Enbridge's Growth Portfolio Is Underappreciated

Enbridge is positioned to benefit from growing oil sands supply dynamics with its Mainline system and regional oil sands pipelines. The regulated Mainline system generates attractive tolls and represents approximately 70% of Canada’s pipeline takeaway capacity. The system offers refinery access to various markets, adding to the network’s attractiveness.

The company also operates regional pipelines that tie directly into the Mainline. Each of these pipelines originates from existing oil sands projects and is underpinned by long-term contracts. Growth projects possess the same economics, positioning the company to benefit from the growing supply.

While crude pipelines are Enbridge’s bread and butter, the company operates a diverse energy portfolio. Gas distribution operations benefit from regulated returns and provide the company with reliable cash flows. Enbridge also operates natural gas pipelines and processing assets that supplement its crude pipeline network. Future natural gas pipeline projects benefit from long-term contracts that are tied into emerging projects. Recently, Enbridge finalized its acquisition of Spectra Energy. The deal positions Enbridge to diversify its operations toward natural gas.

The company intends to increase its annual dividend and has maintained an average distributable cash coverage ratio of approximately 3 times over the past three years. Overall, Enbridge is in a strong position to benefit from the growing oil sands supply, which we expect to outstrip pipeline takeaway capacity in the near term. We expect the Line 3 Replacement to help; we project it to be in service by the end of 2019 and fuel tremendous growth for the company. We believe the stock is undervalued based on the company’s vast growth portfolio, highlighted by the lucrative natural gas projects associated with the Spectra acquisition and the Line 3 Replacement.

This Midstream's Moat Is Wide Midstream companies process, transport, and store natural gas, natural gas liquids, crude oil, and refined products. There are multiple ways for midstream companies to build moats, but efficient scale is the dominant source. Pipelines are characterized by relatively high barriers to entry, high capital costs, and significant regulatory oversight. Regulatory approvals are granted only when an economic need for pipelines exist. Once approval is received, midstream companies typically seek to lock in project economics through long-term contracts with shippers before ever breaking ground on a new project, ensuring that at a minimum project and capital costs are recouped, with potential for excess returns over time. Generally, companies will not pursue expansion opportunities without securing contracted capacity.

While the competition among midstream companies for new projects is fierce due to the finite demand for additional infrastructure, once a pipeline is in service it tends to enjoy excess returns. Single pipelines can be attractive; however, a network of pipelines that serve multiple end markets and are supplied by multiple producing regions is much more valuable. Because oil and gas are fungible, midstream companies can optimize the flow of hydrocarbons across their systems to meet producer or end-user demand while locking in geographic price differentials, or use storage facilities tied to the network to lock in price differentials across time periods.

Extensive regulatory oversight of Enbridge’s assets acts as a barrier for new entrants, with many federal, state, and local agencies involved in permitting, siting, and rate-setting activities. Regulators in Canada and the U.S. permit Enbridge to recover costs to operate pipeline networks by collecting tolls for services. Regulated tolls include the recovery of the pipeline’s investment, a rate of return on the investment, and pipeline operating costs. The regulatory oversight provides stability in returns that typically exceed the company’s cost of capital. As a result, Enbridge generates new project returns on equity that typically range from low double digits to midteens. Regulation also protects pipeline infrastructure from becoming oversupplied, as projects are not approved unless economic need for expansion is demonstrated. As such, regulation keeps out competitors and acts as an intangible asset to existing pipeline operations, such as Enbridge.

The Canadian Mainline crude oil pipeline is the crown jewel of Enbridge’s diverse midstream portfolio. With shipping capacity of approximately 2.85 million barrels a day, the pipeline transports primarily heavy oil from Canada’s oil sands to refineries across North America, including Canada’s east coast, the U.S. Midwest, Cushing, Oklahoma, and the U.S. Gulf Coast. Refinery capacity connected to the Mainline approximates 3.5 mmbbl/d and provides shippers with higher realizations than locations such as Canada’s west coast.

