A Midstream Energy Firm with an Upside Kick

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor or Morningstar's OptionInvestor.

Today, it's my great pleasure to welcome Avi Feinberg, who is an equity analyst covering midstream oil and gas companies.

Avi, thanks for coming.

Avi Feinberg: Thanks for having me, Erik.

Kobayashi-Solomon: So, Avi, I just did an option strategy, a bullish option strategy on a firm that you cover, Spectra Energy.

Feinberg: Yes.

Kobayashi-Solomon: So just wanted to ask you a little bit about this. First of all, can you just walk me through their portfolio of businesses?

Feinberg: Sure. Spectra is one of the largest diversified midstream natural gas companies. And so, their operations include gathering natural gas, processing it, then storing it and transporting it on their very large pipeline network.

Kobayashi-Solomon: Right. Now, when you say midstream, this means that they are not drilling and they are not retailing, right? They are in the middle of that stream.

Feinberg: Exactly. And Spectra also has some downstream operations, which it does at Union Gas, its Canadian Utility.

Kobayashi-Solomon: Okay.

Feinberg: And so, this business distributes the gas locally to about 1.3 million customers.

Kobayashi-Solomon: So the midstream portion is mainly in the United States. The pipelines are mainly in the United States.

<TRANSCRIPT>

Feinberg: That's right.

Kobayashi-Solomon: I know that you were telling me before that there is a regulated part and an unregulated part to Spectra's portfolio. Can you talk a little bit about those?

Feinberg: Sure. On the whole, the way I think about it is that Spectra's cash flows are about 80% fee based, and these fee-based cash flows are completely regulated. So, that includes its pipeline operations, which are about 60% of cash flows or so, and then the utility is about 20% of its cash flows.

Kobayashi-Solomon: I see. That's a Canadian utility.

Feinberg: Yes.

Kobayashi-Solomon: So a regulated entity, it's an interesting thing, right? They ask for permission to spend, let's say, $1 billion, and then they get permission to basically make $1 billion plus 25% or 12%, or something like that on it. Right?

Feinberg: Right. With the utility there is a baseline return on equity of about 8.5%, but Spectra also has incentive regulation up there in Canada, which allows them to share upside earnings above that, that it's able to earn in terms of cost savings, to share in those upside earnings.

The pipelines tend to earn even more favorable rates of return. It may be low teens returns on equity, ballpark, and those are some of those most attractive assets of Spectra as we think.

Kobayashi-Solomon: I mean it's like a toll road for natural gas, right?

Feinberg: Yep. One nice thing about the pipelines is that they are almost like little monopolies in many ways, and so competitors are not allowed to build a competing pipeline.

Kobayashi-Solomon: They have to show some really good reason why there should be two pipelines going in exactly the same direction, right?

Feinberg: Exactly.

Kobayashi-Solomon: Okay. I've got a handle on the regulated side. Let's talk a little bit about the unregulated side.

They've got a joint venture with ConocoPhillips. It's DCP Midstream. Tell me a little bit about that. I know it has to do with natural gas liquids. First of all, what is a natural gas liquid?

Feinberg: So the first part of the value chain, once the natural gas is extracted by the producer is that it needs to be processed in order to meet the long haul pipeline specifications.

So, the processing includes removing impurities like water, carbon dioxide, sulfur and others. And then, in some cases, the gas might also be rich with natural gas liquids or the NGLs that you talked about.

So, these need to be removed in order for the gas to be able to be shipped through the pipeline.

Kobayashi-Solomon: Their pipeline, by the way.

Feinberg: Right. And these natural gas liquids also have economic value of their own, which can be very significant.

Kobayashi-Solomon: One of these that I know very well from being a backyard barbeque is propane.

Feinberg: For sure. Propane is used for heating in the Northwest, or the Northeast. You also have ethane, which is probably the main natural gas liquid that's used by the petrochemical industry primarily. And then butanes are used in blending of gasoline by refiners.

Kobayashi-Solomon: Okay. So, basically this DCP Midstream, what they are doing is they are saying, we'll take out all of these impurities, we'll take out these natural gas liquids, so your natural gas will be able to ship on this pipeline.

Feinberg: Right.

Kobayashi-Solomon: I mean they are dependent on profits depending on the spread between natural gas and the natural gas liquids. Can you talk a little bit about that dynamic?

Feinberg: Sure. DCP Midstream's profits are, like you said, most impacted by, well, they are impacted by all commodity prices, but tend to be most sensitivity to the natural gas liquids prices. So, in scenarios where liquids prices are high, DCP makes all look abundant. In 2008 for, example, they contributed over $700 million of earnings to Spectra.

Kobayashi-Solomon: Very respectable.

Feinberg: Right. The flipside is that in low commodity price environments, DCP does not do as well. So 2009, for example, equity earnings to Spectra from DCP were below $300 million. And the reason being that the natural gas liquids prices were so much lower.

Kobayashi-Solomon: I see. But this is one of the things that really attracted me actually to the story is there is a floor as well, the way the contracts are written. So, basically DCP Midstream is not going to ruin Spectra. Have I got that right?

Feinberg: That's right. You can think of it as a call option on the commodity prices. And so, in a higher scenario, they'll make a lot of money, in a low scenario, they might not make very much money for Spectra, but thanks to the rest of the very stable regulated fee-based cash flows, Spectra does pretty well on the whole.

Kobayashi-Solomon: Yeah. Make sense. Let's talk a little bit about your valuation and your scenario analysis for Spectra. Where do you see a range of stock price outcomes for this?

Feinberg: Well, our fair value estimate for Spectra is $27 right now.

Kobayashi-Solomon: Okay. That's trading right now, I guess, around $22.

Feinberg: Yep.

Kobayashi-Solomon: Okay.

Feinberg: And then, $22 is actually my low case scenario in the case where I think project returns are lower, where volumes might suffer, where DCP might not contribute as much profit…

Kobayashi-Solomon: For an extended period of time, right?

Feinberg: Right. Then it might be closer to $22.

And in a more optimistic high-case scenario, we think Spectra could be worth about $33.

Kobayashi-Solomon: So we could really see some upside past that fair value estimate of yours.

Feinberg: Absolutely.

Kobayashi-Solomon: Avi, thanks a lot for coming in and explaining it.

Feinberg: My pleasure.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more option ideas based on Morningstar's fundamental research.