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ENB investment write up

ENB investment write up

ENB is one of the largest North American midstream companies, generating annual EBITDA of more than C$13bn and Distributable Cash Flow (DCF) of more than C$9.4bn. ENB is well diversified across liquids pipelines, gas transmission pipelines, a gas distribution utility, and renewable power generation. ENB’s earnings have been extremely stable over time, driven by the constructive regulatory environments ENB operates in, which minimize both commodity price risk and volumetric risk. Furthermore, ENB has a strong asset base, transporting 25% of all crude oil in North America including 2/3’s of all Canadian exports to the U.S., and transporting 20% of all the natural gas consumed in the U.S., in addition to owning the largest Natural Gas Distrubtion business in North America.

Additionally, ENB has much greater opportunities to grow DCF than its peers, driven by its Renewables segment, Natural Gas Distribution segment, and C$1.5bn of incremental EBITDA from the expansion of ENB’s Mainline Liquids Pipeline system to be completed in Q421. Management has targeted 5-7% annual DCF growth over time, with 1-2% from operational improvement and 4-5% from growth capex. Finally, ENB employs prudent capital allocation policies, with a strong focus on generating strong ROIC’s over time.

These strengths are offset by longer-term concerns regarding fossil fuel demand given the transition to a low-carbon economy. However, the risk of lower fossil fuel demand in developed countries needs to be balanced against both global population growth, and the rise of the middle class and increased urbanization, which will lead to increased energy demand. Both natural gas and oil demand are expected to increase over time, with a more robust outlook for natural gas going forward. To combat these concerns, ENB continues to invest heavily in its renewables busines and is pursuing low carbon opportunities such as transporting renewable natural gas and hydrogen through its gas pipelines, as well as carbon capture and storage. ENB represents an attractive investment opportunity and should deliver double digit IRR’s over the next 3-5 years even without multiple expansion, driven by an 8% FCF yield combined with 5+% annual DCF growth over time.

Key Stats

Description: Enbridge is a leading North American midstream company with substantial liquids pipelines, gas transmission pipelines, a gas distribution utility, and renewables assets focused in the U.S. and Canada. ENB is one of the largest midstream operators in North America, generating annual EBITDA and DCF of $13bn and $9.4bn, respectively. 25% of all North American crude oil is transported through ENB’s pipelines, and 20% of all the natural gas consumed in the U.S. is transported through the company’s pipelines. Additionally, ENB owns the largest natural gas distribution company in North America, focused on the Province of Ontario. For 2019, 53% of earnings were from liquids pipelines, 29% gas transmission, 13% gas distribution, and 5% from power generation. ENB generates revenue by charging fees to use its transportation and storage assets, as well as for the delivery of natural gas to businesses and homes in its natural gas distribution business, and for electricity generation in its renewables power business.

Asset Base:

Asset Base

Strong asset base with minimal commodity price sensitivity or volumetric risk

ENB’s earnings have been extremely stable over time, with minimal direct commodity price exposure, minimal volumetric risk, and low counterparty risk. This is driven by ENB’s strong asset base, which as noted, transports 25% of all crude oil in North America, and nearly 20% of all the natural gas consumed in the U.S. 98% of ENB’s revenue is generated by its utility business or backed by long term take or pay contracts, Purchase Power Agreements (PPA's), or cost of service contracts cost with high quality counterparties. As a result, only 2% of ENB’s cash flows are directly impacted by commodity price volatility. Furthermore, 95% of ENB’s counterparties are Investment Grade rated, reducing ENB’s counterparty risk.

ENB benefits from regulated monopoly positions across the company’s four major business segments: Liquids Pipelines, Natural Gas Transmission, Natural Gas Distribution and Power Generation. In each of these businesses competition is disallowed by regulators, or substantial barriers to entry exist driven by high capital costs and the necessary regulatory approval needed to build new energy infrastructure. As we have seen in recent years, regulators have strengthened the requirements for new energy infrastructure to be built, increasing the value of existing pipelines in the ground. While this dynamic will lead to lower growth going forward, it helps to entrench ENB’s monopoly position across its major businesses. Each business segment is detailed below.

Liquids Pipelines
Within ENB’s Liquids Pipelines business, 97% of ENB’s counterparties are investment grade rated and largely consist of Integrated Oil and Gas companies (BP, TOTAL, SU, Imperial Oil) and Refiners (MPC, PSX, VLO). Additionally, nearly all of ENB’s assets are backed by long term take or pay contracts, or cost of service contracts, minimizing direct commodity price exposure and reducing volumetric risk.

