Why Kinder Morgan's Earnings Don't Matter

Oil prices have tanked, but the industry giants are still beating earnings and improving year-over-year numbers. Taylor and Tyler explain how that's possible, and when energy investors can expect it to change.

In addition, will the Baker Hughes (BHI) / Halliburton (HAL 1.60%) merger go through, and what will it mean to Schlumberger (SLB 0.26%) if it does? All that and more on this energy edition of Industry Focus.

A full transcript follows the video.

Taylor Muckerman: I hope Rich Kinder has some comfortable boots, because he plans on dying in them. This is Industry Focus.

Tyler, that's what he said! He's an Executive Chairman now, but he plans on sticking around.

Tyler Crowe: That is one heck of a statement for CEO, to really come down on the quarterly statement, be like, (unclear). That's fun.

Muckerman: Yes, he's leaving the CEO. He's going to be Executive Chairman of the largest infrastructure company in the world, I think, for energy as far as that's concerned -- but Executive Chairman, so we're not losing him just yet.

Crowe: No, and like you said, Steve Kean is taking over. He's been the COO for how long now? I think even from the inception back in 2002. He's been there for a really long time. I don't think we're going to see a whole lot of problems in terms of CEO succession, in terms of Kinder Morgan (KMI 2.53%) or anything like that.

More importantly with them it was earnings time.

Muckerman: It was.

Crowe: Kinder Morgan earnings ... that's one of the things with Kinder Morgan and a lot of these midstream companies. A lot of people are going to look at earnings, and I'm going to talk to the camera right now. Don't look at earnings! Earnings don't matter with these kind of companies!

One of the big reasons for that is they're really asset-heavy, they have a lot of depreciation. They can do things like asset writedowns and stuff like that. It doesn't matter as much. Those sort of non-cash charges don't really impact the overall business. You need to look at the cash flow statement.

With Kinder Morgan, these past earnings, cash flow looked great. If you look at it, cash was up and its distributable cash flow was 33% higher than what it plans to pay out to shareholders, giving it that distribution coverage.

Muckerman: Which is what you really want to look at, if you're focusing on the dividend.

Crowe: Absolutely. Looking at that dividend, it means a distribution coverage ratio of 1.33. You cannot ask for a heck of a lot better on a high dividend paying company like Kinder Morgan for a distribution coverage of something like that.

Muckerman: Then also they obviously have enough cash because they went out and made an acquisition of a pipeline up in the Bakken. Was it Highland Partners?

Crowe: Hiland Partners, yes. Harold Hamm -- we're throwing a whole bunch of big names around.

Muckerman: He's giving cash, he's selling for cash.

Crowe: It's a whole lot of stuff going on right here.

Muckerman: It's an ATM over here.

Crowe: Buying Hiland Partners, which was a private midstream company, for $3 billion. They had about 4,000 miles of natural gas and oil gathering pipelines in the Bakken area, as well as multiple fractionation and processing facilities for natural gas, about a million barrels in crude storage, as well as a partner in what is going to be the Double H Pipeline.

It's going to be one of the major exit terminals for Bakken oil. It's going to get it down to Guernsey, Wyoming, which is becoming a large oil hub nowadays, because of so much going on in North Dakota.

It's going to give Kinder Morgan its first real, I guess you could say, play in North Dakota. They almost have absolutely no assets there right now.

Muckerman: Which is crazy to think, because the company is so big and they touch literally every other part of America.

Crowe: Yes. Like you say it's a little weird, but this is a big foray, a big splash into it. It also gets them a little bit more into crude. Like you said, they have those crude oil gathering pipes, something that they've never done before -- it almost questions, maybe that's something they shed later on or something like that, because it doesn't really fit with their asset portfolio.

Now, somebody might say they overpaid a little bit, $3 billion or something like this, but it is going into a new area, trying to really expand, and they can probably build out a lot of projects from there.

We'll see, I don't know. Maybe it was one of those "Toss a little extra money to Harold Hamm to help him out with it."

Muckerman: Good old boy.

Crowe: With that divorce settlement and that half ...

Muckerman: Which was a billion dollars, so that's a little crazy to think about.

But $3 billion for this pipeline, it's not too bad. It fits their model of fee-based revenue. Some big players putting oil into these pipelines as far as contracts are concerned, with Continental (CLR); Harold Hamm obviously using his own pipeline for his Continental Resources, but then Hess (HES 0.65%) as well as Oasis Petroleum (OAS) and a few other people, so they're spread out. They're not solely dependent on one or two firms to provide the oil and future contracts.

But like Fools, energy companies are planning for 5, 10, 20 years out, and that's what you have to look at this as. Yes, Bakken oil might cut back in 2015, but we're going to need it eventually.

Crowe: Yes. On that same vein of the opportunistic, "When the market is down let's try to take a stab at something else," Schlumberger made another really big move in something similar.

They took a large stake in Eurasia Drilling Company. It's a Russian oil services company. They bought it for about $1.7 billion. I think they got half of the operating stake; basically they're the managing partners.

