EUR 850.00 For Business Accounts Only

Morningstar | Refining Operations Aid Best Idea Cenovus; Stock Still Deeply Undervalued

No-moat Cenovus Energy, one of our Best Ideas, reported third-quarter EBITDA from its refining operations of CAD 436 million, its highest results in over five and a half years. EBITDA was up 22% sequentially and over 100% from the year-ago period. The increased results were driven by lower feedstock from the widening of the heavy oil discount. Cenovus’ refining operations helped offset the negative impact of the heavy oil discount on the company’s upstream production. Accordingly, EBITDA from the oil sands segment declined to CAD 680 million from CAD 820 million in the year-ago quarter.

Upstream production averaged 495.6 thousand barrels of oil equivalent per day, down 4% sequentially and slightly ahead of our expectations. The higher-than-expected production was driven by a slower-than-expected slowdown of drilling expectations in the company’s deep basin assets. Oil sands production of 376.7 mboe/d was more or less in line with our expectations. Management tightened its 2018 production guidance  slightly to 481-509 mboe/d, in line with our forecasts. Management also hinted at lower 2019 production if the current environment doesn’t improve. To combat the current environment, Cenovus believes that 55% to 60% of the exposure of its blended heavy volumes can be partially mitigated through its 100 mboe/d of rail capacity, 86.5 mboe/d of pipeline commitments, and its refining capacity.

Construction at the Christina Lake phase G expansion project is progressing on time and below budget. Management expects production to be ready in the second half of 2019 but would not commit to bringing the project on line until the environment is more conducive to upstream production.

Despite anticipated lower price realizations, we are maintaining our $16 (CAD 21) fair value estimate and maintaining our no-moat rating.

The company continues to improve its balance sheet and reduced its net debt by CAD 1.7 billion, to CAD 8 billion, during the quarter. Net debt/adjusted EBITDA stands just above 2 times, and we expect the company to maintain these levels throughout 2019.

The stock is up 3% on the earnings news and is trading near $8.75 (CAD 11.50) per share. We still see tremendous upside in the stock. We believe the market is too narrowly focused on the company's temporary increase in short-term leverage and overlooking the immense growth potential in its oil sands reserves that can be brought on line with solvent-aided process technology.

Despite the upside in the stock, we caution investors that the stock could retreat in the medium term if oil prices fall to our midcycle estimate of $55/bbl or if the heavy oil discount remains high, slowing growth and hampering netbacks. We remind investors, though, that these assumptions are already priced into our model. We expect lower price realizations over the next few quarters, coupled with higher leverage. However, we expect the heavy oil discount to narrow as producers take advantage of rail options in 2019 and pipeline expansion projects are placed into service, beginning with the Line 3 replacement project. Once the discount narrows, we expect the company to begin its industry leading, solvent-assisted technology growth projects.

For a deeper look into Cenovus and its upside, please see our October 2017 report "The King in the North: Cenovus Energy."