1. Steve@AcmeAlpha.com
805 965 8820
Steve Worthington May 2016
“Oil, easy money and the reach for yield”
Presented by Steve Worthington
A Santa Barbara Group Sponsored Event
Thursday, May 26th 2016
Evolutionary technology advances in the last 60 years, much of it economically
perfected in the last 10 years have led to an increase in the supply of global oil
and gas as well as a doubling of oil production in the US over the past decade.
Growth in the demand for energy has been a large driver of the “Commodities
Super Cycle”. The Federal Reserve’s easy money policy has also contributed to
the increase in energy supply and this has had world wide consequences.
Some of these consequences have been good, such as US energy Independence;
the downside has been instability in many energy–exporting countries.
2. Legal Disclaimer
This presentation is not a solicitation or an offering; is for research purposes only.
The past performance information contained herein is not necessarily indicative
of future results and there can be no assurance that an investor will achieve
comparable results or will be able to implement any investment strategy indicated
herein.
The research information contained herein was obtained from public and third
party data sources which are believed to be reliable. There is no representation or
warranty as to the accuracy, completeness or reliability of such information.
This is neither an offer to sell nor a solicitation of any offer to buy any securities.
This research presentation is not an advertisement and is not intended for public
use or distribution.
Steve@AcmeAlpha.com
805 965 8820
Steve Worthington May 2016
3. “Oil, easy money
and the reach for
yield”
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
4. Overview
• How Did We Get Here?
o Fed’s overly accommodative monetary stimulus.
o Aggressive Banking, Investors want to believe
o Oil Commodity Cycle
• Result?
o Excess debt: Defaults in HY Oil & Gas: 21% E&P. 26%
o Increased Risk—House of Cards Economy
o Low/No ROE
o US energy has already corrected: fall off in production
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
5. 2008-Present:
Too easy for too long
Steve Worthington Source: St. Louis Fed
Steve@AcmeAlpha.com
805 965 8820
6. Fed Driven Asset Inflation
The link between equities and GDP has changed
Steve Worthington Source: WSJ, Jack Bogle Steve@AcmeAlpha.com
805 965 8820
7. US Monetary Base & SP500
Steve Worthington Source: Andrew Smithers, St Louis Fed & GMO Steve@AcmeAlpha.com
805 965 8820
9. Geopolitical Aspects of
Energy Supply
• Stop/Crush additional energy technology gains
& infrastructure build out. Keep US relatively
addicted.
• Slow Iran’s return to economic and regional
power; keep a lid on internal pressures.
• Dissuade Russia from aiding Syria; give Europe
alternative and secure oil and gas supplies.
• Short term nationalist behavior: A shortfall of
Forex- Russia, Iran and Iraq.
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
10. Energy Supply Side Evolution
• “New” technologies in oil & gas exploration & production
• Directional Drilling, Fracking and 3D Seismic all evolved over decades
• 1934 Directional Drilling, 1985-91 Horizontal Drilling; Naval Facilities
Engineering Service Center (NFESC) at Port Hueneme
• 1949 Hydraulic Fracking; 1981-1997 George Mitchell Schumpeterian:
fracking cost reduction ca. 100x via slick water fracking - Barnett Shale
• 1973 3D Seismic; a matter of cost & computational horsepower
• In 2000, shale gas represented just 1% of American natural gas
supplies; by 2012 it was 30% and rising
• Similar tale for oil, but later: 2009-14 oil fracking: US oil output ~2X
from 5.5 million barrels per day to 9.6 million at a time when oil
frequently traded for more than $100 a barrel
Steve Worthington Source: EIA, NFESC, The Economist Steve@AcmeAlpha.com
805 965 8820
12. ECON 2 – Supply Side
Competitive response to lower prices:
Produce until marginal cost is equal to marginal revenue.
Steve Worthington Source: Schlumberger, EIA, Arthur Berman Steve@AcmeAlpha.com
805 965 8820
13. Lead times to bring production online have
fallen by an order of magnitude
• 1967 Prudhoe Bay discovered – full production 1981 14 years
• 1970: North Sea – full production 5+ years
• Saudis as swing producers delivered oil below full cost of ROW
• 2007 fall in worldwide demand f(super-cycle, financial recession)
• Technology solutions become economic: 3D seismic, fracking
and directional drilling
• Schumpeterian Economics: Fed, Fools and their Money
• Initially shale economics were unknown, questionable
• US shale oil & gas appear to be the new swing producer
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
15. • Dividend Yield & Growth:
bankers offered up, investors bought it
Industry Debt Spree: OPM
Steve Worthington Source: FT Steve@AcmeAlpha.com
805 965 8820
16. KMI: The largest energy infrastructure Co in North America
Steve Worthington Source: KMI
Steve@AcmeAlpha.com
805 965 8820
17. KMI a brief history
• A merger/roll up of 4 segments natural gas, refined products & CO2
transport/storage Cos. (29 total). Orig. asset sale SFPL1997->KMI
• MLP to merged Common stock co 2014
• Capital markets idea of growth of divs.- funding dries up
• Management deal oriented; OPM capture.