ENB’s key asset in this segment in the Mainline System which will contribute ~60% of segment earnings once the Line 3 Replacement project is completed in late 2021/early 2022. The Mainline has capacity of 3mn barrels/day, and will increase to 3.3mn bpd. The Mainline system is strategically important for Canada, as 2/3’s of Canadian crude exports are transported through the Mainline. The Mainline system transports low-cost crude from Western Canada to more populated areas in Eastern Canada as well as to key refineries in the U.S. in the Midwest, and Gulf Coast region for domestic consumption and for exports. This serves as a key source for heavy crude oil in the U.S. given the destruction of Venezuelan oil production, and reduced OPEC production. 

Additional pipeline systems include the Regional Oil Sands system, which has capacity of 2.35mn barrels/day and contributes 10% of EBITDA for this segment, as well as the Gulf Coast and Mid-Continent Pipelines which contribute 13% of EBITDA.

As shown, ENB has consistently increased EBITDA in its Liquids segment through increased transportation volumes, despite a volatile commodity price environment over the past few years. In 2020, Liquids segment EBITDA is expected to increase by 1% y/y, and transportation volumes are only expected to decline by 3% y/y, despite a 30% decline in average WTI prices. This  demonstrates the resiliency of ENB’s Liquids Pipelines business and the lack of both direct commodity price exposure, and volumetric risk.

Liquids Pipelines stats

Gas Transmission
In ENB’s Gas Transmission business, 91% of counterparties are Investment Grade rated, and revenue is backed by long-term contracts with an average contract length of more than 10 years across the portfolio. 88% of EBITDA is backed by long-term Take or Pay or Cost of Service contracts minimizing both commodity price volatility and volumetric risk. Furthermore, ENB’s customer base is predominantly made up of highly rated counterparties including electric and gas utilities in the U.S. and Canada such as Eversource, Nextera, ConEdison, Fortis, and Duke Energy.

Key assets in this segment include the Texas Eastern transmission system which extends 1700 miles from Texas to New York, and includes 9,070 miles of pipelines, and contributes 30% of EBITDA for the segment. This is a strategically important pipeline for ENB, and the U.S. given that other interstate gas pipelines projects have been cancelled, such as the Atlantic Coast Pipeline. Other assets in this segment include the BC Pipeline which generates C$500mn/yr. of EBITDA as well as a variety of equity interests in key pipelines such as the Gulfstream Natural Gas system, Sabal Trail, and the Nexus pipeline.

This segment has demonstrated stable profitability despite highly volatile commodity prices over the past few years. Specifically, natural gas prices declined by 19% in 2019 and 22% in 2020, but EBITDA only declined by 5% in 2019 and is expected to grow by 2% in 2020.

Gas Transmission stats

Gas Distribution
Enbridge Gas is the largest natural gas utility in North America by volumes and third largest by number of customers. Enbridge Gas serves more than 14 million people in Ontario with 3.8 million customers diversified across: 68% residential, 29% commercial, and 3% industrial. The high percentage of residential customers is positive for ENB, as demand is more stable for residential customers compared to commercial and industrial customers. This business has an allowed ROE of 8.4% but has earned ROE’s of roughly 10% over the past few years driven by various regulatory mechanisms, including savings from amalgamating two prior natural gas utilities. Enbridge Gas is not subject to third-party competition within its service territory, given the regulatory environment.

Renewables
ENB’s renewables operations encompass 2.6GW of generation, with 1.05GW in Canada, 1.04GW in the U.S. and 530MW in Europe. ENB’s renewable portfolio is comprised of 39% onshore wind in the U.S., 25% offshore wind in Europe, 20% onshore wind in Canada, and 9% solar in Canada. While the segment will only contribute 3.5% of earnings for 2020, it will become a more meaningful contributor of earnings over time. Specifically, ENB has partnered with several European utilities on offshore wind projects. Once completed, these projects will be backed by 15-20 year Purchase Power Agreements (PPA’s) with low-mid teen IRR’s on a levered basis, and 8-10% unelvered. There is substantial demand for offshore wind power in areas of the world that lack great onshore wind or solar resources such as Northeast U.S., Europe in the English Channel/North Sea, and many parts of Asia including China. ENB currently has 980MW of offshore wind projects under construction and 2.2GW of projects in development. 

Substantial growth opportunities unlike its Midstream peers

ENB has some of the strongest growth opportunities within the Midstream sector. ENB has guided to 5-7% annual DCF growth through 2023, with growth capex contributing 4-5% per year and operational improvements contributing 1-2% per year. This is in direct contrast to many of ENB’s peers who have guided to low single digit growth if not declining earnings over time (KMI, EPD, WMB, MPLX). Furthermore, ENB has substantial opportunities to continue growing earnings well beyond 2023 as described below.

