The North American energy sector's growth days appear to be in the rearview mirror. At least that's the view of executives at pipeline giant Kinder Morgan (NYSE:KMI) as they discussed what they saw ahead during its second-quarter conference call. That dimming outlook for organic expansion will likely force the company to consider alternative strategies to create shareholder value in the coming years.
Hitting the peak faster than expected
Kinder Morgan's founder, Richard Kinder, provided investors with a candid view of what the company now sees ahead:
Looking beyond 2020, we believe we are operating in a maturing business segment and that our opportunities for viable expansion projects will likely be significantly less than we have experienced over the last several years. If that expectation proves accurate, it will probably reduce our growth potential, but allow us to husband significant cash flow that we can use to increase our dividend, pay down debt, and/or buy back shares under the right conditions.
As Kinder notes, the company doesn't foresee moving forward with as many organic growth projects in the future compared to the recent past. That's due to a combination of factors, including an overabundance of supply and a series of legal setbacks that have delayed projects and caused several cancelations.
CEO Steven Kean noted that the company "had previously talked about being in the range we've been in for about 10 years of $2 billion to $3 billion a year of capital expansion opportunities." However, because of the downturn in the energy market, it only expects to invest about $1.7 billion this year. While the company isn't yet sure what next year's number will be, Kean suggested that it might "hang around the level we're seeing in 2020, maybe a little less."
With the company generating $4.5 billion to $5 billion in annual cash flow and paying around $2.5 billion to shareholders via the dividend, it's on track to produce significant free cash flow next year after funding capital projects. As Kinder pointed out, it could return those funds to investors or pay down debt. The problem with either scenario is that investors highly value growth, which Kinder Morgan will have trouble delivering, given its significantly reduced growth spending rate.
The alternative growth options
With oil and gas production in North America reaching its peak, Kinder Morgan is running low on organic growth opportunities in the midstream sector. However, that doesn't mean the company won't grow at all in the future.
One option it will probably consider is acquisitions. Kinder noted that the company's size, attractive assets, and relatively strong balance sheet put it in position to be a "potential consolidator in the midstream area."
For the company to go that route, a target would need to meet two major criteria. First, Kinder stated that it would not pursue an M&A transaction "to the detriment of our balance sheet." So, it would either need to push its leverage ratio below its target level before making a deal or find an under levered rival. Second, Kinder stated that a deal "would have to be accretive to our distributable cash flow." While those are high hurdles, Kinder Morgan could use acquisitions to grow its earnings and dividend in the future.
Another potential option the company could consider is investing in renewable energy, either by acquiring or developing power generating assets or transmission lines that connect those projects to the electrical grid. Two of its largest rivals, TC Energy (NYSE:TRP) and Enbridge (NYSE:ENB), have sizable power businesses. While TC Energy has sold off its renewable energy assets in recent years to help finance other expansions, it still invests in the power sector, mainly nuclear and natural gas power plants. Meanwhile, Enbridge has a growing renewables business focused on developing offshore windfarms in Europe. It currently anticipates investing $1 billion Canadian ($750 million) per year into renewables. With the global economy expected to spend trillions of dollars in building new renewable energy capacity in the coming years, there wouldn't be any shortage of investment opportunities for a company like Kinder Morgan that has the cash to invest.
Kinder Morgan needs a new growth strategy
Kinder Morgan initially expected that it wouldn't have any problem finding $2 billion to $3 billion of organic expansion opportunities each year, which would give it the fuel to keep growing its cash flow and dividend. Unfortunately, that's no longer the case because oil and gas production in North America has hit a near-term peak. It's also getting nearly impossible to move forward with new pipeline projects, leaving Kinder Morgan's growth engine running on fumes. It will either remain in a state of meager growth or have to switch fuel sources. Though on a brighter note, while it doesn't appeal to growth-focused investors, its more than 7%-yielding dividend should more than satisfy income investors in this low-interest-rate environment.