DBRS Assigns R-1 (low) Rating to TransCanada Keystone Pipeline, LP

DBRS has today assigned an R-1 (low) rating to the Canadian-based Commercial Paper (CP) of TransCanada Keystone Pipeline, LP (Keystone USA or the Partnership) predicated on the strength of the full unconditional and irrevocable guarantee of TransCanada PipeLines Limited (TCPL – rated A with a Stable trend; see separate report), one of the Partnership’s parents (ownership interest will increase over time to 79.99% from about 50%). Furthermore, TCPL’s wholly owned U.S. subsidiary, TransCanada PipeLine USA Ltd., is also a guarantor. The CP program will issue U.S. or Canadian dollar paper up to the equivalent of US$1 billion and will be supported by a US$1 billion 364-day credit facility with a one-year term-out option. The proceeds from Canadian CP will be swapped into U.S. dollars and a forward foreign currency contract entered into to settle on the maturity date of the CP to minimize foreign exchange risk. Keystone USA is expected to be financed with a capital structure consisting of approximately 50% to 60% debt (compared with TCPL’s debt-to-capital of 59% as of September 30, 2008). TCPL’s share of the debt component will initially be financed by partner loans and the above mentioned CP program.

The Partnership represents the U.S. portion of the pipeline, which, together with the Canadian portion (Keystone Canada), forms an integral part of the base Keystone Pipeline System (collectively, Keystone Phase 1). Keystone Canada is expected to be internally financed by TCPL and its partner, ConocoPhillips (COP – rated A with a Positive trend, with ownership interest reducing over time to 20.01% from about 50% ), which also owns Keystone USA in the same proportion.

In addition to the TCPL guarantee, the rating also reflects the following strengths that will prevail with Keystone USA:

(1) When completed, Keystone Phase 1 will be supported by long-term take-or-pay shipper contracts with an average term of 18 years, mostly with strong investment-grade counterparties (about 80% based on DBRS ratings). These commitments will cover about 90% (or 530,000 barrels per day (b/d)) of the pipeline’s design capacity of 590,000 b/d. A capital cost sharing mechanism on a 50/50 basis with shippers, including COP, a major shipper and a partner in the pipeline, should mitigate in part the potential cost overruns often associated with mega-projects. In addition, part of Keystone Phase 1 is composed of converted portions of TCPL’s existing gas pipelines, reducing construction risk to some extent.

(2) The pipeline’s tolling structure includes (a) a fixed toll that recovers fixed costs (including fixed financing costs), effectively eliminating almost all of the throughput risk, since 90% of Keystone Phase 1 capacity has been committed, and (b) a variable toll that covers operating, maintenance and administration expenses on a cost-of-service basis, effectively eliminating operating cost risk. The capital portion of the project is recovered through pre-established fixed tolls adjusted for capital variances shared on a 50/50 basis with shippers due to cost overruns as mentioned above.

(3) Competitive tolling arrangements as expected on completion should ensure the viability of Keystone USA beyond the contract terms. DBRS estimates that a significant portion of the construction costs would have been recovered through depreciation charges during the average 18-year contract term, increasing the competitiveness of future tolls.

(4) TCPL, the operator of Keystone USA, is among the largest pipeline operators in North America, with extensive experience in building and operating pipelines.

(5) One of Keystone USA’s two owners, COP, is also a main shipper, providing strong sponsorship. COP’s interest will be reduced from an original 50% to 20.01% over time, beginning in October 2008, which is in line with its usual participation in strategic pipelines infrastructure.

(6) Bitumen reserves are abundant in the oil sands sector, with new projects coming on stream during 2008 and 2009 and a couple of major projects commencing production after Keystone Phase 1 is in full service in 2010.

The Partnership faces several challenges, which are considered manageable:

(1) Potential project cost overruns and delays could affect the economics and competitiveness of Keystone USA. DBRS believes that the potential for significant cost overruns (beyond contingencies included) that would not be included in the fixed portion of the tolls (and therefore would result in a lower than expected return on investment for Keystone USA and TCPL) is relatively low, as is the potential for delays in construction completion. A substantial portion of project costs (approximately 60%) has been committed through materials and construction contracts awarded.

(2) Should a shipper default prior to or after pipeline completion, Keystone USA would have to bear its portion of the fixed capital cost until a substitute shipper is found, although Keystone USA retains the right to sue for damages for any shipper defaults.

(3) For Keystone Phase 1, approximately 20% of the contracted volumes are with non-investment-grade shippers, which presents an element of uncertainty, although financial assurances in the form of parental guarantees or letters of credit are required and have been obtained for certain shippers.

(4) The global financial crisis and the expected economic slowdown could lead to more delays in oil sands developments, limiting the supply source. However, the postponement of the upgrader projects recently announced by two major oil sands operators could enhance the value of heavy crude pipelines, such as Keystone Phase 1, which ships heavy crude oil to the U.S. Midwest markets and ultimately to the Gulf Coast, where refineries are better equipped to handle heavier crude.

(5) Upward pressure on interest spreads is not expected to abate in the near term, potentially affecting the project financing cost. Similarly, refinancing risk exists, following pipeline completion, which could be aggravated should the credit markets remain tight. In any event, fixed financing costs flowed through to the shippers as part of the fixed tolls should cover most of the related costs. Furthermore, refinancing risk is partly mitigated by the value of Keystone USA’s pipeline capacity, underpinned by the strong take-or-pay long-term transportation contracts as well as the substantial equity component (currently estimated at more than 50%) in the project.

Keystone Phase 1 (a 3,456-kilometre (2,148-mile) 30- and 36-inch pipeline), when completed, will extend from Hardisty, Alberta, to U.S. Midwest markets at Wood River and Patoka, Illinois, and Cushing, Oklahoma (Phase 1). Phased start-up is expected in late 2009, with an initial nominal capacity of 435,000 b/d, which will be expanded to 590,000 b/d in late 2010. The construction of the pipeline began in May 2008. Keystone XL (3,200-kilometre (1,900-mile) 36-inch pipeline), the proposed extension and expansion project, would increase the capacity to 1.09 million b/d from Hardisty to Port Arthur, Texas, and other U.S. Midwest markets, with in-service expected in 2012 or 2013 (currently under discussion with the shippers). The pipeline system is further expandable to 1.5 million b/d at relatively low cost, enhancing future growth opportunities.

The capital cost for Keystone Phase 1 is estimated at approximately US$5.4 billion, with Keystone USA’s share estimated at approximately US$3.7 billion (about US$2.96 billion net to TCPL based on 79.99% ownership interest). The Keystone Pipeline System, Phase 1 and Keystone XL combined, is currently expected to result in a capital investment of approximately US$12 billion between 2008 and 2012. The capital cost sharing mechanism for any project cost overruns between Keystone and the shippers is 50/50 for Phase 1 and 75/25 for Keystone XL.

Notes:

The applicable methodology is Rating Utilities (Electric, Pipelines & Gas Distribution): DBRS Rating Approach, which can be found on our website under Methodologies.

This is a Corporate rating.