Market not sold on Cenovus

Cenovus Energy Inc. thinks bigger is better. The market isn't so sure. Investors drove shares in the Calgarybased energy producer down more than 13 per cent on Thursday, after the company announced a blockbuster $17.7-billion deal to buy assets from ConocoPhillips late on Wednesday.

The acquisition doubles Cenovus' current production and reserves, making it the country's third-largest oil and gas producer by volume.

Make no mistake: the transaction is a bet on higher oil prices, and it unsurprisingly comes with more debt.

Not including Cenovus' planned asset sales, the deal will bring the company's net debt up to approximately $13.5 billion, or roughly 2.5x to 3.0x net-debt to EBITDA for 2018, up from about 1.0x previously.

“Notably, Cenovus goes from exhibiting one of the strongest balance sheets in the peer group, to one of the most levered,” Raymond James analyst Chris Cox told clients.

Those types of numbers are hard for the market to ignore, as is the bought deal financing that will see Cenovus raise more than $3 billion as it sells as much as 215 million shares at $16 each.

That $16 price tag isn't looking like much of a deal after Thursday, when the stock ended down $2.40, or 13.75 per cent, to $15.05 on the Toronto Stock Exchange.

If Cenovus wants to meaningful reduce its debt and leverage, Macquarie Capital Markets analyst Brian Bagnell believes WTI oil prices will need to be well above US$50 per barrel on a sustained basis.

Asset sales will help the company reduce its absolute debt, but they probably won't have much impact on leverage. As Bagnell noted, Cenovus' WTI free cash flow breakeven will be close to US$50 per barrel in 2017 if its planned asset sales occur.

Canaccord Genuity analyst Dennis Fong estimates that the company could see cash flow per share decline by five per cent for each US$1 per barrel dip in WTI oil prices.

The oilsands assets involved demonstrated higher sensitivity to crude pricing during the downturn, and while it is unlikely we'll see a repeat of the 2016 lows, they're still fresh in the minds of investors.

And if oil prices do stage a more durable recovery from here, Cenovus will lose somewhere around 15 to 20 per cent of the upside as a result of contingency payments promised to ConocoPhillips.

Such limitations on the upside benefit of oil price strength may not sit well with energy investors.

That's not to say the deal doesn't have its merits. For example, integrating the bulk of the assets — Conoco's 50 per cent working interest in the Foster Creek and Christina Lake oil sands projects — can essentially be done immediately.

These are also considered best-in-class projects that provide relatively low-risk growth.

But since the additional exposure from these volumes were not offset by increased downstream refining assets, Cenovus appears much more exposed to heavy oil pricing.

The company is also adding conventional gas assets in the Alberta and B.C. Deep Basin, which may be confusing to some as it marks a diversification away from the oilsands.

However, there is a strategic benefit in buying an asset that can produce nearterm growth and provide a source for natural gas liquids.

Cox also pointed out that Cenovus' legacy oilsands production was already outpacing the its net share of heavy oil processing capacity in the downstream operations.

As a result, the company will now be fully exposed to swings in heavy oil differentials for effectively all of the oil sands production being acquired.

While Cenovus sunk, ConocoPhillips rallied sharply, perhaps because some of the proceeds from the deal will go toward its share buyback program and improving its balance sheet.

It's rare to see an oil company repurchase stock when cyclical factors are moving in favour of oil prices.

That's certainly not the route Cenovus has chosen to take, as it opts to deploy capital for an acquisition as opposed to buybacks, despite what investors may have been hoping for.