Canada is a fertile investment ground for global listed infrastructure (GLI) companies, accounting for approximately 10% of our investment universe by market capitalisation. It is represented by both user-pay assets – most notably rail, oil & gas transportation and ports – and more defensive sectors such as utilities and renewables. Canadian infrastructure companies have also been successful in expanding into other markets, most notably into the US and Mexico (due to geography) and parts of Europe, typically France (due to language).
A review of Canadian GLI stocks encompasses much more than just local investment themes. Significantly, Canada and the US are enjoying an energy renaissance at present with record exports of oil and gas. However, in the case of Canada, the optimal infrastructure solution for that export boom, being new pipelines, has been repeatedly delayed due to political interference. As a result, rail/storage has been playing an increasing role in the transportation of oil and gas.
Mark Jones, Senior Investment Analyst at 4D, recently travelled to Canada to meet with management teams from oil & gas infrastructure, regulated utilities, renewables and transport. The trip highlighted how Canadian infrastructure is capitalising on a once-in-a-generation oil and gas production boom and the impact political risk can have on investment outcomes. High level investment meetings suggest a bias in proposed portfolio positioning to natural gas and NGL infrastructure over oil.
Canadian oil & gas exports need for infrastructure
In 2018, the US continued its energy renaissance to become the world’s largest producer of crude oil, with production rising to 11 million barrels per day (up from 9.4 million barrels per day in 2017), eclipsing its previous production high reached in 1970. Combined with Canada, which produced 4.6 million barrels per day (up from 4.2 million barrels per day in 2017), the US and Canada make up almost 20% of global oil production, with both continuing to grow as evidenced by year-on-year growth rates.
The majority of the growth in new oil production has been from shale oil, which through hydraulic fracking can release both oil and dry or wet gas. Hydraulic fracturing involves injecting water, sand and chemicals under high pressure into a bedrock formation via the well. Wet gas will include a number of natural gas liquids (NGLs), most notably propane and ethane. Combined production increases in oil, gas and NGLs is a significant demand driver for new infrastructure, leading to a need for gas processing and/or fractionation facilities; pipelines and/or rail; storage tanks; and export terminals.
All of the above share common characteristics of infrastructure assets, namely:
- one-to-many relationships whereby high capital costs are recovered across many counterparties;
- once established, there are significant barriers to entry for replication and / or competition; and
- pricing stability, either through contracts or regulation.
There is a virtuous cycle between oil and gas production and infrastructure. By definition, the higher the utilisation of shared infrastructure, the lower the unit cost should be for oil and gas producers. This makes US and Canada oil and gas more competitive, both locally and increasingly in the global market.
It is the ability to export to global markets that differentiates the US and Canada and, perversely, provides the most interesting investment opportunity, with Canada currently disadvantaged relative to the US. Like the US, Canada now produces oil, gas and NGLs well in excess of local demand – but unlike the US, due to inadequate infrastructure Canada has limited access to global markets, leading to oil and gas producers receiving lower prices.
This is both a challenge and an opportunity for Canadian infrastructure companies, and on this trip was increasingly the focus of investor meetings. Today, Canada mainly exports oil, gas and NGLs to the US through pipelines.
Challenge of oil transport and pipelines
Canadian oil is mainly exported through three pipelines (not expected to change) - Mainline / Line 3, Keystone and Trans Mountain. Expansions to these three pipelines have all faced significant delays, causing oversupply – which will only worsen over time as production continues to grow.
Twelve months ago all three pipelines were held by listed infrastructure companies, with Trans Mountain subsequently being nationalised by the Canadian government in response to a lack of confidence in its owners’ (Kinder Morgan) ability to receive political and legal support, and to successfully build it.
Indeed, this is the problem faced by all the major oil pipelines, with Enbridge’s Mainline / Line 3 and Keystone XL being delayed not due to economics, but rather political and legal resistance both in Canada and the US. As Enbridge management highlighted in one of our meetings: ‘it is challenging being in the pipeline business at the best of times’.
Enbridge’s Mainline / Line 3 was the most likely to be built, having reached FID ahead of both Trans Mountain and Keystone XL, but has been stalled due to delays in permitting from the Minnesota government, and then further delayed through the courts. A successful challenge to its Environment Impact Statement led to a revision, such that it may not be built until 2022. This is in contrast to Enbridge’s initial estimate of having it built late 2017 (+5 years post initial estimate)!
On an economic basis, pipelines deliver the lowest cost and safest transport of oil, implying any other mode of transport will be less economic and reduce the competitiveness of Canadian oil. Inadequate pipeline capacity therefore creates perverse winners, with alternative transport modes – in particular rail – benefiting in the short-run, and arguably remains how to position for this ‘market failure’.
Opportunity for rail
Canada’s freight rail network is arguably one of the best in the world, nearly unrivalled in breadth and scale apart from the US. It is defined as infrastructure because of the barriers to entry, pricing power, and it being an essential need for parts of the Canadian economy (e.g. commodities such as grain). Crude oil can be transported by rail (termed ‘crude by rail’), albeit at a higher cost (roughly double) than if transported in pipelines. The challenge with crude by rail is being able to receive an adequate return on capital. Duration of contract tends to be short, with volumes being transported only while pipeline capacity is not available. This makes crude by rail both highly accretive for rail companies, but also risky due to volume risk and stranding of locomotive and rolling stock assets. Acknowledging this, Canadian rail companies have enforced ‘take-or- pay’ contracts with all crude by rail volumes. Take-or-pay contracts allow for a minimum return on capital regardless of whether actual volumes are transported or not.
