TMX – How much does a pipeline cost?

Just reading the revelation that when the government manages a project, it will triple the cost that it should probably otherwise take to complete – the TMX expansion is running now at a $30 billion capital cost.

The government doesn’t care about the price tag – it’s just another reason to hand out the slush to favoured entities that managed to game the system. The government, despite being the owner of the project, actually doesn’t “pay” for these inflated costs! A simple economic analysis suggests that the pipeline will be so valuable as it is an inelastic service – the WCS differential to the USA vs. shipping it out to Asia will be very extreme, and this differential will be captured with pipeline tariffs. It will be the customers of the pipeline that are captive to the final cost – essentially CNQ, SU, CVE, etc. are paying another tax.

So how much does it cost to send oil out on the existing Transmountain? It is captured in the tolls and tariff bulletin.

A cubic meter of heavy oil from Edmonton to Westridge (just northwest of Simon Fraser University at the water) costs CAD$26, or about CAD$4.20 a barrel.

The TMX expansion will be increasing the flow of oil by 590,000 barrels a day. It is a guarantee that 100% of the available capacity of the pipeline will be utilized – there is simply too much demand for heavy oil to fuel the refineries in places like India, and companies will be able to receive near-Brent crude pricing on WCS.

590,000 barrels a day works out to 215 million barrels per year, assuming no pipeline outages (a false assumption – there will be maintenance periods which will eat into this amount). But let’s work with the theoretical maximum.

At the existing tariff, the incremental heavy crude will generate $900 million in revenues.

Now we look back at the TMX expansion. We have $30 billion in capital costs. Let’s assume the cost of capital is at 5% – pricing in a 180bps spread on “A” rated credit. That’s $1.5 billion/year in interest costs alone. (I am simplifying this considerably by ignoring the fact that there is some equity in the project, I am assuming it is entirely debt-funded – if you want to include equity returns, the revenues required goes even higher!).

In order to amortize this debt over the course of 30 years, the revenues that need to get applied directly to the debt is $1.9 billion a year. There are also other operating costs to running a pipeline (electricity, administration, maintenance, etc.), but the point is that they will need to collect at least double the rate than they are currently collecting in order to pay the debt on the capital costs.

I’m guessing with other administrative expenses baked in, you are looking at a tariff fee of CAD$9-10/barrel.

Brent is trading at US$75.50/barrel currently, while WTI is US$71.50 and WCS is US$51.

There’s about a US$20-24 differential that can be captured with an increased outlet to the Pacific.

However, at least CAD$5-6/barrel of that is going to get sucked up in pipeline costs due to the astronomical cost increases to construct the TMX expansion.

For comparison, the Enbridge Line 3 expansion cost about CAD$13 billion, and was 1000 miles in length. TMX is about 700 miles in length and is projected to cost CAD$30 billion. While the mountainous terrain is of course more difficult to work with, this is by no means a total mitigating factor the account for the cost differential – it is mostly a function of regulatory compliance, all entirely by design – the government does not have to pay for it.

If TMX was constructed for half as much, the incremental profits would go to the shareholders of the oil producers (minus the various taxes and royalties). However, in this instance, the surplus mostly goes to whoever was awarded the contracts – essentially another form of government spending that is “off balance sheet”. Sadly, this happens all the time, and is another example of how spending (which increases the GDP) does not necessarily generate productivity (the actual value you get by spending).

Losers of the TSX, year to date

Rank ordering year-to-date, losers on the TSX, with a minimum market cap of $50 million:

What strikes out at me?

Canfor Pulp (CFX) – What a miserable industry pulp and paper has been over the past four years. Their profitability last decade has been quite good, and then 2019 hit and that was it. Now they are closing down core assets in British Columbia (their Prince George mill is a considerable producer). Most of their production is destined for export to Asia and the USA, and if there is ever a poster child for how BC is a high-cost jurisdiction to conduct forestry, this one is it. CFP owns 55% of CFX. Contrast this with Cascades (TSX: CAS) which the common stock continues its usual range-bound meandering (remember – they were one of the prime recipients of demand for toilet paper during the onset of Covid-19!). If there is any sense of regression to the mean on CFX, however, it would be a multi-bagger stock. The question would be – when? Solvency is not too particular a concern – they’ve got their lines of credit extended out sufficiently.

