Contractual Resiliency Is The First, And Most Important, Line Of Defense

One of the key differentiating characteristics of midstream issuers in Canada compared with U.S. peers is their strong contractual structures, which provide a material hedge against both macro shocks and industry downside events. This is evident from the selective negative rating actions S&P Global Ratings took in 2020 on Canadian midstream companies, versus U.S. issuers where the magnitude of negative rating activity was much larger.

It is not uncommon for Canadian midstream companies to have 50%-80%, or more, of their revenues backed by some form of commercial support, ranging from fixed-fee contracts, to those that provide more downside protection, such as take-or-pay or cost-of-service structures. Fixed-fee-only contracts are generally considered the weakest, because although they do insulate operators from direct commodity price exposure, such as a decline in cash flows caused by weaker commodity prices, they do not guarantee throughput or volumes on the provider's infrastructure, exposing them to the risk of falling volumes if producer customers reduce drilling activity.

In the U.S., we have seen that contracts are typically fixed-fee with less volume protection. Even in the case of Federal Energy Regulatory Commission-regulated assets, where the approved tolls are capped at a maximum rate, pipeline companies offer their customers attractive rates for competitive reasons. In addition, these contracts do not guarantee base-level cash flow in an event where throughput is declining. In Canada, cost-of-service contracts generally cover both price and volume risks, and ensure a predetermined rate of return, which in our opinion, makes them much more robust and supportive of credit quality.

We think that the presence of the attractive commercial structures in Canada that are available to midstream assets is to some degree a function of the unique attributes of the dominant commodity produced in the region, the oil sands.

• A shut-in of oil sands has risks, especially for steam-assisted production, which requires ongoing injections of steam to warm bitumen. If a prolonged shut-in were to occur, the reservoirs would cool and permanent damage could be done, jeopardizing the life of the asset. With very long useful lives (usually spanning decades) and very low decline rates, it makes sense to preserve the asset, which means maintaining a base level of production.
• Oil sands require significant upfront capital investments, but generally have lower operating costs. Once the producer has invested the capital into the required infrastructure, the decision to produce versus shut-in would come down to whether the revenue from sales covers the cost of actual production or variable costs, such as natural gas to generate steam in the case of steam-assisted gravity drainage.
• We think that these factors play a role in the setup of the commercial platform for pipelines and other midstream assets in Canada. Production does not necessarily correlate with commodity prices; therefore, it makes economic sense for oil sands producers to secure long-term contracts with midstream infrastructure companies that run through the life of their reservoirs. Some of the longest and most robust contracts that we have seen in Canada are attached to midstream assets that service the oil sands. The contracts go out as far as 20-25 years, if not more, and provide strong levels of commercial certainty via cost-of-service and take-or-pay protection backed by the strength of investment-grade-rated producers.

In some cases, we have also seen gathering and processing (G&P) assets backed by long-term take-or-pay contracts in Canada (i.e., NorthRiver Midstream Finance L.P.), which is not very common among peers in the U.S. because these assets generally have weaker contractual protection relative to pipelines, and are also more vulnerable to throughput declines and energy market downturns given their proximity to the wellheads. This strength supports our favorable view of the business' asset and cash flow quality.

Another aspect of the Canadian midstream space is the smaller number of companies that make up the market. Most of these companies have the scale, commercial base, and funding diversity--including access to public capital markets. Although the overall market in the U.S. is much larger in terms of energy production and midstream infrastructure, it is composed of all types of operators, from large-scale, multi-basin-based, and publicly traded corporations, to small, private equity-owned companies that have aggressively levered their balance sheets in pursuit of risk-adjusted returns. Beside using debt to either finance the acquisition of operating assets or building new infrastructure, these smaller, financial sponsor-backed companies have relied on various contracting strategies, some of which are dictated by the region or competition, such as acreage dedication, and commodity-based contracts to capture market share. Although this facilitated the significant growth of shale oil and gas production over the past decade, it also intensified competition within the U.S. midstream space, which is an element we do not see to a large degree in Canada, where the industry is centered on a handful of well-established and larger players. Also, compared with the U.S., Canada's regulatory environment regarding the development of oil and gas infrastructure has been less favorable, which to a certain extent, has prevented the admission of new entrants or led to divestitures as companies exited the country to pursue supportive regulation and business conditions elsewhere. This dynamic, in our opinion, has positively influenced the ability of Canadian midstream issuers to secure long-term contracts because producers' options are relatively limited.

