ENB – Divestor

Enbridge Line 5 and pipeline politics

It is going to be very interesting to see what happens with Enbridge and Line 5.

The reason why the Federal Government cares about keeping Line 5 operational is because it processes about half of the crude oil that is refined for southern Ontario and Quebec. You can take a car to Sarnia and see the refineries.

A shutdown of Line 5 would, needless to say, be very disruptive for the region. There isn’t a good way to get additional capacity into the area – the other routes are fully utilized.

The federal government only cares about what is good for, roughly, the traditional boundaries of Upper and Lower Canada. Any policies that are tailored for areas away from this geography is strictly coincidental.

Thus, the Keystone XL cancellation was of little concern to Ottawa. The usual lip service of condemnation by politicians, when it is so obvious they don’t mean it.

I am still somewhat mystified today that the federal government bought out the Transmountain pipeline project – most people do not know that there is an existing (profitable) pipeline in place. Its existence does not matter an iota to Ottawa.

Line 5, however, is different. It fuels Ottawa’s core geography.

It was not longer than a decade ago when this strategic and political vulnerability was identified and hence the Energy East project was conceived. After the Liberals got into office in October 2015, they proceeded to kill the project with a never-ending wall of regulation.

We fast forward today and see where such lack of strategic thinking is par for the course in Canada.

It is not my job to moralize about the inadequacies of government thinking, but rather to pick out winners and losers.

I am still puzzled why so many people are in love with Enbridge as being a staple in their yield portfolios. There is far more risk than they imagined.

The sentiment will change when there is a real connection between very poor decisions and actual hardship experienced by people. The lag between the two, however, could take many, many years and attribution of blame may be misdirected.

Likewise, few lament over how much richer we could have all been, collectively as a society, had we had our act together to begin with.

Politicians, however, are not rewarded for making optimal or efficient decisions. In fact, they have a gigantic incentive to not solve problems, lest their purpose of existence be threatened.

Mid-stream oil and gas

Low oil prices hurt producers for obvious reasons.

They also are hurting the mid-stream, but this is for less obvious reasons – low prices means curtailment of capital expenditures, which typically mean lower volumes, which means less money for midstream producers. Volume is the dominant variable for the mid-stream, not prices.

The flip side of this equation is lower prices stimulates consumption, which means higher oil prices, which means higher capital expenditures… you get the picture. There is an equilibrium factor that depends on mutually dependent factors in order to “solve the equation”. In Excel, this would typically be a circular equation, but when applied in real life, the input variables are much more fuzzy, and thus it makes the output chaotic and difficult to predict where the true “landing spot” is (which never exists – it is always ever-moving).

The other clear factor is that when oil and gas companies are not making profits, there is an element of counterparty risk.

One broad-brushed way of investing in the US mid-stream sector is through the Alerian MLP ETF (AMLP) which got killed yesterday. The constituent companies are fairly stodgy oil and gas pipeline MLPs which give out most of their income in the form of distributions. Normally MLPs are very adversely taxed for Canadians, but the AMLP structure is a corporation. It distributes its income mostly in the form of a return on capital, but for tax purposes, it is equivalent to foreign income. However, in a registered account, this is a non-factor. At the low of $4.14/unit, it was trading at a yield of 18% and even when factoring in the inevitable decline of shale production in the USA, seems to be a reasonable risk-reward proposition as investors seek yield.

To a lesser degree, Canadians can also invest in Enbridge (TSX: ENB), TransCanada (TSX: TRP), Pembina (TSX: PPL), and for those interested in Albertan intra-provincial pipelines, Inter-Pipeline (TSX: IPL). However, the income to price disparity is not nearly as present as the American analogs (including Kinder Morgan, Williams, etc.).

Pembina, in particular, has gotten killed simply because it faces a risk that the Trans-Mountain pipeline is not going to be constructed, especially with the crash in oil prices and the general incompetency of our Trudeau-led federal government. The assets they picked up from the old Kinder Morgan Canada were quite good. Enbridge and TransCanada should also do well – the big loser going ahead will probably be the oil-by-rail trade – if production slows down, this volume will be the first to get scrapped, not the pipelines.

Pipelines and Inter-Pipeline

I’m not one to typically invest in pipelines. All of them are quite heavily levered, and in most cases, it is justifiable with the predictable streams of cash flows they generate. As a result, the equity is typically treated like a bond by most investors, plus you add a couple percent to make up for the ‘risk premium’.

