CA - Pembina Pipeline: Offering Stability And Growth

2023-08-31 14:11:51 ET

Summary

• Pembina Pipeline Corporation is a Canadian pipeline operator with stable cash flows and good growth prospects in the oil and gas industry.
• The company's operations are evenly split between crude oil, natural gas liquids, and dry natural gas, allowing it to benefit from the growth of these commodities.
• Pembina Pipeline has several growth opportunities, including the Peace Pipeline Expansion and the Cedar LNG liquefaction plant, which will tap into the growing demand for liquefied natural gas in Asia.
• The company has one of the strongest balance sheets in the industry, with relatively low leverage.
• The company should not have any difficulty covering its 6.25% yield, and investors will likely end up with a much better yield-on-cost in a few years.

Pembina Pipeline Corporation ( PBA ) is a large Canadian pipeline operator that is primarily focused on the Western Canadian Sedimentary Basin in Alberta and British Columbia, but it also has some operations in the United States:

Canadian pipeline operators have long been popular investments among retirees or others who are seeking high levels of income and financial stability. Pembina Pipeline’s business model is, in fact, very similar to that of the American pipeline operators, so its cash flows are remarkably stable over time. The company also has fairly good growth prospects, as the demand for natural gas and natural gas liquids continues to rise globally and creates opportunities for producers in the Canadian oil region.

It has been a few months since we last discussed this 6.25%-yielding company, so today is likely a good time to revisit it as energy prices have finally started to trend upward from the slump that they were in over much of the first half of this year.

About Pembina Pipeline Corporation

As stated in the introduction, Pembina Pipeline Corporation is a Canadian pipeline operator with operations primarily in the Western Canadian Sedimentary Basin. This is one of the largest hydrocarbon-rich basins in the world, and it has been the center of the Canadian oil and gas industry for decades. In total, the company has the ability to transport approximately 2.8 million barrels of liquid hydrocarbons. The company also has an impressive 11 million barrels of above-ground liquid hydrocarbon storage, 5.4 billion cubic feet per day of natural gas processing capacity, and 354,000 barrels per day of natural gas liquids fractionation capacity. Overall, this makes Pembina Pipeline the second-largest midstream operator in Canada, after Enbridge ( ENB ).

One of the nicest things about Pembina Pipeline is that its operations are mostly split between crude oil, natural gas liquids, and dry natural gas. We may not think that from the fact that much of the company’s infrastructure is directed toward liquid hydrocarbons, but in fact, about a third of its business comes from each commodity:

This is something that is nice to see, as each of these commodities has different fundamentals. For example, natural gas and natural gas liquids are both expected to experience significant global demand growth over the coming years. In the case of natural gas, this comes from the fact that natural gas is frequently used as a supplementary power source to unreliable solar and wind power. Natural gas liquids are used to manufacture a variety of products including plastics and rubbers. In fact, many of the compounds used to manufacture electric vehicles are made from natural gas liquids. We are also seeing an increase in the number of rural households in North America and abroad converting away from coal and wood in favor of propane for heating and cooking. These things will all drive demand for these products. Crude oil, in contrast, is expected to have mostly stagnant demand in the world’s developed nations while emerging nations increase their consumption of it. Thus, crude oil demand is expected to grow more slowly than the demand for either of the other two products. The fact that Pembina Pipeline’s business is fairly evenly distributed among the three products means that it will be able to benefit from the growth of natural gas and natural gas liquids without having to sacrifice crude oil’s cash cow status.

As I pointed out in my last article on Pembina Pipeline, the company’s cash flows are mostly a function of resource volumes. Here is my description of how the business model works:

“In short, Pembina Pipeline enters into long-term contracts with its customers under which Pembina Pipeline provides transportation, processing, or storage for the customer’s hydrocarbon products. In exchange, the customer compensates Pembina Pipeline based on the volume of resources that are being handled, not on their values. This obviously insulates the company against changes in resource prices, especially when combined with the fact that these contracts include usually include minimum volume commitments that specify a certain quantity of resources that must be sent through Pembina Pipeline’s infrastructure or paid for anyway.”

Approximately 80% to 90% of the company’s EBITDA comes from contracts that employ this business model. As such, Pembina Pipeline’s cash flows tend to be quite stable over time. This chart shows the company’s operating cash flow during each of the past eleven twelve-month periods:

(All figures in millions of Canadian dollars.)

We can quite clearly see that the company’s cash flows did not change very much from period to period. This is something that we can very much appreciate as income investors due to the support that it provides to the company’s dividend.

In a recent article , I pointed out that there are a growing number of signs that the American economy may be about to enter into a recession. Indeed, the Leading Economic Indicators have been negative for 16 straight months . The majority of the strength that has been seen and promoted by politicians and media personalities has been in consumer spending. There are signs that the American consumer is nearing the limit of their ability to spend and keep the economy propped up. A slowdown in consumer spending, and especially a recession, will have an adverse impact on any company that is highly dependent on consumer spending. However, Pembina Pipeline should be relatively immune to any such event. In fact, even a change in energy prices will not affect the company very much. We can see that reflected quite clearly in the company’s operating cash flows, as there was very little variation in the company’s operating cash flows over the 2020 to 2023 period, despite the fact that energy prices varied a lot over the period.