Table 1 summarizes the factors that we consider fundamental in determining the contractual strength of midstream companies, which is a key component of business risk.

Table 1

TC Energy Corp. and Enbridge Inc.--Excellent business risk profiles reflect market-leading positions in Canada. Very strong cash flows supported by varying levels of contractual backstop, and more importantly, the demand-pull characteristics of their assets, place both companies in a very attractive position within the North American midstream sector.

Inter Pipeline Ltd.(IPL)--IPL's strong business risk profile reflects base-level cash flow underpinned by cost-of-service contracts from its oil sands segment, which represents a significant portion of the company's cash flow. Earnings variability is mostly a function of volatility in the natural gas liquids (NGL) segment, as well as the level of commodity exposure in the conventional pipelines segment. The company's conventional pipeline segment, which mainly operates on a fee-based and product-margin structure, experienced a decline in throughput volumes during 2020 because of lower producer activity. After our two-notch downgrade on the company earlier in 2020, we affirmed our 'BBB-' rating in September 2020, after IPL announced the partial sale of its storage assets. The outlook remains negative, however, largely incorporating the uncertainty regarding the contractual strength of the Heartland Petrochemical Facility when it is expected to be commissioned in 2022.

Gibson Energy Inc.--Gibson's cash flow quality has improved significantly over the past couple of years, as the company divested volatile and noncore assets, and reinvested the proceeds into assets backed by stable take-or-pay and fee-based contracts. We raised our rating on Gibson to 'BBB-' from 'BB+' in 2019, and we continue to view the company's contractual strength and business risk favorably, in light of its focus on expanding its infrastructure footprint without compromising cash flow quality. We expect that about 70%-80% of Gibson's run-rate EBITDA will represent take-or-pay and fee-based cash flows, with take-or-pay-only representing 50%-60%; this indicates limited exposure to volume risk. Although some portion of the company's existing take-or-pay contracts are internal in nature, we believe the proportion will decline over time as Gibson commissions new projects, which are contracted with external customers.

Inter Pipeline (Corridor) Inc.--Revenues are 100% contracted with an investment-grade-rated shipper group and have an average remaining life of more than 25 years. This is a cost-of-service arrangement, with essentially no exposure to price or volume risk. The contract provides recovery of all operating costs, depreciation, taxes, and debt-financing costs, and provides a return on equity.

Pembina Pipeline Corp.--Pembina's strong business risk profile reflects a high proportion of take-or-pay and fee-based cash flows, which insulate the company to a considerable degree from unfavorable price movements in the energy markets. We note Pembina's NGL exposure; however, that is also hedged, providing near- to medium-term cash flow visibility.

Keyera Corp.--Keyera has higher reliance on fee-for-service contracts, with a lower proportion of take-or-pay arrangements compared with other Canadian midstream companies. This is reflected in our assessment of the company's business risk, which is satisfactory, or at the lower end of the peer group.

NorthRiver Midstream Finance L.P.--NorthRiver is a gas G&P-focused company with notable contractual support. We estimate that 70%-80% of the company's cash flows will be composed of take-or-pay based contracts through 2022. We lowered our rating on NorthRiver in October 2020, in light of reduced throughput volumes on the company's non-contracted assets, as well as a shift of growth projects to 2022 because of energy market conditions. The company is also exposed to re-contracting risk as its in-place contracts expire, which could potentially increase volume risk because its systems would increasingly rely on producer activity rather than contractual backstops.

Trans Quebec & Maritime Pipelines Inc. (TQM)--TQM is 100% contracted with TransCanada Pipelines Ltd. until 2030. Over the next three years, the company will add about C$382 million of capital to its asset base that will extend its contracting out to 2042. Canada Energy Regulator-approved tolls provide cost recovery with an adequate return. The pipeline also exhibits demand-pull characteristics because it is a critical source of natural gas supplies into the province of Quebec and serves about 60% of Energir Inc.'s gas distribution network in the province.

