Kinder Morgan (NYSE:KMI) and ONEOK (NYSE:OKE) have yields of 8% and 12%, respectively. Dividend investors willing to venture into the oil and natural gas sector will definitely find those numbers enticing, given the fee-based nature of the midstream sector where this pair operates. But there are some key differences here you need to understand before jumping aboard either name.
1. Consistent, not guaranteed
Midstream energy companies own the pipelines, processing plants, storage, and other physical assets that help to move oil and natural gas around the world. This is largely a toll-taker business, in which companies like Kinder Morgan and ONEOK get paid a fee for the use of the assets they own. The price of the products flowing through their systems isn't the main driver of top- and bottom-line performance -- demand is.
That said, Kinder Morgan and ONEOK's customer base is made up of U.S. energy producers. COVID-19 has led to a severe drop in energy demand, with oil and natural gas piling up in storage, and a big decline in energy prices. In this environment, exploration and production names are pulling back very hard. That's led to demand declines for midstream operators. To put a number on that, ONEOK saw a nearly-25% sequential decline in natural gas volumes between the first and second quarters this year. That's a huge change in a very short period of time. To be fair, those volumes have come back, but this downturn has been particularly painful, and it is definitely not over yet -- supply and demand remain materially out of whack, to use a highly technical term. For its part, Kinder Morgan's third-quarter adjusted EBITDA fell 7% year over year, so it's facing headwinds, too.
2. A coverage conundrum
So there's good reason to be worried about both of these dividend payers, despite the historically stable nature of the midstream industry. The question is how worried you should be. In the second quarter ONEOK's distributable cash flow fell short of covering its distribution. That's a worrying sign, even though the company managed 1.06 times coverage in the first half. The problem is that this number is down from 1.47 times coverage in the same period of 2019. Even with volumes coming back, ONEOK's coverage is going to be relatively weak this year.
Kinder Morgan is in a better place, with coverage of 1.8 times in the third quarter. In fact, it has handily covered its dividend in each of the first three quarters of 2020 despite the industry headwinds it's facing. In this respect, Kinder Morgan looks like a safer option. However, there's a very big caveat here.
Kinder Morgan previously announced that it would increase the dividend 25% in 2020. Given the market environment it has opted to only increase the dividend by 5%. While it's hard to complain about that decision, this isn't the first time that Kinder Morgan has said one thing and then done another. In 2016, the midstream giant cut its dividend by 75% just months after telling investors that it was likely to increase it by as much as 10%. In other words, there's a bit of a trust issue here. Kinder Morgan is doing what's right for the company, but if you are looking for dividend consistency, you need to take its dividend commitments with a grain of salt. And a lot of that has to do with its balance sheet.
3. Rising debt
Here's where things start to get interesting. Financial debt to EBITDA is a key leverage metric in the midstream sector, and this number has jumped materially at both Kinder Morgan and ONEOK. Kinder's ratio increased by roughly 20% between the end of 2019 and the second quarter of 2020, and is up 40% through the third quarter. ONEOK's number is up about 55% through just the second quarter. Compare that to peer Enterprise Products Partners, which only saw a 5% increase though the second quarter. And, on top of this, both ONEOK and Kinder Morgan have historically made greater use of leverage than many of their peers.
In a difficult market, both Kinder Morgan and ONEOK are leaning on their balance sheets to ensure they have the liquidity they need to support their businesses. That's not surprising, but it does increase risk because it limits flexibility. In fact, in the case of ONEOK, the additional leverage basically bridged the gap between its dividend and distributable cash flow in the second quarter. That said, the company has also issued stock to help shore up its finances, which dilutes current shareholders. Sure, it managed to sustain the dividend in a tough quarter, but there was a very real cost for investors. That's basically why Kinder Morgan chose to go back on its dividend promise and only hike the 2020 payout by 5% -- it wanted to ensure that it didn't have to cut the dividend again.
The winner is...
At the end of the day, dividend investors comparing ONEOK and Kinder Morgan should probably err on the side of caution and go with Kinder Morgan based on its still-robust distribution coverage. That said, there are midstream companies with better distribution track records and more conservative balance sheets than Kinder Morgan -- Enterprise Products Partners comes to mind. In other words, conservative investors would do well to consider broadening their search beyond this pair if dividend consistency is an important consideration.