As shown below ENB has guided to $16bn of capex through 2023, driving $2bn of incremental EBITDA. To date $6bn has been spent, with $10bn remaining. By business segment, capex will be allocated to:

• Liquids Pipelines: $5bn to be spent mostly on the on the U.S. portion of the Line 3 replacement pipeline, which will add C$1.5bn of EBITDA upon completion in 4Q21/1Q22.
Gas Transmission: $6bn focused on the T-South expansion, Spruce ridge, Atlantic Bridge and modernization projects to improve existing infrastructure.
Gas Distribution: $4bn allocated to normal gas utility capex which involves upgrading aging infrastructure, storm hardening, etc.
Renewables: Predominantly offshore wind projects backed by Purchase Power Agreements (PPA’s), with typical 10-20 year average contract lengths. Because cashflows are determined upfront there are minimal risks to these projects, especially if agreements are made with high quality counterparties, minimizing credit risk. While IRR’s have come down in the renewables business, ENB expects to earn 8-10% IRR’s on an unleveraged basis, selling power to high quality counterparties.

ENB capex

Beyond 2023, ENB has identified more than $28bn of potential capex opportunities as shown below, including more than $10bn for Gas Transmission, $7bn for Liquids Pipelines, $6bn for Gas Distribution, and $5bn for Renewables. Importantly, only 25% of ENB’s opportunity set is focused on the company’s Liquids Pipelines, as the company acknowledges the need for increased investment in Gas Transmission, Gas Distribution, and Renewables. Specifically, ENB has opportunities to modernize its Gas Transmission pipelines, LNG exports from Western Canada and the Gulf Coast, incorporating hydrogen and renewable gas in its gas distribution and gas transmission businesses, and numerous potential offshore wind projects in Europe. ENB is also evaluating opportunities to invest in carbon capture and storage to reduce GHG emissions. 

post 2023 capexAdditionally, ENB expects to increase DCF by 1-2% per year through revenue growth on existing assets and several cost management initiatives. In terms of revenue growth, ENB has 1-2% annual toll and rate increases embedded in many existing contracts, and ENB also expects volumes to recover in the Mainline System. On the cost management side, opportunities include supply chain efficiencies, productivity enhancements, and power cost optimization. ENB expects to achieve $300mn of cost reductions in 2023 and $400mn for 2021.

Prudent capital allocation framework

ENB’s capital allocation balances the needs to maintain a strong balance sheet with strong DCF growth and higher returns on capital over time. Specifically, ENB targets gross leverage between 4.5-5x, a 60-70% DCF payout ratio and $5-6bn of annual capital allocation. Of this capital budget, ENB plans to spend $3-4bn/yr. across organic expansions and optimizations, and up to $2bn/yr. for share repurchases, other capex projects, asset level M&A, or paying down debt. The below slide illustrates ENB’s opportunity cost for each option. Management has ranked its options based on prospective returns (EV/EBITDA), focusing on allocating capital to the highest prospective return categories going forward.

ENB returns based framework

Risks:

Energy transition leading to lower fossil fuel demand going forward

The biggest risk facing the sector is lower fossil fuel demand driven by consumer demand for cleaner energy, an unfavorable regulatory environment, and behavioral shifts driven by COVID-19. Reduced fossil fuel demand could ultimately lead to lower transportation volumes for ENB, as well as increasing the credit risk of ENB’s counterparties.

However, demand for cleaner energy will be offset by global population growth and a growing middle class over the next few decades. Specifically, the global population is projected to grow by 21% from 2020 to 2040, from 7.5 billion people to 9.1 billion, with a corresponding 41% increase in urbanization and a 67% increase in the middle class during that time frame. As a result, the IEA forecasts a 20% increase in global energy demand by 2040, with oil demand increasing by 7% and natural gas demand increasing by 29%. I take these longer-term projections with a grain of salt given the challenging of forecasting commodity prices, changes in low carbon technology, and changes in the political/regulatory environment, however I believe they are directionally useful when evaluating energy demand going forward.

Let’s look at the outlook for natural gas and oil demand over the next 5-10 years as well as actions ENB has taken to diversify its business mix.

Natural gas outlook
In the U.S., 36% of natural gas demand is used for electricity generation, followed by 33% for industrial uses, 16% residential, 11% commercial and 3% transportation. The Industrial sector uses natural gas for heating, and as a feedstock to produce chemicals, fertilizer, and hydrogen. The Commercial and Residential sector uses natural gas for building heating, water heating, cooking and clothes drying. Finally, natural gas is used as a fuel to operate compressors and as vehicle fuel in the form of compressed natural gas and liquefied natural gas.

Besides the 3% of natural gas demand used for transportation, I expect the remaining 97% of natural gas to remain robust over time. Specifically, Wood McKenzie forecasts natural gas demand in North America to increase by 15% from 2020 to 2040 driven by industrial and commercial demand for petrochemicals, increased industrial gas demand, and to replace coal in electricity generation. Natural gas remain a much lower cost fuel source for heating buildings; gas costs roughly 60% than alternatives sources for residential heating. Furthermore, the U.S. has become a large exporter of natural gas over the past few years driven by a low cost of supply, as the largest LNG exporter globally, with LNG exports to Europe and Asia, and pipeline exports to Mexico expected to increase meaningfully. Mexican demand is expected to increase 43% by 2040.

