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When energy prices were in the dumps earlier in the pandemic, Canadian pipeline stocks were solid investments thanks to their stable cash flows and big dividends.

But the sector is facing a couple of stiff challenges, leaving investors with a tough question: Should they stay put?

The basic argument in favour of pipelines is that they have limited exposure to volatile commodity prices – they transport oil and gas; they don’t sell it – providing long-term investors with a smoother ride over time and less exposed to the cyclical nature of oil and gas.

This helped during the darker days of the pandemic, when the price of crude oil plummeted but production volumes remained relatively stable.

Over the past three years, a period that includes the pandemic and economic recovery, pipelines delivered strong returns: TC Energy Corp.’s share price has risen 16 per cent and Enbridge Inc. has risen 18 per cent, not including dividends.

Suncor Inc.’s three-year return lags the pipelines substantially: The oil producer’s share price has declined 3 per cent over this period.

Investors are now facing a new era, though, as commodity prices surge. The price of West Texas Intermediate crude, the North American benchmark, has risen 39 per cent in 2022 alone. Natural gas has risen 90 per cent this year.

These gains have ignited the share prices of Canadian energy producers, which are bathing in cash and raising their dividends. Canadian Natural Resources Ltd.’s share price is up 61 per cent this year and Suncor is up 36 per cent.

Pipelines, meanwhile, are essentially sitting on the sidelines as oil and gas prices soar.

Robert Hope, an analyst at Bank of Nova Scotia, reported last week that TC Energy’s senior management team believes that strong commodity prices won’t have a big impact on the company’s cash flows in the near-term.

Pipeline stocks are also facing at least two challenges.

First, central banks are raising interest rates, which is driving up yields on bonds and guaranteed investment certificates. As a result, dividend-generating stocks have more competition for investor attention, which means that pipelines stocks could struggle if rates rise further.

Second, rising stock valuations suggest that pipeline stocks are no longer cheap.

According to Raymond James, the stocks currently trade at an average of 11.5-times estimated EBITDA (earnings before interest, taxes, depreciation and amortization). That’s above the long-term average of 11-times estimated EBITDA and slightly higher than the sector’s valuation before the pandemic.

That’s not exactly enticing.

However, anyone who can’t resist the allure of steadily rising dividends – 27 consecutive years of increases in the case of Enbridge; 22 years in the case of TC Energy, which kicks off the first-quarter reporting season for the sector on April 29 – may want to tune out the near-term challenges and focus instead on the potential upside.

Canadian energy producers are ramping up production even as they hold off on launching expensive new projects, which should generate more demand for pipelines.

“While the higher commodity prices have yet to entice producers to abandon their capital disciplines – at least en masse – there has been a clear response in production volumes,” Andrew Bradford and Michael Shaw, analysts at Raymond James, said in a note this week.

They believe that TC Energy offers the best opportunity among pipelines at this point. The company has strong growth prospects, with a backlog of $24-billion worth of projects in development.

While the stock’s valuation is elevated, it trades at a discount next to the broader utilities group, providing an offset as interest rates move up, they believe.

“The market is searching for energy exposure,” the Raymond James analysts said.

As investors grow more confident that Canada’s fossil fuel industry will remain in demand for years to come and recognize TC Energy’s growth outlook, the analysts added, “we expect its valuation discount will continue closing, which would in turn provide a boost to TC’s valuation despite the move higher in interest rates.”

The best part? Though pipelines aren’t keeping up with energy producers right now, they are relatively insulated from a correction in oil and gas prices. That smooth ride still means something.

Full disclosure: The author owns shares of Enbridge Inc.

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