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Answer: Kinder Morgan CO2 Company, L.P. (or at least one of the most over-valued...)

Kinder Morgan CO2 Company, L.P. is a subsidiary of Kinder Morgan Energy Partners, L.P. (KMP) that the Kinder Morgan faithful don’t want to talk much about. But the segment is crucial, as it generates 26% of KMP’s total earnings before DD&A and certain items (and the GP’s take), and nearly all of those cash flows flow to the DCF line due to the fact that KMP considers 97% of the capital expenditures in the segment to be “expansion capital” – which, as MLP investors know, are not deducted from DCF; “sustaining capital” is deducted from DCF.  

Between 2010 – 2012, for its CO2 segment, KMP reported $34MM of sustaining capital and $1,230MM of expansion capital, despite no material volume growth in its E&P or CO2 businesses, and aggregate DD&A of $1,329MM. If KMP considered all of the CO2 capital expenditures between 2010 – 2012 to be sustaining capex, which we think is appropriate considering there was no aggregate growth in the segment, then KMP’s total DCF would have been ~26% lower than reported.

We estimate that the CO2 segment currently generates ~1/3 of KMP’s total DCF after the GP's take, despite only representing 7% of total assets. 

The Most Over-Valued E&P in North America Is…? - km1b

This may not be lost on seasoned MLP investors. But there seems to be a lot of interest in this contentious topic lately, as we’ve gotten several questions and comments on it over the last few months. The general view out there on it is something like, ‘It makes no sense, but it is what it is. It’s Kinder Morgan. They do what they want.’  Some have even suggested to us that the SEC won’t do anything about LINN Energy’s (LINE, LNCO) blatantly understated “maintenance capex” (and, as a result, its overstated DCF) because ‘they won’t want to make Kinder Morgan mad.’  But in our view, the fact that KMP does this is indefensible and misleading (as it creates a wide gap between DCF and free cash flow, which most retail investors incorrectly assume are synonymous), and it’s worthy of discussion.  The KMP CO2 segment's expansion capital is funded primarily via equity and debt financing – but with no volume growth, the return on that incremental invested capital will be zero excluding the impact of price. These capital raises finance the distribution payment, not growth, and KMP’s CO2 segment is running to stand still...though it is a cash cow for the GP!

“We define sustaining capital expenditures as capital expenditures which do not increase the capacity of an asset.” - KMP 10-K, page 73.

That is purposefully cryptic. How is KMP defining “the capacity of an asset?” It clearly has nothing to do with the top line, i.e. volume growth.

KM CO2 is really two businesses – a EOR (enhanced oil recovery) E&P; and CO2 production, transportation, and marketing.  The E&P assets generate the majority of the segment's EBITDA.

In 2012 Kinder Morgan was the 5th largest oil producer (gross) in the state of Texas. It’s three oil fields are CO2 floods in the Permian Basin – SACROC, Yates, and Katz/Eastern Shelf. Net to KMP in 2012, production was 39,107 boe/d (90% oil). As of YE12, KMP had 89 MMboe of proved reserves, of which 57 MMboe (64%) were proved developed. The YE12 PV-10 of the E&P assets was $2.7B.

Production and proved developed reserves have been flat-to-down in recent years, with SACROC production flat, Yates in decline, and Katz – where production has disappointed – growing off of a low base to offset some of the aggregate decline. The 2010 – 2012 E&P production CAGR was -3%, and KMP only replaced 92% and 91% of proved developed reserves in 2011 and 2012, respectively. There is no material growth in the E&P segment. KMP has incurred $1,009MM in E&P development costs over the last 3 years, and nearly all of it was considered expansion capital, despite production and reserves declining. Sorry, but, THIS MAKES NO SENSE.

The Most Over-Valued E&P in North America Is…? - kmp graph

Growth in production from KMP’s natural gas plants (from 4,117 boe/d in 2009 to 5,717 boe/d in 2012, a 12% CAGR) has offset some off the E&P decline, but total oil, NGLs and natural gas production still declined at a -2% CAGR over the last three years. And KMP’s CO2 production has remained flat around 1.2 – 1.3 Bcf/d.

The Most Over-Valued E&P in North America Is…? - km3

If we want to think of sustaining capital for the E&P assets as the capital required to keep production and reserves flat (the definition most E&P MLPs use and abuse), let’s try and figure out what that might actually cost KMP today. Annual production over the last two years has come in ~14 MMboe. If KMP replaced 100% of those proved developed producing reserves with the drill bit, what would it cost?  We think that the best way to do this is to look at KMP’s PUD conversion cost, because that is really the heart of KMP’s EOR operation. How much does it cost KMP to move a PUD barrel into the proved developed category?

