July 19, 2017 - Oil and Gas Pipeline Overview and Analysis

Weekly Market Update: Major Index Performance YTD (as of July 14, 2017). S&P 500 (in C$ terms: + 4.3%), TSX (+0.78%), Developed Europe Index (in C$ terms: +12.79%), Canadian Aggregate Bond Index (+1.14%). All measures on a total return basis including dividends reinvested.

Canadian markets were up 1% for the week, following actions by the Bank of Canada to raise short-term interest rates (to 0.75% from 0.50%) for the first time in 7 years. Optimism also sent the Canadian dollar higher to nearly 0.79 (USD) on Wednesday, the highest level in 14 months, as investors are preparing for more future rates hikes in the months to come. Market performance was also helped by a rebound in the price of oil as the WTI rose 5.4% over the week to close at $46.59, on stronger oil demand. U.S. markets were also higher with the S&P 500 and DJIA reaching record intraday highs, led by technology, energy, and materials. Q2 Earnings season also kicked off, led by several major banks on Friday. Major European stock indexes also rose for the week, following signs that major central banks would not take actions to tighten monetary policy as early as believed. Chinese economic data showed the economy grew at a faster than forecasted rate of 6.9% YoY based on strong industrial output, domestic consumption, and investment, though market responses were mixed following announcements that the government will continue to increase scrutiny of the financial system.1

Portfolio Recommendation: North American Pipelines  Macro environment of Natural Gas and Oil are positive for pipelines for at least the next 5 years  Management of our “top picks” are confident in ability to grow dividends and cash flow. This makes them not only great defensive names, but also allows for even more potential stock upside as key growth projects are approved and become operational.  Prefer Canadian names as they tend to be better managed, and have made great acquisitions to gain further exposure to growing US shale and LNG markets.  Pecking order: Enbridge, TransCanada, Williams, Pembina, Kinder Morgan

North American Oil and Gas Pipeline Macro: The oil and gas pipeline business, also known as midstream services, involves the transportation of oil and natural gas from producers to refineries and in some cases on to final consumers. While there are both Canadian and American companies in the space, the companies we will be focusing on have cross border presence, with the larger Canadian companies in particular having sizable US footprints. While the pipeline companies tend to trade in reaction to oil and gas prices, as investors tend to view falling oil prices as a sign for future reductions in production, many pipeline companies’ cash flows actually have limited commodity exposure. For the largest name in our coverage, Enbridge, this commodity exposure on cash flows is under 5%. This lack of commodity exposure comes partly from the fact that pipeline companies operate on what are known as “take-or-pay” contracts. Under a “take or pay” contract, the payor (in this case the shipping companies), is obligated to pay regardless of whether or not the payor uses the services, volumes, or capacity stated under the contract. This means that even if oil production volumes fall below forecasts, and production companies aren’t able to meet demand, the pipeline companies still get paid. These contracts vary in length from around 5 yrs. for shorter life assets such as natural gas and tight oil, but average around 25 years for longer life assets such as oil sands. However, because of the way pipelines have historically traded, the most important macro factors to look for when predicting the future financial stability of pipeline companies is oil and gas production and volumes shipped. 2

World gas consumption growth is expected to remain under 2% over the next few years, with growth mainly being driven by India and China with the replacement of coal-fired power plants by natural gas. Cost economics should drive a similar coal-replacement process on the East Coast of the United States as well, despite Trump’s dreams to revive the coal industry. Slow consumption growth means the market is predicted to remain oversupplied in the next few years, which should lead to a more competitive trading environment. This has prompted the growth of the US natural gas export market. Sabine Pass in Louisiana is the country’s first LNG export terminal, and is currently exporting 2 Bcf/d (billion

1 Bloomberg, BMO Research 2 Enbridge Investor Presentation cubic feet per day). However, by 2020 the U.S. is predicted to be exporting 5-6 times that amount, as five additional export terminals come online. To put that number in perspective, it would represent around 15-17% of the US’s total current gas demand. This would be a substantial increase, and even more interesting considering the U.S. was exporting no natural gas in January 2016. By 2019, the U.S. is expected to become the 3rd largest LNG exporter in the world behind Qatar and Australia, and is predicted to generate 40% of the rise in global gas output between 2016 and 2022. Gas exported from the Sabine Pass can reach any major import terminal within 25 days, and is sourced from a variety of locations including the Motney in western Canada. This is because Canada’s own LNG export facilities on the West Coast won’t be ready until at least 2022. Sabine gas is also contributing to the flexibility of the market, as almost 40% of exports last year were sold under spot transactions, as opposed to traditional longer-term contracts linked to the price of oil. Furthermore, natural gas trade is becoming increasingly political as the availability of US gas internationally means that some eastern European countries may no longer be forced to buy their gas from Russia.3 US LNG exports are on track to shake up the global market, and North American pipeline companies are well positioned to keep the exporters supplied. International exports combined with growing domestic demand from GDP and population growth as well as industrial power generation should see US gas production growing around 3% a year. US natural gas demand is also expected to be driven by domestic ethane demand, which feeds the growing US Gulf Coast petrochemical industry. This means as gas production grows, pipeline infrastructure will have to grow with it. This should put TransCanada, the leader in the North American gas pipeline market, in a good position from both a cash flow and growth perspective. 4

