PUMPING OIL: RUSSIAN WAR AND THE LOGIC OF PIPELINES

Last week, we discussed the tremendous dividend opportunity in the preferred shares of Repsol S.A., one of the world’s largest and most dynamic oil companies.  This week we’re sticking with the oil and gas theme, though our journey won’t be as exotic.  It may be a little more dangerous, though.  This week we’re venturing to war-torn South Ossetia and Georgia.

We can’t seem to get enough of it.  War, that is.  And when it comes to finding reasons for going to war, money always tops the list.  We shouldn’t be embarrassed by that.  From biblical times, kings trundled off to distant lands for economic reasons.  And they did it because it works.  It seems that shoring up the national treasury is still a perfectly reasonable casus belli.

Legitimate for kings, that is.  And it appears that one of the world’s last great kings, who presides over a tremendous military force, has decided that war for economic reasons is precisely what his kingdom needs most at this point.  Vladimir Putin of KGB fame has invaded the former soviet state of Georgia ostensibly to protect the natives of the breakaway republic of South Ossetia, who are, incidentally, neither Russian nor Georgian.  He did it not because Russia loves the Ossetian people.  Rather, he wanted to teach the West – and its proxies – a lesson.

Mr Putin does not want a pro-western regime (Georgia’s) operating so close to his border, while robbing Russia of lucrative oil revenues in the bargain.

GEORGIA: AT THE CROSSROADS OF THE EAST

Since the fall of the former Soviet Union, Western powers have been trying to find a land route for Caspian oil that would circumvent both Russia and Iran.  These two hostile nations, it was figured, would do everything possible to disrupt energy flows to the West.  Nor was it deemed advantageous to allow either nation the cash benefits of moving oil

and gas through its territory.  The solution, therefore, lay with a tiny post-Soviet state called Georgia.

Nestled between the Black and Caspian seas and sharing a border with NATO’s Turkey, Georgia was the perfect solution to the Russian-Iranian threat.  The oil and gas rich Caspian sea nations of Azerbaijan, Kazakhstan and Turkmenistan (home to the world’s third largest reserves after the Middle East and Russia) were to develop their energy resources with Western assistance and pipe it through their own nations to Georgia, Turkey and then on to energy-thirsty Western Europe.

Western oil and gas majors currently possess three pipelines which traverse Georgia, two of which lead to the Black Sea and a third that veers southward through Turkey to the Mediterranean.  Last week’s full scale invasion of Georgia by the Russian army temporarily closed the line running from Baku to Georgia’s Black Sea port of Sup’sa.

Russian control of the Baku-Tbilsi-Ceyhan pipeline

With its conquest of Georgia, Russia has effectively wrested control of the premier non-Russian, European-bound pipeline for Caspian Sea oil and gas, the Baku-Tbilsi-Ceyhan branch.  And in so doing, King Putin has moved one step closer to creating a Europe completely dependent upon Russia for its energy needs.

Latest development: Russia has now amassed a sizeable naval force opposite the Georgian Black Sea port city of Batumi, a major hub from which Kazakh and Trurkmeni oil goes seaborne to the West.  With this move, Russia has essentially sealed shut all prospects for Georgia to profit from pumping oil and gas through its precincts.

HOW DO PIPELINES PROFIT?

The conflict in Georgia demonstrates unequivocally the extraordinary profitablilty of pipelines in general, and in particular those that serve energy hungry regions such as Western Europe and the U.S.  But investors are largely ignorant of the pipeline business and therefore tend to shy away from buying shares in it.  It behooves us now to take a moment to understand exactly how pipelines make their money.

To summarize, pipelines are a highly regulated industry that generates revenue mainly from the following sources:

1. Oil and Gas producers, for transport of their product
2. Marketers
3. Industrial facilities for direct delivery of product
4. Local distribution companies, and
5. Electric power generating plants

In North America, where the probability of war (and its attendant insurance costs) is not factored into pipeline operations, the profitability of seasoned, well-managed outfits is exceptional.  And with spiraling home-heating and fuel prices, transport of oil and gas becomes even more lucrative.

Two companies currently stand out in the pipeline world as outstanding investments.  They both sport P/E’s and price-to-book valuations at the low end of their industry.  And both pay substantial dividends, while offering strong, long term capital appreciation possibilities.  Both are “Master Limited Partnerships” and should therefore be held in a regular brokerage account to maximize current income and tax deferral benefits.

The first is TC Pipelines LP, (TCLP on Nasdaq), a stock that trades for $33.54 and pays a handsome 8.41% quarterly dividend.  The P/E is a modest 12.41 and price to book is a low 1.3x.

TCLP has been in a rising channel for five years and has recently seen two oversold episodes that bode well technically for the coming winter. 

But what’s most impressive about TCLP is its management.  Formed as a spinoff of Canadian pipeline giant TransCanada Pipelines, TCLP’s mandate is essentially to uncover and exploit opportunities in the continental US and Mexico.  With TransCanada’s 50 years experience and massive capitalization behind it, TCLP began chalking up an impressive string of successes immediately upon entering the American market nearly a decade ago. 

The company recently reported increased earnings and an additional rise in its annual cash distribution, to $2.82 per share.  In just the last year and a half payouts have increased by nearly 18%.

Another winner: Oneok Partners LP

TCLP shares an investment with the second of our weekly featured investments, Oneok Partners LP (OKS).  The two split a 50% stake in the Northern Border Pipeline, an increasingly productive operation that delivers gas from the Canadian border terminus near Port Of Morgan, Montana to customers in North and South Dakota, Minnesota, Iowa, Illinois and Indiana.

TCLP has been in a rising channel for five years and has recently seen two oversold episodes that bode well technically for the coming winter. 

But what’s most impressive about TCLP is its management.  Formed as a spinoff of Canadian pipeline giant TransCanada Pipelines, TCLP’s mandate is essentially to uncover and exploit opportunities in the continental US and Mexico.  With TransCanada’s 50 years experience and massive capitalization behind it, TCLP began chalking up an impressive string of successes immediately upon entering the American market nearly a decade ago. 

The company recently reported increased earnings and an additional rise in its annual cash distribution, to $2.82 per share.  In just the last year and a half payouts have increased by nearly 18%.

Another winner: Oneok Partners LP

TCLP shares an investment with the second of our weekly featured investments, Oneok Partners LP (OKS).  The two split a 50% stake in the Northern Border Pipeline, an increasingly productive operation that delivers gas from the Canadian border terminus near Port Of Morgan, Montana to customers in North and South Dakota, Minnesota, Iowa, Illinois and Indiana.

Like TCLP, the Oneok Partners’ chart shows strong current support and an excellent immediate entry point for new investors.  A number of oversold episodes also place it in strong hands going forward.  At $55.67, the stock pays a 7.62% quarterly dividend and has a P/E of only 10.75.

Here, too, management has been outstanding.  They’ve built a strong balance sheet and cash flows, and have recently been raising the dividend and buying back stock.  Look for the dividend to be increased at least once every year. 

It should also be mentioned that Oneok Partners has been developing the unregulated aspect of its business as well or better than anyone else in the pipeline industry.  Almost all the company’s growth is now derived from those businesses.  The company is now in the midst of a two year, $1.6 billion expansion of projects that will last through 2009 and generate earnings of more than $300 million a year starting in 2010.

The Residual Income Report recommends immediate purchase of equal dollar amounts of TCLP at $33.54 and OKS at $55.67.

Matt McAbby
Analyst, Residual Income Report