• October, 2015: KMI issues 10% Conv. Pref.
• Dec 8, 2015: AMC, KMI cuts common div 75%
• Top priority: Maintain credit rating aligned with shareholders: 19 years
• Cash flows 5 categories: O&M, Capex, Debt Paydown & Divs, M&A
• No free lunch yield: hedged position needs a baby sitter & tradeoffs
• Debt covenant key to watch 6.5 x vs.
• Take or pay? Plenty of BKs; converts to pay now contract
Steve Worthington Source: KMI, SEC & Wikipedia Steve@AcmeAlpha.com
805 965 8820
18. Lots of choices: risk v. return
• Heavily regulated: FERC, CPUC, NEB, SEC, CFTC, Jones Act,
EPA
• Key variable: DCF distributable cash flow
• Hedges- Street has forgotten: 97% Take or Pay/Hedged.
o 2016, $1 WTI/bbl crude oil price =$6.5 million
o $0.10 per MMBtu natural gas = $0.6 million,
o 1% change NGL/bbl /WTI/bbl= $2.0 million.
o 100 basis point shift in interest rates = $100 m op income
o $11 of $41 billion of debt subject to variable interest rates
Steve Worthington Source: KMI, SEC Steve@AcmeAlpha.com
805 965 8820
20. KMI Positives
• Management owns 14% of common shares out. (V) R Kinder 11%
• 38% of all natural gas handled by KMI, 84,000 miles of pipelines and
approximately 180 terminals, 8 Jones Act tankers
• Near 100% capacity utilization vs. competition
• GM 71%, G&A 16%, EBDA 40%, 16% DDA, 14% Int. Exp. (2015)
• Stable DCF: 4.6 (2014), 4.7 (2015) 4.7 (2016 E)
• $3.6 B of Distributable Cash Flow (DCF) in excess of divs. for 2016E
• Prior Funding: 50 Debt/50 Equity, Now: 100% excess cashflow
• Oil was down 31% below budget, gas down 45% DCF: $1.233 1Q16
vs 1.242 1Q15: Very Hedged
• 10-15% Project by Project ROI (pre Co. overhead)
Steve Worthington Source: KMI Steve@AcmeAlpha.com
805 965 8820
21. KMI Long Com. vs. Long
Pref. Post Com. Div. Cut.
Steve Worthington Source: SunGard Data Steve@AcmeAlpha.com
805 965 8820
Please see page 2: Legal Disclaimer
22. KMI Return Scenarios
2 ½ year Equity Hedged T note: Conv. Pref. vs. Common –
Returns to date:
Steve Worthington Source: KMI, SEC, AA Research Steve@AcmeAlpha.com
805 965 8820
Please see page 2: Legal Disclaimer
23. THE END: Whereto?
Energy Economics:
• What does all this mean for investors? Pay attention to A) leverage,
ROEs, production hedging B) where cash is going: expl, prod, debt,
share buybacks.
• Extraction businesses have not and will not become secular.
• Lifecycle economics important- geology & reservoir engineering.
• Oil is likely capped at ~$60 for the foreseeable future.
• Decision to first production ~ one month. Easy for Cos. to hedge.
• End Result: 18 months to two years of notable volatility ahead with &
$40-$60/bbl tradable range (mean reversion).
• 2 + years from now, large scale project related production declines will
become noticeable. E.g. Deep Gulf of Mexico, North Sea.
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
24. The following eight slides
provide additional detail
regarding various aspects of
this presentation.
Steve@AcmeAlpha.com
805 965 8820
Steve Worthington
25. Never quite a free market
• Standard Oil Trust 1882-1911 (Sherman Anti Trust 1890)
• Achnacarry Agreement 1928 Three then Seven Sisters
• Texas Railroad Commission 1930s
• Venezuela, Aramco 1950 artificially low transfer pricing (50/50),
• Embargoes: 1967 Six Days War, Yom Kippur War 1973 25%
production cut, 1979 Iranian Revolution, then Iran/Iraq war.
• Saudi ownership Aramco: 1973 (25%), 1974 (60%), 1980 (100%)
• Later Political Motivation: Influence Russian gas & oil pipelines.
• Today, Political Proxy Wars: Dangerous Neighbors. Short term
nationalist behavior: A shortfall of Forex- Russia, Iran and Iraq.
Steve Worthington Steve@AcmeAlpha.com
805 965 8820