Oil production volumes in both the US and Canada also create a positive environment for pipeline companies for at least a 5-10yr. horizon. Canadian oil production is expected to increase, with large contributions from oil sands. The Canadian Association of Petroleum Producers sees output increasing by 270,000 barrels/day in 2017 and another 320,000b/d in 2018, a combined two-year increase that is equal to almost a third of OPEC’s production cuts made earlier this year. As a reminder, the US imports more than 3 million barrels/day of crude from Canada or as much as they import from all other OPEC countries combined. Oil sands production also can’t be easily turned on and off compared with shale production, which means production should be less sensitive to price fluctuations. The vast majority of this oil is transported by Enbridge, and to a lesser extent, TransCanada and Kinder Morgan, three of the largest names in our coverage universe. Growth in Canadian production actually means that the pipeline companies will be constrained over the next few years, and have thus proposed several multi-billion dollar pipeline projects in response. While it is unlikely that all major projects will be completed due to a combination of regulatory and overbuild risk, Enbridge’s Line 3 project seems to most likely. The earliest any of these projects could come online is 2019, meaning that more oil and gas will have to be shipped by rail in the short term. If the majority of the projects are approved however, we could see an overbuild scenario where there is not enough Canadian oil production to meet pipeline capacity, but pipeline completions still represents significant upside potential for the pipeline companies. The key projects to follow are Enbridge’s aforementioned Line 3, Kinder Morgan’s TransMountain expansion, and TransCanada’s Keystone XL. 5

As mentioned in our last two comments, the U.S. has also been ramping up production, and is constantly seeking to replace foreign imports with domestic production, and eventually hopes to become a net oil exporter. This will drive growth in pipeline infrastructure as international oil imports (excluding Canada) most commonly arrive along the Gulf Coast, where many refineries are also located. In contrast, domestic shale production that will most likely replace these imports is sourced mainly from North Dakota and Texas, and will have to be shipped to the refineries by pipeline.

3 Financial Times 4 International Energy Agency 5 Canadian Association of Petroleum Producers

Canadian Pipeline Companies:

Enbridge: 1Q17 Earnings generally fell below consensus expectations, but this was largely due to a later than expected close of the Spectra deal, as well as integration of the two large companies. Outlooks for the company remained unchanged for 2018 and beyond. Management remains confident in their 10-12% dividend growth targets, which is mostly supported by a $31B secured backlog of projects, stable and predictable cash flows from contracts, the potential to gradually increase payout ratio within the 50-60% range, as well as some merger synergies and foreign currency tailwinds. The feasibility of these targets is supported by BMO analyst forecasts, which predict dividend growth of 10% between 2017 and 2018. However, based on a payout ratio of dividends over distributable cash flow, we predict the payout ratio to be higher for 2017 (63%), before returning to 59% in 2018. The company has paid dividends for more than 6 decades, and has increased its dividend for 21 consecutive years. As of March 31st, 2017, the company has $30B of committed credit facilities, up from $20B in 2016, and has $14B in available liquidity that hasn’t been drawn. Enbridge’s revenue stream breakdown is as follows: 47% of EBITDA from liquids transportation, 34% from gas transportation, and 17% from gas distribution utilities. In addition, 95% of their revenue is protected from volume and price movements. The stock price was also hurt after the $37B Spectra merger, partly due to large US mutual funds and ETFs selling their newly acquired Enbridge positions if they didn’t want the Canadian exposure. We believe this provides a good buying opportunity for the stock, and it continues to remain one of our favorites. Strong, stable cash flows as well as consistent dividend growth make it a great defensive play, and projects such as the Line 3 expansion offer great potential upside and growth for the stock price. Enbridge remains our top pick. 6

TransCanada: 1Q17 Earnings generally beat consensus estimates, driven by strong US gas pipeline results (which included stronger than expected contributions from the Columbia Pipeline acquisition), as well as Mexico. Analysts continue to see additional upside from the company due to revenue synergies from the Columbia transaction, new capital projects, and a financing plan that is seeking multiple sources of capital. Last month the company issued $1.5bn in hybrid securities, and also recently filled a $1bn prospectus for common shares to be sold “at-the-market” (a first for the Canadian market), showing the company is well positioned to fund its capital plan without the need for discreet common

