Another bullet shot in the heart of Canadian oil production – Kinder Morgan

Paying attention to Kinder Morgan’s (Parent: NYSE: KMI, daughter: TSX: KML) announcement that they’re stopping non-essential expenditures in relation to the Trans-Mountain pipeline (that goes roughly between Edmonton, Alberta to Burnaby, BC) expansion.

There’s a lot of political rumblings and a ton of public ignorance displayed, which usually is a good recipe for market reactions that lead to opportunity.

KMI owns 70% of KML. KML owns the assets relating to the Trans-Mountain pipeline. The assets currently pump about 300,000 barrels per day and very roughly, in 2017 produced $250 million in operating cash flow (allow me to ignore the very relevant capital expenditures in this post – they spent $618 million, the majority of which was on the Trans-Mountain expansion project – $445 million on pipelines and $173 million on terminals).

There are about 350 million shares outstanding in KML, so the most elementary analysis possible is that if KML decided to pack up shop and just keep the existing (and aging) infrastructure in place, they will generate about 65 cents of cash for shareholders – this is subtracting the amount given to preferred shareholders. Other than the preferred shares and pension liabilities, there are no other material amounts of debt or obligations on the balance sheet that is noteworthy for this analysis.

Obviously this amount would not be enough to sustain the existing stock price – currently CAD$18.44/share – the earnings yield would be around 3.5%, although this would be a very stable yield given that this is the only oil pipeline connecting the west coast of Canada to oil-rich Alberta. The expansion project is expected to bring in $900 million in EBITDA in the first 12 months of operations, plus spot volumes up to another $200 million. Since the project is expected to cost around $7 billion, a financing at 5% would still result in substantial after-tax cash flows.

A tripling of the pipeline capacity will, suffice to say, be extremely profitable for Kinder Morgan. Strategically speaking, the asset is the only oil-carrying pipeline from Alberta to Vancouver (good pipeline map resource here). Vancouver’s sole oil refinery is the Chevron facility, west of SFU. The nearest competitor is refined fuel product from Cherry Point, WA, which makes Vancouver extremely vulnerable to any slowdown/shutdowns in both oil capacity and refining capacity.

Politically speaking, there are a set of huge competing interests at play:
– The federal Liberal government attempted to play a “middle ground” by supporting the pipeline, but they are dragging their feet on doing anything to getting it approved, and one can infer from Bill C-69 that the government intends to create so much regulatory uncertainty in the approval of any major national projects that they simply are not going to be built. Bill C-69 makes it impossible to know what conditions (and thus costs) it will take to approve projects requiring federal environmental assessment (soon to named “impact assessment”) approval. The Liberal government probably realizes at this point there is zero vote-getting ability for them to support the Trans-Mountain expansion, so they will only give lip service toward its approval – and lip service so they can avoid being seen as flip-flopping.
– The Alberta Government, led by NDP Premier Rachel Notley, has a huge economic interest in the pipeline. While inherently most of the people in her party are against pipelines in general, a lot of Alberta’s economy depends on the fortunes of the oil industry and if the NDP are going to have any chance of being re-elected, they need to galvanize the feelings of voters that they (and not UCP leader Jason Kenney) are best to fight Ottawa and British Columbia.
– The BC Government, led by NDP Premier John Horgan, is fighting on a side which inherently favours them. They attempted to enact some provincial regulatory reforms to make it more difficult for the pipeline to proceed, and they can do this because they have the support of their party and also the 3 Green Party MLAs that are strongly against the pipeline (the government is a narrow minority government that requires the support of the 3 Green Party MLAs in order to maintain supply). They have everything to gain by combating Alberta and Ottawa and only a modest amount to lose as not too many NDP supports would support the economic-creation aspects of pipeline construction. In addition, the majority of gains to be made if the pipeline expansion is completed is Albertan oil companies, so this does not favour BC. The BC Government will likely do anything it can to stall the project and will only yield way if required to do so by court judgement – that will be their “out” to explain to the public that they tried.

It appears pretty obvious to me that the current Nash Equilibrium is the pipeline expansion will be indefinitely stalled. It will probably take a Supreme Court ruling to unlock the situation and one is not forthcoming due to the Federal government intentionally deciding to not participating in a planned BC-Alberta reference case – lest the reference (info) definitively decide the matter (which works against the three governments’ existing interests).

Another bullet fired into the heart of Aimia

The Aimia (TSX: AIM) zombie keeps on moving but when the corpse will finally lie down and die is another good question.

Today, it was reported that Esso’s partnership with Aeroplan will terminate at the end of May 2018. Instead, the loyalty program partner that will be picked up is the Loblaws’ (TSX: L) optimum program.

