The Permian is booming, and the pipeline companies that lug all that oil from Point A to Point B are booming, too, with way less risk exposure than the exploration-and-production folks take on. In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Matt Dilallo dig into the businesses behind Kinder Morgan (KMI -0.08%), Enterprise Products Partners (EPD), and Plains All American Pipeline (PAA 1.06%). Tune in to learn what balance-sheet metrics to look for in a midstream company, how to analyze the quality of a midstream player's upcoming projects, how these three companies measure up, some of the most exciting growth opportunities ahead, and more. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Oct. 10, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Oct. 10, and we're discussing pipelines. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Matt Dilallo via Skype. How's it going, Matt?

Matt Dilallo: Doing good! How are you?

Sciple: I'm doing all right! Last time I talked to you on the show, you were talking about moving and had boxes all over your house. How has the progress been going on those projects around the house? 

Dilallo: The boxes are gone. We're all moved in. It's exciting!

Sciple: All moved in. We're here. Today we're going to talk about pipelines. A couple of weeks ago, I had Jason Hall on the show and we talked about T. Boone Pickens' legacy. We also talked a little bit about attacks that had happened on the Saudi Arabian oil facilities. We got a question back from one of our listeners. Leland Payne said, "I appreciated your commentary about the attack on the Saudi Arabian oil facilities and the market reaction for crude oil as a result. It was mentioned that there is a takeaway problem from the Permian Basin. It is my understanding that Kinder Morgan and Enterprise Products Partners are constructing significant pipeline capacity to take away oil and natural gas to the Texas Gulf Coast and to Mexico. I would appreciate hearing a podcast on these two midstream companies. "

Matt, first off, on the pipeline takeaway, constraints in the Permian, for folks that are unfamiliar with what's going on here, what's the high-level story there?

Dilallo: The Permian Basin has a ton of oil and gas. Oil companies have been drilling and drilling and drilling, and they've drilled so much of it that it's overwhelmed the infrastructure that was there. It's slowed down the progress out there and created this huge bottleneck of oil in storage, and then there's too much gas they can't use. So they need infrastructure. That includes pipelines, among the whole bunch of other things, like processing plants, and that type of stuff.

Sciple: Yeah, exactly. Production exploded so much in the past decade or so in these big shale plays, particularly the Permian. I've cited these numbers in the past -- between 2008 and today, the United States accounted for 73% of the increase in oil production worldwide. If you look at natural gas, the Permian Basin accounts for 10% of America's total natural gas volume, and expects to double that output by 2025. When it comes to pulling hydrocarbons out of the ground, that's an incredible growth in production. You have to take this to market. As you mentioned, there's huge oversupplies, which has depressed prices in the region. It's also led to this trend of flaring that's been in the news a lot. Matt, can you talk a little bit about that, and what the controversy has been there?

Dilallo: Flaring is a way of getting rid of gas that they don't have pipelines for. Oil, they can truck to different storage places, but natural gas has to flow through a pipeline or be liquefied. So their options are to either reinject it back into the ground, which costs money, or to flare it off, which is to burn it off. They've been doing that. They burned off so much gas at the end of last year, it was stunning. They could power every home in Texas with the amount of gas they're flaring off, just because it was cheaper to burn it than use it. But these pipelines are going to help solve this problem. They'll be able to monetize this gas.

Sciple: Exactly. Whenever pipelines come online, the cost to get that to market decreases, so it can make economic sense to start delivering this gas to market, which is obviously great. This is a clean-burning fuel that we would like to see put to good use. 

Before we dive into Kinder Morgan and Enterprise Products Partners, I want to talk a little bit about investing in pipelines from a high level. When you first look at a pipeline or a midstream company, what are the first things you pay attention to from a financial metrics point of view, Matt?

Dilallo: There's three things that I look for in a pipeline company. The stability of their cash flow. One of the big draw of pipelines is that they pay these big dividends. That's because they generate very steady cash flow. A lot of times, it's based on these fee-based contracts that they sign with producers. So, an ExxonMobil drills wells in the Permian Basin, and they need to get their oil to the Gulf Coast, so they'll sign a contract to ship, let's say, 100,000 barrels a day on a pipeline. These pipeline companies collect basically a toll booth fee as this oil goes through. They offer stability of cash flow. The number that sets off for me is 85% or more. That gives them a really predictable cash flow. 

The second one is the payout ratio. We mentioned that dividends are a big thing with these pipeline companies. I want to make sure that they can sustain that payout. I'm looking for a payout ratio of less than 80%. Another metric they use is a distribution coverage ratio. The equivalent of that is 1.2. 

