Bloomberg News

Cenovus Gives Safest Oil Sands Returns on Low-Cost Growth

May 08, 2012

Cenovus Energy Inc. (CVE) had the best risk- adjusted returns among Canadian oil sands producers since it started trading 29 months ago, as the company controlled costs while expanding crude production.

The BLOOMBERG RISKLESS RETURN RANKING shows Cenovus, the fifth-largest oil-sands producer, returned 1 percent when factoring in price swings since the company was spun off from Encana Corp. on Dec. 3, 2009. That’s the highest among peers including Suncor Energy Inc. (SU), the largest producer. The Calgary- based company also beat Western Canada Select, the crude derived from Alberta bitumen that trades near a record discount to the U.S. benchmark.

Cenovus uses steam generated by burning natural gas to melt the tar-like bitumen for easier extraction, a cheaper, less labor-intensive method than traditional processes, making it the most profitable in the industry. The stock may continue to reward investors looking to minimize risk in their portfolios while taking advantage of potential for growth from Canada’s oil sands producers, said John Stephenson, who helps manage C$2.7 billion ($2.73 billion) at First Asset Investment Management Inc. in Toronto and holds Cenovus shares.

“They’re well-prepared for the next few years because they can supply their own natural gas and they have one of the best reservoirs in the business,” Stephenson said in an interview.

Beating Imperial, MEG

Imperial Oil Ltd., Canada’s second-largest oil producer by market value, came in second place with a risk-adjusted return of 0.6 percent. MEG Energy Corp. (MEG), at one-third Cenovus’s market value, ranked third among major Canadian oil producers with a return of 0.4 percent.

Cenovus provided higher total returns than Western Canada Select while remaining a third less volatile than the benchmark crude, which fluctuated between $45.80 and $98.18 during the period.

“Cenovus’s oil-sands asset base is among the lowest cost, so the value of the asset just doesn’t swing as much with oil prices or oil-price expectations,” said Randy Ollenberger, an oil and gas analyst at BMO Capital Markets in Calgary.

The most expensive part of the method used by Cenovus, known as steam-assisted gravity drainage, or SAGD, is natural gas, which has been trading near 10-year lows since the beginning of the year. That contrasts with mines owned by Suncor, Canadian Natural Resources Ltd. (CNQ) and Imperial, where labor is the biggest cost.

Highest Gross Margin

Cenovus’s cost-control strategy results in the highest gross margin in the industry, at 91.8 percent compared with 40.5 percent at Suncor and 16.4 percent at Exxon. That means Cenovus turns C$100 of sales into C$92 in profit.

“They’re taking $2 gas and converting it into $100 dollar oil,” said fund manager Stephenson. “That’s a pretty good deal.”

Canada has the world’s third-largest recoverable crude reserves after Saudi Arabia and Venezuela, and the commodity is the nation’s most valuable export worth about C$52 billion in 2010, according to the most recent figures available by Statistics Canada, the government statistics department.

This year through May 3, Cenovus produced a total return of 1 percent while being 15 percent less volatile than the average of the largest oil sands producers, placing it fifth by risk- adjusted return. Nexen Inc. (NXY), more volatile than the average but with the best returns, is the best performer. Nexen’s shares sank 29 percent in 2011.

Refining Hedge

Cenovus’s heavy-oil processing partnership with U.S. refiner Phillips 66 (PSX:US) also gives the company a hedge against swings in the price difference between heavy oil-sands crudes and lighter varieties, said BMO Capital’s Ollenberger.

The Canadian company is part owner of the Wood River, Illinois, and Borger, Texas, refineries, which turn bitumen into jet fuel, gasoline and chemicals. By pairing production with refining, Cenovus effectively hedges itself against some of the risk of crude-price fluctuations, said First Asset’s Stephenson.

“We’re able to handle about 235,000 barrels a day of Canadian heavy crude through the Wood River refinery,” Brian Ferguson, chief executive officer of Cenovus, said in an interview yesterday. “It really reduces the volatility in our cash flow and our earnings performance.”

The gap between heavy Canadian oils and other crudes in the first quarter might have hurt the company’s profit had it not been for the refinery venture’s ability to make more money by buying low-priced crude, he said.