One of the issues when valuating the fundamentals of businesses that have setbacks (and judging whether they can make comebacks or turnarounds) is to determine whether the blow they suffer was critical. In the case of Aeroplan, it was Air Canada and the threat of substitutions. Although Aeroplan/Aimia used to be a subsidiary of Air Canada, it was spun out for financial reasons and it is pretty clear that Air Canada knows that there are other alternatives available (such as doing it in-house). The psychology damage done when you lose your major business partner, coupled with the effect that your business depends on large volumes of customers trying to collect aeroplan miles for the purpose of flying, suggests that the subsequent network effect (or opposite thereof) will significantly devalue Aimia’s offerings. Another way of thinking about this is a negative economy of scale, but from a marketing perspective. Or what would happen if some other competitor to Ebay spontaneously stole 90% of auctions from EBay (we’re talking in the late 90’s/early 2000’s context, not the present day EBay).

The other buzz is that Air Canada is just negotiating for a better deal (since Aeroplan is set to expire in June 2020) but this is wishful thinking. Likewise, Aeroplan can’t just sign up any other airlines spontaneously since it takes quite a bit of time to link up with the electronic information systems of competitor airlines (there is potential they will sign up with a new discount airline brewing in Canada, but the volume of this business will be much, much less and Aeroplan will not be able to receive commercially acceptable terms like they had with Air Canada).

This all points to a huge value trap situation still with Aimia, as I’ve been trying to illustrate since the Air Canada/Aeroplan collapse.

Personally I have cashed out anything of value from my Aeroplan account. As an interm measure they will be (and I notice they have already) devalued their existing rewards to offset their deferred liability balance.

Implications of Canada-USA trade disruption

All of this talk about Donald Trump liking Justin Trudeau in the media was a fantasy perpetuated by the current government to try to paint a picture of how we can “get along”.

Of course, the undercurrents were anything but – not only were there significant trade disputes ongoing (softwood lumber to name one), but the rumblings of NAFTA being pulled and other Canada-US relationship issues are significantly material issues that were not being given sufficient attention.

So now the USA is firing another salvo in the attempt to negotiate a better deal – steel and aluminum tariffs. This is part of a broader negotiation strategy relating to NAFTA and will continue to hurt Canada’s (and Mexico’s) economies because of capital investment uncertainty.

Already with the election of Donald Trump it is perfectly evident that relatively fewer want to invest in Canada when the relative risk/reward ratio is being seriously skewed by corporate hostility in both federal and provincial governments in Canada, coupled with a very business-friendly climate in the USA. This pressure will likely continue with the current presidency.

The gross incompetence of our existing federal government at getting anything done (other than throwing money down a black hole) will be costing Canadians dearly in terms of continuing to decrease our standard of living.

The math on trade disputes is pretty simple.

The United States represents the vast majority of the Canadian export economy (about 75%).

Canada represents about 15% of the United States’ trade exports.

As a result, the USA can inflict much more economic pain to Canada than the other way around. As a result, when the USA decides to tighten the screws (like they are with this speculated tariff on steel and aluminum), it is one more step to negotiating a more beneficial trade deal.

What does this mean for the markets?

Likely in Canada, a lower interest rate as the economy will slow further. This would also decrease the value of the CAD/USD pair.

Canada Budget 2018: Speculation

I speculated this earlier in my 2016 annual report, but these options for the Canadian government are most certainly still in play:

1. Flow-through share deductions will be eliminated.
2. Employee stock option deduction will have a full, instead of half inclusion rate, OR the amount will be capped to some nominal amount (e.g. CAD$50k allowed or something).
3. Taxation of capital gains on principal residences is going to have some restrictions (time, or value) placed.
4. Partial inclusion of capital gains will rise (right now a Canadian taking a capital gain will include 50% of the gain as income; I speculate this will increase to 2/3rds or even 3/4).
5. I do NOT believe the non-tax exemption for private and public health plans will be scrapped. This would be a political nightmare for the government compared to the rather esoteric notions on the items, but this was floated around last year.
6. The GST will rise (probably to 7%).
7. Corporate income taxes, on large corporations, will rise.

The Canadian government is going to be more and more desperate for money – with rising debt and rising interest rates, the interest bite will expand once again (the debt is roughly $650 billion, so a 1% rise is a $6.5 billion interest hike on a $300 billion budget). It is also very unlikely the existing government will focus on cost reduction, hence, they will be looking at every corner to pick away revenues. The items above seem to be the lowest lying fruit, although they each will come with their own political costs. The botched implementation of a corporate tax reform on passive income was met with a significant amount of opposition. The politically easier route would be to simply rack up the deficits and not offend anybody, especially since there will be an election within 20 months.