DBRS Confirms Pembina Pipeline Income Fund at STA-2 (low)

Dominion Bond Rating Service (DBRS) has today confirmed the stability rating of Pembina Pipeline Income Fund (the Fund) at STA-2 (low). This removes the Fund from Under Review with Developing Implications where it was placed on November 1, 2006, following the federal government’s proposed significant changes to the tax rules, which would mean existing income trusts would become taxable beginning in 2011.

The rating confirmation is based on DBRS’s belief that the recently announced increased per unit distribution to $1.32 from $1.20 is sustainable, given the Fund’s strong performance and the numerous growth initiatives over the next few years. There are also certain taxation considerations that could reduce the Fund’s taxes payable in future years. In the interim, the Fund intends to continue to focus on growing the per unit cash distributions, while keeping its credit metrics close to current levels. When further clarity is provided on the ability of income trusts to acquire assets and use trust unit issuance for financing purposes, the Fund could decide to return to a regular taxable corporation structure prior to 2011. However, this should not have a material impact on the Fund’s stability rating.

The Fund maintains stability in earnings and cash flow underpinned by its core pipeline and storage operation with long-lived assets and low maintenance capex. Stability is enhanced by the Alberta Oil Sands Pipeline (AOSPL) and Fort Saskatchewan Storage Limited Partnership (Storage) operations, both supported by long-term contracts effectively on a cost of service basis. These operations currently account for approximately 25% of operating income. The contracted portion of earnings should increase over time. The expected in-service of the Horizon Pipeline (Horizon) in mid-2008 would entail firm contracted revenues for 25 years, regardless of usage, with Canadian Natural Resources Limited (rated BBB (high) with a Negative trend). The project’s estimated cost of approximately $338 million is expected to be partly funded by a recent private notes issuance of $200 million and the ongoing dividend reinvestment plan (DRIP). The conventional feeder pipelines, while presenting moderate growth prospect, will maintain their market position and remain the largest contributor to earnings and cash flow (61% of operating income in the nine months to September 30, 2006 (9M 2006)) in a still active drilling environment.

The growing synthetic crude oil pipeline assets and the expanding midstream operation (with minimal direct commodity pricing risk) should support incremental increases in per unit cash distributions, over time. A 26% cumulative rise is expected in January 2007, based on the recently announced distribution increase, bringing the annualized amount to $1.32/unit compared to a constant distribution of $1.05/unit from 2000 to 2005. The internalization of management in June 2006 should better align the interest of management with that of the unitholders in the longer term. The deferred payments are linked to future growth in distributable cash per unit, and are capped at $15 million, which would require a 100% rise in distribution to $2.64/unit. The related $6 million upfront purchase price was funded by distribution reserves, without affecting cash flow coverages.

The Fund’s biggest challenge remains its ability to mitigate the throughput risk for its conventional feeder pipeline system in the mature oil fields in Alberta and northeast British Columbia. However, the Fund has been able to raise tolls to offset throughput declines, and offers the most economic means of shipping oil to the market. The tolls charged are only a fraction of the wellhead price of crude oil. The rising earnings contribution from AOSPL and midstream, together with strong exploration activity encouraged by the high crude oil prices, are other mitigating factors.

The Fund’s financial ratios should remain relatively stable. Balance sheet leverage may rise in 2007 and 2008 during the construction of Horizon. This may extend to 2009 should the proposed condensate line for an estimated $1 billion capital cost proceed (currently under discussion with the shippers) for start up in late 2009. However, the Fund should be able to keep debt/capital in line with the targeted 35% to 45% range (40% in 9M 2006). Debenture conversions and the DRIP (together accounting for about one-third of the equity base at September 30, 2006) should support the balance sheet, if required. In addition, DBRS expects the Fund to explore avenues, including partnering, to reduce its share of the proposed capital costs of the condensate line, and access the capital market to maintain its credit metrics in line with the parameters of the current stability rating. Regarding the existing indebtedness, refinancing risk is partly mitigated by the Fund’s recent extension of its $260 million credit lines for five years from a one-year extendable term. Private notes maturities of $82 million in 2009 should be easily refinanced. Cash payout based on operating cash flow is expected to remain at the 95% to 96% level, which is fairly typical of the industry, and is supported by distribution reserves.

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