Kinder Morgan's Deal With the Canadian Government

Kinder Morgan's (KMI -0.26%) Trans Mountain pipeline has been long beleaguered by civilian and municipal government opposition. But last week, the Canadian government stepped in to ensure the pipeline would get made, and offered Kinder Morgan's subsidiary a tidy $3.5 billion to take the project off their hands.

In this episode of Industry Focus: Energy, host Sarah Priestley and analyst Taylor Muckerman talk about what the deal will mean for Kinder Morgan and the Canadian government. Find out what Kinder Morgan might do with this cash, who the Canadian government might eventually sell these assets to, and more. Also, the two touch on recent developments in OPEC: the effects of the production cuts, President Trump's divisive plea for increased production, and the all-too-quickly forgotten cyclicality of the oil industry.

A full transcript follows the video.

This video was recorded on June 7, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 7th of June, and we are discussing the Trans Mountain pipeline drama and a little bit about OPEC, too. I'm your host, Sarah Priestley, and joining me in the studio is Motley Fool Canada Premium analyst, Taylor Muckerman. Taylor, welcome back to the studio! It's been too long!

Taylor Muckerman: I know! A few weeks have gone by since we last joined each other here.

Priestley: You've been traveling, you've hiked, you've done all kinds of things. The Caps are in the playoffs.

Muckerman: Yeah. It doesn't really matter to me, but I know Austin behind the glass is probably freaking out, not even remembering what happens until tomorrow evening.

Priestley: [laughs] I have to tell you that we had our FoolFest last week, which is our annual festival for all of our members. A lady came up to me. I didn't ask her for her name, which was very rude, I should have asked. But, she did say that you have a lovely voice. So, there you go.

Muckerman: That's interesting, because Dan Boyd has told me the exact opposite. [laughs] 

Priestley: So, you have an expert ...

Muckerman: That's right.

Priestley: So, big news from Canada. The pipeline company Kinder Morgan, on the planned expansion of the Trans Mountain pipeline, which takes crude oil from Alberta's oil sands to Western British Columbia, the pipeline expansion had faced an awful lot of opposition. We talked about it on the show before. A lot of opposition from indigenous groups and municipal governments, namely those of Vancouver. A lot of federal challenges were mounted against the expansion project. This halted construction on multiple occasions, and it's just caused a huge amount of political upset in Canada. I won't pretend to know about the politics side of it, but Alberta's Premier earlier this year ordered a cease on future imports of wine from British Columbia, as they had imposed a sanction on increasing imports of oil from Alberta. So, you're kind of seeing this whole scenario worsening. 

Kinder Morgan, the pipeline owner and operator of the Trans Mountain pipeline, suspended all non-essential activity on April 8th of this year. The company stated it didn't want to put shareholders at risk on the remaining project spend. At the end of May, I think it was the 28th or 29th, the company announced that it's made a deal with the government in Canada to buy the project. The Canadian government will buy the existing Trans Mountain pipeline and the planned expansion project from Kinder Morgan's subsidiary, which is Kinder Morgan Canada Limited, for $4.5 billion Canadian dollars, $3.5 billion U.S. dollars. The cash deal should close later this year. So, huge news. Very shocking.

Muckerman: It is. They've already invested $1.1 billion. They got that back and then some. A colleague from Motley Fool Pro Canada, Jim Gillies, called this Christmas come early for Kinder Morgan investors, basically removing this multi-year headache and reimbursing them for the money that they basically thought was a sunk cost if they didn't move forward with this project. 

There are still some question marks as to who buys this, will it eventually still go through. $7.4 billion was the associated cost that was expected for this entire project. That's why they backed out of it, because they'd only spent $1.1 billion, and the horizon was, like you said, very uncertain. They quoted unquantifiable risk based on the ongoing efforts of the British Columbian government to block this project that the rest of the country seems to believe is quite necessary.

Priestley: Yes. Some background on the pipeline. It's the only pipeline system in North America that transports both crude oil and refined products to the West Coast, both in Canada and, I think, there's some in Washington state, too, a refinery in Washington state.

Muckerman: Yeah, I believe you're right.

Priestley: The expansion project has been going on for a long time. I was going to say in the pipeline, but that would just be too much. I think they initially filed the application for it in 2013 with the Canadian National Energy Board. 610 miles of pipe. It runs roughly parallel to the existing one. Then, in November of 2016, the federal government in Canada approved the expansion project. They said it was subject to 157 binding conditions that will address potential various impacts of the project, but it was approved. Then, Kinder Morgan proceeded with a lot of the start-up costs that are associated with getting a project of this magnitude off the ground, only to have repeated interruptions, essentially, for permitting issues and a lot of concerns raised with the federal government that actually halted them.

