Pipeline Companies: An Overlooked Investment Opportunity?

Pipeline operators have been making the news as of late— and little of the coverage has been favorable. The media’s main focus has been on the fierce debate over TransCanada Corp.’s (TSX:TRP) $7.6-billion Keystone XL pipeline, which would pump crude oil from the Alberta oil sands to refineries on the U.S. Gulf Coast.

The Obama administration recently rejected the proposal in light of fierce opposition from environmentalists and landowners. The company now plans to reroute the line to address these concerns. It will then reapply for a permit, with an aim to start transporting the crude in 2015.

“Keystone Kops” reference comes at a delicate time for Enbridge

Concern about the safety of pipelines has been heightened by recent leaks that have caused significant environmental damage. For example, on July 25 and 26, 2010, a line in Michigan owned by Enbridge Energy Partners (TSX:ENB,NYSE:ENB) ruptured, spilling 800,000 gallons of oil into a tributary of the Kalamazoo River. Last week, the US National Transportation Safety Board (NTSB) released a scathing report on the incident.

“This investigation identified a complete breakdown of safety at Enbridge,” said NTSB Chairman Deborah A.P. Hersman in a press release. “Their employees performed like Keystone Kops and failed to recognize their pipeline had ruptured and continued to pump crude into the environment.”

The report comes at a delicate time for Enbridge, which is seeking approval for its proposed 1,177-kilometer Northern Gateway pipeline, which will carry 525,000 barrels of oil and 193,000 barrels of condensate a day from Edmonton to Kitimat, BC. Environmentalists and other groups have been raising concerns about the project.

Why pipeline investments are defying the negative press

Pipeline stocks have been holding their own despite the bad press. Units of the Alerian MLP Index ETF (NYSE:AMLP), an exchange traded fund that is a good barometer for the industry, are about where they were a year ago. And the two companies at the center of the storm have seen their share prices rise: TransCanada is up 7.7 percent from this time last year, and Enbridge has jumped 31 percent.

Pipelines have been attracting a lot of investor attention recently, because they offer an attractive mix of stability and higher-than-average dividend yields, two appealing traits in an era of low interest rates and volatile stock markets.

There are two main reasons for this stability. For one, pipeline operators get steady revenue streams from their businesses, often under long-term contracts. TransCanada, for example, says it has signed 17- to 18-year contracts with producers to ship oil through Keystone XL. As well, they’re less exposed to volatile resource prices, because their contracts tend to be fee-based and therefore less affected by swings in commodity prices.

Many pipelines in the US are set up as master limited partnerships (MLPs). This structure is similar in many ways to a Canadian income trust. MLPs don’t pay corporate income tax, which gives them more cash to pay out to unit holders in the form of distributions (similar to the dividends you get from a stock). In addition, MLPs offer investors a potential tax advantage because a portion of the income you get from them can be tax-deferred.

One example of an MLP with a steady payout and rising cash flow is Kinder Morgan Energy Partners LP (NYSE:KMP), which owns or has stakes in 75,000 miles of pipelines and 180 storage terminals. The company ships natural gas, refined petroleum products, crude oil and other chemicals.

Kinder Morgan pays a quarterly distribution of $1.20 a unit, for an annualized yield of 5.7 percent. Its cash flow rose 21 percent in the latest quarter, to $462 million from $382 million a year ago.

Diversified pipeline operators offer greater safety

There are a number of things to keep in mind when looking for pipeline operators to invest in.

For one, you’ll want to see rising cash flow and low debt. Both ensure that the company will be able to maintain (and hopefully increase) its distribution in the future.

In addition, the commodity that the company is shipping could have a significant impact on its longer-term prospects. Right now, natural gas prices are near 20-year lows, partly because new shale gas discoveries are driving up inventories. That could reduce demand for long-distance pipelines in the future, according to Keith Schaefer, publisher of Oil and Gas Investments Bulletin.

“[w]ith so many new shale gas deposits—located all over the US—now every market can be served with ‘local’ gas, greatly reducing the need for pipelines,” wrote Schaefer in a January article. “Dividend-paying pipeline companies have been some of the best performing stocks for resource investors, but the shale gas supply glut may drag them down now, as well.”

A good example of this is the 1,100-kilometer Mackenzie Valley Pipeline, which has been in the planning stages since the 1970s. However, the project is now on hold in light of the new shale deposits in the US.

An example of a more diversified pipeline operator is Inter Pipeline Income Fund (TSX: IPL.UN), which operates a range of energy-related businesses. In western Canada, it has 6,100 kilometers of pipelines, as well as storage facilities with a total capacity of 4.8 million barrels. Its pipelines handle 950,000 barrels of oil sands bitumen and crude oil a day. Inter Pipeline also extracts natural gas liquids (NGLs) and operates a liquid storage business in Europe.

The company is set up as a publicly traded limited partnership, which is similar to an income trust. It pays a monthly distribution of $0.0875 a unit, for a high 5.46 percent yield.

Attention to maintenance is an often-overlooked factor

Something else you’ll want to look for, as the Enbridge incident illustrates, are companies with modern pipelines and sterling safety records. Many of North America’s pipelines are reaching a point where significant repairs will be soon necessary. According to Forbes magazine, 41 percent of US oil pipelines were built in the 1950s and 1960s, and another 15 percent are even older.

That’s something that Enbridge has learned the hard way. So far, the company has spent $800 million on the ongoing Michigan cleanup, plus the costs to repair equipment and retrain its employees.

Securities Disclosure: I, Chad Fraser, hold no positions in any of the companies mentioned in this article.