Canada’s oil sands supply is landlocked and separated from the majority of its refining markets by large distances, relying on pipeline transportation. Pipeline takeaway capacity from the country approximates 4 mmbbl/d, with approximately 70% of the capacity residing on the Mainline system. Increasing environmental and government regulations, as well as political opposition, have made new pipeline projects increasingly difficult to sanction. In our view, Kinder Morgan’s 590 mbbl/d Trans Mountain expansion remains the best opportunity for additional infrastructure in the medium term. However, the pipeline is not expected in service before 2020 and would deliver production to Canada’s west coast. West coast production yields lower price realizations, posing minimal threat to the Mainline system. Furthermore, Western Canada production is projected to exceed pipeline takeaway capacity in the near term, making the Mainline system and its access to various North American refining markets even more desirable.

Enbridge is further exposed to production growth from the oil sands with its regional oil sands pipelines network. The company’s major regional pipelines provide transportation from all three of the oil sands locations but are primarily focused on the largest region, Athabasca. Enbridge has long-term contracts with shippers on each of its existing pipelines with an average duration of 20-25 years. Pipeline expansion projects are underpinned by new production growth projects, and contracts extend over the life of the associated production project.

In addition to the crude oil pipelines, Enbridge’s natural gas pipeline and processing assets benefit from growing production in premium natural gas formations. The Alliance pipeline is the only rich gas export pipeline from the Western Canada Select Basin. Shipments originate from the Horn River, Montney, Duvernay, and Bakken formations and are transported to the U.S. Midwest. Gathering, processing, and fractionation assets are tied into the pipelines, many of which are underpinned by 20-year take-or-pay contracts with producers and generate attractive, regulated returns on capital that exceed the company’s cost of capital.

To further diversify its midstream portfolio, Enbridge operates a regulated natural gas utility and Canada’s largest gas distribution company serving residential, commercial, and industrial customers in Ontario and upstate New York. Regulated returns on equity on the gas utility and gas distribution assets consistently exceed 10%, providing another attractive asset to the portfolio that exceeds the company’s cost of capital.

The combination of attractive regulated returns, near- and long-term expansion projects that are underpinned with long-term contracts, and a vast, diverse midstream network allows Enbridge to realize efficient scale on its midstream asset economics and to generate sustainable excess ROICs. Regulatory approval on crude expansion projects also prevents competitors from undertaking expansion projects without necessary approval, acting as an intangible asset for Enbridge on its Mainline operations. As such, we project that the company will achieve excess returns on capital within five years and conclude that Enbridge possesses an economic moat. Difficulty obtaining regulatory approval on major pipeline expansions, attractive regulated tolls that exceed the company’s cost of capital, and 20- to 25-year contracts on regional pipelines afford the company a wide economic moat.

Cyclicality and Regulation Are Risks Enbridge's profitability is not directly tied to commodity prices, as pipeline transportation costs are not tied to the price of natural gas and crude oil. However, the cyclical supply and demand nature of commodities and related pricing can have an indirect impact on the business as shippers may choose to accelerate or delay certain projects. This can affect the timing for the demand of transportation services and/or new gas pipeline infrastructure.

In addition, regulated assets are subject to economic regulation risk in which regulators or other government entities may change or reject proposed or existing projects, including permits and regulatory approvals for new projects. The proposed Northern Gateway crude pipeline’s approval was overturned by a federal court, affecting Enbridge’s ability to develop new major crude pipeline projects.

Enbridge’s total debt stands at CAD 66 billion. The company’s current cash balance is CAD 745 million. At the end of the most recent reporting period, net debt/trailing EBITDA was 6.6 times. The balance sheet has supported elevated leverage levels over the past three years, driven by increased growth capital spending coupled with the Spectra Energy acquisition. Elevated leverage levels don’t appear to be alarming as we expect the company to generate significant cash flow to offset high spending levels. We believe net debt/trailing EBITDA reached its peak and will gradually return to a more comfortable level below 5 times by the end of 2019. The company also intends to increase its annual dividend at 10% over the next three years. We expect the balance sheet will be able to support dividend growth with the average distributable cash coverage decreasing from 3 times to 2.4 times during the forecast period.