Cenovus Energy is deeply undervalued

Energy investors are benefitting from inane policies constraining oil output

Cenovus Energy (CVE.TO) is one of Canada’s largest oil & gas producers with annual output of about 750,000 Boe/day about 80% of which is liquids and the balance natural gas. Fully integrated, the company has refining capacity for a large portion of the oil it produces. Refinery capacity in Canada and the United States comprises about 500,000 barrels of oil a day.

Refinery operations provide stability in marketing Cenovus’ oil production but have historically had volatile earnings with both profitable and unprofitable years. Strategically refining makes sense but from an economical point of view an investor can largely ignore the value of the downstream operations when deciding whether the shares represent reasonable value.

On January 4, 2021 Cenovus completed a merger with rival Husky Energy bulking up the company to its current size. Many investors avoided the shares concerned that the merger exposed Cenovus to too much debt. That debt leverage is rapidly declining with current commodity prices.

There is a looming energy shortage worldwide today, including a serious shortage of natural gas. I have covered the emerging energy crisis in a separate article. The shortage is the result of poorly thought-through policies of Western democracies who have bought into the “climate change” scare despite its lack of scientific foundation and inconsitency with the laws of physics. Claims that “oil is dead” have been commonplace among left wing leaders like Green Party member Elizabeth May and Bloc Quebec leader Yves-Francois Blanchet, and decisions by so-called ESG investors like the Caisse de Depot and Placement commtting to sell off its investments in oil & gas.

As a result of this stupidity (I will call a spade a spade, and that decision can only hurt the beneficiaries of the Caisse’s holdings) and its parallels elswhere, capital is leaving the oil & gas industry at a time when fossil fuels remain the source of 80% of the world’s energy. Unlike other energy sources, fossil fuel production is characterized by a “decline rate”, the natural declining output from a given oil well over time. In the absence of adequate capital investment, oil & gas production declines.

For oil it costs more or less $25,000 to replace a barrel of oil per day and at a global decline rate somewhere around 15% of the 100 million barrels a day of production, about 15 million x $25,000 = $375 billion of capital is needed to keep production flat. Shale oil production, the source of much of the world’s growth in production for the past couple of decades, has a decline rate typically much higher - between 25% and 40%. President Biden’s efforts to limit shale drilling are not only causing a shortage in America but also a worldwide shortage, since the U.S. imports much of its oil from abroad and must import more when it produces less.

Canadian policies have been among the worst in the industrialized world, leading to a flight of capital from our oil & gas industry which was poised to benefit from growing demand. Energy companies are now using their excess cash flows to pay higher dividends and buy back stock, rather than expanding output for export to the United States or abroad. Canada is damaged by this inane set of policies, but they have created a major opportunity for energy investors in companies operating in the Western Canadian Sedimentary Basin. Oil prices have more than doubled in a year and North American natural gas prices have risen about fourfold.

Cenovus will benefit from this robust environment for prices. I have built a crude model of the company’s operations which is set out below:

I have assumed losses for the refining business for conservatism, and allowed for merger integration costs of $500 million, and modeled oil & gas prices somewhat below current levels. I see the company generating over $10 billion of cash flow which is $7 billion more than planned capital outlays. While debt at $13.5 billion is high, it will come into line very quickly as the free cash flows are applied to the debt balance.

Based on these assumptions, I see a share value of at least $22 as reasonable and see no reason why that will not rise further barring a collapse in oil & gas prices. The risk of such a collapse is tied more to a global recession risk than to anything local, and there is no doubt a global recession is a possibility. If such an economic downturn is does not occur for the next 2 years, Cenovus will have a rock solid balance sheet and by my estimation remain profitable at oil prices half of today’s.

I hold warrants on 7,000 shares of Cenovus.