And then, a healthy balance sheet which is an investment-grade balance sheet. In my book, that means that means that bond rating companies take a look at their books and say, "This company is worthy of investor trust." The typical number that they look at is 4 times debt to EBITDA or less, which is basically a company that's generating enough cash flow per year that within four years, they could pay off their debt. 

Those are the three metrics that I look for.

Sciple: What's attractive particularly about these midstream companies, we talked earlier about this huge increase in production of oil and natural gas. That makes it hard for the folks that are pulling this stuff out of the ground to make money because the price is pushed down. However, the folks that are distributing this product to market, there is more oil and natural gas flowing through the pipes. On these fee-based contracts, they're able to make predictable, increased returns on that. 

One question I have when I look at pipeline companies, it's hard to differentiate one project from another when it comes to what value they're going to return to the firm, and how to differentiate one pipeline company from another. When you look at projects that these companies are investing in, how do you differentiate high-quality projects from low-quality projects when it comes to investing in these companies?

Dilallo: As I mentioned earlier, it's the stability of the cash flow. There's different types of projects that have different types of cash flow backing to them. A gathering pipeline -- so, an oil company drills wells out in, let's say, Texas. Then they put these pipelines right close to gather all the oil and bring it to a central processing plant. These have a lot more variability to them. If the oil production drops from those wells, the revenue will drop. Same thing with natural gas processing plants. Sometimes they're not even volume-based. It'll be the money they can make on the difference between what they buy natural gas, and then what they sell the end product from. I don't like companies that are involved in those types of, they're called gathering and processing. 

I like pipeline companies that do the long haul pipelines. When you're talking about these projects that a Kinder Morgan are building, they're these long pipelines, they're 100% contracted. So they know exactly what they're going to get. Every quarter, every year, they're going to get the same amount of money. I like that stability when I'm looking for a midstream company. 

Sciple: Sure. On the back half of the show, we're going to talk specifically about Kinder Morgan and Enterprise Product Partners. Is there another midstream company that comes to mind that checks off all those boxes that you like to see that maybe investors should pay attention to?

Dilallo: One of the favorites that I have, specifically oil in the Permian Basin, is Plains All American Pipeline. They're a master limited partnership, but they also have a corporate option that investors can do called Plains GP Holdings. There's two different options for investors. It pays a great dividend, 7.5% right now. 

Again, what do I look for? I'm looking for those big three. In this case, it's 85% fee-based cash flow backed by those long-term pipelines. And their dividend payout ratio is actually 50% right now, which is exceptional. That means they're only paying out half of what comes in for the dividend, and the other half they can use to reinvest in pipelines. The third thing that they excel at is their balance sheet. Investment-grade. It has a 3 leverage ratio, which is obviously better than a 4. So they've got a great balance sheet, great payout ratio, steady cash flow. That gives them all this financial flexibility to invest in new projects. I think they're up to seven pipelines that they're working on right now. The most exciting one is this Wink to Webster pipelines, an oil pipeline project with ExxonMobil that will start in 2021. It's going to ship over a million barrels per day from the Permian to the Gulf Coast. It'll help Exxon, putting some oil in some of their refineries, and then they'll export it. So a great project. It'll help Plains grow its dividend. They're looking at least 5% per year for the next several years. It's super safe, like I said, with those great metrics. I think it's a really interesting company for investors to take a look at.

Sciple: Yeah, it's one to check out. The tickers on those are PAA and PAGP. 

OK, Matt, let's talk a little bit about Kinder Morgan and Enterprise Products Partners. The first one of those I want to talk about is Kinder Morgan. Folks not familiar with this company, it's North America's largest transporter of natural gas, refined products and carbon dioxide. It's the top independent storage terminal operator for those substances. When you look at Kinder Morgan off the top, what should investors be aware of with this company?

Dilallo: It's one of the largest energy infrastructure companies. That gives it diversification. Its focus is natural gas. Natural gas being a cleaner burning fuel than oil, that's going to be very important for the company going forward, especially with the amount of natural gas we have. That's going to provide them with a lot of growth opportunities. It's going to be around a lot longer than oil, as far as their growth opportunity. I like them for that natural gas aspect.

Sciple: Yeah, natural gas, there's been a lot of pressure on the price of that product over time, and it's had the same lows for years and years. Does that have any impact on Kinder Morgan as a midstream player? Or are they very insulated based on their contracts around the price of that commodity?

Dilallo: They're basically insulated against natural gas, other than, as we mentioned in the first part of the show, the gathering and processing aspect of it. They've got a little bit of that. But for the most part, they have these long-term contracts with minimum volume contracts, which means they get paid whether or not hydrocarbons actually flow through their pipelines. They're roughly insulated. 

The concern is the near-term growth. With natural gas being so low, there's not going to be as much of drilling for natural gas. That might crimp the band for new pipelines. It might make it less likely that they grow as fast as they could in the near term. But long term, natural gas is really a compelling story.

