Recent newsflow and meetings with company management teams have confirmed our favourable stance on Canadian infrastructure stocks, and after a period of stagnation, we see significant value opportunities in this sector.
Our starting point is the very significant growth in oil and gas production which we see over the coming years in Canada, based on abundant resources and more effective and efficient methods of extraction. Demand for oil and gas for domestic consumption, from the USA and, increasingly, for overseas export, is likely to continue to grow, creating a very significant need for more midstream infrastructure to process, store and transport these commodities.
However, in recent years a number of factors have weighed on both the growth of the sector and the valuations of energy infrastructure stocks. In no particular order, these include concerns over the environmental footprint of Canadian oil production, wider permitting issues on new pipelines and infrastructure, and the funding model for much of the sector taking into account leverage and tax changes. During this period, the well-capitalised companies in the sector have continued to grow their cashflows and dividends, but valuations have not reflected this growth. As negative sentiment is challenged, and negative fundamentals are repaired, we see the opportunity not just for valuations to catch up with this underlying growth, but to begin to reflect the opportunities for these companies in the future.
Looking first at Canadian “oil sands”, many investors and lenders have taken a negative stance on investing given the high energy footprint for extraction in Western Canada. However, the industry has started to push back on this, pointing out that Environmental, Social and Governance (ESG) ratings should not solely focus on emissions, but also on factors such as safety, corruption, social engagement, the rule of law, open and democratic elections, equal rights and respect for indigenous peoples. There is little argument that, when compared to other major oil-producing states such as Saudi Arabia, Russia or Iran, Canada would score relatively well on all these other ESG factors.
The issues around permitting have negatively influenced new pipelines both in the USA and Canada. Most notably, the three planned pipeline expansions to move oil from Alberta to the West Coast of Canada (Trans Mountain Express) and to the USA (Keystone XL and Enbridge’s Line 3) have all met significant regulatory hurdles. However, after a period of uncertainty, we have begun to see real progress for these pipelines, reinforcing the potential growth for the infrastructure sector. Line 3 has been given its final approval by the Minnesota Public Utility Commission, Keystone XL is progressing through the Nebraska courts, and the Canadian federal government has taken ownership of the Trans Mountain Express project in order to ensure this pipeline to the West Coast of Canada is built. Significantly, one of the strongest voices in favour of Canada building more oil and LNG infrastructure, and expediting the permissioning process, has been the current President of OPEC, the UAE Energy Minister Suhail Al Mazrouei. He has highlighted the investment opportunity in the context of the world needing access to the incremental Canadian oil supply, and the UAE has itself invested in Canadian oil production through the Abu Dhabi National Energy Company.
In addition to oil exports, we also believe that the sector will get a very significant boost from the growth of overseas export terminals for gas and natural gas liquids, which will provide access to significant new markets in Asia from the West Coast of Canada. The Ridley Island propane export terminal constructed by AltaGas is expected to be in service by Q1 2019 and both Royal Dutch Shell and Pembina are working towards final investment decisions on LNG export terminals, with the decision on Shell’s LNG Canada project expected before the end of 2018.
The Canadian energy infrastructure stocks have also been impacted by the negative sentiment around Master Limited Partnerships (MLPs), which are tax-efficient equity vehicles set up to own pipeline assets in the USA. This negativity had a contagion effect on the Canadian stocks, and a direct impact on Enbridge and TransCanada who had used MLP vehicles to finance some of their own US assets. The tax benefits of MLP structures were thrown into doubt by the Federal Energy Regulatory Commission (FERC) in March this year, but recent clarifications have been more constructive, and in Enbridge’s case the company has offered to acquire all the minority stakes in MLP vehicles where it is the sponsor, a move which will clean up the corporate structure and also be accretive to the parent company’s cashflow.
In terms of proven oil reserves, Canada ranks number three globally, and a combination of this supply, growing demand, a more constructive permitting environment and well-funded companies could lead to significant growth in earnings, cashflows and dividends and present a compelling case for infrastructure investors over the next decade.
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