RICH KINDER’s Long Con

Detailed Analysis

The title says it all. After months of analysis, discussions with lawyers, and industry experts, we
have come to a stunning conclusion about Kinder Morgan Energy Partners (KM). KM is probably the most
brilliant investment scam the world has ever seen. Engineered 13 years ago by Rich Kinder, this entity
exists for one purpose alone…to enable the General Partner (GP) to systematically loot the Limited
Partners (LP).
First, some background. We are not professional stock analysts, we are retirees. Between us, we
have over 50 years of experience in the oil and gas business, primarily in accounting, finance, and project
analysis. A few months ago, we stumbled into the MLP universe the same way most investors do…looking
for safe high yield dividend stocks to help boost portfolios crippled by a low interest rate environment. We
knew all of the MLP talking points, but having worked at C-corps, we were not intimately familiar with the
structure. So we picked a name we knew, Kinder Morgan, printed the 2009 10k, and started digging in.
Right off the bat there were some huge red flags. A PE at a sky high 57, high debt load, and a
dividend payout ratio that was off the charts. 3Q 2010 payout was $1.11, on earnings of only $0.17. But the
market didn’t seem to care. As the story goes, “MLP’s are different…earnings don’t matter, only cash flow
matters.” While we didn’t quite buy into that, the so called experts clearly did. As a prospective buyer, I
should be interested in cash flows from operations, not the sunk costs of a pipeline built decades ago. We
had almost bought into that logic…that profits aren’t important, when we stumbled across another MLP
oddity, the Incentive Distribution Right (IDR)
The IDR is basically a bonus for the GP of a MLP. The logic behind it seems innocent enough…
lets give the GP a little bit of an incentive to run the business efficiently and increase distributions, thus
aligning the interests of the GP and the LP. That makes sense, there’s just one problem. Set up as a tiered
incentive, Kinder Morgan’s GP was currently getting half of all marginal cash flow. This turned out to be
the clue that helped us to unravel the entire scheme.
You see, though recently retired, having spent most of our professional lives in project analysis,
we have a keen understanding of what it takes to make or break a project in this industry. Before any well
is drilled or pipeline is constructed, a group is assembled to create an economic model of the project to
determine the economic feasibility. For the most part, it’s quite simple really, but it can become tedious,
especially when dealing with a complex project like a phased CO2 flood or a multi-state pipeline for
instance. Once we understood the implications of the IDR on the marginal 1$ of cash flow, the sirens
started blaring.
Here was the basic problem…. The LP was putting up almost all of the capital, but the GP was
getting half of the cash flow right off the top…. That is a huge burden, and our initial thought was that it
would be impossible for the LP to make a decent return on any investment subject to this burden. A few
minutes in excel proved this out. It was almost impossible for the LP to make a profit on any new
expansion project. For the LP To break even…cover overhead, the cost of capital, and maintain the current
dividend yield, any new expansion capital project needed about a 30%+ annual return. That may be
possible for a pure oil company developing new fields, but it is unheard of for a pipeline/terminal company
operating capital intensive CO2 floods in the Permian Basin. On the other hand, the GP could make a huge
profit even if the LP was losing money. Rather than aligning the LP and GP’s interests, this created a huge
incentive for the GP to engage in projects the LP would be better off passing on.
To fully understand the brilliance and complexity of this scheme, one must first go back to 1996.
Rich Kinder, denied the CEO position at Enron, resigns and starts his own company using the relatively
unknown Master Limited Partnership (MLP) business structure. This business structure, it turns out, is
fundamental to the entire scheme. As the MLP trailblazer, Rich had a blank slate to create precedents and
set norms. And written in the black ink of the partnership agreement, Rich inserted the tools he would need
later to turn the benign tax advantaged business structure into a massive investment scam.
Lets start off by discussing the MLP structure. Wikipedia says the MLP:
“combines the tax benefits of a limited partnership with the liquidity of publicly traded
 securities.”
By organizing as a partnership, income is taxed once at a personal level rather than being taxed first at the
corporate tax rate, then again at the personal level as dividends or capital gains. This can result in a real tax
savings of $0.10 to more than $0.25 per dollar of income, depending on the investors marginal tax bracket.
If that were the end of the story, the MLP would indeed be an advantageous tax efficient business structure,
and would be of little use for this investment scam. But, as noted above, written into the partnership
agreement are the tools the GP needs to start funneling money from the partnership and into his pockets.
While it’s actually more complex than this, in Kinder Morgan’s case, as with most MLP’s, the GP
holds a 2% interest in the partnership and runs the business, and the LP holds the remaining 98%. In a
typical partnership setup, this wouldn’t cause any issues. Profit and expenses would be split according to
ownership, and in general all owners interests would be generally aligned. This leads us to the fundamental
flaw (for the LP) in the KM partnership agreement. Income is not shared equally. This, of course isn’t a
secret. In addition to the distributions their 2% would generally entitle them to, the GP also receives
Incentive Distributions Rights (IDR) that bump up their overall take to over 40% of Distributable Cash
Flow (DCF) despite only holding 2% of the equity. For the LP owners, this turns out to be an incredibly
bad deal. To further understand why, lets first take a close look at both the IDR and DCF.
Incentive Distribution Rights
The logic behind the IDR seems innocent enough. Lets give the GP a little bit of incentive to run
the enterprise efficiently and increase distributions. Here is how the IDR works. It is a tiered system, giving
the GP increasing % of total cash as distributions per share increase. The tiers start low, with a 2%
incentive, and end at 50%. Lets look at the first tier for an example. We will simplify it a bit and assume
that there are 100 shares outstanding…2 owned by the GP and 98 by the LP owners. Furthermore, in our
hypothetical quarter, earnings are $15. At this tier, each share would receive a cash dividend of $0.147, and
the GP will receive an additional $0.30 as his IDR.
That doesn’t sound too unfair. Now assume in the next quarter, an investment is made that throws
off an additional $1 of cash flow in the second period. That marginal dollar bumps us up from this tier to
the next tier, which instead of being split 98/2, is split 85/15. So Earnings on the first $15 are distributed the
same as before, and the marginal dollar is distributed this way. $0.85 are distributed evenly among the 100
shareholders, and the remaining $0.15 is distributed to the GP as incentive. This still may not blow your
mind, so lets skip the next tier, 75/25, and skip right to the final tier, at which the marginal dollar of cash
flow is distributed 50/50
Again, lets simplify and assume that this tier starts at $0.25 per share distributions. We could walk
through the steps to see what the absolute split is at this point, but lets just assume that the cumulative split
at this point is 80/20. So on quarter earnings of $25….$20 is divided evenly among the 100 shares, and $5
is sent to the GP as an Incentive payment. Again, we invest in a project, and in the next quarter, we have an
additional $1 of cash flow. The first $25 is distributed as above, but the marginal dollar puts us into the
final 50% tier. So $0.50 is distributed to the 100 shares, and the GP keeps the remaining $0.50 as incentive.
Including his share of the $0.50 distributed to all of the shares, we see that of that marginal dollar of cash
flow, the GP gets $0.51 and the LP gets $0.49.
So what does this mean? KM supporters will say that this is evidence that the GP’s interests are
aligned with the LP’s. In order to increase his own payout, the GP needs to increase cash flow. If he is
