The Dividend Investor's Natural Gas Export Playbook - Part 2

Thesis

Over the next 5 years, a multitude of natural gas export terminals are scheduled to commence operations. This will expand exported volumes of liquified natural gas (LNG) from roughly 14 BCF/d to over 26.5 BCF/day by 2030. The first projects (shown below)are slated to come online one year from now and will culminate in the first wave of an additional 5 BCF/d in 2024 and a total of 8.5 BCF/d by 2025.

1. Golden Pass Trains 1-3 - Capacity of 2.6 BCF/d, in service 2H 2024
2. Plaquemines Phase 1 & 2 - Capacity of 3.4 BCF/d in service 2H 2024
3. Corpus Christi Phase 3 - Capacity of 1.6 BCF/d in service 2H 2025

A secondary round of projects that have reached FID will also serve to ensure these are not just one-off events. These supplementary projects will progress demand growth out to the 2027-2028 horizon.

1. Port Arthur Trains 1 &2 - Capacity of 1.9 BCF, in service 2027
2. Rio Grande - Capacity of 3.6 BCF, in service 2027

As investors, this is an important market dynamic that can be captured for monetary gain. This can be done in several ways but also needs to be identified BEFORE the molecules start flowing. Part 1 of this series focused on the producers of natural gas. Part 2 will focus on the midstream companies that will transport natural gas from the well heads to the export terminals.

Midstream

The midstream sector is ideal for income seeking investors due to its consistent levels of performance. Midstream companies help move molecules from point A to point B and charge a fee to do so. The business model in the midstream sector is usually fee based and structured with take-or-pay contracts that guarantee minimum levels of revenue. This has the benefit of insulating them from the swings in commodity prices.

For a midstream company to experience growth, it needs to increase capacity to sell and increase volumes to fill that capacity. In this episode of my natural gas export series, we will look at two midstream companies that are building expansion projects to accommodate more molecules flowing overseas.

This segment will be looking for stable and reliable income. Similar to my oil dividend series, I believe the midstream sector should hold roughly 30%-40% of one's energy portfolio. Here are my top two picks for this position.

1. Kinder Morgan (NYSE:KMI)

KMI made my list because it is already a front runner in the export game with greater than 50% market share in existing export terminals. KMI is obviously a natural gas dominated play with over 60% of its EBDA generated from the natural gas pipeline segment (KMI reports EBDA instead of EBITDA in its K-10 reports). The rest of its portfolio is supported by its refined products, terminals, and CO2 divisions.

KMI currently supports a healthy 6.8% dividend. While it does not have quite the payout pedigree of a competitor like Enterprise Products, KMI has been growing that dividend since 2018. During that time, the quarterly dividend has grown from $0.125/share to its current value of $0.2825/share. That works out to be 7% average annual growth rate.

A 6.8% dividend certainly makes KMI a viable option as an income producing asset. Let's take a look at how it stands to benefit from increased natural gas exports.

Operational Advantages

KMI already services a bulk of the LNG export terminals that are currently in service, transporting a combined 7 BCF/d. The company is projecting a 50% increase in those volumes once the first wave of new export terminals comes online (targeted for 2H 2024). Beyond that, it is evaluating additional projects and contracts to supply the incremental increases that occur in the 2027/2028 time frames. KMI did not get into this position by mistake. It has the necessary ingredients that exporters want...connections and storage.

Remember how I said the midstream business sells capacity? Just one look at KMI's asset map you can see that its system is connected to every major basin in the US. This gives flexibility to lean on other basins should weather or equipment issues disrupt service to ensure the molecules keep flowing.

More importantly, KMI has the largest natural gas storage capacity of any of the big name midstream companies. Storage is a vital component of any natural gas network to ensure that adequate volumes are available during periods of extreme demand. In the same manner, export terminals rely on storage capacity to help meet their customers' needs should there be interruptions or higher priority customers upstream.

It does not get advertised much but KMI has almost as much capacity as Enterprise Products, Energy Transfer, Enbridge, and Williams combined. This edge over the competition gives customers the confidence that KMI will be able to deliver. I summarized the capacity offered by some of the biggest midstream names in the table below using data from each company's annual K-10 report.