In the Canadian retail space, there’s no better example of this than Enbridge, where investors blissfully clip their 74 cent a quarter dividend, with the promise by management that this will grow 10% a year indefinitely. The fact that there’s 65 billion in debt and 8 billion in preferred shares ahead doesn’t matter because of those high cash flows, so one can safely assume you will receive dividends forever. The current headline yield of 6.6% sure looks good and can only go up from here!

This might sound great, but investors of Kinder Morgan (NYSE: KMI) learned their lesson (2015) that some things can go wrong with this model and when corrections are required, shareholders take the hit and not the senior part of the capital structure. Taking equity risk on Enbridge in exchange for very limited capital appreciation upside is not my idea of a good investment, but I’ll digress.

Enbridge and other pipeline companies do have one virtue – because of intense political opposition, it becomes a lot more difficult to develop pipelines, especially in Canada. Thus, there is a huge element of advantage to incumbents. Even if you gave a competent oil major $30 billion, you wouldn’t be able to replicate Line 3 or Line 5 from scratch. Especially with Canada’s Bill C-69, there is really no point – TransCanada learned the tough way (even without C-69) that Energy East is a dead cause because of politics. The only real option these days are avoiding the federal scene entirely and going for intra-provincial pipeline infrastructure. An example of this is the Coastal Gaslink pipeline, connecting the northeastern BC gas formation to Kitimat, BC for LNG export. Even this has received heavy opposition of all sorts, but they were able to miraculously make agreements with all 30 elected First Nations councils and get the thumbs-up from the provincial NDP government (despite having a Green party coalition partner), which has been one of the big political surprises over the past couple years.

Which brings me to another pipeline company – Inter-Pipeline (TSX: IPL). What has been encumbering the company is the construction of their propane to polypropylene refining facility, which needless to say, is very expensive (all of this political talk of being able to refine your own production is completely uninformed about how expensive these facilities are and how much expertise they require to construct and operate – they don’t come up on their own like marijuana!). Their cost estimate of $3.5 billion is probably conservative and looking at the balance sheet, simply put, they have enough debt as it is without constructing this facility.

Now the media has caught wind that somebody wants to take them over, and somebody floated an unsolicited bid for $30 for the whole thing. Management rejected it, but this is starting to get the stock market interested. It’s an interesting valuation when considering that the enterprise value at IPL stock at $30 is 7 times the annualized revenues (1H-2019), while Enbridge’s is currently 3 times.

Appendix – Bill C-69

Here is a snippet of the new requirements that the environmental impact (now “impact assessment”) agency must consider:

Factors — impact assessment
22 (1) The impact assessment of a designated project, whether it is conducted by the Agency or a review panel, must take into account the following factors:
(a) the changes to the environment or to health, social or economic conditions and the positive and negative consequences of these changes that are likely to be caused by the carrying out of the designated project, including
(i) the effects of malfunctions or accidents that may occur in connection with the designated project,
(ii) any cumulative effects that are likely to result from the designated project in combination with other physical activities that have been or will be carried out, and
(iii) the result of any interaction between those effects;
(b) mitigation measures that are technically and economically feasible and that would mitigate any adverse effects of the designated project;
(c) the impact that the designated project may have on any Indigenous group and any adverse impact that the designated project may have on the rights of the Indigenous peoples of Canada recognized and affirmed by section 35 of the Constitution Act, 1982;
(d) the purpose of and need for the designated project;
(e) alternative means of carrying out the designated project that are technically and economically feasible, including through the use of best available technologies, and the effects of those means;
(f) any alternatives to the designated project that are technically and economically feasible and are directly related to the designated project;
(g) Indigenous knowledge provided with respect to the designated project;
(h) the extent to which the designated project contributes to sustainability;
(i) the extent to which the effects of the designated project hinder or contribute to the Government of Canada’s ability to meet its environmental obligations and its commitments in respect of climate change;
(j) any change to the designated project that may be caused by the environment;
(k) the requirements of the follow-up program in respect of the designated project;
(l) considerations related to Indigenous cultures raised with respect to the designated project;
(m) community knowledge provided with respect to the designated project;
(n) comments received from the public;
(o) comments from a jurisdiction that are received in the course of consultations conducted under section 21;
(p) any relevant assessment referred to in section 92, 93 or 95;
(q) any assessment of the effects of the designated project that is conducted by or on behalf of an Indigenous governing body and that is provided with respect to the designated project;
(r) any study or plan that is conducted or prepared by a jurisdiction — or an Indigenous governing body not referred to in paragraph (f) or (g) of the definition jurisdiction in section 2 — that is in respect of a region related to the designated project and that has been provided with respect to the project;
(s) the intersection of sex and gender with other identity factors; and
(t) any other matter relevant to the impact assessment that the Agency requires to be taken into account.

