We Think the Alliance/Aux Sable Deal Makes Sense for Pembina

Strategist

Stephen Ellis

Pembina offers a fully integrated "store" to its customers, allowing it to retain full economics over the midstream value chain. Its major earlier growth opportunities across liquefied natural gas (a CAD 4 billion-CAD 5 billion net investment in Jordan Cove LNG and the related Ruby pipeline repositioning) and petrochemicals (a CAD 4.5 billion venture with Canada Kuwait Petrochemical) were essentially canceled in early 2021, leading to significant write-offs.

To restart growth, Pembina pursued an ultimately failed bid for Canadian peer Inter Pipeline and may still bid for the government-owned Trans Mountain pipeline sometime in late 2024. Combined, both efforts represent potentially over CAD 20 billion in shareholder capital. This supports our view that Pembina's management prioritizes growth via acquisitions over organic development and optimization of the existing portfolio of assets acquired over the years. This prioritization of growth—management has alluded to cash flow growth of 7%-plus annually—has hurt returns in recent years, as organic projects tend to offer the highest returns. We don't think very highly of the Pembina Gas Infrastructure JV, but the Aux Sable/Alliance deal makes sense to us. 

We think the Cedar LNG project, which is expected to achieve a final investment decision in early to mid-2024, is likely Pembina's best near-term opportunity. We will add it to our model upon a final investment decision and more clarity around eventual costs and ultimate economics for Pembina. Cedar LNG is a 3 million tons/year floating vessel that is fully contracted and part of a partnership with the Haisla Nation. Located in British Columbia, it will provide a valuable output for Canadian gas to reach overseas export markets. All relevant permits look to have been obtained, and the facility will be powered by BC Hydro, making it very attractive with its low carbon emissions profile. The remaining items left appear to be that Pembina is waiting for the outcome of a second engineering study on its design, as well as commercial discussions between LNG Canada and Coastal GasLink, which would likely provide feed gas for the effort.

Business Strategy & Outlook

Pembina's economic moat rating is none. While we think Pembina has several quality assets with long-term contracts in place, we think it has largely grown via acquisition and paid too much for the acquired assets. A material part of the justification and premium for recent deals was future potential projects, specifically high-profile petrochemicals and LNG efforts totaling about CAD 9 billion-CAD 10 billion in capital, that have since been shelved due to poor commercial potential. As a result, Pembina has returns on invested capital that are below its cost of capital, considering its bloated asset base and associated goodwill. We specifically include goodwill due to Pembina’s propensity for dealmaking. This weak ROIC profile is the case even when factoring in higher returns from in-service projects and allowing for the damping effect of an aggressive capital expenditure program where the capital has to be invested before the effort contributes to earnings.

Our confidence level in future returns is also materially affected by the nearly immediate management pivot in 2021 to a CAD 15 billion bid for Inter Pipeline at an expected 15-16 times EBITDA multiple to acquire exposure to petrochemicals projects, after it had to defer its own efforts earlier that year; the bid ultimately failed. It has also formed a 50/50 partnership called Chinook Pathways with an Indigenous group to attempt to purchase the government-owned Trans Mountain pipeline. If successful, we would expect a purchase price of around CAD 15 billion toward the end of 2024, given expected annual cash flows of around CAD 1.5 billion, though the potential range of valuations here is substantial. The Canadian government paid CAD 4.5 billion for the pipeline in 2018, and construction costs have soared to over CAD 30 billion, so a CAD 15 billion price tag would imply a loss for the government. 

Prior deals include the 2019 acquisition of Kinder Morgan Canada and Cochin pipeline for CAD 4.35 billion at an expected EBITDA multiple of 11-12 times and the 2017 CAD 9.7 billion acquisition of Veresen at an expected EBITDA multiple of 12-13 times. Compounding the error is that these deals were done in an environment where midstream valuation multiples were in general decline. We would reconsider our no-moat rating if Pembina would commit to a more thoughtful and valuation-sensitive approach to acquisitions and commit to optimizing its current asset portfolio in a way that would materially improve returns on capital.

The Veresen deal is particularly problematic, as a number of the assets acquired are either declining or expected to decline, or were effectively canceled. The Ruby pipeline (owned equally by Kinder Morgan and Pembina) moves gas from the Rockies to Pacific Northwest and Canadian markets and contributed an estimated CAD 200 million in 2020, but this is expected to decline by as much as 75% as initial contracts expire and reset to market rates. The Ruby pipeline actually filed for bankruptcy in March 2022. The Alliance gas pipeline, which contributed an estimated CAD 250 million in 2020 EBITDA, has also seen earnings fall since the deal, given the lower market rates on its corridor from British Columbia to Chicago. Finally, the Jordan Cove LNG project faced permitting issues and environmental opposition, and the once potential CAD 4 billion-CAD 5 billion net investment for Pembina was deferred indefinitely in early 2021. 

