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Inter Pipeline: An energy play without big energy price risk

Pipelines have a reputation for being steady, predictable investments that generate reliable dividends – but not much excitement.

Inter Pipeline Fund shareholders would beg to differ.

Over the past five years, the Calgary-based company has delivered a sizzling average annual total return, including reinvested distributions, of 27 per cent, crushing the S&P/TSX composite index's annual gain of 2.6-per-cent over the same period.

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To the delight of income investors (disclosure: I'm a shareholder), the shares yield a hefty 5.4 per cent and the company has raised its monthly distribution for three consecutive years, including a hike on Nov. 3.

Risk v. reward

Certainly, Inter Pipeline's recent performance has been unusually strong and will be hard to repeat. But it illustrates that investors don't necessarily need to take on a lot of risk to achieve solid returns.

As a major energy infrastructure business, the company is benefiting from growing volumes on its two oil sands pipelines (a third is under development), robust margins in its natural gas liquids (NGL) extraction business and higher volumes on its three conventional oil pipelines. It's also a growing player in petroleum storage, with the recent purchase of four terminals in Denmark more than doubling its capacity in Europe to 19 million barrels.

But what makes Inter Pipeline attractive to risk-averse investors is that it is largely insulated from volatile energy prices. About 70 per cent of its third-quarter earnings before interest, taxes, depreciation and amortization (EBITDA) came from predictable, long-term transportation and storage contracts with no commodity price exposure.

"It's one of our top holdings and a good way to play the expanding oil sands production without taking on commodity risk," said John Stephenson, senior vice-president and portfolio manager with First Asset Investment Management.

'Triple play'

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Robert Cable, director of wealth management with ScotiaMcLeod in Mississauga, calls Inter Pipeline a prime example of stock that delivers a "triple play" – high income, distribution growth and a rising share price.

"Future returns are likely to be somewhat less than they have been in the recent past, but this company currently pays a terrific income, and it's an income that is very likely to rise further over the next several years. And if that happens, the share price is likely to follow," said Mr. Cable, who owns the shares personally and through the Conservative High Income Portfolio that he manages for clients.

It's worth noting that Inter Pipeline's distribution, which in recent years has been fully taxable in non-registered accounts, will receive more favourable tax treatment starting this year. As a limited partnership that became taxable in 2011, Inter Pipeline expects that nearly all of the distribution will qualify for the dividend tax credit or consist of return of capital, which has no tax consequences until the investor sells the units. Only a "minor portion" will be taxable as "foreign source income."


Not everything about Inter Pipeline's business is predictable. Fractionation or "frac" margins – the spread between the price of liquids such as propane and butane and the price of the natural gas from which they are extracted – are very favourable now, but that could change. To protect itself, the company has hedged part of its NGL liquids production for the next three years to lock in the current high spread.

Analysts have also expressed concern about declining volumes at the company's NGL extraction plant in Cochrane, Alta. Another potential risk is rising interest rates, which would hurt Inter Pipeline and other interest-sensitive stocks.

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Analysts bullish

Still, even after a 19-per-cent gain this year, the shares are rated a "buy" by five analysts and a "hold" by four, with no "sells," according to Bloomberg. "Despite the recent run in the stock, we would still buy it at these levels," Scotia Capital analyst Matthew Akman said in a note. He has a one-year target of $20 on the units, which closed Tuesday at $17.80. The average price target of analysts is $17.89.

Can the juicy distribution be sustained? The company has repeatedly said it can, and with a conservative payout ratio of less than 60 per cent of funds from operations, it has a nice cushion in place. But judging by the number of expansion projects under way and the company's recent comments, it's determined to raise the distribution, not just maintain it.

"We are particularly proud of the fact that Inter Pipeline has consistently increased distributions during a period of high market volatility and uncertainty," president and chief executive officer David Fesyk said in announcing the latest increase. The hike "reflects the confidence we have in Inter Pipeline's future performance given our large inventory of organic growth projects under development."

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