So, as you said, definitely good for Kinder Morgan investors. Really smart move on Kinder Morgan's part. I have no idea how they managed to negotiate that.

Muckerman: I think, as Trump would like to say in this situation, it was a matter of national security, almost, for Canada.

Priestley: Yes. I know that two of Kinder Morgan's executive, I think the President and Vice President, are getting paid a $1.5 million bonus, paid over two years, for negotiating this. A lot of people were balking at that, but that's not that unusual for something of this scale.

Muckerman: No, especially with the scale of this. Jim also did some math, because this has been a recommendation in Motley Fool Pro Canada almost since the beginning of the portfolio. He basically did some math and stripped out the estimated future revenue and earnings from this pipeline if it had been built, along with the $1.1 billion that they had already spent, and he came out to roughly around $800 million of excess capital outside of the discounted cash flows from this pipeline that would have been expected. So, a nice little windfall for this company. If you'd strip out the few million that they paid those executives for negotiating this, you're still left with darn near $800 million in excess compensation.

Priestley: Yes. In terms of how this is going to affect Kinder Morgan going forward -- because a lot of people are looking at this and thinking, they had this backlog of about $12 billion in expansion projects, of which this was about $5 billion of that plan -- what's that going to do for their look at their annual revenue? Obviously, they invest a lot of money upfront in these high-cost, capital-intensive projects to get the very safe annual returns. And now, they're going to miss out on those annual returns. So, what's the plan for the company?

Muckerman: I think, you look at this company, over the last few years, debt has been a big problem for them. I certainly could foresee some of this being used to pay down that debt, and maybe arrive at a more sustainable level to then start addressing, maybe, a higher dividend payment. This company, that was their longtime story, was the dividend yield that they were able to provide on a relatively stable basis. So, maybe they can accelerate that process. Or maybe, because this project has been a big headache for them, a big attention-grabber for management, so, maybe it frees them up a little bit mentally, and they can go find other areas of either Canada or North America that they can build a similar project or spend some of that cash that they just received on growth. But, they still do have growth opportunities, and I don't think paying down debt would be the worst use of this cash.

Priestley: Absolutely. And you're exactly right. CEO Steve Kean, I was just looking at some of his comments, he said they will continue to find investment opportunities. In the past year, the company secured $2.1 billion of new projects. I think they're focused much more on these smaller, higher-return projects.

Muckerman: Yes, and for good reason, as you look at an example like this, spending $1.1 billion and still having an uncertain future until the Canadian government essentially bails you out.

Priestley: Yeah, absolutely. If we look at some of the ongoing expansion that they have, they still definitely have a lot of growth. The majority of their soft capital expenditure is on natural gas pipeline, which, we've talked about before, seems to be the direction of the industry. Their Elba Island liquid natural gas export facility near Savannah, Georgia, that's a $2 billion project which is partially financed with a joint venture from a private equity firm. That's coming online in the middle of this year, with long-term contracts with Royal Dutch Shell, and then we'll be fully up to speed by mid-next year. So, they're already going to start to get a return on that money. They're growing their oil business, investing $1.3 billion there, and investing in CO2 assets and terminals. Terminals are becoming increasingly important, especially as we talk about fracking, and as the U.S. becomes, for really the first time seriously, a major exporter.

Muckerman: Yeah. You've seen the spread between West Texas Intermediate and Permian oil rapidly expand, because there's just so much oil being produced in the Permian, they can't get it out, so the oil, therefore, is being sold at cheaper rates. So, maybe there's some room for growth there. But, I'm sure they'll find a way to spend that money. If not, shareholders might get a special dividend check one of these days. Who knows?

Priestley: One expansion project, just to highlight as for these higher returns goal, the Natural Gas Pipeline Company of America, that they're doing an expansion project with in a joint venture with Brookfield Infrastructure Partners, which we've talked about a ton recently on the show --

Muckerman: Great company.

Priestley: -- it's only a $300 million expansion project that could generate $90 million in incremental earnings per year, which is incredibly impressive.

Muckerman: Yeah, quick payback period.

Priestley: But, as you mentioned, it looks like it could be a lot of shareholder-friendly moves, potentially repurchases, buybacks. I've heard rumors about Enbridge's Canadian midstream assets being on the chopping block that they might be interested in. But, overall, as you said, for this company, it's just a really good shot in the arm, and their balance sheet is going to look a lot healthier.

Muckerman: It should, yeah, if they utilize it properly.

Priestley: So, we were talking before we started the show about how surprising this whole thing was, and the fact that the Canadian government, as you said, they still have to sell this to somebody. They're not planning on becoming pipeline operators. I have a question for you. Who do you think they would sell it to?