successful, the result is a bigger payout for both partners. It may be a bit excessive, but that’s the deal, and
the GP has a proven record of increasing distributions and delivering impressive total returns. Perhaps. But
this begs the question…as a LP owner….if the contract was nearing an end, and you were negotiating a 15
year extension with Rich….is this the contract you would want? Almost certainly not. As we can see, it’s a
terrible deal. It is very important to note that this incentive agreement is not the result of two parties
negotiating out a compensation agreement. Rather, it is the agreement Rich Kinder likely penned 13 years
ago when he founded the company. Though obviously we weren’t there, it is our hypothesis that Rich and
his legal team engineered this entire structure with the intent of ultimately using the provisions within to
misappropriate billions of dollars from investors when the time was right. But we are getting a little bit
ahead of ourselves. Let’s go back and take a look at the above example of the IDR in the 50% Tier.
Per the KM IDR agreement, the 50% tier phases in around $1.00 in annual distributions. With the
2010 distribution at $4.4, and the expected 2011 distribution at $4.6, KM is deep into the 50% tier. As with
income taxes, what is important is the marginal rate. Once the 50% tier kicked in years ago, every single
marginal dollar of cash flow generated by an expansion capital project was subject to this burden. This was
one of the keys to unraveling this entire scheme. As discussed above, between us, we have over 50 years in
the oil and gas business, primarily in project analysis. Before any well is drilled or pipeline is constructed, a
group is assembled to create an economic model of the project to determine the economic feasibility. For
the most part, it’s quite simple really, but it can become tedious, especially when dealing with a complex
project like a phased CO2 flood or a multi-state pipeline for instance. In any case, having done this for
quite a few years, we have a keen understanding of what it takes to make or break an oil and gas project.
Once we understood the implications of the IDR on the marginal 1$ of cash flow, we knew there was a
huge problem.
Here were the basic numbers. The LP put up 98% of the capital for any new projects (expansion
capital) vs. the GP’s 2%. However, after putting up 98%the capital, he only keeps 49% of the cash flows
that the project generates. Our first thought was that there was no way in hell, given the current IDR tier,
that the LP could be making money on any new capital projects.
We hate to devolve into a petroleum economics lesson, but here goes anyway. Though
mechanically different, the IDR is conceptually similar to a royalty interest in US mineral rights. If you
want to drill a well, say in the Eagleford shale in South Texas, you contact the mineral owner in the area
you want to drill, and hammer out a deal with him. Typically, you will give him an upfront bonus, plus a %
of the oil you produce, typically 1/8 to ¼. This is the royalty interest. You pay all of the well costs, and if
you make a well, of every BBL of oil that the well produces, the royalty owner gets his cut off the top, free
and clear of any capital costs or op costs. If the well is a dry hole, of course nobody gets anything. Still, as
you can imagine, this royalty is a pretty big burden on the project economics. A well that might make sense
to drill if you didn’t have to pay the royalty, can start looking pretty crappy once you shave 25% of the cash
flow off the top. 50%, however, is unfathomable. Throughout our careers, out of thousands of projects
we’ve been involved in, the number of projects we could think of that could have been profitable with this
level of burden is around 10. Compounding the issue, it’s actually worse than that, because in their oil and
gas operations, they actually have to pay real royalties first, and then this is tacked this on top…we just
could not understand what was going on.
So we did what we do best, and started tinkering with some economic models. We figured that in
order to cover 9% cost of capital and a 6% distribution, the LP needed at least a 15% annual returns after
the IDR burden for any project to make sense. Our models showed us that any new project needed to have
pre-burden expected returns of around 30%. We knew that this was quite unreasonable, especially for
pipelines. Their CO2 unit perhaps could do that with some substantial price help, but KM’s hedging
program makes even that unlikely with significant portions of their production hedged way below current
prices.
Still stumped…we turned the table around and took a look at the economics from the GP’s point
of view. At that point, the pieces of the puzzle started coming together… Not surprisingly, when you get
51% of a projects cash flow with a only 2% investment, the project economics start to look absolutely
amazing. Imagine a hypothetical pipeline project with a capital cost of $100, and positive cash flow of $10
per year for say 30 years. Looking at the project as a whole, the GP puts up $2, the LP puts up $98, and the
overall return is around 10%. If income was split evenly, the LP would get $9.8 and the GP would get $0.2,
and each would realize about a 10% annual return. But we know that income is not split evenly. The GP
would end up with about $5.10 and the LP with about $4.90. As a result, while the LP’s annual return is
driven down to about 3%, the GP’s effective return is rocketed up over 250%...Their $2 investment paid
out in less than 6 months…. For the LP, we see a return that is way under the cost of capital, resulting in a
net loss on the project.
So, not only is it almost impossible for the LP to make money on a project, it was almost
impossible for to GP to lose money on a capital project. Furthermore, we could envision projects that were
big money losers that still turned out to be profitable for the GP. As you can see…the very mechanism
touted as a way to align the interests of the GP and the LP actually does the opposite. For example, say a
potential project pops up with the above specifications. The LP wants to walk away, in fact, it’s likely that
he never wants to spend another dollar on capital projects ever. The GP, on the other hand sees a home run.
What do they do?
A glance at the disclosures will give you a hint at what happens. It would seem, that as a limited
partner, your rights as a shareholder are almost nonexistent…you have no say in the decision, or even a seat
at the table…in fact that discussion never happens. Over the period we analyzed, 2005-2009, over 10B in
expansion capital was spent, presumably hundreds or even thousands of individual projects…. Few if any it
would seem that generated a dime of profit for the LP.
So now we had some interesting analysis and a hypothesis. Our hypothesis was that the IDR,
instead of aligning the interests of the GP and the LP, actually created a vast division of interest to which
the LP had no defense. The GP had an incentive to spend “expansion capital” on virtually any project with
positive cash flow, regardless of profitability. The LP, on the other hand, virtually assured of a loss on any
project had no incentive to pursue any new opportunities. Furthermore, it looked like the GP was taking full
advantage of this loophole in the contract it put together and was spending $1-2B per year in an effort to
maximize their own profits at the expense of the LP owners.
But this simply left us with more questions. For example, how are they still in business? We
thought for sure a company could get away with something like this for a year or two, but Rich Kinder had
been at this a while…How had they not bled the company dry? How were they paying these large
distributions…over 6% while continuously investing in money losing projects. A glance at the financials
gave us a hint, and a search through the yahoo finance message boards put an idea in our heads.
First, the message boards. It would seem that people either love, or hate KM, with a healthy
majority loving the stock for it’s performance. However, occasionally, a poster will throw out the P-word in
reference to KM…ponzi that is. They usually back it up with the statement of cash flows, which rather
convincingly shows that cash from operations are insufficient by a large margin to support the current cash
distributions, the GP Incentive, and the aggressive capital spending. Lets take a glance at some summarized
2009 data. Rounded
Cash From Operations: 2100M
GP Incentive: 900M
Cash Dist to common units 1200M (Note this includes non-cash i-shares)

