Originally posted 9 October 2017
On Thursday 5 October TransCanada Corporation announced that it was no longer going to spend any more shareholders’ money to seek approval to build a pipeline to the Atlantic coast. While much nasty recrimination will unfold for a few more weeks (the bad Liberals for supporting Bombardier which is paid for by our equalization payments, etc, etc), this remains a carefully thought out corporate decision.
As the headlines and articles below illustrate, the expected decision by TransCanada has led to much finger-pointing, gnashing of teeth and hand-wringing. The usual suspects or villains include: Prime Minister Justin Trudeau, Premier Rachel Notley, the National Energy Board, and that ex-Liberal Minister, the Mayor of Montreal, Denis Coderre.
Notwithstanding reasons to hold these people responsible for a “lost” economic opportunity, the decision provides telling lessons to investors of different stripes.
Successful investors are usually seen as those shrewd analysts of “value creation.” That is to say they are curious about how a company makes money to reward its owners. Value is created by a variety of competitive advantages including: intellectual property rights; dominant market position; lowest cost production; location (think real estate); and government-granted rights (think Russian oligarchs, the CPR); and myth-making (think marketing – think tap vs. bottled water).
A short History of TransCanada
TransCanada Corporation was begotten in the early 1950s after the “great debates” over the proponent’s monopoly to deliver natural gas from the western sedimentary basin to Ontario. C.D. Howe, the Liberal Minister of “Everything” and Industry Czar, was tasked with spiriting through legislation granting monopoly rights to TransCanada to build the pipeline. TransCanada was incorporated by an Act of Parliament in March 1951. The debate came to be a thorn in the side of the Liberal Party under Louis St. Laurent. The Liberal government’s use of closure at the end of this divisive debate led, in part, to John Diefenbaker’s successful campaign at unseating the Liberals in the 1957 federal election.
If we fast-forward to the late 1990s, TransCanada or TCPL (or TRP, its ticker symbol) became much larger when it merged with Nova Corporation, as NOVA split its business between petrochemicals and pipelines. (NOVA, originally Alberta Gas Trunk Pipeline (AGTP) – an Alberta Company, was established in 1954 by the Manning administration. AGTP had a near monopoly over gas distribution in Alberta.) Thus TRP became a very large, Calgary-based pipelines company that unified its national pipelines business with an Alberta gas-gathering and delivery stream.
By the early 2000s, TRP was on the radar screen of Wall Street analysts and investment bankers. TRP, which became a pariah to investors in the mid-1990s when it reduced its dividend, was now an object of great interest. In 2003, the company reorganized to provide the company with greater flexibility in “how it holds its assets in the future.” Restrictive borrowing covenants hampered the firm’s capacity to enter into partnerships with other companies, investing into biomass or hydro electricity, or take a 100 per cent ownership in a U.S. pipeline. The re-organization paved the way towards a future with more and larger capital projects, more equity and debt issuance earning big fees for investment banks.
Rapid growth
In 2003, TRP bought a 30 per cent interest in the Bruce Nuclear generating station in Ontario. TRP has investments in other power stations across North America including facilities in Quebec, New Brunswick, Alberta, Maine and Rhode Island. In 2006, the company entered the wind-power business in Canada with construction of Cartier Wind in Quebec. In 2008, TRP make a $2.8 billion investment in the huge Long Island, N.Y. Ravenswood generating station (2,480 MW). In 2011 TRP entered into solar energy generation with eight projects in Ontario. In 2013, TransCanada signed a unique Joint Industry Partnership with Enbridge to collaborate on research and development into pipeline leak detection. By 2014, Keystone Pipeline System began delivering crude oil to refineries on the Gulf Coast of Texas, with completion of the Gulf Coast pipeline project. See TransCanada history
In July 2016, TransCanada completed its largest transaction acquiring all of the outstanding shares of Columbia Pipeline Group, Inc. for a total price of US$13 billion, along with the assumption of approximately US$2.8 billion of debt. In order to finance this acquisition, TRP sold its Ravenswood plant and other Northeast U.S. power assets.
