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Exxon Inferior to Pipelines in Energy Investing

Exxon Inferior to Pipelines in Energy Investing: Riskless Return
Measuring pipe before changing a drilling bit on Orion's Altair natural gas rig in Edna, Texas. Photographer: Eddie Seal/Bloomberg

Pipeline companies offer the best returns in energy for investors seeking to cash in on the U.S. shale boom while avoiding the volatility of a commodity market that’s seen natural-gas prices reach a 10-year-low and crude bounce above $100 a barrel.

The BLOOMBERG RISKLESS RETURN RANKING shows pipeline companies in the past five years have provided triple the risk-adjusted return of companies that produce and refine oil and gas, such as Exxon Mobil Corp., the next best group. Enbridge Inc. of Canada leads companies on the Bloomberg World Pipelines Index, which returned 2.9 percent when adjusted for price swings. Producers focused on finding and extracting oil and gas gained 0.5 percent.

Pipelines are the toll roads of the energy industry, inoculated against price swings thanks to long-term contracts that lock in fees based on the volume of products they ship. Demand for shipping is expected to grow as oil and gas drilling accelerates in U.S. shale fields. With energy’s best returns and lowest risk, pipelines have attracted investors such as Goldman Sachs Group Inc., which owns 19.1 percent of Kinder Morgan Inc., the parent of the second-biggest U.S. pipeline company.

“These are companies that have multiyear contracts involving products that are essential to the functioning of society,” said Randle Smith, a portfolio manager with Duff & Phelps Investment Management Co. who helps manage $4.9 billion of global utilities and infrastructure investments, including more than 2 million Enbridge shares. “They’re not taking on commodity price risks, so it’s a very secure business model.”

Enbridge’s Lowest Risk

The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period of time, increasing the potential for unexpected losses compared with a security whose price moves at a steady rate.

Enbridge provided a 6.8 percent risk-adjusted return in the past five years, the highest among the 89 companies on the Standard & Poor’s Global 1200 Energy Index, as well as among the 20 biggest pipeline companies in the world as measured by market value. The return was more than triple the 2.1 percent average on the Cushing 30 MLP index, which includes many competitors that operate as partnerships.

Better Than Exxon

The Calgary-based operator’s risk-adjusted return was almost 10 times that of Exxon, which has the top credit rating from three rating companies and is a mainstay of energy portfolios around the world due to its stable returns and dividends. Enbridge had higher returns than 94 percent of energy stocks on the S&P Global index.

Chief Executive Officer Pat Daniel sees no reason for the company to take on riskier investments.

“That’s Enbridge,” he said in an interview. “We’re not a ‘Hail Mary’ kind of company. We’re a grind it out, win it every day, consistent performer.”

Enbridge returned 150 percent to shareholders in the past five years through price appreciation and dividends, the highest among pipeline companies. Enbridge has earned $5.53 billion for shareholders since 2007, slightly higher than the $5.45 billion of Kinder Morgan Energy Partners LP, which had the second-highest risk-adjusted return of pipeline operators after Enbridge.

Enbridge fell 0.3 percent to C$38.83 at the close in Toronto.

Stability Hallmark

Enbridge had the second-lowest volatility of the pipeline companies after TransCanada Corp., another Calgary-based company that is seeking to build a pipeline from Canada’s oil sands to the Texas coast.

Stability has been a hallmark of pipeline companies, whose shipping agreements with refiners and oil and gas producers often last for decades and include regular price increases. Though rising prices can chip away at demand, during the recession of 2007 to 2009, gasoline demand dropped just 3 percent, said Chris Eades, who helps manage more than $2 billion in a pair of pipeline-oriented funds at Legg Mason’s ClearBridge Advisors in New York.

“A 3 percent swing in volumes is not going to make or break one of these pipeline companies’ ability to pay their distribution,” he said.

Soaring Demand for Pipes

The need for pipelines soared in the past five years as improved technology allowed companies to expand production in U.S. shale-rock formations and Canada’s oil sands. North American output may grow 70 percent by 2020, possibly surpassing that of the Middle East, according to Citigroup Inc.

Oil production in North Dakota reached 535,000 barrels a day in January and could grow to 1 million by 2020, said Dan Spears, a fund manager at Swank Capital LLC. Production in the Eagle Ford Shale, almost non-existent in 2007, may grow to 850,000 barrels a day by the middle of this year.