Verde Agritech (NPK) – A foreign fertilizer firm, notably one of their board members got cleared out of half of his position in the company on April 24th on a margin call. I have no other comments on this other than my professed non-knowledge about Potash and the fertilizer industry. I note that Nutrien (NTR) has been trending down for over a year.

Corus Entertainment (CJR.b) – They cut their dividend, and are realizing that their degree of financial leverage is really going to hurt their cash generation, especially in an industry that is becoming more and more questionable for advertising revenues (broadcast television). The risk here is obvious.

VerticalScope (FORA) – How they managed to get over a half-billion valuation when they went public is beyond me. Rode the 2021 “web 3.0” bubble for the maximum (right there with Farmer’s Edge and the like). Given the organic business is marginally profitable and unscalable at best, and given their existing debt-load, good luck!

Vintage Wine (VWE) – This is a US/Nasdaq entity, I don’t know why this went on the TSX screen, but I checked it out anyway. Sales issues (declining), cost containment, and a large amount of debt plague this company. However, if you shop around any of their wineries, they do offer a “Platinum Shareholder Passport“, where if you own 1000 shares (which is now US$1.08/share, not too steep), you qualify for “25% discount on any wine purchase made at Vintage wineries and web stores.”, which quite possibly might be even larger than a $1,080 investment, depending on how much wine you end up buying. Now that’s a non-taxable dividend you can drink to!

Autocanada (ACQ) – How the mighty have fallen. After blowing a considerable amount of capital on share buybacks (the latest substantial issuer bid at $28 – stock is now $16) in 2022, they are finally feeling the pinch of margin erosion, especially from their last quarterly report. There are macroeconomic headwinds in place here, in addition to a not inconsiderable amount of debt. On their balance sheet, they did something smart by financing a $350 million senior unsecured note financing in early 2022 at 5.75% at a 7-year maturity, but there is still $1.2 billion in other floating rate debt on the books, which needless to say is getting very expensive. Even worse yet is the impact when you have to pass these costs onto your customers in financing charges, so suddenly your Land Rover that was a low $799 per two week payment is now $999! At some point, customers walk away and then decide they want a Toyota Corolla, which is also inconveniently unavailable everywhere. See: Gibson’s Paradox.

… a bunch of Oil and Gas drilling companies are on the list. No comment – it is pretty obvious why.

Brookfield (BN) – A surprising name to see on the list. I have a “no investment in entities named Brookfield” policy simply because of complexity. There are so many interrelationships between the various Brookfield entities that I do not want to make it my full-time life to keep appraised with it all.

51 on the list was Aritzia (ATZ) – I have long since given up on predicting women’s retail fashion trends. I note that Lululemon (LULU) is still sky-high in valuation (forward P/E of roughly 30). Victoria’s Secret (VSCO) is trading at a projected P/E of 5. Aritzia has kept a relatively decent balance sheet (only material liabilities is the retail leases they have committed to) and the projected multiple is 20. If you can get into the minds of the clientele, you would probably get more visibility on the future sales of this company. How do institutions do it? Should I go stick out like a sore thumb and go outlet mall shopping?

Anything else strike out at you?

Farmer’s Edge on the edge

Back during sunnier times for most technology ventures (March, 2021), Farmer’s Edge (TSX: FDGE) managed to raise gross proceeds of $144 million in their IPO at $17/share.

Now they are trading at 19 cents per share, and a cursory look at their balance sheet shows that they have $49 million in debt, owed to Fairfax and due early 2025, and $15 million in cash. Even worse, they bled another $15 million for the first quarter.

