The Long and Short
South Bow attractive amidst oil price volatility
This material is a Marketing Communication and does not constitute Independent Investment Research.
Violent day-to-day swings in oil prices have made it extremely difficult to price operating risk for commodity-sensitive credits in the investment grade segment. Comparatively, midstream pipeline credits that are well insulated to changes in oil prices provide stability amid global uncertainty. South Bow Corp (SOBOCN: Baa3/BBB-/BBB-) bonds seem an attractive way to position against ongoing geopolitical risk and related volatility.
The low-‘BBB’ rated SOBOCN is among the bonds trading at the widest spreads in both the intermediate and long end of the credit curve among investment grade midstream operators (Exhibit 1). Brent and WTI prices are currently hovering around $96 per barrel as of this publication, with wild swings in day-to-day prices since early March. Though relatively small, the company exhibits many of the more stable fundamental aspects of the broader midstream segment that attract investors during periods of heightened oil price volatility.
Exhibit 1. Intermediate credit curve for investment grade midstream credits demonstrates attractive valuation for SOBOCN
Source: Santander US Capital Markets LLC, Bloomberg/TRACE BVAL G-spread indications only
SOBOCN trades wide to the rest of the sector as it remains a deleveraging story in progress since its initial spin-off from TC Energy (TRPCN: Baa2/BBB+/BBB+) in October 2024. SOBOCN exited the transaction as a 5x-levered entity with plans in place to reach 4.5x leverage by the end of next year. The company has a $700 million US dollar debt maturity coming due in late 2027, which coupled with new projects coming online in the current year, is expected to enable the company to reduce debt/EBITDA.
Importantly to debt investors, SOBOCN presents a solid liquidity profile to help execute its near-term deleveraging plans. After the $700 million due next year, the next public debt maturity is $1 billion due in 2029. The company has a $1.437 billion revolving credit facility in place through that year, in addition to about $400 million in cash on balance sheet. That means they have enough liquidity to fund debt maturities through 2029 without needing to access capital markets. Operating cash flows have been consistent in excess of $500 million over the past two years and is expected to rise moderately in the current year with the Blackrod project coming online and bringing CAD 40-45 million in EBITDA.
A criticism of SOBOCN credit quality is its commitment to a high dividend payout ratio ($0.50 per share), which is expected to be about $400 million of the $655 million in discretionary cash flows projected for the coming year. Still, it seems that policy offers cushion for management to protect investment grade ratings if operating cash flows slip and the company needs to bolster liquidity. As a smaller operator, SOBOCN has a modest debt footprint of just $4.7 billion in senior debt, as well as $1.1 billion in junior subordinated hybrid securities – which provide another layer of potential cushion to the senior debt holders if conditions rapidly worsen.
Stable cash flows among midstream credits that are not subject to oil price or volume volatility are underpinned by long-term take-or-pay contracts. For SOBOCN, these contracts represent about 85% of annual EBITDA and are seen potentially increasing to as much as 95% in the near term. The weighted average life of existing contracts is over 8 years, with a large percentage of 20-year contracts in place that do not begin expiring until 2030. Furthermore, while natural gas pipeline credits are typically preferred to purely crude operators (like SOBOCN), its customer base benefits as a result. Large, vertically-integrated refiners make up over 95% of customers, with over 90% classified as investment grade credits, vastly reducing counterparty risk.
SOBOCN operates over 3,000 miles of pipeline assets, the majority of which are its Keystone XL pipeline (95% of EBITDA). The company primarily transports crude from the Western Canada Sedimentary Basin (WCBS) to the Gulf states. While small, SOBOCN represents about 16% of all West Canada crude transported to the US. The Keystone XL alone, which ships about 620k bpd, is the third largest egress out of Canada and represents between10-15% of all crude exports. While it is a credit negative that the smaller SOBOCN ships from a single geological basin, the WCBS is an extremely stable output relative to its contract base with approximately 160 Bbbl of reserves.
Worth addressing is the risk of spills and related fines, penalties and litigation. This is a key credit factor for most pipeline credits. SOBOCN’s recent record is less than stellar with two noteworthy spills at Milepost 14 over the past few years – 13,000 barrels in December 2022 and 3,000 in April of last year. Nevertheless, related liabilities to those incidents have been absorbed, and the threat of future spills is mitigated by the company’s strong liquidity profile and other economic cushions to unplanned liabilities.
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