1 Great Energy Stock

There are a lot of potential winners in the midstream industry right now. The energy production boom has turned many of these high-yield stocks into compelling investment opportunities. As with any industry, not all opportunities are created equal. Today we'll take an in-depth look at a stock I consider the best of the best: Kinder Morgan (NYSE: KMI  ) .

Kinder Morgan was formed in 1997 when Richard Kinder and Bill Morgan purchased a pipeline from Enron for $40 million. It was the smallest of beginnings for what would become the country's largest pipeline network 15 years later.

Kinder remains as CEO of Kinder Morgan, and has a personal 24% stake in the company. Working for a symbolic $1 a year, he puts shareholders' interests first and has established a company culture that prohibits wasting money. Kinder Morgan is one of the better investments going, so let's see what makes it tick.

How it works
Kinder Morgan is technically a holding company. It doesn't actually own any assets, instead it makes its money by owning stakes in the other Kinder Morgan companies: Kinder Morgan Energy Partners (NYSE: KMP  ) , Kinder Morgan Management (NYSE: KMR  ) , and El Paso Pipeline Partners (NYSE: EPB  ) . It also owns a 20% stake in a natural gas interstate pipeline called NGLP.

But really, KMP is KMI's primary asset. KMI owns the general partner and incentive distribution rights in KMP, but it also owns 11% of the limited partner units, and together its ownership in KMP amounts to more than 95% of KMI's cash flow. Essentially, when KMP makes money, so does KMI.

The assets                                                                                  
Between KMP and EPB, there are an awful lot of assets under the Kinder Morgan umbrella. Let's start with the 75,000 miles of pipeline that run across the U.S. and into Canada. The sheer size of this network means that Kinder Morgan is connected to essentially every energy producing play in the U.S. It has considerable assets in Texas and Florida, the top two markets in the country for natural-gas-generated electricity.

KMP also owns the Trans Mountain pipeline. The 300,000 barrel per day pipeline connects Alberta's oil sands to British Columbia. The company is currently trying to double capacity on the line, which is frequently oversubscribed, but is running into a bit of opposition from environmental groups and local citizenry.

This isn't just a pipeline company, folks. Kinder Morgan is also the second-largest oil producer in the state of Texas. Approximately a quarter of KMP's cash flow comes from oil. One of the advantages of a midstream company over an explorer and producer is supposed to be reduced risk to commodity price volatility. Clearly that is not the case here, but to the company's credit, it employs a smart hedging strategy. While KMP will not clean up if the price of crude skyrockets, it will also not suffer from a precipitous drop.

The advantage
Though it can be a little difficult to understand where the money is coming from at times, there is one huge upside to investing in KMI versus KMP: taxes. KMI is set up as a tax-paying corporation, which means that investors don't have to deal with the potential headaches of a K-1. For this reason, it is also more IRA friendly. Ultimately, given this convenience, superior management, and KMP's expansive asset base, I'm hard-pressed to recommend a better all-around midstream opportunity than KMI.

All the time investors save not worrying about paperwork can be applied to gushing about dividend yield. Kinder took KMI private in 2007, but brought it public again in 2011. Though it was only listed for part of the year, the stock returned 11%, and is up over 9% so far this year.

Historically, both Kinder Morgan and KMP have been able to pay out more than what the respective entities have budgeted for distributions and dividends. For example, in 2011 KMI budgeted $1.16 annualized per share, but ended up paying out $1.20. Exceeding expectations is par for the course at Kinder Morgan.

Looking ahead
The El Paso merger and ensuing asset dropdowns to KMP, the increased volumes across its system, and the likely growth of its carbon dioxide business mean that the future at Kinder Morgan is quite bright. Distributions to KMI will continue to increase, making the stock a very compelling opportunity for dividend investors. Said investors may also want to check out the Fool's special free report for dividend investing.

Fool contributor Aimee Duffy holds no position in any company mentioned. Click here to see her holdings and a short bio. If you have the energy, check out what she's keeping an eye on by following her on Twitter, where she goes by @TMFDuffy.

Motley Fool newsletter services have recommended buying shares of Kinder Morgan and El Paso Pipeline Partners. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (6) | Recommend This Article (101)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 01, 2012, at 7:36 PM, wolfhounds wrote:

    For tax purposes KMP held in a taxable account is the better investment. As a C Corp., KMI income will always be reduced by federal and state income tax leaving less distributable income. Distributions are taxed as ordinary dividends, further eroding after tax distributions.

    As an MLP, KMP distributions are are tax deferred by reducing the cost basis of the units. MLP's also have an advantage of tax planning through timing of sales. This occurs because they generate taxable losses and deferred intangible costs which are not realized until a sale.

    Gain on sale of units held more than one year will be taxed at long term capital gain rates. More importantly, all the deferred losses and IDC will be realized as ordinary losses that can offset other income. This is a strategy I've several times, but anyone contemplating this should consult a tax accountant or CPA.

  • Report this Comment On October 01, 2012, at 9:05 PM, kayakmastr wrote:

    We know KM is great! There are a couple of KM plays. This essay does not identify why one should go with one or the other or with all. This essay is pretty much useless.

  • Report this Comment On October 02, 2012, at 2:58 AM, rustyrick wrote:

    "Though it can be a little difficult to understand where the money is coming from at times, there is one huge upside to investing in KMI versus KMP: taxes." I can't argue that they seem to make money, and they pay out dividends, but I am more than a little concerned with where MR. Kinder learned how to do that; ENRON.

  • Report this Comment On October 05, 2012, at 2:54 PM, raystom1 wrote:

    I don't think I have ever run into a much wilder spec stock. The current P/E ration is 78!! Watch out below when P/Es contract. raystom1

  • Report this Comment On October 05, 2012, at 6:11 PM, harborrocker wrote:

    How about holding KMP in a Roth IRA? Wouldn't that help avoid taxes on dividends?

  • Report this Comment On October 07, 2012, at 4:31 PM, inmocean wrote:

    KMI warrants allow you to buy the stock at $40/share and they don't expire until 5/25/2017. As the stock's currently at $36 and the warrants cost $3.45, the stock needs to rise 21% in five years. If the stock grows more like KMP,KMR and EP, it should well exceed that.

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