Cenovus Is a Steal

Cenovus Energy CVE announced that first-quarter oil sands production has been operating at lower levels with the widening of the heavy oil discount, which has averaged nearly $27 per barrel. Management now expects first-quarter production of 350-360 thousand barrels of oil per day but reiterated that it expects to meet its 2018 annual target of 364-382 mbbl/d. We are lowering our 2018 oil sands production forecast to 367 mbbl/d from our previous forecast of 376 mbbl/d.

Despite this, we are maintaining our CAD 21 fair value estimate. Because of changes in foreign exchange rates, we are lowering our U.S. dollar-denominated fair value estimate to $16 per share from $17. Cenovus' stock traded down on the lower production news and currently sits well below our valuation. We think the stock could retreat even further if oil prices decline later in the year, as we expect them to do, and as a result of increasing near-term leverage and the heavy oil discount remaining at high levels.

These assumptions are already priced into our model, however. We expect lower price realizations over the next few quarters, coupled with higher leverage. But we expect the heavy oil discount to narrow as producers take advantage of rail options and pipeline expansion projects are placed into service. We still expect Cenovus to reach its desired leverage target of less than 2 times net debt/EBITDA by the end of 2019. At that point, we expect the company to begin its industry-leading solvent-assisted process growth projects.

Despite the downward momentum, Cenovus remains our top pick in the energy sector. We believe the market is too narrowly focused on the company's temporary increase in short-term leverage and is overlooking the immense growth potential in its oil sands reserves that can be brought on line with SAP technology.

SAP Sets Cenovus Up for Savings
Cenovus operates as an integrated oil company, focusing on oil sands development. Conventional crude oil, natural gas liquids, and natural gas production, coupled with refining operations, supplements the company's core operations.

Oil sands projects have long been characterized by high capital requirements and production costs, and Cenovus is not immune. Consequently, most expansion projects aren't economical at $55 per barrel of West Texas Intermediate and struggle to compete with other global supply sources. However, it appears that Cenovus has found its solution with its solvent-aided process, which holds the potential for the lowest-cost oil sands production in the industry. We expect the implementation of this SAP technology, albeit not for another few years, to provide Cenovus with the cost savings needed to be competitive with other marginal supply sources and generate free cash flow in a $55/bbl environment. Based on our analysis, SAP technology could eventually be the lowest-cost method of oil sands production, with most potential production having break-even prices around $45/bbl WTI. Cenovus' recent acquisition of the remaining interest in the Foster Creek Christina Lake partnership provides the company with additional opportunities to showcase its industry-leading cost structure for years to come.

No Moat Yet
Moats are established by companies with durable competitive advantages that enable them to earn sustainable excess returns on capital. They are not cyclical, and severe commodity price headwinds do not preclude best-in-class operators from earning moat ratings if they can still generate significant value in the long run. The competitive advantage of exploration and production companies largely stems from the quality of its acreage. Long-run oil and gas prices are set by the marginal cost of extraction, so the ability to earn excess returns depends on the position of each company's assets on the appropriate cost curve, as well as the ultimate price received for the company's production (realized selling prices can deviate from benchmarks for several reasons). Significant future resource potential is also a vital component of our moat framework because companies with limited low-cost drilling opportunities will be unable to supplant declining production without eroding their profitability.

Oil sands development projects are situated high on the crude oil production cost curve and require higher WTI break-even prices than conventional oil projects. Cenovus' cost structure is greatly affected by the distance required to transport its product to U.S. refineries. Limited pipeline capacity exists to transport production to U.S refineries, and rail transportation, which provides additional outlets, is more expensive. Transportation logistics and the associated costs, coupled with bitumen's heavy and sour oil composition, result in low price realizations for Cenovus' blended product when compared with crude oil benchmarks. After subtracting the costs of condensate, bitumen realization differentials can range from 30% to 55% compared with WTI. Cash break-even oil prices, assuming no return on investment, at current production levels are about $45/bbl WTI at Cenovus' Christina Lake Project and $50/bbl at the Foster Creek Project.

Production growth at Cenovus' existing projects requires high levels of capital spending (exceeding CAD 25,000 per barrel per day of incremental production), coupled with high operating and maintenance costs. As a result, higher break-even oil prices are needed for brownfield expansions, requiring $55/bbl and $65/bbl WTI prices at Christina Lake and Foster Creek, respectively. To make matters worse, greenfield expansion projects require even higher WTI prices to break even using current extraction methods.

However, Cenovus' SAP technology is expected to drastically lower production costs and capital requirements. We expect the break-even prices on brownfield expansions at Christina Lake and Foster Creek to fall to $45/bbl and $55/bbl, respectively, with the new technology. The company's Narrows Lake greenfield expansion project will also boast impressive project break-evens, about $45/bbl WTI. As a result, Cenovus should be able to generate positive cash flow in our midcycle environment. However, implementing the technology is still a few years out, and the company will not benefit from these cost reductions today. In the meantime, Cenovus will continue to be plagued by higher cost structures on its existing bitumen production. Therefore, under the current extraction process, the combination of intensive capital requirements, high transportation costs, low price realizations, high break-even prices, and delay in implementing solvent-aided production hampers Cenovus' ability to generate excess returns on invested capital when we reach our midcycle price forecasts. As such, we do not consider the company to have an economic moat.

Higher Leverage Only Temporary
As with most exploration and production companies, a deteriorating outlook for oil and natural gas prices would pressure Cenovus' profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy.

Cenovus' total debt stands at CAD 9.5 billion, with undrawn credit facilities of CAD 4 billion. The current cash balance is CAD 610 million. At the end of the most recent reporting period, net debt/trailing adjusted EBITDA was 2.8 times.

While the Foster Creek Christina Lake acquisition will inflate leverage, the balance sheet still looks strong, and elevated levels are only temporary. Despite the projected uptick in capital expenditures and the recent acquisition, we expect the company to reach and remain in a net cash position over the forecast period while meeting all of its financial obligations.