Muckerman: That's a good question, one that's really hard to answer, but it would have to be a big company in order to drop that amount of cash. You would have to expect that, even though it's a government, they're probably reluctant to sell it at a loss. I wouldn't write that off entirely. But, I would say, you're looking at companies of the size of Enbridge or TransCanada, who have also both been burned in terms of pipeline expansions within the country. So, maybe, seeing the visibility of this one now, maybe that encourages them to take a closer look. Maybe partners with the government or a joint venture between some bigger companies. 

Or, a company along the lines of a Brookfield Infrastructure Partners. It would be outside of something that they've traditionally done, in terms of the size of this deal, but maybe they partner with somebody else in order to make this happen. They've been freeing up a lot of cash on their balance sheet lately. I think they have about $4.2 billion in liquidity. That almost gets them there. But it would surprise me if they took it on entirely themselves, if that was the way that this all shook out.

Priestley: It would be a big hit, I'm sure. I mean, it's interesting, because it's quite compelling. If they can get over the risk, in terms of the delays, etc., that will be inevitable navigating the political waters for this. But, I know that it had 15-year contracts all sold out when they first announced it. BP was a big initial investor. The Finance Minister last week, going on what you said, they're not looking to make a profit. He said, "We're not seeking to make a profit, we're seeking to ensure the project gets done. But we will always try and make sure the project represents a fair situation for Canadians." So, yes, as you said. Incredibly interesting.

The other point that I wanted to make and get your opinion on, as somebody that's been following the company for a long time, is that for me, Kinder Morgan is this interesting story situation where, a couple of years ago, they were in kind of a similar situation to GE in that they could do nothing right. They had to cut their dividend, they were faced with a seriously poorly weighted balance sheet, and a lot of those other considerations. They've really slimmed down. They're focused on those profitable assets. And now, in this climate, I feel like a decision like this is only going to be seen as a good move. But, it's just such an interesting story from where they have been.

Muckerman: Yeah, they were down in the dumps. It was right around the same time that we initially recommended the company in Pro Canada. We've since doubled or tripled down on it and watched the stock price climb back, not entirely, but quite significantly. Definitely some similarities there to GE in terms of the balance sheet and disruption in the business units, especially with GE so heavily involved in oil and gas now, with Baker Hughes acquisition. Having an influx of cash like this, when it was just a huge question mark, and looking at it and saying, "This is going to just continue to drag us down," it has to be a pretty liberating feeling for everyone involved in Kinder Morgan. 

From the government's side, when they say they're not trying to profit, I believe, on the deal, no. But, it was important enough for them for tax revenue purposes and job purposes that they're definitely profiting in some form or fashion once this pipeline is done, maybe not in terms of a deal price, though.

Priestley: Yeah, absolutely. I know Kinder Morgan, another similarity to GE is that the debt is structured in a complex way. I'm not going to pretend to be savvy on it, but I think it's going to be difficult for them to pay down a lot of their debt the way that it's structured, with the funds that they're getting from this, but there may be workarounds with share sales and things like that that they can fund it with.

Muckerman: I'm sure they'll figure something out over there. The company emerged from the whole Enron debacle, so I'm sure they'll figure something out. One thing that might be a little different about this is that the founder is still very near and dear to the business. So, maybe a little bit more emotional than a GE situation, where everything is on the table, but maybe you don't know what to do. This was more of a survival of this gentleman's entire livelihood.

Priestley: Yeah. Something we really like here at The Fool, founder-led businesses.

Muckerman: Yeah, absolutely.

Priestley: That finishes up our Kinder Morgan discussion. That really took us by surprise. The next thing I wanted to briefly touch on is that the U.S. government has asked Saudi Arabia and some other OPEC producers to increase production of oil by about one million barrels per day, which would be about a 1% global production increase. The reason for this, we've seen prices at the pump rise -- everybody, I'm sure, noticed this -- a lot, the highest rate for more than three years. President Trump took to Twitter to complain about this.

Muckerman: [laughs] Go figure.

Priestley: Yeah. OPEC, just in case anybody doesn't know -- we've actually done a show on a deep dive on OPEC before -- OPEC is the Organization of Petroleum Exporting Countries. This includes 12 of the world's largest oil exporters. They, along with Russia, have been setting production restrictions to try and improve the price of oil. So, what did you make of this?

Muckerman: It's interesting. In a roundabout way, it kind of makes sense. You don't often see a president pleading other countries to increase oil production unless it's going to necessarily benefit us, and this could be one of those situations. Just, not what you typically see, because generally, when we've been asking for higher oil production, it's because we've needed the oil. Now, it's not the case. I would be interested to see if this would have been mentioned if Rex Tillerson was still Secretary of State, given his connections to the oil and gas industry. And just, the way that President Trump really hammered home his approval and support for fossil fuels during his campaign ...

