The latest OPEC meeting ended with shockingly few changes or agreements, Kinder Morgan (NYSE:KMI) dramatically cut its dividend, and two of the world's biggest chemical companies are merging in a way that may or may not set off regulatory alarm bells.
In this episode of Energy Industry Focus, Sean O'Reilly, Taylor Muckerman, and Tyler Crowe go over why the OPEC countries aren't cutting back their quotas, what the Kinder Morgan dividend cut means, and why and how DuPont (NYSE:DD) and Dow Chemical (NYSE:DOW) are combining. They also answer listener mail about the difference between a company and a limited partnership.
A full transcript follows the video.
Sean O'Reilly: OPEC decides to do away with the production quotas they were ignoring anyway, on this episode of Industry Focus.
Greetings, Fools, I am Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Thursday, Dec. 10, 2015. And joining me in studio to talk about all things energy and industrial is Taylor Muckerman and Tyler Crowe. Guys, the gang's back together!
Taylor Muckerman: Yeah, about time.
Tyler Crowe: All together in the same place at the same time. It felt kind of weird, just calling in --
O'Reilly: Well, you called in from Vermont. I don't know what was up with that.
Crowe: Yeah, I called in last week, I was like, "This is kind of weird. I feel like I'm on a phone call."
O'Reilly: Could you hear him OK?
Crowe: Yeah, it's just a different experience.
Muckerman: Technology, yeah.
O'Reilly: It wasn't Skype, so it was probably OK.
Muckerman: Even Skype works well. That's what Ian does.
Crowe: Oh, here? Oh, wow. I didn't know that.
O'Reilly: You learn something new every day. So, before we dive into the big company-specific stories of the week, we have got to talk about last week's OPEC decision, or lack thereof. They basically kept production where it was. They actually did away with their quota. They are not cutting.
The interesting thing that I read was, according to The Wall Street Journal, the group supposedly considered cutting production but decided that a reduction even of 5% wasn't likely to push prices higher if non-OPEC producers, which make up two-thirds of global production, join in cutting. Sad.
Muckerman: Russia is where they're really looking at.
O'Reilly: They're like, "Hint, Russia. Hint, hint." Did you guys hear that rumor, a year ago now, when oil really dropped after that big OPEC meeting, from $80 to $50 or whatever --
Crowe: Yeah, it dropped, like, 25% in a day.
O'Reilly: Supposedly, the Saudi oil minister met with Russia. It wasn't Putin, but it might as well have been Putin. And Russia said they wouldn't cut, so he was like, "All right," and then, boom. Do you guys think it's true that they actually considered cutting by 5%? And do you think it's true that even if they did, it wouldn't matter?
Muckerman: As a group, I don't think they considered it.
Crowe: Yeah, and that's the thing --
O'Reilly: Because Iran --
Crowe: We talk about them as a single entity.
O'Reilly: When they are not.
Crowe: They are so, so far from that.
O'Reilly: Well, Venezuela was begging for a cut.
Crowe: They're like herding cats. You have multiple members who have very, very different agendas when it comes to these meetings. If you look at one of those things, like you were talking about, there was a Wall Street Journal article that did a very good job of highlighting everything that's going on in this, and I would encourage anybody to go and read it. But one of the things they mentioned was, Venezuela, Nigeria, a bunch of countries that are struggling at this oil price, some of the ones that don't have a large revenue source outside of oil --
O'Reilly: We're talking, like, borderline revolution in some of these countries.
Crowe: Well, let's not go that far.
Crowe: What they were saying is, "You guys, we need to cut the quota." So when the, I guess you could say more well-financed areas like Saudi Arabia and some of the other Gulf states, said, "Fine. Everybody, let's get together and agree to a cut." And then the smaller, marginal one says, "Well, we don't want to cut. We can't do that. We're in too much trouble."
And then they said, "Fine, if you don't want to cut, then why should we?" And it's becoming an almost fragmented group. And if you look at what's been going on, they're kind of shooting themselves in the foot, too. It's not like they're not suffering. I think one of the things they mentioned in that article is that Saudi Arabia is burning through $10 billion a month from their -- I wouldn't say slush fund, but their --
O'Reilly: Not only that, but their currency is pegged to the U.S. dollar. They're having to defend that. I saw this crazy thing like short bets against their currency. Because it's a peg, it's a free bet, if they, you know...
Muckerman: Well, and they also started taking debt out in U.S. dollars.