My comments: Good luck! Especially with the very quantifiable “intersection of sex and gender with other identity factors” criterion.

Enbridge Line 3 – Another setback

I do not have shares in Enbridge, but investors today (and probably tomorrow as the news came out mid-day and institutions will look at it overnight to digest the impact on valuation) will be feeling slightly less rich after today’s news that the Minnesota court of appeals deemed the environmental assessment concerning Line 3 to be inadequate.

The net result is that Line 3 will have their construction halted until Enbridge can file an appeal or an amended environmental assessment. This will also result in another round of legal battles with the 3Cs of regulation – committees, commissions and courts and my initial estimate would be at least half a year of delays. I could be wrong.

The reason for the delay is not terribly relevant from a financial standpoint, but the impact of it will be for both Enbridge (who will not be realizing increased cashflows from the increased volume that would be flowing through the pipes the second they are activated – not to mention the capital that has already been sunk into the project), but more importantly, land-locked Albertan/Saskatchewan oil producers that were seeing a light ahead of the tunnel after the presumptive second half of 2020 activation of Line 3.

At CAD$50/share, Enbridge was priced for perfection. Although Enbridge is mostly a cash flow story, an investor is paying a lot in advance in order to realize those cash flows – in addition to the requisite risks to pay back the debt, interest and preferred share dividends. Just wait until Line 3 or Line 5 experiences a spill, or some other adverse event which is currently not baked into the stock (or perhaps another adverse legal ruling that will stall it another couple years). Although the company in 2019 is expected to generate around $4.50/share in cash ($8.9 billion), the inherent growth that is available to Enbridge is a limiting factor – and as such, the accounting income P/E in the 20s (which takes into account depreciation) is unjustified. Coupled with large future capital expenditures, if there is any sort of credit situation that may occur in the future, equity owners will be taking a lot more price risk than the current potential for reward – which wasn’t going to be a stock price that much higher than CAD$50/share.

I would especially take issue with the common share dividend, which is currently $6 billion a year – while they can certainly afford to pay this at present (and management continues to escalate the dividend each year), it is not a financial perpetual motion machine – given the capital expenditure profile, this is currently being partially financed with debt.

There aren’t many free lunches in the stock market, including the pipelines. Companies like Inter Pipeline (TSX: IPL), which has less legal risk than Enbridge, are still at valuations that aren’t incorporating much risk to their future expected cashflows (albeit, in IPL’s case, it is a lot better today than it was a couple years ago where it was trading about 30% higher). It wouldn’t surprise me to see Enbridge follow a similar trajectory, but still maintain its equity dividend.

Students of history will want to pay attention to Kinder Morgan (NYSE: KMI), a supposedly safe and stable pipeline company in 2015:

I’ll leave it at that – pipeline companies are supposed to be stable for their cash generation capabilities, but financially it can be a completely different story.

Somewhat disappointed by Enbridge buyout offer

I’ve been writing about Enbridge (NYSE: ENB) and their process of re-acquiring their daughter entities, including EEP, EEQ and ENF. They already formalized the arrangement with Spectra Energy Partners (NYSE: SEP), which I wrote about earlier.

For EEP, I was anticipating a slightly higher exchange ratio (0.35 vs. the 0.335 offered).

I own call options in EEP. Valuation-wise they should trade like call options in Enbridge, with a minor dividend differential (EEP will declare one more $0.35 distribution for the quarter which option holders will effectively receive by virtue of the exchange arrangement, which will be offset by Enbridge’s quarterly dividend).

Enbridge is getting a steal of a deal on EEP – once the Line 3 expansion project becomes operational (scheduled for 2019 and unlike Trans-Mountain, the regulatory way has already been cleared for construction), the amount of cash flows available will be even more immense than the existing $6.6 billion/year they are currently doing (just eyeballing their June 30, 2018 financial statements). Once stripped of all the politics and drama of pipeline construction, it is a pretty boring company to analyze, but one that is a reasonably valued blue chip component in anybody’s portfolio. The fact that there is so much protection in the industry will assist, in addition to them being able to raise rates at the rate of inflation, while paying down their debt in nominal dollars.

Enbridge is also the type of company that would be able to survive an economic recession – as long as the oil flows. And oil will be flowing for a very long time.

I’m holding onto my call options in EEP. They expire in 2019 so I am in no rush to liquidate the position – as ENB appreciates (and it will), the call option position will also reflect this. I can see ENB heading to around CAD$48-50/share by the end of the year which would put EEP at around $12.60 with a 0.77 CAD/USD. Once I’ve squeezed another dollar out of the position I’ll probably sell the options.