Low oil prices are going to hurt the economy. Maybe not individual pocketbooks at the pump, but it's a huge job creator, and it has been ever since the financial crisis. Even considering the latest downturn in the oil and gas markets, you're still looking at incredible job creation. So, you don't want to drive oil prices down too terribly low too quickly, because you could lose out on a lot of that. And these are high-paying jobs. There are certain pockets of this country that are wondering and scratching their heads and questioning why they supported him in the first place, if he's going to come out and try and drive the price of oil down lower. A million barrels a day, that's a big output boost.

Priestley: Yes. It's an interesting paradox. I think people have gotten used to such low prices after the 2014, 2015 depression that we saw.

Muckerman: And that's representative of people's automotive purchases over the last few years, where light trucks have blown cars out of the water in terms of automotive sales. And it's very similar to what you saw before the financial crisis, before oil spiked. Trucks where the thing to buy, big SUVs, big trucks. And then, all the sudden, gas was $4 a gallon. We're kind of creeping up in that direction now. Don't buy a car based on the current price of gas, is what I'm trying to say.

Priestley: My husband has, for the past 14 years, had a Toyota Tundra. [laughs] 

Muckerman: Well, at least Toyotas generally have a little bit better gas mileage. That's a good truck.

Priestley: He loves his truck.

Muckerman: It's a good truck. I like the Tacomas and the Tundras.

Priestley: He will drive it until it falls apart, I'm sure. But, yes, I think some of the background for this is, the Iran sanctions on crude oil have cut their output by estimated one million, although it's not really known exactly how much --

Muckerman: And Venezuela has run into its own problems, in addition to expected cuts from OPEC.

Priestley: Which, on reflection, could be more to do with the rising oil prices than maybe what we've seen from OPEC. OPEC has been very slow and steady, and the oil prices that we've seen could be more as a result of that. 

One really funny quote, somebody needs a speechwriter. The U.S. Treasury Secretary said, "Various conversations with various parties about different parties that would be willing to increase oil supply to offset the impact of U.S. sanctions on the Iranian oil output," is what he said. I just thought it was a funny quote.

Muckerman: It sounds like he might not exactly know what's happening. Just kind of fumbling through an explanation.

Priestley: Yeah, that's the impression -- that's probably what people think when they listen to me. [laughs] 

Muckerman: [laughs] Oh, come on.

Priestley: "She's fumbling through this, she doesn't know what she's talking about."

Muckerman: Come on, we've been bumbling for 20 minutes. We're good.

Priestley: [laughs] So, investors will get more of a clear idea of this OPEC offset production policy for the second half of the year in Vienna. A meeting is on the 22nd and 23rd of this month. I would be surprised to see -- although, you are the expert here -- if they continue the production caps.

Muckerman: Yeah. They probably deeply want oil more expensive than it is, so my guess is, there are going to have to be some concessions made on the U.S. side if, indeed, that's the outcome, higher oil output from OPEC. $75 is great, it's better than $30, but it's not $80 or $90 or $100. And that's generally what a lot of these countries need to balance their budgets.

Priestley: Yes. And for the everyday consumer, it's such a headline-grabbing thing. "American Airlines will have to put up prices of plane tickets because of oil prices," and things like that. When you actually look at it, it's not a huge increase.

Muckerman: Yeah, it's crazy how quickly people forget that these are cyclical industries. They're not going to stay low forever and they're not going to stay high forever. 

Priestley: The other thing to remember, too, is that the airlines have had it good because they haven't passed on a lot of those cost savings to consumers.

Muckerman: Nope.

Priestley: I'm kind of on the fence about that.

Muckerman: It's good for some airlines, though. You look at Spirit or Southwest and the discount airlines, their main advantage was that they were discounted, but they didn't have any room to the downside to lower prices. These Deltas, the Uniteds, the Continentals of the world, they were milking those high prices. They did have room to lower once fuel costs did. That eroded the advantage of some of these discount airlines like JetBlue, as well. If those prices rise back up, and they can reestablish that advantage, maybe they're worth a look as an investor.

Priestley: We started out talking about Kinder Morgan and ended up talking about discount airlines. [laughs] 

Muckerman: [laughs] That's right. Roundabout way.

Priestley: That's what you get on Industry Focus: Energy. Well, that's it from us today. Do you have anything to add, Taylor?

Muckerman: No, I think that's a great show. Thanks.

Priestley: OK, perfect. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. Thank you to Austin Morgan for producing the show, wearing your Caps attire, is it? [laughs] 

Austin Morgan: Go Caps!

Muckerman: Go Caps!

Priestley: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Taylor, I'm Sarah Priestley. Thanks for listening and Fool on!