Canadian pipeline operators have been delivering something far more interesting than oil and natural gas along their expansive North American networks: They’ve also been providing huge returns to investors within the past eight months as their stock prices soar.
Is the rally sustainable?
For a sector that strives for utility-like stability – which comes from long-term contracts and impossibly high barriers to entry – the gains have been unusually strong.
TC Energy Corp. TRP-T, which operates a sprawling, 93,600-kilometre-long network of natural gas pipelines through Canada, the United States and Mexico, has rallied 48 per cent since July, not including dividends.
Enbridge Inc., ENB-T which has 30,500 kilometres of natural gas pipelines and more than 29,000 kilometres of oil pipelines throughout North America, has risen 43 per cent since April. Woo-hoo! I mean, full disclosure: I own shares.
Falling interest rates, which make dividend-paying stocks look more attractive compared with bonds, no doubt are playing a significant role in the rally. Lower rates also ease the pressure of debt payments.
The depressed Canadian dollar, which has drifted below 70 U.S. cents over the past month, down from 74 U.S. cents throughout most of 2024, is another tailwind. The lowly loonie has enhanced the value of U.S.-dollar revenues.
But the enormity of the pipeline rally suggests more is going on here.
TC Energy completed the spinoff of its crude oil pipelines, now an independent company called South Bow Inc., in October. If the restructuring was designed, in part, to give investors a clear choice between natural gas and oil assets, it was a ringing success.
Enbridge made its own big deal in 2023 when it paid US$9.4-billion for three U.S. utilities to create North America’s largest natural gas utility.
Although the deal initially weighed on Enbridge’s share price, natural gas has been gaining favour with investors – and a certain U.S. political leader in Washington, who has taken a dim view of renewables such as solar and wind.
In the space of a couple of years, gas has emerged as an essential fossil fuel that can satisfy a ravenous appetite for stable, cheap energy in North America.
The rise of power-hungry data centres to support the rollout of artificial intelligence applications – currently set to drive an estimated 100 gigawatts of additional capacity by 2030, according to Patrick Kenny, an analyst at National Bank of Canada – adds significantly to the appeal of natural gas as an energy source.
“With nuclear and scalable, long-duration battery storage still a decade-plus away, natural gas stands out as the only realistic near-term option for adding reliable generation,” Mr. Kenny said in a note last month.
Pipelines – once shunned for their exposure to fossil fuels, the regulatory roadblocks that stood in the way of expansion and the belief that they were poised to fade in importance as renewable energy gained traction – are back in fashion.
But investors, witnessing dividend yields decline as share prices rise, might now be addressing an issue that has not been associated with the sector for many years: The stocks are richly valued.
Enbridge’s dividend yield fell to 5.8 per cent earlier this week, when the share price zoomed above $65 Tuesday, from a high of 8.2 per cent in October, 2023.
Using another approach to valuation, the shares trade at 23 times analysts’ estimated earnings, according to Bloomberg. That is relatively high for a regulated, utility-like investment that can mirror the bond market and implies that a lot of good news is already priced into the stock.
TC Energy has a lower price-to-earnings ratio, 16.5, also according to Bloomberg, but the dividend yield is less attractive at 4.8 per cent.
When compared with 10-year Government of Canada bond yields, pipeline dividend yields offer a relatively paltry incentive for the added risk. The spread is lower than the average over the past five years, according to Mr. Kenny.
Nonetheless, there is no reason to run from a winning theme, even if it looks stretched.
Rising profits should ease valuation concerns over the longer term and can feed into debt repayments and dividend hikes. Additional rate cuts by the Bank of Canada, if inflation remains subdued, should make dividend yields stand out next to government bonds.
More importantly, the bet on pipelines is something that will play out over many years as AI promises to become a reality. The slow rollout might test the patience of short-term investors. For others, collecting big dividends while the world comes to appreciate pipelines as essential infrastructure offers a good reward for staying put.