So 100% of cash from operations is distributed leaving nothing to fund expansion capital. While
interesting, this isn’t news for anyone familiar with KM. KM is much different from the philosophy of most
companies who typically use cash from operations to fund capex, pay down debt, buy back shares, and of
course pay dividends. There are very good reasons for this, primarily that cash from operations has a much
lower cost of capital than other sources. In fact we find that per the MLP agreement, KM must distribute all
cash from operations to shareholders, leaving little flexibility, and as you will see later, a very convenient
excuse.
So with all cash from operations being distributed, funding for all capital projects must come from
either debt, or selling additional shares. KM’s stated policy is that their desired capital structure is 50/50
debt and equity. Looking again at the cash flow statement, we see a total of 1.3B spent on capital, and 2.1B
spent on “investments” which seem to be primarily equity investments in pipelines…notably Rockies
Express and Midcontinent Express. To fund this, debt outstanding was increased 2B, 1.2B of LP shares
were sold, and the balance was misc and the i-shares distribution, which is paid in additional shares rather
than cash.
Clearly this demonstrates that KMP has an ability to sell additional shares and debt. On its face,
there’s really nothing wrong with a company financing capital spending with debt and equity with a big
caveat…. As long as those projects are profitable. As discussed above, it is almost impossible for the
projects to be profitable from the LP perspective, so issuing variable rate debt and millions of shares per
year is incredibly foolish.
Back to the P-word. So the allegations basically are that KM clearly can’t support the capital
spending through cash flow, so they simply sell additional stock to cover cash distributions. At 6+% yield,
the stock looks quite attractive, especially in today’s low yield environment, making it easy to bring in new
investors. Since cash is fungible, it is irrelevant whether the cash is used to fund capital or pay cash
distributions to the GP and LP, the result is the same. We can see that…and do agree that this whole
scheme seems to have some ponzi aspects, but as we dig further into the details, you will see that it is so
much more elaborate than a ponzi scheme….it’s really in its own class. Ponzi was an amateur…the
“Kinder Scam” will go down in history.
Before we go any further, we need to discuss one more critical element to the scheme in detail. As
noted above, when engineering this scheme, Rich and co inserted a few provisions into the MLP agreement
that would enable them to later take full advantage of their limited partners. In a typical business situation,
the scheme, as we have outlined above would fail miserably after a few years…Ultimately, generating cash
to pay distributions requires profits. Not debt, not equity sales, and certainly not DD&A….capitalism
requires profits. As described above, from the limited partners perspective and given the burden of the IDR,
profits are very hard to generate.
Using standard metrics and investment philosophy, even back in 1996 with the tech bubble
starting to ramp up, it is generally accepted that when looking at a dividend stock, you need to look at the
dividend payout ratio…or dividends per share divided by income per share. Not cash flow per share…
income per share. If you want to distribute a $1 dividend per share, you needed at least a dollar of income,
probably more. Investors and analysts expected companies to have a cushion to fund capital spending and
perhaps build a reserve for the hard times. In general, you might expect a good dividend stock to have a
payout ratio of 70%...leaving room for growth, and enough of a cushion that if they had bad quarter, they
wouldn’t need to immediately cut the dividend.
Well, these guys knew in 1996 that the end result of this scheme was going to be low earnings, but
in order to increase distributions, and maintain share prices, they were going to need to distribute way over
100% of earnings. Fortunately, being trailblazers in the MLP world, they had an opportunity to set the
norms, and they did this by creating their own metric, detached from profitability. That metric, which we
will now examine in detail is Distributable Cash Flow (DCF) Fast foreword to the present and you see
earnings of $0.17 per share and distributions of $1.11, giving us an astonishing 650% dividend payout
ratio. More amazing to us…this is accepted by the market as ok…because MLP’s are “different”. In the 3Q
2010 conference call, KM executive Park Shaper made an interesting comment. Regarding net income, he
said “I don't believe that that is overly relevant”, implying that the only thing that was important was cash
flow. Profit is not relevant… Well then…we certainly don’t agree with that, but moving on.
Mathematically, DCF is basically cash from operations. You take net income, ad back in DD&A,
then subtract out what they call sustaining capital. Whatever that number is, is the amount of cash required
by the MLP agreement to be distributed. Sustaining capital represents project dollars capitalized because of
accounting rules, but that do not add value. For example, replacing a pump on a pipeline. It failed, so you
have to replace it, but per the accountants, it’s capital not opex because it has say, a 10 year service life.
Ok…DCF sounds somewhat reasonable, perhaps even fair…right? Well, it’s actually extremely
unfair…you see, this kind of arrangement would only be equitable if cash distributions were distributed
based on the percentage of equity contribution. With KM’s unequal split due to the IDR, this system makes
absolutely no sense for the LP because it effectively gives the GP back DD&A on capital he did not
contribute. It rewards the GP not for performance…generating profits, but by generating DCF, which the
following thought experiment will illustrate, is extremely simple.
Lets say that the GP is getting lazy…running pipelines is a hard and dirty, and lets be honest not
all that profitable. So he proposes the following project. It’s a $100 project, and will generate $10 in DCF
per year. We are missing a lot of data, but it doesn’t sound terrible. So the LP puts up his $98, and the GP
