On Thursday, the U.S. Bureau of Labor Statistics reported that the Consumer Price Index rose 7.5% over the last 12 months, putting inflation at a 40-year high. To combat inflation, the Federal Reserve could begin raising interest rates in March -- with a total of three or four rate hikes expected this year.
Higher cost of goods, more expensive cost of capital, and supply chain constraints are weighing on businesses' bottom lines. However, certain companies have shown they have the pricing power to pass along some of these costs to their customers.
Chevron's capital discipline gives its business longevity
One way to invest in businesses that can perform well during inflationary times is to find the industries causing inflation and avoid the ones most vulnerable to it. Higher oil and gas prices are contributing to inflation right now. The price of West Texas Intermediate crude oil, the U.S. benchmark, and Henry Hub natural gas spot prices are at their highest levels since 2014 as demand outpaces supply.
Chevron has spent the last few years cutting production and maintenance costs and making a timely acquisition during the 2020 downturn so that it can break even at lower oil and gas prices. When the COVID-19 pandemic crippled demand for fossil fuels, Chevron's low cost of production allowed it to perform better than many of its peers. But it still booked a net loss of $5.5 billion.
2021 was a game-changer, as many oil majors had some of their best years since 2014. The below chart is a great illustration of Chevron's leaner business model.
Notice that 2021 revenue was up only 15.5% in five years, but net income was up 70%, and free cash flow increased over 200% -- a sign that Chevron is converting more sales into actual profits.
A lean business operating in the heart of an industrywide boom should allow Chevron to have another excellent year in 2022. In its fourth-quarter 2021 conference call, management indicated it would stay disciplined and keep capital spending under control so as not to overexpand and leave the company vulnerable during a downturn.
In the meantime, Chevron will continue passing along value to shareholders through the dividend and by buying back its own stock. Chevron has a 4.1% yield at the time of this writing.
Kinder Morgan is a cash cow with a high dividend yield
Like Chevron, Kinder Morgan's business is relatively insulted by inflation. As one of the largest energy transportation and storage companies in the U.S., Kinder Morgan provides the infrastructure needed to transport products out of the major oil and gas plays to end markets.
Although Kinder Morgan and Chevron are in the same industry, their businesses are quite a bit different. Kinder Morgan doesn't produce oil and gas or sell it to consumers at gas stations. Rather, its business is focused on investing in pipelines, terminals, liquefied-natural-gas facilities, and other projects. To justify building these multi-year, capital-intensive projects, Kinder Morgan secures long-term take-or-pay and fee-based contracts that make its earnings predictable.
This quality was displayed in 2020 when Kinder Morgan adjusted its full-year guidance in April as the pandemic was becoming a reality. Kinder Morgan's distributable cash flow (DCF) and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) guidance ended up being 99% accurate. Precise forecasting is what many income investors look for because it allows a company to generate stable cash flows that support the dividend.
Kinder Morgan is guiding for $2.5 billion in 2022 net income, DCF of $4.7 billion, adjusted EBITDA of $7.2 billion, and a dividend of $1.11 per share, up from $1.08 per share in 2021. Kinder Morgan's 2022 dividend obligation should cost the company around $2.6 billion, indicating that Kinder Morgan can support its dividend with cash, not debt.
Kinder Morgan's 2022 guidance gives the stock a forward price to earnings ratio of 15.9 and a forward dividend yield of 6.3%.
Offset inflation with passive income
Buying equal parts of Chevron and Kinder Morgan stocks would give an investor an average dividend yield of 5.2% while exposing one's portfolio to many aspects of the oil and gas industry. The dividend yield alone is nearly high enough to offset the impact of inflation. And because Chevron and Kinder Morgan are in an industry that is causing inflation, both companies should benefit.
However, investors should be mindful that if oil and prices level off or begin to fall while costs continue to rise in other sectors of the economy, then we could see a scenario where the oil and gas industry is not as good of an inflation hedge. Oil and gas companies are in a commoditized industry where the companies that have the lowest operating costs tend to win out. Chevron can achieve positive free cash even when oil is in the $40s. And long-term contractual agreements make Kinder Morgan's business resilient to short-term swings in oil and gas prices (as we saw in 2020). So even if production costs go up or profit margins start to decline, Chevron and Kinder Morgan should still generate plenty of FCF to pay and raise their dividends.