O'Reilly: Yeah, they sold their first bonds in years. Let's talk about the small producers, Venezuela and all those guys. They didn't want to cut. They were like, "Oh, no, we want you to cut. We're in too much trouble. We can't cut." The economic analysis as to why at some point somebody should cut for whatever a 5% cut in the decrease of production that would generate, assuming oil goes back to $80 or $90 or whatever. Way less than the extra revenue from the price doubling. That was the reasoning for Saudi Arabia eventually cutting or whatever. I read this a year ago now. But why didn't the smaller producers realize that --
Muckerman: They would have to band together. They couldn't move the needle enough. If Venezuela cut their production by 10%, who cares?
O'Reilly: Why isn't Venezuela going along with what the bigger players want, which is everybody cutting? Is it just Russia?
Muckerman: Yeah, so, if everybody else in OPEC cut, other than Iraq and Saudi Arabia, they wouldn't even be able to cut as much as those two countries combined. So they need more than just the smaller producers in OPEC. Saudi Arabia wants Iraq and Russia predominantly to commit to cutting production, because both of those countries are producing at record levels right now. And Russia has been pretty forthright saying that it's just not going to happen.
O'Reilly: Why? Why not? Is economics not their strong suit? Why don't they realize, "OK, if we cut by 5%, we'll get double the money for the remaining 95%"?
Muckerman: I think because there's a lot of politics as well.
Crowe: There's also a lot of oil that can come online at $60 or $70 per barrel that will capture market share. If we look at what's going on in the United States, we've gone stagnant in terms of drilling in the United States because oil has been so low, and we have reduced the breakeven cost from all these companies getting desperate and trying to find new ways to drill, that we could become much more economical in that $60 or $70 range, and we could be the ones to fill that gap very quickly if prices were to start to rise again. And one of the big reasons they continue to do this is to maintain pressure on those pent-up sources of demand and preserve market share.
O'Reilly: It seems to me the bottom line of this is -- the only saving grace, then, if OPEC's bent on crushing higher cost producers like us, and when I say "us" I mean U.S. shale producers -- is demand.
Muckerman: Well, demand rose faster in 2015 than it did in the past half-decade or more.
O'Reilly: As it should, the price fell in half.
Muckerman: Yeah, that, and countries are catching up to the fact that oil helps build economies. It helped us. I think that a lot of countries are asking themselves, "Why the heck should we be set back having to now take all of our cash that we poured into oil and gas infrastructure and charge head-on into renewables when America and China and Europe got the benefit of using these natural resources to grow as much as they have?" And then, asking these poor countries that are not only relying on them but also producing these natural resources to about-face. So, it's definitely a developed-country agenda versus an emerging-country agenda.
O'Reilly: Cool. Before we move on, I wanted to point our listeners to a newly redesigned focus.fool.com. There, you'll discover a special offer to join the Motley Fool Stock Advisor newsletter for all Industry Focus listeners. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to focus.fool.com to take advantage of that offer. Once again, that is focus.fool.com.
Moving on to the second half of our show, and first on the docket, we've got a potential merger between chemical giants Dow Chemical and DuPont. The deal is not finalized. Obviously, they're in advanced talks. But what's the rationale for combining these two huge companies?
Muckerman: I think, a) it probably gets some activist shareholders off their backs, and b) it looks like they're just gonna split everything up once they do.
O'Reilly: Yeah, what were you saying, that they were shuffling the deck?
Muckerman: Yeah. If they split off these divisions independently as two separate companies into these smaller divisions, they might not move the needle as much. But they can create giants in three separate sectors if they split these companies off after they combine.
O'Reilly: Have any cost savings been mentioned? Or is it just --
Muckerman: You would have to imagine that job cuts are on the table.
Crowe: They're very broad statements when they say stuff like that --
O'Reilly: Right, especially at this stage.
Crowe: -- because the deal isn't finalized in any way. But obviously, that's one of the reasons you would do it, because you bring together --
O'Reilly: They're calling it a deal of equals, so they probably wouldn't even offer a premium for anybody's shares. It would just be like, "Hey!" Smash. And then crumble.
Crowe: Yeah. I think one of the great examples that they gave is, let's talk about agriculture. Both companies are very large in fertilizer manufacturing, as well as even doing some seed technology. And what they thought about doing is, "OK, when we come together, we'll put that agricultural segment into its own little realm. We'll take the cost efficiency, job cuts, who does what well and who doesn't do what well, and we'll make that its own company, and make it competitive with somebody like Monsanto, Agrium, places like that, where they can be competitive in that specific space, and have a larger market share in that specific space."
Muckerman: Basically creating three much more cyclical businesses is what they would be doing. Investors could pinpoint exactly what they want to invest in. To put some numbers to what Tyler said, The Wall Street Journal shows that together, they have 17% of the world's pesticide market, they would be the third-largest supplier of crop chemicals, they would have 41% of the U.S. corn seed business, and 38% of the soybean market. So these aren't small numbers that we're tossing around.