Growth Opportunities

Pembina Pipeline does have some growth opportunities, which is nice because we are unlikely to be satisfied with mere stability. In fact, the company currently plans to invest CAD$800 million into various growth projects over the course of 2023:

We discussed Phase VIII of the Peace Pipeline Expansion in my last article on this company, so there is no reason to discuss it again. For the time being though, that is perhaps the company’s most significant growth project. This project was delayed back in 2020 so it was not brought online under the original timetable that the company was planning. This project is currently expected to start operation sometime in the first half of next year. As such, we can expect it to have an accretive effect on the company’s cash flows and profits at that time.

Another major project that Pembina Pipeline is currently working on is the Cedar LNG liquefaction plant. This is a 50/50 joint venture with the Haisla Nation in Kitimat, British Columbia. The company has been promoting the fact that this facility will be jointly owned by a Native American tribe, but its promotion of this fact is probably just marketing. As I have pointed out in the past, the entire fossil fuel energy sector has been somewhat shunned by the environmental, social, and governance movement that controls a substantial amount of assets. The investors and management of these funds may look more favorably on the company if it cooperates with Native tribes, which could be the reason that it is promoting this aspect of the joint venture. This could ultimately be good for the stock price, although I do not expect a huge impact considering that it is only one project out of many.

The big thing here is that this project is an attempt by Pembina Pipeline to take advantage of the rapidly growing market for liquefied natural gas in Asia. As I pointed out in a blog post from late last year, Asian liquefied natural gas demand is expected to increase by 40% over the 2021 to 2030 period. This is partly due to nations such as China seeking to move away from coal power to natural gas in an effort to improve their air quality. In addition, there are nations like India in the area that are rapidly bringing their economies online, and this economic growth will require increased consumption of all energy sources, including fossil fuels such as crude oil and natural gas. The Cedar LNG plant is located in Kitimat, British Columbia, Canada, which is pretty close to the Pacific Coast:

As such, this project is in a good position to export liquefied natural gas across the Pacific Ocean to Asia. Pembina Pipeline has already signed contracts with customers that are looking to do exactly this. The contracts cover the entire production capacity of this plant, so we can be sure that it will be profitable once it begins operation. There has not been a timetable yet announced though, so we do not know when the plant will begin producing and generating money for the company. In fact, all Pembina Pipeline has stated is that the final investment decision will be made sometime in the fourth quarter of this year. Thus, it is still uncertain whether or not Pembina Pipeline will proceed with this project. However, it is very hard to believe that the company will not proceed with it considering everything that this project has going for it right now.

Financial Considerations

One of the things that we have always liked about Pembina Pipeline is that the company has a very strong balance sheet. We can clearly see this by looking at the leverage ratio, which is defined as total consolidated debt-to-adjusted EBITDA. At the end of 2022, this ratio stood at 3.60x, which is very reasonable. The strongest midstream companies in the industry generally have ratios under 4.0x right now, so Pembina Pipeline was in line with them at the start of this year.

However, two quarters have passed since then, and the company’s finances may have changed a bit. Fortunately, in this case, they have changed for the better. Pembina Pipeline’s second-quarter 2023 earnings report states that the company has a leverage ratio of 3.5x as of June 30, 2023. Wall Street analysts are generally satisfied with anything under 5.0x but, as already mentioned, I like this ratio to be under 4.0x to add a margin of safety to the investment. Nearly all of our recommended companies here at Energy Profits in Dividends are under that 4.0x ratio for this reason. Pembina Pipeline easily satisfies our requirements here.

Dividend Analysis

One of the biggest reasons that we invest in midstream companies like Pembina Pipeline is that they tend to have remarkably high dividend yields. Pembina Pipeline is no exception to this as the company yields 6.25% at the current price. This is admittedly not as good as the 7.00% yield that we would like to achieve, but Pembina Pipeline has a long history of raising its dividend over time. At least, that is true when measuring the dividend in the company’s native currency of the Canadian dollar. It does fluctuate a bit for investors that purchase the shares on the New York Stock Exchange since the dividend is converted to U.S. dollars at the prevailing exchange rate:

We can see that it generally grows even in U.S. dollar terms over time though. This is nice for our purposes since it should mean that anyone buying today will end up with a 7%+ yield on cost in a few years at most. As is always the case though, we want to ensure that the company can actually afford the dividends that it pays out. After all, we do not want to be the victims of a dividend cut, since that would reduce our incomes and almost certainly cause the stock price to decline.

The usual way that we judge a company’s ability to pay its dividends is by looking at its free cash flow. During the twelve-month period that ended on June 30, 2023, Pembina Pipeline reported a leveraged free cash flow of CAD$3.5481 billion. The company’s dividends only cost it CAD$1.677 billion over the same period. Thus, it appears that Pembina Pipeline is having no difficulty covering its dividends. We should not have to worry too much about a dividend cut anytime soon.

Conclusion

In conclusion, Pembina Pipeline is one of the largest and most well-financed midstream companies in Canada. The company’s business model provides it with an enormous amount of stability, which is something that we should be able to appreciate as income investors. The company also has quite a few projects in development that will drive its growth over the coming years.

When combined with the company’s historic dividend growth, Pembina Pipeline Corporation should have a very attractive yield-on-cost in a few years. Overall, this company continues to be one of the better companies in the midstream space and should serve investors well if the economy does enter into a recession in the near future.

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