TC Energy Is Getting Ready for LNG Canada's Startup

Strategist

Stephen Ellis

TC Energy faces many of the same challenges as Canadian pipeline peer Enbridge but also offers important contrasts. Both firms offer a 5%-7% growth profile and a utilitylike 95%-98% of earnings that are highly regulated or contracted, with several years of project backlog, despite Enbridge largely focusing on oil assets, while TC’s focus is natural gas. However, we also anticipate that any major new pipeline project for either firm will face substantial stakeholder challenges from a legal, regulatory, or community perspective, raising the risks and costs. We see this in the rather painful Coastal GasLink project for TC Energy, where capital costs have soared. 

The most critical differences between Enbridge and TC Energy arise from their approaches to energy transition. Canadian carbon emissions taxes are expected to increase to CAD 170 a ton by 2030, meaning it is critical that TC Energy, with its natural gas exposure, follow Enbridge’s approach to rapidly reduce its carbon emission profile and continue to pursue projects like the Alberta Carbon Grid, which will be able to transport more than 20 million tons of carbon dioxide. These taxes potentially increase costs for Canadian pipes compared with US pipes but also make hydrogen a viable alternative to gas-powered electricity generation by 2030 in Canada, presenting an emerging threat. TC Energy recently introduced targets to reduce its Scope 1 and 2 intensity by 30% by 2030 and reach net zero by 2050, which is a start. 

While we think the renewables business lacks an economic moat today, we think it is an important area of investment for TC Energy that it needs to pursue. The renewables investments can compete for capital across the rest of the portfolio, generating reasonable returns on capital, allowing the overall enterprise to adapt to the markets as they evolve. As a result, we expect TC Energy's Bruce Power business to be a critical area of investment going forward. The spinoff of the liquids business (South Bow) in the latter stages of 2024 can facilicate a capital reallocation effort across TC Energy's businesses in a positive fashion, in our view.

Business Strategy & Outlook

We award TC Energy a narrow moat rating based on efficient scale. The combination of top-tier asset and contract quality, regulatory protection on existing pipelines, attractive near- and long-term pipeline projects, and a vast, diverse pipeline network allows TC Energy to generate durable excess returns on invested capital. About 75% of TC Energy’s EBITDA is from natural gas pipelines across the US, Canada, and Mexico. The remainder of the business is mainly liquids pipelines (18% of EBITDA) and power and storage (7%). The company generates annual ROICs on new projects of 7%-10%, well ahead of its cost of capital. 

Despite the high quality of TC Energy’s operations, our moat rating is narrow instead of wide because of concerns regarding the durability of its return on invested capital over 10 years or more. TC Energy isn’t as exposed to the high carbon intensity of oil sands production as peers. Similarly, with the end of the Keystone XL, TC Energy’s remaining portfolio of projects is more low-risk and low-profile in terms of potential pushback from regulatory, legal, and community stakeholders. 

Instead, we consider the development of renewable hydrogen as a replacement for gas-powered electricity generation a key threat, as both US and European governments are engaging in a significant regulatory push toward making hydrogen viable as a better alternative to gas power generation. Canadian carbon taxes are projected to reach CAD 170 a ton by 2030, as hydrogen costs are expected to decline to about CAD 1 per kilogram over the same time frame. With per ton carbon costs this high, hydrogen can easily be considered a viable alternative compared with many developed countries where carbon taxes are materially lower, reducing the hydrogen threat. Thus, TC Energy is under more pressure than most natural gas firms to pivot accordingly to protect its business. 

TC Energy's initial targets of a 30% reduction in Scope 1 and 2 intensity by 2030 and net zero by 2050 is a start, but the company needs to do more, given Canada's carbon position. Canada is shifting toward a carbon tax of CAD 170 a ton by 2030 from CAD 40 in 2021. The impact is more material for oil sands projects, which are very carbon-intensive, versus natural gas efforts. As a result, TC Energy is not exposed to the same level of supply/producer risk as peers, but it will still need to explore ways to decarbonize, given the high taxes and emerging threat from hydrogen.

Midstream moats are primarily earned via an efficient scale moat source. Efficient scale refers to situations where companies are effectively serving a very limited market size, and potential competitors have little incentive to enter the market because by doing so, they would lower the industry’s returns to below the cost of capital. While the midstream industry is massive, individual companies connect a limited number of markets to one another. Therefore, the underlying routes they serve can each be considered individual, localized markets to which efficient scale applies. Even though low-cost shale oil and gas production in North America has grown rapidly, we've seen little evidence of speculative capacity additions with the majority of a pipeline’s takeaway capacity being contracted before starting construction, ensuring that new capacity is added in an efficient manner.

Midstream markets exhibit several of the characteristics we look for in efficient scale markets. Demand for oil and gas products is growing slowly and should peak within the next decade or two, discouraging potential new entrants. Incremental demand can be met by incumbent companies at a very low cost, typically via compression, twinning a pipeline, or other means, making it difficult for new entrants to see a profitable investment opportunity. Demand is also fairly inelastic for oil and gas, meaning potential new entrants can’t simply undercut existing operators on price to gain market entry. There are also significant barriers to entry in terms of multi-billion-dollar investments to build new pipelines and related investments as well as satisfying regulatory and other stakeholder concerns, which have only increased in recent years. Finally, exiting the market is extremely difficult, as assets can operate for decades safely with minimal maintenance investment, and repurposing older pipelines that may have low utilization for a higher and better use is a key skill set of good midstream management teams.

New pipelines are typically constructed to allow shippers or producers to take advantage of large price differentials (basis differentials) between two market hubs because supply and demand is out of balance in both markets. Pipeline operators will enter into long-term contracts with shippers to recover the project’s construction and development costs as well as a return on capital, in exchange for a reasonable tariff that allows a shipper to capture a profitable differential, and capacity will be added until it is no longer profitable to do so. 

