By David McColl
As one of two dominant Canadian pipeline companies, and with a strong U.S. presence, Enbridge (ENB) has assembled a strong network of pipelines collecting toll-like revenue. Its regulated returns on equity have consistently exceeded its cost of capital, helping secure a narrow moat rating. However, last month we raised our economic moat rating to wide, in recognition of a structural shift in Enbridge's economics and in response to a secular shift in supply/demand dynamics. We believe Enbridge is the best-positioned pipeline operator to service the Canadian oil sands and Bakken shale, by constructing and operating a reliable network of feeder pipelines. These unregulated pipelines tend to provide returns in excess of the regulated rate pipelines to which they connect. The company's dominant position, existing assets, recent acquisitions, and plans to expand capacity will shift Enbridge's revenue mix more strongly in favor of its higher-return liquids pipeline business.
Making the Case for a Wide Moat
Enbridge's wide economic moat is a result of the regulated nature of its assets, its ability to lock out competing pipelines from an area, its significant growth opportunities, and our belief that the firm will continue to develop projects that achieve a return on capital in excess of its cost of capital (beyond our 2012-16 projection).
Enbridge operates one of the largest liquids pipeline networks in North America, with more than 2.5 million barrels per day of export capacity from Canada to the United States. This includes its advantage as the dominant operator of feeder pipelines in Canada's oil sands region, which is expected to double production in the next decade, and its growing position in the surging Bakken shale play. The liquids pipelines can move light, heavy, and synthetic crude oil from as far north as the oil sands all the way into the Chicago hub. The recent acquisition and reversal of the Seaway Pipeline allows Enbridge to move crude from Chicago into the largest refining market in the world, located on the U.S. Gulf Coast. Its existing assets are high quality when considered on a stand-alone basis, but together form an integrated pipeline network that allows the company to capture greater returns across the midstream value chain.
The mainstay of Enbridge's pipeline model is regulated rates of return. The vast majority of the company's pipelines are regulated by the National Energy Board in Canada and the Federal Energy Regulatory Commission in the United States, and allowed returns on equity are attractive enough to lock in economic returns on capital. Thus, by virtue of regulation, Enbridge is all but guaranteed to outearn its cost of capital. This is the fundamental driver of the company's economic moat.
The company's most significant asset is the Canadian Mainline, which runs from Edmonton into the Lakehead System and also into Montreal; this constitutes the Enbridge Mainline. Its return on equity is variable since the costs to transport liquids (the tolls) are governed by the July 2011 competitive tolling settlement. While this is based on previous tolling settlements and cost-of-service principles, earnings are subject to variability associated with throughput volume and costs. Terms that backstop the CTS include a threshold ROE of between 11% and 15% over a five- to 10-year period. This provides a spread of ROE/common equity of 3%-7%.
Barriers to Entry
Regulation also provides Enbridge with strong barriers to entry, enabling the firm to lock out its competition. A competitor seeking to develop a new pipeline in an area with existing pipes is at a structural and regulatory disadvantage if the existing line has either spare capacity or the ability to expand the pipeline using compressor stations or adding another pipeline on an existing right-of-way. These types of expansions are usually at a significantly lower cost than a new pipeline, with a lower risk of regulatory or landowner intervention, and represent a structural advantage for an existing pipeline.
In addition, regulators will often consider whether a new pipeline is needed in an area already serviced. Regulators tend to consider whether a new pipe would result in higher transportation costs. Higher costs can happen if a new pipeline would result in a significant reduction in utilized capacity. Because of the cost-of-service nature, a reduction in the long-term utilization will result in lower revenue for a given toll. This lower revenue might no longer offset the cost to maintain and operate a pipeline. When this happens, the pipeline would either need to be shut down (because it is no longer profitable) or the tolls would need to be increased. This illustrates how a new and competing pipeline that results in lower overall utilization of the existing pipeline could result in higher costs for shippers. For this reason, existing pipelines have a regulatory advantage that reinforces the structural advantages.
Over the next decade, we expect to see a shift in Enbridge's earnings from natural gas to liquids-rich opportunities. Growth in the firm's natural gas business unit will come from unregulated rate gas plants that remove natural gas liquids from a gas stream before it enters North America's pipeline system for residential, commercial, or industrial use. While we consider the gas plants to have the narrowest economic moat, they support Enbridge's existing natural gas pipeline infrastructure, which has a wide economic moat.
The most significant shift is taking place in the company's wide-moat liquids business unit, which should benefit from the growing volumes associated with the oil sands and Bakken plays. These plays will require gathering systems to move the liquids out of the regions, and Enbridge is well positioned to construct and operate these unregulated pipelines, which tend to provide returns in excess of the regulated common carrier pipelines such as the Mainline. Moreover, many of these opportunities will provide long-term support and potential growth for the Mainline, as the Bakken and oil sands volumes will connect directly into its existing pipeline network.
When we consider the regulated and unrelated pipeline assets on their own, they tend to have wide economic moats with ROEs that should continue to exceed the cost of equity over the life of a pipeline. Viewing the company's assets as a whole, the case for a wide economic moat is strengthened as its portfolio of rate-based assets should provide Enbridge with growing returns that, in general, reflect the growing share of earnings associated with its business units. Its highest returns are estimated to come from the liquids unit, which we expect to become a more important piece of Enbridge's corporate earnings.