6 BMO Research, Enbridge Investor Presentations equity issuances. This is in addition to being able to fund near-term capex through cash flow from operations, a dividend reinvestment plan, and good access to capital markets. The timing of the spend for the company’s natural gas expansion projects also places the majority of capex (~80%) in 2019E and 2020E, which is when most of the company’s ongoing capital program will be entered into service and providing substantial free cash flow. The company expects annual dividend growth in the upper end of the 8-10% range, supported by earnings and cash flow growth, as well as strong coverage ratios. Again, these targets are supported by BMO analyst forecasts, showing 10% dividend growth from 2017- 2018, and payout ratios decreasing from 60% this year, to 53% in 2018. Looking further, dividend coverage outlook based on comparable distributable cash flow per share ranges from 1.6x-2.0x from 2017-2020, providing confidence that the management will be able to comfortably hit dividend targets. TransCanada is another company providing consistent dividend and cash flow growth, and is a good option for an investor wanting to capture US LNG export growth in the years to come. Would rank TransCanada almost on par with Enbridge in terms of consistency and stability, but see less potential upside for the stock due to the uncertain approval of TransCanada’s major project (Keystone XL), as opposed to peer projects. 7

Pembina: 1Q17 earnings represented a second consecutive strong beat. The company has also received a lot of positive support from analysts for its announcement of a $9.7bn acquisition of Veresen Inc, a highly synergistic asset that will offer accretion from year one, though market reactions were soft potentially driven by merger risk-arbitrage trades. The acquisition will help Pembina’s long term growth profile, and diversify its customer base, hydrocarbon revenue mix, and geography. Management remains confident in 6% dividend growth in the medium term and believes there is ample retained cash to fund growth without any further equity issuances. Management is also targeting 8-10% cash flow per share growth through 2020. Pembina is a great company, and although projected dividend growth is weaker than Enbridge and TransCanada, would be a good add to a portfolio that wants to increase pipeline exposure, but wants diversification from Enbridge and TransCanada, who’s performance may be more linked to approval of major expansion projects. 8

US Pipeline Companies:

Kinder Morgan: The Company reported strong 1Q results, mostly in line with consensus, but beating on numbers such as distributable cash flow. The CO2 and terminal businesses beat estimates, while the natural gas and Canadian businesses were below estimates on lower transportation and TransMountain Expansion (TMX) volumes. Management also noted they were seeing positive developments so far in 2Q, but there seems to be some uncertainty surrounding dividend guidance, and how the company plans to grow dividends while also covering growth and maintenance capex. This could be helped by growth capex slowing down beyond 2018 as a couple major projects are brought online and begin to generate cash flow, but more guidance will need to be given on these projects at Q2 earnings release. Another uncertainty for the company comes in the form of interest rates, as $10.8 billion of their debt is at a floating rate, which could significantly impact their DCF generation if we see interest rates rise. Another important update investors will be waiting on is the company’s TMX. There is large potential upside for the company if the project is completed in a timely manner, but there is still a massive amount of uncertainty for the project. While Trudeau gave the project Federal approval, the provincial BC government led by the NDP party seems determined to block it. This is on top of the recent BC wildfires which have the potential to cause further delays. Kinder Morgan’s stock has been beaten down since dividends were slashed in 2015 and could offer a speculative play in a rebound, but this turnaround seems to rely on too many uncertain factors for us to make a confident investment in the company at the moment. Hopefully management can clarify some of these uncertainties at Q2 earnings release, with particular highlights of dividend growth ability, and progress on the TMX. 9

Williams: The Company reported a slight beat in earnings for 1Q17 results, and the main highlight for the quarter was the announced $2.1b sale of the Geismar plant. However, we are still waiting for clarification on the planned uses for the proceeds. The company’s biggest growth driver is probably its Transco pipeline, which delivers natural gas to a variety of customers on the East Coast of the US. The Northeast continues to offer a lot of natural gas opportunity, with Williams well positioned in the Marcellus shale field. Williams Partners, a subsidiary of Williams Companies (the parent stock we are covering), has around a 34% market share in the region and low cost of capital. Williams was the pipeline company that was most hurt following dividend cuts in 2015, but management now seems dedicated to reducing company debt as well as growing dividends. Management appears on track to reduce debt of the parent company by $500m in 2017, and will pay all borrowings under its credit facility in 2018. This deleverage should put the company in a strong position to

7 BMO Research, TransCanada Investor Presentations 8 BMO Research, Pembina Investor Presentations 9 BMO Research, TransCanada Investor Presentations drive dividend growth or even target share repurchases. This should really start to ramp up in 2018 as Transco and gas growth in the North East continues due in part to coal to gas generation conversion. Analysts believe that Williams could have the ability to grow distributions at 15%+ from 2018 and beyond, as well as being able to keep a healthy balance sheet to self-fund new projects. Williams is well positioned for natural gas growth, and faces relatively fewer regulatory challenges in expanding their market share and pipeline capability in this core business. These factors coupled with potentially stronger than expected dividend growth lead us to prefer Williams to Kinder Morgan in US pipelines. 10

Cecil Hayhoe Gwyneth Pryse-Phillips Matt Ciprietti Investment Advisor Investment Advisor Investment Representative (416) 359-5361 (416) 359-5384 (416) 359-4135

[email protected] [email protected] [email protected]

Sources: Bloomberg, JP Morgan, Thomson, Moody’s & BMO Nesbitt Burns Capital Markets research

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10 BMO Research, Williams Investor Presentations