very many west-to-east pipelines that have been built. It cuts across the northern section of a number of major pipeline systems.

The second new source of natural gas supply is the shale plays and that really started with the Barnett, but Fayetteville and Woodford are producing a fair amount, with the Haynesville, the Marcellus, and hopefully, the Eagleford all sitting out there as well. The Midcontinent Express was, again, one among several industry projects designed to help transport primarily Barnett and Woodford Shale gas from Oklahoma and Texas through Louisiana, through Mississippi, into Alabama to interconnect with the major pipeline systems that distribute gas to the midcontinent and to the east coast.

The third new supply source is LNG [liquefied natural gas]. A number of new LNG re-gas facilities have come online in the US the last couple years and there are still a couple more to come. They need access
to the natural gas distribution network, so that was our play with the Louisiana pipeline. All of these projects were fully contracted with customers before we started building them.

LNG is interesting. With the low price of natural gas in the U.S., which is in part a function of all of the shale production that has been generated, relative to natural gas prices worldwide, there is some question as to whether LNG will come in, or whether it will be in any significant volumes. It doesn’t directly impact us. We have sold the capacity on the Kinder Morgan Louisiana Pipeline for 20 years, but it does raise questions about how significant this new source of supply will be.

I refer to these supply sources as ‘new,’ but really ‘shifting’ is a better word. It’s more like growing sources of supply — they were essentially all in existence already.

We also have a fourth significant pipeline project, the Fayetteville Express pipeline, which is coming out of the Fayetteville Shale, which will be in service in late 2010 or early 2011.

We expect, over time, as the shales continue to develop, that there will be additional opportunities for pipeline projects. The other side to that is that plentiful natural gas supplies may cause natural gas demand to grow more rapidly than is currently projected. Then, there are going to be some opportunities on the demand side to connect new power plants. And if you’re going to use natural gas for transportation, there’s going to have to be a distribution system mapped to stations where it can be sold. There will be opportunities.

 

PGT: Talk a little bit about that relationship between the pipelines and storage.

Shaper: Storage, clearly, is hugely valuable. It looks like it’s going to fill up beyond historic highs this year. It is a valuable service to pipeline customers whether they’re LDCs who have fluctuating demand, especially in the winter, or power plants where similar things are going on but in the summer. They will have hot days where they need to run all out. They need access to that gas immediately. And so those kinds of services are hugely valuable to them.

And so being able to integrate the two — having a big storage position and having a big delivery capacity — really allows us to provide better service to our customers, services that they find more valuable. As opposed to a pipeline that doesn’t have any storage or a storage facility that doesn’t have any pipeline access. They have to go out and contract with two different parties and the coordination between the two isn’t always as good. Having both really does give us a leg up
in meeting our customers’ needs.

 

PGT: Looking longer term, how do you see Kinder Morgan’s business changing?

Shaper: I don’t necessarily see major changes. We would always like to expand our assets. We always like to add assets that are similar to the ones we already have, so we’re always looking for acquisitions. We have to find the right kind of assets, generally those that have stable cash flows. We need to be able to buy at reasonable prices, but we would love to be able to add more assets through acquisitions.

My guess is that for the most part our future acquisitions will be similar to the kinds of assets that we hold today. But if you go back five years, we weren’t as big in the natural-gas segment
as we are today because of all the expansion projects. The CO2 side has grown significantly. You go back eight years ago, we were a tiny terminals player and now we’re the largest independent terminal operator in North America. You go back three years ago, we weren’t in Canada. And now, we’re a reasonably large player in Canada.

And so those things happen. We’re optimistic. We know the characteristics of the assets that we’re looking for, and we’ll find some that fit and either buy them or build them at a reasonable cost.

 

PGT: In the short term do you fear that the completion of the Rockies Express will result in a glut of natural gas in the eastern U.S.?

Shaper: There will be shifting of bottlenecks, and it will be interesting to see how they play out. They will be a function of new pipes coming online, new supply sources and where they are located.

For the longer term you have to think about what would happen if you had a piece of pipe that goes from Point A to Point B and a supply source suddenly becomes available at Point B. That may diminish the need to transport from Point A to Point B. If that’s all your pipeline does, you’re vulnerable to that. When your contracts come up, you may have a difficult time renewing them or you may have to renew them at lower rates.

Part of the distinction here is that you’re talking about new assets. At least the way we approach it, we won’t build unless we have contracts that go out for an extended period of time, ten years, generally, at a minimum.

For existing assets, they tend to be more than just point-to-point transportation because with an asset that is in service, we’re looking for other opportunities to take advantage of that asset and we can build extensions off of these pipelines to access other markets. You can extend it into another market off the end. You can extend it from the front end to other sources of supply. There’s a whole variety of things that you can do with an asset. So you become less sensitive to having one particular supply and destination point. What you hope is that you’ve made that pipeline integral to the overall distribution network so that there’s still demand for it, even as the supply sources and demand shift — although demand tends to shift a little bit more slowly than supply does.

So there are issues [related to natural gas supply] and they’ll have to be worked out. From a pipeline perspective, it’s more evolutionary. It happens over a number of years. As contracts come up, that’s something that we’ve had to be sensitive to over time and that we’ll continue to be sensitive to. I’ll give you a good example of it.

Back in 1999, what was then the private general partner of Kinder Morgan merged with KN Energy. KN Energy’s single largest asset was NGPL, Natural Gas Pipeline Corporation of America, the largest supplier of natural gas into Chicago. Well, in the years immediately prior to that and in the year following that, there were two new pipes coming into Chicago. Northern Border was coming in and then Alliance. Northern Border was an existing pipeline that built an extension and Alliance was a brand-new pipeline coming from Canada into Chicago. The thought was that there’s going to be a flood of gas into Chicago. It’s going to be terrible for NGPL, and NGPL is going to get hurt. Truthfully, even advice from industry experts was that we, in essence, shouldn’t be buying. KN bought the general partner, but we took over operations. It was, in essence, us taking over KN.

What actually happened: there was a transition period and during that transition period things were a little bit difficult for NGPL. It probably had to discount a little bit more on transportation contracts when those contracts came up for renewal. But really, what was going on was NGPL, as the established pipeline in the market, had all of the inter-connects up there. And so even though two other pipelines were coming into the market, if they wanted to get into the LDC [local distribution centers], they really needed to go through the NGPL distribution network. So NGPL had a distinct advantage there and could offer more services, whether it’s storage or pipeline services, or whatever, to those customers.

It had what turned out to be an advantaged, competitive position relative to the new pipelines. Further, what ended up happening is additional pipe capacity was built out of Chicago to the east. And so a lot of that new gas coming in, basically, just went right through the Chicago market and on to other markets further east.