It's that same idea. You want to look at someplace that's worse than U.S. shale right now, look at Russian oil and gas companies.

Muckerman: Take that, Putin!

Crowe: Yes, take that! We totally messed with you guys. Actually, probably Saudi Arabia did a better job than we did.

This gives Schlumberger a stake in what is going to be one of the largest non-OPEC sources of oil for the next 30, 40, 50 years. If you look at not only Russia's conventional reserves but as well its massive, massive shale oil reserves, this could be one of the largest players for the next 40 years.

To get that sort of access, it's going to be very critical for Schlumberger. Especially since Schlumberger is one of those nice high-tech companies, it's going to be able to bring that technology into Russia through Eurasia Drilling, and already have that footprint of the relationships and the contracts that are already in place with them.

Muckerman: Yes, and it gets them closer to China; probably going to be producing their own oil and gas at a pretty high level with the shale resources they supposedly have.

They're an ex-North American company for the most part, unlike Baker Hughes and Halliburton, who are around 50-60% of their revenues come from North America.

I kind of dig this move. They have the opportunity in the future to purchase the rest of the company if it works out like they think it will; a nice little door for this company into one of the largest oil producers and natural gas producers in the world.

Crowe: Yes. Going on to one last thing; talking about the Schlumberger, they made this announcement right on top of their earnings. We've got a couple more earnings that we should cover. We had the Big Three in oil services just recently announced ...

Muckerman: Soon to be the Big Two!

Crowe: Soon to be the Big Two. Do we want to count Weatherford International (NYSE: WFT) as the third one?

Muckerman: I'll don't always look at that as ...

Crowe: They're just kind of the after ... yes, so we'll just say the Big Two.

Baker Hughes, Schlumberger, and Halliburton all surprisingly beat on earnings estimates and improved on their year-over-year numbers.

Now, anybody armchair quarterbacking the oil industry right now would say, "What the heck's going on here? How the heck are these guys beating on estimates, when we've seen oil get absolutely shellacked?"

Muckerman: Yes, they're the next leg from the producers. They need the upstream spending. Upstream spending hasn't been cut back yet. Everyone's just been announcing cutbacks, so they're still making the money that they were promised into 2014, probably still into the first quarter of this year.

I would look for it to flatten out, no growth this quarter, but the second quarter and third quarter of 2015 you shouldn't be shocked if you see some depressed earnings and revenue out of these companies.

But on the Baker Hughes/Halliburton side, because they're looking at some cost savings in the merger if it does go through -- which seems a little bit more likely now, with oil continuing to fall -- those cost savings aren't going to be diminished, but they will be enhanced as far as their overall impact because revenue will be less but you'll see the expenses collapse even more so on a percentage-wise basis.

I think that the deal makes a lot more sense. Even though it's still, like we said a 10, 15, 20, 30-year deal, it's going to have a nice immediate impact, I think, while revenues continue to slip in 2015.

Crowe: Yes, we're already starting to see a little bit of hint of that. Baker Hughes also announced, with its earnings piece, that it was cutting 1,000 jobs off of its ...

Muckerman: And Schlumberger was like 7,000 -- or 9,000 maybe.

Crowe: Yes, so everybody is like, "Hey, we had a great quarter! But now we're going to fire everybody because we're getting ready for something that's looking a little ugly."

Just looking forward, of those ... well, the two guys now, we can't really completely judge it because we don't know what Halliburton and Baker Hughes are going to look like completely, when they get done ...

Muckerman: They're probably going to divest some assets.

Crowe: Because of the divestments and stuff like that. But your knee-jerk reaction, which one are you looking at to maybe survive this or even come out of it a little bit better?

Muckerman: I'm a Halliburton shareholder, so I'm going to have to stick to my guns on this. I do like Schlumberger. They are involved a little bit more in the deep water. They're a high tech company, but so is Halliburton.

You saw Schlumberger say, "We weren't necessarily hit that hard in this quarter because now companies want the more efficient equipment." They're willing to pay a little bit more money, maybe not on an aggregate level, but per machine, because they want to make sure that they're not losing any money out in the field.

So I look at Schlumberger and Halliburton, which is the reason why I'm looking at those rather than a Weatherford, because they have that technology that's going to drive the future.

Halliburton is more toward the fracking side, so maybe they have a little bit more near-term weakness because North America is such a big portion of their business, but I could see these two being equals coming up, unless Halliburton can take their fracking technology internationally, which they've slowly started to do in China and Argentina; then I think they're the big winner.

Crowe: I guess we'll just have to see what happens when the next shoe drops, when it comes to oil prices.

Muckerman: That's right!

Crowe: But for now, we'll wait on a few more earnings. I think we have refiners coming up next week, a couple others.

Muckerman: Interesting sector, because you would expect that they would be making a ton of cash right now.

Crowe: They should be making a killing.

Muckerman: But with gas prices reduced as well, they could be pinched.

Crowe: Well, let's find out. Next week, refiners. Two weeks from now, big oil. We've got a lot of earnings stuff coming up. We'll be covering them here on Industry Focus. We'll see you next time.

Muckerman: Fool on!