As production from Canada's oil sands charges ahead, pipeline giant Enbridge Inc. is betting it can harness major volume gains on its crude oil mainline by fixing toll rates and abandoning guaranteed revenues. But the bold strategic shift brings uncommon risks to a sector loved by investors for its steady earnings.
Enbridge agreed to a 10-year deal that will tie its cash flow to the volume of crude flowing through its main oil pipeline network. It's a significant departure from the current system, whose pricing mechanism largely ensures set amounts of revenue even as the amount of crude actually flowing through the line fluctuates.
The company is hoping fixed toll rates will provide cost certainty for producers, and entice them to ship with Enbridge. The pipeline operator is looking ahead to years of production increases from Canada's oil sands, and wants to capture as much market share as possible.
But the strategy creates uncertainty for Enbridge's bottom line.
Standard & Poor's warned last week the new toll deal, which must still be approved by the National Energy Board, "will increase the business risk of the Enbridge system."
"Credit metrics, which we have previously indicated are weak, may not be sufficient to support the increase in business risk at the current rating," the ratings agency said, changing its outlook on the company from stable to negative.
For decades, the Enbridge mainline system has been the company's heart, and a major contributor to the company's stellar earnings record. It's a 2.1-million barrel per day pipe network that in 2009 carried 71 per cent of Canada's oil exports. Enbridge has agreed to stick to a fixed toll, at $3.85 (U.S.) for every barrel flowing from Hardisty, Alta. to Chicago, Ill. The toll will rise every year at three-quarters the rate of Canadian inflation.
The current rate, however, is less than it's currently charging. As a result, with the pipe under capacity - about 1.5-million barrels are now flowing - Enbridge will see a hit of roughly 10 per cent to its mainline earnings this year. The mainline, in turn, is expected to form just under 30 per cent of the company's 2011 expected profit.
That could decline in the next few years, especially if TransCanada Corp. is successful in gaining approval for its Keystone XL line, which would add a further 500,000 barrels per day of Canadian pipe capacity. Although growth in domestic oil production is expected to partially compensate, at least some of those barrels are likely to be drawn from the Enbridge system. Analysts say Enbridge throughput could drop as low as 1.35-million a day, creating an even bigger financial hit in coming years.
So why is Enbridge taking this route? In part, it believes a fixed toll will encourage companies to put crude on its network.
"It has the potential to be risky in the near to mid-term," said Chad Friess, an analyst with UBS Securities. "But if volumes out of Western Canada meet expectations, this could really drive huge earnings growth. The numbers are kind of staggering, to be honest."
The strategy fits with the industry's high hopes for Canada's oil sands. Between now and 2020, the Canadian Association of Petroleum Producers believes oil sands output will nearly double. Overall crude flow, it believes, will grow by 1.1-million barrels, a 40 per cent increase.
Using the CAPP projections, Mr. Friess calculated that by 2020, Enbridge could see its mainline profits grow by as much as $300-million. That's nearly double the $330-million it brought in last year.
Any revenue increase is also magnified by the fact that under the old system, annual depreciation would have actually led to a roughly 18 per cent decrease in returns over the next 10 years.
"By doing this, they basically say, 'we no longer have a declining asset,'" Mr. Friess said. Caution is, of course, called for. Oil sands projects have routinely experienced delays and startup problems, and the CAPP projections have historically proven optimistic. Other new pipelines - including Enbridge's own Northern Gateway, and the expansion of Kinder Morgan's Trans Mountain system - could also siphon off new barrels.