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Pipelines Look Promising

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Gordon Pape

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Contributing editor Tom Slee joins us this week with a look at why Canada's pipeline industry offers several attractive opportunities for investors. Tom managed millions of dollars in pension money during his career and is an expert on taxation as well. Here is his report.

Tom Slee writes:

We may finally be seeing some light at the end of the tunnel. According to The Economist, "A virus is spreading through financial markets. Investors have been struck by a bout of optimism".

Certainly the overall sentiment is changing. After five very lean years there are clear signs of improved momentum in the global economy. Forecasters are more optimistic. The 2008 financial crisis no longer casts a deep shadow and confidence is growing. Of course we have had false dawns before. This time, though, the recovery seems to have traction as we head into 2014.

There are several encouraging signs. First and foremost, all of the developed economies are enjoying growth. We need this broad-based international strength in order to sustain the improvement. Certainly the euro area has problems but even there the numbers are looking better. Second quarter European GDP expanded after six quarters of decline and there are no new emergencies. Keep in mind that this is the grouping where for years countries took turns at tottering on the brink of financial collapse. Elsewhere, China has slowed but is still growing at 7.5%, an astonishing rate.

Another big plus is the move towards market-based U.S. long-term interest rates. Despite all of the chaos caused by the Fed's mixed signals, North American bond yields are now much more realistic. For years these were unsustainably low and everybody knew that a painful adjustment was coming. There are dire warnings about a further upward surge but that is unlikely. A lot of analysts believe that our fixed-income markets are now essentially at fair value, a healthy situation. America's private economy is the world's biggest net creditor and capital allocator. International business will welcome realistic interest rates.

There is also the perception that private sector fiscal austerity is starting to ease. Surveys such as the U.S. purchasing managers' reports show unexpectedly strong increases. Companies seem to have tuned out the ongoing problems in Washington and are spending more. Business and household balance sheets are in good shape.

I am not suggesting that it's onward and upward from now on. There are bound to be setbacks. The recovery is still fragile. Nevertheless, there are clear indications that the leading economies are on a firmer footing. As a matter of fact, the Canadian stock market, almost unnoticed, is already starting to reflect the improved fundamentals. Some subtle changes have been taking place.

As BMO's recent Fourth Quarter Viewpoint pointed out, we are no longer dealing with a macro market. In other words, stocks no longer move in tidal waves as people respond to breaking news. To put it more bluntly, there is less of the herd instinct. Professional investors are at a serious disadvantage in macro markets. There is little point in identifying the most promising industries and carefully selecting stocks if everything is going to be swept away by news of another financial disaster. As one analyst pointed out, accurately forecasting earnings is not much use if every so often the market believes that the world is coming to an end. Here at IWB we have factored broad fluctuations into our recommendations but they have made stock selections difficult.

According to the S&P/TSX and S&P 500 Average Stock Correlation Indexes, knee jerk reaction has declined significantly. Sectors are reacting differently, if at all, to dramatic news. Fundamental growth prospects are driving industries such as manufacturing and transportation. I think that this reflects the fact that money managers are more confident and thinking longer term. The shift away from macro to micro forces also gives us an opportunity to improve our investment performance by applying traditional research techniques.

Pipelines look promising

The best way to start is by identifying the industries with the most potential and one that I particularly like at the moment is Canadian pipelines. Some other sectors are more exciting but these companies, with their long-term lucrative contracts and expansion plans, offer a combination of income and capital gains. The projected total returns are attractive.

In addition, despite the growing confidence, I am not sure that we are totally out of the economic woods yet. Pipelines give us a defensive straddle in case the economy tanks. If it does, the new Fed chairperson will step in and drive interest rates lower. The pipelines' handsome yields are then going to give the stocks a lift. Keep in mind that many of these companies are still increasing their distributions.

As to the industry itself, with all the high profile controversies over projects such as TransCanada's Keystone XL it's very easy to lose sight of the total picture. The fact is that Canada has a serious pipeline pinch. Our energy production continues to surge but we lack the facilities to transport it. And the problem is going to get worse. Canadian crude oil output is forecast to jump to 6.7 million barrels daily by 2030, up from 3.2 million barrels in 2012. Oil sands capital expenditures are running at $23 billion per annum and producers are already worried about rationing because of insufficient pipeline capacity. Greg Stingham, a vice president with the Canadian Association of Petroleum Producers, has pointed out that "We need more transportation capacity to send our output to market - it's very tight". Congested pipelines are the main factor in driving down Canadian heavy crude prices to deep discount levels.

