Over time, the US and Canadian energy markets have become more integrated. Energy trade and cross-border asset ownership are just some examples of this interconnectedness. Enbridge’s (ENB) simplification plan, which includes acquiring its sponsored MLPs Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP), is a company-level example of the overlap between US and Canadian midstream. Today, we discuss the investment characteristics of Canadian midstream companies. While we have discussed Canadian midstream in the past (see this 2017 post for more context), today we approach the topic from a different angle and focus mostly on investment considerations.
For midstream investors, Canadian energy infrastructure corporations are a natural extension for inclusion in investment products that include US MLPs and energy infrastructure companies given the similarity of their assets. While their fee-based cash flow characteristics and asset profiles are similar (pipelines, storage tanks, processing plants), it’s worth exploring the investment characteristics of Canadian energy infrastructure companies and how those compare to the North American midstream universe and MLPs.
For our analysis, we’ll look primarily at five Canadian midstream corporations – TransCanada (TRP), Enbridge (ENB), Inter Pipeline (IPL), Keyera (KEY), and Pembina Pipeline (PPL). All five have market caps exceeding $5 billion and have been publicly traded for more than ten years. The size and longevity of these companies introduces some bias and is important to keep in mind when looking at the performance, yield, and correlation data below. While ENB, TRP, and PPL also have listings on the New York Stock Exchange (the NYSE ticker for PPL is PBA), the data presented below is based on their Canadian listings on the Toronto Stock Exchange (TSX). We used the Alerian Midstream Energy Index (AMNA) to represent North American midstream, and we used the Alerian MLP Index (AMZ) to represent MLPs. In some data sets, AMNA is excluded given back-tested data is available through November 2014. (Due to popular demand, we’re working on this, so please bear with us.)
Canadian infrastructure names held up better as oil prices nosedived.
As WTI oil prices fell from over $107 per barrel on June 20, 2014, to $26 per barrel on February 11, 2016, Canadian infrastructure companies demonstrated a lower correlation with oil prices than MLPs and held up better from a price performance perspective. For a detailed discussion of why MLPs exhibited a higher correlation with oil prices during the oil downturn, see our white paper on MLPs and crude correlations.
Why were Canadian names more resilient? For one, none of these companies cut their dividend in the aftermath of oil’s decline that began in 2014. While that likely helped, other possible explanations include Canadian investors’ comfort with oil price swings and familiarity with energy investing, and as a derivative, energy infrastructure investing. For example, energy-related companies represent 27% of the market cap on the TSX as of August 31, 2018. While it’s not an apples-to-apples comparison, energy’s weighting in the S&P 500 was just 5.9% and utilities’ weighting was 2.8% as of August 31, 2018.
Looking at indexed performance since WTI prices hit a relative peak on June 20, 2014, Canadian infrastructure names have seen much better performance than US MLPs. They sold off as oil prices fell but not as severely. As shown below, TRP is the only entity that is trading higher now than it was in June 2014. On a year-to-date basis, price performance has been weaker for Canadian energy infrastructure companies compared to MLPs and the North American midstream universe, with TRP the only name outperforming the AMNA Index. It bears noting that Western Canadian Select (WCS), the benchmark for Canadian heavy crude, has lagged the improvement in WTI crude prices due to takeaway constraints. As of Friday, WCS was trading $34/bbl below WTI compared to a $26/bbl discount at the start of 2018. For context, long-term correlations were greater with WTI than WCS for the companies analyzed, so WCS weakness is probably not the only contributing factor. Another headwind may include the regulatory environment in Canada, where pipeline projects have faced severe delays and cancellations in some cases, stifling growth opportunities. Because Canadian companies held up well in the downturn, investors may have positioned portfolios to be less defensive as oil prices have improved, or the underperformance year-to-date may reflect that MLPs had more ground to make up than Canadian names given relative performance in the downturn.
Canadian names offer healthy yields, though lower than MLPs.
When it comes to midstream investing, MLPs (represented by the AMZ) tend to offer higher yields than corporations because MLPs do not pay taxes at the entity level. Canadian corporations still provide attractive yields of 5.0% or more, and their yields are generally in line with the yield provided by the North American midstream universe as represented by the AMNA Index. For reference, some Canadian companies pay their dividends monthly, including IPL, KEY, and PPL (PBA on the NYSE also pays monthly).
Even for US listings of TRP, ENB, and PBA, dividends are still paid based on Canadian dollars (CAD). On their websites, TRP and ENB note that US shareholders will receive dividends in US dollars (USD) at the prevailing exchange rate on the payment date for TRP and on the record date for ENB, as explained in its investor FAQ. In other words, the dividends are exposed to currency risk, which is discussed in more detail below.
US residents receiving dividends from Canadian companies may notice a withholding tax applied to their dividends. A US resident that qualifies for the benefits of the US-Canada income tax treaty (more information) may have a withholding rate of 15%, as opposed to the 25% withholding rate generally applied to non-residents of Canada. Clearly, consult with your tax advisor for detailed information specific to your situation and the nature of the account (taxable or non-taxable) in which securities are held.
Currency exposure adds another wrinkle.
An additional wrinkle for US investors to keep in mind when investing in Canadian names is foreign exchange risk. The Canadian dollar has weakened in recent years from near parity in 2010 -2012 to $0.767, as of September 14th, as shown below. For US investors in stocks priced in CAD, a weaker CAD (or stronger USD) is negative if the investor sells the stock and converts the proceeds back to USD.
For those receiving dividends paid in CAD and converted to USD, the weaker CAD in recent years has likely put a dent in their income, even as dividends in CAD have increased. To use a simplified example, the average CAD/USD rate was $0.905 in 2014 and $0.771 in 2017. If those averages were applied to a CAD dividend of $1.00 in 2014 and $1.20 in 2017, the USD amounts would be $0.905 and $0.925, respectively. The currency impact would have largely erased the 20% dividend increase, resulting in only a 2.2% “real” (currency-adjusted) dividend increase.
Canadian midstream companies can provide added diversification to investment products or portfolios owned by US investors. While the asset profile and fee-based cash flow characteristics are similar to US midstream companies and MLPs, Canadian companies have unique investment characteristics that may require added consideration on the part of investors. Indeed, investors will likely need to weigh diversification benefits and the lower correlation with WTI oil prices against complicating factors like tax implications and currency risk.