O'Reilly: So you say three more cyclical businesses. That sounds kind of negative to me.
Muckerman: Well, yeah, you're talking about the agriculture business that floats in waves, and then their petrochemical business is affected by oil prices, which is a cyclical business. And I'm not sure what the third one would be.
Crowe: It looked like it was gonna be specialty products. I think one of the examples was Kevlar.
Muckerman: Kevlar, yeah, that's one of DuPont's main products.
Crowe: That sounds like the least cyclical.
Muckerman: But you look at a lot of this, and this would impact not just investors but consumers as well. I would be surprised if you go an entire day without touching something that was produced with a product of one of these two companies.
Crowe: And what makes it odd is, when you get large mergers like this, one of the obvious things that comes up is regulatory approval. Too much market share, like we're seeing with Baker Hughes-Halliburton, they're running into a lot of regulatory approval --
O'Reilly: Yeah, over a year now.
Crowe: Yeah. And one of the reasons is, somebody gains too much market share, and there's the antitrust laws related to having basically absolute dominance and control of a market, where you can price-gouge customers and things like that. But this is why this one is weird. This is like, "Oh, we're gonna break up so we don't have regulatory issues," but you're gonna break up into the specific segments of the market that you're gonna have control of. So how is the regulatory environment going to look with that? It's like, yeah, you're smaller, but you're...
Muckerman: The advantages are still the same.
O'Reilly: Well, the final story of the day. Dun dun dun -- Kinder Morgan cuts its dividend. In a press release put out by the company titled "Kinder Morgan Announces 2016 Outlook" -- that sounds harmless enough, right? -- the company noted that they expected to pay dividends of $0.125 per share, instead of the current $0.51 per share, beginning in the fourth quarter of 2015 and into fiscal year of 2016. This decrease enables the company to use a significant portion of cash flow to fund the equity portion of its expansion capital requirements, eliminates the need to raise equity capital, and maintains a solid investment-grade rating. The stock was up on the news, so is this a good thing?
Muckerman: Long term, probably so.
Muckerman: It was up because it was the big overhang.
Crowe: Everybody was pricing. They have to do something here pretty drastic. What was it, it's down 60%...
Muckerman: Thirty percent since Thanksgiving. So I think all the dividend investors were selling out, because they're like, "This has gotta be cut; it's gonna be cut." And then, do you look up some longer-term investor buying in today because it's up a few percent today?
O'Reilly: I was reading this and I was like, "This seems positive." You know what I mean?
Muckerman: Yeah. If your investment horizon is three years or longer, then sure, it is, because a lot of people are saying that they won't be able to raise the dividend until the next two or three more years. But you're still getting in your 3% yield.
O'Reilly: They're talking about expansion as well, it's not like --
Muckerman: Eh, I wouldn't pump the brakes on expansion just yet, because right now they've just freed up some cash -- they're not going to tap the debt markets or equity markets. So the only cash they have available to spend outside of financing debt and maintenance is this money they just saved from cutting the dividend, which is a couple billion dollars. So it's no small change, but compared to a company like this, it is pretty small change when you're really thinking about gross to move the needle on a year-over-year basis.
O'Reilly: Did you ever think you'd see the day, Tyler?
Crowe: Yes. I did. I wouldn't say specifically Kinder Morgan, but ...
O'Reilly: Right, that's what I was talking about.
Crowe: One of the tangents, and interesting things I've seen about this is, since this happened there's been a lot of talk about the master limited partnership in the pipeline space. I know Kinder Morgan is not a master limited partnership, it's a C-corp, but they act that way.
And there's so much to talk about its being a broken model, or a flawed model. It's not. It's a model that has been abused by management teams and pressured into unsustainable acts by shareholders and activists. I was actually reading the transcript from that announcement, and the first question from announcing a dividend cut was an analyst saying, "Well, when are you gonna raise it again?"
O'Reilly: You're missing the point, ma'am.
Muckerman: It's a shift in mind-set, yeah.
Crowe: These companies are being pressured by investors, Wall Street analysts, to raise these dividends at almost breakneck paces to keep up with inflation, to get yields, some sort of return over Treasury bonds that are 2%. And it's led to these unsustainable management practices, where it says, "Oh, we don't need to maintain any cash flow to grow our business. We can just go to the debt and equity markets whenever the heck we want."
