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

DBRS has today confirmed the Stability Rating of Pembina Pipeline Income Fund (the Fund) at STA-2 (low) and has concurrently confirmed the secured and unsecured notes ratings for its main subsidiary, Pembina Pipeline Corporation (Pembina or the Company), at BBB (high) and BBB, respectively.

DBRS believes that the Fund’s current cash distribution per unit of $1.44 on an annualized basis is sustainable and could rise over time, based on its solid financial profile and relatively stable operations with substantial growth prospects. The underpinnings are the underlying long-lived assets, supported largely by long-term contracts or regulated returns. The contracted and regulated businesses accounted for approximately 43% of EBITDA for the nine months ended September 30, 2007, (9M 2007) and will rise when Horizon Pipeline (Horizon) commences in mid-2008 as scheduled, providing a measure of stability of earnings and cash flow. Canadian Natural Resources Limited (rated BBB (high) with a Negative trend) is the exclusive shipper on Horizon, with expansion prospects in the longer-term.

The increasing importance of the oil sands segment should reduce Pembina’s reliance on the conventional crude oil pipelines, servicing the mature fields in western Canada. It should enhance Pembina’s competitive position in the growing transportation of the Canadian oil sands, in addition to its existing Syncrude Pipeline (Syncrude – formerly Alberta Oil Sands Pipeline) under long-term contract with Syncrude Canada. The potential return of the Fund to a regular taxable corporation structure prior to 2011 (pending taxation of income trusts beginning in 2011) is not expected to have a material impact on the Company’s credit ratings as it intends to maintain its focus on steadily growing its business, while keeping its credit metrics within the parameters of the current rating categories. Certain taxation considerations could reduce the Fund’s taxes payable to at least 2013.

The conventional feeder pipelines, while presenting limited growth prospects, will maintain the Company’s market position as the largest feeder pipeline operator. This segment remains the largest contributor to earnings and cash flow (58% of EBITDA in 9M 2007) in a still active drilling environment for crude oil. The Company has been able to raise tolls to offset declining throughputs (although volumes have remained stable over the past three years) as it still provides the most economic means of transportation for the shippers. The Alberta government’s recently announced increase in royalty payments (by up to 20%) from 2009 is not likely to have a material impact on Pembina’s operation in the favourable commodity-pricing environment expected by DBRS over the medium term.

The Fund has maintained relatively stable balance sheet leverage (43% in 9M 2007), which could rise during the higher capital spending years in 2008 and 2009 (capex of $223 million planned for 2008) as a result of the remaining capital investments in Horizon and other growth initiatives. The latter includes midstream expansions and the proposed Nipisi Lake project (estimated cost of $325 million). Cash flow-to-debt ratio has progressively improved to 0.27 times from 0.18 times in 2003 with strong EBIT-to-interest coverage (6.6 times). The Fund’s ability to issue trust units and/or convertible debentures to finance major expansions or new projects is key to maintaining its financial profile, given its generally more than 90% payout from operating cash flow (89% for the rolling 12 months to September 30, 2007). A previous ongoing equity source from its Distribution Reinvestment Plan (DRIP), deployed to cover about one-third of the growth capex from 2002 to 9M 2007, was temporarily suspended in June 2007 for cost of capital considerations.

Furthermore, the Fund’s rising cash distributions to the unitholders (up 37% to $1.44 per unit on an annualized basis since 2005), while supported by its expanding asset base, has limited the Fund’s ability to fully fund growth projects from cash flow generated internally, as typical of the trust industry. The increasing distributions would also increase the deferred payments payable in 2009 (capped at $15 million plus adjustments) associated with the internalization of management in June 2006, which are performance-based. Despite this, the move to internalize management should allow the Fund to better align its interest with that of the unitholders.

An emerging challenge for Pembina is its growing midstream business, about half of which (12% to 13% of EBITDA in 9M 2007, as estimated by DBRS) is tied to merchant activities in terminalling, storage and hub services (with the remainder on long-term contracts). This could introduce volatility into an otherwise stable operation, although DBRS considers it manageable, given its relatively small size. Furthermore, Pembina has focused on fee-based businesses for processing crude into a higher-value sweet product with little direct exposure to commodity price risk. The foregoing should be achievable through a combination of contractual arrangements with the producers, most of which are also users of the feeder pipelines, and short-term financial hedging.

DBRS expects the Fund to maintain its conservative financing approach and to access the equity markets, potentially following the start-up of Horizon as seen in past acquisitions or expansions, with a view to managing its capital structure. The growing oil sands pipeline assets and the expanding midstream activities should provide incremental cash flow to fund in part its capital needs. A large portion of the Horizon project was pre-funded through the Company by $200 million of long-dated private bonds issued in September 2006. Further, the Company increased its five-year bank facilities to $500 million (from $230 million) in July 2007, with no repayments until maturity, which should provide additional liquidity in the ensuing years. Debt maturities of approximately $82 million, due in 2009, should be readily refinanced, given the Fund’s strong credit metrics and market acceptance. Existing convertibles of about $50 million will likely be converted to equity over the next two years as these are in the money, which will slightly improve Pembina’s balance sheet and credit metrics.

Longer-term growth opportunities include the proposed condensate project for an estimated $1.2 billion capital cost for start-up in the next decade, with potential partnering or other arrangements to reduce the cost burden.

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