Investment overview
I have written on Cenovus Energy Inc. (CVE, Financial)(TSX:CVE, Financial) in the past as a quality stock in the oil sands space. On March 29, the company announced an agreement to acquire ConocoPhillips’ (COP, Financial) 50% interest in the Foster Creek Christina Lake partnership. After the acquisition was announced, the stock slumped by nearly 13%. While the near-term reaction has been negative, seveal factors make the acquisition attractive in the long term.
Before going into the specifics of the deal, I must mention OPEC will be meeting to discuss an extension of the production cut. In all probability, the production cut will be extended, which will ensure oil remains firmly at current levels, even if it does not move significantly higher in 2017.
The big acquisition- financing
Cenovus Energy has agreed to acquire ConocoPhillips’ 50% interest in the FCCL oil sands partnership and a majority of its Canadian Deep Basin assets for a total consideration of $13.3 billion. This includes $10.6 billion in cash and 208 million Cenovus common shares.
To fund the cash portion, Cenovus will use its cash on hand, existing credit facility capacity and committed bridge loans. The company will also make subsequent payments to ConocoPhillips.
Further, the company announced a bought-deal offering to sell 187.5 million common shares. The shares will sell for $16 each for a total consideration of around $3 billion.Ă‚
The markets reacted negatively to this news as the bought-deal offering will cause shareholder dilution. In addition, Cenovus will see a significant increase in debt. Over the long term, however, the deal is not a major concern.
The big acquisition- production growth
From a production perspective, the acquisition is likely to add 298,000 barrels of oil equivalents per day (70% liquids) based on 2017 estimates. With ConocoPhillips’ 50% interest, Cenovus will see incremental production of 178,000 barrels of oil equivalents per day. Further, the acquisition of the Deep Basin assets will add 120,000Â barrels of oil equivalents per day to production.
On a pro-forma basis, Cenovus Energy expects production for fiscal 2017 to be 588,000 barrels per day, which is likely to be 103% higher than fiscal 2016 production. Further, the company’s expects fiscal 18 pro-forma production to be 515,000 barrels per day (including the impact of potential asset sales).
The deal doubles the company’s production. If oil prices remain solid and trend higher, the negative perception of the acquisition will change relatively quickly. Even at $60 per barrel oil in fiscal 2018, Cenovus Energy expects free funds flow (before dividends) to be $1.5 billion. At $70 per barrel oil, free fund flow can potentially reach $2 billion. With my view being bullish on oil, I do see good times ahead.
While the deal does increase the company’s debt in the near term, Cenovus Energy is already looking at measures to reduce debt. Non-core asset sales will infuse liquidity and reduce debt in the foreseeable future. At the same time, if oil does trend higher, free cash flow from operations will potentially be utilized to reduce debt. It is important to note that with $25 to $30 per barrel in estimated field break-even levels, I expect strong cash flow generation in the coming years.
The acquisition of the Deep Basin assets is also a key positive for the long term. For 2017, production is estimated to be 120,000 barrels of oil equivalents per day, which is likely to increase to 170,000 barrels by 2018. The Deep Basin has nearly 1,500 potential drilling locations and 2P reserves of 725 million barrels of oil equivalents. There is a lot of untapped potential here. If oil prices remain steady, there is significant room for resource exploitation.
Conclusion
Cenovus Energy has stabilized after is decline following the acquisition announcement. I am certainly not expecting the stock price to surge anytime soon, but I do see the current sideways to marginally lower movement as an opportunity to accumulate the stock for the medium to long term.
The company has a deep drilling inventory and the break-even levels are attractive. Even if oil trades at $60 to $70 in the next 24 to 36 months, Cenovus is likely to generate enough free cash flow to reduce debt and pay decent dividends.
Disclosure: No positions in the stocks discussed.
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