Sciple: Yeah, it burns cleaner than coal and those other traditional power sources. That's where the grid is headed, certainly. When it comes to the new projects that Kinder Morgan is investing in, they have a number of projects set to come online in the Permian specifically. Can you talk a little bit about those, Matt, and what we should be paying attention to there?

Dilallo: Just in the past couple of weeks, they brought on the Gulf Coast Express pipeline, which is this long haul and natural gas pipeline that will transport two billion cubic feet of gas per day from the Permian. To put that in perspective, as we mentioned earlier, the Permian was flaring like 500 billion cubic feet. It'll help absorb most of that, and then give the industry room for growth. It's completely fee-based. 100% of the capacity is locked up. It's a great project for Kinder Morgan. They're going to collect these steady fees. That's the first one.

And then they've got another one that's set to come online next year, called the Permian Highway pipeline. Very similar. I think it's about 2.1 billion cubic feet of capacity. A little bit different location, along the Gulf Coast, but very similar type of idea and concept, taking all that associated natural gas out of the Permian that producers are wasting and bringing it to market outlets. 

Then they have a third one that's called Permian Pass that's in development. It's not in their backlog right now. But given the amount of growth that the region's expected, it's probably locked to be green lighted within the next year or so, would be my guess. Kinder Morgan CEO, Steve Kean, commented on the conference call, said that they need basically a Gulf Coast Express pipeline per year. That tells you that they're going to need this Permian Pass eventually. 

And then, they've got a bunch of other projects related to that, the downstream. They have all this gas flowing to the Gulf Coast that needs an outlet. It's going to go to petrochemical complexes, it's going to go to LNG export facilities, utilities. They're involved along the Gulf Coast region, which is where all this gas is going to pour into.

Sciple: At the same time that they've been investing in all these new projects, as there's huge demand with all this natural gas and oil coming out of the Permian, they've also been divesting from some of their older assets in Canada. Can you talk a little bit about that? I know that's been something that played out over a number of years, and they've finally gotten those assets off their back a little bit.

Dilallo: Yeah. Kinder Morgan initially thought that Canada was going to be a great place to invest in growth wise. They had this pipeline called the Trans Mountain pipeline that took oil from the oil sands out to the west coast. It's the only one that does that. They were going to expand the capacity by three times. However, they ran into a lot of opposition. It became such a headache that they ended up selling it to the government of Canada. That's led them to look for options for the rest of their Canadian assets. They ended up packaging, they have a publicly traded company called Kinder Morgan Canada, they sold that to another pipeline company called Pembina Pipeline in an all-stock deal. Kinder Morgan owned 70% of that, so they're going to get Pembina stock. And then they sold a related pipeline called Cochin pipeline that takes, they call it diluent, and what it does is, it helps take that really molasses-like oil that they produce in the oil sands, and it helps dilute it so that it flows through pipelines. They sold those projects and pipelines and all that to Pembina. They'll get cash for it. That gives them money to pay down debt, and then, the Pembina stock that they'll probably cash in on in the next year or so. They could use that to buy back stock or invest in new projects.

Sciple: You mentioned paying down some of that debt. Kinder Morgan does tick up a little bit above that 4 EBITDA number you like to see out of a midstream company. Any thoughts on that leverage level and how that's progressing over time?

Dilallo: It was like 5.9 a couple of years ago. That was way too high. They've gotten it down to, after the sale, 4.4. That's a much more comfortable level. That's actually within their comfort zone because they're such a big company and have so much fee-based cash flow. They're not as concerned with a 4 number that I would like to see. I wouldn't mind if they pushed it down a little bit more, but it's still a comfortable balance sheet.

Sciple: Sure. Last thing on Kinder Morgan. Looking out at their dividend, they cut their dividend significantly in 2015, but they've started ticking it back up over recent years. They announced a plan in 2017 where they would raise their dividend 60% in 2018, 25% in 2019, and another 25% in 2020. What's the trajectory on dividend increases past that framework that they've laid out? What should we be paying attention to there from the company?

Dilallo: When they sold the Trans Mountain pipeline, they said that their aim is to secure $2 [billion to] $3 billion of new projects each year. At the low end, that would enable them to grow their earnings by about 4% per year. At a minimum, I would expect that they could do that low-to-mid-single-digit dividend growth going forward. I think that's a safe area. They're going to cover their payout by about 50%. So kind of like Plains, it's very safe dividend. It's got a good yield. I think it'll be maybe 5% per year going forward, which isn't amazing, but it's still pretty solid.

Sciple: Sure. When you own the backbone of U.S. natural gas infrastructure, with the way that is projected to move going forward, it seems like it could be a high-probability bet for some income going forward. 