Sometimes it is really difficult to make money in a particular sector and no matter how much money you throw at it ($620 million and counting), the story doesn’t change.

The Teck Sweepstakes, Round 4

Previous edition (Round 3).

On April 26, 2023, Teck had to tuck in its tail and announce that the division between its mining and coal units would be postponed and that the board would consider a more simplified option. They could not get a 2/3rds majority vote.

Today, we have news that a Canadian mining titan, Pierre Lassonde, is interested in purchasing the coal mining unit of Teck for an undisclosed price.

This isn’t exactly a known secret – there was an article just a month ago about this.

My guess is that this is just media-baiting to facilitate more selling of the stock.

Price is everything. Using an unlevered 2x/EBITDA (which would be a price that clearly anybody would salivate getting a relatively stable business for), the coal unit would fetch a pre-tax $15 billion, or just under half of Teck’s market cap.

Perhaps the scheme is to put up $5 billion in equity, and borrow $10 billion (half of it can be a flat-out debt offering, and the other $5 billion can be functionally borrowed from Teck in exchange for a 5-10% perpetual revenue royalty or some other form of financial engineering), and suddenly you have the makings of a very asymmetric transaction – on the buy-side, your ROE will be insanely huge, while on the sell-side, Teck hopes to receive a re-rating on its stock AND retain some cash flow to fund the capital expenditures of your future copper mines. Win-win!

Glencore would surely be interested in the assets as well, but in either case, the palms of the government will have to be greased to facilitate this.

From a psychological standpoint, it feels like that the cited pipeline of physical copper shortages is reaching a feverish pitch. It is being spoken as if it is conventional wisdom, and that makes me very cautious with respect to the market.

I remember this script playing out before – Potash Corp was going to be taken over by BHP in 2010, but the government put the brakes on this in short order. A strategic difference is that Teck’s copper operations mainly lie in South America, while Potash Corp’s reserves were in Canada.

However, Teck’s coal mining operation is situated in British Columbia. Perhaps Lassonde thinks that he can obtain the assets for cheaper than Glencore via less regulatory stress.

Teck’s stock is trading at a price that it has not seen for over a decade. Teck’s history in the past has always been punctuated by massive booms and busts – with the current cycle obviously being in boom territory (fortunes were made if you got in during the busts!). While it is likely that their copper operations will make bundles of money, the question then becomes one of valuation – my deep suspicion is that this baseball game being played is down to the last three innings. I also very much doubt that shareholders are going to get an exit decided for them (i.e. I think the chances of an outright sale of the coal unit and a subsequent special dividend is next to nothing). There’s too much of a management incentive to keeping the company’s gravy train going for at least another few years.

Finally, in today’s edition of “everybody has to be a macroeconomist to invest in this market”, while all indications suggest that the economy is still humming along, commodities at the later stages of an economic cycle are the textbook asset that you don’t want to be exposed to. There are other mitigating factors (i.e. the inflation and monetary policy situation), but given the contraction of liquidity in the US (not to mention the looming debt crisis), coupled with mixed messages, makes me very defensive about matters. My crystal ball, while seeing some patches of clarity here and there, still remains considerably murky.

Bank of Canada QT Progression

Another $23 billion of Canadian government bonds matured off the Bank of Canada balance sheet on May 1:

What’s interesting is that the Government of Canada ordinarily will receive a lot of tax remissions by April 30. In the past couple years, between the last April data point and the first May data point, the number spiked up about $10 billion, but this time the amount was up less than a billion dollars. Spend, spend, spend!

The $182 billion in bank reserves remaining continue to earn member institutions a very adequate 4.5% deposit rate – I’m sure the public really loves the annualized $8.2 billion dollars (that’s about $210 per Canadian!) being graciously donated to the big banks, risk-free. Why bother lending money to customers when you can get it so good from the BoC?

The next few slabs of QT are $6 billion on June 1, $9 billion on August 1, and $24 billion on September 1.