puts up his $2. Rather than actually investing in a pipeline or a well this time, the GP just takes the $100 in
cash, and puts it in his desk drawer. At the end of the year, he pulls out $10, and distributes it according to
the IDR schedule. $5.10 for him, and $4.90 for the LP. For ten years, this investment chugs along just fine,
generating the expected DCF on schedule. Then, of course, in year 10, the project terminates when the cash
is gone. What we have is a project that generates DCF, but absolutely no profit, and you can see why this is
problem. DCF can literally be created on a whim. By basing the GP’s compensation on a metric not tied to
profit, he now has a mechanism from which he can essentially rob you blind (and he is).
Back to our example, after year 10, we can see the damage. The GP, with his $2 investment has
made $51, while the LP has lost$49. It would seem that not many people understand this concept, but the
above illustration is exactly what is happening when a good chunk of cash flow is coming from DD&A.
Now, obviously, the GP isn’t actually investing in piles of cash, but the above example could just as easily
be an oil well or a pipeline. In this industry, both oil wells and pipelines have characteristics that are very
helpful to this whole scheme…They are very capital intensive, but once you are done, they produce cash
flows with very little opcosts. Thus…much like our example above, we can generate cash flow without
profit.
Lets say we can drill an oil well that will produce 100BBL of oil per day. We can model the cash
flows over the life of that well and determine a value. In working project analysis, you quickly find that the
most critical question to ask the engineer is…ok that’s nice…how much can you drill it for. If it’s a 1MM
shallow vertical, we can probably make a project out of it. If, however, it is a 10MM deep horizontal well,
it’s probably not going to make the cut. With KM, however, profits don’t matter…only cash flow does, so
in a sense, the GP is rather insensitive to the cost to drill that well….he only cares about the cash flow it
will generate…after all, it’s not his capital that is paying for it. He can overpay for any cash generating
asset and still make a ton of money. Obviously, there are limits to how far the GP can push this before it
falls apart, and in general it is in his best interest to get the highest return possible, but the evidence
strongly indicates that the GP is taking full advantage of the weaknesses he inserted into the MLP
agreement.
Lets take a minute to recap what we have discovered so far. We now know that due to deliberately
inserted flaws in the MLP agreement, the interests of the GP and LP, rather than being aligned, could
hardly be further apart. Our working hypothesis is that from the LP perspective, any new capital projects
are almost guaranteed to be unprofitable, though admittedly they will likely generate cash flow.
Furthermore, so far as we can tell, nobody, save the GP realizes what is happening. In fact, the LP
investors seem fat and happy with their 6%+ distributions and significant historical returns. There are a few
who can smell the stink, but they really don’t understand where it is coming from. When they bring up
concerns on the message boards, they are typically shouted down and dismissed.
Lets now move foreword again and opine on how they keep it going. The longevity of the scheme
can be attributed to many things, but first and foremost, the key to its success has been KM’s ability to sell
additional shares and obtain debt financing. The market, it would seem, believes in this man, Rich Kinder,
and his ability to run pipelines. Furthermore, he has a reputation as a straight arrow…He is perhaps the one
man who escaped from Enron with a better reputation than before. The chatter on the streets is that had
Rich stayed on and been promoted to Enron CEO, he would have cut the crap before it started and Enron
never would have collapsed. In any case, there have been remarkably few challenges to KM’s credibility.
The finance sites are littered with praises for KM and Rich Kinder, probably with a ratio of 100:1. We can’t
help but think that had one of the professional analysts actually done some analysis rather than writing
about how he walked on water, this game could have been ended years ago. But we digress.
The key to the scam is the ability to raise debt and equity capital. This is the key to it’s success,
and we believe will soon be the key to its demise. So, lets imagine for a moment that nobody was willing to
buy additional shares or lend money at a reasonable rate. What would happen? Ideally….all expansion
capital spending would cease since it could not be funded from operations. DCF from pipelines would
likely stay fairly stable, but DCF generated from CO2 operations would immediately start declining. We
would expect a typical mature Permian basin field to have a natural production decline of around 10-15%.
However, within KM’s ongoing CO2 floods….we would expect a much steeper decline. If they actually
stopped injecting new CO2…we would expect production to crash and cease almost entirely within a few
years. So as a whole, absent expansion capital we would expect that DCF would of course cease growing,
and then decline into the future as oil production declined and operating costs increased on aging pipelines.
As DCF decreased, we would actually work our way back through the IDR tiers in reverse making valuing
those cash flows an interesting project if nothing else. As noted…this is perhaps what would happen…
ideally.
However, we have a hunch that in fact, KM’s situation is not ideal. Let us first put forth another
hypothesis. Of the capital spending classified as expansion capital, and thus exempted from the DCF
calculation, our hypothesis is that a significant portion is actually misclassified. We suspect that another
gift for himself Rich wrote in the MLP agreement was a lot of discretion for the GP in deciding whether a
capital project is classified as sustaining or expansion. Lets take a look at some incentives created by
leaving expansion capital out of the DCF calculation.
Essentially, we have created two classes of capital with very different costs for the GP, again
taking the GP and LP interests out of alignment. An example will illustrate this. Lets assume that our MLP