Now that we have established a firm competitive advantage for KMI, what is KMI doing to build off this strength to capture more market share? KMI continues to invest in critical infrastructure to ensure its pipelines are the ones that the molecules flow on.

These projects focus on the nearest basins, namely the Haynesville and the Eagle Ford. In the image below, you can see that these projects will direct over 4 BCF/d to the Gulf Coast, with a whopping 2 BCF/d dedicated to the Plaquemines export terminal.

To bundle all this together we need to know one more fact. We need to understand what KMI can transport today so that we understand how much all of this will move the needle.

In 2022, KMI transported a total of 39 BCF/d. Therefore, we are looking at a potential 10% increase in transported volumes from just four of the 12 projects currently in the KMI pipeline (shown below). This will translate into roughly 6% higher cash flows for the business and larger pools of FCF available for distribution once the capital expense of these projects rolls off the annual budgets.

Debt

KMI currently sits at a debt level of 4.0x debt to EBITDA ratio. This sits somewhere in the 'average' zone, being a full turn higher than industry leader EPD. While net debt has reduced from $38 billion in 2016 to $31 billion in 2023, near term maturities over the next few years will cause some competing interests to develop.

KMI has $1.9 billion and $1.5 billion worth of maturities due in 2024 and 2025 respectively. The firm has stated that it plans to stay in the range of 4.5x net debt to EBITDA so all signs point to refinancing of near term debt. The 'anti-debt' crowd may not enjoy this news against the backdrop of high interest rates, but I believe over the long haul this is the appropriate move.

At the current clip of capital spending, the dividend consumes a significant amount of remaining FCF. So far in 2023, after also accounting for share repurchases, KMI only has $260 million of unallocated funds to pay down its debt. KMI would be forced to forgo pursuing projects that are necessary to maintain its advantage in the export market. This opportunity cost is too great. Ultimately, I believe investors will see a larger reward over the long term by growing the company at this time versus trimming down its debt profile.

Valuation

The midstream space is boring. And that is a good thing for income investors. We want growing and reliable income to be the cornerstone of the portfolio. That is the premier reason to have the portfolio weighted so heavily to the midstream space.

The midstream model has shifted in the last 5 years for these companies, with a focus on organically funded growth to minimize the reliance on debt. Being capable of self-fund all growth projects without having to tap a bank is a huge selling point to investors.

But the market only values these projects for their cash generation capabilities, and as a result, shares largely trade with yield. This effectively creates both a price ceiling and floor for the share price. As shown below, over the last three years, KMI and its peer group's share price have tracked their respective dividend. I like these charts to get a general sense of value as each company's income generating abilities grow over time.

Buying when yields are starting to compress only means two things. Less income and higher capital risk. Conversely, as yields expand, investors are rewarded with higher incomes and less capital risk. With the dividend continuing to grow against a dropping share price and several promising projects in the pipeline, I view KMI as a buy.

2. Williams Companies (NYSE:WMB)

WMB doesn't have the same pure fit with the export industry that KMI does. However, its Transco pipeline is hard to match. The Transco pipeline is the headline asset for WMB, which deploys 10,000 miles of pipe to stretch from New York, down through the sunbelt and into Texas. This pipeline network accounts for 15% of the entire country's natural gas transportation.

Having a major artery like this means that even if it does not supply the export terminals directly, it is a good bet that the molecules will travel through WMB pipe at some point on their journey from underground to the boat. More importantly, you can see the connection points between three large energy hubs. On northeast end of the Transco pipeline we have the Marcellus shale, on the Texas side we have the Eagle Ford. Snuggled up in the middle is the Haynesville shale.

Again, sourcing and capacity will be key to growing its business a reap the benefits of new volumes associated with LNG exports. WMB has projects planned to further extend the capacity and connection points of this mega pipeline system.