The other company that we're going to talk about today is Enterprise Products Partners. A little bit bigger than Kinder Morgan. A $60 billion company, about 30% larger than Kinder Morgan. When you compare Enterprise Products to Kinder Morgan, what are the main differences folks should see? What should stand out to you about this company specifically?

Dilallo: The big difference is, Enterprise is a master limited partnership, whereas Kinder Morgan is a regular corporation. Master limited partnership can be a little bit more challenging for investors. You can't own those in an IRA, for example. You have to have them in a regular brokerage account. And they send what's called a schedule K-1 for taxes vs. the 1099 that most of us are familiar with. That can complicate your tax a little bit. They come later in the year. That's just something to be aware of. 

The other big difference is, where Kinder Morgan is natural gas, Enterprise Products Partners is diversified, however, natural gas liquids is their big thing. We use that a lot to make petrochemicals. It's one of the main building blocks for plastics. They're much more focused on that, which is a niche market, but it's been a very great and profitable niche for them.

Sciple: Yeah. Another difference between them and Kinder Morgan is, Enterprise Products has a much more conservative balance sheet relative to Kinder Morgan, down in the threes on their debt-to-EBITDA. When you look at that part of the business, what stands out to you?

Dilallo: Definitely, the stronger balance sheet gives them more financial flexibility. They can invest in more growth projects. They have more capacity to make acquisitions if they find good deals. In this business, especially with what the industry's been through the past couple of years, the stronger the balance sheets, the better. That definitely gives them a competitive advantage.

Sciple: Yeah. When we take a look at the products they're investing in going forward, they have two pipelines currently operating in the Permian. What else are they investing in and going forward to start to grow their asset base?

Dilallo: I mentioned that they're very big into the NGLs and petrochemicals. One of the interesting deals they just signed was with LyondellBasell Industries. They're going to build a PDH plant. What it does, it'll take propane, which is one of those NGLs, and convert it to this basic building block for plastics. It's going to supply that to the chemical company under a long-term contract. If fits in well with what they're trying to do, to find outlets for these NGLs. Again, it's like oil and natural gas. We have so much of it here in the States that our options are to use it or to export it. They're doing both. They're building export projects for the NGLs, and then they're building these petrochemical plants that will use it. 

On the export side, in addition to some NGL export projects, they've got this Sea Port Oil Terminal, or the SPOT terminal. That's an offshore export terminal. The reason that's interesting is that one of the ways that they can ship oil overseas is these very large crude carriers which carry two million barrels. They're so big that they can't fit into a lot of the ports. The only way to fully fill them up is to do it offshore. Otherwise, they have to truck oil; they can partially fill it and then they'll take these little ships and fill them up. But this allows them to do it much more efficiently. This is going to be built offshore. It'll be a much cheaper and more efficient way to export oil. That one could come online in a couple of years. 

With these projects, it gives them a lot of visibility into growth. They've got $6 billion in projects currently under construction, with five to 10 that they're working on. A lot of growth coming online with them.

Sciple: On that export deal, they're partnering with Chevron. Obviously a great partner to have in the oil exploration and production area. When you look at Enterprise Products Partners, the dividend, obviously very important for them, yielding over 66% -- [laughs] excuse me, not 66%.

Dilallo: [laughs] That'd be amazing.

Sciple: [laughs] Yeah, that'd be pretty good! Yielding over 6%. They've increased their dividend for 61 straight quarters. Can it get much safer than this dividend that this company has paid out?

Dilallo: It's one of the safest in the midstream sector. We mentioned the metrics before, but 85% plus fee-based cash flow, 1.7 coverage ratio, which is really good. And then, the top-notch balance sheet. This is, in my opinion, one of the safest dividends in the energy industry. 

Sciple: Yeah. If you can get a safe 6% dividend when it appears that the growth that's going to come out of this region, and the current market environment, it appears very attractive. 

When you look at these three companies that we've talked about today -- Plains All American, Enterprise Products Partners, and Kinder Morgan -- of those three, if you had to only buy one today, which one would you be most excited about buying?

Dilallo: It's a really tough question, because I like all three. I own Enterprise and Kinder Morgan personally. Of those two that I already own, I recently added to Enterprise. I just really like the strength of the balance sheet, the diversification, the growth projects they have coming online. We mentioned Kinder Morgan has some longer-term opportunities in natural gas, but there's a lot more visibility with Enterprise Products Partners in the near term with all those projects that they've signed up for. That's my favorite right now.

Sciple: Awesome! Matt, thanks for coming on the show, as always! We're looking forward to having you on again soon!

Dilallo: Thanks for having me!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Matt Dilallo, I'm Nick Sciple. Thanks for listening and Fool on!