Reflecting pipeline constraints, Canadian crude by rail peaked in December 2018 when it transported over 350 thousand barrels of crude per day. It is likely this will be surpassed, with potential for a multi-year boom in crude by rail haulage. Crude by rail is highly earnings accretive for rail companies because hauls are generally long, typically from Alberta, Canada to the Gulf Coast, Texas (~4,000 kilometres). This is further reinforced by government intervention to solve this market failure. In December 2018, the Alberta government signed contracts to haul a minimum of 120 thousand barrels of oil per day over three years starting July 2019. To this end, crude by rail could export above 500 thousand barrels of oil per day in the next 6-18 months.
The other ancillary winner is oil storage through tanks or terminal assets. Oil storage tanks are highly contracted assets, typically under long-term fixed fee arrangements with growth predicated on new oil production. Demand for oil storage tanks also increases when flexibility is required on transport.
Flexibility is required when an oil producer batches its oil to a number of different end points via a number of different modes. Today, this is the case for a Canadian oil producer whereby they will batch oil to be transported on a number of pipelines as well as crude by rail. Therefore, oil storage with adjacent connections to pipelines and a crude by rail loading facility has increasing strategic value, as evidenced by growth in oil storage tanks at hubs in Hardisty, Alberta.
A crude by rail loading terminal allows access to many destinations throughout Canada and the US. Rail shipping costs from Hardisty to Cushing, Oklahoma or the Gulf Coast, Texas are not made public, but are estimated by reporting services at between US$12 and US$15 per barrel, with additional terminal fees at both ends. The value of crude by rail was recently highlighted by Imperial Oil, with management commenting ‘rail is increasingly competitive compared to the pipeline alternative, and is an attractive means for us to get to the mid-Western or Gulf coast markets’.
To conclude, in regard to oil transport infrastructure, in the short-run rail and storage will be beneficiaries. In the medium to long-run, we reiterate our view that all three pipelines will go ahead because:
- they are essential services required by the Canadian oil sands industry to remain competitive;
- the Federal Governments in both Canada and the US have reiterated their support for all projects; and
- the companies involved have credible environmental, social and corporate governance track records and reputation.
Natural gas and NGLs better placed
In regard to natural gas and NGLs, similar issues prevail. Just like oil, Canada’s production in natural gas continues to grow strongly as TransCanada management highlighted: ‘There is a lot of gas out there just waiting on price’. TransCanada transports over 50% of Canada’s gas production through its Nova gas transmission (NGTL) pipeline system and is the owner of the future pipeline Coastal Gas Link. Because of the oversupply (relative to Canadian local demand), Canadian natural gas tends to trade at a C$1 to C$2 discount to Henry Hub gas prices in the US. Henry Hub is a natural gas pipeline located in Louisiana that serves as the official delivery location for futures contracts on the New York Mercantile Exchange (NYMEX). Natural gas export is constrained by pipeline capacity, with production more or less matching pipeline capacity. This has been compounded by a lack of liquefied natural gas (LNG) export terminals. By comparison, over the last decade the US has reached commercial operation on a number of LNG export facilities including Cameron, Corpus Christi, Freeport and Sabine Pass, with a large number of additional facilities still to be developed.
Fortunately, Canadian infrastructure companies appear to be much more successful in ‘solving’ for oversupply in natural gas, with both additional pipeline capacity and LNG export facilities in development. This has been due to:
- less political and legal resistance to natural gas and NGL infrastructure;
- taking advantage of Canada’s west coast proximity to Asia relative to Texas, US; and
- creating new markets (for natural gas and NGLs) by going up the value chain.
All of this is leading to Canada’s infrastructure companies successfully deploying significant amounts of investment, which in turn will lead to solid earnings growth over the short to medium run.
To illustrate capital being employed to natural gas pipelines, TransCanada has reached FID (Final Investment Decision) and is building Coastal Gas Link – a 670km pipeline connecting gas from the Montney and Duvernay shale gas basins to the port, with an estimated capital cost of C$6.2bn and an in-service date of 2023. This will be the feeder pipeline for Shell’s LNG Canada, which will allow Canadian gas producers to receive Asia netback natural gas prices (at a significant premium to Canadian natural gas prices). Further, there is a high probability the pipeline will be expanded to allow for incremental trains / supply out of LNG Canada.
In NGLs, a similar dynamic is playing out with Canadian infrastructure companies building export terminals for propane and butane, namely Alta Gas and Pembina Pipeline. Combined with new petrochemical facilities in Alberta, whereby propane will be used as feedstock for higher value products such as propylene and polypropylene, the current oversupply is quickly being addressed. With Canadian infrastructure companies better ‘solving’ for oversupply in natural gas and NGLs, this leads to other opportunities – namely increased production in gas and NGLs, which in turns leads to demand for gas processing / fractionation and storage.
In conclusion, this leads to a bias in portfolio positioning towards natural gas and NGLs infrastructure over oil.
An enlightening read. It isn't often you find analysis looking at investing opportunities abroad outside of the major economies, which is unfortunate given that many of the most promising investments are to be found in the places where most investors aren't looking.