Here are the relevant disclosures from the 2010, 2011, and 2012 10-K’s:

“During 2010...we incurred $248.0 million in capital costs which resulted in the development of 10.0 million barrels of crude oil and 1.3 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”

“For 2011, we incurred $372.8 million in capital costs, and in prior years, we incurred $43.6 million in capital costs related to the Katz field unit. Combined, these capital investments resulted in the development of 7.3 million barrels of crude oil and 0.9 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category. We also developed 3.0 million barrels of crude oil and 0.0 million barrels of natural gas liquids reserves with the development of the Katz (Strawn) unit CO2 flood where the produced gas containing natural gas liquids is injected with the CO2.”

“For 2012, we incurred $353 million in capital costs, and this capital investment resulted in the development of 6.0 million barrels of crude oil and 1.8 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”

The Most Over-Valued E&P in North America Is…? - km4

Some comments:

• For scope, Denbury Resources' (DNR) PUD Conversion cost in 2012 was $21.60/boe, and it is a higher cost EOR player.  KMP's 2012 PUD conversion cost of $45/boe is very poor.

• The trend in capital efficiency is negative, likely due to activations on the fringes of SACROC and Yates, and disappointing results/cost overruns at Katz.

• The 2010 PUD conversion costs are low because of a large positive performance revision at Yates; the 2011 and 2012 combined PUD conversion costs were $45.38/boe and $33.15/boe excluding and including PD performance revisions, respectively.

• $33.15/boe x 14MM boe = $464MM of annual capital required to keep the proved developed reserve base flat.

The non-E&P CO2 segment assets (CO2 production, transportation, and marketing) will have organic growth going forward, as KMP plans to ramp production from ~1.2 Bcf/d currently to 1.7 Bcf/d by 2017. That is the main driver of the 2013 capex increase (+$200MM total before the recent acquisition).  But still, this segment should have some sustaining capex allocated to it. DD&A on these assets are ~$50MM/year, in line with the non-E&P capital expenditures in 2010 and 2011, which resulted in no production growth. Thus, ~$50MM/year is, in our view, a fair number for sustaining capex for the CO2-only assets.

Putting the two pieces together, we argue that sustaining capex on the entire segment should be between $400MM - $500MM per year (and growing), versus the 2013 guidance of $17MM. Of course, that’s never going to happen unless a regulator makes it happen, as it would shave off more than a $1.00/unit of annual KMP DCF.

On valuation…

In 1H13, KMP’s CO2 segment generated $691MM of earnings before DD&A and certain items; if we annualize that and allocate the segment $80MM of annual corporate G&A, then it will do ~1.3B of EBITDA in 2013, or 26% of the consensus EBITDA estimate for all of KMP before the GP’s take, $5.0B. But most of that EBITDA is flowing directly to the DCF line because no material sustaining capex is deducted. So with KMP in the 50/50 IDR split, the GP takes ~46% of the total distributions, and, by our estimates, the CO2 segment alone will generate ~$700MM of DCF net to KMP in 2013 (~1/3 of total DCF).  With KMP yielding 6.45% 2013e DCF, the market is valuing this asset net to KMP at ~$11B.

Compare this to the YE12 PV-10 of the E&P assets of $2.7B, and the book value of the entire CO2 segment as of 6/30/13 of $2.8B (we estimate that this is $1.4B E&P and $1.4B non-E&P).  And, recall, the GP’s take is over 46% of the distributions, so the value net to KMP is roughly half of those figures.  If KMP were to sell the segment and distribute the proceeds, we have a hard time believing that it would amount to more than $3 - 4B after the GP's take. 

The point is that the CO2 segment inside KMP is massively overvalued, largely due to understated sustaining capex and the failure of the market to recognize that it's a depleting asset (and valuing it with a yield target).  But is it a moot point?  Well, it has been for years, and Kinder Morgan will never sell or spin the segment.  But, if you own KMI/KMP, you should at least know about this; and if your content to just 'play the game,' so be it.

On the recent E&P acquisition...

"In June [2013], KMP acquired the Goldsmith Landreth San Andres Unit in West Texas from Legado Resources for approximately $285 million. Goldsmith includes more the 6,000 acres in Ector County and is in the early stages of a CO2 flood development. The unit currently produces approximately 1,250 bpd of oil and is projected to peak at approximately 10,000 bpd in about 10 years. Also of importance, as part of the transaction KMP obtained a long-term CO2 supply contract with volumes growing to 150 MMcf/d over the next few years." - KMP 2Q13 Press Release

This acquisition is not surprising to us, even the big multiple of $228,000/boe/d.  After all, the purchase price and all future capital expenditures are excluded from DCF, financed at the KMP level, and KMI will take ~50% of all future cash flows.  A no-brainer for the GP.  Really, as long as the market lets KMI/KMP get away with it, KMI supporters should push for as many CO2 segment acquisitions as possible.  

There must be a great deal of cognitive dissonance that comes with owning (or shorting!) KMI/KMP...

Kevin Kaiser

Senior Analyst