WMB has a lesser dividend compared to KMI, coming in at 5.3%. This dividend has been growing since 2016, at a rate of about 6% over the last 5 years. While this is largely unimpressive compared to some of the bigger names in the MLP space, we will see that WMB's balance sheet fundamentals will allow Williams to be a growth play in the MLP space.

Operational Advantages

WMB obviously has an anchor asset in the Transco Pipeline. This flagship asset is one that can have a springboard effect for future growth. To extend the reach of Transco, WMB has 22 planned projects entering service between now and the end of 2025.

WMB's major projects start at the key basins.

1. The Louisiana Energy Gateway is being constructed to delivery 1.8 BCF/d from the Haynesville basin into the Transco pipeline.

2. The Texas to Louisiana Energy Pathway will expand the Transco connections in South Texas to increase volumes out of the Eagle Ford basin by 0.4 BCF/d.

3. The Susquehanna and Utica expansion projects will boost capacity out of the Marcellus shale by approximately 0.45 BCF/d.

The Louisiana Energy Gateway needs supporting projects to feed the massive 1.8 BCF/d pipeline. WMB plans to incrementally increase its gathering and processing capacity by using the South Mansfield, Mansfield, and Haynesville West projects for an additional 850 MMCF/d gathering capacity to help feed into the Transco main artery. These projects are scheduled to go into service in 2023, 2024, and 2025 respectively.

To wrap this up, let's again look at how much impact potential these projects have. We can conservatively estimate the major pipeline business to transport an additional 2 BCF/d and the gathering and process business to feed an additional 600 MMCF/d when all projects are in service. In Q2, WMB's average pipeline volumes was approximately 21 BCF/d while its gathering volumes exceeded 18 BCF/d. Working these volumes into the balance sheet, the six projects mentioned have the potential to lift earnings by approximately 5%.

Debt

WMB stands at a slightly healthier position than KMI with a net debt to EBITDA ratio of 3.5x. It also has a similar maturity profile over the next several years. The major difference between KMI and WMB is the amount of unallocated funds remaining after paying the dividend and paying for capital projects.

Over the first six months of 2023, WMB generated nearly $2.9 billion in cash from operations. With $1.1 billion paid in dividends and $1.2 billion spent on capital expenses, $600 million remains to give WMB operational flexibility. This runs out to be $1.2 billion on an annual basis. While this could be deployed to reduce its debt profile, I believe investors would also be better served to devote excess cash to growing the business.

WMB's debt structure also has a healthy cadence with no year in the 5 year horizon having any monumental balance due. This will allow WMB the opportunity to use its excess cash flows the opportunistically trim the debt profile.

Valuation

Similar to KMI, WMB's share price is lagging the current growth rate in the dividend. WMB has a smaller dividend than typical in the midstream sector but this also has its advantages. The excess free cash flow that is not earmarked for dividends and capital projects provides valuable flexibility.

Management can use this flexibility to continue to accelerate growth projects or opportunistically retire debt without creating pressure on the balance sheet. WMB has the tools to grow its business to become stronger and leaner. Investors also get access to the largest natural gas pipeline in the United States. With the strong debt profile, slate of projects under construction, and ample excess free cash, I view WMB as a buy at current price points.

Summary

In Part 2 of my natural gas playbook, we have explored two different midstream companies that are heavily focused on natural gas transportation. Kinder Morgan is already top dog when it comes to natural gas exports thanks to the connectivity of its system and vast storage capacities. KMI has several large products under construction to bolster its already leading position. Most notably, 2 BCF of additional pipeline capacity to feed the Plaquemines terminal when it comes online.

My second candidate was The Williams Companies. WMB has the largest US natural gas pipeline in its Transco pipeline. This pipeline has the Eagle Ford basin on the Texas end, the Haynesville basin in the middle, and the Marcellus shale on the North East End. This connectivity from one pipeline is unmatched. WMB is growing the extensions of the Transco pipeline to boost connections to these basins as well as building bolt on gathering and processing projects.

Both KMI and WMB will see additional earnings potential as volumes increase across their businesses. In Part 3, I will explore companies that run and operate export terminals.