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New Permit Moves Keystone XL Forward

Our fair value estimates for TransCanada and Enbridge are unchanged.

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Enbridge Inc
Enbridge Inc
TC Energy Corp
TC Energy Corp

President Donald Trump has rescinded his initial presidential permit for the Keystone XL pipeline and issued a new one for the project. The now outdated permit was based on a 2014 environmental impact study performed by President Barack Obama’s administration. In November 2018, a Montana judge ruled that the study was incomplete and halted construction on the project. The new permit, issued by Trump himself, does not require an environmental impact study and aims to undercut the legal proceedings that are holding up the project. We believe that TransCanada TRP can now proceed with the work necessary to begin construction once all permits are received. Accordingly, we think there is still time for construction to begin in the first half of 2019, and we still expect the Keystone XL to be placed into service by the end of 2021. Because of this, we are maintaining our $53 (CAD 70) fair value estimate and narrow moat rating for TransCanada.

While the news is welcomed by TransCanada, the market does not appear to see it as a positive for Enbridge ENB. With the Keystone XL fully contracted at 90% of its capacity, it represents a risk to Enbridge’s Mainline utilization levels. However, we think that investors are mistakenly worried about underutilization of the Mainline while competing pipelines are placed into service. Even if the Keystone XL and Trans Mountain Expansion are placed into service as we forecast, we expect only minor underutilization of the Mainline until Canadian crude supply ramps up to our forecast levels. We expect all the major pipeline expansions to be operating near full capacity within the next decade. Accordingly, we are maintaining our $47 (CAD 62) fair value estimate and wide moat rating for Enbridge.

We Still See Upside in TransCanada TransCanada's stock has been on a tear in 2019, increasing 20% year to date while the U.S. and Canadian markets have increased only 12%. Despite the appreciation, we still see more than 15% upside. With Canadian pipeline expansion expected to add 1.8 million barrels a day of new capacity in the near term, there is some uncertainty regarding the utilization of the legacy Keystone system. But we are confident that the Keystone system will be fully utilized in the long term, with only a few quarters of minor underutilization. TransCanada secured commitments for 90% of the Keystone XL capacity but will move 200 thousand barrels a day of commitments from the legacy Keystone system. However, that leaves more open spot capacity on the legacy system that serves the Midwest market. Eventually, the entire pipeline system will operate near full targeted capacity when Canada ramps its supply to our forecast levels and maximize returns on the project.

We think the market also continues to overlook the positive impact that the CAD 47 billion growth portfolio will have on cash flows and the balance sheet. We think investors have placed too much emphasis on less important outside factors, such as the widening of the heavy oil discount, the Federal Energy Regulatory Commission’s proposed tax regulations, and rising interest rates. Once the Keystone XL is placed into service, we expect that coupled with various natural gas growth projects will generate CAD 3.5 billion in incremental EBITDA, which will support dividend growth and improve the balance sheet.

TransCanada’s current annual dividend stands at CAD 3 per share. While this lags peers, it’s still attractive at a 5% yield and offers superior growth to Enbridge’s dividend. We expect TransCanada to increase its dividend at 9% annually over the next five years while maintaining a comfortable coverage ratio that approaches 1.7 times and improving the balance sheet.

Enbridge One of Our Top Picks Despite the Mainline underutilization risk, Enbridge remains one of our top picks in the energy sector. We see more than 25% upside in the stock paired with a 6% (and growing) dividend yield. We think investors are also overlooking Enbridge's big picture and are too narrowly focused on the company as a dividend stock. Because of this, we think they are not focused enough on cash flows from the growth portfolio. Enbridge sports CAD 18 billion of near-term commercially secured capital projects in its growth portfolio, highlighted by the Line 3 replacement project. Once placed into service, we expect the Line 3 replacement project coupled with various natural gas growth projects to generate almost CAD 3 billion of incremental EBITDA, supporting dividend growth.

Enbridge’s Line 3 replacement project would restore Line 3 to its initial capacity of 760 thousand barrels per day, adding 370 thousand barrels a day of new pipeline capacity. Similar to other mainline routes, the Line 3 replacement will be a common-carrier pipeline. The pipeline is expected to originate in Hardisty, Alberta, and connect to the United States in Minnesota, where it will connect to other U.S. pipelines. It will provide additional access to refineries in eastern Canada; Cushing, Oklahoma; the U.S. Midwest; and the U.S. Gulf Coast at an expected cost of $7.5 billion. Shipments on the expanded Line 3 can displace feedstock in eastern Canada, but most important, they can capitalize on the heavy oil refining capacity in the U.S. Gulf Coast while ensuring stability of crude receipts for Minnesota refineries. Construction has already begun on the Canadian portion of the pipeline expansion, while construction on the Minnesota portion is not expected to begin until early 2020 after the announcement of the revised timeline.

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About the Author

Joe Gemino

Senior Equity Analyst
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Joe Gemino, CPA, is a senior equity analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.. He covers Canadian oil and gas companies.

Before joining Morningstar in 2015, Gemino held equity analyst roles for Goldman Sachs and Gate City Capital Management. Before business school, he was a technical accountant for Citigroup and Northern Trust.

Gemino holds a bachelor’s degree and a master’s degree in accountancy from the University of Notre Dame along with a master’s degree in business administration from the University of Chicago Booth School of Business. He holds the Certified Public Accountant designation.

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