Many companies likely regret their bullish bets on oil right now. Kinder Morgan (NYSE:KMI), however, isn't one of them. The energy company, which produces oil in Texas through enhanced recovery projects using carbon dioxide, has held on to the business even though some investors did not think it was a strategic fit. Kinder Morgan disagrees, and COO Steve Kean had a lot of good things to say about the company's oil business at a recent energy conference.
Risk and reward
When asked about the company's oil business, and more specifically about the higher returns it had been known to generate relative to its pipeline and terminals business, Kean had this to say:
The reason that the rate of return is higher there is, quite frankly, we focus on the projects that will -- because we are exposed to commodity price risk in that business, we focus only on those projects that generate a 20% or better rate of return on the oil price assumptions that were used at the time. And then, you see the track record there of historical performance. We've been able to do a little bit better than that, but some of that has been, over this entire period, a generally uplifting oil price.
The company's oil unit tends to be its highest-returning business. It needs to be, because unlike most of the company's fee-based assets, this business exposes Kinder Morgan to commodity prices. That is an issue when oil prices fall, as seen this year. However, the company's view is that its hedging program mitigates some of the risk from falling oil prices, at least in the short term. However, that only goes so far, as Kean acknowledged.
[...], the returns are absolutely affected by oil prices. I mean, again, we hedge, but our hedge program is heavier in the front years and lighter in the out years. So, we seek and we've been able to historically get a higher return on the investments that we make in the CO2 business because we are exposed to commodity prices. We want to see a higher return to compensate for that higher risk, and we've been able to get it.
So far, the company's risk-taking has worked, as Kinder Morgan has earned the higher returns it sought. But that's not the only reason it continues to like its oil business.
Kinder Morgan's carbon advantage
The other reason is because Kinder Morgan controls its supply of carbon dioxide, which is a key strategic asset. Kean noted this when he said:
We have CO2 because we have the CO2 source and the CO2 transport business. There's certain oil in West Texas that is very economically recoverable, even at today's prices very economically recoverable. But, the only way you can get it out is with CO2. And we have one of the only sources of -- one of the only supplies of CO2 that's commercially usable in West Texas. So, that gives us the ability to demand and obtain higher returns because we're in a niche. But, those returns are undoubtedly affected by a lower oil price.
The following slide shows that the company owns and operates the best source for carbon dioxide used in enhanced oil recovery. That gives it a distinct competitive advantage to inexpensively produce oil using that carbon dioxide. The company also sells this material to third parties, so it's an important integrated system both internally and externally.
While oil has quickly fallen out of favor with investors, Kinder Morgan still loves its oil business. Not only does the business earn higher returns than its other assets, but the company controls a strategic supply of carbon dioxide that is critical in keeping its production costs low. That's why we'll likely see the company keep pumping oil for years to come.
Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.