Pipeline stocks are solid defensive plays

TransCanada has the most upside because only some of the additional earnings from its proposed Keystone XL pipeline, which will carry oil directly from Alberta to the U.S. refineries near the Gulf coast, are currently priced into its stock, analysts say.

On the flip side, there is also more risk for this company’s stock. Analysts assume that the final approval for Keystone XL from the U.S. government, which is due in December, will be forthcoming — despite strong opposition from American environmentalists. However, nothing is certain in the political arena.

Enbridge’s major growth project is Northern Gateway, twin pipelines that will run from Edmonton to Kitimat, B.C., which is near Prince Rupert, that will supply oil from the oilsands to Asia. However, this project is not set to go ahead until around mid-decade, and it’s in only the early stages of the regulatory approval process. Northern Gateway also is facing significant opposition from First Nations, whose land it will cross, as well as from environmentalists.

Meanwhile, there is less enthusiasm for Pembina Pipeline Corp., also based in Calgary, because its business operates similar to that of an income trust — which it was up until a year ago. This means it distributes most of its cash flow and, as a result, it doesn’t have the cash or reserves of Enbridge and TransCanada to deal with problems, should they arise.

Enbridge and TransCanada have major pipelines that transporting oil and/or natural gas from Western Canada to the provinces in the East as well as to the U.S. Pembina’s network serves Alberta and British Columbia.

As the infrastructure required in this sector is so large and expensive, companies focus on return of capital. Prices are regulated, either through tolls set by formulas or though long-term contracts, which usually include minimum volumes, and are approved by regulators. This provides for stability in earnings.

Generally, there is little risk in the pipelines sector, but there are exceptions. The discovery — and rapid development — of inexpensive shale gas in the eastern U.S. has lowered both the price of natural gas and the volumes on TransCanada’s Canadian “mainline” system.

Although volumes will never return to previous levels, they should increase to profitable levels in the next couple of years as production moderates, says Robert Mark, an analyst with Montreal-based MacDougall MacDougall & MacTier Inc. in Toronto.

There was a frenzy of shale gas production in the past few years because lease owners had to produce to keep their leases, but this period is coming to an end. In the meantime, TransCanada, its customers and regulators are working on adjustments to the tolls that will be fair for everyone.

Here’s a look at the three companies in more detail:

Enbridge Inc. operates the world’s longest crude oil and liquids pipeline system, which runs from Fort McMurray, Alta., through Chicago to Cushing, Okla., in the south, and to Montreal in the east.

Transporting oil is Enbridge’s main business, but it also has natural gas pipelines from Fort St. John, B.C., through Chicago to Toronto, and distributes gas to retail customers in Ontario. The company also partly owns Gaz Métro Inc., which distributes natural gas in Quebec.

Besides Northern Gateway, Enbridge and a U.S. partner are proposing to build a pipeline from Cushing to Texas to compete with TransCanada’s Keystone XL.

The company doesn’t have as many projects on the go as it had in the past, Mark points out, but management’s still expecting 10% growth in earnings, which he says is “huge” for a pipeline company.

“There is very good visibility for the continuation of strong earnings per share growth for several years,” adds Ryan Crowther, vice president with Bissett Investment Management Ltd. in Calgary and co-lead manager of Bissett Canadian Dividend Fund, sponsored by Toronto-based Franklin Templeton Investments Corp., which holds the stock.

However, Pierre Lacroix, analyst with Desjardins Securities Inc. in Toronto, is less confident. Although he notes that Enbridge is looking for international acquisitions — possibly in Colombia and Australia — there’s nothing concrete yet.

Lacroix, who notes the risks in international ventures, points out that Enbridge had made a successful investment in a Colombian pipeline in the past, which it sold in 2009. So, Enbridge’s management team, which he considers to be good, has the experience to take advantage of a good opportunity if one emerges.

Mark and analysts with Royal Bank of Canada’s capital markets division in Toronto have a “buy” rating on the stock, with 12-month price targets of $36 and $37, respectively. Lacroix and the research team with TD Securities Inc. in Toronto rate it a “hold,” with price targets of $31 and $33, respectively. The 758 million outstanding shares closed at $33.45 on Sept. 30.

Enbridge’s net income was $675 million on revenue of $9.7 billion in the six months ended June 30, vs $510 million on revenue of $7.5 billion in the corresponding period a year earlier.

Pembina Pipeline Corp. Although Mark likes the management of this company, he doesn’t like Pembina’s business model because the firm pays out almost all of its cash flow.

So, if anything goes wrong — such as an oil spill — the company would have to cut its dividend, borrow from its bank or access the capital markets — and the timing might not be good for the last option.

Mark points out that Pembina’s higher dividend yield of 6%, vs 3%-4% for Enbridge and TransCanada, reflects this risk. He also notes that Pembina stock is popular right now because interest rates are so low; as a result, it may not do as well when interest rates rise eventually.

The TD analysts recommend reducing portfolio holdings in Pembina, with a 12-month price target of $20. The 168 million outstanding shares closed at $25.65 on Sept. 30.

Pembina’s net income was $91 million on revenue of $906 million for the six months ended June 30, vs $90 million on revenue of $675 million in the corresponding period the year prior.

Transcanada Corp. Pipelines are about 60% of this company’s business, and its system connects with virtually all the major natural gas basins in North America. The other 40% is power generation — from natural gas, hydro, nuclear and wind, mainly in Alberta, Ontario and the U.S. northeast — which is sold mainly through long-term contracts.

Besides Keystone XL, Trans-Canada is building pipelines to connect with shale natural gas deposits in Alberta and B.C. and in the Marcellus basin in the U.S., Lacroix notes. TransCanada also is involved in refurbishing nuclear power plants in Ontario.

Crowther had added Trans-Canada’s stock to the Bissett fund earlier this year. Lacroix, Mark and the TD Securities’ research team all have “buy” ratings on the stock, with 12-month target prices of $45, $47 and $47, respectively. The 703 million outstanding shares closed at $42.54 on Sept. 30.

TransCanada’s net income was $860 million on revenue of $4.4 billion in the six months ended June 30, vs $651 million on revenue of $3.9 billion in the corresponding period a year earlier.  IE