All of this bodes well for the pipeline companies and the outlook is even better when we shift to a North American overview. This is an important perspective because U.S. refineries have the capacity to soak up millions of barrels a day of Canadian production but here again there is a pipeline shortage. As a result, Standard & Poor's has a positive rating on its oil and gas storage and transportation sub-industry. Natural gas and liquid fuel consumption is increasing and offers growth opportunities for the U.S. pipelines. A recent study by the Natural Gas Association of America concluded that the U.S. and Canada will require an annual average midstream investment of US$10 billion per annum over the next 25 years to accommodate growing oil and gas infrastructure needs.

That having been said, the industry has its problems. As we all know, pipelines have been getting a lot of bad press recently. BP's Deepwater Horizon spill in the Gulf of Mexico was a terrible disaster and soured a lot of people on the entire industry. As a result, there is increasing opposition to projects such as Kinder Morgan's Trans Mountain proposal and Enbridge's Northern Gateway. Future expansion is going to be slower and costly.

Nevertheless, it's apparent that development of the Bakken formation, which straddles the U.S./Canadian border, is flooding the oil market. Production from this new source is outstripping its pipeline capacity. We now have wide crude price differentials across the continent. There is a growing demand for more capacity to move this output to market.

Inter Pipeline

Amongst the companies, Inter Pipeline (TSX: IPL, OTC: IPPLF) continues to rack up impressive earnings. Since inception in 1997, IPL has become one of the largest energy infrastructure players in Canada and it continues to expand rapidly. A $2.6 billion Polaris/Cold Lake project is expected to come on stream in early 2015. We should see earnings of about $1.25 a share in 2014 with an increase to the $1.50 range in 2015. The stock is a recommendation of our companion Income Investor newsletter.

My only reservation is that because of the recent stock market surge, the stock at $25.51 and paying a $1.29 to yield 5.06% is relatively expensive for shorter term investors. With a 12-month target of $27, the total return potential is about 11%. Longer term, however, this is an excellent investment and I would be a buyer on any weakness.

Keyera Corp.

Keyera Corp. (TSX: KEY, OTC: KEYUF) is also an Income Investor pick. This is another company that I like but here again it's not cheap and only suitable for longer term investors. KEY is a top-flight natural gas and natural gas liquids midstream company with a market capitalization of about $4.5 billion. Recent earnings have been beating expectations and should reach $2.15 a share in 2013 with a further advance to $2.50 next year. Most encouraging as far as investors are concerned is that the company is sharing its wealth with its investors. KEY recently increased its dividend to $2.40 a year while raising capital expenditures by $140 million, a sure sign of confidence.

Trading at $59.59 and yielding 4.03% Keyera is not cheap and with a Bay Street target of $63 the stock provides a potential 9.7% total return. Longer term, though, this is an attractive investment and I shall monitor its progress.

Enbridge Inc.

My number one pipeline pick remains Enbridge (TSX. NYSE: ENB). I realize that sounds repetitious and unimaginative because we have had this stock on our Buy list since 1999 when it was recommended at $8 (split adjusted). Since then the shares have grown 560% while the dividend has increased regularly to the current $1.26. Based on original cost, that represents a 15.75% yield equal to about 22.4% from a bond in a non-registered account.

Given the track record, it's very easy to fall in love with this stock, always a bad move. However, I have resisted the temptation and taken a fresh, hard look at Enbridge. The numbers still look very good.

Enbridge operates the longest crude oil and liquids pipeline in the world. In addition, it owns Canada's largest natural gas distribution company. The key, though, is management's aggressive but carefully controlled vast long-term expansion program, funded by preferred share issues while interest rates remain low and by internally generated cash flows.

With a $35 billion growth plan in the 2013-2017 time frame, ENB has arranged the undertakings to come on stream in sequence and generate funds for succeeding projects. The net result is that Enbridge has avoided diluting the stock with a stream of common share issues and had cash to steadily increase its distributions.

Earnings this year should come in at about $1.85 a share and increase to $2.15 in 2014. Further out, we could see $2.40 a share in 2015. Dividends are expected to continue growing at more than 10% per annum.

It's an impressive outlook and because the stock was hurt by the surge in interest rates it trades at only 22 times next year's earnings and represents good value. Therefore Enbridge remains one of our portfolio cornerstones.

Action now: Enbridge is a Buy at C$45.84, US$43.76 with a $54 target. I have set a $38 revisit level.

About the author:

Gordon Pape
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 1.0/5 (1 vote)

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