Beyond the growth-oriented mindset, Pembina can do more on the environmental, social, and governance front. Canada is expected to charge CAD 170 per ton of carbon emissions by 2030, far higher than most developed countries presently, meaning the threat to Canadian energy firms is more material and immediate than most. Some of Pembina’s oil assets serve oil sands projects, which are some of the highest-carbon-emission-intensity basins that we cover, while its gas assets would see material threats from renewable hydrogen displacing gas-powered electricity generation. Thus, in some ways, the potential Trans Mountain deal is committing Pembina to spend billions on more threatened assets, versus expanding its opportunity set across carbon capture projects such as the recent Alberta Carbon Grid.

Looking beyond the high prices paid, Pembina’s asset portfolio is generally high quality. The two primary criteria we use to assess midstream entities are asset and contract quality. The portfolio is fairly evenly divided among oil, gas, and natural gas liquids, offering a wider and more diverse level of investment options. Contract quality is straightforward about 70% of earnings are take-or-pay or regulated under long-term (usually decade-plus) contracts, another 15%-20% fee for service, with the remainder exposed to commodity pricing (for example, marketing). About 60% of the business is oil, gas, and natural gas liquids pipelines, 30% facilities (gas, condensate, and natural gas liquids services), and the remainder is marketing. 

We estimate Pembina’s most valuable asset is the Peace pipeline system, which generates around one fourth of the company's EBITDA. This system moves oil, natural gas liquids, and condensate to Edmonton and Fort Saskatchewan, Alberta, from northwestern Alberta. This system is primarily attractive for the near-continuous investment opportunities it offers, as Pembina’s phase one investment in Peace begin in 2013. Pembina initially deferred phases seven and nine with COVID-19 but decided to proceed with these projects in 2021 and phase eight in 2022. 

On the negative side, we also estimate about 50% of Pembina’s EBITDA is related to assets that directly serve oil sands and heavy oil projects as well as handle gas. While we expect the earnings stream to be stable in the near term, we anticipate more challenges going forward as oil sands projects are some of the highest-carbon-intensity basins we cover. With Canada’s per ton carbon emissions tax increasing to CAD 170 by 2030, we expect more contract disputes between producers and pipelines over any incremental costs, particularly if the basin’s economics are not competitive. We also flag concerns with the U.S. refinery slate, which has historically been quite complex and preferred heavy Canadian crude, as renewable diesel volumes are increasingly rapidly and threaten to displace Canadian heavy. Even if Pembina is successful in passing along its costs to producers and Canadian consumers, the higher tariffs may make the pipes less competitive against U.S. pipes, as the country currently does not have any plans to institute a carbon tax. Finally, for the gas assets in particular, the high per ton carbon emissions tax allows hydrogen to become a viable threat to gas-powered electricity generation by 2030.

Material ESG exposures create additional risk for midstream investors. In this industry, the most significant exposures are greenhouse gas emissions (from upstream extraction, midstream operations, and downstream consumption), and other emissions, effluents, pipeline spills, and opposition and protests. In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as production limits, and removal of existing infrastructure. 

Midstream emissions are relatively low in the lifecycle of oil and gas, and midstream firms have relatively lower risk than upstream and downstream firms from carbon taxes. Canadian firms already pay carbon taxes on their carbon emissions, most of which are generally passed to their shippers and other customers. Spills represent a major threat and have created great resistance from environmentalists, Indigenous groups, and other climate-conscious groups. Examples of the opposition are seen in President Joe Biden’s revocation of the Keystone XL presidential permit and legal challenges facing the Dakota Access pipeline system.

Pembina has committed to a "30 by 30" program for its greenhouse gas emissions: It plans to reduce its intensity levels by 30% from 2019 levels by 2030. However, it has yet to commit to a net zero by 2050 target like Canadian peers Enbridge and TC Energy have already done.

None

Economic Moat

Pembina Pipeline

Pembina Pipeline Corp. engages in the provision of transportation and midstream services. It operates through the following segments: Pipelines, Facilities, Marketing and New Ventures, and Corporate. The Pipelines segment includes conventional, oil sands and transmission pipeline systems, crude oil storage and terminalling business and related infrastructure. The Facilities segment consists of processing and fractionation facilities and related infrastructure that delivers the firm's customers with natural gas and NGL services. The Marketing and New Ventures segment undertakes value-added commodity marketing activities, including buying and selling products and optimizing storage opportunities. The company was founded on September 29, 1954 and is headquartered in Calgary, Canada.

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All financial figures are approximate and in Canadian dollars unless otherwise noted. This news release refers to adjusted earnings before interest, taxes, depreciation and amortization ("adjusted EBITDA"), and adjusted cash flow from operating activities ("adjusted cash flow"), which are financial measures that are not defined by Generally Accepted Accounting Principles ("GAAP").

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