DBRS Confirms Pembina at BBB (high), Trend Stable

DBRS has today confirmed the ratings on the Senior Unsecured Notes (the Unsecured Notes) and the 7.38% Senior Secured Notes (the Secured Notes) of Pembina Pipeline Corporation (Pembina or the Company) at BBB (high), with Stable trends. DBRS rates the Secured Notes and the Unsecured Notes equally, reflecting: (1) the Secured Notes only account for a small portion (5%, or $61.5 million) of total debt outstanding; and (2) Pembina has no intention to issue additional Secured Notes. The current ratings are underpinned by Pembina’s relatively stable pipeline businesses (Conventional Pipelines (regulated on a complaints basis)) and Oil Sands & Heavy Oil (long-term contracts), which accounted for 65% of operating income in the first half (H1) of 2011 and its solid interest coverage and cash flow metrics. Although the total debt ratio (including convertible debentures) was relatively high, the senior debt leverage ratio remained moderate, in line with historical levels.

The rating confirmation incorporates the successful completion of the Nipisi and Mitsue oil sands pipeline projects within budget and on schedule in mid-2011. Following completion, Pembina’s project risk has been reduced. In addition, Nipisi and Mitsue helped to mitigate Pembina’s moderately higher business risk as a result of its expansion into the gas gathering and processing businesses over the past few years. The majority of the capacity of these two newly built pipelines has been contracted for ten years (with extension rights) with two anchor shippers, Cenovus Energy Inc. (rated A (low)) and Canadian Natural Resources Limited (CNRL; rated BBB (high)). The contracts provide for full recovery of operating expenses proportionate to capacity under contract, providing earnings and cash flow stability. Nipisi and Mitsue are expected to increase Pembina’s EBITDA by approximately $40 million (13% of 2010 EBITDA).

Following the 2009 acquisition of Cutbank Complex (Cutbank; a natural gas gathering and processing business) and during the construction of Nipisi and Mitsue and other projects, debt levels increased materially to $1.6 billion in H1 2011 from $1.2 billion in 2009, while the equity base was limited to a modest amount of new share/unit issuances as the Company paid most of its cash flow to shareholders/unitholders. The transfer to International Financial Reporting Standards (IFRS) from Canadian Generally Accepted Accounting Principles (GAAP) in 2011 also slightly lowered the equity base. During this period, total debt-to-capital increased from 50.0% to 59.8% (2006: 39.9%), which was relatively high compared with its peers. As a result of higher debt levels and the fact that cash flow from projects under construction was not yet generated, the cash flow-to-total debt ratio has weakened, declining from 26.9% in 2008 to just 17.3% in H1 2011. Although the ratio remained in DBRS’s current rating range, a further decline of this ratio could cause a concern. However, despite higher debt levels, EBITDA interest coverage (5.38 times) remained relatively strong.

Pembina’s expansion into the Midstream & Marketing (terminals and gas storages) and Gas Services (natural gas gathering and processing) businesses over the past few years entails moderately higher business risk than the pipeline operations. In H1 2011, these two segments accounted for 35% of operating income (2006: 21%). The terminals and storage businesses are exposed to seasonable demand changes and economic conditions. While Pembina takes no commodity price risk as it does not own the product, it does take volume risk on its fee-for-service business, although the majority of its EBITDA is under long-term take-or-pay arrangements. Terminals and storage are under a 20-year contract whereas over 88% of Cutbank’s capacity is on a firm service basis until 2014; nearly 70% of revenue from Cutbank in 2010 was derived from take-or-pay contracts.

Pembina’s Conventional Pipelines system faced a decline in throughput through 2010, reflecting a natural depletion of conventional oil reserves in the region. However, throughput in H1 2011 increased, benefiting from higher oil production in the Cardium and Deep Basin Cretaceous formations (which is expected to remain stable over the near to medium term).

Going forward, Pembina’s low-risk pipeline operations are expected to remain a major contributor to cash flow. The Company’s Conventional Pipelines earnings are based on a variety of toll agreements including ship-or-pay contracts (which allow Pembina to recover costs and earn a reasonable return) and market-based contracts (which allow the Company to increase tariffs to compensate for lower throughput). This segment faces limited competition. Pembina is further supported by increased earnings from its oil sands pipelines, including the two newly built systems, Nipisi and Mitsue, which are based on contracted volumes, regardless of actual volumes shipped.

DBRS believes that Pembina will likely continue to diversify its asset base to cope with the potential long-term decline in conventional oil production in the region. Given the current dividend payout (over 99% of cash flow, DBRS adjusted), future expansion capex and acquisitions will have to be financed with external funds. As Pembina’s current debt levels are high for a pipeline company with a substantial portion of assets in the non-regulated assets, DBRS expects the Company to remain disciplined with its financing plans and maintain the debt-to-capital ratio within DBRS’s current rating category.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating North American Pipeline and Diversified Energy Companies, which can be found on our website under Methodologies.