is cruising along in a steady state, generating a DCF of $100 per quarter, and the 50/50 IDR tier is the
marginal rate. Now, lets say that a pump on our pipeline has failed and it costs $1 to replace. How does this
affect DCF? Well, it depends. The pump is likely a capital asset, but if it has failed prematurely, say 2 years
into an expected 10 year life, your accountant is going to make you expense it. This of course will reduce
DCF by $1, and reduce the distribution by the corresponding amount. And that is actually kind of
interesting. It turns out that the GP’s share of that quarters distribution will be reduced by $0.51, and the
LP’s will be reduced by $0.49. You see…the IDR works both ways, and now creates a new incentive for
the GP. This example illustrates how in a very real way…a marginal dollar of expense costs the GP $0.51,
though he is only a 2% owner. Of course, he isn’t actually paying it, but at the margin, he may as well be.
This is an important breakthrough.
Now lets assume the same situation, but that the pump failed at the end of it’s expected life. Now
your accountant tells you to capitalize the costs associated with the pump. NI isn’t immediately affected,
but it is likely this project falls into sustaining capital, and is thus subtracted out when calculating DCF. So
the resulting impact to DCF is identical to when we just expensed the pump…in effect, sustaining capital is
just another expense when calculating DCF.
Finally, lets look at one more scenario. Maybe rather than replacing the pump with an identical
model, we go another route. Maybe we replace it with a bigger pump that theoretically expands capacity.
Maybe we replace it with a more efficient model that will decrease opcosts. Now, maybe we can reclassify
this routine pump replacement as expansion capital. What effect does this have on DCF. In this case, we
see that since expansion capital is excluded from the DCF calculation, the pump replacement now has
absolutely no effect on DCF. Of course the project must be funded, and will be at the standard split…98%
from the LP and 2% from the GP. By simply reclassifying the project, the GP can reduce his effective cost
from 51% to 2%.
Think about that for a minute. Not only is the MLP agreement almost certainly vague, there are no
checks on this process…it’s not as if the LP is looking at each project with veto power, saying, no…I don’t
think that’s right. And we doubt the external auditors care….they may test the expense vs. capital
decisions, but not what kind of capital it is. Through this mechanism, the GP yields a very powerful, and
unchecked tool to manipulate DCF. Not only can they use it to screw over the LP owners, but if a quarter is
looking a little light on DCF, simply reclassing a few million from sustaining to capex could help you hit
your quarter’s target.
Furthermore, in the oil business, we can think of dozens, if not hundreds of kinds of projects that
fall into a gray area…with the incentives at hand….the ability to reduce cost by 96%, you can bet which
side of the fence a vast majority of those projects land on. And that’s just assuming they are trying to be
somewhat honest, that we can tell, there are no checks in place, so they could be cramming a lot more in
expansion capital than anyone knows.
But wait…it actually gets better, we can think of a few more items that are easy to cram from
operating costs into the expansion capital account. Capitalized OH, capitalized interest, and capitalized
CO2 costs. All together, these could easily be a few hundred million, depending on how aggressive they are
in their capitalization program. In any case, the LP would be better off not capitalizing any of these items,
since the GP’s $0.49 gain is the LP’s loss.
The incentive isn’t limited to transferring sustaining projects to expansion, however. Since every
marginal dollar of expense costs them $0.51, they have an incentive to cut everything down to the bare
bones and skimp on preventative maintenance. So what is the bottom line? Clearly only a full audit of all
capital spending could determine the full scope of the issue, but our guess, is that anywhere from 25-50%
of annual expansion capital is actually required spending. This includes capitalized CO2, overhead, interest,
and projects that were not really discretionary. So back to our original question…if outside funding dried
up, KM would still need say 300-500M a year to fund nondiscretionary expansion capital. We are not sure
how that would unfold…given the specific mandates in the MLP agreement to distribute all DCF. In a best
case scenario, it would be funded internally, creating a pretty big dent in the current distribution. Since the
share price itself is basically a multiple of the payout, it is somewhat reasonable to assume that a reduction
in payout of say 25% would decrease the value of the stock by a similar amount. This does not take into
account the reductions in future DCF we would see corresponding to declining oil production.
Lets circle back around for a minute and form another general hypothesis. Knowing all that we
know, our hypothesis could now be, that the KM enterprise is nothing more than an elaborate scheme
devised by Rich Kinder to launder investor cash through a functioning energy company, and into his
pocket. Going back to our example above where we assumed the GP got lazy and instead of investing in
actual pipelines, just started stacking the money in piles, and distributing it ponzi-style. We would say that
from the LP’s perspective, with their prospective low, or zero return projects, a pile of cash may be a better
investment than capitalized CO2 and easier to recover in the lawsuits that will likely follow.
Now, we know that the analysis above is a lot to take in. Trust us, we tried several times to write
readable shorter summaries, but simply couldn’t. So we thought that taking you step by step down the road
of discovery we took was the next best alternative. So now we are at the end of that road, and left with a
few questions to wrap up. First off, you may be asking….ok, well that’s a nice hypothesis…I need to
double check a few things, but ok. If you are right….where is the proof.
Glad you asked. If our hypothesis is correct, and the GP is investing in projects that are
