DBRS Downgrades Ratings of Inter Pipeline Ltd.

DBRS Limited (DBRS) downgraded the Issuer Rating and the Unsecured Medium Term Notes rating of Inter Pipeline Ltd. (IPL or the Company) to BBB from BBB (high). The downgrades remove the ratings from Under Review with Negative Implications where they were placed on December 21, 2017 (please refer to DBRS’s Press Release, “DBRS Places Inter Pipeline Ltd. Under Review With Negative Implications”). All trends are Stable. The ratings of Inter Pipeline (Corridor) Ltd. (Corridor; rated A (low)/R-1 (low) with Stable trends by DBRS and100% owned by IPL) are not affected by this rating downgrade, as debt at Corridor is non-recourse to IPL.

DBRS rating actions follow the Company’s decision to construct the $3.5 billion Heartland Petrochemical Complex (HPC or the Project) that consists of an integrated propane dehydrogenation (PDH) and polypropylene (PP) facility in Alberta. The Project will be designed to produce 525,000 tonnes of polypropylene per year. 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. The Project is expected to be in service by late 2021. The Company expects to spend approximately $700 million on the Project in 2018 (approximately $500 million spent as at Q1 2018).

IPL plans to finance the 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 (DRIP). IPL does not expect the need for a material, underwritten equity offering.

IPL expects to underpin the Project with take-or-pay contracts with suppliers of propane in western Canada and polypropylene buyers and marketers in the United States with the target of securing between 70% to 85% of the total processing capacity under take-or-pay contracts by the time the Project is in service. The Company has indicated that the initial contracting stage has been completed and resulted in securing certain take-or-pay contracts with an average term of nine years. The take-or-pay agreements are structured to provide a fixed return on capital fee to IPL, plus a recovery of variable and fixed operating and transportation costs. IPL intends to use any uncontracted volumes produced for its own commercial purposes.

DBRS considers the petrochemical and processing business to be riskier, relative to the contractually secured pipelines business, because of the higher volatility in the income stream and high level of competition. As noted, IPL is targeting to mitigate the volatility by securing take-or-pay contracts. IPL’s existing business profile reflects a diversified portfolio of energy infrastructure assets largely supported by medium- to long-term cost-of-service and fee-based contracts. On a full year basis, the Company expects $450 million to $500 million of EBITDA to come from HPC after the Project is completed. DBRS has downgraded IPL’s ratings because of the: (1) uncertainty with respect to achieving the targeted level of take-or-pay contracts as the Project is not yet fully commercially secured, (2) construction risk: although IPL has expertise in the execution of major oil sands transportation projects, the long build-out period for HPC has the potential for delays and cost overruns as the Project will be the first of its kind in Alberta and a new business for IPL; (3) incremental commodity risk to the extent capacity remains uncontracted; and (4) counterparty credit risks, related to the take-or-pay contracts. All these risks could have a negative impact on the future quality and stability of the Company’s earnings. Consequently, in DBRS’s opinion a one-notch downgrade is appropriate at this time.

DBRS notes that future market conditions could change in the four-year Project construction window, causing uncertainty as to commodity prices, the cost of propane supplies, price realization for polypropylene sales which could influence the duration of contracts, quality of counterparties and volumes. As IPL has not disclosed details of any executed contracts for competitive reasons, the associated credit quality of counterparties and re-contracting risks are not known at the current time. DBRS believes that due to the current glut of propane supplies in Alberta, the contract profile for HPC is likely to be tilted more towards propane producers compared with polypropylene buyers. Failure to secure the desired level of take-or-pay contracts could result in higher commodity exposure for the Company and result in increased earnings volatility. DBRS notes that IPL’s commodity exposure has been growing since the 2016 acquisition of Williams Canada off-gas business.

Alberta’s spot propane prices, which form a significant portion of the input costs for HPC, have been generally lower compared to the spot propane prices at Mont Belvieu, Texas, providing IPL with a material input cost advantage in producing lower-cost polypropylene compared with U.S. producers. However, this dynamic could change in the future. Possible factors that could impact the propane cost advantage include increased U.S. shale gas production and the associated liquids including propane driving down propane prices in the United States and severe cold weather triggering a spike in Canadian propane prices. Furthermore, IPL is a new entrant to the polypropylene market and will be competing with sizable, well-established U.S. Gulf Coast polypropylene producers that are better positioned to withstand price competition.

DBRS notes that the cash flow from HPC lags the capital spending until the Project is placed in service. Based on DBRS’s assumptions, credit metrics are expected to be pressured with higher debt levels during the construction period and recover after the Project is placed in service. IPL plans to fund the equity portion of the Project with proceeds from existing DRIP and does not expect the need for a material underwritten equity offering. DBRS notes that should the DRIP participation rates be lower in the future either due to general weakness in the stock markets or sustained weakness in IPL’s share price, the Company may need to source additional equity and/or debt.

DBRS notes that at the time the Project is placed in service, should the Company successfully contract at the target level of 70% to 85% of the plant capacity under long duration (over ten years) take-or-pay arrangements with strong investment-grade counterparties, DBRS will reassess the BBB ratings. However, ratings could be negatively impacted should the Company’s contract profile reflect shorter duration contracts with weak counterparties for over 50% of the plant capacity, or if a significant portion of plant capacity remains uncontracted.

IPL’s Q1 2018 results were in line with expectations with stable earnings from the oil sands and conventional pipeline systems. Higher earnings in the NGL processing segment, helped by improved fractionation spreads, were partly offset by weaker performance in the bulk liquids storage segment because of lower utilization levels.

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 methodologies are Rating Companies in the Pipeline and Diversified Energy Industry (December 2017) and Rating Companies in the Oil and Gas and Oilfield Services Industries (August 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.

DBRS will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving this report, contact us at info@dbrs.com.

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