Furthermore, natural gas continues to be a key source for electricity generation, given it is cleaner and less expensive than coal fired generation (which still provides 22% of electricity generation), and is more reliable than renewables in many parts of the U.S. Natural gas provides critical baseload generation capacity needed to balance the intermittency of renewables. In fact, Natural Gas power plants will make up 23% of new electricity generation capacity coming online in the U.S. from 2021-2023. Furthermore, natural gas generation capacity is forecasted to continuing increase through 2050, per the EIA (Energy Information Association). As a result, I expect transportation volumes to remain robust across ENB’s Natural Gas Transmission business for decades to come.

newt generation 2021 2023

EIA Reference Case

Liquids outlook
COVID-19 has certainly led to lower demand for refined products such as gasoline, diesel, and jet fuel as end use demand for transportation has declined materially. The shift to remote work will likely have a negative impact on oil demand going forward due to reduced travel. Additionally, over time the electrification of transportation will also have a negative impact. However, these trends need to be balanced against the increase in energy demand from global population growth and increased urbanization described above. Additionally, only about 27% of oil demand is used for road transportation, the category of demand most likely to be displaced over time. The remaining 73% of demand is divided across: 18% road freight, 3% buses, 7% aviation, 5% maritime, 13% petrochemicals, 5% industrial, 6% buildings, 6% power generation, and 10% other (agriculture, lubricants, etc.), which are unlikely to be displaced in the near-term.

As shown below, Godman Sachs expects global oil demand to increase by ~7% by 2030, driven by increased demand due to GDP growth offset by increased Electric Vehicle (EV)/Hybrids penetration, increases in remote work, and engine fuel efficiencies. While I believe EV’s and Hybrids will take greater market share than the below forecast, GS’s analysis is directionally correct. It is unlikely oil demand will be materially lower in 2030 than it is today.

oil demand forecast

Similarly, IEA forecasts oil demand to continue growing through 2040 driven by a 5% increase in demand from heavy duty vehicles, 11% from maritime/aviation, and a 31% increase in petrochemical demand, offset by declining passenger vehicle demand. 

Furthermore, Canadian crude oil has lower breakeven costs than many other global sources, and as such will continue to be a valuable resource even if overall oil demand eventually declines. Additionally, Canadian crude exports to the U.S. represent the primary source of heavy crude oil presently, given sanctions on Venezuela, and lower OPEC output. As a result, ENB’s crude pipelines will continue to be an important asset for transporting Canadian heavy oil to the U.S.

ENB’s mitigation of risks

For ENB, I don’t see material impacts to their business over the next 5-10 years. While oil demand could plateau or experience much lower demand growth, ENB is well positioned given the low cost of supply in Canada which ENB transports. Additionally, demand for natural gas will likely increase as mentioned above. Importantly, ENB continues to allocate more capital towards its natural gas and renewables business relative to its Liquids pipelines business. Through 2023, 31% of ENB’s capex will be allocated to its Liquids pipelines business, and beyond 2023 only 25% of ENB’s capex will be allocated to liquids pipelines. As a result, the percentage of ENB’s earnings from liquids pipelines will naturally decrease as an overall percentage of earnings over the next 3-5 years.

Additionally, ENB already has a growing renewables business and can utilize its existing natural gas pipelines and storage assets to transport and store low carbon fuel sources such as hydrogen, renewable natural gas, renewable fuel/diesel, and CO2. Currently, ENB does not have much exposure to these areas, but has projects in development across all of these areas in its Natural Gas Distribution business, and expects to allocate a meaningful amount of capital to low carbon fuels over time. Hydrogen can ultimately used as a fuel source for electricity generation, fuel for commercial and residential buildings. ENB is also evaluating investments in carbon capture and storage projects. Ultimately, ENB has time to transition its business towards lower carbon fuel sources. 

Financials:

Model

Valuation:

ENB currently trades at 17.1x 2021 EPS and 14.6x 2022 EPS. Additionally, the company trades at 11.6x 2021 EV/EBITDA and 10.6x 2022 EBITDA. Given ENB’s strong and improving DCF generation, ENB represents an attractive investment trading at an 8% FCF yield with 5-7% annual DCF growth expected over the next 5 years.

There is also a massive disconnect between prospective returns on ENB’s bonds and ENB equity. You can earn a 2% return purchasing an unsecured ENB bond maturing in 2029, a 3.4% return on an unsecured ENB bond maturing in 2049, or 13-15% for ENB’s equity. A 10+% equity risk premium for a stable company is unjustified in my opinion.

ENB securities

Source: Bloomberg

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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