unprofitable for the LP, we would expect to see the results showing up in the financials, and indeed they
are. We would expect to first find limited earnings growth overall, and a gradual reduction in earnings per
share as new shares are issued, diluting current owners. This hypothesis proves out beautifully. Going back
to 2005, we see a NI of 335M, which bounces around, and declines slightly to 332M in 2009. This despite
over 10B invested in “expansion capital” if you include equity investments…a whole different topic. Got
that?? They spent over $10 billion dollars and couldn’t manage to increase net income by even a penny.
Since shares outstanding increased from 220M to nearly 300M over that time, that same amount of income
is now shared with 36% more shareholders. NI went from ~$1.5 per share down to ~$1.10. So on income,
just as our hypothesis predicted, Shareholders are being diluted by additional shares issued to finance
projects with apparently no additional income.
Also concerning, debt increases from 8.3B to 13.6B. Over 2005-2009 where income was stagnant,
DD&A increase from ~$350M to ~$850M, a 150% increase… astounding!! We discussed above what it
meant when your cash was coming from DDA. Not surprisingly, given the mechanics of the IDR, the GP’s
take nearly doubled over 2005-2009 from $480M to $930M. All of these results lead to some big red flags,
including a sky high PE of 57 (yahoo finance) and a 3Q 2010 payout of 6.5X earnings (1.11/0.17)
All of this supports our hypothesis… the GP is effectively laundering cash through the capital
accounts, investing in crappy projects that lose money for the LP, and then pocketing half of the DCF.
Further proof lies in the 2009 10k, which gives us earnings from 2 recent high profile projects,
Midcontinent express and Rockies Express.
The Rockies Express had 2009 Earnings of $98.5M… this on what is roughly a $7B pipeline of
which KM owns half. To be fair, lets add back in DD&A to get an approximate cash flow. Using straight
line, a $3.5B investment with a 35 year life has DD&A rate of about $100M…we love round numbers. So
gross, the project is yielding around 5.7%. This is, of course before the IDR…so back that down by half
again, and we are under 3% return on the LP’s investment. In this industry, 10-15% would be required to
interest a straight player, and as we mentioned, the KM LP needs closer to 30% for any project to be
worthwhile… One project does not make a trend, lets keep looking.
The Midcontinent express had earnings of $14.7M, though it was only online for about half of the
year, so lets just assume annualized it would have been $30M. This pipeline had a cost of around 2.2B,
again which KM owns 50%. Using the same DD&A assumptions as with Rockies Express, we come up
with an annual DD&A rate of 30M, we’ll call it a 5.5% gross return, adjusted for the IDR, under 3% . Not
so good. Honestly we were expecting to see gross returns in the 10-15% range, but these two high profile,
projects aren’t even in the ballpark.
So now we have some analysis , and a hypothesis that appears to be substantially proved out by
the facts in the 2009 10k. There are a few more loose ends we would like to discuss, and then talk about
some possible scenarios going foreword. After pulling all of this together, to be honest, we felt pretty good
about ourselves. After all, it’s not every day you stumble across a Madoff style investment scam run by a
guy with Enron roots. So, we thought we were pretty smart guys. However, there are a few issues that
confuse us, after all, we aren’t wall street Guru’s.
The first issue that confuses us is KM’s interest swaps, and their overall interest expense. KM
shows total interest expense for 2009 at 409M, and total debt at 13538M, giving us an average rate of 3%.
That’s pretty damn low. Now we realize the deficiencies in this quick analysis, but it still seems incredibly
low. Glancing at their outstanding notes, we see quite a few bond issues outstanding, with rates ranging
from 4% to 9%...we didn’t really analyze anything, but the average looks somewhere around 6% - 7%.
Further reading in the 2009 10k gets into a discussion of swaps that honestly just went over our
heads. We understand the basic idea of a swap…. A party with a fixed rate debt and a party with a variable
rate debt simply swap…for various reasons. They have about 5.2B of debt subject to these swaps,
according to the 10k… We assume that these swaps are the mechanisms KM has used to reduce it’s
effective rate. We understand KM’s desire to swap into an ultra low variable rate loan (despite the risks),
but what we are confused about is the counterparty’s motive, especially on some of the bonds with higher
rates. For example, we can see how perhaps a party would be interested in swapping a very low variable
rate with KM for say, a fixed rate at 4-5%. Depending on the circumstances, that could be a pretty even
swap. But what if the rate was higher…wouldn’t KM need to bring some cash to the table to equalize the
values? Where does that show up in the financials…as an asset? We don’t think we see it in interest
expense. Perhaps somewhere in the expansion capital account? As we noted, this is a bit over our heads…
perhaps an expert in this field can look in more detail.
As if that wasn’t weird enough, it looks like rather than reporting the nominal value of debt, they
may be using a fair value. In effect saying, yeah, the nominal value of these is X, but because we are doing
such a good job on our swaps, our effective interest rate is lower, and therefore, the fair value of the debt is
lower than the nominal value. Ok…not sure we are buying that, but honestly there is a good chance we are
wrong on this. Again, however, this brings us back to the counterparties….if KM claims they are
making(or saving) a few hundred million a year off these swaps, isn’t somebody else losing a few hundred
million? Why? It just sound shady, that’s all we are saying.
Here’s an idea…since adjusting debt for PV is a good idea, how about you adjust your
investments the same way? Rockies Express generates 100M in cash a year for the LP. Even using an
outrageously low discount rate, you’d be lucky to NPV that thing anywhere close to 2B. We’d actually
value that cash flow somewhere around 700M, so a 2.8B loss sounds a little bit closer to reality. What does
that do to earnings?