Crude Price Gap

“They’re capturing the full value chain and avoiding the problems that some competitors have,” with discounted prices for sellers of Western Canada Select, Stephenson said. The difference between the Canadian crude and West Texas Intermediate reached a record gap of $36 on March 7.

Imperial, 70-percent owned by Exxon Mobil Corp. (XOM:US), is currently spending about C$9 billion to build a bitumen mine, where the hydrocarbon-saturated sand is scraped from near the surface, transported in some of the largest trucks on earth and boiled in giant tanks to separate the oil. Imperial also operates a chain of gas stations in Canada.

Oil-sands miners, which have the best recovery rates from their reserves, face volatile labor costs in Alberta’s tight market. The province of 3.7 million people is looking for ways to stimulate immigration, Premier Alison Redford has said.

Best In-Situ Assets

The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period of time, increasing the potential for unexpected losses.

Cenovus has about 8.2 billion barrels of economically recoverable bitumen on 2.1 million acres in Alberta’s oil sands region.

“They have arguably the best in-situ oil sands assets in the region,” said Robert Mark, who helps manage C$4.5 billion in assets at MacDougall, MacDougall & MacTier Inc., a Montreal- based investment firm. “Anyone who knows the sector knows that Cenovus’s assets are top-drawer.”

Cenvous’s cash from operations, a metric used by analysts to measure oil producers’ performance while factoring out investment costs, expanded to C$665 million in the first quarter, almost four times the C$150 million it saw in the fourth quarter of 2009. That compares with a doubling to C$3.4 billion at Suncor and a 13-percent increase to C$1.1 billion at Imperial Oil Ltd. (IMO)

1.4 Million Acres

“You’re hugely advantaged if you have high quality assets,” Ferguson, the CEO, said. “And we have a very broad and deep portfolio.” The company’s 1.4 million acres of oil sands leases were acquired over the past three decades, he said.

So far in the second quarter, volatility at Cenovus has remained below average, while smaller producers like MEG, Athabasca Oil Sands Corp. (ATH) and Canadian Oil Sands Ltd. have posted better returns as the price differential between Western Canada Select and West Texas Intermediate crudes has diminished, reducing the companies’ perceived risk among investors.

Rising cash flow has helped Cenovus reduce the need for debt, which stands at about C$6.5 billion and translates to a debt-to-market cap ratio of 0.15, according to data compiled by Bloomberg. That compares with C$14.3 billion in outstanding notes and a ratio of 0.21 at Suncor.

Dividend Support

The company pays a dividend to investors that helps support the stock “from a valuation point of view,” BMO’s Ollenberger said. “It makes them a little more defensive.”

The company’s 22-cent quarterly dividend has a 12-month yield of 2.4 percent, according to data compiled by Bloomberg. The indicated yield is 2.6, the data showed.

Cenovus uses less steam and water than some competitors because of the rich bitumen deposits of its reserves, lowering operating costs and capital investment needed for larger steam generators, said CEO Ferguson. It also reduces the environmental footprint, something investors are increasingly focused on, said Mark, the MacDougall fund manager.

“Companies that can show water is being re-used and that they’re being energy efficient will have a competitive advantage,” he said. “Lowering steam-to-oil ratios helps on costs and the environment.”

Water Use Reductions

Technology improvements, including the use of chemicals mixed with steam to further reduce the amount of water and energy used in extraction, will help maintain the pace of cost reduction and make better use of its resource, Ferguson said.

Cenovus got a boost when it was allowed to keep oil-fields in southeastern Saskatchewan and low-cost gas fields in Alberta in the separation from Encana. Conventional oil and natural-gas liquids production made up 75,000 barrels a day, or 48 percent of its output in the first quarter.

The conventional oil assets are “not a big deal for them,” Ollenberger said. “Those provide a little bit of diversification.”

To contact the reporters on this story: Jeremy van Loon in Calgary at jvanloon@bloomberg.net; Gene Laverty in Calgary at glaverty@bloomberg.net

To contact the editor responsible for this story: Susan Warren at susanwarren@bloomberg.net


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