“All these guys have got to build more storage and more pipelines to get their oil to market,” Spears said.

Pipelines have cost advantages over other sectors of the industry. Drilling for oil and gas has become more expensive as exploration moves farther offshore or into more drilling-intensive formations like shale, said Bob Brackett, an analyst with Sanford C. Bernstein & Co. in New York. The cost of finding and developing a barrel of oil has risen 14 percent annually for the past 10 years.

Tougher Rocks

Some of the inflation is cyclical, based on the price of labor; the rest is a result of “the rocks getting tougher” and requiring more expensive production techniques, Brackett said in an interview. Reducing those costs “would take a technical breakthrough that we haven’t seen yet.”

While the cost of drilling was rising, market volatility pushed oil to $145.29 a barrel in 2008, then down to $33.87 the same year before rising again to about $102 this month. Natural gas reached $13.577 per million British thermal units in 2008 then fell this month to less than $1.975, the lowest since 2002.

Those price swings have cut into profits for both explorers and refiners such as Marathon Petroleum Corp. and Valero Energy Corp. Rising prices for Brent crude, the international benchmark, has increased costs and hurt profitability for U.S. refiners on the East Coast, which rely on imports to process fuel, said Zach Parham, an analyst with Bloomberg Industries.

International Oil Spikes

Brent spiked to a high of $126.65 in 2011 as political turmoil spread in the Middle East. It rose again to a high of $126.22 this year, driven by demand from China and Iran’s threat to close the Strait of Hormuz, the sea lane that carries a fifth of the world’s oil, according to data compiled by Bloomberg.

Oil service and equipment companies also have seen more volatility as fluctuating prices drove demand for drilling. The 15-company Philadelphia Oil Service Sector Index returned 0.1 percent, after adjusting for volatility, during a five-year period that saw offshore demand evaporate in the Gulf of Mexico following the 2010 BP Plc oil spill and onshore demand explode from new shale fields.

Many of the pipeline networks operated by Enbridge and its rivals were already in place when the North American drilling boom began. The U.S. already had 278,000 miles (447,000 kilometers) of gas transmission lines and 160,000 miles of oil and products lines, according to the U.S. Transportation Department.

Well-Placed Networks

Many of Enbridge’s existing pipelines were already in or near the new sources of oil and gas, ClearBridge’s Eades said. Its Canadian mainline system was built in the 1950s, for instance, and was well-positioned when Canada’s tar sands region began producing oil.

It’s not all clear sailing for pipelines. Many new projects are facing increasing environmental scrutiny and greater oversight by regulators concerned about leaks and safety. Environmental groups were able to block TransCanada’s proposed Keystone XL line from Canada to Texas, at least temporarily, because of concerns it might pollute water in Nebraska.

At the same time, new gas fields such as the Marcellus Shale in Pennsylvania have been developed closer to major East Coast cities, reducing the need for long-haul pipelines to those areas, said Greg Reid, managing director of Salient Partners LP, which has about $600 million invested in energy infrastructure.

Companies are finding ways to adapt, often by expanding or repurposing existing pipelines.

Reconfiguring Existing Pipes

Kinder Morgan plans to boost its oil shipments in Canada by expanding its decades-old Trans Mountain pipeline, which runs from Alberta to Vancouver. Kinder also is considering a conversion of its Pony Express gas line to carry oil from expanding production in North Dakota’s Bakken shale.

Spectra Energy Corp., whose Texas Eastern system has shipped gas northward since the 1940s, said April 12 it may reverse part of the system to carry gas from the Marcellus to new power plants in the U.S. Southeast.

After the Keystone project was blocked, Enterprise Products Partners LP has worked with Enbridge to reverse the Seaway pipeline between Cushing, Oklahoma, and Houston. Coupled with other expansions, the project will enable Enbridge to ship an additional 500,000 barrels a day of crude from Canada to Texas.

Daniel, the Enbridge CEO, sees no reason to change the business model any time soon.

“Our society is kind of aimed at rewarding risk-takers, but if you can get to the end result without taking risk, why do it?” he said. “Why risk your investors’ money if you can get there with a low-risk investment?”

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