Moving along, if nothing else, this variable rate debt has the possibility to blow up in their faces
Enron style. Say our analysis is correct, and the markets dry up for KM, increasing their borrowing costs to,
oh 6% (much less 10 or 15). We can assume that this would roughly double their annual interest expense,
reducing DCF by another 400M, and reducing the distribution accordingly. That’s another huge hit, and the
corresponding reduction in share price would be dramatic. And that’s at a modest 6%. If the markets froze
completely, and they were simply unable to refinance debt as it rolled over, like the 700M due in March
2011, they could literally be forced into bankruptcy.
Also of interest to us was the recent switch to using equity investments in their pipeline projects.
In these, they generally own 50% of the project, but don’t consolidate the equity investments into their
financials, instead reporting on them as investments. This way, they get to keep a lot of things off balance
sheet. We aren’t going to elaborate, but again, this sounds a bit shady to us, and we bet someone more
knowledgeable on these arrangements could find something interesting if they could crack that nut.
We could probably add some more, but this seems like a good place to wrap it up…we think that
we have put enough pieces of information out there to have other analysts review our work. Please do.
So, knowing what we know, what happens now. We suspect that over the next few months, this
analysis will circulate, and be confirmed by analysts across the spectrum, .putting some pressure on the
stock. We also suspect that KM will vigorously deny just about everything. That is fine…if we are wrong,
proving it should be relatively simple. For starters, they could release a detailed breakdown of all the
capital spending over the past 5 years. What was it spent on, and what was the realized return, both for the
LP, and for the GP. We can’t wait to see it.
After a few months, we assume there will be some sort of shareholder uprising by the LP. What
happens from there, we really can’t say. We do know that the KM enterprise does operate a vast pipeline
system that produces real cash flows, cash flows with real values. Looking at more recent data, we would
assume that cash flow is about 2.5B per year. We would then bring it down by about 1B to account for
higher expected interest rates and a modest capital budget, leaving us with annual free cash flow of about
1.5B, using a multiple of 10, the whole enterprise might have a value of 15B. Now, if you can strip the GP
of his ownership and give the debtors who enabled this scam a haircut, it is possible that a substantial % of
the LP’s ownership may be able to be kept intact. That, of course is a best case scenario. What we think is
more likely is that the substantial debt will be unable to be refinanced and the LP equity owners will be
mostly wiped out.

