DBRS Places Inter Pipeline Ltd. Under Review With Negative Implications

DBRS Limited (DBRS) placed the Issuer Rating and Unsecured Medium Term Notes ratings of Inter Pipeline Ltd. (IPL or the Company) Under Review with Negative Implications. Inter Pipeline (Corridor) Ltd.’s (Corridor; 100% owned by IPL) ratings are not affected by this rating action, as debt at Corridor is non-recourse to IPL. The rating action follows IPL’s announcement that its board of directors has authorized the construction of the 100%-owned $3.5 billion Heartland Petrochemical Complex that consists of an integrated propane dehydrogenation (PDH) and polypropylene (PP) facility in Alberta’s Sturgeon County (the Project or the facility). The Project is expected to be in service by late 2021. DBRS has placed IPL’s ratings Under Review with Negative Implications because of the considerable uncertainty arising from: (1) the significant capital cost associated with the Project and potential variances in estimated costs; (2) the duration of contracts, associated re-contracting risk, and the credit quality of contracted counterparties as DBRS has not reviewed any executed contracts; (3) future market conditions, notably the cost of propane supplies and the price realization for polypropylene sales; and (4) any incremental volume and price risks associated with uncontracted capacity. DBRS is concerned that the significant capital commitment and incremental commodity and contracting risks could have a negative impact on the future quality and stability of the Company’s earnings, and consequently may result in DBRS taking a negative rating action.

The Project
The Project will be designed to produce 525,000 tonnes per year of polypropylene. The PDH facility will process approximately 22,000 barrels per day of locally sourced propane into polymer grade propylene (PGP). The PGP will then be used as feedstock at the PP facility and processed into polypropylene, a recyclable plastic resin used in a number of products such as packing material, automobile parts, textiles and currency notes. Other construction activities associated with the Project include product storage facilities and rail loading assets to facilitate the transport of polypropylene pellets to North American markets. Approximately $400 million has been spent to date on the budgeted $3.5 billion Project, excluding a 96 MW central utility block to be constructed by IPL and owned by a third party. The Province of Alberta (rated AA, Negative trend, by DBRS) has awarded $200 million of royalty credits under its Petrochemical Diversification Program to the Project. The credits were provided in support of the construction of the PDH facility and will be monetized over a three-year period once the Project is operational. The facility will be the first of its kind in Alberta and a new line of business for IPL.

Commercial Arrangements
IPL is planning to underpin the Project with take-or-pay-type contracts with suppliers of propane in Western Canada and polypropylene consumers and marketers in the United States. IPL is conducting a two-phase contracting process to underpin the Project. The Company has indicated that Phase 1 has been completed and resulted in securing certain take-or-pay contracts with an average term of nine years. Details on the level of plant capacity contracted or the counterparties have not been disclosed at this stage because of confidentiality agreements. Phase 2 contracting is expected to commence in early 2018 with the objective of securing between 70% and 85% of the total petrochemical processing capacity under take-or-pay contracts over the next four years. IPL intends to utilize the uncontracted capacity for its own commercial purposes. The take-or-pay agreements are structured to provide a fixed return on capital payment to IPL, plus a recovery of variable and fixed operating and transportation costs. IPL expects an annual run rate of approximately $450 million to $500 million in EBITDA from the facility upon completion of contracting.

Funding
IPL plans to finance the $3.5 billion Project with approximately 60% debt and 40% equity, using a combination of capacity available under its existing $1.5 billion credit facility, undistributed cash flow from operations, issuance of new term debt, hybrid debt securities and proceeds from the existing dividend re-investment programs. IPL does not expect the need for a material, underwritten equity offering.

DBRS Rating Considerations

(1) Construction Risk: DBRS notes that IPL’s credit profile is moderated by the construction risk for the Project, and the execution risks associated with the four-year scheduled construction period. Assuming IPL achieves take-or-pay contracts at the lower end of its expected target of 70%, approximately 30% of the expected EBITDA for the Project could be exposed to commodity risk. Since detailed engineering is 85% complete for the PDH facility and front-end engineering and design is approximately 70% complete for the PP facility, these cost estimates could change. Significant cost escalation and schedule delays beyond the expected commissioning date for the Project could pressure credit metrics and have a negative impact on the rating. The long construction period results in considerable uncertainty as to future market conditions, final contractual arrangements and commodity prices, which could influence the duration of contracts, quality of counterparties, volumes and price risks.

(2) Contractual Framework: As announced, IPL has secured several take-or-pay contracts with an average contract length of nine years, but has not disclosed individual contract details or the credit quality of counterparties. The Company plans to sign additional take-or-pay contracts during the four-year construction phase to reach 70% to 85% of the facility’s production capacity. A lower percentage of take-or-pay arrangements could result in non-recovery of capital costs and inability to pass through fixed and variable costs of the business. There is uncertainty as to the duration of the overall contracts on completion of the Project, as some contracts could be for the short term and expose the Company to re-contracting risk. IPL’s existing business risk profile is supported by earnings from a diversified portfolio of energy infrastructure assets largely supported by medium- to long-term cost-of-service (COS) and fee-based contracts. IPL’s current oil sands transportation segment, consisting of the Cold Lake, Polaris and Corridor pipeline systems, is underpinned by long-term COS contracts with strong investment-grade counterparties. Although the Project adds diversification to the Company’s business, DBRS notes that IPL’s credit profile could be weakened by the addition of contracts with largely unrated or non-investment grade counterparties in its petrochemical business.

(3) Commodity Risk: DBRS expects the proportion of IPL’s commodity-based EBITDA to rise from current levels with the addition of the petrochemical business. Failure to secure the desired level of take-or-pay contracts could result in a higher commodity exposure for the company and result in increased earnings volatility. The commodity exposure could vary between propane price risk and polypropylene price risk. Edmonton propane prices, which form a significant portion of the input costs for the facility, have been generally lower compared to the spot propane prices at Mont Belvieu, Texas, providing IPL a key input cost advantage in producing lower-cost polypropylene compared with producers located in the U.S. Gulf Coast. However, DBRS notes that the price gap could dissipate if in the future increased U.S. shale gas production drives down propane prices in the United States or if severe cold weather conditions in Western Canada cause higher demand for propane for space heating needs trigger a spike in Canadian propane prices. Lower-than-planned utilization levels as a result of soft product demand or downtime at the facility could also result in higher unit costs and have an impact on the cost competitiveness of the facility. IPL is also a new entrant to the polypropylene market and will be competing with sizable, well-established U.S. Gulf Coast polypropylene producers. Some of these producers are integrated and diversified global petrochemical players that are better positioned to withstand price competition.

(4) Financing Plan: The Project is the largest capital program undertaken in the Company’s history. IPL plans to fund the Project with debt as indicated above, along with undistributed cash flow and equity from its dividend reinvestment plan. The Company does not expect the need for material, underwritten equity offerings to finance its funding obligations. DBRS notes that IPL’s plan to fund the Project with approximately 60% debt and 40% equity is higher than the approximately 55% debt-to-capital ratio at Q3 2017 for IPL, on a non-consolidated basis. Should the participation rates be lower in the future for the dividend reinvestment plan than anticipated by IPL, or if significant cost overruns on the Project are incurred, the Company may need to source additional equity and/or debt to fill its capital commitments.

DBRS will review the contractual arrangements, final engineering and design cost estimates for the Project and the financing plans in greater detail as information becomes available in order to assess the impact on the ratings.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodology is Rating Companies in the Pipeline and Diversified Energy Industry
(December 2017), which can be found on dbrs.com under Methodologies.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.