How To Pick Pipeline Trusts
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Pipeline trusts are terrific additions to any diversified portfolio; their cash flows are generous, predictable and sustainable. When you buy a pipeline trust, you’re buying a combination of long-lasting energy infrastructure cash-cow machines used to transport and store oil and gas. Many pipeline trusts are involved in some of the largest and longest-lasting oil projects in North America, thus enabling them to secure long-term contracts to transport oil from productions to refineries.
What are some of the key characteristics of pipeline trusts?
- Strong competitive advantages from high barriers to new competitions due to hefty capital costs, government regulations and brands.
- Pipelines have longevity and low maintenance.
- Revenues are largely fixed while capital expenditures are minimal. (Translation: reliable cash flows)
- Not much growth potential. Buying at the right price is crucial, because you don’t want to be stuck with a low yielding and slow growing investment.
- Unlike oil and gas production trusts, pipeline trusts’ transportation revenues are generally decoupled from commodity prices.
- Since pipeline trusts must compete with other income-based securities, share prices are sensitive to the prevailing interest rates.
What to look for in a pipeline trust?
- Squeaky-clean balance sheets - We want to turn away trusts burdened with massive debts on their balance sheets. Trusts with conservative capital structures desensitize themselves from rising interest rates, and give them little wiggle room to expand. The key ratio to look for is the Debt-to-Equity ratio. Here are several examples: Inter Pipeline (0.56), Pembina Pipeline (0.75) and Fort Chicago Energy Partners (1.99 - ouch!)
- Positive cash flow - As with all income trusts, ensure the pipeline business generates enough money to maintain existing infrastructures and to pay us cash distributions. Normally, I’d glance over the cash flow statement from MSN Finance, but there underlies a problem; capital expenditures lump both maintenance and expansions together. Since a few of the major pipeline trusts, likeInter Pipeline and Pembina Pipeline) are currently in expansion mode, I have to discern maintenance from other growth initiatives. Otherwise, MSN Finance will confuse me into thinking that these trusts are bolstering the distributions with new shares and debts — a very yucky situation. There are no short-cuts. Investors must download and soak up the annual reports to separate out the maintenance expenses.
- Payout ratios - This goes hand-in-hand with the positive cash flow criterion above. The lower the payout ratio, the safer the distributions. Do not blindly accept the payout ratios from third-party sources, such as MSN Finance, due to discrepancies in how distributable cash flows are calculated. It’s best to crunch the payout ratio yourself. An example is coming.
- High S&P Stability Rating - A trust with a high S&P stability rating has a better chance of sustaining the distribution. Most of the high quality individual trusts have an SR-2 rating, whereas “portfolios of funds” tend to have the SR-1 rating. Some of the SR-2 rated trusts include CML Healthcare, Pembina Pipeline, RioCan and Yellow Pages. It’s too bad that S&P doesn’t rate all the available trusts. However if a trust is listed and it’s below SR-2, don’t bother investing.
Example: Inter Pipeline
There are several popular pipeline trusts at your disposal, but I’ll pick Inter Pipeline since Money Gardener has been nagging me a couple of times. 
When you buy Inter Pipeline, you become part-owner of the following enduring assets:
- 5,900 kilometres long of petroleum pipelines (Four conventional oil pipelines, and two oil sand pipelines).
- 3.6 million barrels of storage in western Canada.
- The above assets pipe 822,000 barrels per day of oil sands bitumen, conventional crude oil and gas plant condensate, with a market share of 18% in western Canadian conventional volumes and 50% of oil sands volumes. These represent 44% of earnings.
- 3 major natural gas liquids extraction facilities in southern Alberta on the TransCanada system. These facilities are processing 4.2 billion cubic feet/day of natural gas and producing 142,100 barrels/day of natural gas liquids for now, but have the capacity to process 6.2 bcf/d of natural gas, and 195,000 b/d of natural gas liquids. (Don’t ask me what these numbers mean.
) These represent 41% of earnings. - More impressively, their natural gas extraction facilities are responsible for processing 40% of Alberta’s natural gas export.
- 9 bulk liquid storage terminals in UK, Germany and Ireland. These represent 15% of earnings.
You can find Inter Pipeline’s distribution history here. As of this writing, the trust is trading at $9.51 with an 8.85% yield. The distribution is 85% taxable with remaining as tax-deferred capital gains (return of capital). Do keep in mine that although unitholders have been indulged with a bountiful yield, in exchange, they settled with an uninspiring 3.2% distribution growth rate.
Inter Pipeline has a positive cash flow. According to the cash flow statement, operational cash flow in 2006 is $201 mil. At first glance, this cash flow doesn’t cover the $160 mil cash distributions to unitholders and the $65 mil in capital expenditures, but wait. As I alluded to earlier, part of the capital expenditures is assigned to growth. According to page 40 of their 2006 annual report, only $5.6 mil was “sustaining capital expenditures”. The effective payout ratio after sustaining capital expenditures is around a healthy 82% ($160 / [$201-$5.6]).
Unfortunately, S&P doesn’t have a rating on Inter Pipeline.
Valuation wise, the best two times to buy Inter Pipeline were in 1999 when investors were flocking to growth oriented technology stocks, and in Nov 2006 when Finance Minister, Mr. Flarity, detonated the Halloween bomb on taxing income trusts. Moving forward, I don’t see any more corrections in the horizon unless Bank of Canada hints further hikes are lurking beyond Sep 2007. The units have settled in the range of $9.00 and $9.80 and trending upward. The trust is suited for RRSP, because the tax on distributions can be deferred inside in registered accounts.
Disclosure: I don’t hold Inter Pipeline nor any other pipeline trusts. As always, I’m an amateur investor. Do not buy or sell securities based solely on the information provided on this site.
Examples of other pipeline trusts:
Good post.
One point I would argue is that it is crucial to buy these when they are cheap, as compared with common stocks. The fact that distributions are paid monthly plays into the ‘bird in the hand’ theory IMO.
For example:
IPL.UN is yielding, lets say 9%
So each month you wait to invest $5,000, you are essentially missing out on $37.50, assuming your cash is not earning interest while it waits.
Wait 6 months in the hopes that the trust will drop in price, and you’ve just missed out on $225, while the drop in price that you were waiting for is far from certain.