Pipelines are approved by regulators only when there is an economic need, and pipeline development takes years. Regulatory oversight is provided by the Federal Energy Regulatory Commission and at the state and local levels, and new pipelines under consideration have to contend with onerous environmental and other permitting issues. 

A network of pipelines serving multiple end markets and supplied by multiple regions is typically more valuable than a scattered collection of assets. A pipeline network allows the midstream firm to optimize the flow of hydrocarbons across the system and capture geographic differentials, use storage facilities to capture price differentials over time, and direct more hydrocarbons through its system via storage and gathering and processing assets, ensuring security of flows and higher fees. 

The major consideration for assessing evidence of a moat for a midstream firm is asset quality, where we consider the firm's competitive strengths and assets within the efficient scale regional markets it serves. Asset quality is evaluated based on the location of the individual assets, the type of asset (for example, pipeline versus gathering and processing), the cost-competitiveness of the basins the assets serve, capital intensity, and the overall quality of the network. Basin cost-competitiveness is important as pipelines are likely to remain relevant longer if connected to a low-cost hydrocarbon supply. Further, some of the highest-quality midstream firms have a dense network of assets that connect to key refineries, basins, and market hubs and are a reliable transportation provider for shippers. This connectivity encourages shippers to use the pipelines but also protects the midstream entity. The asset integration prevents another third party from extracting rents by owning an asset that is part of the route to the most profitable market.

TC Energy’s assets are some of the highest-quality assets we cover. The crown jewels of its portfolio are the NGTL and Mainline natural gas pipelines and the Keystone crude pipeline. The natural gas pipelines transport natural gas from the Western Canadian Sedimentary Basin into the oil sands and the US. Canada has limited takeaway capacity. The NGTL and Mainline systems operate 75% of the takeaway capacity; the industry would crumble without the infrastructure. The scale of TC Energy’s operations is vast, as it deals with 100,000 landowners, 200 Indigenous communities, 35 US states, seven Canadian provinces, and 12 Mexican states.

The Keystone is the second-largest crude pipe and is imperative to the Canadian crude industry. It delivers crude to the two principal US markets: the Gulf Coast and the Midwest. With crude supply growing in western Canada, the Keystone is needed now more than ever. In addition to these premium assets, TC Energy operates US natural gas pipelines in the fast-growing Marcellus and Utica regions of the US and Mexican pipelines, which bring much-needed gas to Mexico.

Contract quality is primarily assessed by term, with long-term contracts (10-plus years) being preferred with take-or-pay provisions. Contract quality does not directly support the efficient scale moat source, but it more directly speaks to the durability of excess returns. Entities that are primarily oriented around pipelines are the strongest positioned, as they obtain the longest terms. Long-term contracts for pipelines tend to be made up mostly of capacity reservation fees and a more modest transportation fee. Shippers must pay the reservation charges in any scenario, ensuring rents for the pipelines. The smaller transportation fees are only paid based on actual volumes shipped. Less well-positioned firms typically contain a large component of gathering and processing, storage, fractionation, or other business areas, where it is harder to argue that advantages will persist over the long run, and contract terms tend to be only a few years, reflecting the reduced barriers to entry compared with pipelines.

TC Energy’s assets also possess solid contract quality. Existing NGTL and Mainline pipelines are fully contracted with take-or-pay contracts that have 10-year average terms. Its gas pipelines generally operate under highly conservative and low-risk contracting structures, using cost of service in Canada, and FERC indexing in the United States. Each of the projects in Mexico is underpinned by 25-year take-or-pay agreements with Mexican state-owned agencies, ensuring that project and capital costs and an attractive return are recovered. The strong contracts extend through the liquids business as well, as the Keystone is fully contracted under a 20-year contract, and the other liquids pipe serve US refineries with a complex slate that values Canadian heavy crude. Finally, its power business (Bruce Power) operates with 30-plus-year contracts with Ontario.

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.

Narrow

Economic Moat

TC Energy

TC Energy Corporation engages in the provision of energy infrastructure services. It operates through the following business segments: Canadian Natural Gas Pipelines, U.S. Natural Gas Pipelines, Mexico Natural Gas Pipelines, Liquids Pipelines, Power and Storage, and Corporate. The Canadian Natural Gas Pipelines segment consists of regulated natural gas pipelines. The U.S. Natural Gas Pipelines segment manages the regulated natural gas pipelines, regulated natural gas storage facilities, midstream, and other assets. The Mexico Natural Gas Pipelines invests on regulated natural gas pipelines in Mexico. The Liquids Pipelines handles investments on crude oil pipeline systems. The Power and Storage segment consists of power generation plants and non-regulated natural gas storage facilities. The company was founded in 1951 and is headquartered in Calgary, Canada.

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TC Energy Corp. engages in the provision of energy infrastructure services. It operates through the following business segments: Canadian Natural Gas Pipelines, U.S. Natural Gas Pipelines, Mexico Natural Gas Pipelines, Liquids Pipelines, Power and Energy Solutions, and Corporate. The Canadian Natural Gas Pipelines segment refers to regulated natural gas pipelines. The U.S. Natural Gas Pipelines segment manages the regulated natural gas pipelines, regulated natural gas storage facilities, midstream, and other assets. The Mexico Natural Gas Pipelines invests on regulated natural gas pipelines in Mexico. The Liquids Pipelines handles investments in crude oil pipeline systems. The Power and Energy Solutions segment include power generation plants and non-regulated natural gas storage facilities. The company was founded in 1951 and is headquartered in Calgary, Canada.

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