Some thoughts:

• Thoughts on using the MLP as a vehicle for a ponzi-like scheme…It’s brilliant, and quite possibly
legal. Furthermore, you eliminate the possibility that disgruntled investors show up and try to cash
out before it blows. They have no recourse but to sell the shares to the next sucker, until that
becomes impossible.

• I-shares- traded under the ticker KMR, an i-share is essentially identical to a standard share of
KMP, with one notable exception….instead of paying cash dividends, they simply issue additional
shares, this effectively costs the GP nothing, but it boosts cash flow considerably. This is why
owners tout the i-shares every chance they get... if they could convert all shares to i-shares, they
could probably run this scheme indefinitely. Granted, they with the KMP/KMR discount was
lower, but i-shares are a critical part of the scam…they aren’t going anywhere, despite some
recent commentary by the “experts.”

• Equity financing – It’s great for this scheme because while the cost of capital is real to the diluted
owners… about 13% including increased IDR to the GP… it doesn’t show up on the income
statement like interest expense does…This helps to cover up the incredibly bad investment results.
• The GP can increase his IDR just by issuing a share of LP stock. One share is issued for say $70.
This of course dilutes the LP share in current cash flows, because now he has to pay the new
shareholder the annual distribution, and the GP an IDR on the additional distribution. It is nice that
occasionally the GP will graciously waive his share of distributions until an equity funded project
becomes operational, but this doesn’t change any of our analysis. It would actually make it worse,
since they don’t always do this.

• IDR Incentives: As detailed above, the existence of the IDR actually creates a large disconnect
between the LP and GP. We did some scenario analysis, and while arbitrary, we can’t justify any
IDR type incentive over about 5%. Once you get past that, the incentive to create cash flow at the
expense of the LP is too great. In general though, incentivizing cash flow over profits is a recipe
for disaster, one that shareholders of KMP,KMR, and likely all MLP’s with IDR’s will soon find
out.

• GP Going Private, and now Public: We suspect that Rich Kinder spent 1996 to roughly 2006
laying the groundwork for his huge payoff. Building up the company, gaining trust, and reaching
that 50% IDR Tier. Once he felt he was ready to take it to the next level, he took the GP private. It
is our hypothesis that this was primarily to hide the obscene profits he would be making once he
ramped up capital spending. So they took it private, then started kicking the scam into high gear.
They have succeeded in doubling the IDR, now over 1B per year. Of course, now they just need to
get out before the whole scheme goes boom. We don’t think they will make it…they got greedy
and now they are too fat to get out, but we are sure they will try. Maybe they can unload their
shares on Exxon, move to Bermuda, and watch the fireworks from there. Another option would be
to have the LP buy out the GP, but that would be a huge transaction, and another raw deal for the
LP.

• GP support:There have been several situations where in order to allow the LP to make its
distributions, the GP has foregone or refunded its distributions, though it was not clear they were
required to. This is encouraging to LP owners… a generous and kind hearted GP that is looking
after them….and is truly interested in maintaining enterprise value….Bull. This is just a matter of
the GP doing what it takes to keep the golden goose alive. If it takes a few hundred million of
medicine to keep him alive another year, and you are getting 1B a year… you do it. The scrutiny
of a miss could bring the whole scheme down and they know it.

• Some thoughts on tax efficiency: to those who preach about the tax efficiency of the MLP
structure…as we have demonstrated, the IDR associated with KM, and possibly most MLP’s more
than wipes out any MLP tax benefits. It’s basic math really. End of story. This is likely true for all
MLP’s with an IDR What does this mean for other companies? While we did look at other MLP’s
in our research, we’ll leave the hard core analysis to others. Of the ones we looked at, none appear
to have pushed the envelope as aggressively as Kinder, but that doesn’t make them honest.

• GP’s LP holdings: Some will point out that the GP, and Rich personally has shares in addition to
the 2% used in our analysis. It is our opinion that these shares are held in order to maintain control
should the LP’s revolt. The MLP agreement gives the LP few rights, and makes it almost
impossible for the LP to get rid of the GP, but it is possible. Holding a small stake makes a
successful revolt even more unlikely. While they lose money on these shares just like everyone
else, it’s just a cost of doing business they more than make up on the backside.
• Regarding the GP going public again…. Buyer beware…..yes, the GP has a sweet deal as
illustrated above, but you could be buying into a huge lawsuit….we wouldn’t touch it with a 10
foot pole.
• Certain Items: This basically gives the GP another tool by which to manipulate DCF, and it’s
payout. Say a storm causes expenses of 10MM….if the targeted DCF is looking light for the
quarter, they can just classify it as a certain item, exempting those expenses from the DCF
calculation, and therefore, shifting those costs from themselves to the LP owners.
• Is it illegal?: We are not lawyers, but lawyers we discussed this with seem to think that it is legal.
 All of the disclosures are in the right places, including some interesting quotes from the 2009 10k:

“The interests of KMI may differ from our interests and the interests of our unitholders.”
and
“As a result, there is a risk that important business decisions will not be made in the best
interests of our unitholders.”
For sure, the GP thinks he is covered by the underlying contracts and disclosures. He is probably
correct. The one way to nail them may be to get them on their investor presentations that show healthy
stock returns and ROI’s by segment. Of course, those are always presented as gross returns…if they were
fair and subtracted out the GP incentive, those returns would not merit a presentation every couple of
weeks. In short, they’ve been promoting KMP and KMR stock for years with misleading analysis, though
they are intimately familiar with what a rotten investment it is. Does this mean cuffs for the Kinders,
Shaper, Dang, and the rest of the senior management crew? We don’t know, but we think they deserve it.
They have likely misappropriated tens of billions of dollars with this scam, and as it unravels, tens of
thousands of income investors are going to suffer. We say strip all the assets from the deep pockets of the
GP, including Rich, and Goldman Sachs, then send them all to the pokey. Then give all of the bondholders
who were in on the scheme a 50% haircut to teach them a lesson. By doing this, a good chunk of the value
that remains in this enterprise can be salvaged for the LP victims of this scam.

*This is not investment advice. It is a hypothesis put forth to the investing community for further analysis.
Sources of data include the 2009 10k, various finance sites, hundreds of articles on KM and other MLP’s,
and thousands of message board post. We can not vouch for the accuracy of any of these.
This work is based on SEC filings, current events, interviews, corporate press releases, and what we've
learned in our research. It may contain errors and you shouldn't make any investment decision based solely
on what you read here.