The midstream earnings season has started with a bang and lots of whimpers.

The bang was from the dent lower energy prices left on Kinder Morgan’s (NYSE: KMI) dividend growth plans, now down to a range of 6% to 10% for 2016, from the prior promise of 10% for years to come. Whimpering can still be heard with Kinder Morgan’s share price down 12% in the three trading sessions since it backtracked on the dividend and released quarterly results widely described as disappointing.

Perhaps the analysts were too aggressive with their estimates, but no one who’s paid attention to the energy sector over the last year should have been surprised.

Third-quarter cash earnings of Kinder Morgan’s operating segments were down 1% year-over-year, hardly a disaster given the 50% drop in crude prices over that time span, an even greater decline in the price of natural gas liquids and a discount approaching 40% on natural gas.

It helped, of course, that Kinder Morgan has in the last year completed projects costing more than $2 billion, in addition to spending $3 billion on an acquisition. That spending helped put the company $42.5 billion in debt, though Kinder’s buyout of its MLP affiliates last year is the main reason its debt now amounts to a hefty 5.8 times recent annual EBITDA (earnings before interest, taxes, depreciation and amortization.)

On the other hand, Kinder Morgan is saving almost $700 million this year in reduced payouts after taking out its higher-yielding MLPs, and more than $400 million in cash taxes through the first nine months of the year, also as a result of the consolidation.

That’s how it’s affording this year’s 15% dividend increase, a promise it now plans to keep with $300 million in cash earnings to spare, down from the $650 million cushion projected at the outset of the year.  That means distributable cash flow will undershoot the original target by 7% amid the dramatic decline in energy prices since that plan was made. The shortfall makes plain the rationale for slowing next year’s dividend growth; the company doesn’t want payouts to exceed distributable cash flow.

Does all of this warrant the 12% markdown on the already ailing share price? Probably not. Some of the recent selling was almost certainly caused by hedging ahead of the big $1.6 billion convertible preferred offering, meant to make further equity issuance unnecessary until mid-2016. And some of it was clearly disappointment with another downbeat outlook, though Kinder Morgan’s was if anything overdue.

As a result the dividend yield is up to 7.4%, which will eventually seem too high even if, god forbid, the payout does rise only 6% next year.

The money raised via the even higher-yielding convertible offering will be spent on high-return projects backed by financial commitments from producers as well as consumers of energy.

Lost in the understandable concern over Kinder Morgan’s current challenges was its founder’s optimism about demand for natural gas, which is expected to grow 5% this year and, according to one study cited by Richard Kinder last week, a cumulative 40% by 2025.

It was the steadily rising domestic demand for natural gas that turned midstream players like Kinder Morgan into giants long before shale revived U.S.  energy production.  And demand remains the one unquestionably bullish side of the energy equation as cheap natural gas displaces coal and nuclear plants in power generation and spurs the construction of chemical plants.

I’m a tiny but illustrative part of this process. In a month or so I will replace the old and inefficient oil burner in my western Massachusetts home with a gas line, saving many hundreds of dollars annually on fuel bills. I’m lucky to be able to do so, because my local distribution company, Berkshire Gas, has declared a moratorium on such switches in other parts of the state, citing inadequate gas supply.

Berkshire Gas is one of the committed backers of Kinder Morgan’s proposed Northeast Energy Direct Project, which would pipe plentiful natural gas from the Marcellus into Massachusetts and other New England states starting in 2018. It’s said only the completion of this project will alleviate the gas supply crunch and allow it to lift the moratorium.

Kinder Morgan makes its case   Source: Northeastenergyfuture.com

My electricity supplier, meanwhile, is backing another Marcellus-to-New England gas pipeline promoted by Spectra Energy (NYSE: SE). Last winter, the abrupt closure of a Massachusetts coal power plant spiked many electricity bills in this area by hundreds of dollars a month.

The state Department of Public Utilities recently ruled that local utilities can recover their commitments to pipeline projects like Kinder Morgan’s and Spectra’s from their customers. The increased gas supply should lower the region’s relatively high energy bill, though this remains disputed by environmentalists opposed on principle to new investments in fossil fuels as well as some politicians.

None of this will bail out Kinder Morgan this week or next month. But if you take a broader historic view of how the midstream sector grew, and is continuing to grow, by catering to America’s energy demand, you’ll gain useful perspective  on the current shale bust and its surprisingly limited toll on middlemen like Kinder.

Portfolio Update

A Yield Worth Locking In

We’re on record in highlighting Kinder Morgan’s hefty debt load and criticizing its ill-timed Bakken acquisition earlier this year.

But the 7% shortfall in cash flow relative to a budget drawn up a year ago is a sign of resilience rather than terminal weakness, given the extent of the slump in energy prices.

Those prices are now at levels guaranteeing domestic production will decline over time, even as demand continues to grow. And it is demand that can’t be met over the long haul without a thriving midstream sector.

As for the $1.6 billion mandatory convertible preferred offering priced today, there’s a lot of confusion out there about the high yield and Kinder Morgan’s reasons for pursuing the deal.

The offering priced at an effective yield a shade under 10%, so in effect the company is offering investors in these hybrid securities an incremental 2.6% of annual yield over the common dividend for the next three years in exchange for foregoing the benefit of capital appreciation from the first 17.5% regained by KMI’s stock over that time. (There’s also a floor conversion price of $9.65 per share, which is not a very valuable put option.)

Buyers of the preferreds are betting that KMI shares will appreciate less than 17% if they appreciate at all over the issue’s three-year term, justifying their choice of higher yield with reduced capital appreciation prospects. One way to capture the yield advantage while hedging the appreciation risk is to sell KMI common short while buying the preferreds, a strategy that very likely contributed to the recent price drop.

Kinder Morgan, meanwhile, has solved its equity financing needs for the next nine months or so, while limiting the cost of issuing equity before a share price recovery. It’s clearly able to issue much cheaper debt, but is constrained by the imperative to preserve the investment-grade credit rating and the need to work off the leverage added to buy out its MLP affiliates last year.

This looks like a fair deal all around, though we still prefer the common to the preferred given the decent likelihood of a significantly higher share price in three years.

The common shares’ current 7.4% yield undervalues Kinder Morgan’s long-term growth opportunities and overemphasizes  the dimmed near-term outlook. We’d be willing to clip the coupons for now while waiting on the capital gains. Buy KMI below the reduced limit of $35.