And that doesn't make sense over the long term. Companies that do this, it's kind of a reckless move. And you need to, in some ways, generate some internal cash flow and spend it wisely. To expect companies to every quarter give out all of their distributable cash flow and tap the debt markets when they need something, it doesn't work. I don't see why anybody would think that is a sustainable proposition over the long term.
O'Reilly: Got it. And actually, on that note, we have a mailbag question that relates to MLPs, so maybe we can weigh in here. So before we wrap up, we have a listener mailbag from Ignacio Salvo of Orlando, Florida --
Crowe: You killed my father. Prepare to die.
O'Reilly: The Princess Bride reference, for everybody.
Crowe: Sorry, Ignacio.
O'Reilly: He knows how awesome his name is.
Crowe: I hope so.
O'Reilly: Yeah. Ignacio writes, "Hi, guys. I've started looking into what companies I could add to my portfolio to take advantage of the opportunities in the energy sector today. One of them is Spectra Energy Corporation (NYSE:SE). This company has nice margins, free cash flow, and a nice dividend. The problem I'm having is that there's also Spectra Energy Partners Limited Partnership (NYSE:SEP). What's the difference between the two, and which might be the better choice? Love the show. Ignacio."
Crowe: Well, thanks for the props on the show. So, the difference between Spectra Energy and Spectra Energy Partners is that limited partnership, general partner relationship that you see very commonly among master limited partners. Spectra Energy Partners is specifically a partner that owns assets -- pipelines, storage, logistics assets -- and they churn out cash. And the general partner, Spectra Energy, it's basically the manager of those assets.
And when it's spun off into the limited partnership, it's basically saying, "Hey, we're gonna own part of these assets and manage them, but we wanted to give you an opportunity to have direct ownership of those assets, not the company itself."
And so, what happens with that partnership is, they pay a distribution, which goes back to unitholders, which, in some cases, a certain percentage goes to the general partner, and then the rest goes to the public unitholders. So if you're looking at the limited partnership, you just directly own assets, versus at the general partnership, you own a company with management and everything that goes along with it.
O'Reilly: What are the risks?
Muckerman: And if you own Spectra Energy, you own portions of Spectra Energy Partners, so you're getting a two-for-one with those shares.
Crowe: And they also own another partnership --
Muckeman: DCP Midstream (NYSE:DCP). Smaller, but, yeah, they own it.
O'Reilly: Getting more to his question, which one do you like more and why?
Muckerman: I personally like Spectra Energy, which is why I own it personally.
O'Reilly: Because you have to double-dip, or is it less risky, or...?
Muckerman: Well, just the fact that they own both MLPs, they get the distribution right. So you get the benefit of these high payouts from Spectra Energy Partners, from a DCP Midstream, and then you also get the benefit of a regular corporate structure. You don't have the complexity of an MLP, which has shown recently to really confound some day-to-day investors.
Crowe: And annoying K1 filings. There are special tax implications when you own a partnership versus a general partner.
Muckerman: Especially a partnership that is doing well, because you have to pay taxes on their performance rather than if an MLP loses money, there's no special taxes for you. That's for you to talk to a tax professional about. But anyway, they're both paying high dividends and distributions, expected to grow over the next few years. They've got a great region that they're operating in on the East Coast, from Florida all the way up to the New England area and a little bit in the Great Lakes and Canada.
Personally, I think they have a solid customer base, 90% of which is investment grade, a lot of downstream customers that aren't necessarily affected by low oil prices. And they have a big backlog of projects, but not nearly as big as what Kinder Morgan was promising. A lot of them are in underserved areas of the country.
Crowe: And just to throw it out there, talking about that pressure of paying out all their cash flow, Spectra Energy Partners does not. They retain a certain percent.
O'Reilly: Conservatism wins the day.
Crowe: Right. They're conservative with it. They retain that cash flow. They use that to grow the business, rather than consistently going elsewhere to find funding sources.
Muckerman: And you pay for that in the yield. It's around 5.5% now versus the peer group of 7.2% -- 5.5% is great.
Crowe: Who complains about 5% yields?
Muckerman: Not me. And that's for Spectra Energy Partners. Their peer group is just over 7%, so you're looking at a little bit lower on the yield. But if it's safe, if those companies have to cut their yield, 7.2% is an afterthought.
O'Reilly: Cool. Well, that is it for us, Fools. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at email@example.com. And as always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against the stocks, so don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe and Taylor Muckerman, I am Sean O'Reilly. Thanks for listening, and Fool on!
Taylor Muckerman owns shares of Halliburton and Spectra Energy. Tyler Crowe has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Halliburton, Kinder Morgan, and Spectra Energy. The Motley Fool recommends DCP Midstream Partners. 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.