New Investments Widen Enbridge's Economic Moat
Enbridge's attractive assets and location, size, scale, and access to capital put it in the best position to capitalize on the boom in liquids and natural gas production in North America. With an announced portfolio of potential projects of CAD 47 billion, there is significant room for Enbridge to expand its businesses. While the company's chances of securing the entirety of the potential are a bit of a pipe dream, we are confident in Enbridge's ability to successfully execute its CAD 13 billion in projects that it has allocated capital for, and we believe it should be able to capture most of its CAD 7 billion in unallocated, or risk capital, projects over 2012-16. More than 75% of its growth projects are focused on liquids, including opportunities in the oil sands, Bakken, and to a lesser degree the Gulf of Mexico. Enbridge's risk capital is for liquids opportunities in the Eagle Ford, Permian, and Niobrara. Modest growth is expected from natural gas (including NGL) opportunities in British Columbia, the Appalachia (Marcellus growth), Rockies, Mid-Continent, and the Texas, Oklahoma, and Gulf Coast region of the U.S. Most of these opportunities will be driven by shale and tight gas plays.
At its core, Enbridge's strategy is to build out takeaway capacity for two of the continent's biggest oil resource plays: the oil sands and the Bakken shale. This takeaway capacity will be in the form of additional gathering systems that will feed these liquids into its existing pipeline network. To secure volume commitments for its long-haul pipelines, Enbridge is aggressively building out crude oil gathering systems in both the oil sands and the Bakken.
Bolstering the Moat by Tying Gathering Systems Into the Enbridge Network
Once the gathering systems are in place, barriers to entry should prevent competition from significantly eroding Enbridge's position in the oil sands and Bakken, while supporting the company's strategy of tying these systems into its existing pipeline network. While our discussion on barriers to entry focused on long-haul common carrier pipelines, similar logic applies to the gathering systems. Existing pipelines can be expanded with compressor stations or adding an additional pipeline on an existing right-of-way. These types of expansions are usually at a lower cost than a new pipeline, with a lower risk of regulatory or landowner intervention. Combined, these represent a structural advantage for the gathering systems in that they should be able to lock out competitors and thus support Enbridge's wide economic moat.
With competitors locked out and the systems tied into its existing network, Enbridge should be well positioned to boost the volumes flowing through its Mainline, Spearhead, and Seaway Pipelines. As volumes from the oil sands and Bakken ramp up, the gathering systems need to have access to these interstate pipelines that can move products to markets like the Chicago area, or into Ontario. For example, the Mainline can move oil sands bitumen (diluted) and Bakken crude to the Chicago area, where the Spearhead (and proposed Flanagan South Pipeline) move crude oil from the Chicago area into the Cushing, Okla., hub.
While TransCanada (TRP) has been seeking approval of the Keystone XL pipeline, Enbridge has stolen some of its main rival's thunder with its 50% acquisition of the Seaway Pipeline, which competes with TransCanada's proposed Gulf Coast Pipeline that will run from Cushing to the Gulf Coast. The acquisition bolsters Enbridge's competitive advantage, as it has secured a pipeline system that can move bitumen from northern Alberta and crude from the Midwest all the way down to the U.S. Gulf Coast, in addition to Bakken crude. Following the acquisition, Seaway was quickly reversed and is now flowing 150,000 barrels per day. By 2014 we look for the pipeline to grow to 850,000 bpd after additional modifications increase the capacity to 400,000 bpd in 2013.
Natural Gas and Natural Gas Processing
The balance of Enbridge's portfolio includes natural gas pipelines, gas gathering systems, and processing plants. Enbridge's long-haul gas pipelines, particularly its Alliance Pipeline, are wide-moat assets in and of themselves. Gathering systems face the long-term threat of natural reservoir declines offsetting incremental production, and while processing plants tend to earn returns that exceed the weighted average cost of capital, the cash flows tend to be influenced more directly by commodity price volatility. Unless the processing plants are fee-based, the volatility can influence long-run returns, which are also at risk from competing processing plants (low barriers to entry). Thus, we tend to view these assets as having a narrow economic moat.
Processing plants are traditionally constructed near liquids-rich gas fields, such as the Granite Wash play in Texas and Oklahoma and part of the Horn River in northeastern British Columbia. Enbridge has been expanding its processing plant business and building off its success with the Aux Sable processing plant, which removes NGLs off the gas stream that flows down the 50% Enbridge-owned Alliance Pipeline. The Alliance Pipeline transports liquids-rich natural gas from northeastern British Columbia to Aux Sable. Once the liquids are removed, the natural gas stream from the Alliance Pipeline is of sufficient quality for use in local gas distribution networks or storage facilities that feed these networks. Part of the stripped natural gas from Alliance flows into the Vector Pipeline (60% Enbridge-owned), which ships natural gas to the Dawn hub in Ontario. We would consider these pipelines to have a narrow moat.
All told, Enbridge intends to invest CAD 1.7 billion in its natural gas business over the next five years. The majority of this capital will be directed toward natural gas processing such as the CAD 1.1 billion Cabin Gas Plant. Enbridge will also invest CAD 600 million in other processing and gathering systems. Aside from its natural gas business, Enbridge will invest CAD 900 million in three solar projects and a geothermal project through its alternative energy business. We estimate that earnings from these businesses, which include its corporate unit, could increase from CAD 146 million in 2011 to CAD 389 million at the end of 2016. The total contribution to 2016 earnings would increase slightly to 16% from 13% in 2011.
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