Three energy producers with sizable mismatch between price and prospects

These well-managed, diversified businesses all trade well below their fair value estimates.

Vikram Barhat 14 March, 2018 | 5:00PM

The North American energy sector is poised for a strong resurgence led by the United States as the major oil producer roars back to global dominance. In fact, oil production growth in the U.S. is expected to supply as much as 80% of the global oil demand growth for the next five years, while Canada, Brazil and Norway supplying the rest, according to Oil 2018, a five-year market forecast by the International Energy Agency (IEA).

The forecast could breathe a renewed sense of optimism in the energy sector, and boost the investment case for specific players, at a time when it appears to be struggling to shake off its spectacular underperformance last year. The Morningstar U.S. Energy Index has fallen more than 5% year-to-date (expressed in U.S. dollars) as of March 9, while the S&P/TSX Capped Energy Index has slipped more than 11% for the same period, picking up exactly where it left off in 2017.

With both the U.S. and Canadian energy sectors swimming in red, opportunistic investors may find much-needed and long-awaited entry points to buy into prominent energy producers at attractive discounts. These are well-managed, diversified businesses that stand to benefit from demand growth, rising oil prices and economic stability, and are able to withstand geopolitical events and negative headlines, according to Morningstar equity research.

Enbridge Inc.
Ticker: ENB
Current yield: 6.10%
Forward P/E: 16.8
Price: $41.37
Fair value: $64
Data as of March 12, 2018

 Enbridge (ENB) generates, distributes and transports energy in Canada and the U.S. through a vast network of crude and natural gas pipelines on both sides of the border. The company also owns and operates a regulated natural gas utility and Canada's largest natural gas distribution company. Additionally, Enbridge produces renewable and alternative energy.

The Canadian energy giant is well positioned to benefit from growing oil sands supply dynamics with its Mainline system, which "generates attractive tolls and represents approximately 70% of Canada's pipeline takeaway capacity," says a Morningstar equity report.

The company's regional pipelines, the report says, originate from existing oil sands projects and are supported by long-term contracts.

While crude pipelines are Enbridge's bread and butter, the company operates a diverse energy portfolio including a gas distribution business that benefits from regulated returns and provides the company with reliable cash flows. "Regulated ROEs on the gas utility and gas distribution assets consistently exceed 10%, compared with the average allowed ROE for U.S. utilities of 9.6%," says Morningstar equity analyst Joe Gemino. "Enbridge's utilities provide additional attractive assets to the portfolio that exceed the company's cost of capital and generate higher returns than their U.S. counterparts."

A combination of factors ranging from significant regulatory oversight, high barriers to entry and efficient scale underpin the company's strong competitive advantage. Regulators in both Canada and the U.S. permit Enbridge to recover costs to operate its pipeline networks by collecting regulated tolls that allow for the recovery of the pipeline's investment, as well as a rate of return on the investment, providing stable returns that exceed the cost of capital, says Gemino, who puts the stock's fair value at $64.

Dividend seekers will find it particularly attractive that the company "intends to increase its annual dividend at 10% over the next three years," he adds.

TransCanada Corp.
Ticker: TRP
Current yield: 4.46%
Forward P/E: 17.5
Price: $56.62
Fair value: $72
Data as of March 12, 2018

A leading energy infrastructure company with pipeline and power generation assets in Canada, the U.S. and Mexico,  TransCanada (TRP) owns a network of over 67,000 km of natural gas pipelines, as well as the Keystone Pipeline system. The company also has stakes in 20 power-generation facilities.

Much of its growth is derived from expansion programs and strategic acquisitions. "TransCanada is developing five natural gas pipeline projects in Mexico, where natural gas pipeline shipments are expected to double by 2020," says a Morningstar equity report.

Once completed, the announced projects, worth approximately $3.5 billion, could generate nearly $540 million in annual EBITDA, the report says.

Expansion in Mexico also serves to diversify TransCanada's natural gas operations away from Western Canada, where gas production has been losing steam.

Furthermore, the company's US$13 billion acquisition of Columbia Pipeline Group adds about 24,000 km of interstate natural gas pipelines, positioning TransCanada in the fast-growing Marcellus and Utica regions. "In addition, Columbia's $7 billion in future projects provides TransCanada with additional opportunities for growth beyond its current [$23 billion] capital program," says Gemino, whose $72 fair value estimate for the stock suggests nearly 30% upside.

With the political environment becoming more favourable to the liquids pipeline business, the Keystone XL is expected to obtain its remaining approvals, and have the pipeline up and running by the end of 2021. "Overall, TransCanada is in a strong position to benefit from the growing supply and demand of natural gas and boasts a strong growth asset in the Keystone XL," says Gemino. "The stock is undervalued based on current projects and near-term growth and represents one of the best values in the Canadian energy sector."

The company also intends to increase its dividend by 8% to 10% annually over the next four years, notes Gemino.

Enterprise Products Partners LP
Ticker: EPD
Current yield: 6.51%
Forward P/E: 16.8
Price: US$25.90
Fair value: US$30
Data as of March 12, 2018

A master limited partnership, or MLP,  Enterprise Products Partners (EPD) transports and processes natural gas, natural gas liquids, crude oil, refined products and petrochemicals. It's one of the largest midstream companies with operations across the U.S., and a leader in the natural gas liquids (NGL) market.

"While many other midstream operators are playing checkers, Enterprise Products is a chess master," says a Morningstar equity report. "It is the pre-eminent midstream infrastructure company, vertically integrated with best-in-class assets at nearly every point in the midstream value chain."

The firm enjoys a dominant position in NGL with assets that are well positioned to benefit as exports from the U.S. increase over time. "We expect its dominance in this area to grow materially over the coming years, supporting healthy growth prospects," says Morningstar sector strategist Stephen Ellis, adding that the firm's sustainable competitive advantages stem from efficient scale. "On each of the major factors we use to evaluate midstream firms -- asset quality, location and contracts quality -- Enterprise stands out with differentiated advantages," he adds.

Enterprise's asset base quality is outstanding, and for producers seeking options for their hydrocarbons, the company offers an extensive menu, says Ellis, who assesses the stock to be worth US$31.

The crown jewel of Enterprise's assets is its comprehensive NGL network, which offers deep access to Mount Belvieu, a strategic location along the U.S. Gulf Coast. "Enterprise was one of the first in the industry to recognize the shortage of NGL infrastructure in the U.S., and the eventual shift toward exports, and has built an impossible-to-replicate collection of assets across the value chain, positioning it to capture differentials between U.S. and international markets," says Ellis, who projects ROICs to average about 12% over the next five years, well above its 6.9% cost of capital.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Enbridge Inc46.73 CAD0.06
Enterprise Products Partners LP29.08 USD0.31
TC Energy Corp67.27 CAD0.55

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.