As of June 2017, TransCanada had assets of $87 billion, long-term debt of $31.3 billion and common equity of $20.5 billion. In its recent June quarter, the company generated $2.7 billion in cash from operations and paid out about $700 million in common and preferred share dividends.
Shareholder value
The key to increasing shareholder value (and rising dividends and executive salaries tied to the value of the shares) was the need to add to the future revenue stream of the company. And that meant new projects. Hence Keystone was commenced in 2000s to marry TRP’s expertise in pipeline and regulatory management with the growing production of Alberta’s oilsands. Keystone relies, and relied, upon the desire of the oilsands industry to gain a market in the United States- that is the refineries in Illinois or on the Gulf Coast. With the first stage completed in 2014, the XL component was frozen for nearly eight years as the Obama administration (U.S. State Department) tried to navigate both environmental objections and the industry’s push for permission to expand the system.
Given the regulatory deadlock south of the border, in 2013 TRP initiated the Energy East project as a back-up plan should Keystone XL not proceed, a rational thing to do. Over time the Energy East project also began to get mired in regulatory dramas, environmental opposition, NIMBYism, and inter-regional political power politics. Part of the difficulty stemmed from the public’s growing distaste of the federal Conservatives’ obvious defence of energy interests over the environment. However with the election of Donald Trump and his approval of the Keystone XL project, the writing was on the wall. Changes in the regulatory process may have been an irritant to TRP, but the company’s commitment to shareholders to grow its earnings and cash flow steadily, trumped carrying forward an increasingly fraught investment. Energy East statement
The statement’s reference to a charge of upwards of $1 billion in after-tax non-cash charges seems to have fallen on deaf media ears. In any event, TRP’s share price has gained over the past two trading days since the announcement.
The general message to TRP shareholders and debtholders seems to be “who cares?” A billion here or there- so what? with so much liquidity swirling around. But not only do investors lose (although the market probably had discounted the decision already) but so too does our society. Capital and human energy are scarce commodities. In the fruitless pursuit to curry favour, politicians prostrate themselves at the feet of corporate overlords (think Amazon) while corporate kingpins seek support from regulatory and bureaucratic elites.
Challenge to investors from climate change
TRP appears to understand the need to diversify its pipeline portfolio as well as its energy portfolio. In a speech given by Governor Mark Carney of the Bank of England on 29 September 2015, Carney presented a compelling argument to Lloyd’s of London on the need to consider climate change in its business affairs. Carney BoE 29 September 2015 Although Carney focussed primarily on the insurance industry, he went on to discuss “transition risks.” According to Carney:
A ‘market’ in the transition to a 2 degree world can be built. It has the potential to pull forward adjustment – but only if information is available and crucially if the policy responses of governments and the technological breakthroughs of the private sector are credible. That is why, following our discussions at the FSB last week, we are considering recommending to the G20 summit that more be done to develop consistent, comparable, reliable and clear disclosure around the carbon intensity of different assets.
Thus for Carney, corporations will need to do more to disclose their approach to climate change. This will enable investors to scrutinize more accurately the long-term economics of oil and natural gas production. We are deluding ourselves if we believe that Canada’s oilsands will see major investments again on the scale of the Albian Sands or the Fort Hills expansions. Capital markets’ analysts are becoming more vigilant in identifying stranded assets and reclamation liabilities.
Prudent investors will look for much higher returns to compensate for such risks that are becoming relevant in analysing any corporation’s future cash flow. More government-directed investment funds, such as the vast Norwegian state pension fund, will begin reducing their exposure to fossil fuel energy producers. Indeed, the Supreme Court’s decision whether to grant leave to appeal on the Redwater Resources case may influence the nature of security-taking in the future by financial institutions.
TRP’s decision is another reminder that Alberta’s dependence on oil and natural gas to sustain its economy, is on the wane.