TransCanada fair value surges despite Keystone controversy

Pipeline delay may accelerate the regulatory process of Energy East, which could be viewed as bullish for TransCanada, says David McColl, equity analyst.

David McColl 24 January, 2014 | 2:00PM Ashley Redmond
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Ashley Redmond: I'm Ashley Redmond for Morningstar.ca, and today we're going to be talking about the Canadian energy sector. On the line is David McColl, and he is going to be discussing the key players involved in moving crude oil out of Canada via pipeline and how these companies are really positioning themselves given the uncertain regulatory environment for new projects.

David McColl: Great, thanks for having me Ashley.

Redmond: So, David, you recently raised your fair value of TransCanada to $53. Can you comment on this?

McColl: Yes, definitely. It really builds off your introduction about looking at the entire Canadian energy space. We did a detailed assessment of expected production from Western Canada, expected export volumes from Western Canada, and [tried to decipher] whether there were sufficient crude oil pipelines to move light, medium, and heavy crude from Western Canada out to markets; whether it's in British Columbia, Ontario, or down to the U.S. Gulf Coast.

What we concluded was that TransCanada appears to be the best positioned [company] to actually [seize] the opportunity to move crude out of the province. What we expect is [that] its Energy East Pipeline will insulate TransCanada from the ongoing political debates surrounding Keystone XL, and those are actually key to the higher fair value estimate, which is now $53 per share.

I’ll point out that Energy East is a new proposal from TransCanada, and the idea is to move crude oil, primarily light and probably some diluted bitumen, from Hardisty, Alberta all the way down into the Ontario and Québec market and eventually out to New Brunswick.

Redmond: David, we keep hearing about Keystone XL and it seems like everyone is divided. Half of the people think we need it, half of the people think we don't. So can you comment on this?

McColl: Yes. Keystone XL is interesting. I think a lot of people have lost the big picture and also veered away from some of the key elements of this pipeline, which actually make it quite frankly needed for Western Canada. We don't see many new pipelines coming online until 2017, and this includes Keystone XL. It's now about two to three years later than we anticipated.

The reason why it's so important is not only because of our short pipeline capacity in Western Canada, but it's actually going to take a lot of heavy crude and diluted bitumen from Hardisty, so that it comes from the oil sands and it's probably going to go all the way down into Cushing area in Oklahoma, before making its way to the Gulf Coast. It’s important for people to keep in mind that the Gulf Coast refining market, while we think it's going to be swimming in light crude oil produced from the U.S.; it's still going to be importing lots of heavy crude primarily from foreign markets.

So, there is a definite home for Canadian crude there, and that's why Keystone XL is so well-positioned to come online if it gets regulatory approval.

Redmond: David, rail has really caught the attention of people in the industry. Can you touch on its importance?

McColl: Rail is such an important piece right now in Canada. We talk about that a fair bit in our report. If we look back about two to three years, rail was very small coming out of Western Canada, maybe 15,000 to 20,000 barrels per day. Not a whole lot, and typically it has just been temporary transportation for very small pipeline bottlenecks that came up. But why it's so important now is because rail volumes in 2013 have skyrocketed to well over 175,000 barrels per day, and if we don't see new pipelines come online, this could increase to well over half a million barrels per day by 2017. So, that's a significant increase.

[However, rail] is roughly twice as expensive as pipeline. So that helps create a good economic case to bring on new pipelines, but rail is definitely here to stay at least until 2017 at the earliest.

Redmond: So it sounds like the economics really support a pipeline over rail. So, how does that provide some context to the Keystone debate?

McColl: Well, what we have to keep in mind with the Keystone debate is that right now rail has effectively come in and provided this transportation medium, and one of the key, I guess we could say, opposition movements against Keystone XL was if we stop Keystone XL we can stop production from Alberta's oil sands. Well, what we have seen is rail come in and really fill this void.

Now the real question is, will it be approved? If it's approved when will it be approved? Or could we start seeing other alternatives developed?

Redmond: So what happens if Keystone XL is not approved and what if it's not approved or even delayed until the next presidential election?

McColl: Well, this was some of the sensitivity analysis that we did in our report and helps kind of underpin our fairly positive outlook of TransCanada right now. Let's suppose we have a situation where Keystone XL instead of being approved in early 2014, which is what we had thought last year, let's say it's pushed back until the next presidential administration, that would be kind of a late 2016, early 2017 approval. Well, if that were to happen, we actually think it would be very positive for TransCanada, and it could add $3 per share valuation.

The reason why that's the case is [because] we see Energy East—and if it gets accelerated we think that would come online in 2017 versus 2020. I would point out that TransCanada expects a 2017 startup. We're just a little bit more skeptical due to production. So that's positive.

On the other hand, you could say well, what if it's not approved? What if it's actually denied by the current administration and even denied by the next administration? An interesting thing with Keystone XL is the roughly 1.5 billion to 2 billion of steel pipes [that] they purchased can be used for Energy East. So, it actually becomes, kind of, a wash on the valuation and we'd still sit at about $53 per share.

So it's important for producers, but not necessarily as important as it once was for TransCanada.

Redmond: Okay. So, if the next administration didn't approve Keystone as well, just as we're looking forward, it wouldn't have a huge impact on the valuation, but what about Energy East? Would that have a huge impact?

McColl: Well, the key thing with Energy East is if it's accelerated to 2017, that's where we could see this $3 per share upside in valuation. So, it could be quite positive for TransCanada. On the other hand if we were to see these projects go ahead as we believe they will, it's not necessarily going to cause any big spike from where we are today in valuation.

Redmond: Okay. So, it sounds like Canada would still need pipeline capacity if Keystone was cancelled and Energy East went ahead. So, in that scenario what should investors do?

McColl: I think the key thing for people to keep in mind is if we do see this scenario happen where Keystone XL isn't even kicked down the road and is effectively cancelled, one of the initial reactions might be to say, well, we know there's going to be plenty of need for pipelines to come online. So, what if we are to jump, for example, at Enbridge? Enbridge has its Northern Gateway project which has been talked about a lot and that is effectively an export pipeline to the West Coast of BC.

In our report we caution investors not to view a cancellation of Keystone XL as an opportunity to jump into Enbridge. The reason why is that we view it similarly to the Mackenzie Valley pipeline project. It has a lot of aboriginal territory to cross, a lot of regulatory or political issues to deal with and Mackenzie was delayed for over 30 years. So, we actually think Northern Gateway is at risk of not going ahead.

So, really in summary I think for investors, if they were to see a cancellation as we indicate in our report, it actually makes sense to view it as a buying opportunity possibly for TransCanada because cancelling Keystone XL shifts some pipelines to Energy East and it has no impact on valuation. Although, I'm fairly certain there would be a negative reaction initially for the stock price.

Redmond: Thanks, David, a lot of great information and an interesting perspective on TransCanada and Enbridge.

McColl: Great. Thank you very much, Ashley.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Enbridge Inc34.75 USD0.00Rating
TC Energy Corp38.31 USD0.38Rating

About Author

David McColl

David McColl  David McColl is an equity analyst for Morningstar, covering Canadian oil and natural gas companies.

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