The Credit Quality Of The Customer Base Has Evolved

Given their reliance on long-term contracts, Canadian midstream issuers are inherently exposed to the credit quality of their counterparties, which are mainly the upstream oil and gas companies. Because of heightened volatility and abrupt price erosion in the commodities markets, 2020 was a difficult year for the energy producers globally. S&P Global Ratings took negative rating actions on almost all of the Canadian oil and gas companies. Although this represented a decline in the creditworthiness of their producer customers, the overall commercial base for the Canadian midstream issuers has largely remained of an investment-grade quality, even after the downgrades. As a result, we did not revise our view of the business risk profiles or lower our ratings on midstream issuers--with a few exceptions--during the market downturn. Furthermore, we also generally see midstream companies as having a diversified customer mix due to the scale and jurisdictional coverage of their infrastructure assets, which eventually mitigates counterparty risk to a considerable degree. Of note, we lowered our rating on one pipeline issuer (Inter Pipeline (Corridor) Inc.) because of deteriorating counterparty credit quality, which was primarily linked to the downgrade on its largest shipper, Canadian Natural Resources Inc. (CNRL). We lowered our rating on Corridor to 'BBB' from 'BBB+' in March 2020, and to 'BBB-' in February 2021, because of deterioration in shipper credit quality. CNRL constitutes 70% of the company's shipper and revenue base. In our view, when companies rely solely, or heavily, on a single counterparty to meet most of their obligations, and the replacement of existing contracts at current rates is not likely, the rating on the counterparty generally caps the company's stand-alone credit profile (SACP).

On a forward-looking basis, we remain cognizant of the fact that the credit quality of upstream companies will largely follow the trajectory of oil and gas demand and supply fundamentals, which are now increasingly influenced by the rapid adoption of cleaner energy alternatives that is accelerating the energy transition and shortening the bridge to peak oil demand.

ESG Factors Will Influence The Industry's Growth Potential

Given the midstream industry's critical role and place in the broader energy value chain, ESG factors continue to be a dominant theme for issuers. Pipeline companies operate as intermediaries, enabling the flow of produced oil and gas to downstream consumers, and emitting greenhouse gases in the process. Other significant environmental risks include transportation spills, contamination, and land use--all of which have made it more difficult for midstream operators to obtain the necessary permits from regulatory authorities for the buildout of new infrastructure. Environmental activism, protests, and legal challenges have often resulted in cost overruns and delays for projects that are in the construction or development stages, ultimately leading to weaker, or infeasible economics. Increasing concerns about hydrocarbon production and usage are also contributing to negative social sentiment toward the oil and gas industry, which has had a trickle-down effect for midstream companies that are now facing public and political resistance to expansion activities.

Canada's inability to build adequate takeaway capacity for its energy products because of these challenges was considerably exposed during 2018-2019, when the price differential between West Texas Intermediate and Western Canadian Select widened to as much as C$46/barrel, as both pipelines and storage were full, and producers had no choice but to rely on expensive rail to transport their products to refineries in the U.S. Midwest and Gulf Coast. Although ESG factors continue to influence the direction and pace of growth for the midstream industry, in our opinion, the Canadian midstream companies for now are mostly insulated from any abrupt, or rather, accelerated disruption risks because of their strong contractual foundations. Although it is likely that these companies could realize lower profits in the future if existing contracts are renegotiated at reduced tolls, barriers to entry because of challenges in the development of new infrastructure provide a meaningful competitive advantage to the currently installed asset base, ultimately preserving long-term value. In our opinion, however, the growth potential and opportunities for Canadian midstream operators will mostly be kept in check, as ESG concerns and regulatory hurdles will likely cap the upside for the broader industry.

On Jan. 27, 2021, we revised the industry risk assessment for the midstream industry to intermediate risk (3) from low risk (2) for our global midstream issuers, reflecting increasing environmental and social risks posed by climate change and greenhouse gas emissions, and the threat these risks pose to the future production and use of hydrocarbons over the longer term.

Despite Turbulence, Debt Capital Markets Were Very Active Last Year

Credit markets were supportive during 2020, enabling companies to raise debt to fund expansion activities, refinance upcoming maturities, or shore up their balance sheets from a liquidity standpoint. We have compiled a list of debt transactions that were executed during the year, which illustrates the magnitude of activity despite the commodity market headwinds. Collectively, these transactions amounted to about C$10 billion in value (US$ issuances translated at C$1.26/US$).

Table 2

Table 3

S&P Global Ratings credit analyst April Shi contributed research to this report.